The following discussion and analysis should be read in conjunction with "Selected Consolidated Financial Data" and our financial statements and the related notes included in this report.

Overview

Innovative Solutions and Support was founded in 1988. The Company designs, develops, manufactures and sells flight information computers, large flat-panel displays and advanced monitoring systems that measure and display critical flight information, including data relative to aircraft separation, airspeed, altitude as well as engine and fuel data measurements.

Our sales are derived from the sale of our products to the retrofit market and, to a lesser extent, original equipment manufacturers. Our customers include the DoD and their commercial contractors, aircraft operators, aircraft modification centers and various OEMs. Although we occasionally sell our products directly to the DoD, we primarily have sold our products to commercial customers for end use in DoD programs. Sales to defense contractors are on commercial terms, although some of the termination and other provisions of government contracts are applicable to these contracts.

Our cost-of-sales related to product sales is comprised of material components purchased through our supplier base and direct in-house assembly labor and overhead costs. Many of the components we use in assembling our products are standard, although certain parts are manufactured to meet our specifications. The overhead portion of cost of sales is primarily comprised of salaries and benefits, building occupancy, supplies, and outside service costs related to our production, purchasing, material control and quality departments, and warranty costs.

Our cost of sales related to Engineering-modification and development (EMD) is comprised of engineering labor, consulting services, and other cost associated with specific design and development projects.

We intend to continue investing in the development of new products that complement our current product offerings and will expense associated research and development costs as they are incurred.

Our selling, general and administrative expenses consist of sales, marketing, business development, professional services, and salaries and benefits for executive and administrative personnel as well as facility costs, recruiting, legal, accounting, and other general corporate expenses.

We sell our products to agencies of the United States and foreign governments, aircraft operators, aircraft modification centers and original equipment manufacturers. Our customers have been and may continue to be affected by the ongoing adverse economic conditions that currently exist both in the United States and abroad. Such conditions may cause our customers to curtail or delay their spending on both new and existing aircraft. Factors that can impact general economic conditions and the level of spending by our customers include but are not limited to general levels of consumer spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting spending behavior. In addition, spending by government agencies may in the future be further reduced due to declining tax revenues associated with this economic downturn. If our customers curtail or delay their spending or are forced to declare bankruptcy or liquidate their operations due to continuing adverse economic conditions, our revenues and results of operations will be adversely affected. However, we believe that in a declining economic environment customers that may have otherwise elected to purchase newly manufactured aircraft will instead be interested in retrofitting existing aircraft as a cost effective alternative, which will create a market opportunity for our products.

On November 25, 2008, Eclipse Aviation filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code. Given the early stages if the bankruptcy proceedings, it is unclear at this

time what the precise impact the Eclipse's bankruptcy will have. During the fiscal year ended September 30, 2008, Eclipse accounted for approximately 42% of the Company's overall revenues.

During the fourth quarter of fiscal 2008, the Company took steps to limit its overall exposure to Eclipse, including by increasing the allowance for doubtful accounts and inventory obsolescence specifically for Eclipse by $4.1 million and $1.9 million, respectively. In response to the lost future revenues from Eclipse and the overall downward turn in the economy, the Company reduced its overall headcount by 52 people. The reductions affect most of the departments in the Company with the majority of the reductions coming from the engineering department. The Company expects to see a significant reduction in its overall headcount costs in fiscal 2009 as a result of these actions.

Results of Operations

Fiscal Year Ended September 30, 2008 Compared to Fiscal Year Ended September 30, 2007

Net sales. Net sales increased $12.2 million or 66% to $30.5 million for fiscal 2008 from $18.3 million for fiscal 2007. Flat panel display system sales for fiscal 2008 grew by $13.9 million or 142% from fiscal 2007 while air data sales for fiscal 2008 declined by $1.7 million or 20% from fiscal 2007. The increase in net sales was the result of a $1.3 million increase in EMD flat panel display system sales associated with the Eclipse 500, Pilatus PC-12 and C-130 airplanes. The increase in product sales of $10.9 million for fiscal 2008 was the result of increased shipments of flat panel display systems associated with the Eclipse 500, and the 757/767 product sold to American Airlines and Federal Express as these programs moved from development into production. The decline in air data product sales was a result of variability in customer demand that is not directly attributable to any particular customer or specific product.

Cost of sales. Cost of sales increased $6.4 million or 45% to $20.6 million, or 67% of net sales, for fiscal 2008 from $14.2 million, or 77% of net sales, for fiscal 2007. The increase in the dollar amount was mainly due to increased volume and the establishment of an inventory reserve associated with the suspension of activity related to the Eclipse program (Eclipse Aviation filed under Chapter 11 of the US Bankruptcy Code on November 25, 2008), offset by a decrease in the direct costs associated with various EMD projects. The dollar amount of product cost of sales increased by $8.6 million or 96% in fiscal 2008 from fiscal 2007. On a percent to product sales basis the increase amounted to eight percentage points from the prior fiscal year.

Research and development. Research and development expenses increased $5.1 million, or 99% to $10.3 million, or 34% of net sales for fiscal 2008 from $5.2 million or 28% of net sales for fiscal 2007. The dollar increase was a result of a significant increase in staffing and other project costs in order to bring a variety of projects to completion in fiscal 2008. When you combine research and development expenses with EMD cost of sales, combined engineering research and development related expenses increased by $2.9 million or 29% to $13.3 million in fiscal 2008 from $10.4 million in fiscal 2007. The combined increase was due to increased salaries and associated benefits tied to employee additions, consultants and supplies.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $6.5 million or 41% to $22.3 million, or 73% of net sales, for fiscal 2008 from $15.8 million, or 86% of net sales, for fiscal 2007. The increase in the dollar amount was principally due to the establishment of a bad debt reserve related to the Company's decision to suspend activity related to the Eclipse program (Eclipse Aviation filed under Chapter 11 of the US Bankruptcy Code on November 25, 2008) and expenses associated with the termination of the former CEO and the retirement of the former CFO.

Interest (income) expense, net. Net interest income decreased $1.5 million or 51% to $1.4 million for fiscal 2008 from $2.9 million for fiscal 2007. The net interest income decline in fiscal 2008 was due to lower average cash balances during the year.

Other income. Other income was $17.3 million for fiscal 2008 primarily as a result of the receipt of $17.0 million in proceeds related to the settlement of the Company's trade secret litigation and $0.3 million related to short-swing profit disgorgement proceeds from a shareholder.

Income tax. The income tax expense for fiscal 2008 was $1.5 million and the income tax benefit for fiscal 2007 was $5.1 million. The effective tax rate for fiscal 2008 was an expense of 24% and for fiscal 2007 the effective tax rate was a benefit of 37%. For fiscal 2008 there was no tax benefit due to the inability of the Company, per the provisions of FAS 109, to recognize the tax benefits associated with the current year pretax loss and the need to establish a valuation allowance to eliminate the book value of all deferred tax assets based upon the negative evidence that exists. The effective tax rate for fiscal 2007 differs from the statutory rate due to state tax expense, partially offset by the utilization of research and development tax credits.

Net income (loss). As a result of the factors described above, our net loss for fiscal 2008 was $7.9 million. The net loss for fiscal 2007 was $8.8 million. On a fully diluted basis, the loss per share of $0.47 for fiscal 2008 compares to a loss per share of $0.52 for fiscal 2007.

Fiscal Year Ended September 30, 2007 Compared to Fiscal Year Ended September 30, 2006

Net sales. Net sales increased $1.6 million or 10% to $18.3 million for fiscal 2007 from $16.7 million for fiscal 2006. Flat panel display system sales for fiscal 2007 grew by $3.4 million or 53% while air data sales for fiscal year 2007 declined by $1.8 million or 17% from fiscal 2006. The increase in net sales was the result of a $2.5 million increase in EMD flat panel display system sales associated with the Eclipse 500 and Boeing KDC10 airplanes. The increase in EMD sales more than offset a $0.9 million or 5% year over year decline in product sales that resulted because of a decline in demand for air data products as well as certification delays on hardware transitioning from development to production.

Cost of sales. Cost of sales increased $5.6 million or 64% to $14.1 million, or 77% of net sales, for fiscal 2007 from $8.6 million, or 51% of net sales, for fiscal 2006. The increase in the dollar amount and percent to sales was mainly due to higher EMD sales in fiscal 2007 as well as incurring higher cost on the Eclipse program, over and above the amount Eclipse paid the Company for system development. The dollar amount of product cost of sales increased by $1.0 million or 12% in fiscal 2007 from fiscal 2006. On a percent to product sales basis the increase amounted to nine percentage points from the prior fiscal year.

Research and development. Research and development expenses decreased $1.5 million, or 24% to $5.2 million, or 28% of net sales for fiscal 2007 from $6.7 million or 40% of net sales for fiscal 2006. The dollar decrease was principally due to allocating $5.2 million of research and development expense to EMD cost of sales. The allocation was necessary to match non recurring engineering cost with corresponding non recurring engineering sales in the year. When you combine research and development expenses with EMD cost of sales, combined engineering research and development related expenses have increased by $3.1 million or 44% to $10.4 million in fiscal 2007 from $7.3 million in fiscal 2006. The combined increase was due to increased salaries and associated benefits tied to employee additions, consultants and supplies.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $5.9 million or 60% to $15.8 million, or 86% of net sales, for fiscal 2007 from $9.9 million, or 59% of net sales, for fiscal 2006. The increase in both the dollar amount and percent to sales was principally due to legal and other fees relating to defense of our intellectual property.

Interest (income) expense, net. Net interest income decreased $0.2 million or 7% to $2.9 million for fiscal 2007 from $3.1 million for fiscal 2006. The net interest income decline in fiscal 2007 was due to lower average cash balances in the year.

Income tax. The income tax benefit for fiscal 2007 was $5.1 million. The income tax benefit for fiscal 2006 was $2.5 million. The increase in the amount of tax benefit in fiscal 2007 was the result of a higher loss before income tax in fiscal 2007.

The effective tax rate for fiscal 2007 was a benefit of 37% and for fiscal 2006 the effective tax rate was a benefit of 47%. For fiscal 2007 the effective tax rate differs from the statutory rate due to state tax expense, partially offset by the utilization of research and development tax credits. For fiscal 2006 the effective tax rate differs from the statutory rate due to the benefit for state income taxes and an adjustment to the tax payable accounts, partially offset by the loss of benefit from the deduction for domestic production activities and the exclusion for extraterritorial income due to the taxable loss for the year.

Net income (loss). As a result of the factors described above, our net loss for fiscal 2007 was $8.8 million. The net loss for fiscal 2006 was $2.9 million. On a fully diluted basis, the loss per share of $0.52 for fiscal 2007 compares to a loss per share of $0.17 for fiscal 2006.

Related-Party Transactions:

The Company incurred legal fees of $129,000, $146,000 and $357,000 with a law firm that is a shareholder of the Company for the years ended September 30, 2008, 2007 and 2006, respectively. The fees paid and services rendered were comparable with the fees paid and services rendered prior to the law firm's investment in the Company.

For the years ended September 30, 2008, 2007 and 2006, respectively, we incurred service fees of $67,000, $18,000 and $25,000 with a commercial graphics firm controlled by an individual who is married to a shareholder and daughter of the Company's Chairman and Chief Executive Officer.

Liquidity and Capital Resources

Our primary source of liquidity was cash flow generated in prior fiscal years. We require cash principally to finance inventory, payroll and accounts payable.

Cash flow provided by operating activities was $4.2 million in fiscal 2008 as compared to $10.6 million used in operating activities in fiscal 2007. The $14.8 million difference was attributable to a $17.0 million legal settlement, a decrease in accounts receivable of $0.9 million (principally the Eclipse reserve) and a decrease of $6.9 million in the change in prepaid expenses and other assets partially offset by a $5.4 million decrease in the change in accounts payable. The Company had negative operating cash flow of $1.6 million in fiscal 2006 primarily as a result of the net operating loss realized.

Cash used in investing activities was $0.6 million, $3.9 million and $0.7 million for fiscal year 2008, 2007, and 2006 and consisted of spending for licensing fees, production equipment and laboratory test equipment.

Cash used in financing activities was $17.7 million for fiscal year 2008 and consisted primarily of the special dividend of $16.7 million paid along with share repurchases of $1.0 million. Cash provided by financing activities was $0.6 million for fiscal year 2007 and consisted primarily of proceeds from stock option exercises. Cash used in financing activities was $17.9 million for fiscal 2006. The primary use of cash for financing activities in fiscal year 2006 was attributable to share repurchases of $18.1 million.

To accommodate future growth, in 2001 we purchased 7.5 acres of land in the Eagleview Corporate Park, Exton, Pennsylvania, where we built a 44,800 square foot facility that is expandable to 65,200 square feet. Both the land and building cost approximate $6.5 million, $4.3 million of which was funded through an Industrial Development Bond (IDB) and the remainder from cash from operations.

The IDB previously required the Company to maintain certain financial covenants including a ratio of liabilities to earnings before interest, taxes and depreciation and amortization (EBITDA), fixed charge ratio and a minimum tangible net worth. As of June 30, 2006, the Company was in violation of certain of these financial covenants. The defaults were subsequently waived and an amendment to the agreement was entered into with the lender whereby the defaulted covenants were modified. Effective November 30, 2007 prior loan agreement covenants were changed to only require the Company to maintain at all times unencumbered cash and marketable securities having a market value of at least $20.0 million and a minimum Tangible Net Worth of $65.0 million. The lender, however, agreed on January 10, 2008 to discontinue the Tangible Net Worth covenant so that the only remaining requirement is that the Company maintain at all times unencumbered cash and marketable securities having a value of at least $20.0 million. As of September 30, 2008, the Company was in compliance with this requirement.

Our future capital requirements depend on numerous factors, including market acceptance of our products (in particular flat panel display systems), the timing and rate of expansion of our business, acquisitions, joint ventures and other factors. We have experienced increases in our expenditures since our inception consistent with growth in our operations, personnel, and product line and we anticipate that our operations and expenditures will continue to increase in the foreseeable future. We believe that our cash and cash equivalents will provide sufficient capital to fund our operations for at least the next twelve months. However, we may need to raise additional funds through public or private financing or other arrangements in order to support more rapid expansion of our business than we currently anticipate. Potential lenders may have suffered losses related to their lending and other financial relationships, especially because of the general weakening of the national economy and increased financial instability of many borrowers. As a result, lenders may become insolvent or tighten their lending standards, which could make it more difficult for us to borrow or to obtain new financing on favorable terms or at all. Our financial condition and results of operations would be adversely affected if we were unable to obtain cost-effective financing in the future. Further, we may develop and introduce new or enhanced products, respond to competitive pressures, invest in or acquire businesses or technologies or respond to unanticipated requirements or developments.

Our contractual obligations of as of September 30, 2008 mature as follows:

                                                Payments Due by Period
                                          Less than                                 After
 Contractual Obligations      Total        1 Year      1-3 Years    4-5 Years      5 Years
 Interest on loan from
 Chester County
 Industrial Dev.
 Auth.(1)                  $ 1,207,731   $   172,533    $ 345,066    $ 345,066   $   345,066
 Principal on Chester
 County Industrial Loan      4,335,000             -            -            -     4,335,000
 Operating Lease                39,065        39,065            -            -             -
 Capital Leases,
 including interest             55,152        13,788       27,576       13,788             -
 Puchase Obligations(2)      3,215,641     2,673,858      109,447      432,336             -

                           $ 8,852,589   $ 2,899,244    $ 482,089    $ 791,190   $ 4,680,066

º (2)
º A "purchase obligation" is defined as an agreement to purchase goods or services that is enforceable and legally binding on the company and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments entered in the ordinary course of business vendors and subcontractors pertaining to fulfillment of our current order backlog.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements.

Inflation

We do not believe inflation had a material effect on our financial position or results of operations during the past three years, however, we cannot predict future effects of inflation.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The Company's most critical accounting policies are revenue recognition, income taxes, inventory valuation, share-based compensation, and warranty reserves.

Revenue recognition

The Company recognizes revenue under the provisions of Staff Accounting Bulletin No. 104, "Revenue Recognition" (SAB 104).

The Company enters into certain sales arrangements that include multiple deliverables as defined in Emerging Issues Task Force (EITF) Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables." The Company identifies all goods and/or services that are to be delivered separately under a sales arrangement and allocates revenue to each deliverable based on fair value. In general, revenues are separated between product sales and EMD sales. The allocated revenue for each deliverable is then recognized using appropriate revenue recognition methods.

The Company accounts for transactions with software that is more than incidental to the products under Statement of Position (SOP) 97-2. "Software Revenue Recognition" and EITF Issue 03-5, "Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software." For Software arrangements that include multiple elements, revenue is allocated to the various elements, including post contract customer support (PCS), if applicable, based on vendor-specific objective evidence of fair value. Revenue for each element other than PCS is recognized when all of the following criteria are met: 1) there is persuasive evidence that an arrangement exists; 2) delivery has occurred or services have been rendered; 3) the seller's price to the buyer is fixed or determinable; and 4) collectability is reasonably assured. The portion of revenue allocated to PCS should be recognized as revenue ratably over the term of the PCS arrangement because PCS services are assumed to be provided ratably.

Sales related to certain long-term contracts requiring development and delivery of products over several accounting periods are accounted for under the American Institute of Certified Public Accountants (AICPA) SOP 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." We consider the nature of these contracts as well as the types of products and services provided when determining appropriate accounting treatment for a particular contract. We recognize our construction-type contracts using either the percentage-of-completion method or completed contract method of accounting. We record sales relating to these contracts using the percentage-of-completion method when we determine that progress toward completion is reasonable and reliably estimable and the contract is long-term in nature; we use the competed contract method for all others.

The Company offers its customers extended warranties for additional fees. These warranty sales are recorded as deferred revenue and recognized as sales on a straight-line basis over the warranty period.

Income taxes

Income taxes are recorded in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" (SFAS 109). Provisions for federal and state income taxes are calculated on reported financial statement pre-tax income based on current tax law. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities and expected benefits of utilizing net operating loss carryforwards. The impact on deferred taxes of changes in tax rates and laws, if any, applied to the years during which temporary differences are expected to be settled, are reflected in the consolidated financial statements in the period of enactment.

As required by SFAS 109, we record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. In evaluating our ability to recover our deferred tax assets we consider all available positive and negative evidence, including our operating results, ongoing tax planning, and forecasts of future taxable income on a jurisdiction by jurisdiction basis. In the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the valuation allowance which would reduce the provision for income taxes.

Effective October 1, 2007 (the first day of fiscal 2008), we adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 states that a tax benefit from an uncertain tax position may be recognized only if it is "more likely than not" that the position is sustainable based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with a taxing authority having full knowledge of all relevant information. A tax benefit from an uncertain position was previously recognized if it was probable of being sustained. Under FIN 48, the liability for unrecognized tax benefits is classified as noncurrent unless the liability is expected to be settled in cash within 12 months of the reporting date. We have elected to record any interest or penalties from the uncertain tax position as income tax expense (see Note 9).

We prepare and file tax returns based on our interpretation of tax laws and regulations, and we record estimates based on these judgments and interpretations. In the normal course of business, our tax returns are subject . . .