COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

INDEX

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PART I.  FINANCIAL INFORMATION

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Item 1.  Financial Statements

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(unaudited)

See notes to consolidated financial statements.

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COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(unaudited)

See notes to consolidated financial statements.

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COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

See notes to consolidated financial statements.

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COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - CONSOLIDATED FINANCIAL STATEMENTS

The consolidated balance sheet as of September 30, 2005 and the related consolidated statements of income and comprehensive (loss) income for the three and nine-month periods ended September 30, 2005 and the consolidated statements of changes in stockholders’ equity and the consolidated statements of cash flows for the nine-month periods ended September 30, 2005 and 2004 have been prepared by Communications Systems, Inc. and Subsidiaries (the Company or we) without audit.  In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows at September 30, 2005 and 2004 and for the nine months then ended have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted.  It is suggested these condensed financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s December 31, 2004 Annual Report to Shareholders.  The results of operations for the periods ended September 30 are not necessarily indicative of the operating results for the entire year.

In June 2005 the Company issued 32,484 shares of the Company’s common stock to the Employee Stock Ownership Plan in payment of its 2004 obligation.  In a non-cash transaction, the Company recorded additional stockholders’ equity of $552,214 (reflecting the market value of the stock at the time of the contribution) and reduced accrued expenses by the same amount.

Reclassifications

Certain prior year amounts reported on the Company’s consolidated balance sheet have been reclassified to conform to 2005 presentation. Such reclassifications had no impact on total consolidated assets, net income or stockholders’ equity. On the Company’s consolidated balance sheets, investments and other assets, previously disclosed on separate lines, have been combined on a single line. December 31, 2004 balance sheet amounts reflect the reclassification of certain assets and liabilities of both Image Systems and Austin Taylor Communications Ltd.  from continuing operations to discontinued operations. The Company’s income statement for the three and nine months ended September 30, 2005 reflects the reclassifications of the operating results to discontinued operations of Image Systems and Austin Taylor Communications Ltd. Effective October 1, 2005, the Company negotiated an agreement to sell the inventory, equipment and all intangibles (trade names, intellectual property, etc.) of Image Systems to Richardson Electronics, Ltd. for approximately $1.5 million.  Subject to final determination, the Company expects to record a small gain on the sale in the fourth quarter of 2005.  The pending sale of Austin Taylor was in the process of negotiation as of September 30, 2005. The Company expects to complete the sale of this business unit within the next three months.

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STOCK BASED COMPENSATION PLANS

The Company has adopted the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” but applies APB Opinion No. 25, “Accounting for Stock Issued to Employees” for measurement and recognition of stock-based transactions with its employees and accordingly no stock-based employee compensation cost is reflected in net income.  If the Company had elected to recognize compensation cost for its stock based transactions using the method prescribed by SFAS No. 123, pro forma net income and net income per share would have been as follows:

NOTE 2 - INVENTORIES

Inventories summarized below are priced at the lower of first-in, first-out cost or market:

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NOTE 3– GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the amount by which the purchase price (including liabilities assumed) and transaction costs of acquired businesses exceed the estimated fair value of the net tangible assets and separately identifiable assets of these businesses.  Under Statement of Financial Accounting Standards (SFAS) No. 142 “Goodwill and Other Intangible Assets” Goodwill and intangible assets with indefinite useful lives are not amortized, but are tested at least annually for impairment.  We reassess the value of our reporting units and related goodwill balances at the beginning of the first quarter of each fiscal year and at other times if events have occurred or circumstances exist that indicate the carrying amount of goodwill may not be recoverable.  Accordingly, we have determined that there was no impairment as of January 1, 2004 and no events occurred during the nine months ended September 30, 2005 that indicated our remaining goodwill might be impaired. As of September 30, 2005 the Company had net goodwill of $5,254,000.  Intangible assets with definite useful lives (consisting of a royalty agreement) will continue to be amortized over its estimated useful life of five years. Amortization included in costs and expenses was $34,000 for the nine months ended September 30, 2005 and 2004.

NOTE 4 – WARRANTY

We provide reserves for the estimated cost of product warranties at the time revenue is recognized.  We estimate the costs of our warranty obligations based on our warranty policy or applicable contractual warranty, historical experience of known product failure rates, and use of materials and service delivery costs incurred in correcting product failures.  Management reviews the estimated warranty liability on a quarterly basis to determine its adequacy.  The actual warranty expense could differ from the estimates made by the company based on product performance.

The following table presents the changes in the Company’s warranty liability for the nine months ended September 30, 2005 and 2004, the majority of which relates to a five-year obligation to provide for potential future liabilities for network equipment sales.

NOTE 5 – CONTINGENCIES

A former officer of one of the Company’s subsidiaries has challenged the Company’s determination of the retirement benefit payable to be provided to the former officer.  The former officer has asserted that, in addition to the retirement benefit the Company has provided, the Company should also provide a supplemental retirement benefit of approximately $100,000 per year to the former officer based on language in his employment contract with the subsidiary and a related letter executed by the Company when the former officer entered into the employment contract.  The Company has denied the former officer’s claim for a supplemental retirement benefit.  While the former officer has threatened to commence a lawsuit with respect to his claim, as of the date of this report, the Company has not

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received any formal notice that legal proceedings have been started.  If the former officer initiates legal action, the Company will vigorously defend against any claims that may be asserted.

In the ordinary course of business, the Company is exposed to legal actions and incurs costs to pursue and defend legal claims.  Company management is not aware of any other outstanding or pending legal actions that would materially affect the Company’s financial position or results of operations.

NOTE 6 – DISCONTINUED OPERATIONS

Net income includes the discontinued operations of Image Systems, the Company’s medical and technical imaging business unit located in Eden Prairie, Minnesota, and Austin Taylor Communications Ltd. of Bethesda, Wales, the Company’s U.K. provider of cabling and related telephony products.  Effective October 1, 2005, the Company negotiated an agreement to sell the inventory, equipment and all intangibles (trade names, intellectual property, etc.) of Image Systems to Richardson Electronics, Ltd. for approximately $1.5 million.  Subject to final determination, the Company expects to record a small gain on the sale in the fourth quarter of 2005.  The pending sale of Austin Taylor was in the process of negotiation as of September 30, 2005. The Company expects to complete the sale of this business unit within the next three months. These operations have met the requirements to be reported as discontinued operations in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”.

The results of discontinued operations for the three and nine months ended September 30, 2005 and 2004 are summarized as follows:

At September 30, 2005 and December 31, 2004 the major components of assets and liabilities of the discontinued operations were as follows:

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NOTE 7 – SEGMENT INFORMATION

The Company classifies its continuing businesses into three segments: Suttle, which manufactures U.S. standard modular connecting and wiring devices for voice and data communications; Transition Networks and MiLAN Technology, which designs and markets data transmission, computer network and media conversion products and print servers; and JDL Technologies,(JDL), which provides telecommunications network design, specification and training services to educational institutions; Corporate includes non-allocated corporate general and administrative expenses. There are no material intersegment revenues.  Information concerning the Company’s continuing operations in the various segments for the nine-month periods ended September 30, 2005 and 2004 is as follows:

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Information concerning the Company’s operations in the various segments for the three-month periods ended September 30, 2005 and 2004 is as follows:

NOTE 7 - INCOME TAXES

In the preparation of the Company’s consolidated financial statements, management calculates income taxes based upon the estimated effective rate applicable to operating results for the full fiscal year.  This includes estimating the current tax liability as well as assessing temporary differences resulting from different treatment of items for tax and book accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded on the balance sheet. These assets and liabilities are analyzed regularly and management assesses the likelihood that deferred tax assets will be recovered from future taxable income. The Company’s effective income tax rate was approximately 38% for the nine months ended September 30, 2005 and 2004 which approximates the estimated annual effective tax rate.

Distributions by Suttle Caribe, Inc. to the parent company, of income earned prior to December 31, 2000, are subject to a tollgate tax at rates which, depending on various factors, range from 3.5% to 10%.  Tollgate taxes of approximately $860,000 have been accrued on prior earnings and will likely be paid in 2005.

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NOTE 8 – NET INCOME PER SHARE

Basic net income per common share is based on the weighted average number of common shares outstanding during each year. Diluted net income per common share takes into effect the dilutive effect of potential common shares outstanding.  The Company’s only potential common shares outstanding are stock options, which resulted in a dilutive effect of 146,667 shares and 36,651 shares for the periods ended September 30, 2005 and 2004, respectively.  The Company calculates the dilutive effect of outstanding options using the treasury stock method. The total number of non-dilutive stock options outstanding was 598,808 at September 30, 2005 and 1,111,024 at September 30, 2004.

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

Communications Systems, Inc. (herein collectively called “CSI”, “our” or the “Company”) is a Minnesota corporation organized in 1969 which operates directly and through its subsidiaries located in the United States, Costa Rica and the United Kingdom. CSI is principally engaged in the manufacture and sale of modular connecting and wiring devices for voice and data communications, digital subscriber line filters, structured wiring systems and the manufacture of media and rate conversion products for telecommunications networks. CSI also provides network design, training services, general contracting of infrastructure installations, provisioning of high-speed internet access and maintenance support of network operation centers for K-12 schools.

Net income includes the discontinued operations of Image Systems, a medical and technical imaging business unit located in Eden Prairie, Minnesota, and Austin Taylor Communications Ltd. of Bethesda, Wales, the Company’s U.K. provider of cabling and related telephony products.  Effective October 1, 2005, the Company negotiated an agreement to sell the inventory, equipment and all intangibles (trade names, intellectual property, etc.) of Image Systems to Richardson Electronics, Ltd. for approximately $1.5 million.  Subject to final determination, the Company expects to record a small gain on the sale in the fourth quarter of 2005.  The pending sale of Austin Taylor was in the process of negotiation as of September 30, 2005. The net loss from discontinued operations was $241,000 for the third quarter of 2005 compared with a loss of $224,000 for the third quarter of 2004. For the nine months ended September 30, 2005 the loss from discontinued operations was $756,000 compared to $421,000 in the same period in 2004.

Nine Months Ended September 30, 2005 Compared to

Nine Months Ended September 30, 2004

Consolidated sales from continuing operations in 2005 increased 11% to $82,696,000 compared to $73,618,000 in 2004.  Consolidated income from continuing operations in 2005 was consistent at $5,722,000 compared to $5,729,000 in the first nine months of 2004. CSI’s efforts of transitioning to three principal business units: Suttle, JDL Technologies and Transition Networks/MiLAN Technology are progressing as planned and previously announced.  The sale of Image Systems and the pending sale of Austin Taylor will complete this effort to operate three business units.  In addition, the Company’s core business units providing broadband products and Digital Subscriber Line (DSL) products continue to show growth in the first nine months of 2005.

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Suttle sales increased to $35,851,000 in the first nine months of 2005 compared to $29,029,000 in the same period of 2004 due to increased volumes with existing and new customers.  Sales to the major telephone companies increased 28% to $19,904,000 in 2005 compared to $15,519,000 in 2004.  Sales to these customers accounted for 56% and 53% of Suttle’s U.S. customer sales in 2005 and 2004, respectively.  Sales to distributors, original equipment manufacturers (OEMs), and electrical contractors increased to $9,798,000 in 2005 compared to $6,966,000 in 2004. Suttle discontinued contract manufacturing operations and sales in the fourth quarter of 2004.  Contract manufacturing sales totaled $2,480,000 in the first nine months of 2004.

Suttle’s gross margins increased to $10,145,000 in the first nine months of 2005 compared to $7,054,000 in the same period in 2004. The gross margin percentage was 28% in 2005 compared to 24% in 2004. The gross margin percentage increase was due to cost reductions gained by shifting more manufacturing to the lower cost plant in Costa Rica and from continuing to outsource more manufacturing of certain products to Asia.  Selling, general and administrative expenses increased slightly to $4,402,000 in the first nine months of 2005 compared to $3,799,000 in the same period in 2004. The increase was primarily due to increases in sales incentives and selling expenses. Suttle’s operating income was $5,744,000 in the first nine months of 2005 compared to operating income of $3,255,000 in the same period of 2004.

Transition Networks / MiLAN Technology segment sales decreased to $34,942,000 in the first nine months of 2005 compared to $38,634,000 in the same period in 2004. The decrease in sales was due to softer demand for media conversion products in 2005.  Gross margin decreased to $13,470,000 in the first nine months of 2005 from $15,738,000 in 2004. The MiLAN Technology business unit in this segment recorded an inventory write-down adjustment of approximately $1.1 million dollars in the second quarter of 2005. Gross margin as a percentage of sales was 39% in 2005 compared to 41% in 2004.  Selling, general and administrative expenses increased to $12,967,000 in the first nine months of 2005 compared to $12,245,000 in 2004 due to an increase in the sales force headcount and marketing program expenses.  Operating income for this segment decreased to $503,000 in the first nine months of 2005 compared to $3,493,000 in the same period in 2004. On July 1, 2005, CSI consolidated the MiLAN and Transition Networks business units into one operating unit under the direction of the Transition Networks management.  Operations subsequent to July 1, 2005 have proven to be successful and include a 30% reduction in the MiLAN staff.

Sales by JDL Technologies, Inc. (the Company’s education consulting business unit) increased to $11,903,000 in the first nine months of 2005 compared to $5,956,000 in the same period in 2004.  The increase was due to higher sales of network equipment and connectivity services in 2005 as compared to 2004 due to new contracts awarded with new and current client school districts. Gross margin in the first nine months of 2005 increased to $4,634,000 compared to $2,936,000 in the same period of 2004.  Gross margin as a percentage of sales decreased to 39% in 2005 from 49% in the 2004 period due to an increase in lower margin sales of network equipment to client school districts.  Selling, general and administrative expenses increased to $3,379,000 in the first nine months of 2005 compared to $2,225,000 in the same period of 2004 due to higher headcount and marketing expenses.  JDL’s operating income was $1,256,000 in the first nine months of 2005 compared to operating income of $712,000 in the same period in 2004.

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Consolidated net investment and other income increased $251,000 in the first nine months in 2005 compared to 2004 due to earnings of higher cash and money market investment balances.  Income from continuing operations before income taxes increased to $6,028,000 in the nine-month period in 2005 compared to $5,790,000 in the same period in 2004.  The Company’s annualized effective income tax rate was 38% in 2005 compared to 37% in 2004.  Net income including discontinued operations through the first nine months of 2005 decreased slightly to $2,981,000 compared to $3,251,000 in the same period in 2004.

Three Months Ended September 30, 2005 Compared to

Three Months Ended September 30, 2004

Consolidated sales from continuing operations increased 13% to $30,108,000 in the three-month period ended September 30, 2005 compared to $26,677,000 in the same period in 2004.  Consolidated income from continuing operations increased to $3,216,000 in the three months ended September 30, 2005 compared to $2,770,000 in the same period in 2004.

Suttle sales increased to $11,777,000 in 2005 compared to $10,301,000 in 2004 due to increased volumes in traditional telephony products and DSL filters.  Suttle’s gross margins increased to $3,464,000 in 2005 compared to $2,798,000 in 2004 due to higher volumes and outsourcing more manufacturing in Asia.  Selling, general and administrative expenses increased slightly to $1,468,000 in the third quarter of 2005 compared to $1,312,000 incurred in the same period of 2004. The increase was primarily due to increases in sales incentives and selling expenses.  Suttle increased operating income to $1,995,000 in the third quarter of 2005 compared to operating income of $1,486,000 in the same period in 2004.

Transition Networks / MiLAN Technology segment sales decreased to $11,802,000 in the third quarter of 2005 compared to $13,438,000 in the same period in 2004 due to softer market demand for media conversion products. Gross margin decreased to $5,080,000 in 2005 from $5,511,000 in 2004.  Gross margin as a percentage of sales increased to 43% in 2005 compared to 41% in 2003. The gross margin percentage increase was due primarily to reductions in material and product component costs in manufacturing and through efficiencies gained by combining the Transition Networks and MiLAN Technology business units effective July 1, 2005.  Selling, general and administrative expenses increased slightly to $4,018,000 in 2005 compared to $3,978,000 in 2004.  Operating income decreased to $1,063,000 in the third quarter of 2005 compared to $1,533,000 in the same period of 2004.

Sales by JDL Technologies, Inc. (the Company’s education consulting business unit) increased to $6,530,000 in the third quarter of 2005 compared to $2,937,000 in the same period in 2004. The increase was due to higher sales of network equipment and connectivity services in 2005 as compared to 2004 due to new contracts awarded with new and current client school districts. JDL’s gross margin increased to $2,033,000 in the third quarter of 2005 compared to $1,238,000 in the third quarter of 2004.  Gross margin as a percentage of sales in the third quarter of 2005 decreased to 31% from 42% in the 2004 period due to increased sales of lower margin network equipment with several large client school districts.  Selling, general and administrative expenses increased to $1,270,000 in the third quarter of 2005 compared to $738,000 in the same period of 2004. The increase in SG&A is due to additional consulting fees, increased headcount for sales, services, and marketing departments and increased travel and lodging expenses.  JDL’s operating income was $763,000 in the third quarter of 2005 compared to $501,000 in the 2004 third quarter.

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Net investment and other income in the third quarter of 2005 increased by $114,000 in 2005 compared to 2004 due to earnings on higher cash and money market investment balances.  Net income including discontinued operations for the third quarter of 2005 was $1,777,000 compared to net income of $1,537,000 in the third quarter of 2004.

Liquidity and Capital Resources

At September 30, 2005, the Company had $23,527,000 of cash and cash equivalents compared to $25,843,000 of cash and cash equivalents at December 31, 2004.  The Company had working capital of approximately $65,771,000 and a current ratio of 6.4 to 1 compared to working capital of $64,603,000 and a current ratio of 6.2 to 1 at the end of 2004.

Net cash provided by operating activities was $1,318,000 in the first nine months of 2005 compared to net cash provided by operating activities of $13,395,000 in the same period in 2004.  The cash flow reduction was due primarily to an increase in the level of trade receivables and inventories and a decrease in the level of trade accounts payable attributable to primarily to normal fluctuations in timing of collections and purchases and payments of inventory.

Net cash used in investing activities was $2,490,000 in the first nine months in 2005 compared to $3,940,000 in the same period in 2004.  In March 2004, the Company acquired substantially all of the outstanding shares of Image Systems Corporation for a cash purchase price per share of $0.643 or approximately $2.8 million in total consideration net of cash acquired. In the first nine months in 2005 cash investments in new plant and equipment totaled $2,490,000 compared to $1,138,000 in 2004.  Plant and equipment purchases in both years were financed by internal cash flows.  The Company expects to spend $2,800,000 in total on capital additions in 2005. Also, the Company will receive approximately $1,500,000 from the sale of the inventory and equipment of Image Systems over the next nine month period.

Net cash used in financing activities was $1,216,000 in the first nine months of 2005 compared to net cash used in financing activities in 2004 of $854,000.  At September 30, 2005 Board authorizations are outstanding to purchase an additional 270,000 shares.  Cash dividends paid in the first nine months of 2005 was approximately $1,705,000 compared to $985,000 in the same period in 2004. There were no borrowings on the line of credit during the first nine months of 2005.

In the opinion of management, based on the Company’s current financial and operating position and projected future expenditures, sufficient funds are available to meet the Company’s anticipated operating and capital expenditure needs.

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Critical Accounting Policies

Our critical accounting policies, including the assumptions and judgements underlying them, are discussed in our 2004 Form 10-K in Note 1 Summary of Significant Accounting Policies included in our Consolidated Financial Statements.  There were no significant changes to our critical accounting policies during the nine months ended September 30, 2005.  These policies have been consistently applied in all material respects and disclose such matters as allowance for doubtful accounts, sales returns, inventory valuation, warranty expense, income taxes, revenue recognition, asset impairment recognition and foreign currency translation.  On an ongoing basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the result of which form the basis for making judgements about the carrying value of assets and liabilities that are not readily apparent from other sources.  Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions.  Management on an ongoing basis reviews these estimates and judgements.

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R) (revised 2004), “Share-Based Payment”, which amends FASB Statement No. 123 and will be effective for public companies for interim or annual periods beginning after June 15, 2005. The new standard will require us to expense employee stock options and other share-based payments. The Company has not yet determined how it will value future grants or whether it will elect to adjust prior periods upon adoption of SFAS No. 123(R) (revised 2004). Effective April 14, 2005 the Securities Exchange Commission amended the new rule which now allows companies to implement Statement No. 123(R) at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005.  Accordingly, the Company will comply with Statement No. 123R with the interim financial statements for the first quarter of 2006.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk.

The Company has no freestanding or embedded derivatives.  All contracts that contain provisions meeting the definition of a derivative also meet the requirements of, and have been designated as normal purchases or sales.  The Company’s policy is to not use freestanding derivatives and to not enter into contracts with terms that cannot be designated as normal purchases or sales.

The vast majority of our transactions are denominated in U.S. dollars; as such, fluctuations in foreign currency exchange rates have historically not been material to the Company.  At September 30, 2005 our bank line of credit carried a variable interest rate based on the London Interbank Offered Rate (Libor) plus 2%.  The Company’s investments are money market type of investments that earn interest at prevailing market rates and as such do not have material risk exposure.

Based on the Company’s operations, in the opinion of management, no material future losses or exposure exist relative to market risk.

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized.

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