NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)

(1) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     In the opinion of management, the accompanying interim unaudited condensed consolidated balance sheets, statements of operations and cash flows contain all adjustments necessary to present fairly the financial position of Advanced Energy Industries, Inc., a Delaware corporation, and its wholly owned subsidiaries (the “Company”) at September 30, 2003 and December 31, 2002, and the results of their operations for the three- and nine-month periods ended September 30, 2003 and 2002, and cash flows for the nine-month periods ended September 30, 2003 and 2002.

     The unaudited financial statements presented herein have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and note disclosures required by accounting principles generally accepted in the United States. The financial statements should be read in conjunction with the audited financial statements and footnotes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002, filed March 27, 2003.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company’s management to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and accompanying footnotes. Actual results could differ materially from those estimates.

      GOODWILL AND INTANGIBLES — Goodwill and certain other intangible assets with indefinite lives, if present, are not amortized. Instead, goodwill and other intangible assets are subject to periodic (at least annual) tests for impairment. The impairment testing is performed in two steps: (i) the Company assesses goodwill for a potential impairment loss by comparing the fair value of a reporting unit with its carrying value, and (ii) if an impairment is indicated by a reporting unit whose fair value is less than its carrying amount, the Company measures the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill.

     In the fourth quarter of 2002, the Company completed its evaluation of the goodwill and intangible assets recorded as a result of the acquisitions of Aera, which it acquired on January 18, 2002, Dressler, which it acquired on March 28, 2002, and the remaining 40.5% of LITMAS that the Company did not previously own on April 2, 2002. In the fourth quarter of 2002, the Company also performed its annual goodwill impairment test, and concluded that because the estimated fair value of the Company’s reporting units exceeded their carrying amounts, no impairment of goodwill was indicated. As the Company is required to perform the test for impairment at least annually, it is reasonably possible that a future test may indicate impairment, and the amount of impairment may be material to the Company.

     Goodwill and other intangibles consisted of the following as of December 31, 2002:

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     Goodwill and other intangibles consisted of the following as of September 30, 2003:

     Aggregate amortization expense related to other intangibles for the three-month periods ended September 30, 2003 and 2002 was approximately $1.1 million and $1.6 million, respectively, and approximately $3.5 million for the nine-month periods ended September 30, 2003 and 2002. Estimated amortization expense related to the Company’s acquired intangibles fluctuates with changes in foreign currency exchange rates between the U.S. dollar and the Japanese yen and the euro. Estimated amortization expense for each of the five years 2004 through 2008 is as follows:

     During the third quarter of 2003, the Company determined that one of its mass flow controller products would require a significant technological investment in order to conform to changing customer technologies which would enable it to be accepted by the semiconductor capital equipment industry. As a result, the Company performed an assessment of the carrying value of the related intangible asset. This assessment consisted of estimating the intangible asset’s fair value and comparing the estimated fair value to the carrying value of the asset. The Company estimated the intangible asset’s fair value using a cash flow model assuming the technological investment was made, discounted at discount rates consistent with the risk of the related cash flows, and applying a hypothetic royalty rate to the projected revenue stream. Based on this analysis the Company determined that the fair value of the intangible asset was minimal and recorded an impairment of the carrying value of approximately $1.2 million, which has been reported as an intangible asset impairment in the accompanying condensed consolidated financial statements.

      FOREIGN CURRENCY TRANSLATION — The functional currency of the Company’s foreign subsidiaries is their local currency. Assets and liabilities of international subsidiaries are translated to U.S. dollars at period-end exchange rates, and statement of operations activity and cash flows are translated at average exchange rates during the period. Resulting translation adjustments are recorded as a separate component of stockholders’ equity.

     Transactions denominated in currencies other than the local currency are recorded based on exchange rates at the time such transactions arise. Subsequent changes in exchange rates result in foreign currency transaction gains and losses which are reflected in income as unrealized (based on period end translation) or realized (upon settlement of the transactions). Unrealized transaction gains and losses applicable to permanent investments by the Company in its foreign subsidiaries are included as cumulative translation adjustments, and unrealized translation gains or losses applicable to non-permanent intercompany receivables from or payables to the Company and its foreign subsidiaries are included in income.

     The Company recognized gains on foreign currency transactions of approximately $290,000 and $299,000 for the three- and nine-month periods ended September 30, 2003, respectively. In the second quarter of 2002, the Company recognized a net foreign currency gain of approximately $4.5 million, the

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majority of which was related to an intercompany loan of Japanese yen (which was settled in January 2003) that Advanced Energy U.S. made to its subsidiary Advanced Energy Japan K.K. (“AE-Japan”) (which has a functional currency of yen) for the purpose of effecting the acquisition of Aera. The loan was transacted in the first quarter of 2002, for approximately 5.7 billion yen (approximately $44 million based on an exchange rate of 130:1). During the first quarter of 2002, the exchange rate between the U.S. dollar and the Japanese yen remained relatively stable, and an immaterial loss was recorded related to this intercompany loan. During the second quarter of 2002, the U.S. dollar weakened significantly against the yen to approximately 119:1, resulting in a gain of approximately $4.6 million.

      REVENUE RECOGNITION — The Company generally recognizes revenue upon shipment of its products and spare parts, at which time title passes to the customer, as its shipping terms are FOB shipping point, the price is fixed and collectibility is reasonably assured. Generally, the Company does not install its products. In certain limited instances, some customers have negotiated product acceptance provisions relative to specific orders. Under these circumstances the Company defers revenue recognition until the related acceptance provisions have been satisfied. Revenue deferrals are reported as customer deposits and deferred revenue in the accompanying condensed consolidated balance sheets.

     In certain instances, the Company requires its customers to pay for a portion or all of their purchases prior to the Company building or shipping these products. Cash payments received prior to shipment are recorded as customer deposits and deferred revenue in the accompanying balance sheets, and then recognized as revenue upon shipment of the products. The Company does not offer price protection to its customers or allow returns, unless covered by the Company’s normal policy for repair of defective products.

     The Company has an arrangement with one of its major customers, a semiconductor capital equipment manufacturer, in which completed products are shipped to the customer and held by it in its warehouse. The customer draws products from this inventory as needed, at which time title passes to the customer and the Company recognizes revenue. The customer is subject to the Company’s normal warranty policy for repair of defective products.

     In certain instances the Company delivers products to customers for evaluation purposes. In these arrangements, the customer retains the products for specified periods of time without commitment to purchase. On or before the expiration of the evaluation period, the customer either rejects the product and returns it to the Company, or accepts the product. Upon acceptance, title passes to the customer, the Company invoices the customer for the product, and revenue is recognized. Pending acceptance by the customer, such products are reported on the Company’s balance sheet at an estimated value based on the lower of cost or market, and are included in the amount for demonstration and customer service equipment, net of accumulated depreciation.

      INCOME TAXES — The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires deferred tax assets and liabilities to be recognized for temporary differences between the tax basis and financial reporting basis of assets and liabilities, computed at current tax rates, as well as for the expected tax benefit of net operating loss and tax credit carryforwards. During the third quarter of 2003, the Company recorded a valuation allowance of $22.4 million against all of its United States and foreign net deferred tax assets in jurisdictions where the Company has recognized significant operating losses. This valuation allowance was recorded because the Company has incurred significant operating losses in 2001, 2002 and year-to-date through September 30, 2003. Given such experience, and along with continuing volatility in our customers’ industries, management could not conclude that it was more likely than not that the net deferred tax asset would be realized. While there are indications that the industries in which the Company operates may improve in 2004 and 2005, these indications have not yet resulted in a substantial increase in orders from the Company’s customers. Accordingly, the Company’s management, in accordance with SFAS No. 109, in evaluating the recoverability of the net deferred tax asset, placed greater weight on the Company’s historical results as compared to projections regarding future taxable income. If the Company generates future taxable income, in the appropriate tax jurisdiction, against which these tax attributes may be applied,

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some portion or all of the valuation allowance will be reversed and a corresponding reduction in income tax expense will be reported in future periods.

     When recording acquisitions, the Company has recorded valuation allowances due to the uncertainty related to the realization of certain deferred tax assets existing at the acquisition dates. The amount of deferred tax assets considered realizable is subject to adjustment in future periods if estimates of future taxable income are changed. Any reversals of valuation allowances recorded in purchase accounting will be reflected as a reduction of goodwill in the period of reversal.

      RESTRUCTURING COSTS — Restructuring charges include the costs associated with actions taken by the Company in response to the continuing downturn in the semiconductor capital equipment industry and as a result of the ongoing execution of the Company’s strategy. These charges consist of costs that are incurred to exit an activity or cancel an existing contractual obligation, including closure of facilities and employee termination related charges.

     Effective January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Exit or Disposal Activities.” This statement addresses significant issues regarding the recognition, measurement and reporting of costs that are associated with exit and disposal activities, including restructuring activities that were previously accounted for pursuant to the guidance set forth in Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material effect on the Company’s financial position or results of operations, however expense recognition of certain restructuring activities in 2003 have been reported in later periods under SFAS No. 146 than would have been the case under EITF Issue No. 94-3.

     At the end of 2002, the Company announced major changes in its operations to occur through the end of 2003. These included establishing a new manufacturing facility in China, consolidating worldwide sales forces, a move to Tier 1 suppliers, primarily in Asia, and the intention to close or sell certain facilities.

     Associated with the above plan, the Company recognized charges of approximately $1.0 million in the third quarter of 2003 that consisted primarily of the recognition of expense for involuntary employee termination benefits associated with the Company’s second quarter headcount reduction, asset impairments incurred as a result of exiting its Longmont, Colorado manufacturing facilities, and the involuntary termination of 20 employees in the third quarter of 2003.

     In the second quarter of 2003, the Company recognized charges that consisted primarily of the involuntary termination of 55 manufacturing and administrative personnel in the Company’s U.S. operations. Certain of the employees were terminated and paid prior to the end of the second quarter of 2003, which resulted in restructuring charges totaling approximately $768,000 for the three months ended June 30, 2003. In addition, certain employees were required to render service beyond a minimum retention period (generally 60 days). In accordance with SFAS No. 146, the Company measured the termination benefits at the communication date, but approximately $170,000 was recognized as expense during the third quarter of 2003, and approximately $170,000 will be recognized as expense in the fourth quarter of 2003 as these employees complete their service requirement.

     The Company also recorded charges totaling approximately $1.5 million in the first quarter of 2003 primarily associated with manufacturing and administrative personnel headcount reductions in the Company’s Japanese operations. In accordance with Japanese labor regulations the Company offered voluntary termination benefits to all of its Japanese employees. The voluntary termination benefits were accepted by 36 employees prior to March 31, 2003, with termination dates in the second quarter of 2003. All termination benefits were paid in the second quarter of 2003.

     At September 30, 2003, outstanding liabilities related to the 2003 and 2002 restructuring charges were approximately $3.2 million. At December 31, 2002, outstanding liabilities related to the 2002 restructuring charges were approximately $6.0 million. Liabilities for restructuring charges are reported as part of other accrued expenses on the accompanying condensed consolidated balance sheets.

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     The Company recorded restructuring charges totaling $9.1 million in 2002, primarily associated with changes in operations designed to reduce redundancies and better align the Company’s Aera mass flow controller business within its operating framework. The Company’s restructuring plans and associated costs consisted of $6.0 million to close and consolidate certain manufacturing facilities, and $3.1 million for related headcount reductions of approximately 223 employees.

     The following table summarizes the components of the restructuring charges, the payments and non-cash charges, and the remaining accrual as of September 30, 2003:

      STOCK-BASED COMPENSATION — Prior to May 7, 2003 the Company had five stock-based compensation plans, which are more fully described in Note 16 to the Company’s Form 10-K for the year ended December 31, 2002. On May 7, 2003 the Company’s stockholders approved the 2003 Stock Option Plan (the “2003 Plan”), the 2003 Non-Employee Directors’ Stock Option Plan (the “2003 Directors’ Plan”) and an amendment to the Employee Stock Purchase Plan (“ESPP”).

     The 2003 Plan provides for the issuance of up to 3,250,000 shares of common stock. Shares may be issued under the 2003 Plan on exercise of incentive stock options or non-qualified stock options granted under the 2003 Plan or as restricted stock awards. Stock appreciation rights may also be granted under the 2003 Plan, and the shares represented by the stock appreciation rights will be deducted from shares issuable under the 2003 Plan. The exercise price of incentive stock options and non-qualified stock options may not be less than the market value of the Company’s common stock on the date of grant. The Company has the discretion to determine the vesting period of options granted under the 2003 Plan, however option grants will generally vest over four years, contingent upon the optionee continuing to be an employee, director or consultant of the Company. As of September 30, 2003, 2,732,000 shares of common stock were available for grant under this plan. The Company’s 1995 Employee Stock Option Plan terminated upon stockholder approval of the 2003 Plan, however existing stock options outstanding under the 1995 Employee Stock Option Plan remain outstanding according to their original terms.

     The 2003 Directors’ Plan provides for the issuance of up to 150,000 shares of common stock on exercise of non-qualified stock options granted under the 2003 Directors’ Plan. The exercise price of options granted under the 2003 Directors’ Plan may not be less than the market value of the Company’s common stock on the date of grant. Non-employee directors are automatically granted an option to purchase 15,000 shares on the first date elected or appointed as a member of the Company’s board, and 5,000 shares on any date re-elected as a member of the board. Options granted on the date first elected or appointed as a member of the Company’s board immediately vest as to one-third of the shares subject to the grant, then another one-third on each of the first two anniversaries of the date granted, provided the optionee continues to be a director. Options granted upon re-election are immediately exercisable. As of September 30, 2003, 125,000 shares of common stock were available for grant under this plan. The Company’s Non-Employee Directors Stock Option Plan terminated upon stockholder approval of the 2003

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Directors’ Plan, however existing stock options outstanding under the Non-Employee Directors Stock Option Plan remain outstanding according to their original terms.

     The Company’s ESPP was amended to increase the number of common shares reserved for issuance under the plan from 200,000 shares to 400,000 shares. At September 30, 2003, approximately 185,000 shares remained available for future issuance.

     The Company accounts for employee stock-based compensation using the intrinsic value method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. With the exception of certain options granted in 1999 and 2000 by a shareholder of Sekidenko prior to its acquisition by the Company (which was accounted for as a pooling of interests), all options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant. Therefore, no stock-based compensation cost is reflected in the Company’s net loss.

     Had compensation cost for the Company’s plans been determined consistent with the fair value-based method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net loss would have increased to the following adjusted amounts:

     Cumulative compensation cost recognized with respect to options that are forfeited prior to vesting is reflected as a reduction of compensation expense in the period of forfeiture. Compensation expense related to awards granted under the Company’s employee stock purchase plan is estimated until the period in which settlement occurs, as the number of shares of common stock awarded and purchase price are not known until settlement.

     For SFAS No. 123 purposes, the fair value of each option grant and purchase right granted under the ESPP are estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

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     Based on the Black-Scholes option pricing model, the weighted-average estimated fair value of employee stock option grants was $14.89 and $14.01 for the three months ended September 30, 2003 and 2002, respectively, and was $9.59 and $20.42 for the nine months ended September 30, 2003 and 2002, respectively. The weighted-average estimated fair value of purchase rights granted under the ESPP was $4.74 and $12.72 for the three months ended September 30, 2003 and 2002, respectively, and was $4.71 and $10.87 for the nine months ended September 30, 2003 and 2002, respectively.

      EARNINGS PER SHARE — Basic (loss) earnings per share (“EPS”) is computed by dividing net (loss) income by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS, except that the numerator is increased to exclude certain charges which would not have been incurred, and the denominator is increased to include the number of additional common shares that would have been outstanding (using the if-converted and treasury stock methods), if securities containing potentially dilutive common shares (convertible notes payable, options and warrants) had been converted to such common shares, and if such assumed conversion is dilutive. Due to the Company’s net loss for the three- and nine- month periods ended September 30, 2003 and 2002, basic and diluted EPS are the same, as the assumed conversion of all potentially dilutive securities would be anti-dilutive. Potential shares of common stock issuable under options and warrants for common stock at September 30, 2003 and 2002 were approximately 4.1 million and 3.3 million, respectively. Potential shares of common stock issuable upon conversion of the Company’s convertible subordinated notes payable were approximately 5.4 million and 5.8 million, respectively.