Note 1. Basis of Presentation

In the opinion of management the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of the results for such periods.  The results for any interim period are not necessarily indicative of the results to be expected for the full fiscal year.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles have been condensed or omitted.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities.  On an ongoing basis, we evaluate our esti matesestimates and judgments, including those related to revenue recognition, inventories, income taxes, and stock-based compensation.  Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.  These financial statements should be read in conjunction with the Company's most recent audited financial statements included in its report on Form 10-K for the year ended June 30, 2010.

Note 2. Net Income per Share

Basic net income per share excludes dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted net income per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the income of the Company.  As Unearned ESOP shares are released or committed-to-be-released the shares become outstanding for earnings-per-sharenet income-per-share computations.

The Company follows ASC 718 in establishing standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, as well as transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that maybemay be settled by the issuance of those equity instruments.  ASC 718 requires that the cost resulting from all share-based payment transactions be recognized in the financial statements based on the fair value of the share-based payment.  ASC 718 establishes fair value as the measurement objective in accounting for share-based payment transactions with employees, except for equity instruments held by employee share ownership plans.

As of DecemberMarch 31, 2010,2011, there was approximately $78,878$62,144 of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense over the next 1.751.5 years.  The total deferred tax benefit related to these awards is approximately $6,997.$5,569.

The Company has one employee stock option plan under which options may be granted, the 2007 Stock Option and Restricted Stock Plan (the "2007 Plan"). The Board of Directors may grant options to acquire shares of common stock to employees of the Company at the fair market value of the common stock on the date of grant.  Generally, options granted have a two-year vesting period based on two years of continuous service and have a ten-year contractual life.  Option grants provide for accelerated vesting if there is a change in control.  Shares issued upon the exercise of options are from those held in Treasury.  The 2007 Plan was approved by the Company's shareholders at the Company's Annual Meeting on November 30, 2007 and supercedessupersedes the Company's 2000 Stock Option Plan (the "2000 Plan").  ;OptionsOptions covering 400,000 shares were authorized for issuance under the 2007 Plan, of which 99,800 have been granted and 87,10082,400 are outstanding as of DecemberMarch 31, 2010.2011.  While no further grants of options may be made under the 2000 Plan, as of DecemberMarch 31, 2010, 61,0002011, 59,600 options remain outstanding, vested and exercisable from the 2000 Plan.

ASC 718 requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes option valuation model, which incorporates various assumptions including those for volatility, expected life and interest rates.

The table below outlines the weighted average assumptions that the Company used to calculate the fair value of each option award for the sixnine months ended:

The Company pays dividends quarterly and anticipates that it will be able to continue to pay comparable regular quarterly dividends in the foreseeable future. While the Company has paid a special cash dividend of $1.00 per share in each of December 2009 and 2010, there is no assurance that the Board of Directors will declare a comparable special dividend in 2011.  Expected stock price volatility is based on the historical volatility of the Company’s stock. The risk-free interest rate is based on the implied yield available on U.S. Treasury issues with an equivalent term approximating the expected life of the options. The expected option life (in years) represents the estimated period of time until exercise and is based on actual historical experience.

The following table summarizes stock option activity during the sixnine months ended DecemberMarch 31, 2010:2011:

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing sale price of the company’s common stock as reported on the NYSE-Amex on March 31, 2011 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders if all option holders had exercised their options on March 31, 2011.  This amount changes based on the fair market value of the company’s common stock.  The total intrinsic values of the options exercised was $26,324 and $10,373, during the sixnine months ended DecemberMarch 31, 2011 and 2010 was $66,929 and 2009, respectively.  The intrinsic value of stock options outstanding and exercisable as of December 31, 2010 and 2009 was $443,108 and $123,394,$23,046, respectively.

The Company at certain times enters into standby letters of credit agreements with financial institutions primarily relating to the guarantee of future performance on certain contracts.  Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at DecemberMarch 31, 2010.2011.  As a government contractor, the Company is continually subject to audit by various agencies of the U.S. Government to determine compliance with various procurement laws and regulations.  As a result of such audits and as part of normal business operations of the Company, various claims and charges can be asserted against the Company.  It is not possible to predict the outcome of such actions.  Currently the Company has no claims or assertions pending or threatened against it.

Note 5.   Recently Issued Accounting Standards

In July 2010, the FASB issued ASU 2010-20, “Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The standard amends ASC Topic 310, “Receivables” to enhance disclosures about the credit quality of financing receivables and the allowance for credit losses by requiring an entity to provide a greater level of disaggregated information and to disclose credit quality indicators, past due information, and modifications of its financing receivables.  ASU 2010-20 was effective for interim or annual fiscal years beginning after December 15, 2010 for public entities and had no effect on the Company’s financial statements.

The Company sponsors a leveraged employee stock ownership plan (the "ESOP") that covers all nonunion employees who work 1,000 or more hours per year and are employed on June 30.  The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends on unallocated shares received by the ESOP.  All dividends on unallocated shares received by the ESOP are used to pay debt service.  Dividends on allocated ESOP shares are recorded as a reduction of retained earnings.  As the debt is repaid, shares are released and allocated to active employees, based on the proportion of debt service paid in the year.  The Company accounts for its ESOP in accordance with FASB ASC 718-40.  Accordingly, the shares purchased by the ESOP are reported as Unearned ESOP Shares in the statement of financial position.  As shares are released or committed-to-be-released, the Company reports compensation expense equal to the current average market price of the shares, and the shares become outstanding for earnings-per-sharenet income-per-share (EPS) computations.   ESOP compensation expense was $128,375$126,533 and $108,843$110,530 for the three month periods ended DecemberMarch 31, 20102011 and 2009,2010, respectively.  ESOP compensation expense was $235,408$361,941 and $199,742$310,273 for the sixnine month periods ended DecemberMarch 31, 20102011 and 2009,2010, respectively.    The ESOP shares as of DecemberMarch 31, 20102011 and 20092010 were as follows:

Overview

Espey Mfg. & Electronics Corp. (the “Company”) is a power electronics design and original equipment manufacturing (OEM) company with a long history of developing and delivering highly reliable products for use in military and severe environment applications. All design, manufacturing, and testing is performed in our 150,000+ square foot facility located at 233 Ballston Ave, Saratoga Springs, New York. Espey is classified as a “smaller reporting company” for purposes of the reporting requirements under the Securities Exchange Act of 1934, as amended.  Espey’s common stock is publicly-traded on the NYSE-Amex under the symbol “ESP.”

Espey began operations after incorporation in New York in 1928.  We strive to remain competitive as a leader in high power energy conversion and transformer solutions through the design and manufacture of new and improved products by using advanced and “cutting edge” electronics technologies.

Espey is ISO 9001:2008 certified and our primary products are power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, ups systems, antennas and high power radar systems. The applications of these products include AC and DC locomotives, shipboard power, shipboard radar, airborne power, airborne radar, ground-based radar, and ground mobile power.

Espey services include design and development to specification, build to print, design services, design studies, environmental testing services, metal fabrication, plating and painting services, and development of automatic testing equipment. Espey manufacturing is vertically integrated, meaning that the Company produces individual components (including inductors), populates printed circuit boards, fabricates metalwork, paints, plates, wires, qualifies, and fully tests items, mechanically, electrically and environmentally, in house.

Business is solicited from large industrial manufacturers and defense companies, the government of the United States, foreign governments and major foreign electronic equipment companies.  In certain countries the Company has external sales representatives to help solicit and coordinate foreign contracts. The Company is also on the eligible list of contractors of agencies of the United States Department of Defense and generally is automatically solicited by such agencies for procurement needs falling within the major classes of products produced by the Company. In addition, the Company directly solicits bids from the United States Department of Defense for prime contracts.  Espey contracts with the government of the United States under cage code 20950 as Espey Mfg. & Electronics Corp. and cage code 98675 as Espe yEspey Mfg. & Electronics Corp., Saratoga Industries Division.

There is competition in all classes of products manufactured by the Company from divisions of the largest electronic companies, as well as many small companies. The Company's sales do not represent a significant share of the industry's market for any class of its products. The principal methods of competition for electronic products of both a military and industrial nature include, among other factors, price, product performance, the experience of the particular company and history of its dealings in such products. The Company, as well as other companies engaged in supplying equipment for military use, is subject to various risks, including, without limitation, dependence on United States and foreign government appropriations and program allocations, the competition for available military business, and government termination of orders for convenience.

New orders received in the first sixnine months of fiscal 2011 were approximately $24.6$30.1 million, representing a 224%120% increase overfrom the amount of new orders received in the first sixnine months of fiscal 2010.  These orders are in line with the Company’s strategy of getting involved in long-term high quantity military and industrial products and are predominately for follow-on production of mature products.  The Company's backlog was $42.9$41.5 million at DecemberMarch 31, 20102011 which includes $32.2$29.9 million from three customers compared to $33.9$33.1 million at DecemberMarch 31, 20092010 which included $23.0$21.3 million from twothree significant customers.  The backlog for the Company represents the estimated remaining sales value of work to be performed under firm contracts.

The outstanding quotations encompass various new and previously manufactured power supplies, transformers, and subassemblies.  However, there can be no assurance that the Company will acquire any or all of the anticipated orders described above, many of which are subject to allocations of the United States defense spending and factors affecting the defense industry and military procurement generally.

Management, along with the Board of Directors, continues to evaluate the need and use of the Company’s working capital.  Capital expenditures are expected to be approximately $800,000 for fiscal 2011.   Expectations are that the working capital will be required to fund orders, dividend payments, and general operations of the business.  From time to time, management along with the Mergers and Acquisitions Committee of the Board of Directors examine opportunities involving acquisitions or other strategic options, including buying certain products or product lines.  The criteria for consideration are synergies with the Company’s existing product base and accretion to earnings.

Critical Accounting Policies and Estimates

Management believes our most critical accounting policies include revenue recognition and estimates to completion.

A significant portion of our business is comprised of development and production contracts.  Generally, revenues on long-term fixed-price contracts are recorded on a percentage of completion basis using units of delivery as the measurement basis for progress toward completion.

Percentage of completion accounting requires judgment relative to expected sales, estimating costs and making assumptions related to technical issues and delivery schedule.  Contract costs include material, subcontract costs, labor and an allocation of overhead costs.  The estimation of cost at completion of a contract is subject to numerous variables involving contract costs and estimates as to the length of time to complete the contract.  Given the significance of the estimation processes and judgments described above, it is possible that materially different amounts of expected sales and contract costs could be recorded if different assumptions were used, based on changes in circumstances, in the estimation process.  When a change in expected sales value or estimated cost is determined, change schanges are reflected in current period earnings.

Results of Operations