• Veterinary Market: We currently market the blood analysis system in the veterinary market under the name VetScan VS2®. Through March 2006, we marketed the blood analysis system in the veterinary market as the VetScan®, now referred to as the VetScan Classic. We continue to support and service our current population of VetScan VS2 and VetScan Classic chemistry analyzers.

In September 2007, we introduced a veterinary hematology instrument under the name VetScan HM5™. The VetScan HM5 offers a 22-parameter complete blood count (CBC) analysis, including a five-part differential cell counter specifically designed for veterinary applications. In May 2004, we introduced a veterinary hematology instrument that offers an 18-parameter CBC analysis, including a three-part white blood cell differential, marketed originally as the VetScan HMII, and is now referred to as the VetScan HM2™. We currently purchase the hematology instruments from Diatron Medical Instruments PLC. of Budapest, Hungary. Through April 2004, we marketed a veterinary hematology instrument under the name VetScan HMT. We continue to support and service our current population of VetScan HM5, VetScan HM2, VetScan HMII and VetScan HMT hematology instruments. We also market reagent kits to be used with our hematology instruments which we currently purchase from three suppliers: Clinical Diagnostic Solutions, Inc., Diatron and Mallinckrodt Baker BV.
On July 1, 2008, our sales office in Darmstadt, Germany was incorporated as Abaxis Europe GmbH to market, promote and distribute diagnostic systems for medical and veterinary uses. As a result, Abaxis Europe GmbH became a wholly-owned subsidiary of Abaxis. The subsidiary was formed to provide customer support in a timely manner in response to the growing and increasingly diverse services needs of customers in the European market.

Our sales for any future periods are not predictable with a significant degree of certainty, and may depend on a number of factors outside of our control, including but not limited to inventory or timing considerations by our distributors. We generally operate with a limited order backlog because our products are typically shipped shortly after orders are received. As a result, product sales in any quarter are generally dependent on orders booked and shipped in that quarter. Our expense levels, which are to a large extent fixed, are based in part on our expectations of future revenues. Accordingly, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. As a result, any such shortfall would negatively affect our operating results and financial condition. In addition, our sales may be adversely impacted by pricing pressure from competitors. Our ability to be consistently profitable will depend, in part, on our ability to increase the sales volumes of our Piccolo and VetScan products and to successfully compete with other competitors. We believe that period to period comparisons of our results of operations are not necessarily meaningful indicators of future results.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and the sensitivity of these estimates to deviations in the assumptions used in making them. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. However, there can be no assurance that our actual results will not differ from these estimates.
We have identified the policies below as critical because they are not only important to understanding our financial condition and results of operations, but also because application and interpretation of these policies requires both judgment and estimates of matters that are inherently uncertain and unknown. Accordingly, actual results may differ materially from our estimates. The impact and any associated risks related to these policies on our business operations are discussed below. A more detailed discussion on the application of these and other accounting policies are included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008.
Revenue Recognition and Deferred Revenue. Our primary customers are distributors and direct customers in both the medical and veterinary markets. Revenues from product sales, net of estimated sales allowances and rebates, are recognized when (i) evidence of an arrangement exists, (ii) upon shipment of the products to the customer, (iii) the sales price is fixed or determinable and
(iv) collection of the resulting receivable is reasonably assured. Rights of return are not provided. We recognize revenue associated with extended maintenance agreements ratably over the life of the contract. Amounts collected in advance of revenue recognition are recorded as a current or non-current liability based on the time from the balance sheet date to the future date of revenue recognition. We provide incentives in the form of free goods or extended maintenance agreements to customers in connection with the sale of our instruments. Revenues from such sales is allocated separately to the instruments and incentives based on the relative fair value of each element. Revenues allocated to incentives is deferred until the goods are shipped to the customer or is recognized ratably over the life of the maintenance contract. We periodically offer trade-in programs to customers for trading in an existing instrument to purchase a new instrument and we will either provide incentives in the form of free goods or reduce the sales price of the instrument. These incentives in the form of free goods are recorded according to the policies described above. Distributor and Customer Rebates. We offer distributor pricing rebates and customer incentives from time to time. The distributor pricing rebates are offered to distributors upon meeting the sales volume requirements during a qualifying period. The distributor pricing rebates are recorded as a reduction to gross revenues during the qualifying period. Cash rebates are offered to customers who purchase specific instruments during a promotional period. Cash rebates are recorded as a reduction to gross revenues. Sales and Other Allowances. We estimate a provision for defective reagent discs as part of sales allowances when we issue credits to customers for defective reagent discs. We also establish, upon shipment of our products to distributors, a provision for potentially defective reagent discs, based on estimates derived from historical experience. The provision for potentially defective reagent discs was recorded in sales allowances, using internal data available to estimate the level of inventory in the distribution channel, the lag time for customers to report defective reagent discs and the historical rates of defective reagent discs. Starting on July 1, 2007, the provision for potentially defective reagent discs is recorded as part of warranty reserves, instead of sales allowances, since we replace defective reagent discs rather than issue a credit to customers. Changes in our estimates for accruals related to provisions for defective reagent discs have not been material to our financial position or results of operations. In the future, the actual defective reagent discs may exceed our estimates, which could adversely affect our financial results.

Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts based on our assessment of the collectibility of the amounts owed to us by our customers. In determining the amount of the allowance, we make judgments about the creditworthiness of customers which is mostly determined by the customer's payment history and the outstanding period of accounts. We specifically identify amounts that we believe to be uncollectible and the allowance for doubtful accounts is adjusted accordingly. An additional allowance is recorded based on certain percentages of our aged receivables, using historical experience to estimate the potential uncollectible and our assessment of the general financial condition of our customer base. If our actual collections experience changes, revisions to our allowances may be required, which could adversely affect our operating income.
Warranty Reserves. We provide for the estimated future costs to be incurred under our standard warranty obligation on our instruments. Our standard warranty obligation on instruments is two years. The estimated contractual warranty obligation is recorded when the related revenue is recognized and any additional amount is recorded when such cost is probable and can be reasonably estimated. While we engage in product quality programs and processes, including monitoring and evaluating the quality of our suppliers, our estimated accrual for warranty exposure is based on historical experience, estimated product failure rates, material usage and freight incurred in repairing the instrument after failure and known design changes.
A provision for defective reagent discs is recorded when related sales are recognized and any additional amounts are recorded when such costs are probable and can be reasonably estimated, at which time they are included in cost of revenues. Prior to July 1, 2007, we primarily issued a credit to customers for defective reagent discs and, therefore, the provision for estimated costs for defective reagent discs, which includes the replacement costs and freight of a defective reagent disc, was recorded as part of sales and other allowances. Starting on July 1, 2007, the provision for defective reagent discs is recorded as part of warranty reserves, since we replace defective reagent discs rather than issue a credit to customers.
We analyze the adequacy of the ending accrual balance of warranty reserves each quarter. The determination of warranty reserves requires us to make estimates of the expected costs to repair or replace the instruments and to replace defective reagent discs under warranty. If actual repair or replacement costs of instruments or replacement costs of reagent discs differ significantly from our estimates, adjustments to cost of revenues may be required.
Inventories. We state inventories at the lower of cost or market, cost being determined using standard costs which approximates the first-in, first-out (FIFO) method. Inventories include material, labor and overhead. We establish provisions for excess, obsolete and unusable inventories after evaluation of future demand and market conditions. If future demand or actual market conditions are less favorable than those estimated by management or if a significant amount of the material were to become unusable, additional inventory write-downs may be required, which would have a negative effect on our operating income.
Long-Lived Assets. The carrying value of our long-lived assets is reviewed for impairment, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We look to current and future profitability, as well as current and future undiscounted cash flows, excluding financing costs, as primary indicators of recoverability. An impairment loss would be recognized when the sum of the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposal is less than the carrying amount. If impairment is determined to exist, any related impairment loss is calculated based on fair value.
Income Taxes. We account for income taxes under the provisions of SFAS No. 109, "Accounting for Income Taxes." Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts to be recovered.
Share-Based Compensation Expense. Effective April 1, 2006, we adopted SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)") using the modified prospective method. Under the fair value provisions of SFAS No. 123(R), we recognize share-based compensation expense, net of an estimated forfeiture rate, for those shares expected to vest over the requisite service period of the award to employees and directors.
We use the Black-Scholes option pricing model to determine the fair value of stock options granted prior to March 31, 2006. Determining the appropriate fair value model and calculating the fair value of share-based awards requires highly subjective assumptions, as described below.
• Risk-free interest rate: The risk-free interest rate is based on U.S. Treasury yields in effect at the time of grant for the expected term of the option.

• Expected stock price volatility: We estimate the volatility of our common stock at the date of grant based on the historical volatility of our common stock.

• Expected term: We estimate the expected term of stock options granted based on historical exercise and post-vesting termination patterns, which we believe are representative of future behavior.

• Expected dividends: We have not paid cash dividends on our common stock and we do not anticipate paying cash dividends in the foreseeable future; consequently, we use an expected dividend yield of zero.

For restricted stock units, the assumptions to calculate compensation expense is based on the fair value of our stock at the grant date. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future.
As required by SFAS No. 123(R), employee share-based compensation expense recognized is calculated based on the awards expected to vest and reduced for estimated forfeitures. The forfeiture rate is estimated based on historical data of our share-based awards that are granted and cancelled prior to vesting and upon historical experience of employee turnover. Changes in estimated forfeiture rates and differences between estimated forfeiture rates and actual experience may result in significant, unanticipated increases or decreases in share-based compensation expense from period to period. To the extent we revise our estimate of the forfeiture rate in the future, our share-based compensation expense could be materially impacted in the quarter of revision, as well as in following quarters.
Fair Value Measurements. Effective April 1, 2008, we adopted SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157") to measure the fair value of our financial assets and financial liabilities. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy under SFAS No. 157 are described below:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities. We used Level 1 assumptions for our cash and cash equivalents and certificate of deposits, which are traded in an active market. The valuations are based on quoted prices that are readily and regularly available in an active market, and accordingly, a significant degree of judgment is not required. Level 2: Directly or indirectly observable market based inputs used in models or other valuation methodologies. As of September 30, 2008, we did not have any Level 2 financial assets or liabilities.
Level 3: Unobservable inputs that are supported by little or no market data and require the use of significant management judgment. Assets utilizing Level 3 inputs consist of our auction rate securities. Since the credit market is currently illiquid for auction rate securities, our estimates are subject to significant judgment by management.
The valuation of our auction rate securities is subject to uncertainties that are difficult to predict and the interpretations of relevant market data are subject to uncertainties and require significant judgment. Factors that may impact our valuation in the future include, changes to credit ratings of the securities, changes to the underlying assets supporting the auction rate securities, rates of default of the underlying assets, discount rates, strength and quality of the credit market and liquidity. Due to the uncertainty inherent in the valuation process, estimates of fair value may differ significantly from the values that would have been obtained had an active market for the auction rate securities existed, and the differences could be material.
RESULTS OF OPERATIONS
We develop, manufacture, market and sell portable blood analysis systems for use in the human or veterinary patient-care setting to provide clinicians with rapid blood constituent measurements. We operate in two segments: (i) the medical market and (ii) the veterinary market. See "Segment Results" in this section for a detailed discussion.

Total Revenues
Revenues by Geographic Region and by Product Category. Revenues by geographic
region based on customer location and revenues by product category during the
three and six months ended September 30, 2008 and 2007 were as follows (in
thousands, except percentages):

                                          Three Months Ended                                                 Six Months Ended
                                             September 30,                       Change                        September 30,                      Change
                                                                        Increase/         Percent                                        Increase/         Percent
Revenues by Geographic Region             2008            2007         (Decrease)         Change            2008           2007         (Decrease)         Change
North America                          $   22,482       $ 21,071       $     1,411               7 %      $ 42,777       $ 40,240       $     2,537               6 %
Percentage of total revenues                   81 %           84 %                                              82 %           84 %
Europe                                      4,341          3,175             1,166              37 %         7,726          6,232             1,494              24 %
Percentage of total revenues                   16 %           13 %                                              15 %           13 %
Asia Pacific and rest of the world            865            946               (81 )            (9 %)        1,757          1,651               106               6 %
Percentage of total revenues                    3 %            3 %                                               3 %            3 %

Total revenues                         $   27,688       $ 25,192       $     2,496              10 %      $ 52,260       $ 48,123       $     4,137               9 %




                                         Three Months Ended                                                 Six Months Ended
                                            September 30,                       Change                        September 30,                      Change
                                                                       Increase/         Percent                                        Increase/         Percent
Revenues by Product Category             2008            2007         (Decrease)         Change            2008           2007         (Decrease)         Change
Instruments                           $    6,892       $  7,462       $      (570 )            (8 %)     $ 14,694       $ 13,926       $       768               6 %
Percentage of total revenues                  25 %           30 %                                              28 %           29 %
Reagent discs and kits                    18,734         15,680             3,054              19 %        33,627         29,939             3,688              12 %
Percentage of total revenues                  68 %           62 %                                              64 %           62 %
Other products                             1,317          1,598              (281 )           (18 %)        2,427          3,335              (908 )           (27 %)
Percentage of total revenues                   4 %            6 %                                               5 %            7 %

Product sales, net                        26,943         24,740             2,203               9 %        50,748         47,200             3,548               8 %
Percentage of total revenues                  97 %           98 %                                              97 %           98 %
Development and licensing revenue            745            452               293              65 %         1,512            923               589              64 %
Percentage of total revenues                   3 %            2 %                                               3 %            2 %

Total revenues                        $   27,688       $ 25,192       $     2,496              10 %      $ 52,260       $ 48,123       $     4,137               9 %

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007
North America. During the three months ended September 30, 2008, total revenues in North America increased 7%, or $1.4 million, as compared to the three months ended September 30, 2007. Components of the change in North America were as follows:
Instruments. During the three months ended September 30, 2008, total revenues from instruments sold in North America decreased 10%, or $653,000, as compared to the three months ended September 30, 2007. The primary factors of the change were as follows:
(i) Sales of our Piccolo chemistry analyzers in North America (excluding the U.S. government) decreased 11%, or $176,000. The decrease was partially offset by an increase in sales of our Piccolo chemistry analyzers to the U.S. government of 30%, or $93,000, primarily due to an increase in the U.S. Military's needs for these products, which were not predictable.
(ii) Sales of our VetScan chemistry analyzers in North America increased 34%, or $552,000, primarily due to quality improvements on our analyzers.
(iii) Sales of our hematology instruments in North America decreased 40%, or $1.1 million, primarily due to a shift in our sales and marketing focus to our VetScan chemistry analyzers and reagent discs during the second quarter of fiscal 2009. Reagent discs and kits. During the three months ended September 30, 2008, total revenues from reagent discs and kits sold in North America increased 16%, or $2.0 million, as compared to the three months ended September 30, 2007. The primary factors of the change were as follows:
(i) Medical reagent discs sales in North America (excluding the U.S. government) . . .