PINNACLE DATA SYSTEMS INC

The Company reviewed its net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance due to the continuing uncertain economic environment and the Company’s pre-tax loss for the nine months ended September 30, 2009. At that time, the Company’s net deferred tax assets primarily consisted of temporary differences related to inventory reserves and federal net operating loss (“NOL”) carryforwards. Based on the Company’s analysis and application of the GAAP framework, the Company established a valuation allowance of $1.6 million against its net deferred tax assets.

During the third quarter of 2010, the Company concluded that its operations had demonstrated sustainable profitability, and that future taxable income would more likely than not allow for realization of benefits from existing deferred income tax assets. Accordingly, the Company reversed substantially all of its deferred tax asset valuation allowance. As a result, the year-to-date U.S. effective tax rate for the third quarter of 2010 was approximately 34%, versus an effective rate of approximately 22% applied in the first six months of 2010. The combined impact of the valuation allowance reversal and the adjustment of the year-to-date U.S. effective tax rate resulted in a $1.3 million net non-cash benefit.

During the quarter ended September 30, 2011, we recorded net income of $214,000, or $0.03 per diluted share, versus net income of $1,673,000, or $0.21 per diluted share, for the prior year quarter (including a $1.3 million net tax benefit related to the reversal of most of our deferred tax asset valuation allowance). During the nine months ended September 30, 2011, we recorded net income of $949,000, or $0.12 per diluted share (including $0.3 million related to research and development tax credit adjustments), versus net income of $2,282,000, or $0.29 per diluted share, for the prior year period (including the $1.3 million valuation allowance reversal benefit noted above). See below for further discussion of consolidated and reportable segment results of operations for the three and nine months ended September 30, 2011 and 2010.

We reviewed our net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance due to the continuing uncertain economic environment and our pre-tax loss for the nine months ended September 30, 2009. At that time, our net deferred tax assets primarily consisted of temporary differences related to inventory reserves and federal net operating loss (“NOL”) carryforwards. Based on our analysis and application of the GAAP framework, we established a valuation allowance of $1.6 million against our net deferred tax assets.

During the third quarter of 2010, we concluded that our operations had demonstrated sustainable profitability, and that future taxable income would more likely than not allow for realization of benefits from existing deferred income tax assets. Accordingly, we reversed substantially all of our deferred tax asset valuation allowance. As a result, the year-to-date U.S. effective tax rate for the third quarter of 2010 was approximately 34%, versus an effective rate of approximately 22% applied in the first six months of 2010. The combined impact of the valuation allowance reversal and the adjustment of the year-to-date U.S. effective tax rate resulted in a $1.3 million net non-cash benefit.

The decrease in net income for the third quarter of 2011 compared to the prior year quarter primarily was due to a $1.3 million net tax benefit recorded during the third quarter of 2010 associated with the aforementioned reversal of most of our valuation allowance against deferred tax assets. This partially was offset by the previously described $0.1 million tax benefit in the third quarter of 2011 related to the finalization of amended tax returns for prior years impacted by the R&D tax credit study. Furthermore, higher operating expenses in the current year quarter reflect investments in personnel necessary to grow and support the business. Overall gross profit was flat with strong Service segment sales growth offsetting lower Product segment results. Service segment sales increased 14% due to the growth of business in the U.S. and Europe for both new customers and new programs within existing customers. Interest expense was zero as the Company did not utilize its line of credit during the third quarter of 2011.