NOTE 1—BASIS OF PRESENTATION

The Company

BIOLASE, Inc., (the “Company”) incorporated in Delaware in 1987, is a biomedical company that develops, manufactures, and markets lasers in dentistry and medicine. The Company currently operates in one business segment with laser systems that are designed to provide clinically superior performance for many types of dental procedures with less pain and faster recovery times than are generally achieved with drills, scalpels, and other dental instruments. The Company also markets and distributes dental imaging equipment and other products designed to improve technologies for applications and procedures in dentistry and medicine.

Basis of Presentation

The unaudited consolidated financial statements include the accounts of the Company and its consolidated subsidiaries and have been prepared on a basis consistent with the December 31, 2011 audited consolidated financial statements and include all material adjustments, consisting of normal recurring adjustments and the elimination of all material intercompany transactions and balances, necessary to fairly present the information set forth therein. These unaudited, interim, consolidated financial statements do not include all the footnotes, presentations and disclosures normally required by accounting principles generally accepted in the United States of America (“GAAP”) for complete consolidated financial statements. Certain amounts have been reclassified to conform to current period presentations.

Use of Estimates

The preparation of these consolidated financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Significant estimates in these consolidated financial statements include allowances on accounts receivable, inventory and deferred taxes, as well as estimates for accrued warranty expenses, the ability of indefinite-lived intangible assets and goodwill to be realized, revenue deferrals for multiple element arrangements, effects of stock-based compensation and warrants, contingent liabilities and the provision or benefit for income taxes. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may differ materially from those estimates.

Critical Accounting Policies

Information with respect to the Company’s critical accounting policies which management believes could have the most significant effect on the Company’s reported results and require subjective or complex judgments by management is contained on pages 41 to 43 in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (“2011 Form 10-K”). Management believes that there have been no significant changes during the nine months ended September 30, 2012 in the Company’s critical accounting policies from those disclosed in Item 7 of the Company’s 2011 Form 10-K, except with regard to restricted cash as set forth below.

Restricted Cash

The Company maintains depository accounts controlled by Comerica Bank to be held for repayment of lines of credit and accrued interest expense or disbursement to the Company’s operating bank account, pursuant to the terms of two revolving credit facility agreements with the bank. There were no restricted cash balances as of September 30, 2012. See Note 8 – Lines of Credit and Other Borrowings for further discussion.

Fair Value of Financial Instruments

The Company’s financial instruments, consisting of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities, approximate fair value because of the short maturity of these items. Financial instruments consisting of lines of credit approximate fair value, as the interest rates associated with the lines of credit approximates the market rates for debt securities with similar terms and risk characteristics.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market or, if none exists, the most advantageous market, for the specific asset or liability at the measurement date (referred to as the “exit price”). The fair value should be based on assumptions that market participants would use, including a consideration of nonperformance risk. Level 1 measurement of fair value is quoted prices in active markets for identical assets or liabilities.

Money market securities. Money market securities are cash equivalents, which are included in cash and cash equivalents, and consist of highly liquid investments with original maturities of three months or less. Management uses quoted active market prices for identical assets to measure fair value. The Company had money market securities of approximately $451,000 and $0 at September 30, 2012 and December 31, 2011, respectively.

Liquidity and Management’s Plans

The Company has suffered recurring losses from operations during the three years ended December 31, 2011. Although the Company’s revenues increased for the three and nine months ended September 30, 2012, compared to the corresponding periods in 2011, the Company incurred a loss from operations and a net loss during these periods.

At September 30, 2012, the Company had approximately $6.2 million in working capital. The Company’s principal sources of liquidity at September 30, 2012 consisted of approximately $1.3 million in cash and cash equivalents, $10.3 million of net accounts receivable, and $5.1 million of available borrowings under two revolving credit facility agreements.

On May 24, 2012, the Company entered into two revolving credit facility agreements with Comerica Bank which provide for borrowings of up to $8.0 million. The Company had approximately $2.2 million of borrowings outstanding under these lines of credit as of September 30, 2012. See Note 8 – Lines of Credit and Other Borrowings for additional information.

The Company’s ability to meet its obligations in the ordinary course of business is dependent upon its ability to sell its products to end-users through its direct sales force and through distributors, establish profitable operations through increased sales and decreased expenses, and obtain additional funds when needed. Management intends to increase sales by increasing the Company’s product offerings, expanding its direct sales force, and expanding its distributor relationships both domestically and internationally.

There can be no assurance that the Company will be able to increase sales, reduce expenses, or obtain additional financing, if necessary, at a level to meet its current obligations. As a result, the report of the Company’s independent registered public accounting firm on its consolidated financial statements for the year ended December 31, 2011 contained an explanatory paragraph stating that there is a substantial doubt regarding the Company’s ability to continue as a going concern.

The accompanying consolidated financial statements have been prepared on a going concern basis that contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include adjustments relating to the recoverability of recorded asset amounts or the amounts or classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

From time to time, the Company may attempt to raise capital through either equity or debt offerings. The Company’s capital requirements will depend on many factors, including, among other things, the effects of any acquisitions it may pursue as well as the rate at which its business grows, with corresponding demands for working capital and manufacturing capacity. The Company could be required, or may elect, to seek additional funding through public or private equity or debt financing. However, a credit facility, or additional funds through public or private equity or other debt financing, may not be available on terms acceptable to the Company or at all, or that any such financing activity would not be dilutive to its stockholders. Without additional funds and/or increased revenues, the Company may not have enough cash or financial resources to operate for the next twelve months.

On February 22, 2012, the Company entered into a definitive termination agreement (the “2012 Termination Agreement”) with Henry Schein, Inc. (“HSIC”), a leading U.S. dental product and equipment distributor and the Company’s former exclusive distributor in North America. The 2012 Termination Agreement, which was completed on April 12, 2012, terminated and superseded all prior agreements with HSIC. Pursuant to the 2012 Termination Agreement, the Company purchased HSIC’s inventory of Waterlase MD Turbo laser systems and HSIC released its liens on the Company’s assets. The Company paid the entire purchase price by offsetting accounts receivable currently due from HSIC from sales made in the normal course of business. None of the funds used to offset the purchase price were related to the original sales of the MD Turbo laser systems that were purchased. See Note 13 – Non-recurring Event for further discussion.