UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 29, 2007

or

For the transition period from                 to

Commission File Number: 001-33301

ACCURAY INCORPORATED

(Exact Name of Registrant as Specified in Its Charter)

1310 Chesapeake Terrace
Sunnyvale, California    94089
(Address of Principal Executive Offices Including Zip Code)

(408) 716-4600
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file reports), and (2) has been subject to such filing requirements for the past 90 days.                      Yes   x  No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o  Accelerated filer o  Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).                    Yes o  No x

As of February 1, 2008, there were 55,126,775 shares of the Registrant’s Common Stock, par value $0.001 per share, outstanding.

Accuray Incorporated

Form 10-Q for the Quarter Ended December 31, 2007

Table of Contents

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PART I. FINANCIAL INFORMATION

Item 1.   Financial Statements

Accuray Incorporated

Condensed Consolidated Balance Sheets

(in thousands, except share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Accuray Incorporated

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Accuray Incorporated

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Accuray Incorporated

Notes to Condensed Consolidated Financial Statements

December 31, 2007 and 2006

1. DESCRIPTION OF BUSINESS

Organization

                Accuray Incorporated (the “Company”) was incorporated in California in December 1990 and commenced operations in January 1992. The Company was reincorporated in Delaware in February 2007 prior to the completion of its initial public offering (“IPO”).  The Company designs, develops and sells the CyberKnife system, an image-guided robotic radiosurgery system used for the treatment of solid tumors anywhere in the body.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Fiscal Year

                On October 1, 2006, the Company prospectively changed its fiscal calendar to a 52- or 53- week period.  The Company’s fiscal year ends on the Saturday closest to June 30^th, so that in a 52-week period, each fiscal quarter consists of 13 weeks. The additional week in a 53-week year is added to the fourth quarter, making such quarter consist of 14 weeks. Fiscal years 2008 and 2007 are both comprised of 52 weeks.  For ease of presentation purposes, the condensed financial statements and notes refer to December 31, 2007 and 2006 as the quarter end dates.

Basis of Presentation and Principles of Consolidation

                In December 2003, the Company formed a wholly owned subsidiary, Accuray International SARL, headquartered in Geneva, Switzerland. The purpose of Accuray International is to manage the sales, marketing and service activities of Accuray’s international subsidiaries. In January 2004, the Company formed a wholly owned subsidiary, Accuray Europe SARL, headquartered in Paris, France. The purpose of Accuray Europe is to market the Company’s products in Europe. In January 2005, the Company completed the purchase of the High Energy Systems Division (“HES”) of American Science and Engineering, Inc. (“AS&E”) and integrated this operation into the Company’s existing manufacturing operation. In October 2005, the Company formed a wholly owned subsidiary, Accuray UK Ltd, headquartered in London, United Kingdom. The purpose of Accuray UK is to market the Company’s products in the United Kingdom and other countries in northern Europe. In December 2005, the Company formed a wholly owned subsidiary, Accuray Asia Limited, headquartered in Hong Kong, SAR. The purpose of Accuray Asia is to market the Company’s products in Asia. In January 2007, the Company formed a wholly owned subsidiary, Japan Accuray KK, headquartered in Tokyo, Japan.  The purpose of Japan Accuray is to market the Company’s products in Japan.  In June 2007, the Company formed a wholly owned subsidiary, Accuray Spain, S.L.U.  The purpose of Accuray Spain is to market the Company’s products in Spain.  In December 2007, the Company formed a wholly owned subsidiary, Accuray Medical Equipment (India) Private Ltd. (“Accuray India”).  The purpose of Accuray India is to market the Company’s products in India.  The condensed consolidated financial statements include the accounts of the subsidiaries, and all inter-company transactions and balances have been eliminated.

The accompanying condensed consolidated balance sheet as of December 31, 2007, the condensed consolidated statements of operations for the three and six months ended December 31, 2007 and 2006, and the condensed consolidated statements of cash flows for the six months ended December 31, 2007 and 2006 and other information disclosed in the related notes are unaudited.  The condensed consolidated balance sheet as of June 30, 2007 was derived from the Company’s audited consolidated financial statements at that date.  The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the year ended June 30, 2007.

The accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“US GAAP”), pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and note disclosures required for complete financial statements have been condensed or omitted pursuant to such rules and regulations.  The unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial

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statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to fairly state the Company’s consolidated financial position as of December 31, 2007, consolidated results of operations for the three and six months ended December 31, 2007 and 2006 and cash flows for the six months ended December 31, 2007 and 2006.  The results for the three and six months ended December 31, 2007 are not necessarily indicative of the results to be expected for the year ending June 30, 2008 or for any other interim period or for any future year.  Certain prior period balances have been reclassified to conform to current period presentation.

Use of Estimates

                The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Key estimates and assumptions made by the Company relate to stock-based compensation, valuation allowances for deferred tax assets, valuation of excess and obsolete inventories, impairment of long-lived assets and goodwill, deferred revenue and deferred cost of revenue. Actual results could differ from those estimates.

Foreign Currency

                The Company’s international subsidiaries use their local currencies as their functional currencies. For those subsidiaries, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense accounts at average exchange rates during the year. Resulting translation adjustments are recorded directly to accumulated comprehensive income within the statement of stockholders’ equity. Foreign currency transaction gains and losses are included as a component of other income (expense).

Cash and Cash Equivalents

                The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash equivalents consist of amounts invested in money market accounts and amounted to $173.2 million and $191.4 million at December 31, 2007 and June 30, 2007, respectively.

Fair Value of Financial Instruments

                The carrying values of the Company’s financial instruments including cash and cash equivalents, accounts receivable and accounts payable are approximately equal to their respective fair values due to the relatively short-term nature of these instruments.

Concentration of Credit Risk and Other Risks and Uncertainties

                At December 31, 2007, the Company’s cash and cash equivalents were mainly deposited with one major financial institution.  In January 2008, the Company expanded its portfolio to include short-term securities which include fixed-income securities, commercial paper, term notes and marketable debt securities.  These investments are placed with high-credit quality financial institutions, which limits the credit exposure from any one financial institution or instrument.

Accounts receivable are typically not collateralized. The Company performs ongoing credit evaluations of its customers and maintains reserves for potential credit losses. Accounts receivable are deemed past due based on the contractual terms of the relevant customer contract. Accounts are charged against the allowance for doubtful accounts once collection efforts are unsuccessful. Historically, such losses have been within management’s expectations. The Company’s allowance for doubtful accounts was approximately $20,000 at both December 31, 2007 and June 30, 2007.  For the three and six months ended December 31, 2007, the Company had one customer that represented approximately 18% and 17% of revenue, respectively.  For the three months ended December 31, 2006, the Company had five customers that represented approximately 65% of revenue.  There were no customers that represented more than 10% of revenue for the six months ended December 31, 2006.  At December 31, 2007 and June 30, 2007, the Company had two and three customers that represented approximately 52% and 61% of accounts receivable, respectively.

                The Company is subject to risks common to companies in the medical device industry including, but not limited to: new technological innovations, dependence on key personnel, dependence on key suppliers, protection of proprietary technology, compliance with government regulations, uncertainty about widespread market acceptance of products and product liability. The Company’s products include components subject to rapid technological change. Certain components used in manufacturing have relatively few alternative sources of

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supply, and establishing additional or replacement suppliers for such components cannot be accomplished quickly. While the Company has ongoing programs to minimize the adverse affects of such uncertainty and considers technological change in estimating its allowances, uncertainty continues to exist.

                The products currently under development by the Company may require clearance by the U.S. Food and Drug Administration (“FDA”) or other international regulatory agencies prior to commercial sales. There can be no assurance that the Company’s products will receive the necessary clearance. If the Company is denied such clearance or such clearance is delayed, it could have a material adverse impact on the Company.

Inventories

                Inventories are stated at the lower of cost (on a first-in, first-out basis) or market. Excess and obsolete inventories are written down generally based on historical sales and forecasted demand, as judged by management. The Company determines inventory and product costs through the use of standard costs which approximate actual average costs.

Revenue Recognition

                Revenue is generated from the sale of products, shared ownership programs, and by providing related services, which can include installation services, post-contract customer support (“PCS”), training and consulting. The Company’s products include software that is essential to the functionality of the products and accordingly, the Company accounts for the sale of its products pursuant to Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition (“SOP 97-2”), as amended.

                The Company recognizes product revenues for sales of the CyberKnife system, additional upgrades, replacement parts and accessories when there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection of the fee is probable and delivery has occurred as prescribed by SOP 97-2. Customer payments received in advance of product shipment are recorded as customer advances and are recognized as revenue or deferred revenue upon product shipment or installation.

                For arrangements with multiple elements, the Company allocates arrangement consideration based upon vendor specific objective evidence (“VSOE”) of fair value of the respective elements. VSOE of fair value for the services element is based upon the Company’s standard rates charged for the services when such services are sold separately or based upon the price established by management having the relevant authority when that service is not yet being sold separately. When contracts contain multiple elements, and VSOE of fair value exists for all undelivered elements, the Company accounts for the delivered elements, principally the CyberKnife system, based upon the “residual method” as prescribed by SOP No. 98-9, Modification of SOP No. 97-2 with Respect to Certain Transactions. If VSOE of fair value does not exist for all the undelivered elements, all revenue is deferred until the earlier of: (1) delivery of all elements, or (2) establishment of VSOE of fair value for all undelivered elements.

                For PCS arrangements that include specified or committed upgrades for which the Company has not established VSOE of fair value, all revenue is deferred and accounted for as described above. Once all specified upgrade obligations have been delivered, all revenue is recognized ratably over the remaining life of the PCS arrangement.

                Sales of additional upgrades as optional extras prior to the delivery of all specified upgrade obligations are considered additional elements of the original arrangement and associated revenues are deferred and accounted for as described above.  Sales of additional upgrades after delivery of all specified upgrade obligations, as stated in the original contract, are considered separate arrangements and are recognized once all revenue recognition criteria are met.

In fiscal year 2006, the Company began selling PCS contracts that only provide for upgrades when and if they become available. The Company has established VSOE of the fair value of PCS in these circumstances.  For arrangements with multiple elements that include the CyberKnife system, installation services, training services and a PCS service agreement, the Company recognizes the CyberKnife system and installation services revenue following installation and acceptance of the system by application of the residual method as prescribed in SOP No. 98-9 when VSOE of fair value exists for all undelivered elements in the arrangement, including PCS.

                Other revenue primarily consists of upgrade revenues related to the sale of specialized services specifically contracted to provide current technology capabilities for units previously sold through a distributor into the Japan market. The upgrade programs include elements where VSOE of fair value has not been established for the PCS. As a result, associated revenues are deferred and recognized ratably over the term of the PCS arrangement, generally four years.

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                Service revenue for providing PCS, which includes warranty services, extended warranty services, unspecified when and if available product updates and technical support is deferred and recognized ratably over the service period, generally one year, until no further obligation exists. At the time of sale, the Company provides for the estimated incremental costs of meeting product warranty if the incremental warranty costs are expected to exceed the related service revenues. Training and consulting service revenues, that are not deemed essential to the functionality of the CyberKnife system, are recognized as such services are performed.

                Costs associated with providing PCS and maintenance services are expensed when incurred, except when those costs are related to units where revenue recognition has been deferred. In those cases, the costs are deferred until the recognition of the related revenue and are recognized over the period of revenue recognition.

                For all sales, the Company uses either a signed agreement or a binding purchase order as evidence of an arrangement. Sales to third party distributors are evidenced by distribution agreements governing each relationship together with binding purchase orders on a transaction-by-transaction basis. The Company records revenues from arrangements with distributors based on a sell-through method where revenue is recognized upon shipment of the product to the end user customer, and once all other revenue recognition criteria are met. These criteria require that persuasive evidence of an arrangement exists, the fees are fixed or determinable, collection of the resulting receivable is probable and there is no right of return.

                The Company’s agreements with customers and distributors generally do not contain product return rights.

                The Company assesses the probability of receivable collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. The Company generally does not request collateral from its customers. If the Company determines that collection of a receivable is not probable, the Company will defer recognition of the revenue until receipt of cash.

                The Company also enters into shared ownership programs with certain customers. Under the terms of such programs, the Company retains title to its CyberKnife system, while the customer has use of the product. The Company generally receives a minimum monthly payment and earns additional revenues from the customer based upon their use of the product. The Company may provide unspecified upgrades to the product during the term of each program when and if available. Upfront, non-refundable payments from the customer are deferred and recognized as revenue over the contractual period. Revenues from shared ownership programs are recorded as they become earned and receivable and are included within shared ownership program revenues in the consolidated statements of operations.

                The CyberKnife systems associated with the Company’s shared ownership programs are recorded within property and equipment and are depreciated over their estimated useful life of ten years. Depreciation and warranty expense attributable to the CyberKnife shared ownership systems are recorded within cost of shared ownership programs.  The shared ownership programs typically have a term of five years. During this term the customer has the option to purchase the CyberKnife system at pre-determined prices based on the period the system has been in use and considering the minimum monthly payment already received. Revenue from such sales is recorded in accordance with the Company’s revenue recognition policy, taking into account the PCS and any other elements that might be purchased as part of the arrangement. During the three and six months ended December 31, 2007, $3.4 million and $6.5 million, respectively, of products revenue was recognized in the consolidated statement of operations for the sale of two and three CyberKnife system units, respectively, that were formerly part of the Company’s shared ownership programs.  At December 31, 2007 and June 30, 2007, the Company had $600,000 and $3.6 million, respectively, recorded in deferred revenue related to the sale of such CyberKnife systems.

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Future minimum revenues under shared ownership arrangements as of December 31, 2007 are as follows (in thousands):

Total usage-based fee revenues, included in shared ownership revenue, earned from shared ownership programs were $2.3 million and $4.0 million for the three and six months ended December 31, 2007, respectively, and $2.0 million and $3.6 million for the three and six months ended December 31, 2006, respectively.

The Company also recognizes revenue and cost of revenue related to long-term manufacturing contracts using contract accounting on the percentage-of-completion method in accordance with SOP No. 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.  The Company recognizes any loss provisions from the total contract in the period such loss is identified. During the three and six months ended December 31, 2007 and 2006, no revenues or loss provisions have been recorded. As of December 31, 2007 and June 30, 2007, $945,000 and $323,000, respectively, of costs have been recorded in deferred cost of revenue related to the contract manufacture of  non-medical products.

Deferred Revenue and Deferred Cost of Revenue

                Deferred revenue consists of deferred product revenue, deferred shared ownership program revenue, deferred service revenue and deferred other revenue. Deferred product revenue arises from timing differences between the shipment of products and the satisfaction of all revenue recognition criteria consistent with the Company’s revenue recognition policy. Deferred shared ownership program revenue results from the receipt of advance monthly minimum lease payments, which is recognized ratably over the term of the shared ownership program. Deferred service revenue results from the advance payment by customers for services to be delivered over a period of time, usually one year. Service revenue is recognized ratably over the service period. Deferred other revenue results primarily from the Japan upgrade services programs and is due to timing differences between the receipt of cash payments for those upgrades and final delivery to the end user customer. Deferred cost of revenue consists of the direct costs associated with the manufacture of units, direct service costs and deferred costs associated with the Japan upgrade services programs for which the revenue has been deferred in accordance with the Company’s revenue recognition policies. Deferred revenue, and associated deferred cost of revenue, expected to be realized within one year are classified as current liabilities and current assets, respectively.

Impairment of Long-Lived Assets

                In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, the Company reviews long-lived assets, including property and equipment, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Under SFAS No. 144, an impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Through December 31, 2007, there have been no such impairment losses.

Stock-Based Compensation

Effective July 1, 2006, the Company adopted SFAS No. 123R, Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95 (“SFAS 123(R)”) using the modified prospective method under which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted or modified after the effective date and (b) based on the previous requirements of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) for all awards granted to employees prior to the effective date of SFAS 123(R) that remained unvested on the effective date. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under previous literature.

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                SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Stock-based compensation expense was recorded net of estimated forfeitures for the three and six months ended December 31, 2007 and 2006 such that expense was recorded only for those stock-based awards that are expected to vest.  During the six months ended December 31, 2006, upon adoption of SFAS 123(R), the Company recorded a cumulative effect of a change in accounting principle of approximately $838,000, net of tax of $0, to reflect this change in accounting for estimated forfeitures related to periods prior to July 1, 2006.

The Company believes that the fair value of the stock options granted is more reliably measurable than the fair value of the services received in exchange. Prior to the Company’s IPO, the Company engaged an unrelated third-party appraisal firm to assist management in this process by providing a valuation analysis that valued the Company’s common stock.   Following the IPO, the fair value of the Company’s common stock was determined by its closing market price as published by the Nasdaq Global Market.

Under SFAS 123(R), the Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the table below. Expected volatility was based on the historical volatility of a peer group of publicly traded companies. The expected term of stock options was based upon the vesting term of the Company’s stock options (i.e., 25% on the first anniversary of the vesting start date and 36 equal monthly installments thereafter) and on its partial life history. The risk-free rate for the expected term of the option was based on the U.S. Treasury Constant Maturity rate.

During the three and six months ended December 31, 2007, the estimated fair value of the stock options granted was calculated at each date of grant using the Black-Scholes option pricing model, using fair values of common stock between $12.80 and $29.25 per share.  For the three and six months ended December 31, 2007, the Company recognized $3.0 million and $6.2 million, respectively, of stock-based compensation expense for stock options granted to employees.  During the three and six months ended December 31, 2006, the Company recognized $2.9 million and $5.1 million, respectively, of stock-based compensation expense for stock options granted to employees.

The following weighted-average assumptions were used during the three and six months ended December 31, 2007 and 2006, respectively:

In January 2007, the Company implemented the 2007 Employee Stock Purchase Plan (“ESPP”).  Under the ESPP, qualified employees are entitled to purchase common stock at 85% of the fair market value on specified dates.  The estimated fair value of ESPP shares was calculated at the date of grant using the Black-Scholes option pricing model, using the fair value of the Company’s common stock as determined by its closing market price published by the Nasdaq Global Market, except for its initial purchase period, which used a fair value of common stock of $18.00 as determined by the Company’s public offering price.  Expected volatility was based on the historical volatility of a peer group of publicly traded companies. The expected term of options was based upon the offering period of the ESPP.  The risk-free rate for the expected term of the ESPP option was based on the U.S. Treasury Constant Maturity rate. For the three and six months ended December 31, 2007, the Company recognized $284,000 and $563,000, respectively, of compensation expense related to its ESPP.  The following weighted-average assumptions were used to value ESPP shares at the date of grant:

(1)   There were no ESPP shares granted during the three and six months ended December 31, 2006.

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During the three and six months ended December 31, 2007, the Company recognized $1.0 million and $1.8 million of stock-based compensation expense, net of forfeitures, for restricted stock units granted in connection with the 2007 Incentive Award Plan.   No restricted stock units were issued as of December 31, 2006.

Excess tax benefits from tax deductions for exercised options and disqualifying dispositions, in excess of the deferred tax asset attributable to stock compensation costs for such options are credited to additional paid-in capital. Realized excess tax benefits for the three and six months ended December 31, 2007 were $382,000 and $718,000, respectively.  There were no realized excess tax benefits for the three and six months ended December 31, 2006.

During the three and six months ended December 31, 2007, the Company capitalized stock-based compensation costs of $335,000 and $588,000 respectively, which were included as components of inventory and deferred cost of revenue.  No costs were capitalized during the three and six months ended December 31, 2006 due to immateriality.

Net Income Per Common Share

                Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of dilutive common shares outstanding during the period. Dilutive shares outstanding are calculated by adding to the weighted shares outstanding any common stock equivalents from outstanding stock options, restricted stock units and warrants based on the treasury stock method. In periods when net income is reported, the calculation of diluted net income per share typically results in lower earnings per share than is calculated using the basic method. In periods when a net loss is reported, potential shares from stock options, restricted stock units and warrants are not included in the calculation because they would have an anti-dilutive effect, meaning the loss per share would be reduced. Therefore, in periods when a loss is reported, the calculation of basic and diluted net loss per share results in the same value.

                For the three and six months ended December 31, 2007, basic net income per share was based on weighted-average shares of 54,736,764 and 54,380,054, respectively.  For the three and six months ended December 31, 2007, diluted net income per share was based on weighted-average shares of 61,292,905 and 61,256,532, respectively.  For the three and six months ended December 31, 2006, basic and diluted net income per share were based on weighted average shares of 16,209,175 and 16,234,121, respectively.  The number of anti-dilutive shares excluded from the calculation of diluted income per share was as follows:

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The following table sets forth the basic and diluted per share computations:

Income Taxes

The Company is required to estimate its income taxes in each of the tax jurisdictions in which it operates prior to the completion and filing of tax returns for such periods.  This process involves estimating actual current tax expense together with assessing temporary differences in the treatment of items for tax purposes versus financial accounting purposes that may create net deferred tax assets and liabilities.  For the three and six months ended December 31, 2007, the provision for income taxes was determined using the annual effective tax rate method for those entities which are projected to be profitable for the year.

The Company records a valuation allowance to reduce its deferred tax assets to the amount the Company believes is more likely than not to be realized.  Because of the uncertainty about the realization of the deferred tax assets, the Company has recorded a full valuation allowance against its deferred tax assets.

In June 2006, the FASB issued FASB Interpretation No. 48. Accounting for Uncertainty in Income Taxes (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement in accordance with SFAS No. 109, Accounting for Income Taxes (“FAS 109”), and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The Company adopted the provisions of FIN 48 effective July 1, 2007.

As a result of the implementation of FIN 48, the Company recognized a tax reserve for uncertain tax positions of $252,000, which was accounted for as a reduction to the July 1, 2007 balance of retained earnings.  Furthermore, the Company had $4.8 million of unrecognized tax benefits, all of which would affect its income tax expense if recognized.  The unrecognized tax benefits mainly relate to federal and state net operating losses and research tax credits.  There have been no material changes in unrecognized tax benefits since July 1, 2007.  The Company files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions.  Due to attributes being carried forward, the statue of limitations remains open for U.S., states, and non-U.S. income tax examinations for tax years from 1999 and forward.

In accordance with FIN 48, the Company classifies interest and penalties as a component of tax expense.  Such interest and penalties were immaterial as of December 31, 2007.

Segment Information

                The Company has determined that it operates in only one segment in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”) as it only reports profit and loss information on an aggregate basis to its chief operating decision maker. The Company’s long-lived assets maintained outside the United States are insignificant.

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The following summarizes revenue by geographic region (in thousands):

Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations (“SFAS 141R”).  SFAS 141R changes accounting for acquisitions that close beginning in 2009.  More transactions and events will qualify as business combinations and will be accounted for at fair value under the new standard.  SFAS 141R promotes greater use of fair values in financial reporting.  Some of the changes will introduce more volatility into earnings.  SFAS 141R is effective for fiscal years beginning on or after December 15, 2008.  The Company has not yet determined the impact this standard will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (“SFAS 159”), which allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities under an instrument-by-instrument election. Subsequent measurements for the financial assets and liabilities an entity elects to fair value will be recognized in earnings. SFAS 159 also establishes additional disclosure requirements. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted provided that the entity also adopts SFAS No. 157, “Fair Value Measurement” (“SFAS 157”). The Company has not yet determined the impact this standard will have on its consolidated financial statements.

In September 2006, the FASB issued SFAS 157. The standard defines fair value and provides a framework for using fair value to measure assets and liabilities. SFAS 157 establishes the principle that fair value should consider characteristics specific to the asset or liability based on the assumptions that market participants would use when pricing the asset or liability. SFAS 157 is effective for fiscal years beginning after November 15, 2007, though early adoption is permitted. The Company has not yet determined the impact this standard will have on its consolidated financial statements.

3. BALANCE SHEET COMPONENTS

Accounts receivable, net

Accounts receivable, net consists of the following (in thousands):

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Inventories

                Inventories are stated at the lower of cost (first-in, first-out) or market, and consist of the following (in thousands):

Property and Equipment, net

                Property and equipment, net consists of the following (in thousands):

                Depreciation and amortization expense related to property and equipment for the three months ended December 31, 2007 and 2006  was $2.0 million and $1.4 million, respectively. Depreciation and amortization expense related to property and equipment for the six months ended December 31, 2007 and 2006 was $3.8 million and $2.7 million, respectively.  Accumulated depreciation related to the CyberKnife systems attributable to the shared ownership programs at December 31, 2007 and June 30, 2007 was $3.8 million and $3.3 million, respectively.

4. GOODWILL AND OTHER PURCHASED INTANGIBLES

                In accordance with SFAS No.  142, Goodwill and Other Intangible Assets (“SFAS 142”), goodwill and other intangible assets with indefinite lives are not amortized.  Intangible assets with determinable useful lives are amortized on a straight line basis over their useful lives. SFAS 142 requires that the Company perform an annual test for impairment of intangible assets with indefinite lives, and interim tests if indications of potential impairment exist. The Company performed the annual test for impairment in December 2007 concluding that there was no impairment of goodwill.

                The amortization expense relating to intangible assets for both the three and six months ended December 31, 2007 was approximately $65,000 and $129,000.  The amortization expense relating to intangible assets for both the three and six months ended December 31, 2006 was approximately $64,000 and $129,000.  The following represents the gross carrying amounts and accumulated amortization of amortized intangible assets at December 31, 2007 and June 30, 2007 (in thousands):

                The following table represents the estimated useful life of the intangible assets subject to amortization:

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The estimated future amortization expense of purchased intangible assets as of December 31, 2007, is as follows (in thousands):

5. SERVICE PLAN CONTRACTS

                Service contract revenue for providing parts, warranty, product updates and upgrades and customer support is deferred and recognized ratably over the contractual service period, generally one year, until no further obligation exists.

                Deferred service contract revenue included in deferred revenue was (in thousands):

                Costs incurred under service contracts included in cost of revenue were approximately $6.3 million and $2.4 million for the three months ended December 31, 2007 and 2006, respectively. Costs incurred under service contracts included in cost of revenue were approximately $10.7 million and $3.4 million for the six months ended December 31, 2007 and 2006, respectively.

6. COMMITMENTS AND CONTINGENCIES

Royalty Agreements

                In January 1991, July 1997 and January 1999, the Company entered into license and royalty agreements in exchange for exclusive licenses to use certain technologies.  Under these agreements, the Company is obligated to pay a predetermined amount for each CyberKnife system shipped that includes the licensed technologies.   Royalty expense recognized in cost of revenue or deferred cost of revenue sold under these agreements amounted to approximately $113,000 and $182,000 during the three and six months ended December 31, 2007, respectively, and $105,000 and $314,000 for the three and six months ended December 31, 2006, respectively. Of these amounts, the expense recorded in relation to Stanford University (“Stanford”) was $50,000 and $80,000 for the three and six months ended December 31, 2007, respectively, and $40,000 and $70,000 for the three and six months ended December 31, 2006, respectively.  At December 31, 2007 and June 30, 2007, the Company had accrued amounts of approximately $130,000 and $90,000, respectively, which are included in other accrued liabilities in the condensed consolidated balance sheets relating to these license and royalty agreements. Of these amounts, approximately $50,000 and $45,000 at December 31, 2007 and June 30, 2007, respectively, were in relation to Stanford.

Contingencies

From time to time, the Company may become involved in litigation relating to claims arising from the ordinary course of business. Management does not believe the final disposition of these matters will have a material adverse effect on the financial position, results of operations or future cash flows of the Company.

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Software License Indemnity

                Under the terms of the Company’s software license agreements with its customers, the Company agrees that in the event the software sold infringes upon any patent, copyright, trademark, or any other proprietary right of a third party, it will indemnify its customer licensees, against any loss, expense, or liability from any damages that may be awarded against its customer. The Company includes this infringement indemnification in all of its software license agreements and selected managed services arrangements. In the event the customer cannot use the software or service due to infringement and the Company cannot obtain the right to use, replace or modify the license or service in a commercially feasible manner so that it no longer infringes, then the Company may terminate the license and provide the customer a refund of the fees paid by the customer for the infringing license or service. The Company has recorded no liability associated with this indemnification, as it is not aware of any pending or threatened actions that are probable losses.

7. COMMON STOCK

                As of December 31, 2007, 55,267,398 and 55,045,347 shares, of common stock were issued and outstanding, respectively. As of June 30, 2007, 53,798,643 shares of common stock were issued and outstanding.

In August 2007 the Company announced that the Board of Directors had approved a stock repurchase plan that authorized the Company to repurchase shares of its common stock.  Under the plan, the Company has the ability to acquire up to $25.0 million of common shares in the open market over a period of one year.  During the three months ended December 31, 2007, the Company has repurchased 183,888 shares of its common stock for $2.8 million at an average price of $15.33.  During the six months ended December 31, 2007, the Company had repurchased 222,051 shares of its common stock for $3.3 million at an average price of $15.05.  Such shares were not retired nor returned to the status of authorized, unissued shares.  Accordingly, such shares remain issued and classified as treasury stock as of December 31, 2007.  The Company accounts for its treasury stock under the par value method. At December 31, 2007, the par value of the Company’s treasury stock was immaterial.

In the period from January 1, 2008 through February 8, 2008 we repurchased 569,100 shares of our common stock for $7.3 million, at an average repurchase price of $12.77.

Stock Option Plans

In 1993, the Company’s stockholders approved the 1993 Stock Option Plan (the “1993 Plan”). Under the 1993 Plan, the Board of Directors is authorized to grant options to purchase shares of common stock at fair value, as determined by the Board of Directors, to employees, directors and consultants for up to 1,744,268 shares.

                In 1998, the Company’s stockholders approved the 1998 Equity Incentive Plan (the “1998 Plan”). Under the 1998 Plan, the Board of Directors is authorized to grant options to purchase shares of common stock to employees, directors and consultants for up to 14,100,000 shares.

                In 2007, in connection with the Company’s IPO, the Board of Directors approved the 2007 Incentive Award Plan (the “2007 Plan”).  Under the 2007 Plan, the Board of Directors is authorized to award stock-based grants to employees, directors, and consultants for up to 4,500,000 shares.  As of December 31, 2007, the 1993 Plan and the 1998 Plan continued to remain in effect along with the 2007 Plan; however, options can no longer be granted from the 1993 and 1998 Plans.

Generally, the Company’s outstanding options vest at a rate of 25% per year. However, certain options granted to certain employees vest based upon performance. Continued vesting typically terminates when the employment or consulting relationship ends.

                The maximum term of the options granted to persons who own at least 10% of the voting power of all outstanding stock on the date of grant is 5 years. The maximum term of all other options is 10 years.

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The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between the fair value of the Company’s common stock on December 31, 2007 of $15.01 over the exercise price for stock options) that would have been received by option holders if all options had been exercised on December 31, 2007. The total intrinsic value of options exercised in the three months ended December 31, 2007 and 2006 was approximately $8.1 million and $9,000, respectively. The total intrinsic value of options exercised in the six months ended December 31, 2007 and 2006 was approximately $17.6 million and $176,000, respectively. Cash received from option exercises for the three months ended December 31, 2007 and 2006 was $1.0 million and $6,000, respectively.  Cash received from option exercises for the six months ended December 31, 2007 and 2006 was $2.5 million and $52,000, respectively.

As of December 31, 2007, there was approximately $26.5 million, net of forfeitures, of unrecognized compensation cost related to unvested stock options which is expected to be recognized over a weighted-average period of 2.42 years. The Company’s current practice is to issue new shares to satisfy share option exercises.  The total fair value of shares vested during the three months ended December 31, 2007 and 2006 were $3.2 million and $2.0 million, respectively.  The total fair value of shares vested during the six months ended December 31, 2007 and 2006 were $8.0 million and $5.1 million, respectively.

The weighted average grant date fair values of options granted were $10.42 and $10.40 per share for the three months ended December 31, 2007 and 2006, respectively.  The weighted average grant date fair values of options granted were $9.22 and $10.39 per share for the six months ended December 31, 2007 and 2006, respectively.

Employee Stock Purchase Plan

                In  2007 the Board of Directors approved the 2007 Employee Stock Purchase Plan.  Under the ESPP, the Company is authorized to issue up to 1,000,000 shares of common stock.  Qualified employees may purchase shares of common stock through payroll deductions at a price per share that is 85% of the lesser of the fair market value of our common stock as of the beginning of an applicable offering period or the applicable purchase date, with purchases generally occurring every six months.  Employees’ payroll deductions may not exceed 10% of their compensation.  Employees may purchase up to 2,500 shares per period provided that the value of the shares purchased in any calendar year may not exceed $25,000, as calculated pursuant to the purchase plan.

                The ESPP was initiated during fiscal year 2007.  In November 2007, the Company issued approximately 134,000 shares in relation to its ESPP for $1.9 million.  The weighted average fair value ESPP option price was $6.11 for both the three and six months ended December 31, 2007.  The ESPP was not in affect as of December 31, 2006.  As of December 31, 2007, there was approximately $580,000 of unrecognized compensation cost related to the ESPP, which is expected to be recognized over the next five months.

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Restricted Stock Units

Under the 2007 Plan, restricted stock units are granted generally with a vest rate of 25% per year. However, certain restricted stock units granted to certain employees vest 10% upon the first year anniversary of the grant date, 20% upon the second year anniversary of the grant date, 30% upon the third year  anniversary of the grant date and 40% upon the fourth year anniversary of the grant date. Continued vesting typically terminates when the employment relationship ends.

Restricted stock unit activity for the six months ended December 31, 2007 was as follows:

As of December 31, 2007, there was approximately $16.7 million of unrecognized compensation cost related to restricted stock units, which is expected to be recognized over a weighted-average period of 3.16 years.

8. RELATED PARTY TRANSACTIONS

                The Company recognized revenue of approximately $1.3 million during each of the three months ended December 31, 2007 and 2006, respectively, and $2.5 million during each of the six months ended December 31, 2007 and 2006, respectively, relating to products and services provided to Meditec.  Meditec’s parent, Marubeni Corporation, is a stockholder of the Company. At December 31, 2007 and  June 30, 2007, amounts of $6.0 million and $7.7 million, respectively, were recorded as deferred revenue and customer advances relating to payments made by Meditec for certain products and services. At December 31, 2007 and June 30, 2007, $0 was due from Meditec.

                The Company recognized revenue of approximately $199,000 and $389,000 during the three months ended December 31, 2007 and 2006, respectively, and $369,000 and $3.5 million during the six months ended December 31, 2007 and 2006, respectively, relating to products and services provided to Stanford.   The Company’s former Chief Executive Officer, Dr. John R. Adler, Jr., is an active member of the faculty at Stanford. Currently, he is a member of the Company’s Board of Directors and holds the position of Professor of Neurosurgery and Radiation Oncology at Stanford. At December 31, 2007 and June 30, 2007, amounts of approximately $597,000 and $231,000, respectively, were recorded as deferred revenue and customer advances relating to payments made by Stanford. At December 31, 2007 and June 30, 2007, $275,000 and $0 were due from Stanford, respectively.  The Company also has a license agreement with Stanford as disclosed in Note 6.

                In April 2006, the Company entered into a consulting agreement with Dr. Adler, which terminated any prior consulting agreements.  Under this consulting agreement, Dr. Adler was entitled to receive a maximum compensation of $137,000 per year, payable at the beginning of each quarter beginning on April 1, 2006. Additionally Dr. Adler entered into a consulting agreement with the CyberKnife Society in April 2006. The Company assumed the contractual obligations of the CyberKnife Society under this agreement, effective as of October 3, 2006. Under this consulting agreement, Dr. Adler provided services to the CyberKnife Society and was entitled to receive a maximum compensation of $76,000 per year, payable at the beginning of each quarter beginning on April 1, 2006.

                In April 2007, the Company entered into a new consulting agreement with Dr. Adler, which terminated all prior consulting agreements.  Under the new consulting agreement, Dr. Adler is entitled to receive a maximum compensation of $149,100 per year, payable at the beginning of each quarter beginning on April 1, 2007.  This agreement has a term of one year and will renew for successive one-year periods, unless either party provides 30 days’ written notice of termination prior to the expiration of each one-year period. The Company recognized consulting expense for Dr. Adler of $37,000 and $75,000 for the three and six months ended December 31, 2007, respectively, and $53,000 and $88,000 during the three and six months ended December 31, 2006, respectively, pursuant to these agreements.

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

                The following discussion and analysis of our financial condition as of December 31, 2007 and results of operations for the three and six months ended December 31, 2007 and 2006 should be read together with our financial statements and related notes included elsewhere in this report.  This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth under “Risk Factors” and elsewhere in this report. We urge you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.  All forward-looking statements included in this report are based on information available to us on the date of this report, and we assume no obligation to update any forward-looking statements contained in this report.

In this report, “Accuray,” the “Company,” “we,” “us,” and “our” refer to Accuray Incorporated.

Overview

                We have developed the first and only commercially available intelligent robotic radiosurgery system, the CyberKnife system, designed to treat solid tumors anywhere in the body as an alternative to traditional surgery. The CyberKnife system combines continuous image-guidance technology with a compact linear accelerator that has the ability to move in three dimensions according to the treatment plan. Our image-guidance technology continuously acquires images to track a tumor’s location and transmits any position corrections to the robotic arm prior to delivery of each dose of radiation. Our compact linear accelerator, or linac, is a compact radiation treatment device that uses microwaves to accelerate electrons to create high-energy X-ray beams to destroy the targeted tumor. This combination, which we refer to as intelligent robotics, extends the benefits of radiosurgery to the treatment of tumors anywhere in the body. The CyberKnife system autonomously tracks, detects and corrects for tumor and patient movement in real-time during the procedure, enabling delivery of precise, high dose radiation typically with sub-millimeter accuracy. The CyberKnife procedure requires no anesthesia, can be performed on an outpatient basis and allows for the treatment of patients that otherwise would not have been treated with radiation or who may not have been good candidates for traditional surgery. In addition, the CyberKnife procedure avoids many of the potential risks and complications that are associated with other treatment options and is more cost effective than traditional surgery.

                In July 1999, we obtained 510(k) clearance from the FDA to market the CyberKnife system for the treatment of tumors and certain other conditions in the head, neck and upper spine. In August 2001, we received FDA clearance for the treatment of tumors anywhere in the body where radiation treatment is indicated. In September 2002, we received a CE mark for the sale of the CyberKnife system in Europe. The CyberKnife system has also been approved for various indications in Japan, Korea, Taiwan, China and other countries. Our customers have reported that over 40,000 patients worldwide have been treated with the CyberKnife system since its commercial introduction.

                In the United States, we sell to customers, including hospitals and stand-alone treatment facilities, directly through our sales organization, which as of December 31, 2007 included 94 sales personnel. Outside the United States, we sell to customers in over 50 countries directly through our sales organization, which as of December 31, 2007 included 25 sales personnel, and through distributors. Our international sales and service offices include Paris, France, Hong Kong, China and Tokyo, Japan.

                Our CyberKnife systems are either sold to our customers or placed with our customers pursuant to our shared ownership programs. As of December 31, 2007, we had 126 CyberKnife systems installed at customer sites, including 115 sold directly to customers and 11 pursuant to shared ownership programs.  Of the 126 systems  installed, 82 are in the Americas, 32 are in Asia (including Japan) and 12 are in Europe.

Under the shared ownership program, we retain title to the CyberKnife system while the customer has use of the system. Our shared ownership contracts generally require a minimum monthly payment from the customer, and we may earn additional revenue based on the usage of the system at the site. Generally, minimum monthly payments are equivalent to the revenue generated from treating three to four patients per month, and any revenue received from additional patients is shared between us and the customer. We expect to continue to offer shared ownership programs to new customers and believe the number of installed units pursuant to, and revenue from, our shared ownership programs to increase in future periods, but to decrease as a percentage of total revenue as we recognize more revenue from CyberKnife systems sold to customers, or as shared ownership units are purchased by customers.

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                We manufacture and assemble our CyberKnife systems at our manufacturing facility in Sunnyvale, California. We purchase major components, including the robotic manipulator, treatment table or robotic couch, magnetron, which creates the microwaves for use in the linear accelerator, imaging cameras and computers from outside suppliers, some of which are single source. Our reliance on single source suppliers could harm our ability to meet demand for our products in a timely and cost effective manner. However, in most cases, if a supplier were unable to deliver these components, we believe that we would be able to find other sources for these components subject to any regulatory qualifications, if required. We manufacture certain other electronic and electrical subsystems, including the linear accelerator. We then assemble and integrate these components with our proprietary software and perform testing prior to shipment to customer sites.

                We generate revenue by selling the CyberKnife system and by providing ongoing services and upgrades to customers following installation of the CyberKnife system. The current list price for the CyberKnife system is approximately $4.2 million, which includes installation, initial training and a one-year warranty. We also offer optional hardware and software, technical enhancements and upgrades to the CyberKnife system as part of our multiyear service plans. Currently, our most comprehensive service plan is our Diamond Elite multiyear service plan, or Diamond plan. Under our Diamond plan, customers are eligible to receive up to two upgrades per year, when and if available. The Diamond plan has a list price of $460,000 per year, and provides for annual renewal for four years including the one-year warranty period. The customer may cancel the service plan at any time. As of December 31, 2007, 86 of our customers had purchased service plans. Prior to introducing our Diamond plan, we offered legacy service plans, some of which continue to have future upgrade obligations. In these cases, we recognize revenue, including Cyberknife product revenue, only when all upgrade obligations are satisfied.

                The CyberKnife procedure is currently covered and reimbursed by Medicare and other governmental and non-governmental third-party payors. Medicare coverage currently exists in hospital outpatient settings and in free-standing clinic settings. For the 2007 calendar year, under the finalized Medicare payment rules, the national payment rates for procedures billed using Medicare billing codes for treatments using the CyberKnife system are $3,896 for the first treatment and $2,645 for each treatment thereafter, up to a maximum of five treatments.  For the calendar year 2008, the Centers for Medicare and Medicaid Services, or CMS, has published increased payment rates as compared to 2007.  The published payment rates for the calendar year 2008 are $3,930 for the first treatment and $2,871 for each treatment thereafter.  We do not expect these changes to have a material impact on our consolidated financial position or results of operations for the year ended June 30, 2008.

                Our total net revenue was $52.0 million and $100.7 million during the three and six months ended December 31, 2007. Our net income was $2.3 million and $4.6 million during the three and six months ended December 31, 2007.  Our net cash used in operating activities was $15.2 million during the six months ended December 31, 2007.  As of December 31, 2007, our backlog was approximately $659.9 million.

                Our future success will depend in large part on our ability to establish and maintain a competitive position in the market. To compete successfully, we will need to continue to demonstrate the advantages of our products and technologies over alternative procedures, products and technologies, and convince physicians and other healthcare decision makers of the advantages of our products and technologies. Our business and sales and installation cycle does not immediately create recognizable revenue. As such, we must invest in sales and marketing activities 12 to 18 months prior to realizing the revenue from those activities. Our ability to achieve and maintain long-term profitability is largely dependent on our ability to successfully market and sell the CyberKnife system and to control our costs and effectively manage our growth.

Material Weaknesses in Internal Controls

                In connection with the audit of our consolidated financial statements for the year ended June 30, 2007, our independent registered public accounting firm identified material weaknesses and significant deficiencies in our internal controls over financial reporting. These material weaknesses and significant deficiencies relate to a lack of segregation of duties, inadequate review procedures,  and the misapplication of accounting policies, including policies related to revenue recognition and stock-based compensation.

                Our efforts to remediate these material weaknesses in our internal controls over financial reporting consist of the following corrective actions: (i) hiring and training additional, qualified finance and accounting personnel; and (ii) strengthening our processes and procedures related to complex revenue recognition and equity transactions. However, even after these corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks.

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                Although we have taken measures to remediate the material weaknesses as well as other significant deficiencies and control deficiencies, we cannot assure you that we have identified all, or that we will not in the future have additional material weaknesses, significant deficiencies and control deficiencies.

Financial Operations

Sales and Installation Cycle

       The CyberKnife system has a relatively long sales and installation cycle because it is a major capital item and requires the approval of senior management at purchasing institutions. The typical sales and installation cycle is 12 to 18 months in duration and involves multiple steps. Initial steps may include pre-selling activity followed by execution of a letter of intent, or LOI, which is typically non-binding in nature but which sets forth the customer’s intention to acquire a CyberKnife system.  The next step is typically the execution of a terms agreement setting forth the business and economic terms for the sale of the CyberKnife system and multiyear service plan. After execution of a terms agreement, the customer typically has a 30 to 45 day window in which to complete final negotiation of legal terms for the sale of the CyberKnife system. We bifurcated the process of negotiating agreements on business and legal terms in order to reduce the level of sales force involvement in negotiation of legal terms and improve the efficiency of our customer contracting process. The last step in the sales and installation cycle is installation of the CyberKnife system. Prior to installation, a purchasing institution must typically obtain a radiation device installation permit, and in some cases a certificate of need, both of which must be granted by state and local government bodies. In addition, the purchasing institution must build a radiation shielded facility or upgrade an existing facility to house the CyberKnife system.  We typically receive a deposit at the time the terms agreement is entered into, and the remaining balance for the sale of the CyberKnife system upon installation. The customer also typically selects a service plan at the time of signing a CyberKnife system terms agreement and enters into the service plan agreement prior to installation of the system.

Upon installation, we typically recognize the CyberKnife system sale price minus the fair value of one year of service. We recognize the fair value of the first year of service as revenue pro rata over the twelve months following installation. In addition, if the customer has purchased our Diamond plan and assuming annual renewals, we would receive a $460,000 payment at the beginning of each of the second, third and fourth years of the multiyear service plan and recognize the revenue pro rata over each year.

Legacy Service Plans

                Prior to introducing our Diamond plan, we offered a Platinum Elite multiyear service plan, or Platinum plan. These legacy service plans are structured so that we have an obligation to deliver two upgrades per year over the course of the multiyear service plan. If we fail to deliver the upgrades, our customers are entitled to receive refunds of up to $200,000. Since November 2005, we have not offered these legacy service plans to new customers.

                The Platinum plan obligates us to deliver two upgrades per year during the term of the contract. We have not yet established fair value for those future obligations; hence, generally accepted accounting principles in the United States, or U.S. GAAP, requires that we cannot begin to recognize any of the revenue derived from the sale of the CyberKnife system or the associated service plans until those obligations have been fulfilled. Therefore, the payments made by our customers who have our legacy Platinum plan are categorized as deferred revenue and are recognized as revenue once we fulfill all obligations to deliver upgrades. Once we fulfill all upgrade obligations with respect to a specific Platinum plan, we ratably recognize the revenue from the sale of the CyberKnife system and the Platinum plan over the remaining life of the contract.

Upgrades

                Customers may purchase additional upgrades as optional extras prior to the delivery of all specified upgrade obligations. Such additional upgrades are considered elements of the original arrangement and associated revenues are deferred until the earlier of: (1) delivery of all elements, or (2) establishment of VSOE of fair value for all undelivered elements. Sales of additional upgrades after delivery of all specified upgrade obligations, as stated in the original contract, are considered separate arrangements and are recognized once all revenue recognition criteria are met.

Warranty

                All customers purchasing a CyberKnife system receive a one-year warranty. In the event that a customer does not purchase a multiyear service plan, we recognize the CyberKnife system sale price less the fair value of one year of support upon installation. We recognize the value of one year of support pro rata over the twelve months following installation. If the customer does purchase a multiyear service plan, the revenue recognition is as described above.

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Shared Ownership Programs Revenue

                As of December 31, 2007, our shared ownership programs involved U.S. sites only. We recognize revenue monthly from our shared ownership programs that consists of a minimum monthly payment. We also recognize usage-based revenue in excess of the monthly minimum based on usage reports from our customers. We recognized revenue from shared ownership programs of $3.0 million and $5.4 million  for the three and six months ended December 31, 2007, respectively, and $2.6 and $4.8 for the three and six months ended December 31, 2006, respectively.  In limited cases, we received nonrefundable upfront payments from shared ownership program customers which are treated as deferred revenue and recognized over the term of the contract.

                The CyberKnife system shared ownership units are recorded within property and equipment and are depreciated over their estimated life of ten years. Depreciation and warranty expense attributable to shared ownership units are recorded within cost of shared ownership programs as they are incurred.

Japan Customized Service Revenue

                In May and December 2003, we entered into separate contractual arrangements to deliver customized services to our distributor in Japan for 22 CyberKnife systems previously sold. These customized services consist of two upgrade levels and are being delivered over an extended period concurrent with the distributor’s efforts to coordinate delivery with their end user customers. Once the obligations under the upgrade programs for these 22 systems are complete, we do not plan to offer this customized service program and will instead be offering our standard multiyear service plans.

International Sales Revenue

                For international sales, we recognize revenue once we have met all of our obligations associated with the purchase agreement, other than undelivered service elements for which we have vendor specific objective evidence, or VSOE, of fair value. In most cases, this occurs after the distributor has shipped the unit to the end user, assuming all other obligations have been satisfied. Payments are sometimes secured through letters of credit. In situations where we are directly responsible for installation, we recognize revenue once we have installed the CyberKnife system and have confirmed performance against specification.

In situations with legacy plans where we have future obligations related to software upgrades that are subject to potential refunds, we defer revenue from the sale and service of the CyberKnife system until the final upgrade has been delivered and accepted. After we have delivered all upgrades associated with a service plan and thus eliminated any contractual right to a refund, we ratably recognize the revenue from the sale of the CyberKnife system and the plan over the remaining life of the contract or until we have VSOE of the fair value of the remaining undelivered elements. Net revenue from international customers was $20.3 million and $39.1 million for the three and six months ended December 31, 2007, respectively, compared to $8.9 million and $20.3 million for the three and six months ended December 31, 2006.

Backlog

       Beginning with the quarter ended March 31, 2007, we revised our definition of backlog to consist of the sum of deferred revenue, future payments that our customers are contractually committed to make and signed contingent contracts that we believe have a substantially high probability of being booked as revenue from CyberKnife system purchase agreements, service plans and minimum payment requirements associated with our shared ownership programs. We adopted this new definition of backlog in part because of the changes in our customer contracting process under which customers initially enter into a terms agreement setting forth the business and economic terms for the sale of a CyberKnife system and then have a specified time frame in which to negotiate legal terms. Contingencies associated with contingent contracts that are included within backlog may include final negotiation and agreement upon our legal terms for the sale of the CyberKnife system, state or local government approval of a certificate of need for the installation of a radiosurgery system, approval by the board of directors of the hospital or other purchaser of the system, establishment of legal entities by purchasers of systems and completion of financing arrangements by purchasers of systems. We review, on a quarterly basis with respect to each contingent contract included in backlog, whether

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customer engagement and progress toward satisfaction of contingencies warrant continued inclusion of the contract within backlog.   We previously defined backlog as the sum of the following two components: deferred revenue and future payments that our customers are contractually committed to make, but which we have not yet received.

                As of December 31, 2007, our backlog under this new definition was approximately $659.9 million. Of the total backlog, $364.9 million represented CyberKnife system sales, and $295.0 million represented revenue from service plans and other recurring revenues. We anticipate that this backlog will be recognized over the next five years as installations occur, upgrades are delivered and services are provided. Although backlog includes contractual commitments from our customers, we may be unable to convert all of this backlog into recognized revenue due to factors outside our control.

Results of Operations

Overview

                Our results of operations are divided into the following components:

                Net revenue.  Our net revenue consists primarily of product revenue (revenue derived from the sale of CyberKnife systems and the sale of linacs for other uses), shared ownership programs revenue (revenue generated from shared ownership programs), services revenue (revenue generated from sales of service plans and training) and other revenue (revenue from specialized upgrade services for units previously sold in Japan).

                Cost of revenue.  Cost of revenue consists primarily of material, labor and overhead costs. In future periods we expect cost of revenue to remain reasonably consistent with current levels due to our achieving nearly full absorption of manufacturing overhead costs associated with increased production volumes, improved efficiencies for supplies and materials and improved labor and manufacturing efficiencies.

                Selling and marketing expenses.  Selling and marketing expenses consist primarily of costs for personnel and costs associated with participation in medical conferences, physician symposia, and promotional activities. In future periods, we expect selling and marketing expenses to grow in absolute terms as we increase headcount and further increase participation in trade shows and symposia and invest in other marketing and promotional activities, but to decrease as a percentage of total net revenue as we leverage our existing infrastructure and realize economies of scale.

                Research and development expenses.  Research and development expenses consist primarily of activities associated with our product development, regulatory, and clinical organizations. In future periods, we expect research and development expenses to grow in absolute terms as we increase headcount and development activities, but to decrease as a percentage of total net revenue as we leverage our existing infrastructure and realize economies of scale.

                General and administrative expenses.  General and administrative expenses consist primarily of compensation and related costs for finance and human resources, and expenses related to accounting, legal and other consulting fees. In future periods, we expect general and administrative expenses to grow in absolute terms as we incur costs related to the reporting requirements of a public company and additional costs related to the overall growth of our business, but to decrease as a percentage of total net revenue as we leverage our existing infrastructure and realize economies of scale.

                Interest and other income.  Interest and other income consist primarily of interest earned on our cash and cash equivalents.

                Interest and other expense.  Interest and other expense consist primarily of sales tax expense, losses from the disposal of property and equipment and foreign exchange transaction losses.

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Deferred Revenue—Legacy Multiyear Service Plans

                We are required to defer all of the revenue associated with our legacy multiyear service plans, including our Platinum and Gold service plans, until we have satisfied all of the specified obligations related to the delivery of upgrades to the CyberKnife system during the life of the service plan. This includes deferring the cash received for the sale of the CyberKnife system and multiyear service plans until we have delivered all upgrades which the customer is eligible to receive. Once we have satisfied all our obligations for delivery of upgrades under the plans, we recognize revenue pro rata over the remaining life of the service plan. We have not offered these legacy multiyear service plans to new customers since we introduced our Diamond plan in October 2005, but continue to service 45 legacy plans as of December 31, 2007. Therefore, our deferred revenue has been higher in certain periods where we have installed more units with legacy contracts, but should continue to decrease as we satisfy the contractual obligations and recognize the revenue associated with those installed units.

Three Months Ended December 31, 2007 Compared to Three Months Ended December 31, 2006

                Net revenue

Total net revenue for the three months ended December 31, 2007 increased $25.7 million from the three months ended December 31, 2006.  In the three months ended December 31, 2007, 12 CyberKnife system units were installed, including 11 units sold and one attributable to our shared ownership programs, compared to seven CyberKnife system units installed, including six units sold and one attributable to our shared ownership programs during the three months ended December 31, 2006.  Product revenue for the three months ended December 31, 2007 increased $19.8 million from the three months ended December 31, 2006. The increase was primarily attributable to an increase in the number of new CyberKnife system units for which we recognized revenue in the three months ended December 31, 2007 and a change in the mix of service plans.  In accordance with our revenue recognition policy and reflecting the terms of our service plans, we recognized revenue from the sale of 14 CyberKnife system units sold for the three months ended December 31, 2007, compared to six CyberKnife system units sold in the three months ended December 31, 2006.  Of the 14 CyberKnife system units sold, we satisfied all revenue recognition criteria for three units previously sold to a distributor in China during the three months ended December 31, 2007.  As of September 30, 2007, these units were recorded in deferred revenue.  Accordingly, we recognized $5.6 million of products revenue related to these units during the three months ended December 31, 2007.  Also included in products revenue during the three months ended December 31, 2007, is $3.4 million related to the purchase by a third party of two of our Cyberknife system units that had been in our shared ownership programs.  In addition, we recognize revenue ratably over the remaining lives of the service plans for those legacy multiyear service plans where we have satisfied our upgrade delivery obligations.  During the three months ended December 31, 2007 and 2006, we recognized products revenue attributable to these legacy multiyear plans for 14 units and one unit, respectively.

Service revenue for the three months ended December 31, 2007 increased approximately $5.3 million from the three months ended December 31, 2006, which was primarily attributable to an increase in the number of customer sites under service plans driven by the increase in our installed base.  Shared ownership programs revenue for the three months ended December 31, 2007 increased approximately $459,000 from the three months ended December 31, 2006, primarily due to an increase in usage-based fee revenues.  Revenue from upgrade services in Japan, classified as “Other revenue” in our condensed consolidated statements of operations, slightly increased approximately $121,000 for the three months ended December 31, 2007 from the three months ended December 31, 2006 due to an increase in upgrade services provided to our installed systems in Japan.

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Cost of revenue

                Total cost of revenue for the three months ended December 31, 2007 increased $12.5 million from the three months ended December 31, 2006. The increase was primarily attributable to an increase in the number of CyberKnife systems recognized as revenue and an increase in the number of customer sites under service plans during the three months ended December 31, 2007 compared to the three months ended December 31, 2006. As a percentage of total net revenue, total cost of revenue for the three months ended December 31, 2007 increased to 46.5% as compared to 44.2% for the three months ended December 31, 2006.   The corresponding decrease in gross margin percentage was a result of an increase in CyberKnife system shipments through our distributor channel and the sale of CyberKnife system units that had been in our shared ownership programs,  both of which typically have lower gross margins than direct sales to customers.

                Selling and marketing expenses

Selling and marketing expenses for the three months ended December 31, 2007 increased $1.4 million from the three months ended December 31, 2006. The increase was primarily attributable to an increase of $1.2 million in salary and related costs largely due to increased headcount, and an increase of $307,000 in travel expenses as a result of increasing our international sales presence. As a percentage of total net revenue, selling and marketing expenses for the three months ended December 31, 2007 decreased to 21.5% as compared to 37.1% for the three months ended December 31, 2006.

                Research and development expenses