Summary of BSQUARE CORP /WA

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
From time to time, information provided by us, statements made by our employees or information included in our filings with the Securities and Exchange Commission ("SEC") may contain statements that are "forward-looking statements" involving risks and uncertainties. In particular, statements in "Management's Discussion and Analysis of Financial Condition and Results of Operations" relating to our revenue, profitability, growth initiatives and sufficiency of capital may be forward-looking statements. The words "expect," "anticipate," "plan," "believe," "seek," "estimate" and similar expressions are intended to identify such forward-looking statements. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that could cause our future results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us. Many such factors are beyond our ability to control or predict. Readers are accordingly cautioned not to place undue reliance on forward-looking statements. We disclaim any intent or obligation to update any forward-looking statements, whether in response to new information or future events or otherwise. Important factors that may cause our actual results to differ from such forward-looking statements include, but are not limited to, the factors discussed in Item 1A of Part II of this quarterly report, our quarterly report for the quarterly periods ended March 31, 2008 and June 30, 2008 and in Part I of our annual report on Form 10-K for the year ended December 31, 2007 entitled "Risk Factors." Overview
We provide software and engineering services to the smart device marketplace. A smart device is a dedicated purpose computing device that typically has the ability to display information, runs an operating system (e.g., Microsoft® Windows® CE 6.0) and may be connected to a network via a wired or wireless connection. Examples of smart devices include set-top boxes, home gateways, point-of-sale terminals, kiosks, voting machines, gaming platforms, PDAs, handheld data collection devices, personal media players and smartphones. We primarily focus the sale of our software and engineering services to customers developing smart devices that utilize embedded versions of the Microsoft Windows family of operating systems, specifically Windows CE, Windows XP Embedded and Windows Mobile™. However, with acquisition of customers and rights to license Adobe Flash Lite technology from NEC Corporation of America, we expect to support customers who are using Adobe Flash Lite technology in other operating systems such as Linux and Symbian.
We have been providing software and engineering services to the smart device marketplace since our inception. Our customers include world class original equipment manufacturers (OEMs), original design manufacturers (ODMs), silicon vendors (SVs), peripheral vendors, and enterprises with customized device needs such as retailers and wireless operators that market and distribute connected smart devices. The software and engineering services we provide our customers are delivered, utilized and deployed throughout various phases of our customers' device life cycle, including design, development, customization, quality assurance and deployment.
Critical Accounting Judgments
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company's critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and those that require a company to make its most difficult and subjective judgments, often as a result of the need to make estimates related to matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments and assumptions that are relevant to understanding our results. For additional information see Item 1 of Part I, "Financial Statements - Note 1 - Summary of Significant Accounting Policies." Although we believe that our estimates, assumptions and judgments are reasonable, they are necessarily based upon presently available information. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

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Revenue Recognition
We recognize revenue from software and engineering service sales when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the selling price is fixed or determinable; and collectability is reasonably assured. Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents, time records and customer acceptance, as and when applicable, are used to verify delivery. We assess whether the selling price is fixed or determinable based on the contract and/or customer purchase order and payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer's payment history.
We recognize software revenue upon shipment provided that no significant obligations remain on our part and substantive acceptance conditions, if any, have been met. Service revenue from time and materials contracts and training services is recognized as services are performed. For certain fixed-price professional engineering service contracts that require significant production, modification, or customization of software, we account for these arrangements using the percentage-of-completion method under Statement Of Position ("SOP") 81-1, as contemplated by paragraph 7 of SOP 97-2. We use the percentage-of-completion method of accounting specified within SOP 81-1, as contrasted to alternative approaches outlined in SOP 81-1, because it is the most preferable method to recognize revenue based on the nature and scope of our fixed-price professional engineering service contracts; it is a better measure of periodic income results than other methods in our case and it better matches revenue recognized with the costs incurred in our instance. Percentage of completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. We rely on estimates of total expected hours as a measure of performance in order to determine the amount of revenue to be recognized. Revisions to hour and cost estimates are recorded in the period the facts that give rise to the revision become known.
We also enter into arrangements in which a customer purchases a combination of software licenses, engineering services and post-contract customer support or maintenance ("PCS"). As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including how the price should be allocated among the deliverable elements if there are multiple elements, whether undelivered elements are essential to the functionality of delivered elements, and when to recognize revenue. PCS includes rights to upgrades, when and if available, telephone support, updates, and enhancements. When vendor specific objective evidence ("VSOE") of fair value exists for all elements in a multiple element arrangement, revenue is allocated to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when the same element is sold separately. Accordingly, the judgments involved in assessing VSOE have an impact on the recognition of revenue in each period. Changes in the allocation of the sales price between deliverables might impact the timing of revenue recognition but would not change the total revenue recognized on the contract.
When elements such as software and engineering services are contained in a single arrangement, or in related arrangements with the same customer, we allocate revenue to each element based on its relative fair value, provided that such element meets the criteria for treatment as a separate unit of accounting. In the absence of fair value for a delivered element, we allocate revenue first to the fair value of the undelivered elements and allocate the residual revenue to the delivered elements. In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a delay of revenue recognition for the delivered elements until the undelivered elements are fulfilled. As a result, contract interpretations and assessments of fair value are sometimes required to determine the appropriate accounting.
When elements such as engineering services and royalties are contained in a single arrangement, we recognize revenue from engineering services as earned in accordance with the criteria above even though the effective rate per hour may be lower than typical because the customer is contractually obligated to pay royalties on their device shipments, some of which may be guaranteed. We recognize royalty revenue when we receive the royalty report from the customer or when such royalties are contractually guaranteed and the revenue recognition criteria are met, particularly that collectability is reasonably assured.

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Deferred revenue includes deposits received from customers for service contracts, customer advances under OEM licensing agreements and unamortized maintenance and support contract revenue. Allowance for Doubtful Accounts
Our accounts receivable balances are net of an estimated allowance for doubtful accounts. We perform ongoing credit evaluations of our customers' financial condition and generally do not require collateral. We estimate the collectability of our accounts receivable and record an allowance for doubtful accounts. We consider many factors when making this estimate, including analyzing accounts receivable and historical bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in customer payment history, when evaluating the adequacy of the allowance for doubtful accounts. Because the allowance for doubtful accounts is an estimate, it may be necessary to adjust it if actual bad debt expense exceeds the estimated reserve. Investments
We account for investments in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). We adopted SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157") as of January 1, 2008 to measure the fair value of certain of our financial assets required to be measured on a recurring basis, including available-for-sale securities. Under SFAS No. 157, based on the observability of the inputs used in the valuation techniques, the Company is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Directly or indirectly observable market based inputs or unobservable inputs used in models or other valuation methodologies.
Level 3: Unobservable inputs that are not corroborated by market data. The inputs require significant management judgment or estimation.
We adopted FASB Staff Position No. 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active" ("FSP 157-3"), which was issued in October 2008 and became effective immediately for any unissued financial statements. FSP clarifies the application of SFAS No. 157 to financial assets for which an active market does not exist. Specifically, FSP 157-3 addresses the following SFAS No. 157 application issues:
a. How the reporting entity's own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered when measuring fair value when relevant observable inputs do not exist.

b. How available observable inputs in a market that is not active should be considered when measuring fair value.

c. How the use of market quotes (for example, broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value.

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FSP 157-3 applies to financial assets within the scope of accounting pronouncements that require or permit fair value measurement in accordance with SFAS No. 157. We obtained an independent valuation of our ARS as of September 30, 2008 and have determined the fair value to be $6,059,000 as compared to par value of $6,525,000. As a result, we recorded an unrealized loss on our ARS of $466,000 for the three months ended September 30, 2008. Although we are uncertain as to when the liquidity issues relating to these investments will improve, we consider these issues to be only temporary. In addition, we have the intent and ability to hold these investments for a period of time sufficient to allow for any anticipated recovery in market value. Therefore, this unrealized loss is not included in earnings, but is reflected in other comprehensive income within shareholders' equity. It is possible that additional declines in fair value may occur in the future. If general economic conditions worsen or specific factors used in determining fair value deteriorate, we may further adjust the carrying value of these investments. Stock-Based Compensation
We record compensation expense associated with stock options and other forms of equity compensation in accordance with SFAS No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. We record expense over the vesting period using the straight-line method. Compensation expense for awards under SFAS No. 123R includes an estimate for forfeitures.
At September 30, 2008, total compensation cost related to stock options granted under our Stock Option Plan but not yet recognized was $552,000, net of estimated forfeitures. This cost will be amortized on the straight-line method over a period of approximately 1.4 years and will be adjusted for subsequent changes in estimated forfeitures.
At September 30, 2008, total compensation cost related to restricted stock awards granted under our Stock Option Plan but not yet recognized was $78,000. This cost will be amortized on the straight-line method over a period of approximately six months.
At September 30, 2008, total compensation cost related to restricted stock units granted under our Stock Option Plan but not yet recognized was $205,000. This cost will be amortized on the straight-line method over a period of approximately 1.5 years.
Taxes
As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the countries in which we operate. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance, or increase this allowance in a period, it may result in an expense within the tax provision in the statements of operations. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have provided a full valuation allowance on deferred tax assets because of our uncertainty regarding their realizability. If we determine that it is more likely than not that the deferred tax assets would be realized, the valuation allowance would be reversed. In order to realize our deferred tax assets, we must be able to generate sufficient taxable income.
Because we do business in foreign tax jurisdictions, our sales may be subject to other taxes, particularly withholding and earnings distribution taxes. The tax regulations governing these other taxes are complex, causing us to have to make assumptions about the appropriate tax treatment and estimates of such taxes.

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Results of Operations
   The following table presents certain financial data as a percentage of total
revenue for the periods indicated. Our historical operating results are not
necessarily indicative of future results.

                                             Three Months                  Nine Months
                                          Ended September 30,          Ended September 30,
                                           2008           2007         2008           2007
                                              (unaudited)                  (unaudited)
 Revenue:
 Software                                      54 %         66 %          60 %            65 %
 Service                                       46           34            40              35

 Total revenue                                100          100           100             100

 Cost of revenue:
 Software                                      42           49            47              49
 Service                                       31           25            27              26

 Total cost of revenue                         73           74            74              75

 Gross profit                                  27           26            26              25

 Operating expenses:
 Selling, general and administrative           18           19            18              19
 Research and development                       4            4             4               4

 Total operating expenses                      22           23            22              23

 Gain on sale of patents                        2            -             1               -

 Income from operations                         7            3             5               2

 Interest and other income                      -            1             -               2

 Income before income taxes                     7            4             5               4
 Income tax expense                             -           (1 )           -               -

 Net income                                     7 %          3 %           5 %             4 %

Revenue
Total revenue consists of sales of software and engineering services to smart device makers. Software revenue consists of sales of third-party software and sales of our own proprietary software products which include software licenses, software development kits and smart device reference designs as well as royalties from our software products and royalties from certain engineering service contracts. Engineering service revenue is derived from hardware and software development activities, support contracts, fees for customer training, and rebillable expenses.
Total revenue was $16.2 million for the three months ended September 30, 2008 and $13.6 million for the three months ended September 30, 2007, representing an increase of $2.6 million, or 19%. This increase was driven by engineering service revenue, partially offset by lower software sales. Total revenue was $48.7 million for the nine months ended September 30, 2008 and $43.8 million for the nine months ended September 30, 2007, representing an increase of $4.9 million, or 11%. This increase was due to an increase in both software and engineering service revenue.
Revenue from customers located outside of North America includes revenue attributable to our foreign operations, as well as software and engineering services billed to foreign customers from our operations located in North America. We currently have operations outside North America in Taipei, Taiwan and Tokyo, Japan. Revenue from customers located outside of North America was $1.4 million for the three months ended September 30, 2008 and $1.2 million for the three months ended September 30, 2007, representing an increase of $200,000, or 17%. This increase was primarily due to a 227% increase in Asia Pacific service revenue. Revenue from customers located outside of North America was $4.2 million for the nine months ended September 30, 2008 and $2.9 million for the nine months ended September 30, 2007, representing an increase of $1.3 million, or 45%. This increase was

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primarily due to a 202% increase in Asia Pacific service revenue. Software revenue
Software revenue for the three and nine months ended September 30, 2008 and 2007 is presented below (dollars in thousands):

                                                  Three Months Ended                Nine Months Ended
                                                    September 30,                     September 30,
                                                 2008             2007            2008             2007
                                                     (unaudited)                       (unaudited)
Software revenue:
Third-party software                          $    7,885         $ 8,065        $  27,022        $ 25,438
Proprietary software                                 831             886            2,370           2,890

Total software revenue                        $    8,716         $ 8,951        $  29,392        $ 28,328


Software revenue as a percentage of
total revenue                                         54 %            66 %             60 %            65 %

Third-party software revenue as a
percentage of total software revenue                  90 %            90 %             92 %            90 %

The vast majority of our third-party software revenue is comprised of the resale of Microsoft Embedded operating systems. The biggest portion of our proprietary software revenue is attributable to royalty revenue from service contracts.
Third-party software revenue was $7.9 million for the three months ended September 30, 2008 and $8.1 million for the three months ended September 30, 2007, representing a decrease of $200,000, or 2%. We generated $277,000 in Flash Lite licensing revenue for the three months ended September 30, 2008 compared to none for the three months ended September 30, 2007. We generated $23,000 in Solidcore S3 Control licensing revenue for the three months ended September 30, 2008 compared to none for the three months ended September 30, 2007.
Third-party software revenue was $27.0 million for the nine months ended September 30, 2008 and $25.4 million for the nine months ended September 30, 2007, representing an increase of $1.6 million, or 6%. This increase was due primarily to $1.4 million in Flash Lite software licensing revenue and Solidcore S3 Control licensing revenue that were not present in the same period in 2007.
Proprietary software revenue was $831,000 for the three months ended September 30, 2008 and $886,000 for the three months ended September 30, 2007, representing a decrease of $55,000, or 6%. Proprietary software revenue was $2.4 million for the nine months ended September 30, 2008 and $2.9 million for the nine months ended September 30, 2007, representing a decrease of $500,000, or 17%. These decreases were due primarily to lower SDIO revenue and lower service contract royalties as certain guaranteed minimum royalties expired. Royalty revenue from service contracts was $172,000 for the three months ended September 30, 2008 and $420,000 for the three months ended September 30, 2007. Service contract royalty revenue was $847,000 for the nine months ended September 30, 2008 and $1.2 million for the nine months ended September 30, 2007.
Service revenue
Service revenue was $7.5 million for the three months ended September 30, 2008 and $4.7 million for the three months ended September 30, 2007, representing an increase of $2.8, or 60%. Service revenue represented 46% of total revenue for the three months ended September 30, 2008 and 34% of total revenue for the three months ended September 30, 2007. This increase was primarily due to services provided to Ford Motor Company ("Ford") under a new project, which began in May 2008. Revenue under this arrangement was $2.6 million for the three months ended September 30, 2008 compared to none in the prior year. Billable hours increased by 68% for the three months ended September 30, 2008, compared to the prior year, driven by higher activity levels in both the North

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American and Asia Pacific regions. Service revenue in the Asia Pacific region increased 227% and represented 11% of service revenue for the three months ended September 30, 2008, compared to 6% for the three months ended September 30, 2007.
Service revenue was $19.3 million for the nine months ended September 30, 2008 and $15.5 million for the nine months ended September 30, 2007, representing an increase of $3.8 million, or 25%. Service revenue represented 40% of total revenue for the nine months ended September 30, 2008 and 35% of total revenue for the nine months ended September 30, 2007. Growth in core engineering services revenue in both North America and Asia Pacific drove the increase for the reasons mentioned above, partially offset by a decrease in rebillable revenue of $736,000. Billable hours increased by 33% for the nine months ended September 30, 2008 compared to the prior year, driven by higher activity levels in both the North American and Asia Pacific regions. Service revenue in the Asia Pacific region increased 202% and represented 11% of service revenue for the nine months ended September 30, 2008 compared to 4% for the nine months ended September 30, 2007.
Gross profit and gross margin
Cost of revenue related to software revenue consists primarily of license fees and royalties for third-party software products, the costs of components for our hardware reference designs, product media, product duplication and manuals. Amortization of intangible assets, acquired from Vibren Technologies Inc. in June 2005 and from NEC of America in December 2007, is also included in cost of software revenue and was $22,000 for the three months ended September 30, 2008 and zero for the three months ended September 30, 2007. Amortization of intangible assets included in cost of software revenue was $66,000 for the nine months ended September 30, 2008 and $96,000 for the nine months ended September 30, 2007. Cost of revenue related to service revenue consists primarily of salaries and benefits for our engineers, contractor costs, . . .