EXFO ELECTRO OPTICAL ENGINEERING INC (Form: 20-F, Received: 11/29/2006 09:19:24)

Our subordinate voting shares have been quoted on the NASDAQ National Market under the symbol EXFO and listed on The Toronto Stock Exchange under the symbol EXF since our initial public offering on June 29, 2000. Prior to that time, there was no public market for our subordinate voting shares. The following table sets forth, for the periods indicated, the high and low closing sales prices per subordinate voting share as reported on the NASDAQ National Market and the Toronto Stock Exchange.

On November 21, 2006, the last reported sale price for our subordinate voting shares on the NASDAQ National Market was US$5.57 per share and the last reported sale price for our subordinate voting shares on the Toronto Stock Exchange was CA$6.39 per share.

Table of Contents

Item 10. Additional Information

A.	Share Capital

Not Applicable

B. Memorandum and Articles of Association

Incorporated by reference to our registration statement on Form F-1 dated June 9, 2000 (File No. 333-38956).

C. Material Contracts

Except as otherwise disclosed in this annual report and our financial statements and notes included elsewhere in this annual report, we have no other material contracts.

D. Exchange Controls

Subject to the following paragraph, there is no law or governmental decree or regulation in Canada that restricts the export or import of capital, or affects the remittance of dividends, interest or other payments to non-resident holders of our subordinate voting shares, other than withholding tax requirements.

There is no limitation imposed by Canadian law or by our articles of incorporation or our other charter documents on the right of a non-resident to hold or vote subordinate voting shares, other than as provided by the Investment Canada Act, the North American Free Trade Agreement Implementation Act (Canada) and the World Trade Organization Agreement Implementation Act . The Investment Canada Act requires notification and, in certain cases, advance review and approval by the Government of Canada of an investment to establish a new Canadian business by a non-Canadian or of the acquisition by a “non-Canadian” of “control” of a “Canadian business”, all as defined in the Investment Canada Act . Generally, the threshold for review will be higher in monetary terms for a member of the World Trade Organization or North American Free Trade Agreement.

E. Taxation

United States Taxation

The information set forth below under the caption “United States Taxation” is a summary of the material U.S. federal income tax consequences of the ownership and disposition of subordinate voting shares by a U.S. Holder, as defined below. These discussions are not a complete analysis or listing of all of the possible tax consequences of such transactions and do not address all tax considerations that may be relevant to particular holders in light of their personal circumstances or to persons that are subject to special tax rules. In particular, the information set forth under the caption “United States Taxation” deals only with U.S. Holders that hold subordinate voting shares as capital assets within the meaning of Section 1221 of the Internal Revenue Code of 1986, as amended, and who do not at any time own individually, nor are treated as owning 10% or more of the total combined voting power of all classes of our stock entitled to vote. In addition, this description of U.S. tax consequences does not address the tax treatment of special classes of U.S. Holders, such as financial institutions, regulated investment companies, traders in securities who elect to mark-to-market their securities, tax-exempt entities, insurance companies, partnerships, persons holding subordinate voting shares as part of a hedging, integrated or conversion transaction or as part of a “straddle,” U.S. expatriates, persons subject to the alternative minimum tax, persons who acquired their subordinate voting shares through the exercise or cancellation of employee stock options or otherwise as compensation for services, dealers or traders in securities or currencies and holders whose “functional currency” is not the U.S. dollar. This summary does not address estate and gift tax consequences or tax consequences under any foreign, state or local laws other than as provided in the section entitled “Canadian Federal Income Tax Considerations” provided below.

Table of Contents

As used in this section, the term “U.S. Holder” means a beneficial owner of subordinate voting shares that is for U.S. federal income tax purposes:

(a)

an individual citizen or resident of the United States;

(b)

a corporation created or organized under the laws of the United States or any state thereof and the District of Columbia;

(c)

an estate the income of which is subject to United States federal income taxation regardless of its source;

(d)

a trust if (1) a court within the United States is able to exercise primary jurisdiction over its administration and one or more U.S. persons have authority to control all substantial decisions of the trust or (2) the trust has a valid election in effect under applicable U.S. Treasury regulations to be treated as a U.S. person; or

(e)

any other person whose worldwide income or gain is otherwise subject to U.S. federal income taxation on a net income basis;

If a partnership or other flow-through entity holds subordinate voting shares, the U.S. federal income tax treatment of a partner will generally depend upon the status of the partner or other owner and upon the activities of the partnership or other flow-through entity. If you are a partner of a partnership holding subordinate voting shares, you should consult your tax advisor.

Holders of subordinate voting shares who are not U.S. Holders, sometimes referred to as “Non-U.S. Holders”, should also consult their own tax advisors, particularly as to the applicability of any tax treaty.

The following discussion is based upon:

·	the Internal Revenue Code;

·	U.S. judicial decisions;

·	administrative pronouncements;

·	existing and proposed Treasury regulations; and

·	the Canada - U.S. Income Tax Treaty.

Any of the above is subject to change, possibly with retroactive effect, so as to result in U.S. federal income tax consequences different from those discussed below. We have not requested, and will not request, a ruling from the U.S. Internal Revenue Service with respect to any of the U.S. federal income tax consequences described below, and as a result, there can be no assurance that the U.S. Internal Revenue Service will not disagree with or challenge any of the conclusions we have reached and describe here.

The following discussion is for general information only and is not intended to be, nor should it be construed to be, legal or tax advice to any holder of subordinate voting shares and no opinion or representation with respect to the U.S. federal income tax consequences to any holder is made. Holders of subordinate voting shares are urged to consult their tax advisors as to the particular consequences to them under U.S. federal, state, local and applicable foreign tax laws of the acquisition, ownership and disposition of subordinate voting shares.

Table of Contents

Dividends

Subject to the discussion of passive foreign investment companies below, the gross amount of any distribution paid by us to a U.S. Holder will generally be subject to U.S. federal income tax as foreign source dividend income to the extent paid out of our current or accumulated earnings and profits, as determined under U.S. federal income tax principles. Such income will be includable in the gross income of a U.S. Holder on the day received by the U.S. Holder. The amount of any distribution of property other than cash will be the fair market value of such property on the date of the distribution. In the case of a taxable corporate U.S. Holder, such dividends will be taxable as ordinary income and will not be eligible for the corporate dividends received deduction, which is generally allowed to U.S. corporate shareholders on dividends received from a domestic corporation. In the case of an individual U.S. Holder, under recently enacted tax legislation such dividends should generally be eligible for a maximum tax rate of 15% for dividends received before January 1, 2011, provided such holder holds the subordinate voting shares for at least 60 days and certain other conditions are satisfied, including, as we believe to be the case, that we are not a “passive foreign investment company”. To the extent that an amount received by a U.S. Holder exceeds such holder’s allocable share of our current and accumulated earnings and profits, such excess will be applied first to reduce such U.S. Holder’s tax basis in his subordinate voting shares, thereby increasing the amount of gain or decreasing the amount of loss recognized on a subsequent disposition of the subordinate voting shares. Then, to the extent such distribution exceeds such U.S. Holder’s tax basis, it will be treated as capital gain. We do not currently maintain calculations of our earnings and profits for U.S. federal income tax purposes.

The gross amount of distributions paid in Canadian dollars, or any successor or other foreign currency, will be included in the income of such U.S. Holder in a U.S. dollar amount calculated by reference to the spot exchange rate in effect on the day the distributions are paid regardless of whether the payment is in fact converted into U.S. dollars. If the Canadian dollars, or any successor or other foreign currency, are converted into U.S. dollars on the date of the payment, the U.S. Holder should not be required to recognize any foreign currency gain or loss with respect to the receipt of Canadian dollars as distributions. If, instead, the Canadian dollars are converted at a later date, any currency gains or losses resulting from the conversion of the Canadian dollars will be treated as U.S. source ordinary income or loss for foreign tax credit purposes. U.S. Holders are urged to consult their own tax advisors concerning the U.S. tax consequences of acquiring, holding and disposing of Canadian dollars.

A U.S. Holder may be entitled to deduct, or claim a foreign tax credit for, Canadian taxes that are withheld on dividends received by the U.S. Holder, subject to applicable limitations in the Code. Any amounts recognized as dividends will generally constitute foreign source “passive income” or, in the case of certain U.S. Holders, “financial services income” for U.S. foreign tax credit purposes. A U.S. Holder will have a basis in any Canadian dollars distributed equal to their U.S. dollar value on the payment date. The rules governing the foreign tax credit are complex, and additional limitations on the credit apply to individuals receiving dividends from foreign corporations if the dividends are eligible for the 15% maximum tax rate on dividends described above. U.S. Holders are urged to consult their tax advisors regarding the availability of the foreign tax credit under their particular circumstances.

A Non-U.S. Holder of subordinate voting shares generally will not be subject to U.S. federal income or withholding tax on dividends received on subordinate voting shares unless such income is effectively connected with the conduct by such Non-U.S. Holder of a trade or business in the United States.

Table of Contents

Sale or Exchange

A U.S. Holder’s initial tax basis in the subordinate voting shares will generally be cost to the holder. A U.S. Holder’s adjusted tax basis in the subordinate voting shares will generally be the same as cost, but may differ for various reasons including the receipt by such holder of a distribution that was not made up wholly of earnings and profits as described above under the heading “Dividends.” Subject to the discussion of passive foreign investment companies below, gain or loss realized by a U.S. Holder on the sale or other disposition of subordinate voting shares will be subject to U.S. federal income taxation as capital gain or loss in an amount equal to the difference (if any) between the U.S. Holder’s adjusted tax basis (determined in U.S. dollars) in the subordinate voting shares and the U.S. dollar value of the amount realized on the disposition of such subordinate voting shares. Capital gains of non-corporate taxpayers, including individuals, derived with respect to a sale, exchange or other disposition prior to January 1, 2011 of subordinate voting shares held for more than one year are subject to a maximum federal income tax rate of 15%. The deductibility of capital losses is subject to limitations. In the case of a non-corporate U.S. Holder, the federal tax rate applicable to capital gains will depend upon:

·	the holder’s holding period for the subordinate voting shares, with a preferential rate available for subordinate voting shares held for more than one year; and

·	the holder’s marginal tax rate for ordinary income.

Any gain realized will generally be treated as U.S. source gain and loss realized by a U.S. Holder generally also will be treated as from sources within the United States.

The ability of a U.S. Holder to utilize foreign taxes as a credit to offset U.S. taxes is subject to complex limitations and conditions. The consequences of the separate limitation calculation will depend upon the nature and sources of each U.S. Holder’s income and the deductions allocable thereto. Alternatively, a U.S. Holder may elect to claim all foreign taxes paid as an itemized deduction in lieu of claiming a foreign tax credit. A deduction does not reduce U.S. tax on a dollar-for-dollar basis like a tax credit, but the availability of the deduction is not subject to the same conditions and limitations applicable to foreign tax credits.

If a U.S. Holder receives any foreign currency on the sale of subordinate voting shares, such U.S. Holder may recognize ordinary income or loss as a result of currency fluctuations between the date of the sale of subordinate voting shares and the date the sale proceeds are converted into U.S. dollars.

A Non-U.S. Holder of subordinate voting shares generally will not be subject to U.S. federal income or withholding tax on any gain realized on the sale or exchange of such subordinate voting shares unless:

·	such gain is effectively connected with the conduct by such Non-U.S. Holder of a trade or business in the United States; or

·	in the case of any gain realized by an individual Non-U.S. Holder, such Non-U.S. Holder is present in the United States for 183 days or more in the taxable year of such sale and certain other conditions are met.

Foreign Personal Holding Company

Under recently enacted legislation, the foreign personal holding company rules are repealed for taxable years of U.S. shareholders ending after December 31, 2004.

Table of Contents

Passive Foreign Investment Company

We believe that our subordinate voting shares should not currently be treated as stock of a passive foreign investment company for United States federal income tax purposes, but this conclusion is a factual determination made annually and thus may be subject to change based on future operations as well as the composition and valuation of our assets. In particular, a significant portion of our gross assets are comprised of cash and short-term investments, which the PFIC rules treat as passive without regard to the purpose for which we hold those assets. If the proportion of these passive assets were to increase relative to the fair market value of our other assets, we may be treated as a passive foreign investment company. In general, we will be a passive foreign investment company with respect to a U.S. Holder if, for any taxable year in which the U.S. Holder holds our subordinate voting shares, either:

·	at least 75% of our gross income for the taxable year is passive income; or

·	at least 50% of the average value of our assets is attributable to assets that produce or are held for the production of passive income.

For this purpose, passive income includes income such as:

·	dividends;

interest;

·	rents or royalties, other than certain rents or royalties derived from the active conduct of trade or business;

·	annuities; or

·	gains from assets that produce passive income.

If a foreign corporation owns at least 25% by value of the stock of another corporation, the foreign corporation is treated for purposes of the passive foreign investment company tests as owning its proportionate share of the assets of the other corporation and as receiving directly its proportionate share of the other corporation’s income.

If we are treated as a passive foreign investment company, a U.S. Holder that did not make a qualified electing fund election or, if available, a mark-to-market election, as described below, would be subject to special rules with respect to:

·	any gain realized on the sale or other disposition of subordinate voting shares; and

·	any “excess distribution” by us to the U.S. Holder.

Generally, “excess distributions” are any distributions to the U.S. Holder in respect of the subordinate voting shares during a single taxable year that are greater than 125% of the average annual distributions received by the U.S. Holder in respect of the subordinate voting shares during the three preceding taxable years or, if shorter, the U.S. Holder’s holding period for the subordinate voting shares.

Under the passive foreign investment company rules,

·	the gain or excess distribution would be allocated ratably over the U.S. Holder’s holding period for the subordinate voting shares;

·	the amount allocated to the taxable year in which the gain or excess distribution was realized would be taxable as ordinary income;

·	the amount allocated to each prior year, with certain exceptions, would be subject to tax at the highest tax rate in effect for that year; and

·	the interest charge generally applicable to underpayments of tax would be imposed in respect of the tax attributable to each such year.

Table of Contents

A U.S. Holder owning actually or constructively “marketable stock” of a passive foreign investment company may be able to avoid the imposition of the passive foreign investment company tax rules described above by making a mark-to-market election. Generally, pursuant to this election, such holder would include in ordinary income, for each taxable year during which such stock is held, an amount equal to the increase in value of the stock, which increase will be determined by reference to the value of such stock at the end of the current taxable year compared with their value as of the end of the prior taxable year. Holders desiring to make the mark-to-market election should consult their tax advisors with respect to the application and effect of making such election.

In the case of a U.S. Holder who does not make a mark-to-market election, the special passive foreign investment company tax rules described above will not apply to such U.S. Holder if the U.S. Holder makes an election to have us treated as a qualified electing fund and we provide certain required information to holders. For a U.S. Holder to make a qualified electing fund election, we would have to satisfy certain reporting requirements. We have not determined whether we will undertake the necessary measures to be able to satisfy such requirements in the event that we were treated as a passive foreign investment company.

A U.S. Holder that makes a qualified electing fund election will be currently taxable on its pro rata share of our ordinary earnings and net capital gain, at ordinary income and capital gains rates, respectively, for each of our taxable years, regardless of whether or not distributions were received. The U.S. Holder’s basis in the subordinate voting shares will be increased to reflect taxed but undistributed income. Distributions of income that had previously been taxed will result in a corresponding reduction of basis in the subordinate voting shares and will not be taxed again as a distribution to the U.S. Holder. U.S. Holders desiring to make a qualified electing fund election should consult their tax advisors with respect to the advisability of making such election.

United States Backup Withholding and Information Reporting

A U.S. Holder will generally be subject to information reporting with respect to dividends paid on, or proceeds of the sale or other disposition of, our subordinate voting shares that are paid within the United States or through some U.S. related financial intermediaries to U.S. Holders, unless the U.S. Holder is a corporation or comes within certain other categories of exempt recipients. A U.S. Holder that is not an exempt recipient will generally be subject to backup withholding with respect to the proceeds from the sale or the disposition of, or with respect to dividends on, subordinate voting shares unless the U.S. Holder provides a taxpayer identification number and otherwise complies with applicable requirements of the backup withholding rules. In addition, backup withholding may apply if the U.S. Holder fails to provide an accurate taxpayer identification number, or to report interest and dividends required to be shown on its federal income tax returns. Backup withholding is not an additional tax. Any amount withheld under these rules will be creditable against the U.S. Holder’s U.S. federal income tax liability or refundable to the extent that it exceeds such liability. A U.S Holder who does not provide a correct taxpayer identification number may be subject to penalties imposed by the United States Internal Revenue Service.

Non-U.S. Holders will generally be subject to information reporting and possible backup withholding with respect to the proceeds of the sale or other disposition of subordinate voting shares effected within the United States, unless the holder certifies to its foreign status or otherwise establishes an exemption and the broker does not have actual knowledge or reason to know that the holder is a U.S. holder. Payments of dividends on or proceeds from the sale of subordinate voting shares within the United States by a payor within the United States to a non-exempt U.S. or Non-U.S. Holder will be subject to backup withholding if such holder fails to provide appropriate certification. In the case of such payments by a payor within the United States to a foreign partnership other than a foreign partnership that qualifies as a “withholding foreign partnership” within the meaning of such Treasury regulations, the partners of such partnership will be required to provide the certification discussed above in order to establish an exemption from backup withholding tax and information reporting requirements.

Canadian Federal Income Tax Considerations

The following is a summary of the material Canadian federal income tax considerations generally applicable to a U.S. person who holds subordinate voting shares and who, for the purposes of the Income Tax Act (Canada) (the “ITA”), and the Canada-United States Income Tax Convention (1980) (the “Convention”), as applicable and at all relevant times:

Table of Contents

·	is resident in the United States and not resident in Canada,

·	holds the subordinate voting shares as capital property,

·	does not have a “permanent establishment” or “fixed base” in Canada, as defined in the Convention; and

·	deals at arm’s length with us. Special rules, which are not discussed below, may apply to “financial institutions”, as defined in the ITA, and to non-resident insurers carrying on an insurance business in Canada and elsewhere.

This discussion is based on the current provisions of the ITA and the Convention and on the regulations promulgated under the ITA, all specific proposals to amend the ITA or the regulations promulgated under the ITA announced by or on behalf of the Canadian Minister of Finance prior to the date of this annual report and the current published administrative practices of the Canada Customs and Revenue Agency. It does not otherwise take into account or anticipate any changes in law or administrative practice nor any income tax laws or considerations of any province or territory of Canada or any jurisdiction other than Canada, which may differ from the Canadian federal income tax consequences described in this document.

Under the ITA and the Convention, dividends paid or credited, or deemed to be paid or credited, on the subordinate voting shares to a U.S. person who owns less than 10% of the voting shares will be subject to Canadian withholding tax at the rate of 15% of the gross amount of those dividends or deemed dividends. If a U.S. person is a corporation and owns 10% or more of the voting shares, the rate is reduced from 15% to 5%. Subject to specified limitations, a U.S. person may be entitled to credit against U.S. federal income tax liability for the amount of tax withheld by Canada.

Under the Convention, dividends paid to specified religious, scientific, charitable and similar tax exempt organizations and specified organizations that are resident and exempt from tax in the United States and that have complied with specified administrative procedures are exempt from this Canadian withholding tax.

A capital gain realized by a U.S. person on a disposition or deemed disposition of the subordinate voting shares will not be subject to tax under the ITA unless the subordinate voting shares constitute taxable Canadian property within the meaning of the ITA at the time of the disposition or deemed disposition. In general, the subordinate voting shares will not be “taxable Canadian property” to a U.S. person if they are listed on a prescribed stock exchange, which includes The Toronto Stock Exchange, unless, at any time within the five-year period immediately preceding the disposition, the U.S. person, persons with whom the U.S. person did not deal at arm’s length, or the U.S. person together with those persons, owned or had an interest in or a right to acquire more than 25% of any class or series of our shares.

If the subordinate voting shares are taxable Canadian property to a U.S. person, any capital gain realized on a disposition or deemed disposition of those subordinate voting shares will generally be exempt from tax by virtue of the Convention if the value of the subordinate voting shares at the time of the disposition or deemed disposition is not derived principally from real property, as defined by the Convention, situated in Canada. The determination as to whether Canadian tax would be applicable on a disposition or deemed disposition of the subordinate voting shares must be made at the time of the disposition or deemed disposition.

Holders of subordinate voting shares are urged to consult their own tax advisors to determine the particular tax consequences to them, including the application and effect of any state, local or foreign income and other tax laws, of the acquisition, ownership and disposition of subordinate voting shares.

F. Dividends and Paying Agents

Not Applicable.

G. Statement by Experts

Not Applicable.

Table of Contents

H. Documents on Display

Any statement in this annual report about any of our contracts or other documents is not necessarily complete. If the contract or document is filed as an exhibit to the registration statement, the contract or document is deemed to modify the description contained in this annual report. You must review the exhibits themselves for a complete description of the contract or document.

You may review a copy of our filings with the SEC, including exhibits and schedules filed with it, at the SEC’s public reference facilities at 100 F Street, N.E., Washington, D.C. 20549 and at the regional offices of the SEC located at 233 Broadway, New York, New York 10279 and at the Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain copies of such materials from the Public Reference Section of the SEC, Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC at 1-800-SEC-0330 for further information on the public reference rooms. The SEC maintains a Web site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC. Although we make many of our filings with the SEC electronically as a foreign private issuer, we are not obligated to do so.

You may read and copy any reports, statements or other information that we file with the SEC at the addresses indicated above and you may also access them electronically at the Web site set forth above. These SEC filings are also available to the public from commercial document retrieval services.

We are required to file reports and other information with the SEC under the Securities Exchange Act of 1934. Reports and other information filed by us with the SEC may be inspected and copied at the SEC’s public reference facilities described above. As a foreign private issuer, we are exempt from the rules under the Exchange Act prescribing the furnishing and content of proxy statements and our officers, Directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions contained in Section 16 of the Exchange Act. Under the Exchange Act, as a foreign private issuer, we are not required to publish financial statements as frequently or as promptly as United States companies.

I. Subsidiary Information

See Item 4.C. of this annual report.

Table of Contents

Item 11. Qualitative and Quantitative Disclosures about Market Risk

Market Risk

Currency Risk

Our measurement currency is the Canadian dollar. We are exposed to currency risks due to the export of our Canadian-manufactured products, the large majority of which are denominated in US dollars. These risks are partially hedged by operating expenses denominated in US dollars, the purchase of raw materials in US dollars and forward exchange contracts. The increased strength of the Canadian dollar, compared to the US dollar, over the last couple of years caused our operating expenses, as well as our foreign exchange loss, to increase. Any further increase in the value of the Canadian dollar in the upcoming months will negatively affect our results of operations.

We enter into forward exchange contracts to manage the risk of exchange rate fluctuations between the Canadian and US dollar on cash flows related to anticipated future revenue streams denominated in US dollars. We do not enter into forward exchange contracts for hedging purposes.

Considering the significant increase in the value of the Canadian dollar compared to the US dollar during fiscal 2005, we entered into additional forward exchange contracts to protect our results of operations. As at August 31, 2005, we held forward exchange contracts to sell US dollars at various forward exchange rates with a contractual value of $33.6 million compared to $63.8 million as at August 31, 2006.

The following table summarizes the forward exchange contracts in effect as at August 31, 2006, classified by expected transaction dates, none of which exceed three fiscal years, as well as the notional amounts of such contracts (in thousands of US dollars) along with the weighted average contractual exchange rates under such contracts. The notional amounts of such contracts are used to calculate the contractual payments to be made under these contracts.

	Years ending August 31,
	2007		2008		2009

Forward exchange contracts to sell US dollars in exchange for Canadian dollars Contractual amounts	$	37,000	$	17,800	$	9,000
Weighted average contractual exchange rates		1.1676		1.1388		1.1010

Fair Value

The fair value of forward exchange contracts, which represents the difference between their contractual amounts and their current trading values, amounted to an unrecognized gain of $5,451,000 as at August 31, 2006 ($2,937,000 as at August 31, 2005).

Interest rate risk

We are exposed to the impact of interest rate changes and changes in the market values of our short-term investments. We do not use derivative financial instruments for our short-term investments. As at August 31, 2006, our short-term investments consist of debt instruments issued by nine (six in 2005) high-credit quality corporations and trusts. These debt instruments bear interest at fixed rates and may have their fair market value adversely impacted due to a rise in interest rates. However, due to their very short-term maturity, we consider this risk to be insignificant. For the purposes of managing our cash position, we have established a cash management policy, which we follow and monitor on a regular basis. These short-term investments will be used for working capital and other general corporate purposes, including potential acquisitions.

Table of Contents

Credit risk

Financial instruments that potentially subject us to credit risk consist primarily of our cash, our short-term investments, our accounts receivable and our forward exchange contracts. As mentioned in the interest rate risk section, our short-term investments consist of debt instruments issued by high credit quality, corporations and trusts. Our cash and forward exchange contracts are held with or issued by high credit quality, financial institutions; therefore, we consider the risk of non-performance on these instruments to be remote.

Generally, we do not require collateral or other security from customers for trade accounts receivable; however, credit is extended to customers following an evaluation of creditworthiness. In addition, we perform ongoing credit reviews of all our customers and establish an allowance for doubtful accounts receivable when accounts are determined to be uncollectible. Allowance for doubtful accounts amounted to $352,000 and $451,000 as at August 31, 2005 and 2006, respectively.

Table of Contents

Item 12. Description of Securities Other than Equity Securities

Not Applicable.

PART II.

Item 13. Defaults, Dividends Arrearages and Delinquencies

Not Applicable.

Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds

Not Applicable.

Item 15. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as at the end of the period covered by this annual report. Based on that evaluation, the Chief Executive Officer and Chief Financial Office have concluded that these disclosure controls and procedures are effective.

(b) Management’s Annual Report on Internal Control over Financial Reporting

EXFO management is responsible for establishing and maintaining adequate internal control over financial reporting. EXFO’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in Canada. ¹

EXFO’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of EXFO; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles generally accepted in Canada, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of EXFO; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of EXFO’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

¹ Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in Canada (“Canadian GAAP”) and significant differences in measurement and disclosure from generally accepted accounting principles in United States (“U.S. GAAP”) are set out in note 20 to our consolidated financial statements included elsewhere in this annual report.

Table of Contents

The recent acquisition of Consultronics Limited has been excluded from management’s assessment of internal controls as at August 31, 2006, because it was acquired by the company on January 26, 2006, and it was not possible for management to conduct an assessment of Consultronics’ internal control over financial reporting in the period between the consummation date and the date of management’s assessment. The acquired business of Consultronics represented less than 10% of the company’s total consolidated assets and revenues as at and for the year ended August 31, 2006.

Management conducted an evaluation of the effectiveness of EXFO’s internal control over financial reporting based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that EXFO’s internal control over financial reporting was effective as at August 31, 2006.

(c) Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the period covered by this annual report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

100

Table of Contents

Item 16. [Reserved]

Item 16A . Audit Committee Financial Expert

Our Board of Directors has determined that Mr. André Tremblay, CA, chairman of our audit committee is an audit committee financial expert. Mr. Tremblay is independent of management. For a description of Mr. Tremblay’s education and experience, please refer to Item 6A. The other members of the Audit Committee are Mr. Pierre Marcouiller, Mr. Guy Marier and Mr. Michael Unger which are all Independent. For a description of their respective education and experience, please also refer to Item 6A.

Item 16B . Code of Ethics

In 2003, we adopted a code of ethics that applies to our chief executive officer, our chief financial officer and our manager of financial reporting and accounting. A copy of this code of ethics has been filed as exhibit 11.1 to last year annual report. In March 2005, the Board updated and adopted the following policies:

·	Board of Directors Corporate Governance Guidelines;

·	Code of Ethics for our Principal Executive Officer and Senior Financial Officers;

·	Ethics and Business Conduct Policy;

·	Statement of Reporting Ethical Violations (Whistle Blower).

A copy of those policies has been filed respectively as exhibits 11.2 through 11.5 inclusively to last year annual report. All these policies are also readily available on our website at www.exfo.com . Accordingly, we believe that our corporate governance practices are in alignment to current regulatory requirements.

As reported at item 7B of this annual report, previous to the coming into force of the requirement for a code of ethics, we had entered into a lease agreement with G. Lamonde Investissements financiers inc., a company controlled by our chief executive officer, for premises located at 465 Godin Avenue in Quebec City, Quebec and on September 1, 2004, we were released from our obligations under this lease with a final payment of $194,000. In addition, in September 2002, we acquired from G. Lamonde Investissements financiers inc. the building located at 436 Nolin Street. The purchase price paid was based on an independent third party valuation and the transaction was approved by our audit committee and Board of Directors with Mr. Lamonde abstaining.

Item 16C . Principal Accountant Fees and Services

Audit Fees

During the financial years ended August 31, 2005 and August 31, 2006, our principal accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $214,000 and $247,000 respectively for the audit of our annual consolidated financial statements and services in connection with statutory and regulatory filings.

Audit-Related Fees

During the financial years ended August 31, 2005 and August 31, 2006, our principal accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $62,000 and $148,000, respectively for services mainly related to Sarbanes-Oxley Act.

Tax Fees

During the financial years ended August 31, 2005 and August 31, 2006, our principal accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $185,000 and $210,000, respectively for services related to tax compliance, tax advice and tax planning.

All Other Fees

Not applicable.

101

Table of Contents

Audit Committee Pre-Approval Policies and Procedures

On September 25, 2002, our audit committee adopted a policy requiring prior approval by the audit committee of the annual audit plan and fees which has been integrated in the Audit Committee Charter (refer to Item 6C for further details on the Audit Committee Charter. In the event any adjustments to audit fees may be required during the course of a financial year, such adjustments shall be approved by the chairman of the audit committee, acting alone, and shall be reported to the full audit committee at its next meeting.

In the case of non-audit fees (excluding tax matters), the policy provides that proposals shall be submitted to the chairman of the audit committee and our chief financial officer at the same time and the chairman of the audit committee will be responsible for approval of such proposal, subject to any modifications that he may require. The chairman will make a report to the full audit committee at its next meeting.

As concerns tax services to be provided by our principal accountant, our policy provides that the principal accountant will present to the audit committee for pre-approval, on or before the beginning of each financial year, an engagement for tax matters that are foreseeable for the upcoming year and the audit committee shall be responsible for pre-approval thereof, subject to any modifications it may make to such proposals. In the event tax services are required that were not pre-approved by the audit committee, the procedure set forth in the previous paragraph will apply.

During the financial year ended on August 31, 2006, 100% of tax fees were approved by the audit committee pursuant to this policy. During the financial year ended on August 31, 2006, only full-time permanent employees of our principal accountant, PricewaterhouseCoopers LLP, performed work to audit our financial statements.

Item 16D. Exemptions from the Listing Standards for Audit Committees

Not Applicable.

Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers

Not Applicable.

PART III.

Item 17 . Financial Statements

Not Applicable.

Item 18 . Financial Statements

See pages F-2 to F-42.

102

Table of Contents

Item 19. Exhibits

Number	Exhibit
1.1	Amended Articles of Incorporation of EXFO (incorporated by reference to Exhibit 3.1 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
1.2	Amended By-laws of EXFO (incorporated by reference to Exhibit 1.2 of EXFO’s annual report on Form-20F dated January 15, 2003, File No. 000-30895).
1.3	Amended and Restated Articles of Incorporation of EXFO (incorporated by reference to Exhibit 1.3 of EXFO’s annual report on Form 20-F dated January 18, 2001, File No. 000-30895).
2.1	Form of Subordinate Voting Share Certificate (incorporated by reference to Exhibit 4.1 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
2.2	Form of Registration Rights Agreement between EXFO and Germain Lamonde dated July 6, 2000 ) (incorporated by reference to Exhibit 10.13 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
3.1	Form of Trust Agreement among EXFO, Germain Lamonde, GEXFO Investissements Technologiques inc., Fiducie Germain Lamonde and G. Lamonde Investissements Financiers inc. (incorporated by reference to Exhibit 4.2 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.1	Agreement of Merger and Plan of Reorganization, dated as of November 4, 2000, by and among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments, Inc., Robert G. Klimasewki, William G. May, Jr., David J. Farrell and William S. Gornall (incorporated by reference to Exhibit 4.1 of EXFO’s annual report on Form 20-F dated January 18, 2001, File No. 000-30895).
4.2	Amendment No. 1 to Agreement of Merger and Plan of Agreement, dated as of December 20, 2000, by and among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments, Inc., Robert G. Klimasewski, William G. May, Jr., David J. Farrell and William S. Gornall (incorporated by reference to Exhibit 4.2 of EXFO’s annual report on Form 20-F dated January 18, 2001, File No. 000-30895).
4.3	Agreement of Merger, dated as of August 20, 2001, by and among EXFO, Buyer Sub, and Avantas Networks Corporation and Shareholders of Avantas Networks corporation (incorporated by reference to Exhibit 4.3 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.4	Amendment No. 1 dated as of November 1, 2002 to Agreement of Merger, dated as of August 20, 2001, by and among EXFO, 3905268 Canada Inc., Avantas Networks Corporation and Shareholders of Avantas Networks (incorporated by reference to Exhibit 4.4 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.5	Offer to purchase shares of Nortech Fibronic Inc., dated February 6, 2000 among EXFO, Claude Adrien Noel, 9086-9314 Québec inc., Michel Bédard, Christine Bergeron and Société en Commandite Capidem Québec Enr. and Certificate of Closing, dated February 7, 2000 among the same parties (including summary in English) (incorporated by reference to Exhibit 10.2 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.6	Share Purchase Agreement, dated as of March 5, 2001, among EXFO Electro-Optical Engineering, Inc., John Kennedy, Glenn Harvey and EFOS Corporation (incorporated by reference to Exhibit 4.1 of EXFO’s Registration Statement on Form F-3 filed on July 13, 2001, File No. 333-65122).
4.7	Amendment Number One, dated as of March 15, 2001, to Share Purchase Agreement, dated as of March 5, 2001, among EXFO Electro-Optical Engineering, Inc., John Kennedy, Glenn Harvey and EFOS Corporation. (incorporated by reference to Exhibit 4.2 of EXFO’s Registration Statement on Form F-3 filed on July 13, 2001, File No. 333-65122).
4.8	Share Purchase Agreement, dated as of November 2, 2001 between JDS Uniphase Inc. and 3905268 Canada Inc. (incorporated by reference to Exhibit 4.8 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.9	Intellectual Property Assignment and Sale Agreement between EFOS Inc., EXFO Electro-Optical Engineering, Inc., John Kennedy, Glenn Harvey and EFOS Corporation. (incorporated by reference to Exhibit 4.3 of EXFO’s Registration Statement on Form F-3 filed on July 13, 2001, File No. 333-65122).

103

Table of Contents

4.10	Offer to acquire a building, dated February 23, 2000, between EXFO and Groupe Mirabau inc. and as accepted by Groupe Mirabau inc. on February 24, 2000 (including summary in English) (incorporated by reference to Exhibit 10.3 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.11	Lease Agreement, dated December 1, 1996, between EXFO and GEXFO Investissements Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1, 1999 (including summary in English) (incorporated by reference to Exhibit 10.4 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.12	Lease Agreement, dated March 1, 1996, between EXFO and GEXFO Investissements Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1, 1999 (including summary in English) (incorporated by reference to Exhibit 10.5 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.13	Lease renewal of the existing leases between 9080-9823 Québec inc. and EXFO, dated November 30, 2001(incorporated by reference to Exhibit 4.13 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.14	Loan Agreement between EXFO and GEXFO Investissements Technologiques inc., dated May 11, 1993, as assigned to 9080-9823 Québec inc. on September 1, 1999 (including summary in English) (incorporated by reference to Exhibit 10.9 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.15	Resolution of the Board of Directors of EXFO, dated September 1, 1999, authorizing EXFO to acquire GEXFO Distribution Internationale inc. from GEXFO Investissements Technologiques inc. (including summary in English) (incorporated by reference to Exhibit 10.10 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.16	Form of Promissory Note of EXFO issued to GEXFO Investissements Technologiques inc. dated June 27, 2000 ) (incorporated by reference to Exhibit 10.12 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.17	Term Loan Offer, dated March 28, 2000, among EXFO and National Bank of Canada as accepted by EXFO on April 3, 2000 (including summary in English) (incorporated by reference to Exhibit 10.11 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.18	Employment Agreement of Germain Lamonde dated May 29, 2000 (incorporated by reference to Exhibit 10.15 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.19	Employment Agreement of Bruce Bonini dated as of September 1, 2000 (incorporated by reference to Exhibit 4.24 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.20	Employment Agreement of Juan-Felipe Gonzalez dated as of September 1, 2000 (incorporated by reference to Exhibit 4.25 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.21	Employment Agreement of David J. Farrell dated as of December 20, 2000 (incorporated by reference to Exhibit 4.26 of EXFO’s annual report on Form 20-F dated January 18, 2002, File No. 000-30895).
4.22	Deferred Profit Sharing Plan, dated September 1, 1998 (incorporated by reference to Exhibit 10.6 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.23	Stock Option Plan, dated May 25, 2000 (incorporated by Reference to Exhibit 10.7 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.24	Share Plan, dated April 3, 2000 (incorporated by reference to Exhibit 10.8 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.25	Directors’ Compensation Plan (incorporated by reference to Exhibit 10.17 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No. 333-38956).
4.26	Restricted Stock Award Plan, dated December 20, 2000 (incorporated by reference to Exhibit 4.21 of EXFO’s annual report on Form 20-F dated January 18, 2001, File No. 000-30895).
4.27	Asset Purchase Agreement by and Among EXFO Electro-Optical Engineering Inc., EXFO Gnubi Products Group Inc., gnubi communications, L.P., gnubi communications General Partner, LLC, gnubi communications Limited Partner, LLC, gnubi communications, Inc., Voting Trust created by The Irrevocable Voting Trust Agreement Among Carol Abraham Bolton, Paul Abraham and James Ray Stevens, James Ray Stevens and Daniel J. Ernst dated September 5, 2002 (incorporated by reference to Exhibit 4.30 of EXFO’s annual report on Form 20-F dated January 15, 2003, File No. 000-30895).

104

Table of Contents

4.28	EXFO Protocol Inc. Executive Employment Agreement with Sami Yazdi signed November 2, 2001 (incorporated by reference to Exhibit 4.28 of EXFO’s annual report on Form 20-F dated January 15, 2003, File No. 000-30895).
4.29	Second Amending Agreement to the Employment Agreement of Bruce Bonini dated as of September 1, 2002, (incorporated by reference to Exhibit 4.29 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.30	Severance and General Release Agreement with Bruce Bonini dated August 8, 2003, (incorporated by reference to Exhibit 4.30 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.31	Separation Agreement and General Release with Sami Yazdi dated April 1, 2003, (incorporated by reference to Exhibit 4.31 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.32	Executive Employment Agreement of James Stevens dated as of October 4, 2003, (incorporated by reference to Exhibit 4.32 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.33	Termination Terms for John Holloran Jr. dated May 28, 2003, (incorporated by reference to Exhibit 4.33 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.34	Employment Agreement of Pierre Plamondon dated as of September 1, 2002, (incorporated by reference to Exhibit 4.34 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
4.35	Long-Term Incentive Plan, dated May 25, 2000, amended in October 2004 and effective January 12, 2005 (incorporated by reference to Exhibit 4.35 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
4.36	Deferred Share Unit Plan, effective January 12, 2005 (incorporated by reference to Exhibit 4.36 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
4.37	Asset Purchase Agreement by and Among EXFO Electro-Optical Engineering Inc., Consultronics Limited., Andre Rekai, Consultronics Europe Limited, Consultronics Development Kft. and Consultronics Inc. dated January 5, 2006.
8.1	Subsidiaries of EXFO (list included in Item 4C of this annual report).
11.1	Code of Ethics for senior financial officers, (incorporated by reference to Exhibit 11.1 of EXFO’s annual report on Form 20-F dated January 15, 2004, File No. 000-30895).
11.2	Board of Directors Corporate Governance Guidelines (incorporated by reference to Exhibit 11.2 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
11.3	Code of Ethics for our Principal Executive Officer and Senior Financial Officers (incorporated by reference to Exhibit 11.3 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
11.4	Ethics and Business Conduct Policy (incorporated by reference to Exhibit 11.4 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
11.5	Statement of Reporting Ethical Violations (Whistle Blower) (incorporated by reference to Exhibit 11.5 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
11.6	Audit Committee Charter (incorporated by reference to Exhibit 11.6 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
11.7	Human Resources Committee Charter (incorporated by reference to Exhibit 11.7 of EXFO’s annual report on Form 20-F dated November 29, 2005, File No. 000-30895).
12.1	Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
12.2	Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
13.1	Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
13.2	Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

105

Table of Contents

SIGNATURES

The registrant hereby certifies that it meets all of the requirements for filing on Form 20 -F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf.

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

1 Nature of Activities

EXFO Electro-Optical Engineering Inc. (“EXFO”) designs, manufactures and markets a comprehensive line of test and measurement solutions for the global telecommunications industry. The Telecom Division, which represents the company’s main business activity, offers integrated test solutions to network service providers, cable operators, system vendors and optical component manufacturers. The Life Sciences and Industrial Division mainly leverages core telecom technologies to offer value-added solutions for life sciences applications and high-precision assembly processes, such as those required for microelectronics, optoelectronics and medical devices. EXFO’s products are sold in approximately 70 countries around the world.

2 Summary of Significant Accounting Policies

Basis of presentation

These consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) in Canada and significant differences in measurement and disclosure from U.S. GAAP are set out in note 20. These consolidated financial statements include the accounts of the company and its domestic and international subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Accounting estimates

The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting years. Significant estimates include the allowance for doubtful accounts receivable, the amount of tax credits recoverable, the provision for excess and obsolete inventories, the useful lives of capital assets, the valuation of long-lived assets, the future income taxes valuation allowance, the amount of certain accrued liabilities and deferred revenue as well as stock-based compensation costs. Actual results could differ from those estimates.

Reporting currency

The measurement currency of the company is the Canadian dollar. The company has adopted the US dollar as its reporting currency. The financial statements are translated into the reporting currency using the current rate method. Under this method, the financial statements are translated into the reporting currency as follows: assets and liabilities are translated at the exchange rate in effect on the date of the balance sheet, while revenues and expenses are translated at the monthly average exchange rate. Foreign exchange gains and losses arising from such translation are included in the cumulative translation adjustment in shareholders’ equity.

In the event that management decides to declare dividends, such dividends would be declared in Canadian dollars.

F-6

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Foreign currency translation

Foreign currency transactions

Transactions denominated in currencies other than the measurement currency are translated into the measurement currency as follows: monetary assets and liabilities are translated at the exchange rate in effect on the date of the balance sheet, and revenues and expenses are translated at the exchange rate in effect on the date of the transaction. Non-monetary assets and liabilities are translated at historical rates. Foreign exchange gains and losses arising from such translation are reflected in the statements of earnings.

Foreign subsidiaries

The financial statements of integrated foreign operations are remeasured into the measurement currency using the temporal method. Under this method, monetary assets and liabilities are remeasured at the exchange rate in effect on the date of the balance sheet. Non-monetary assets and liabilities are remeasured at historical rates, unless such assets and liabilities are carried at market, in which case, they are remeasured at the exchange rate in effect on the date of the balance sheet. Revenues and expenses are remeasured at the monthly average exchange rate. Foreign exchange gains and losses arising from such remeasurement are reflected in the statements of earnings. The company has no self-sustaining foreign subsidiary for which the functional currency is not the US dollar.

Forward exchange contracts

Forward exchange contracts are utilized by the company to manage its foreign currency exposure. The company’s policy is not to utilize those derivative financial instruments for trading or speculative purposes.

The company’s forward exchange contracts, which are used to hedge anticipated US-dollar-denominated sales, qualify for hedge accounting; therefore, foreign exchange translation gains and losses on these contracts are recognized as an adjustment of the revenues when the corresponding hedged sales are recorded.

Realized and unrealized foreign exchange gains or losses associated with forward exchange contracts, which have been terminated or cease to be effective prior to maturity, are deferred in the balance sheet and recognized in the earnings of the period in which the underlying hedged transaction is recognized.

Short-term investments

Short-term investments are valued at the lower of cost and market value. Cost consists of acquisition cost plus amortization of discount or less amortization of premium. All investments with original maturity of three months or less and that are not required for the purposes of meeting short-term cash requirements are classified as short-term investments.

F-7

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Inventories

Inventories are valued on an average cost basis, at the lower of cost and replacement cost for raw materials and at the lower of cost and net realizable value for work in progress and finished goods.

Property, plant and equipment and amortization

Property, plant and equipment are recorded at cost less related government grants and research and development tax credits. Amortization is provided on a straight-line basis over the estimated useful lives as follows:

		Term
Land improvements		5 years
Buildings		25 years
Equipment		2 to 10 years
Leasehold improvements		The lesser of useful life and remaining lease term

Intangible assets, goodwill and amortization

Intangible assets primarily include the cost of core technology and software, net of accumulated amortization. Core technology represents the existing technology acquired in business combinations that has reached technological feasibility. Amortization is provided on a straight-line basis over the estimated useful lives of five years for core technology and four and ten years for software.

Goodwill represents the excess of the purchase price of acquired businesses over the estimated fair value of net identifiable assets acquired. Goodwill is not amortized but must be tested for impairment on an annual basis or more frequently if events or circumstances indicate that it might be impaired. Recoverability of goodwill is determined at the reporting unit level using a two-step approach. First, the carrying value of a reporting unit is compared to its fair value, which is determined based on a combination of discounted future cash flows and a market approach. If the carrying value of a reporting unit exceeds its fair value, the second step is performed. In this step, the amount of impairment loss, if any, represents the excess of the carrying value of goodwill over its fair value and the loss is charged to earnings in the period in which it is incurred. For the purposes of this impairment test, the fair value of goodwill is estimated in the same way as goodwill is determined in business combinations; that is, the excess of the fair value of a reporting unit over the estimated fair value of its net identifiable assets.

The company elected to perform its annual impairment test in May of each fiscal year for all its existing reporting units.

Impairment of long-lived assets

Long-lived assets are reviewed for impairment when events or circumstances indicate that cost may not be recoverable. Impairment exists when the carrying value of an asset or group of assets is greater than the undiscounted future cash flows expected to be provided by the asset or group of assets. The amount of impairment loss, if any, is the excess of the carrying value over the fair value. The company assesses fair value of long-lived assets based on discounted future cash flows.

F-8

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Warranty

The company offers its customers warranties of one to three years, depending on the specific products and terms of the purchase agreement. The company’s typical warranties require it to repair or replace defective products during the warranty period at no cost to the customer. Costs related to original warranties are accrued at the time of shipment, based upon estimates of expected rework and warranty costs to be incurred. Costs associated with separately priced extended warranties are expensed as incurred.

Revenue recognition

For products in which software is incidental, the company recognizes revenue when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed and determinable, and collection of the resulting receivable is reasonably assured. In addition, provisions are made for estimated returns, warranties and support obligations.

For products in which software is not incidental, revenues are separated into two categories: product and post-contract customer support (PCS) revenues, based upon vendor-specific objective evidence of fair value. Product revenues for these sales are recognized as described above. PCS revenues are deferred and recognized ratably over the years of the support arrangement. PCS revenues are recognized at the time the product is delivered when provided within one year of delivery; the costs of providing this support are insignificant (and accrued at the time of delivery) and no software upgrades are provided.

For all sales, the company uses a binding purchase order as evidence that a sales arrangement exists.

Delivery generally occurs when the product is handed over to a transporter for shipment.

At the time of the transaction, the company assesses whether the price associated with its revenue transaction is fixed and determinable and whether or not collection is reasonably assured. The company assesses whether the price is fixed and determinable based on the payment terms associated with the transaction. The company assesses collection based on a number of factors, including past transaction history and the creditworthiness of the customer. Generally, collateral or other security is not requested from customers.

Most sales arrangements do not generally include acceptance clauses. However, when a sales arrangement does include an acceptance provision, acceptance occurs upon the earliest of receipt of a written customer acceptance or expiration of the acceptance period. For these sales arrangements, the sale is recognized when acceptance occurs.

Revenue for extended warranties is recognized on a straight-line basis over the warranty period.

Advertising costs

Advertising costs are expensed as incurred.

F-9

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Government grants

Grants related to operating expenses are included in earnings when the related expenses are incurred. Grants related to capital expenditures are deducted from the related assets. Grants are included in earnings or deducted from the related assets, provided there is reasonable assurance that the company has complied and will comply with all the conditions related to the grant.

Research and development expenses

All expenses related to research, as well as development activities that do not meet generally accepted criteria for deferral are expensed as incurred, net of related tax credits and government grants. Development expenses that meet generally accepted criteria for deferral, in accordance with the Canadian Institute of Chartered Accountants (CICA) handbook Section 3450, “Research and Development”, are capitalized, net of related tax credits and government grants, and are amortized against earnings over the estimated benefit period. Research and development expenses are mainly comprised of salaries and related expenses, material costs as well as fees paid to third-party consultants.

As at August 31, 2006, the company had not deferred any development costs.

Income taxes

The company provides for income taxes using the liability method of tax allocation. Under this method, future income tax assets and liabilities are determined based on deductible or taxable temporary differences between financial statement values and tax values of assets and liabilities, using enacted income tax rates for the years in which the differences are expected to reverse.

The company establishes a valuation allowance against future income tax assets if, based on available information, it is more likely than not that some or all of the future income tax assets will not be realized. Since 2003, the company records a full valuation allowance against future income tax assets (note 16).

Earnings per share

Basic earnings per share are determined using the weighted average number of common shares outstanding during the year.

Diluted earnings per share are determined using the weighted average number of common shares outstanding during the year, plus the effect of dilutive potential common shares outstanding during the year. This method requires that diluted earnings per share be calculated (using the treasury stock method) as if all dilutive potential common shares had been exercised at the latest at the beginning of the year or on the date of issuance, as the case may be, and that the funds obtained thereby (plus an amount equivalent to the unamortized portion of related stock-based compensation costs) be used to purchase common shares of the company at the average market price of the common shares during the year.

F-10

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Stock-based compensation costs

Since September 1, 2003, the company accounts for all forms of employee stock-based compensation using the fair value-based method. Stock-based compensation costs are amortized to expense over the vesting periods.

Prior to fiscal 2004, no stock-based compensation costs were recognized for employee stock-based compensation. However, the company is required to disclose pro forma information with respect to net earnings (loss) and net earnings (loss) per share as if stock-based compensation costs were recognized in the financial statements for all reporting years using the fair value-based method for outstanding stock options granted prior to September 1, 2003 (note 14).

New accounting standards and pronouncements

In January 2005, the CICA issued four new accounting standards in relation to financial instruments: Section 3855, "Financial Instruments - Recognition and measurement"; Section 3865, "Hedges"; Section 1530, "Comprehensive Income"; and Section 3251, "Equity".

Section 3855 expands on Section 3860, "Financial Instruments - Disclosure and Presentation", by prescribing when a financial instrument is to be recognized on the balance sheet and at what amount. It also specifies how financial instrument gains and losses are to be presented in the financial statements.

Section 3865 provides an alternative to Section 3855 for entities that choose to designate qualifying transactions as hedges for accounting purposes. It replaces and expands on Accounting Guideline 13, "Hedging Relationships", and on the hedging guidance in Section 1650, "Foreign Currency Translation", by specifying how hedge accounting is applied and what disclosures it requires.

Section 1530, "Comprehensive Income", introduces a new requirement to temporarily present certain gains and losses outside net income.

Consequently, Section 3250, "Surplus", has been revised as Section 3251, "Equity".

Sections 1530, 3251, 3855 and 3865 apply to fiscal years beginning on or after October 1, 2006. The company will adopt these new standards on September 1, 2007. While the company is currently assessing the effects of these new standards, impacts consistent with the adjustments described under note 20 item b) of these consolidated financial statements are expected.

F-11

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

3 Business Combination

On January 26, 2006, the company acquired substantially all the assets of Consultronics Limited. Based in Toronto, Canada, and with operations in the United Kingdom and Hungary, Consultronics was a privately held company specializing in x-Digital Subscriber Line (xDSL), Internet Protocol TV and Voice-over-Internet Protocol (VoIP) test solutions for broadband access networks.

This acquisition was settled for a total cash consideration valued at $19,093,000 or $18,838,000 net of $255,000 of cash acquired. The total consideration includes severance expenses of $660,000 for the termination of employees of the acquired business as well as other acquisition-related costs of $822,000. As at August 31, 2006, a portion of the total consideration, in the amount of $816,000, was not yet paid. From this amount, $631,000 is related to severance expenses and has been recorded as restructuring charges payable (note 4), while the remainder of $185,000, relating to acquisition-related costs, has been recorded as an account payable related to a business combination (note 9). Severance expenses will be fully paid in fiscal 2007.

This acquisition was accounted for using the purchase method and, consequently, the results of operations of the acquired business have been included in the consolidated statement of earnings of the company since January 26, 2006, being the date of acquisition.

The purchase price, including acquisition-related costs, was allocated based on the estimated fair value of acquired net assets at the date of acquisition as follows:

Assets acquired
Current assets	$	5,135
Property, plant and equipment		3,115
Core technology		8,709
Current liabilities assumed		(2,826	)
Loans assumed		(402	)
Net identifiable assets acquired		13,731
Goodwill		5,107
Purchase price, net of cash acquired	$	18,838

Acquired core technology is amortized on a straight-line basis over its estimated useful life of five years.

This business, including acquired goodwill, reports to the Telecom Division. Acquired goodwill is deductible for tax purposes.

F-12

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

4 Special Charges

Impairment of long-lived assets

Fiscal 2004

In fiscal 2004, the company put one of its buildings (located in Quebec City) up for sale and received, at the beginning of fiscal 2005, a formal purchase offer for this building. Based on that offer, the company concluded that the building was impaired and it recorded an impairment loss of $620,000 in fiscal 2004, representing the excess of the carrying value of the building over its expected selling price. However, during the first quarter of fiscal 2005, some conditions of the formal purchase offer were not met and the offer was declined. During fiscal 2005, the company withdrew the building from the market and continued to use it. This building reported to the Telecom Division.

Fiscal 2006

In June 2006, the company entered into an agreement to sell its building (located in Rochester, NY) along with some equipment and it recorded an impairment charge of $604,000 in the third quarter of fiscal 2006, representing the excess of the carrying value of these assets over the net expected selling price of $1,200,000. The sale of these assets was finalized in the fourth quarter of 2006 for the net expected selling price. This amount is included in the other receivables in the balance sheet as at August 31, 2006, and it will be recovered in the first quarter of fiscal 2007. These assets report to the Life Science and Industrial Division.

Restructuring and other charges

Fiscal 2004 and 2005

During fiscal 2004, the company approved a restructuring plan to consolidate the operations of its Life Sciences and Industrial Division, transferring its Rochester, NY, operations mainly to its facilities in Toronto. This consolidation process, which started in August 2004, was completed during fiscal 2005.

Overall, for that process, the company incurred $2,515,000 in restructuring and other charges, from which $2,033,000 was recorded in fiscal 2004 and the remaining $482,000 was recorded in 2005. The overall costs, which were recorded in the restructuring and other charges in the statements of earnings of the corresponding years, are detailed as follows: $855,000 for severance expenses for the layoff of all employees at the Rochester facilities, $1,261,000 mainly for the impairment of the building in Rochester and the remaining $399,000 for other expenses such as training and recruiting expenses and transfer of assets.

Finally, in fiscal 2005 and 2004, the company recorded adjustments of $190,000 and $304,000, respectively to the fiscal 2003 and 2001 plans because actual charges, mainly for leased equipment, were lower than expected.

F-13

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following tables summarize changes in the restructuring charges payable since August 31, 2003:

Year ended August 31, 2006

	Balance as at August 31, 2005		Additions		Payments			Adjustments		Balance as at August 31, 2006
Fiscal 2006 plan (note 3)
Severance expenses	$	−	$	660	$	(29	)	$	−	$	631

Fiscal 2003 plan
Exited leased facilities		150		−		(90	)		−		60

Total for all plans (note 9)	$	150	$	660	$	(119	)	$	−	$	691

Year ended August 31, 2005

	Balance as at August 31, 2004		Additions		Payments			Adjustments			Balance as at August 31, 2005
Fiscal 2004 plan
Severance expenses	$	467	$	83	$	(550	)	$	−		$	−
Other	$	−	$	399	$	(399	)	$	−		$	−
		467		482		(949	)		−			−

Fiscal 2003 plan
Severance expenses		109		−		(77	)		(32	)		−
Exited leased facilities		386		−		(229	)		(7	)		150
Other		197		−		(46	)		(151	)		−
		692		−		(352	)		(190	)		150

Fiscal 2001 plan
Exited leased facilities		10		−		(10	)		−			−

Total for all plans (note 9)	$	1,169	$	482	$	(1,311	)	$	(190	)	$	150

F-14

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Year ended August 31, 2004

	Balance as at August 31, 2003		Additions		Payments			Adjustments			Balance as at August 31, 2004
Fiscal 2004 plan
Severance expenses	$	−	$	772	$	(305	)	$	−		$	467

Fiscal 2003 plan
Severance expenses		1,233		−		(870	)		(254	)		109
Exited leased facilities		748		−		(362	)		−			386
Other		295		−		(90	)		(8	)		197
		2,276		−		(1,322	)		(262	)		692

Fiscal 2002 plans
Other		68		−		(68	)		−			−

Fiscal 2001 plan
Exited leased facilities		124		−		(72	)		(42	)		10
Total for all plans	$	2,468	$	772	$	(1,767	)	$	(304	)	$	1,169

5 Inventories

	As at August 31,

		2006		2005

Raw materials	$	14,353	$	9,373
Work in progress		1,043		934
Finished goods		9,227		7,442

	$	24,623	$	17,749

F-15

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

6 Property, Plant and Equipment

	As at August 31,

	2006				2005

		Cost		Accumulated amortization		Cost		Accumulated amortization

Land and land improvements	$	4,249	$	1,082	$	3,179	$	815
Buildings		14,417		6,262		9,206		2,250
Equipment		33,562		28,263		33,216		29,553
Leasehold improvements		2,788		2,017		2,395		1,659

		55,016	$	37,624		47,996	$	34,277

Less:
Accumulated amortization		37,624				34,277

	$	17,392			$	13,719

As at August 31, 2005 and 2006, unpaid purchases of property, plant and equipment amounted to $111,000 and $176,000, respectively.

7 Intangible Assets and Goodwill

	As at August 31,

	2006				2005

		Cost		Accumulated amortization		Cost		Accumulated amortization

Core technology	$	47,629	$	38,972	$	35,554	$	32,214
Software		6,781		4,490		6,607		4,345

		54,410	$	43,462		42,161	$	36,559

Less:
Accumulated amortization		43,462				36,559

	$	10,948			$	5,602

F-16

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Amortization expenses for intangible assets in each of the next five fiscal years will amount to $2,877,000 in 2007, $2,337,000 in 2008, $2,252,000 in 2009, $2,200,000 in 2010 and $1,099,000 in 2011.

Changes in the carrying value of goodwill are as follows:

	As at August 31,

		2006		2005

Balance - Beginning of year	$	20,370	$	18,393
Addition from business combination (note 3)		5,107		−
Foreign currency translation adjustment		1,665		1,977

Balance - End of year (note 19)	$	27,142	$	20,370

8 Credit Facilities

The company has a line of credit that provides for advances of up to CA$10,000,000 (US$9,037,000). This line of credit bears interest at prime rate (prime rate in 2005). As at August 31, 2006, this line of credit was unused.

The company also has another line of credit, which provides for advances of up to CA$4,500,000 (US$4,067,000) for letters of guarantee. As at August 31, 2006, an amount of CA$2,073,000 (US$1,873,000) was reserved from this line of credit (note 12).

Finally, the company has a third line of credit of $12,000,000 for the foreign currency exposure related to its forward exchange contracts. As at August 31, 2006, an amount of $751,000 was reserved from this line of credit.

These lines of credit are renewable annually. Short-term investments, accounts receivable, inventories and all tangible and intangible assets of the company are pledged as collateral against these lines of credit.

9 Accounts Payable and Accrued Liabilities

	As at August 31,

		2006		2005

Trade	$	7,487	$	5,781
Salaries and social benefits		5,991		4,526
Warranty		1,006		725
Commissions		835		211
Restructuring charges (note 4)		691		150
Business combination (note 3)		185		−
Other		1,142		808

	$	17,337	$	12,201

F-17

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Changes in the warranty provision are as follows:

	As at August 31,

		2006			2005

Balance - Beginning of year	$	725		$	390
Provision		895			869
Settlements		(708	)		(583	)
Addition from business combination		31			−
Foreign currency translation adjustment		63			49

Balance - End of year	$	1,006		$	725

10 Long-Term Debt

	As at August 31,

		2006		2005

Loans collateralized by equipment, bearing interest at 4.9%, repayable in monthly installments of $10,600 including principal and interest, maturing in 2010	$	461	$	−
Loans collateralized by equipment, bearing interest at 9.6%, fully repaid in fiscal 2006		−		332

		461		332

Less: Current portion		107		134

	$	354	$	198

As at August 31, 2006, minimum principal repayments required in each of the next four years will amount to $107,000 in 2007, $113,000 in 2008, $118,000 in 2009 and $123,000 in 2010.

11 Commitments

The company entered into operating leases for certain of its premises and equipment, which expire at various dates through September 2013. As at August 31, 2006, minimum rentals payable under these operating leases in each of the next five years will amount to $1,748,000 in 2007, $1,223,000 in 2008, $1,177,000 in 2009, $1,200,000 in 2010 and $990,000 in 2011 for total commitments of $6,888,000.

For the years ended August 31, 2004, 2005 and 2006, rental expenses amounted to $1,219,000, $1,370,000 and $1,523,000, respectively.

F-18

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

12 Contingencies

Class action

On November 27, 2001, a class action suit was filed in the United States District Court for the Southern District of New York against the company, four of the underwriters of its Initial Public Offering and some of its executive officers pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and Sections 11, 12 and 16 of the Securities Act of 1933. This class action alleges that the company’s registration statement and prospectus filed with the Securities and Exchange Commission on June 29, 2000, contained material misrepresentations and/or omissions resulting from (i) the underwriters allegedly soliciting and receiving additional, excessive and undisclosed commissions from certain investors in exchange for which they allocated material portions of the shares issued in connection with the company’s Initial Public Offering; and (ii) the underwriters allegedly entering into agreements with customers whereby shares issued in connection with the company’s Initial Public Offering would be allocated to those customers in exchange for which customers agreed to purchase additional amounts of shares in the after-market at pre-determined prices.

On April 19, 2002, the plaintiffs filed an amended complaint containing master allegations against all of the underwriters in all of the 310 cases included in this class action and also filed an amended complaint containing allegations specific to four of the company’s underwriters, the company and two of its executive officers. In addition to the allegations mentioned above, the amended complaint alleges that the underwriters (i) used their analysts to manipulate the stock market; and (ii) implemented schemes that allowed issuer insiders to sell their shares rapidly after an initial public offering and benefit from high market prices. As concerns the company and its two executive officers in particular, the amended complaint alleges that (i) the company’s registration statement was materially false and misleading because it failed to disclose the additional commissions and compensation to be received by underwriters; (ii) the two named executive officers learned of or recklessly disregarded the alleged misconduct of the underwriters; (iii) the two named executive officers had motive and opportunity to engage in alleged wrongful conduct due to personal holdings of the company’s stock and the fact that an alleged artificially inflated stock price could be used as currency for acquisitions; and (iv) the two named executive officers, by virtue of their positions with the company, controlled the company and the contents of the registration statement and had the ability to prevent its issuance or cause it to be corrected. The plaintiffs in this suit seek an unspecified amount for damages suffered.

In July 2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint and a decision was rendered on February 19, 2003. Only one of the claims against the company was dismissed. On October 8, 2002, the claims against its officers were dismissed pursuant to the terms of Reservation of Rights and Tolling Agreements entered into with the plaintiffs.

F-19

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

In June 2003, a committee of the company’s Board of Directors conditionally approved a proposed settlement between the issuer defendants, the individual defendants, and the plaintiffs. If approved, the settlement would provide, among other things, a release of the company and of the individual defendants for the conduct alleged in the action to be wrongful in the amended complaint. The company would agree to undertake other responsibilities under the settlement, including agreeing to assign away, not assert, or release certain potential claims the company may have against its underwriters.

On June 25, 2004, the Plaintiffs moved for preliminary approval of the settlement. The court granted the preliminary approval motion on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the Notice Administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members beginning on November 15, 2005. A settlement fairness hearing was held on April 24, 2006; however, no ruling has been issued yet by the court. If the court determines that the settlement is fair to the class members, the settlement will be approved. The settlement provides that, if the plaintiffs do not obtain any recovery from the underwriter defendants, the members of the class action would receive an amount not expected to exceed $2,507,678. Any direct financial impact plus any legal fees are expected to be borne by the company’s insurance carriers. However, there can be no assurance that this proposed settlement would be approved and implemented in its current form, or at all. Therefore, it is not possible to predict the final outcome of the case, nor to determine the amount of any possible losses. If the settlement process fails, the company will continue to defend its position in this litigation that the claims against it, and its officers, are without merit. Accordingly, no provision for this case has been made in the consolidated financial statements as at August 31, 2006.

Letters of guarantee

As at August 31, 2006, in the normal course of its operations, the company had outstanding letters of guarantee of CA$2,073,000 (US$1,873,000), which expire at various dates through fiscal 2010 and that were reserved from one of the lines of credit (note 8) .

13 Share Capital

Authorized - unlimited as to number, without par value

Subordinate voting and participating, bearing a non-cumulative dividend to be determined by the Board of Directors, ranking pari passu with multiple voting shares

Multiple voting and participating, entitling to ten votes each, bearing a non-cumulative dividend to be determined by the Board of Directors, convertible at the holder’s option into subordinate voting shares on a one-for-one basis, ranking pari passu with subordinate voting shares

F-20

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following table summarizes the share capital activity since August 31, 2003:

	Multiple voting shares					Subordinate voting shares
	Number			Amount		Number			Amount			Total amount

Balance as at August 31, 2003		37,900,000		$	1		25,139,908		$	492,451		$	492,452

Public offering ⁽¹⁾		−			−		5,200,000			29,164			29,164
Exercise of stock options (note 14)		−			−		111,071			254			254
Exercise of restricted stock awards (note 14)		−			−		89,504			−			−
Redemption		−			−		(5,340	)		(5	)		(5	)
Resale		−			−		5,340			5			5
Share issue expenses		−			−		−			(137	)		(137	)

Balance as at August 31, 2004		37,900,000			1		30,540,483			521,732			521,733

Exercise of stock options (note 14)		−			−		71,699			148			148
Exercise of restricted stock awards (note 14)		−			−		53,592			−			−
Share issue expenses		−			−		−			(6	)		(6	)

Balance as at August 31, 2005		37,900,000			1		30,665,774			521,874			521,875

Exercise of stock options (note 14)		−			−		182,425			557			557
Exercise of restricted share units (note 14)		−			−		4,770			−			−
Conversion of multiple voting shares into subordinate voting shares		(757,000	)		−		757,000			−			−
Reclassification of stock-based compensation cost to share capital upon exercise of stock awards		−			−		−			200			200
Elimination of deficit by reduction of share capital ⁽²⁾		−			−		−			(373,711	)		(373,711	)

Balance as at August 31, 2006		37,143,000		$	1		31,609,969		$	148,920		$	148,921

(1)	On February 12, 2004, pursuant to a Canadian public offering, the company issued 5,200,000 subordinate voting shares for net proceeds of $29,164,000 (CA$38,438,400), after deduction of underwriting commission of $1,215,000 (CA$1,601,000).

(2)	Upon the approval of the Board of Directors dated August 31, 2006, the company eliminated its deficit against its share capital.

F-21

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

14 Stock-Based Compensation Plans

The maximum number of additional subordinate voting shares issuable under the Long-Term Incentive Plan and the Deferred Share Unit Plan cannot exceed 6,306,153 shares. The maximum number of subordinate voting shares that may be granted to any individual on an annual basis cannot exceed 5% of the number of outstanding subordinate voting shares.

Long-term incentive plan

In May 2000, the company established a Stock Option Plan for directors, executive officers and employees and those of the company’s subsidiaries, as determined by the Board of Directors. In January 2005, the company made certain amendments to the existing Stock Option Plan, including the renaming of the plan to Long-Term Incentive Plan, which includes stock options and restricted share units.

Stock Options

The exercise price of stock options granted under the Long-Term Incentive Plan is the market price of the common shares on the date of grant. Stock options granted under the plan generally expire ten years from the date of grant and generally vest over a four-year period, with 25% vesting on an annual basis commencing on the first anniversary of the date of grant. The Board of Directors may accelerate the vesting of any or all outstanding stock options upon the occurrence of a change of control.

The following table summarizes stock option activity since August 31, 2003:

	Years ended August 31,

	2006						2005						2004

	Number			Weighted average exercise price			Number			Weighted average exercise price			Number			Weighted average exercise price
				(CA$)						(CA$)						(CA$)
Outstanding - Beginning of year		2,763,759		$	19			2,934,518		$	21			3,176,613		$	23
Granted		31,992			6			246,233			6			536,500			5
Exercised		(182,425	)		(4	)		(71,699	)		(3	)		(111,071	)		(3	)
Forfeited		(173,951	)		(18	)		(345,293	)		(27	)		(667,524	)		(23	)

Outstanding - End of year		2,439,375		$	20			2,763,759		$	19			2,934,518		$	21

Exercisable - End of year		1,852,870		$	25			1,650,404		$	28			1,331,707		$	32

The intrinsic value of stock options exercised during the year ended August 31, 2006, was CA$552,000.

The weighted average grant-date fair value of stock options granted during fiscal 2004, 2005 and 2006 amounted to $2.73, $3.51 and $4.76, respectively.

F-22

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The fair value of stock awards granted in fiscal 2004, 2005 and 2006 was estimated using the Black-Scholes options valuation model with the following weighted average assumptions:

	Years ended August 31,

	2006	2005	2004

Risk-free interest rate	3.9%	3.6%	2.7%
Expected volatility (based on historical volatility)	87%	95%	100%
Dividend yield	Nil	Nil	Nil
Expected life	66 months	66 months	49 months

The company is required to make pro forma disclosures of net earnings (loss) and net earnings (loss) per share for any periods included in the financial statements, as if the fair value-based method of accounting had been applied to outstanding unvested awards granted prior to September 1, 2003. Consequently, if the fair value-based method had been applied to unvested stock options granted prior to September 1, 2003, and outstanding as at August 31, 2004, 2005 and 2006, the net earning (loss) per share and the pro forma net earning (loss) per share would have been the same for all reporting years.

The following table summarizes information about stock options as at August 31, 2006:

	Stock options outstanding									Stock options exercisable

Exercise price		Number		Weighted average exercise price			Aggregate intrinsic value		Weighted average remaining contractual life		Number		Weighted average exercise price			Aggregate intrinsic value
(CA$)				(CA$	)		(CA$	)					(CA$	)		(CA$	)
$2.50 to $3.36		419,655	$	2.50		$	1,402		6.1 years		273,313	$	2.50		$	913
$3.96 to $5.84		547,687		5.07			422		7.6 years		206,464		4.92			190
$6.22 to $9.02		193,200		6.52			−		7.4 years		94,260		6.82			−
$14.27 to $20.00		476,396		15.78			−		5.2 years		476,396		15.78			−
$29.70 to $43.00		564,436		36.27			−		4.2 years		564,436		36.27			−
$51.25 to $68.17		199,771		65.76			−		4.0 years		199,771		65.76			−
$83.66		38,230		83.66			−		4.0 years		38,230		83.66			−

		2,439,375	$	20.26		$	1,824		5.7 years		1,852,870	$	25.19		$	1,103

Restricted Share Units (RSUs)

RSUs are “phantom” shares that rise and fall in value based on the value of the company’s subordinate voting shares and are redeemable for actual subordinate voting shares or cash at the discretion of the Board of Directors on the vesting dates established by the Board of Directors at the time of grant. The vesting dates are subject to a minimum term of three years and a maximum term of ten years from the award date. RSUs granted under the plan expire at the latest ten years from the date of grant.

F-23

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following table summarizes RSUs activity since January 2005:

	Years ended August 31,

		2006		2005

Outstanding - Beginning of year		176,185		−
Granted		173,803		176,185
Exercised		(4,770	)	−
Forfeited		(17,341	)	−

Outstanding - End of year		327,877		176,185

None of the RSUs outstanding as at August 31, 2005 and 2006 were redeemable. As at August 31, 2006, the weighted average remaining contractual life of the outstanding RSUs was 8.9 years. The weighted average grant-date fair value of RSUs granted during fiscal 2005 and 2006 amounted to $4.68 and $5.39, respectively.

Deferred share unit plan

In January 2005, the company established a Deferred Share Unit (DSU) Plan for the members of the Board of Directors as part of their annual retainer fees. Each DSU entitles the Board members to receive one subordinate voting share. DSUs are acquired on the date of grant and will be redeemed in subordinate voting shares when the Board member will cease to be Director of the company.

The following table summarizes DSU activity since January 2005:

	Years ended August 31,

		2006	2005

Outstanding - Beginning of year		23,734	−
Granted		19,556	23,734

Outstanding - End of year		43,290	23,734

None of the DSUs outstanding as at August 31, 2005 and 2006 were redeemable. The weighted average grant-date fair value of DSUs granted during fiscal 2005 and 2006 amounted to $4.47 and $5.81.

Stock appreciation rights plan

In August 2001, the company established the Stock Appreciation Rights Plan for certain employees. Under that plan, eligible employees are entitled to receive a cash amount equivalent to the difference between the market price of the common shares on the date of exercise and the exercise price determined on the date of grant. Stock appreciation rights granted under the plan generally expire ten years from the date of grant and vest over a four-year period, with 25% vesting on an annual basis commencing on the first anniversary of the date of grant.

F-24

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following table summarizes stock appreciation rights activity since August 31, 2003:

	Years ended August 31,

	2006				2005				2004

		Number		Weighted average exercise price		Number		Weighted average exercise price		Number			Weighted average exercise price

Outstanding - Beginning of year		19,000	$	12		13,000	$	16		9,000		$	24
Granted		5,500		6		6,000		4		6,000			5
Forfeited		−		−		−		−		(2,000	)		(19	)

Outstanding - End of year		24,500	$	11		19,000	$	12		13,000		$	16

Exercisable - End of year		11,000	$	18		7,500	$	24		4,250		$	30

The following table summarizes information about stock appreciation rights as at August 31, 2006:

	Stock appreciation rights outstanding			Stock appreciation rights exercisable

Exercise price		Number	Weighted average remaining contractual life		Number

$2.21		2,000	6.6 years		1,500
$4.51 to $6.50		17,500	8.4 years		4,500
$22.25		2,500	4.4 years		2,500
$45.94		2,500	4.0 years		2,500

		24,500	7.4 years		11,000

Restricted stock award plan

In December 2000, the company established a Restricted Stock Award Plan for employees of EXFO Burleigh. This plan expired in December 2004. Each stock award entitled employees to receive one subordinate voting share at a purchase price of nil. Stock awards granted under the plan vested over a four-year period, with 25% vesting on an annual basis commencing on the first anniversary of the date of grant. According to the plan, upon the involuntary termination of a member of the defined management team, all outstanding restricted stock awards granted to such an employee automatically vested.

F-25

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following table summarizes restricted stock awards activity since August 31, 2003:

	Years ended August 31,

		2005		2004

Outstanding - Beginning of year		53,592		143,096
Exercised		(53,592	)	(89,504	)

Outstanding - End of year		−		53,592

15 Other Disclosures

Net research and development expenses

Net research and development expenses comprise the following:

	Years ended August 31,

		2006			2005			2004

Gross research and development expenses	$	19,488		$	15,878		$	15,668
Research and development tax credits and grants		(4,084	)		(3,688	)		(3,278	)

	$	15,404		$	12,190		$	12,390

Government grants

During 1998, the company entered into an agreement with the Quebec Minister of Industry, Commerce, Science and Technology (“The Minister”). Pursuant to this agreement, the Minister agreed to contribute, in the form of grants, up to CA$2,220,000 (US$1,995,000) over the period from January 1, 1998, through December 31, 2002, payable based on the number of full-time jobs created during that period.

Since the beginning of the program, the company has claimed and received the maximum amount of CA$2,220,000. However, these grants were subject to the condition that jobs created pursuant to the agreement be maintained for a period of at least five years from the date of creation. Since the beginning of the program, the company deferred in the balance sheet CA$1,450,000 (US$1,307,000) from the amounts received until it received the final approval by the sponsor of the program related to jobs created. In fiscal 2006, the sponsor of the program granted the company with its final approval and the company recorded a non-recurring revenue of CA$1,450,000 (US$1,307,000) in the earnings from operations in the statement of earnings of fiscal 2006.

F-26

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Furthermore, since 2000, companies operating in the Quebec City area are eligible for a refundable credit granted by the Quebec provincial government. This credit is earned based on the increase of eligible production and marketing salaries incurred in the Quebec City area at a rate of 40%. From the total amount received by the company so far under this program, CA$774,000 (US$700,000) was deferred and was included in government grants in the balance sheet. This amount will be recognized in the statement of earnings upon the final approval of eligible salaries by the sponsor of the program. Should repayments of any amounts received pursuant to this program be required, such repayments, less related deferred revenue, will be charged to earnings as the amount of any repayment becomes known.

Following is a summary of the classification of these and certain other grants and credits (government grants) in the statements of earnings of the reporting years.

Cost of sales for the years ended August 31, 2004, 2005 and 2006, is net of government grants of $3,000, $89,000 and $262,000, respectively.

Selling and administrative expenses for the years ended August 31, 2004, 2005 and 2006, are net of government grants of $5,000, $32,000 and $76,000, respectively.

Research and development expenses for the years ended August 31, 2004, 2005 and 2006, are net of government grants of $80,000, $22,000 and $4,000, respectively.

Defined contribution plans

The company maintains separate defined contribution plans for certain eligible employees. These plans, which are accounted for on an accrual basis, are summarized as follows:

·	Deferred profit-sharing plan

The company maintains a plan for certain eligible Canadian resident employees, under which the company may elect to contribute an amount equal to 2% (1% prior to June 2005) of an employee’s gross salary, provided that the employee has contributed at least 2% of his/her gross salary to a tax-deferred registered retirement savings plan. Cash contributions to this plan and expenses for the years ended August 31, 2004, 2005 and 2006, amounted to CA$141,000 (US$106,000), CA$221,000 (US$179,000) and CA$363,000 (US$316,000), respectively.

401K plan

The company maintains a 401K plan for eligible U.S. resident employees. Under this plan, the company must contribute an amount equal to 3% of an employee’s current compensation. During the years ended August 31, 2004, 2005 and 2006, the company recorded cash contributions and expenses totaling $187,000, $134,000 and $126,000, respectively.

F-27

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

16 Income Taxes

The reconciliation of the income tax provision calculated using the combined Canadian federal and provincial statutory income tax rate with the income tax provision in the financial statements is as follows:

	Years ended August 31,

		2006			2005			20 04

Income tax provision at combined Canadian federal and provincial statutory tax rate (32% in 2006, 31% in 2005 and 32% in 2004)	$	3,430		$	307		$	(3,011	)

Increase (decrease) due to:
Foreign income taxed at different rates		(85	)		(580	)		(767	)
Non-taxable income		(207	)		(827	)		(128	)
Non-deductible expenses		527			784			1,205
Tax deductions		−			(81	)		(169	)
Change in enacted rates		497			−			274
Effect of consolidation of subsidiaries		61			(209	)		(1,384	)
Previous year tax recovery		−			−			(1,406	)
Other		239			(146	)		446
Change in valuation allowance		(1,877	)		3,375			3,954

	$	2,585		$	2,623		$	(986	)
The income tax provision consists of the following:
Current
Canadian	$	2,573		$	2,513		$	(577	)
Other		12			110			(409	)

		2,585			2,623			(986	)
Future
Canadian		2,687			(1,445	)		(1,104	)
United States		(601	)		(1,723	)		(2,448	)
Other		(209	)		(207	)		(402	)

		1,877			(3,375	)		(3,954	)

Valuation allowance
Canadian		(2,687	)		1,445			1,104
United States		601			1,723			2,448
Other		209			207			402

		(1,877	)		3,375			3,954

	$	2,585		$	2,623		$	(986	)

Details of the company’s income taxes:
Earnings (loss) before income taxes
Canadian	$	13,202		$	3,092		$	(7,740	)
United States		(2,103	)		(953	)		(5,879	)
Other		(379	)		(1,150	)		4,209
	$	10,720		$	989		$	(9,410	)

Most of the company’s income tax provision for fiscal 2005 and 2006 represents income taxes payable at the Canadian federal level, which are reduced by research and development tax credits that are recorded against gross research and development expenses in the statements of earnings.

F-28

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Significant components of the company’s future income tax assets and liabilities are as follows:

	As at August 31,

		2006			2005

Future income tax assets
Long-lived assets	$	4,453		$	4,902
Provisions and accruals		7,315			7,406
Government grants		−			209
Deferred revenue		486			318
Share issue expenses		531			590
Research and development expenses		8,527			7,292
Losses carried forward		18,118			18,424

		39,430			39,141
Valuation allowance		(38,543	)		(38,406	)

		887			735

Future income tax liabilities
Research and development tax credits		(887	)		(735	)

Future income tax assets, net	$	−		$	−

As at August 31, 2006, the company had available operating losses in several tax jurisdictions, against which a full valuation allowance of $18,118,000 was recorded. The following table summarizes the year of expiry of these operating losses by tax jurisdiction:

	Canada				United States
Year of expiry	Federal		Provinces		and Other

2008	$	1,252	$	92	$	1,857
2009		5,186		394		599
2010		4,677		327		266
2011		168		86		-
2013		-		-		876
2015		1,666		1,670		-
2022		-		-		9,406
2023		-		-		11,621
2024		-		-		6,700
2025		-		-		6,690
2026		1,694		1,696		2,737
Indefinite		1,702		1,775		1,996

	$	16,345	$	6,040	$	42,748

As at August 31, 2006, in addition to operating losses, the company had available research and development expenses in Canada amounting to $33,745,000 at the federal level and $15,276,000 at the provincial level, against which a full valuation allowance of $8,527,000 was recorded. These expenses can be carried forward indefinitely against future years’ taxable income in their respective tax jurisdiction.

F-29

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Finally, as at August 31, 2006, the company had available research and development tax credits at the Canadian federal level in the amount of $3,697,000 that can be carried forward against future years’ income taxes payable over the next ten years. These tax credits were not recorded in the balance sheet as at August 31, 2006.

17 Earnings per Share

The following table summarizes the reconciliation of the basic weighted average number of shares outstanding and the diluted weighted average number of shares outstanding:

	Years ended August 31,

		200 6	200 5	2004

Basic weighted average number of shares outstanding (000’s)		68,643	68,526	66,020
Plus dilutive effect of:
Stock options (000’s)		502	422	502
Deferred share units (000’s)		31	8	−
Restricted share units (000’s)		99	8	−
Restricted stock awards (000’s)		−	17	93

Diluted weighted average number of shares outstanding (000’s)		69,275	68,981	66,615

Stock awards excluded from the calculation of the diluted weighted average number of shares outstanding because their exercise price was greater than the average market price of the common shares (000’s)		1,628	1,962	2,128

The diluted net loss per share for the years ended August 31, 2004 and 2005, was the same as the basic net loss per share since the dilutive effect of stock options, deferred share units, restricted share units and restricted stock awards should not be included in the calculation; otherwise, the effect would be anti-dilutive. Accordingly, diluted net loss per share for those years was calculated using the basic weighted average number of shares outstanding.

F-30

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

18 Financial Instruments

Short-term investments

Short-term investments consist of the following:

	As at August 31,

		2006		2005

Commercial paper denominated in Canadian dollars, bearing interest at annual rates of 3.92% to 4.31% in 2006 and 2.44% to 2.75% in 2005, maturing on different dates between September 2006 and January 2007 in fiscal 2006, and September 2005 and January 2006 in fiscal 2005	$	104,437	$	104,883

Fair value

Cash, accounts receivable, accounts payable and accrued liabilities as well as long-term debt, are financial instruments whose carrying values approximate their fair values.

The fair value of short-term investments, based on market value, amounted to $104,883,000 and $104,437,000 as at August 31, 2005 and 2006, respectively.

The fair value of forward exchange contracts, which represents the difference between their contractual amounts and their current trading value, amounted to unrecognized gains of $2,937,000 and $5,451,000 as at August 31, 2005 and 2006, respectively.

Credit risk

Financial instruments that potentially subject the company to credit risk consist primarily of cash, short-term investments, accounts receivable and forward exchange contracts. The company’s short-term investments consist of debt instruments issued by nine (six in 2005) quality high-credit corporations and trusts. The company’s cash and forward exchange contracts are held with or issued by quality high-credit financial institutions; therefore, the company considers the risk of non-performance on these instruments to be remote.

Generally, the company does not require collateral or other security from customers for trade accounts receivable; however, credit is extended to customers following an evaluation of creditworthiness. In addition, the company performs ongoing credit reviews of all its customers and establishes an allowance for doubtful accounts receivable when accounts are determined to be uncollectible. Allowance for doubtful accounts amounted to $352,000 and $451,000 as at August 31, 2005 and 2006, respectively.

F-31

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Interest rate risk

As at August 31, 2006, the company’s exposure to interest rate risk is summarized as follows:

Cash		Non-interest bearing
Short-term investments		As described above
Accounts receivable		Non-interest bearing
Accounts payable and accrued liabilities		Non-interest bearing
Long-term debt		As described in note 10

Forward exchange contracts

The company is exposed to currency risks as a result of its export sales of products manufactured in Canada, substantially all of which are denominated in US dollars. These risks are partially hedged by forward exchange contracts and certain operating expenses. As at August 31, 2005 and 2006, the company held contracts to sell US dollars at various forward rates, which are summarized as follows:

	Contractual amounts		Weighted average contractual forward rates

As at August 31, 2005
September 2005 to August 2006	$	26,000		1.2630
September 2006 to November 2007		7,600		1.2500
As at August 31, 2006
September 2006 to August 2007	$	37,000		1.1676
September 2007 to June 2009		26,800		1.1261

19 Segment Information

The company is organized under two reportable segments: the Telecom Division and the Life Sciences and Industrial Division. The Telecom Division offers integrated test solutions to network service providers, cable operators, system vendors and component manufacturers throughout the global telecommunications industry. The Life Sciences and Industrial Division mainly leverages developed and acquired core telecom technologies for high-precision assembly and research sectors.

The reporting structure reflects how the company manages its business and how it classifies its operations for planning and measuring performance.

F-32

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following tables present information by segment:

	Year ended August 31, 2006

	Telecom Division			Life Sciences and Industrial Division		Total

Sales	$	107,376		$	20,877	$	128,253
Earnings from operations	$	6,679		$	1,383	$	8,062
Unallocated items:
Interest and other income							3,253
Foreign exchange loss							(595	)

Earnings before income taxes							10,720
Income taxes							2,585

Net earnings for the year						$	8,135

Government grants (note 15)	$	(1,307	)	$	−	$	(1,307	)

Amortization of capital assets	$	6,689		$	1,228	$	7,917

Stock-based compensation costs	$	962		$	70	$	1,032

Impairment of long-lived assets (note 4)	$	−		$	604	$	604

Capital expenditures	$	3,049		$	329	$	3,378

	Year ended August 31, 2005

	Telecom Division		Life Sciences and Industrial Division			Total

Sales	$	80,120	$	17,096		$	97,216
Earnings (loss) from operations	$	763	$	(962	)	$	(199	)
Unallocated items:
Interest and other income							2,524
Foreign exchange loss							(1,336	)

Earnings before income taxes							989
Income taxes							2,623

Net loss for the year						$	(1,634	)

Amortization of capital assets	$	6,504	$	2,588		$	9,092

Stock-based compensation costs	$	897	$	66		$	963

Capital expenditures	$	1,408	$	93		$	1,501

F-33

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

	Year ended August 31, 2004

	Telecom Division			Life Sciences and Industrial Division			Total

Sales	$	58,882		$	15,748		$	74,630
Loss from operations	$	(5,557	)	$	(5,013	)	$	(10,570	)
Unallocated items:
Interest and other income								1,438
Foreign exchange loss								(278	)

Loss before income taxes								(9,410	)
Income taxes								(986	)

Net loss for the year							$	(8,424	)

Amortization of capital assets	$	6,643		$	3,372		$	10,015

Stock-based compensation costs	$	417		$	32		$	449

Impairment of long-lived assets (note 4)	$	620		$	−		$	620

Restructuring and other charges (note 4)	$	−		$	1,261		$	1,261

Capital expenditures	$	607		$	244		$	851

Total assets by reportable segment are detailed as follows:

	As at August 31,

		2006		2005

Telecom Division	$	93,853	$	64,655
Life Sciences and Industrial Division		11,339		11,449
Unallocated assets		113,967		114,853

	$	219,159	$	190,957

Unallocated assets are comprised of cash, short-term investments and income taxes and tax credits recoverable.

F-34

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Carrying value of goodwill by reportable segment is detailed as follows:

	As at August 31,

		2006		2005

Telecom Division	$	22,545	$	16,092
Life Sciences and Industrial Division		4,597		4,278

	$	27,142	$	20,370

Sales to external customers by geographic region are detailed as follows:

	Years ended August 31,

		2006		2005		2004

United States	$	59,457	$	56,282	$	40,019
Canada		8,767		6,830		5,818
Latin America		8,380		3,127		3,547

		76,604		66,239		49,384
Europe, Middle East and Africa		32,379		19,396		13,706
Asia-Pacific		19,270		11,581		11,540

	$	128,253	$	97,216	$	74,630

Sales were allocated to geographic regions based on the country of residence of the related customers. In fiscal 2004, 2005 and 2006, one customer represented more than 10% of sales with 13.8% of sales ($10,325,000) in fiscal 2004, 23.3% of sales ($22,629,000) in 2005 and 13.8% of sales ($17,706,000) in 2006. For fiscal 2004, 2005 and 2006, the most important customer purchased from the Telecom Division.

Long-lived assets by geographic region are detailed as follows:

	As at August 31,

		2006		2005

Canada	$	51,724	$	35,690
United States		3,758		5,601

	$	55,482	$	41,291

Long-lived assets consist of property, plant and equipment, the long-lived asset held for sale, intangible assets and goodwill.

F-35

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

20 United States Generally Accepted Accounting Principles

As a registrant with the Securities and Exchange Commission in the United States (SEC), the company is required to reconcile its financial statements for significant differences between generally accepted accounting principles as applied in Canada (Canadian GAAP) and those applied in the United States (U.S. GAAP). Furthermore, additional significant disclosures required under U.S. GAAP and Regulation S-X of the SEC are also provided in the accompanying financial statements and notes. The following summarizes the significant quantitative differences between Canadian and U.S. GAAP, as well as other significant disclosures required under U.S. GAAP and Regulation S-X of the SEC not already provided in the accompanying financial statements.

Reconciliation of net earnings (loss) to conform to U.S. GAAP

The following summary sets out the significant differences between the company’s reported net earnings (loss) and net earnings (loss) per share under Canadian GAAP as compared to U.S. GAAP. Please refer to corresponding explanatory notes in the Reconciliation Items section.

			Years ended August 31,

				2006			2005			2004

Net earnings (loss) for the year in accordance with Canadian GAAP			$	8,135		$	(1,634	)	$	(8,424	)
Stock-based compensation costs	a	)		−			−			(867	)
Unrealized losses on forward exchange contracts	b	)		−			(1,286	)		(280	)

Net earnings (loss) for the year in accordance with U.S. GAAP				8,135			(2,920	)		(9,571	)

Other comprehensive income (loss)

Foreign currency translation adjustment				12,322			15,669			5,969
Unrealized gains on forward exchange contracts	b	)		5,394			2,313			689
Reclassification of realized gains on forward exchange contracts in net earnings (loss)	b	)		(2,880	)		(65	)		−
Comprehensive income (loss)			$	22,971		$	14,997		$	(2,913	)

Basic and diluted net earnings (loss) per share in accordance with U.S. GAAP			$	0.12		$	(0.04	)	$	(0.14	)

Basic weighted average number of shares outstanding (000’s)				68,643			68,526			66,020
Diluted weighted average number of shares outstanding (000’s)				69,275			68,981			66,615

F-36

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Reconciliation of shareholders’ equity to conform to U.S. GAAP

The following summary sets out the significant differences between the company’s reported shareholders’ equity under Canadian GAAP as compared to U.S. GAAP. Please refer to the corresponding explanatory note in the Reconciliation Items section.

			As at August 31,

				2006			2005			2004

Shareholders’ equity in accordance with Canadian GAAP			$	196,234		$	173,400		$	157,327
Forward exchange contracts	b	)		5,451			2,937			1,975
Goodwill				(11,908	)		(11,042	)		(10,008	)

Shareholders’ equity in accordance with U.S. GAAP			$	189,777		$	165,295		$	149,294

F-37

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The following table summarizes the shareholders’ equity activity under U.S. GAAP since August 31, 2003:

	Share capital			Contributed surplus		Deficit			Deferred stock-based compensation costs			Other capital			Accumulated other comprehensive income		Shareholders’ equity

Balance as at August 31, 2003	$	565,291		$	1,519	$	(454,588	)	$	(1,278	)	$	5,429		$	5,219	$	121,592

Net loss for the year		−			−		(9,571	)		−			−			−		(9,571	)
Stock-based compensation costs		1,737			−		−			339			(760	)		−		1,316
Foreign currency translation adjustment		−			−		−			−			−			5,969		5,969
Unrealized gains on forward exchange contracts		−			−		−			−			−			689		689
Public offering (note 13)		29,164			−		−			−			−			−		29,164
Exercise of stock options (note 13)		254			−		−			−			−			−		254
Share issue expenses (note 13)		(137	)		−		−			−			−			−		(137	)
Premium on resale of share capital		−			18		−			−			−			−		18

Balance as at August 31, 2004		596,309			1,537		(464,159	)		(939	)		4,669			11,877		149,294

Net loss for the year		−			−		(2,920	)		−			−			−		(2,920	)
Stock-based compensation costs		1,213			−		−			(776	)		425			−		862
Foreign currency translation adjustment		−			−		−			−			−			15,669		15,669
Unrealized gains on forward exchange contracts		−			−		−			−			−			2,248		2,248
Exercise of stock options (note 13)		148			−		−			−			−			−		148
Share issue expenses (note 13)		(6	)		−		−			−			−			−		(6	)

Balance as at August 31, 2005		597,664			1,537		(467,079	)		(1,715	)		5,094			29,794		165,295

Net earnings for the year		−			−		8,135			−			−			−		8,135
Stock-based compensation costs		−			−		−			344			610			−		954
Foreign currency translation adjustment		−			−		−			−			−			12,322		12,322
Unrealized gains on forward exchange contracts		−			−		−			−			−			2,514		2,514
Exercise of stock options (note 13)		557			−		−			−			−			−		557
Reclassification of stock-based compensation costs upon exercise of stock awards (note 13)		200			−		−			−			(200	)		−		−

Balance as at August 31, 2006	$	598,421		$	1,537	$	(458,944	)	$	(1,371	)	$	5,504		$	44,630	$	189,777

F-38

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Accumulated other comprehensive income is comprised of the following:

			As at August 31,

				2006		2005		2004

Foreign currency translation adjustment
Current year			$	12,322	$	15,669	$	5,969
Cumulative effect of prior years				26,857		11,188		5,219

				39,179		26,857		11,188
Unrealized gains on forward exchange contracts	b	)
Current year				2,514		2,248		689
Cumulative effect of prior years				2,937		689		−

				5,451		2,937		689

			$	44,630	$	29,794	$	11,877

Statements of cash flows

For the years ended August 31, 2004, 2005 and 2006, there were no significant differences between the statements of cash flows under Canadian GAAP as compared to U.S. GAAP, except for the subtotal before change in non-cash operating items, whose presentation is not permitted under U.S. GAAP.

Reconciliation items

a) Accounting for stock-based compensation

Until August 31, 2003, and to conform to U.S. GAAP, the company measured stock-based compensation costs using the intrinsic value method (APB 25, "Accounting for Stock Issued to Employees"). However, since September 1, 2003, and as described in item e) below, the company accounts for stock-based compensation costs for awards granted after that date, using the fair value-based method to conform to Statement of Financial Accounting Standard (SFAS) 123, “Accounting for Stock-Based Compensation” and subsequently, SFAS123(R), “Share-Based Payments”.

Stock Purchase Plan

Under APB 25, compensation costs related to the stock purchase plan were measured as the difference between the fair value of the purchased stock and the purchase price paid by plan participants. Compensation costs were amortized to expense over a period of five years, being the restriction period. This plan terminated at the time of the Initial Public Offering on June 29, 2000. Compensation costs related to this plan became fully amortized during fiscal 2004.

F-39

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

Long-Term Incentive Plan

Until August 31, 2003, and under APB 25, compensation costs related to the long-term incentive plan were measured as the difference between the market price of the underlying stock at the date of grant and the exercise price of the stock option. These compensation costs were amortized to expense over the estimated vesting period up to a maximum of four years. Compensation costs related to stock options granted prior to September 1, 2003, and accounted for under APB 25 became fully amortized during fiscal 2004.

Restricted Stock Award Plan

Under APB 25, compensation costs related to the restricted stock award plan were measured as the difference between the market price of the underlying stock at the date of grant and the exercise price of the stock award, which was nil. These compensation costs were amortized to expense over the estimated vesting period up to a maximum of four years, being the acquisition period. Compensation costs related to this plan, which were accounted for under APB 25, became fully amortized during fiscal 2004.

Until August 31, 2003, no compensation costs were recognized for these stock-based compensation plans under Canadian GAAP.

b) Forward exchange contracts

The forward exchange contracts entered into by the company prior to September 1, 2003, did not qualify for hedge accounting treatment under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities”; accordingly, changes in the fair value of these derivatives were charged to earnings. However, on September 1, 2003, the company implemented the documentation for the designation, documentation and assessment of the effectiveness of its forward exchange contracts, for the purposes of applying hedge accounting. With this documentation in place, the forward exchange contracts entered into by the company since September 1, 2003, qualify for hedge accounting treatment under U.S. GAAP. Consequently, under U.S. GAAP, changes in the fair value of these contracts are charged to other comprehensive income. Upon the recognition of the hedged sales, accumulated changes in fair value are reclassified in the statements of earnings.

Under Canadian GAAP, foreign exchange translation gains and losses on forward exchange contracts are recognized as an adjustment of the revenue when the corresponding sales are recorded, regardless of whether the contracts were entered into before or after September 1, 2003.

Based on the portfolio of forward exchange contracts as at August 31, 2006, the company estimates that the portion of the unrealized gain on forward exchange contracts as of August 31, 2006, and that will be realized and reclassified to net earnings over the next fiscal year amounts to $2,872,000.

F-40

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

c) Research and development tax credits

Under Canadian GAAP, all research and development tax credits are recorded as a reduction of gross research and development expenses in the statements or earnings. Under U.S. GAAP, tax credits that are refundable against taxable income are recorded in the income taxes. These tax credits amounted to $1,761,000, $2,169,000 and $2,546,000 for fiscal 2004, 2005 and 2006, respectively. This difference has no impact on the net earnings (loss) and the net earnings (loss) per share figures for the reporting years.

d)	Elimination of deficit by reduction of share capital

As at August 31, 2006, under Canadian GAAP, the company proceeded to eliminate its deficit against its share capital (note 13). However, under U.S. GAAP, such elimination is not permitted, which creates a permanent difference of $373,711,000 in the deficit and the share capital between the Canadian GAAP and U.S. GAAP figures. This difference has no impact on the total amount of the shareholders’ equity.

e)	New accounting standards and pronouncements

Adopted in fiscal 2006

In November 2004, the Financial Accounting Standard Board (FASB) issued SFAS 151, “Inventory Costs”, an amendment to ARB No. 43, Chapter 4. The amendments made by SFAS 151 improves financial reporting by clarifying that any abnormal amount of idle facility expenses, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. This SFAS is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The company adopted this new statement on September 1, 2005, and its adoption had no significant impact on its financial statements.

In December 2004, the FASB issued SFAS 123(R), “Share-Based Payments”. This statement supersedes ABP 25, “Accounting for Stock Issued to Employees” and related implementation guidance, and revises SFAS 123 in a number of areas. Under SFAS 123(R), all forms of share-based payment to employees result in compensation cost recognized in financial statements. This statement is effective for fiscal years beginning after June 15, 2005. The company adopted this statement on September 1, 2005, using the modified prospective application method of transition and its adoption had no significant impact on its financial statements.

Under U.S. GAAP, until August 31, 2003, the company elected to measure compensation costs related to grants of stock options and stock awards using the intrinsic value method of accounting. In this instance, however, under SFAS 123(R), the company is required to make pro forma disclosures of net earnings (loss) and net earnings (loss) per share for any periods included in the financial statements that ended prior to the adoption of SFAS 123(R) (i.e., fiscal 2004 and 2005) as if the fair value-based method of accounting had been applied to outstanding unvested awards granted prior to September 1, 2003. Consequently, if the fair value-based method had been applied to these awards, the pro forma net earnings (loss) per share would have been the same as the net earnings (loss) per share for all reporting periods.

F-41

Table of Contents

EXFO Electro-Optical Engineering Inc.

Notes to Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)

The fair value of options or awards granted was estimated using the Black-Scholes options pricing model.

To be adopted after fiscal 2006

In May 2005, the FASB issued SFAS 154, “Accounting Changes and Errors Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3”. This statement replaces APB 20, “Accounting Changes” , and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” , and changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. In general, this statement requires a company to account for the adoption of a new accounting policy by applying the new principle to prior accounting periods as if that principle had always been adopted. This statement is effective for accounting changes or corrections of errors in fiscal years beginning after December 15, 2005.

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting to Uncertainty in Income Taxes”, which clarifies the accounting for uncertainties in income taxes recognized in accordance with SFAS 109, “Accounting for Income Taxes”. The interpretation is effective for fiscal years beginning after December 15, 2006. The company will adopt this interpretation on September 1, 2007, and has not yet assessed the impact its adoption will have on its financial statements.

F-42

Title of each class	Name of each exchange on which registered
Subordinate Voting Shares without par value	NASDAQ
Subordinate Voting Shares without par value	TSX

	Years ended August 31,
	2006			2005			2004			2003			2002
	(in thousands of US dollars, except share and per share data)
Consolidated Statements of Earnings Data:
*Amounts under Canadian GAAP*
Sales	$	128,253		$	97,216		$	74,630		$	61,930		$	68,330
Cost of sales ⁽¹⁾		57,275			44,059			34,556			36,197			52,366
Gross margin		70,978			53,157			40,074			25,733			15,964

Operating expenses
Selling and administrative		40,298			31,782			25,890			26,991			33,881
Net research and development		15,404			12,190			12,390			15,879			12,782
Amortization of property, plant and equipment		3,523			4,256			4,935			5,210			5,096
Amortization of intangible assets		4,394			4,836			5,080			5,676			12,451
Impairment of long-lived assets and goodwill		604			−			620			7,427			23,657
Government grants		(1,307	)		−			−			−			−
Restructuring and other charges		−			292			1,729			4,134			2,880
Total operating expenses		62,916			53,356			50,644			65,317			90,747
Earnings (loss) from operations		8,062			(199	)		(10,570	)		(39,584	)		(74,783	)
Interest and other income		3,253			2,524			1,438			1,245			1,456
Foreign exchange loss		(595	)		(1,336	)		(278	)		(1,552	)		(458	)
Earnings (loss) before income taxes and amortization and write-down of goodwill		10,720			989			(9,410	)		(39,891	)		(73,785	)
Income taxes		2,585			2,623			(986	)		15,059			(25,451	)
Earnings (loss) before amortization and write-down of goodwill		8,135			(1,634	)		(8,424	)		(54,950	)		(48,334	)
Amortization of goodwill		−			−			−			−			38,021
Write-down of goodwill		−			−			−			−			222,169
Net earnings (loss) for the year	$	8,135		$	(1,634	)	$	(8,424	)	$	(54,950	)	$	(308,524	)
Basic and diluted net earnings (loss) per share	$	0.12		$	(0.02	)	$	(0.13	)	$	(0.87	)	$	(5.09	)
Basic weighted average number of shares used in per share calculations (000’s)		68,643			68,526			66,020			62,852			60,666
Other consolidated statements of earnings data:
Gross research and development	$	19,488		$	15,878		$	15,668		$	17,133		$	17,005
Net research and development	$	15,404		$	12,190		$	12,390		$	15,879		$	12,782
*Amounts under U.S. GAAP*
Net earnings (loss) for the year	$	8,135		$	(2,920	)	$	(9,571	)	$	(48,201	)	$	(382,893	)
Basic and diluted net earnings (loss) per share	$	0.12		$	(0.04	)	$	(0.14	)	$	(0.77	)	$	(6.31	)
Basic weighted average number of shares used in per share calculations (000’s)		68,643			68,526			66,020			62,852			60,666

	As at August 31,
	2006		2005		2004		2003		2002
	(in thousands of US dollars)
Consolidated Balance Sheets Data:
*Amounts under Canadian GAAP*
Cash	$	6,853	$	7,119	$	5,159	$	5,366	$	9,128
Short-term investments		104,437		104,883		83,969		52,010		40,553
Working capital		143,985		135,288		115,141		76,659		91,374
Total assets		219,159		190,957		172,791		146,254		177,926
Long-term debt (excluding current portion)		354		198		332		453		564
Share capital		148,921		521,875		521,733		492,452		489,611
Shareholders’ equity	$	196,234	$	173,400	$	157,327	$	129,826	$	165,406
*Amounts under U.S. GAAP*
Cash	$	6,853	$	7,119	$	5,159	$	5,366	$	9,128
Short-term investments		104,437		104,883		83,969		52,010		40,553
Working capital		149,436		138,225		117,116		78,225		91,305
Total assets		212,702		182,852		164,758		138,020		161,314
Long-term debt (excluding current portion)		354		198		332		453		564
Share capital		598,421		597,664		596,309		565,291		560,943
Shareholders’ equity	$	189,777	$	165,295	$	149,294	$	121,592	$	150,999

		Format
Instrument Type	Typical Application	NSP Market			Manufacturer/R&D Market
		FTB 400 Modules	FTB 200 Modules	Handhelds	IQS-500 Modules	Benchtop Instruments
ADSL/ADSL2+ Service Verification Tool	Based on a DSL “golden modem”, these units are used to test the function, speed and quality of a DSL service at the subscriber premises.			X

Broadband source	Used for testing wavelength-dependent behavior of fiber cables and DWDM optical components.				X	X

Chromatic dispersion analyzer	Measures increasing levels of chromatic dispersion in high-capacity optical networks. Chromatic dispersion is a physical phenomenon inherent to optical fiber and optical components that causes information bits to spread along a network. This degrades the quality of the transmission signal and, in turn, limits the transmission speed carried by optical networks.	X

Clip-on coupling device	Clips to an optical fiber and allows non-invasive testing.			X

		Format
Instrument Type	Typical Application	NSP Market			Manufacturer/R&D Market
		FTB 400 Modules	FTB 200 Modules	Handhelds	IQS-500 Modules	Benchtop Instruments
Fibre Channel tester	Brings FC-0, FC-1 and FC-2 logical layer Fibre Channel testing to services delivered via transport protocols, such as DWDM, SONET /SDH and dark fiber. It provides valuable timing information and buffer credit estimation for Fibre Channel network deployment.	X			X

Gigabit Ethernet tester	Measures data integrity for high-speed Internet protocol telecommunications in metro and edge networks.	X	X		X

10 Gigabit Ethernet tester	Benchmarks and verifies high-speed 10 Gbit/s Ethernet network performance and service-level agreements.	X	X		X

HDTV, SDTV and IPTV service test instrument	Used to test the quality and functionality of standard and high definition television signals that are delivered over higher-rate ADSL, ADSL2+ and VDSL2 transmission technologies.			X

Laser wavelength meter	Performs high-accuracy, absolute wavelength measurements of continuous wave (CW) laser sources.					X

Laser spectrum analyzer	Performs high-resolution, spectral characterization of continuous CW laser sources					X

Telephone for traditional voice and VoIP service testing	Used by telephone line and DSL installers to test the proper functioning of both traditional and next-generation voice and data communication services.			X

Live fiber detector	Clips on to a fiber and is used to detect the presence and direction of a signal without interrupting the traffic.			X

Loss test set	Integrates a power meter and a light source to manually or automatically measure the loss of optical signal along a fiber.	X	X	X	X	X

Multiwavelength meter	Measures the power and drift for multiple wavelengths in a DWDM system.	X			X	X
Narrowly tunable laser	A laser that can be precisely tuned to simulate a DWDM light sources. Used primarily for testing optical amplifiers.				X

Next-generation SONET/SDH analyzer	Full SONET/SDH protocol testing functionality, including support for GFP, V.CAT, and LCAS next generation enhancements.	X			X

Optical amplifier	Boosts the power of laser sources. Used for the testing and calibration of test systems.				X

Optical coupler	Used in test system to combine sources or signals. Also used as splitters to monitor signals.				X

· CWDM/FTTH passive optical component test system	Used to automatically characterize all critical specifications, including spectral insertion loss, polarization-dependent loss and optical return loss of a CWDM passive component or a FTTH splitter with a high degree of accuracy, ease of use and speed.
· Cable assembly and component test system	Used to perform insertion loss and mandrel-free reflection measurements with the highest degree of accuracy and repeatability on short fiber assemblies (including multifiber patchcords, hybrids and fan-out patchcords) and components like PLC splitters and fiber arrays.
· DWDM passive component test system	Used to automatically characterize all critical specifications, including spectral insertion loss, polarization-dependent loss and optical return loss of a DWDM passive component with a high degree of accuracy, ease of use and speed.

Light Sources and Accessories
*Product Type*	*Product*	*Typical Application*
UV Light Sources	Novacure® Acticure® Omnicure® S1000 Omnicure® S2000	Used to initiate photo chemical reactions in polymer-based materials for a variety of end use applications. Examples include adhesive curing for manufacturing of high value-added items such as medical devices, micro-electronic and opto-electronic components, displays, and data storage devices.
Fluorescent Light Sources	X-Cite® 120XL X-Cite® 120 PC	Fluorescence light source that attaches directly to most microscopes currently sold by major microscopes manufacturers.

Computer Control Module	ACS-1000	Electronic interface module used to connect EXFO UV light sources to computers or computer networks for process automation.
Optical Accessories		Optional custom delivery optics used with EXFO UV light sources to tailor the properties of the light beam to end-user applications.
High Power Fiber Light Guide		Provides an equal distribution of light energy to multiple cure sites with 50% more throughput than standard fiber guides.
Optical Instruments
*Product Type*	*Product*	*Typical Application*
Radiometer	R5000 R2000	Handheld, broadband optical radiometers used in conjunction with EXFO UV light sources to ensure process quality control at the end-user location.
Cure-Site Radiometer		Attachments for the R2000 and R5000 radiometers that enable optical measurements under customer specific configurations. Examples include the cure-ring radiometer, which measures the output power of light from an EXFO cure ring; ideal for applications that requires a uniform 360° exposure.
Precise Motors/Stages	IW-700 Inchworm Motors	High-resolution optical alignment, fiber-optic alignment, semiconductor positioning, materials research.
	TSE-820 Inchworm Stages
	UHVL Inchworm Motors
Precision Positioning Instruments
*Product Type*	*Product Line*	*Typical Application*
Micromanipulators	PCS-6000 Micromanipulators	Electrophysiology research such as patch clamp recording experiments on cells from the brain and central nervous system.
Micromanipulators	PCS-5000 Micromanipulators
Microscope Platforms	Gibraltar Platform/Stage	Stable mechanical platforms that facilitate cellular research with micropositioning and microinjection systems.
Microinjection Systems	MIS-5000 Microinjection Manipulator	Microinjection and nuclear transfer for genetics and reproductive sciences research.
Microinjection Systems	PiezoDrill Inertial Impact Drill
Microelectrode Positioner	LSS-8000 Inchworm System	Electrophysiology research such as intracellular recording experiments

Location	Use of Space	Square Footage	Type of Interest
436 Nolin Street Quebec (Quebec)	Manufacturing of telecom products	44,164	Owned
400 Godin Avenue Quebec (Quebec)	Research and development, manufacturing, management and administration	128,800	Owned
2260 Argentia Road Mississauga (Ontario)	Partially occupied for research and development, manufacturing of life science and industrial products and administration	25,328 ⁽¹⁾	Leased
2650 Marie-Curie, St-Laurent (Quebec)	Research and development, manufacturing and administration	26,000	Leased
160 Drumlin Circle Concord (Ontario)	Fully occupied building for research and development, manufacturing of EXFO’s Copper Access Business Unit products, product management, administration	23,500	Owned
Vármegye utca 3-5 (Ausztria Ház) Budapest, Hungary	Research and development, services (installation, training, support and maintenance) and administration	2,500	Leased
Omega Enterprise Park Electron Way, Chandlers Ford, Hampshire England	Partially occupied for European customer service, sales management, administration and research and development	10,000	Leased

Strategic objectives for fiscal 2007	Key performance indicators for fiscal 2007
Increase sales through market-share gains	20% sales growth year-over-year
Maximize profitability	7% in earnings from operations
Focus on innovation	35% of sales from new products (on the market two years or less)

Consolidated statements of earnings data:		2006			2005			2004		2006		2005		2004
Sales	$	128,253		$	97,216		$	74,630		100.0	%	100.0	%	100.0	%
Cost of sales ⁽¹⁾		57,275			44,059			34,556		44.7		45.3		46.3
Gross margin		70,978			53,157			40,074		55.3		54.7		53.7
Operating expenses
Selling and administrative		40,298			31,782			25,890		31.4		32.7		34.7
Net research and development		15,404			12,190			12,390		12.0		12.5		16.6
Amortization of property, plant and equipment		3,523			4,256			4,935		2.7		4.4		6.6
Amortization of intangible assets		4,394			4,836			5,080		3.4		5.0		6.8
Impairment of long-lived assets		604			−			620		0.5		−		0.8
Government grants		(1,307	)		−			−		(1.0	)	−		−
Restructuring and other charges		−			292			1,729		−		0.3		2.3
Total operating expenses		62,916			53,356			50,644		49.0		54.9		67.8
Earnings (loss) from operations		8,062			(199	)		(10,570	)	6.3		(0.2	)	(14.1	)
Interest and other income		3,253			2,524			1,438		2.5		2.6		1.9
Foreign exchange loss		(595	)		(1,336	)		(278	)	(0.5	)	(1.4	)	(0.4	)
Earnings (loss) before income taxes		10,720			989			(9,410	)	8.3		1.0		(12.6	)
Income taxes		2,585			2,623			(986	)	2.0		2.7		(1.3	)
Net earnings (loss) for the year	$	8,135		$	(1,634	)	$	(8,424	)	6.3	%	(1.7	)%	(11.3	)%
Basic and diluted net earnings (loss) per share	$	0.12		$	(0.02	)	$	(0.13	)

Segment information
Sales:
Telecom Division	$	107,376		$	80,120		$	58,882		83.7	%	82.4	%	78.9	%
Life Sciences and Industrial Division		20,877			17,096			15,748		16.3		17.6		21.1
	$	128,253		$	97,216		$	74,630		100.0	%	100.0	%	100.0	%
Operating earnings (loss):
Telecom Division	$	6,679		$	763		$	(5,557	)	5.2	%	0.8	%	(7.4) %
Life Sciences and Industrial Division		1,383			(962	)		(5,013	)	1.1		(1.0	)	(6.7	)
	$	8,062		$	(199	)	$	(10,570	)	6.3	%	(0.2	)%	(14.1	)%
Research and development data
Gross research and development	$	19,488		$	15,878		$	15,668		15.2	%	16.3	%	21.0	%
Net research and development	$	15,404		$	12,190		$	12,390		12.0	%	12.5	%	16.6	%

Consolidated balance sheets data:
Total assets	$	219,159		$	190,957		$	172,791

(1) The cost of sales is exclusive of amortization, shown separately.

Year ending August 31,		2007		2008		2009		2010		2011 and later		Total

Long-term debt	$	107,000	$	113,000	$	118,000	$	123,000	$	−	$	461,000
Operating leases		1,748,000		1,223,000		1,177,000		1,200,000		1,540,000		6,888,000

Total commitments	$	1,855,000	$	1,336,000	$	1,295,000	$	1,323,000	$	1,540,000	$	7,349,000

Expiry dates:	Contractual amounts		Weighted average contractual forward rates
September 2006 to August 2007	$	37,000,000	1.1676
September 2007 to June 2009		26,800,000	1.1261

Stock Options	Number	% of issued and outstanding	Weighted average exercise price
Chairman of the Board, President and CEO (one individual)	179,642	7%	$	9.05
Board of Directors (five individuals)	194,375	8%	$	6.23
Management and Corporate Officers (eight individuals)	313,836	13%	$	15.42
	687,853	28%	$	11.16

Restricted Share Units (RSUs)	Number	% of issued and outstanding
Chairman of the Board, President and CEO (one individual)	59,913	14%
Management and Corporate Officers (ten individuals)	255,616	60%
	315,529	74%

Deferred Share Units (DSUs)		Number		% of issued and outstanding
Board of Directors (five individuals)		43,290		100%

Name and Municipality of Residence		Positions with EXFO
STEPHEN BULL Quebec City, Quebec		Vice-President, Research and Development, Telecom Division
NORMAND DUROCHER St-Sauveur, Quebec		Vice-President, Human Resources
ALLAN FIRHOJ Georgestown, Ontario		Vice-President and General Manager, Life Sciences and Industrial Division
ROBERT FITTS Minesing, Ontario		Vice-President, Product Management - Copper Access Products
ÉTIENNE GAGNON Quebec City, Quebec		Vice-President, Product Management - Optical and Protocol Products
LUC GAGNON St-Augustin-de-Desmaures, Quebec		Vice-President, Telecom Manufacturing Operations
JUAN-FELIPE GONZÁLEZ Montreal, Quebec		Vice-President, Telecom Sales - International
GERMAIN LAMONDE Quebec City, Quebec		Chairman of the Board, President and Chief Executive Officer
PIERRE MARCOUILLER Magog, Quebec		Independent Director
GUY MARIER Lakefield Gore, Quebec		Independent Director
PIERRE PLAMONDON, CA Quebec City, Quebec		Vice-President, Finance and Chief Financial Officer
BENOIT RINGUETTE Quebec City, Quebec		Corporate Secretary and Legal Counsel
DAVID A. THOMPSON Newton, North Carolina		Independent Director
ANDRÉ TREMBLAY Outremont, Quebec		Independent Director
MICHAEL UNGER Richmond Hill, Ontario		Independent Lead Director
DANA YEARIAN Lake Forest, Illinois		Vice-President, Telecom Sales - North America

Annual Retainer for Directors: ⁽¹⁾	CA$50,000 ⁽²⁾	US$43,550 ⁽³⁾
Annual Retainer for Committee Chairman:	CA$5,000	US$4,355 ⁽³⁾
Annual Retainer for Committee Members:	CA$3,000	US$2,613 ⁽³⁾
Fees for all Meetings Attended per day in Person:	CA$1,000	US$871 ⁽³⁾
Fees for all Meetings Attended per day by Telephone:	CA$500	US$436 ⁽³⁾

Name	Annual Compensation Paid in Cash (US$) ⁽¹⁾	Annual Compensation Paid in DSUs (#) ⁽²⁾	Estimated Value of DSUs at the time of grant (US$) ⁽³⁾	Total Attendance Fees Paid in Cash (US$) ⁽¹⁾
Pierre Marcouiller ⁽⁴⁾	27,001	3,812	21,775	6,533
Guy Marier ⁽⁴⁾	27,001	3,812	21,775	6,968
David A. Thompson ⁽⁵⁾	27,613	4,308	25,000	3,049
André Tremblay ⁽⁶⁾	28,743	3,812	21,775	6,097
Michael Unger ⁽⁷⁾	28,743	3,812	21,775	6,533

Name and Principal Position	Financial Years	Salary ⁽¹⁾ ($)	Bonus ⁽²⁾ ($)	Other Annual Compensation ($)	Securities Under Options ⁽³⁾ (#)	Restricted Share Units ⁽⁴⁾ (#)	All Other Compensation ($)
Germain Lamonde, President and Chief Executive Officer	2006	271,753 ^(US) 312,000 ^(CA)	147,558 ^(US) 169,412 ^(CA)	−	11,218	21,477	−
	2005	243,605 ^(US) 300,000 ^(CA)	121,729 ^(US) 149,909 ^(CA)	−	17,942	13,089	−
	2004	206,751 ^(US) 275,000 ^(CA)	57,115 ^(US) 75,969 ^(CA)	−	−	−	−
Pierre Plamondon, Vice-President Finance and Chief Financial Officer	2006	165,691 ^(US) 190,230 ^(CA)	60,167 ^(US) 69,078 ^(CA)	−	3,653	6,994	4,283 ^(US) (5) 4,918 ^(CA)
	2005	151,441 ^(US) 186,500 ^(CA)	48,735 ^(US) 60,017 ^(CA)	−	5,383	33,927	2,316 ^(US) (5) 2,852 ^(CA)
	2004	135,328 ^(US) 180,000 ^(CA)	17,451 ^(US) 23,211 ^(CA)	−	−	−	1,429 ^(US) (5) 1,901 ^(CA)

Measure	Weighting Mr. Lamonde and Mr. Plamondon	Weighting Mr. Firhoj
Sales	35%	30%
Earnings	15%	25%
Gross margin	25%	25%
Customer satisfaction (quality and on time delivery)	25%	20%
Personal objectives (multiplier)	0% - 125%	0% - 125%

	Number of Options	% of Issued and Outstanding Options	Weighted Average Exercise Price ($US/Security)
President and CEO (one individual)	179,642	7.36%	9.05
Board of Directors (five individuals)	194,375	7.97%	6.23
Management and Corporate Officers (eight individuals)	313,836	12.87%	15.42

	Number of RSUs	% of Issued and Outstanding RSUs	Weighted Average Fair Value at the Time of Grant $US/RSU
President and CEO (one individual)	34,566	10.54%	4.73
Board of Directors (five individuals)	-	-	-
Management and Corporate Officers (ten individuals)	184,161	56,17%	4.66

Measure	Weighting ALL
Sales	35%
Earnings	15%
Gross margin	25%
Customer satisfaction (quality and on time delivery)	25%
Personal objectives (multiplier)	0% - 125%

	Number of DSUs	% of Issued and Outstanding DSUs	Weighted Average Fair Value at the Time of Grant $US/DSU
Board of Directors (five individuals)	43,290	100%	5.07

DSUs #	Weighted Average Fair Value at the Time of Grant US$/DSU	Vesting
19,556	5.81	At the time Director cease to be a member of the Board of the Corporation

RSUs #	Fair Value at the Time of Grant US$/RSU	Vesting ⁽¹⁾
61,253	4.76	100% on the fifth anniversary date of the grant in December 2005 subject to early vesting up to 1/3 on the third anniversary date of the grant and up to 50% of the remaining units on the fourth anniversary date of the grant if the performance objectives are fully attained. ⁽²⁾
86,700	5.59	50% on the third and fourth anniversary dates of the grant in February 2006. ⁽³⁾
1,500	6.50	50% on the third and fourth anniversary dates of the grant in February 2006. ⁽³⁾
13,850	6.58	50% on the third and fourth anniversary dates of the grant in February 2006. ⁽³⁾
3,500	5.90	50% on the third and fourth anniversary dates of the grant in June 2006. ⁽⁴⁾
2,000	6.27	50% on the third and fourth anniversary dates of the grant in June 2006. ⁽⁴⁾
5,000	5.16	1/3 on each of the third, fourth and fifth anniversary dates of the grant in August 2006 ⁽⁵⁾

Name	RSUs #	Percentage of Net Total of RSUs Granted to Employees in Financial Year (%)	Fair Value at the Time of Grant US$/RSU	Vesting ⁽¹⁾
Germain Lamonde	21,477	12.36	4.76	100% on the fifth anniversary date of the grant in December 2005 subject to early vesting up to 1/3 on the third anniversary date of the grant and up to 50% of the remaining units on the fourth anniversary date of the grant if the performance objectives are fully attained. ⁽²⁾
Pierre Plamondon	6,994	4.02	4.76	100% on the fifth anniversary date of the grant in December 2005 subject to early vesting up to 1/3 on the third anniversary date of the grant and up to 50% of the remaining units on the fourth anniversary date of the grant if the performance objectives are fully attained. ⁽²⁾

Name and Position or Office with the Corporation	Principal Occupation or Employment	Residence	Director Since
Germain Lamonde Chairman of the Board, President and Chief Executive Officer	Chairman of the Board, President and Chief Executive Officer, EXFO Electro-Optical Engineering Inc.	Quebec City, Quebec, Canada	September 1985
Pierre Marcouiller ^(1) (2) Independent Director	Chairman of the Board and Chief Executive Officer, Camoplast Inc. (a supplier of automotive and recreational vehicle parts)	Magog, Quebec, Canada	May 2000
Guy Marier ^(1) (2) Independent Director	Executive Consultant	Lakefield Gore, Quebec, Canada	January 2004
André Tremblay ^(2) (3) Independent Director	Founder and Managing Partner, Trio Capital Inc. (a private equity fund management company)	Outremont, Quebec, Canada	May 2000
Dr. David A. Thompson, Ph.D. ⁽²⁾ Independent Director	Vice-President& Director, Hardware & Equipment Technology Strategy, Corning Cable Systems (involved in manufacturing innovative products for the telecommunications industry) ⁽⁵⁾	Newton, North Carolina, USA	June 2000
Michael Unger ^(1) (4) Independent Lead Director	Executive Consultant	Richmond Hill , Ontario, Canada	May 2000

Name	Subordinate Voting Shares Owned		Currently Exercisable Options Owned as of November 1, 2006				Total Subordinate Voting Shares Beneficially Owned ⁽³⁾		Multiple Voting Shares Beneficially Owned ⁽³⁾		Total Percentage of Voting Power
	Subordinate Voting Shares Owned		In-the-money ⁽¹⁾		Out-the-money ⁽²⁾		Total Subordinate Voting Shares Beneficially Owned ⁽³⁾		Multiple Voting Shares Beneficially Owned ⁽³⁾		Total Percentage of Voting Power
	Number	Percent	Number	Percent	Number	Percent	Number	Percent	Number	Percent	Percent
Germain Lamonde ⁽⁴⁾	483,500	*	50,000	*	104,968	*	638,468	*	37,143,000	100	92.3
Pierre Plamondon	35,427 ⁽⁵⁾	*	20,000	*	54,631	*	110,058	*	−	−	*
Pierre Marcouiller	5,000	*	21,875	*	23,882	*	50,757	*	−	−	*
Guy Marier	1,000	*	−	*	6,250	*	7,250	*	−	−	*
David A. Thompson	2,100	*	21,875	*	17,734	*	41,709	*	−	−	*
André Tremblay	6,650 ⁽⁶⁾	*	21,875	*	19,691	*	48,216	*	−	−	*
Michael Unger	−	*	21,875	*	20,568	*	42,443	*	−	−	*

Name	Securities Under Options Granted ⁽¹⁾ (#)	Exercise Price ⁽²⁾ (US$/Security)	Expiration Date
Germain Lamonde	25,402 5,080 70,000 50,000 17,942 11,218	$26.00 $22.25 $9.13 $1.58 $4.51 $4.76	June 29, 2010 January 10, 2011 October 10, 2011 September 25, 2012 February 1, 2015 December 6, 2015
Pierre Plamondon	8,700 10,000 5,000 9,240 19,000 25,000 5,383 3,653	$26.00 $45.94 $34.07 $22.25 $9.13 $1.58 $5.13 $4.76	June 29, 2010 September 13, 2010 October 11, 2010 January 10, 2011 October 10, 2011 September 25, 2012 October 26, 2014 December 6, 2015

Name	DSUs			RSUs
Name	Number	Percentage	Estimated Average Value at the time of grant US$/DSU ⁽¹⁾	Number	Percentage	Fair Value at the time of grant US$/RSU ⁽²⁾
Germain Lamonde	−	−	−	13,089 ⁽³⁾	3.1%	4.69
	−	−	−	21,477 ⁽⁴⁾	5.0%	4.76
	−	−	−	25,347 ⁽⁵⁾	5.9%	6.02
Pierre Plamondon	−	−	−	3,927 ⁽³⁾	1.0%	4.69
	−	−	−	30,000 ⁽⁶⁾	7.0%	4.69
	−	−	−	6,994 ⁽⁴⁾	1.6%	4.76
	−	−	−	8,430 ⁽⁵⁾	2.0%	6.02
	−	−	−	4,500 ⁽⁷⁾	1.1%	6.02
Pierre Marcouiller	8,349 ⁽⁸⁾	19.3%	5.07	−	−	−
Guy Marier	8,349 ⁽⁸⁾	19.3%	5.07	−	−	−
David A. Thompson	9,894 ⁽⁸⁾	22.8%	5.07	−	−	−
André Tremblay	8,349 ⁽⁸⁾	19.3%	5.07	−	−	−
Michael Unger	8,349 ⁽⁸⁾	19.3%	5.07	−	−	−
Juan-Felipe Gonzalez	−	−	−	3,998 ⁽³⁾	0.9%	4.69
	−	−	−	30,000 ⁽⁶⁾	7.0%	4.69
	−	−	−	6,716 ⁽⁴⁾	1.6%	4.76
Allan Firhoj	−	−	−	2,443 ⁽³⁾	0.6%	4.69
	−	−	−	10,000 ⁽⁶⁾	2.3%	4.69
	−	−	−	4,602 ⁽⁴⁾	1.1%	4.76
	−	−	−	6,145 ⁽⁵⁾	1.4%	6.02
Dana Yearian	−	−	−	5,000 ⁽⁹⁾	1.2%	5.16
	−	−	−	6,645 ⁽⁵⁾	1.6%	6.02
Other executive officers as a group	−	−	−	9,023 ⁽³⁾	2.1%	4.69
	−	−	−	51,500 ⁽⁶⁾	12.1%	4.69
	−	−	−	16,708 ⁽⁴⁾	3.9%	4.76
	−	−	−	25,235 ⁽⁵⁾	5.9%	6.02
	−	−	−	20,500 ⁽⁷⁾	4.8%	6.02
All of the directors and executive officers as a group	−	−	−	32,480 ⁽³⁾	7.6%	4.69
	−	−	−	121,500 ⁽⁶⁾	28.4%	4.69
	−	−	−	56,497 ⁽⁴⁾	13.2%	4.76
	−	−	−	71,802 ⁽⁵⁾	16.8%	6.02
	43,290	100%	5.07	25,000 ⁽⁷⁾	5.9%	6.02

Designation of Class	Number of Securities held in escrow	Percentage of Class
Subordinate Voting Shares	nil	nil
Multiple Voting Shares	nil	nil

	Multiple Voting Shares Beneficially Owned ⁽¹⁾					Subordinate Voting Shares Beneficially Owned ⁽¹⁾					Total Percentage of Voting Power

Name	Number		Percent			Number		Percent			Percent

Germain Lamonde ⁽²⁾		37,143,000		100	%		483,500		1.53	%		92.27	%
Fiducie Germain Lamonde ⁽³⁾		1,900,000		5	%		Nil		Nil			4.71	%
G. Lamonde Investissements Financiers inc. ⁽⁴⁾		35,243,000		95	%		Nil		Nil			87.44	%
FMR Corporation ⁽⁵⁾		Nil		Nil			4,624,700		14.62	%		1.15	%
Kern Capital Management, LLC ⁽⁶⁾		Nil		Nil			4,596,700		14.53	%		1.14	%

Location	Square Footage	Annual Rent	Expiry Date
465 Godin	24,000	CA$144,000	November 30, 2006