U NITED S TATES S ECURITIES
      AND E XCHANGE C OMMISSION


Washington,
      D.C. 20549




FORM
      10-QSB




Quarterly
      Report of Small Business Issuers under Section 13 or 15(d) of the Securities
      Exchange Act of


1934
      for
      the quarterly period ended September 30, 2006




Commission
      File No. 000-14247




**I** **SO** **R** **AY** **,
      I** **NC.**


(Exact
      name of registrant as specified in its charter)




Minnesota
              (State
                or other jurisdiction of incorporation or
              organization)
            41-1458152
              (I.R.S.
                Employer Identification No.)350
                Hills St., Suite 106
              Richland,
                Washington
              (Address
                of principal executive offices)
            99354
              (Zip
                Code)Issuer's
                telephone number, including area code:(509)
                375-1202




Check
        whether the issuer has (1) filed all reports required to be filed by Section
        13
        or 15(d) of the Exchange Act during the past 12 months (or for such shorter
        period the Company was required to file such 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 shell company (as defined in
          Rule
          12b-2 of the Exchange Act):  Yes o No x






Number
                of shares outstanding of each of the issuer's classes of common
                equity:Class
            Outstanding
                as of November 10, 2006Common
                stock, $0.001 par value
            15,853,852Transitional
                Small Business Disclosure Format : YesoNox









**ISORAY,
      INC.**




**Table
      of Contents**







PagePART
                I FINANCIAL INFORMATION
            
            
            1Item
                1. Consolidated Unaudited Financial Statements
            
            
            1Consolidated
                Balance Sheets
            
            
            1Consolidated
                Unaudited Statements of Operations
            
            
            2Consolidated
                Unaudited Statements of Cash Flows
            
            
            3Notes
                to Consolidated Unaudited Financial Statements
            
            
            4Item
                2. Management's Discussion and Analysis of Financial Condition and
                Results of Operations
            
            
            9Item
                3. Controls and Procedures
            
            
            16PART
                II OTHER INFORMATION
            
            
            17Item
                6. Exhibits and Reports on Form 8-K
            
            
            17SIGNATURES
            
            
            18










**PART
      I.**  **FINANCIAL
      INFORMATION**





**Item
      1.**  **Financial
      Statements**




**IsoRay,
      Inc. and Subsidiary**


**Consolidated
      Balance Sheets**


**September
                  30,****2006**
              
              **June
                  30,****(Unaudited)**
              
              **2006****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              5,160,557
              
              $
              2,207,452Accounts
                  receivable, net of allowance for doubtful accountsof
                  $63,237 and $85,183, respectively
              
              
              652,255
              
              
              596,447Inventory
              
              
              217,788
              
              
              161,381Prepaid
                  expenses
              
              
              193,771
              
              
              161,546Total
                  current assets
              
              
              6,224,371
              
              
              3,126,826Fixed
                  assets, net of accumulated depreciation
              
              
              1,608,257
              
              
              1,642,293Deferred
                  financing costs, net of accumulated amortization
              
              
              252,501
              
              
              274,358Licenses,
                  net of accumulated amortization
              
              
              268,419
              
              
              273,475Other
                  assets, net of accumulated amortization
              
              
              347,383
              
              
              338,987Total
                  assets
              
              $
              8,700,931
              
              $
              5,655,939**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Current
                  liabilities:Accounts
                  payable and accrued expenses
              
              $
              654,062
              
              $
              584,296Accrued
                  payroll and related taxes
              
              
              706,827
              
              
              614,645Accrued
                  interest payable
              
              
              13,699
              
              
              11,986Notes
                  payable, due within one year
              
              
              46,031
              
              
              51,351Capital
                  lease obligations, due within one year
              
              
              190,266
              
              
              183,554Convertible
                  debentures payable, due within one year
              
              
              455,000
              
              
              455,000Total
                  current liabilities
              
              
              2,065,885
              
              
              1,900,832Notes
                  payable, due after one year
              
              
              569,608
              
              
              581,557Capital
                  lease obligations, due after one year
              
              
              162,642
              
              
              220,415Asset
                  retirement obligation
              
              
              68,953
              
              
              67,425Total
                  liabilities
              
              
              2,867,088
              
              
              2,770,229Shareholders'
                  equity:Preferred
                  stock, $.001 par value; 6,000,000 shares authorized:Series
                  A: 1,000,000 shares allocated; no shares issued and outstanding
              
              
              -
              
              
              -Series
                  B: 5,000,000 shares allocated; 91,298 and 144,759 shares issued
                  andoutstanding
              
              
              91
              
              
              145Common
                  stock, $.001 par value; 194,000,000 and 100,000,000 shares authorized;15,853,852
                  and 15,157,901 shares issued and outstanding
              
              
              15,854
              
              
              15,158Subscriptions
                  receivable
              
              
              -
              
              
              (6,122,007
              )Additional
                  paid-in capital
              
              
              22,291,594
              
              
              22,538,675Accumulated
                  deficit
              
              
              (16,473,696
              )
              
              (13,546,261
              )Total
                  shareholders' equity
              
              
              5,833,843
              
              
              2,885,710Total
                  liabilities and shareholders' equity
              
              $
              8,700,931
              
              $
              5,655,939
  The
                  accompanying notes are an integral part of these financial
                  statements.


1


**IsoRay,
      Inc. and Subsidiary**


**Consolidated
      Statements of Operations**


**Three
      Months Ended September 30, 2006 and 2005 (Unaudited)**




**Three
                  months ended**
                **September
                  30,****2006**
              
              **2005**Product
                  sales
              
              $
              1,025,444
              
              $
              210,915Cost
                  of product sales
              
              
              1,288,145
              
              
              720,166Gross
                  loss
              
              
              (262,701
              )
              
              (509,251
              )Operating
                  expenses:Research
                  and development
              
              
              245,598
              
              
              25,782Sales
                  and marketing expenses
              
              
              672,930
              
              
              315,039General
                  and administrative expenses
              
              
              1,733,132
              
              
              960,949Total
                  operating expenses
              
              
              2,651,660
              
              
              1,301,770Operating
                  loss
              
              
              (2,914,361
              )
              
              (1,811,021
              )Non-operating
                  income (expense):Interest
                  income
              
              
              40,183
              
              
              6,959Financing
                  expense
              
              
              (53,257
              )
              
              (155,628
              )Non-operating
                  income (expense), net
              
              
              (13,074
              )
              
              (148,669
              )Net
                  loss
              
              $
              (2,927,435
              )
              $
              (1,959,690
              )Basic
                  loss per share
              
              $
              (0.19
              )
              $
              (0.22
              )Shares
                  used in computing net loss per share:Basic
              
              
              15,300,747
              
              
              8,830,965
  The
                  accompanying notes are an integral part of these financial
                  statements.




2


**IsoRay,
      Inc. and Subsidiary**


**Consolidated
      Statements of Cash Flows**


**Three
      Months Ended September 30, 2006 and 2005
      (Unaudited)**


**Three
                  months ended**
                **September
                  30,****2006**
              
              **2005****CASH
                  FLOWS FROM OPERATING ACTIVITIES:**Net
                  loss
              
              $
              (2,927,435
              )
              $
              (1,959,690
              )Adjustments
                  to reconcile net loss to net cash used by operating activities:Depreciation
                  and amortization of fixed assets
              
              
              89,426
              
              
              45,961Amortization
                  of deferred financing costs and other assets
              
              
              39,773
              
              
              55,592Accretion
                  of asset retirement obligation
              
              
              1,528
              
              
              -Noncash
                  share-based compensation
              
              
              781,443
              
              
              -Merger
                  consulting fees paid by issuance of common stock
              
              
              -
              
              
              330,000Changes
                  in operating assets and liabilities:Accounts
                  receivable, net
              
              
              (55,808
              )
              
              (86,056
              )Inventory
              
              
              (56,407
              )
              
              (38,226
              )Prepaid
                  expenses
              
              
              (32,225
              )
              
              (61,458
              )Accounts
                  payable and accrued expenses
              
              
              69,766
              
              
              (248,232
              )Accrued
                  payroll and related taxes
              
              
              92,182
              
              
              90,177Accrued
                  interest payable
              
              
              1,713
              
              
              52,493Net
                  cash used by operating activities
              
              
              (1,996,044
              )
              
              (1,819,439
              )**CASH
                  FLOWS FROM INVESTING ACTIVITIES:**Purchases
                  of fixed assets
              
              
              (55,390
              )
              
              (253,833
              )Additions
                  to licenses and other assets
              
              
              (21,256
              )
              
              (54,458
              )Net
                  cash used by investing activities
              
              
              (76,646
              )
              
              (308,291
              )**CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Proceeds
                  from sales of convertible debentures payable
              
              
              -
              
              
              550,000Principal
                  payments on notes payable
              
              
              (17,269
              )
              
              (19,436
              )Principal
                  payments on capital lease obligations
              
              
              (51,061
              )
              
              (4,408
              )Proceeds
                  from cash sales of common shares pursuant to private placement,
                  net of
                  offering costs
              
              
              4,702,931
              
              
              -Proceeds
                  from cash sales of preferred stock, pursuant to exercise of warrants
              
              
              8,709
              
              
              -Proceeds
                  from cash sales of common stock, pursuant to exercise of warrants
              
              
              -
              
              
              56,937Proceeds
                  from cash sales of common stock, pursuant to exercise of options
              
              
              382,485
              
              
              70,548Net
                  cash provided by financing activities
              
              
              5,025,795
              
              
              653,641Net
                  increase in cash and cash equivalents
              
              
              2,953,105
              
              
              (1,474,089
              )Cash
                  and cash equivalents, beginning of period
              
              
              2,207,452
              
              
              1,685,731**CASH
                  AND CASH EQUIVALENTS, END OF PERIOD**
              
              $
              5,160,557
              
              $
              211,642
  The
                  accompanying notes are an integral part of these financial
                  statements.




3


**IsoRay,
      Inc.**


**Notes
      to the Unaudited Consolidated Financial Statements**


**For
      the three-month periods ended September 30, 2006 and 2005**








**1.** **Basis
          of Presentation**





The
      accompanying consolidated financial statements are those of IsoRay, Inc., and
      its wholly-owned subsidiary (“IsoRay” or the “Company”). All significant
      intercompany accounts and transactions have been eliminated in
      consolidation.





The
      accompanying interim consolidated financial statements have been prepared in
      conformity with U.S. generally accepted accounting principles, consistent in
      all
      material respects with those applied in the Company’s Annual Report on Form
      10-KSB for the fiscal year ended June 30, 2006, except for the July 1, 2006
      adoption of Statement of Financial Accounting Standards No. 123R,
“Share-Based Payment” (“SFAS 123R”) — See Note 2. The financial information is
      unaudited but reflects all adjustments, consisting only of normal recurring
      accruals, which are, in the opinion of the Company’s management, necessary for a
      fair statement of the results for the interim periods presented. Interim results
      are not necessarily indicative of results for a full year. The information
      included in this Form 10-QSB should be read in conjunction with the Company’s
      Annual Report on Form 10-KSB for the fiscal year ended June 30,
      2006.





**2.**  **Share-Based
      Compensation**





Prior
      to
      July 1, 2006, the Company accounted for share-based employee compensation,
      including stock options, using the method prescribed in Accounting Principles
      Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* and
      related interpretations (“APB 25”). Under APB 25, if stock options are granted
      at market price then no compensation cost is recognized, and a disclosure is
      made regarding the pro forma effect on net earnings assuming compensation cost
      had been recognized in accordance with Statement of Financial Accounting
      Standards No. 123, *Accounting
      for Stock-Based Compensation* (“SFAS
      123”). During December 2004, the Financial Accounting Standards Board
      (“FASB”) issued SFAS 123R, *Share-Based
      Payment* ,
      which
      requires companies to measure and recognize compensation expense for all
      share-based payments at fair value. SFAS 123R eliminates the ability to account
      for share-based compensation transactions using APB 25, and generally requires
      that such transactions be accounted for using prescribed fair-value-based
      methods. SFAS 123R permits public companies to adopt its requirements using
      one
      of two methods: (a) a “modified prospective” method in which compensation
      costs are recognized beginning with the effective date based on the requirements
      of SFAS 123R for all share-based payments granted or modified after the
      effective date, and based on the requirements of SFAS 123 for all awards granted
      to employees prior to the effective date of SFAS 123R that remain unvested
      on
      the effective date or (b) a “modified retrospective” method which includes
      the requirements of the modified prospective method described above, but also
      permits companies to restate based on the amounts previously recognized under
      SFAS 123 for purposes of pro forma disclosures either for all periods presented
      or prior interim periods of the year of adoption. Effective July 1, 2006,
      the Company adopted SFAS 123R using the modified prospective method. No
      share-based employee compensation cost was reflected in the statement of
      operations prior to the adoption of SFAS 123R. Results for prior periods have
      not been restated.





The
      following table presents the share-based compensation expense recognized in
      accordance with SFAS 123R during the three months ended September 30, 2006
      and
      in accordance with APB 25 during the three months ended September 30,
      2005:




4





Three
                months ended September 30,2006
            
            2005Cost
                of product sales
            
            $
            50,833
            
            $
            --Research
                and development
            
            
            11,835
            
            
            --Sales
                and marketing
            
            
            46,781
            
            
            --General
                and administrative
            
            
            671,994
            
            
            --Total
                share-based compensation
            
            $
            781,443
            
            $
            --





The
      adoption of SFAS 123R reduced income before income tax expense and net income
      for the three months ended September 30, 2006 by $781,443. Basic loss per
      common share for the three months ended September 30, 2006 would have been
      $0.14
      if the Company had not adopted SFAS 123R, compared to reported basic loss per
      common share of $0.19. The total value of the stock options awards is expensed
      ratably over the service period of the employees receiving the awards. As of
      September 30, 2006, total unrecognized compensation cost related to stock-based
      options and awards was $944,407 and the related weighted-average period over
      which it is expected to be recognized is approximately 1.23 years.





The
      Company currently provides stock-based compensation under three equity incentive
      plans approved by the Board of Directors: the Amended and Restated 2005 Employee
      Stock Option Plan, the Amended and Restated 2005 Stock Option Plan, and the
      2006
      Director Stock Option Plan. Stock option awards granted from these plans are
      granted at the fair market value on the date of grant, and vest over a period
      determined at the time the options are granted, generally ranging from zero
      to
      three years, and generally have a maximum term of ten years. For stock options
      with graded vesting terms, the Company recognizes compensation cost on a
      straight-line basis over the requisite service period for each separately
      vesting portion of the award as if the award was, in substance, multiple
      awards.





A
      summary
      of stock option activity within the Company’s share-based compensation plans and
      charges for the three months ended September 30, 2006 is as
      follows:





Shares
            
            
            Price
                (a)
            
            
            Life
                (b)
            
            
            Value
                (c)Outstanding
                at June 30, 2006
            
            
            3,129,692
            
            $
            2.05Granted
                (d)
            
            
            627,900
            
            
            3.15Exercised
            
            
            (321,416
            )
            
            1.19Outstanding
                at September 30, 2006
            
            
            3,436,176$
            
            
            2.33
            
            
            9.04
            
            $
            3,667,141Expected
                to vest at September 30, 2006
            
            
            3,380,949
            
            $
            2.32
            
            
            9.04
            
            $
            3,629,538Vested
                and exercisable at September 30, 2006
            
            
            2,789,770
            
            $
            2.04
            
            
            8.98
            
            $
            3,510,462





(a)
            Weighted
                average price per share.


(b)
            Weighted
                average remaining contractual life.


(c)
            Aggregate
                intrinsic value.


(d)
            All
                options granted had exercise prices equal to the ending market price
                of
                the Company’s common stock on the grant
                date.





The
      aggregate intrinsic value of options exercised during the three months ended
      September 30, 2006 was $702,763.




5


The
      weighted average fair value of stock option awards granted and the key
      assumptions used in the Black-Scholes valuation model to calculate the fair
      value are as follows for the three months ended September 30, 2006 and 2005:




Three
                months ended
              September
                30,2006
            
            2005Weighted
                average fair value of options granted
            
            $
            2.10
            
            $
            0.68Key
                assumptions used in determining fair value:Weighted
                average risk-free interest rate
            
            
            4.90
            %
            
            4.60
            %Expected
                life of the option (in years)
            
            
            5.51
            
            
            8.50Expected
                stock price volatility
            
            
            75.00
            %
            
            30.00
            %Expected
                dividend yield
            
            
            0.00
            %
            
            0.00
            %





The
      Black-Scholes option valuation model was developed for use in estimating the
      fair value of traded options which have no vesting restrictions and are fully
      transferable. In addition, option valuation models require the input of highly
      subjective assumptions, including the expected stock price volatility. Because
      changes in the subjective input assumptions can materially affect the fair
      value
      estimate, in management’s opinion, the existing models do not necessarily
      provide a reliable single measure of the fair value of its employee stock
      options. The risk-free interest rate is based on the U.S. treasury security
      rate
      in effect as of the date of grant. The expected lives of options and the
      volatility are based on historical data of the Company.





The
      following table illustrates the effect on net loss and net loss per common
      share
      for the three months ended September 30, 2005 as if the Company had applied
      the fair value recognition provisions of SFAS 123 to all outstanding stock
      option awards for periods presented prior to the Company’s adoption of SFAS
      123R:





Three
                monthsEnded
                September 30,2005Net
                loss, as reported
            
            $
            1,959,690Stock-based
                compensation expense determinedUnder
                fair value methods for all stock options
            
            
            156,000Proforma
                net loss
            
            $
            2,115,690Net
                loss per share:Basic,
                as reported
            
            $
            0.22Basic,
                pro forma
            
            $
            0.24





**3.**  **Loss
      per Share**





The
      Company accounts for its income (loss) per common share according to SFAS No.
      128, *Earnings
      Per Share* .
      Under
      the provisions of SFAS No. 128, primary and fully diluted earnings per share
      are
      replaced with basic and diluted earnings per share. Basic earnings per share
      is
      calculated by dividing net income (loss) available to common shareholders by
      the
      weighted average number of common shares outstanding, and does not include
      the
      impact of any potentially dilutive common stock equivalents. Common stock
      equivalents, including warrants to purchase the Company's common stock and
      common stock issuable upon the conversion of notes payable, are excluded from
      the calculations when their effect is antidilutive. Basic weighted average
      shares outstanding for the year ended June 30, 2005 have been adjusted to
      reflect the exchange ratio contained in the merger transaction dated July 28,
      2005. At June 30, 2006 and 2005, the calculation of diluted weighted average
      shares does not include preferred stock, options, or warrants that are
      potentially convertible into common stock as those would be antidilutive due
      to
      the Company’s net loss position.





6


Securities
      that could be dilutive in the future as of September 30, 2006 and 2005 are
      as
      follows:





September
                30,2006
            
            2005Preferred
                stock
            
            
            91,928
            
            
            1,260,732Preferred
                stock warrants
            
            
            173,292
            
            
            224,300Common
                stock warrants
            
            
            4,768,563
            
            
            354,627Common
                stock options
            
            
            3,436,176
            
            
            2,310,046Convertible
                debentures
            
            
            109,639
            
            
            997,078Total
                potential dilutive securities
            
            
            8,579,598
            
            
            5,146,783




**4.**  **Risks
      and Uncertainties**





The
      Company’s financial statements have been prepared on a going concern basis,
      which contemplates the realization of assets and settlement of liabilities
      and
      commitments in the normal course of business. However, our large operating
      losses and accumulated deficit, among other things, raise substantial doubt
      about our ability to continue as a going concern. Management plans to raise
      additional financing (including the sale of additional equity or borrowings)
      and
      grow the revenues of our core product while continually analyzing other market
      opportunities. However, no assurance can be given that such financing will
      be
      completed on terms acceptable to the Company or that the Company will be able
      to
      meet its revenue targets. If the Company is unable to obtain additional
      financing and grow revenues, we may have to curtail our business or cease
      operations. The financial statements do not include any adjustments relating
      to
      the recoverability of assets and classification of liabilities that might be
      necessary should the Company be unable to continue as a going
      concern.





**5.**  **Return
      of Subscription Receivable Shares**





The
      Company had previously entered into Purchase Agreements with Mercatus &
Partners, Limited, a United Kingdom private limited company (“Mercatus”) in
      December 2005 that permitted Mercatus to purchase 1,748,146 shares of common
      stock subject to the receipt of funding. As no funding had been received, on
      May
      18, 2006, the Company requested the return of the share certificates. After
      significant delay and the Company’s attainment of a court order, the share
      certificates were returned. On August 8, 2006, the share certificates were
      cancelled and the Purchase Agreements were terminated. The Company then reversed
      the subscription receivable and the related entry to additional paid-in
      capital.





**6.**  **August
      2006 Stock Purchase Agreement**





On
      August
      17, 2006, the Company sold certain shares of its common stock and warrants
      to
      purchase common stock pursuant to a Common Stock and Warrant Purchase Agreement
      (the "Purchase Agreement") dated August 9, 2006. The securities were issued
      to
      25 accredited investors pursuant to the exemption from registration provided
      by
      Section 4(2) of the Securities Act of 1933, as amended. MicroCapital, LLC acted
      as the lead investor for the transaction. Net proceeds of $4.7 million was
      received by the Company in exchange for the issuance of 2,063,000 shares of
      common stock and warrants to purchase 2,063,000 shares of common stock. In
      addition, brokers assisting the Company with the capital raise were issued
      warrants to purchase 206,300 shares of common stock on identical terms as the
      warrants issued to investors. If all warrants were exercised, the Company would
      receive $6,808,500.





7


Pursuant
      to the Purchase Agreement, the purchase price per share of the Company’s common
      stock was $2.50, and the accompanying warrants were issued with an exercise
      price of $3.00 per share. The warrants and the Purchase Agreement contain
      anti-dilution provisions, including one providing that, if the Company issues
      stock or rights to acquire stock at a price less than $2.00 (excluding certain
      issuances such as options to employees, directors and certain consultants and
      shares issued in connection with licensing or leasing transactions), the Company
      is required to issue to each investor additional shares equal to 25% of what
      such investor purchased in the original transaction. The warrants are
      exercisable by the holder (subject to anti-dilution and adjustment provisions)
      for a period of five years from the date of issuance. The warrants are callable
      by the Company for 45 days after a period of 60 trading days in which the price
      of the underlying stock exceeds $4.50 per share for 30 of the 60 days, and
      only
      if a registration statement covering the underlying shares is
      effective.





In
      connection with the Purchase Agreement, the Company also entered into a
      Registration Rights Agreement whereby the Company has agreed to file a
      registration statement to cover the re-sale of the shares of common stock sold
      and issuable upon exercise of the warrants. Under the Registration Rights
      Agreement, the Company has agreed to file the registration statement within
      60
      days of the closing, cure any defect causing the registration statement to
      fail
      to be effective within 10 business days, and cause suspension periods for the
      registration statement to not exceed 60 days in any 360 day period. If the
      Company fails to comply with these provisions, the Company will be required
      to
      pay as liquidated damages an amount equal to 2% of the aggregate purchase price
      paid by the investors for each 30 day period during which the failure continues,
      not to exceed 10% of the aggregate purchase price. A Form SB-2 Registration
      Statement to register these shares was filed with the SEC on October 16, 2006
      and amended on October 19, 2006 and is currently pending SEC
      review.





**7.**  **Settlement
      Agreements with Former Executives**





In
      September 2006, the Company entered into a settlement agreement with a former
      executive. As part of the settlement the Company agreed to pay the former
      executive $100,000 in September 2006 and $215,000 in January 2007.





Also
      in
      September 2006, the Company reached a preliminary settlement agreement, subject
      to approval of the Board of Directors, with its former Chief Financial Officer.
      The preliminary settlement calls for payments totaling $288,000, with the timing
      of these payments under negotiation.


**8.**  **Subsequent
      Event**





Supply
      Contract





On
      October 6, 2006, IsoRay Medical, Inc., the wholly owned subsidiary of the
      Registrant, entered into a Contract with FSUE "SSE - Research Institute of
      Atomic Reactors" ("RIAR") in Russia. The Contract provides for delivery to
      IsoRay Medical of purified Cs-131 isotope, which is used by IsoRay Medical
      to
      produce its proprietary Cs-131 brachytherapy seed used in the treatment of
      prostate cancer. The total value of the Contract over its term, which expires
      on
      May 1, 2014, is $6,300,000. Delivery of the isotope is scheduled to commence
      in
      January 2007 and continue through December 2013, upon submission of written
      orders by IsoRay Medical forty-five days in advance of the planned date of
      delivery.





IsoRay
      Medical also entered into an Agreement for Exclusive Right to Buy on October
      6,
      2006 with RIAR. This Agreement gives IsoRay Medical the exclusive right to
      purchase the Cs-131 isotope produced by RIAR for a period of seven years, or
      through October 6, 2013.




8


**ITEM
      2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
      OPERATION**





***Caution
      Regarding Forward-Looking Information***





*All
      statements contained in this Form 10-QSB, other than statements of historical
      facts, that address future activities, events or developments are
      forward-looking statements, including, but not limited to, statements containing
      the words "believe," "expect," "anticipate," "intends," "estimate," "forecast,"
      "project," and similar expressions . All statements other than statements of
      historical fact are statements that could be deemed forward-looking statements,
      including any statements of the plans, strategies and objectives of management
      for future operations; any statements concerning proposed new products,
      services, developments or industry rankings; any statements regarding future
      economic conditions or performance; any statements of belief; and any statements
      of assumptions underlying any of the foregoing. These statements are based
      on
      certain assumptions and analyses made by us in light of our experience and
      our
      assessment of historical trends, current conditions and expected future
      developments as well as other factors we believe are appropriate under the
      circumstances. However, whether actual results will conform to the expectations
      and predictions of management is subject to a number of risks and uncertainties
      described under “Risk Factors” beginning on page 14 below and in the “Risk
      Factors” sections of our Form 10-KSB for the fiscal year ended June 30, 2006 and
      our amended Registration Statement on Form SB-2 initially filed on November
      10,
      2005 and amended on October 24, 2006 that may cause actual results to
      differ materially.*





*Consequently,
      all of the forward-looking statements made in this Form 10-QSB are qualified
      by
      these cautionary statements and there can be no assurance that the actual
      results anticipated by management will be realized or, even if substantially
      realized, that they will have the expected consequences to or effects on our
      business operations. Readers are cautioned not to place undue reliance on such
      forward-looking statements as they speak only of the Company's views as of
      the
      date the statement was made. The Company undertakes no obligation to publicly
      update or revise any forward-looking statements, whether as a result of new
      information, future events or otherwise.*





**Critical
      Accounting Policies and Estimates**





The
      discussion and analysis of the Company’s financial condition and results of
      operations are based upon its consolidated financial statements, which have
      been
      prepared in accordance with accounting principles generally accepted in the
      United States of America. The preparation of these financial statements requires
      management to make estimates and judgments that affect the reported amounts
      of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      liabilities. On an on-going basis, management evaluates past judgments and
      estimates, including those related to bad debts, inventories, accrued
      liabilities, and contingencies. Management bases its estimates on historical
      experience and on various other assumptions 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. The accounting policies
      and
      related risks described in the Company’s annual report on Form 10-KSB as filed
      with the Securities and Exchange Commission on September 28, 2006 are those
      that
      depend most heavily on these judgments and estimates. As of September 30,
      2006, there have been no material changes to any of the critical accounting
      policies contained therein except for the adoption of SFAS 123R as noted
      below.





**Share-Based
      Compensation**





As
      part
      of our adoption of SFAS 123R as of July 1, 2006, we were required to
      recognize the fair value of share-based compensation awards as an expense.
      We
      apply the Black-Scholes option-pricing model in order to determine the fair
      value of stock options on the date of grant, and we apply judgment in estimating
      key assumptions that are important elements in the model such as the expected
      stock-price volatility, expected stock option life and expected forfeiture
      ratios. Our estimates of these important assumptions are based on historical
      data and judgment regarding market trends and factors. If actual results are
      not
      consistent with our assumptions and judgments used in estimating these factors,
      we may be required to record additional share-based compensation expense, which
      could be material to our results of operations.





9


**Adoption
      of SFAS 123R**





During
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      SFAS 123R, which requires companies to measure and recognize compensation
      expense for all share-based payments at fair value. Share-based payments include
      stock option and nonvested share grants. We grant options to purchase common
      stock to some of our employees and directors under various plans at prices
      equal
      to the market value of the stock on the dates the options were granted. We
      historically have accounted for stock options using the method prescribed in
      APB
      25 whereby if stock options are granted at market price then no compensation
      cost is recognized, and disclosed the pro forma effect on net earnings assuming
      compensation cost had been recognized in accordance with SFAS 123. SFAS 123R,
      which was effective for us beginning on July 1, 2006, eliminates the ability
      to
      account for share-based compensation transactions using APB 25, and generally
      requires that such transactions be accounted for using prescribed
      fair-value-based methods. SFAS 123R permits public companies to adopt its
      requirements using one of two methods: (a) a “modified prospective” method
      in which compensation costs are recognized beginning with the effective date
      based on the requirements of SFAS 123R for all share-based payments granted
      or
      modified after the effective date, and based on the requirements of SFAS 123
      for
      all awards granted to employees prior to the effective date of SFAS 123R that
      remain unvested on the effective date or (b) a “modified retrospective”
method which includes the requirements of the modified prospective method
      described above, but also permits companies to restate based on the amounts
      previously recognized under SFAS 123 for purposes of pro forma disclosures
      either for all periods presented or prior interim periods of the year of
      adoption. We have decided to adopt SFAS 123R using the modified prospective
      method.





During
      the three months ended September 30, 2006, we recognized $781,443 of
      compensation expense related to the expensing of stock options in accordance
      with SFAS 123R. Approximately $51,000, $12,000, $47,000, and $672,000 of this
      amount is included in cost of products sales, research and development, sales
      and marketing, and general and administrative expenses, respectively, in the
      accompanying consolidated statements of operations. As of September 30,
      2006, total unrecognized compensation cost related to stock-based options was
      $944,407 and the related weighted-average period over which it is expected
      to be
      recognized is approximately 1.23 years.





**Results
      of Operations**




**Three
      months ended September 30, 2006 compared to three months ended September 30,
      2005**





**Revenues.** The
      Company generated sales of $1,025,444 during the three months ended September
      30, 2006, compared to sales of $210,915 during the three months ended September
      30, 2005. The increase of $814,529 or 386% is due to increased sales volume
      of
      the Company’s 131 Cs
      seed.
      During the three months ended September 30, 2006, the Company sold its 131 Cs
      seed
      to 23 different medical centers as compared to 10 centers during the
      corresponding period of 2005.





10


**Cost
      of product sales.** Cost of
      product sales was $1,288,145 for the three months ended September 30, 2006
      compared to cost of product sales of $720,166 during the three months ended
      September 30, 2005. The increase of $567,979 or 79% was due to the higher
      production levels during the three months ended September 30, 2006 which were
      related to the increase in sales volume over the corresponding period from
      2005.
      The major components of the increase were wages, benefits and related taxes,
      materials, depreciation, third-party preload services, share-based compensation,
      and rent and occupancy expenses.  Wages, benefits, and related taxes
      increased about $201,000 to approximately $374,000 for the three months ended
      September 30, 2006 due to the hiring of additional production employees to
      support the higher production levels. Materials costs increased about $297,000
      to approximately $421,000 in 2006, due to increased sales volumes. Depreciation
      expense increased about $42,000 to approximately $83,000 in 2006 due to the
      addition of equipment that was placed in service during the second half of
      the
      fiscal year ended June 30, 2006. Third-party preload services also increased
      by
      about $58,000 to approximately $74,000 for the three months ended September
      30,
      2006 due to the higher volume of sales. Share-based compensation expense was
      approximately $51,000 and $0 for the three months ended September 30, 2006
      and
      2005, respectively, as the Company implemented SFAS 123R on July 1, 2006. Rent
      and occupancy expenses were approximately $39,000 and $0 for the three months
      ended September 30, 2006 and 2005, respectively, as the Company moved into
      its
      independent production facility in the second half of fiscal year 2006. These
      increases were offset by lower payments to Pacific Northwest National Laboratory
      (“PNNL”) as the Company discontinued using PNNL’s facilities and personnel to
      manufacture its product during fiscal year 2006. For the three months ended
      September 30, 2005, the Company paid PNNL approximately $235,000 under a
      production contract. The Company has continued to use PNNL for certain
      analytical support functions and paid PNNL approximately $80,000 during the
      three months ended September 30, 2006.





**Gross
      loss.** Gross
      loss was $262,701 for the three month period ended September 30, 2006. This
      represents an improvement of $246,550 or 48% over the corresponding period
      of
      2005’s gross loss of $509,251. The improvement in gross loss is due to higher
      revenues and greater production efficiency.





**Research
      and development.** Research
      and development expenses for the three month period ended September 30, 2006
      were $245,598 which represents an increase of $219,816 or 853% over the research
      and development expenses of $25,782 for the corresponding period of 2005. The
      major components of the increase were wages, benefits and related taxes,
      protocol studies, consulting, and share-based compensation. Wages, benefits
      and
      related taxes were approximately $64,000 and $0 for the three months ended
      September 30, 2006 and 2005, respectively, as the Company hired research
      scientists. Protocol studies expenses increased about $73,000 to approximately
      $76,000 for the three-months ended September 30, 2006 as more patients were
      enrolled in these studies. Consulting expenses increased about $65,000 to
      approximately $88,000 as the Company continues to refine the production of
      isotopes. Share-based compensation expense was approximately $12,000 and $0
      for
      the three months ended September 30, 2006 and 2005, respectively, as the Company
      implemented SFAS 123R on July 1, 2006.





**Sales
      and marketing expenses.** Sales
      and
      marketing expenses were $672,930 for the three months ended September 30, 2006.
      This represents an increase of $357,891 or 114% compared to the three months
      ended September 30, 2005’s expenditures of $315,039 for sales and marketing.
      During the three months ended September 30, 2006, approximately $392,000 was
      paid for wages, including payroll-related taxes, travel, office and other
      support expenses on behalf of our sales and marketing and customer service
      staff
      and approximately $47,000 represents share-based compensation expense. The
      balance was spent on advertising, market research, and trade shows and
      conferences. The increase over the prior year is due to increased sales and
      marketing personnel and increased expenses to market the Company’s 131 Cs
      seeds
      through promotional materials and conventions and tradeshows as the Company
      continues its efforts to expand its market share.




11


**General
      and administrative expenses.** General
      and administrative expenses for the three months ended September 30, 2006 were
      $1,733,132 compared to general and administrative expenses of $960,949 for
      the
      corresponding period of 2005. The increase of $772,183 or 80% is primarily
      due
      to approximately $672,000 of share-based compensation expense related to the
      implementation of SFAS 123R on July 1, 2006, a one-time severance accrual of
      $288,000, approximately $100,000 of increased payroll costs due to a higher
      headcount, approximately $27,000 relating to investor relations expenses, and
      approximately $12,000 relating to higher insurance premiums due to the growth
      of
      the Company. These increased expenses were partially offset by a reduction
      in
      consulting fees of approximately $330,000 which represents merger consulting
      fees incurred in the three months ended September 30, 2005.





**Operating
      loss.** Due to
      our significant research and development expenditures, additional
      responsibilities as a reporting company, rapid structural growth, and product
      revenues not covering production costs, we have not been profitable, and have
      generated operating losses since our inception. In the three months ended
      September 30, 2006, the Company had an operating loss of $2,914,361 which is
      an
      increase of $1,103,340 or 61% over the operating loss of $1,811,021 for the
      three months ended September 30, 2005. Included in the operating loss for the
      three months ended September 30, 2006 is share-based compensation expense of
      $781,443 due to the implementation of SFAS 123R during the period and a one-time
      severance accrual of $288,000. Without these two expense items, our operating
      loss would have had only a marginal increase.





**Interest
      income.** Interest
      income increased by $33,224 or 477% to $40,183 for the three months ended
      September 30, 2006. Interest income is mainly derived from excess funds held
      in
      certain near-liquid accounts.





**Financing
      expense.** Financing expense for the three months ended September 30, 2006 was $53,257
      or a
      decrease of $102,371 or 66% from financing expense of $155,628 for the
      corresponding period in 2005. Included in financing expense is interest expense
      of approximately $31,000 and $104,000 for the three months ended September
      30,
      2006 and 2005, respectively. The decrease in interest expense is due to the
      conversion of debentures to common stock during the fiscal year ended June
      30,
      2006 partially offset by interest expense related to the Hanford Area Economic
      Investment Fund Committee (HAEIFC) loan that was entered into in June 2006.
      The
      remaining balance of financing expense represents the amortization of deferred
      financing costs which decreased due to the write-off in fiscal year 2006 of
      the
      deferred financing costs relating to the debentures that were converted to
      common stock partially offset by the amortization of the HAEIFC deferred
      financing costs.





**Liquidity
      and capital resources** .
      At
      September 30, 2006, cash and cash equivalents amounted to $5,160,557. During
      the
      three months ended September 30, 2006, the Company issued 2,063,000 shares
      of
      common stock at a price of $2.50 per share and 2,269,300 common stock warrants
      (including broker warrant commissions) with an exercise price of $3.00 per
      share
      pursuant to a round of institutional funding. This funding provided
      approximately $4.7 million, net of offering costs. Additionally, the Company
      issued 327,636 shares of common stock pursuant to the exercise of common stock
      options and preferred stock warrants, which were exchanged for common stock
      immediately upon exercise. The Company received $391,194 in cash pursuant to
      these exercises.




The
      Company had approximately $4.7 million cash on hand as of October 31,
      2006 **.** As of
      that date management believes that the Company’s monthly required cash operating
      expenditures were approximately $800,000. Management believes that assuming
      expenditures continue at approximately the same monthly rate and that it is
      able
      to fund a portion of its equipment purchases with the HAEIFC loan, that the
      Company’s cash on hand will fund operating expenditures through the beginning of
      March 2007. This is based on the Company attaining its current revenue targets
      and the ability to efficiently manufacture our product. If we should experience
      disruptions in our revenues then our monthly cash requirements would increase
      and necessitate that we obtain additional funding prior to February
      2007.





12


Our
      growth plans for fiscal 2007 include expanding sales to new customers, growing
      sales volume with existing customers, and expanding production capability
      through the purchase of additional equipment. The Company has also begun a
      review of its current facilities and future needs. The Company continues to
      use
      PNNL to provide third-party assay of its products, but has otherwise vacated
      PNNL facilities. This review includes evaluating the Company’s need for space
      given its growth projections. It is anticipated that additional employees and
      production equipment will be needed to meet future growth. This will create
      the
      need for additional production and office space that would be leased through
      an
      operating lease.





IsoRay
      has three loans outstanding as of September 30, 2006. The first loan is from
      the
      Benton-Franklin Economic Development District (“BFEDD”) in an original principal
      amount of $230,000 and was funded in December 2004. It bears interest at eight
      percent and has a sixty month term with a final balloon payment. As of September
      30, 2006, the principal balance owed was $201,312. This loan is secured by
      certain equipment, materials and inventory of IsoRay, and also required personal
      guarantees, for which the guarantors were issued approximately 70,455 shares
      of
      common stock. The second loan is a line of credit from Columbia River Bank,
      which provides credit in the amount of $375,000. It bears interest at a floating
      prime plus two percent rate, and is secured by certain accounts receivable
      and
      inventory and personal guarantees, for which the guarantors were issued
      approximately 107,401 shares of common stock. As of September 30, 2006, no
      balance was outstanding on the line of credit. The line of credit expires on
      March 1, 2007. The third loan is from the Hanford Area Economic Investment
      Fund
      Committee and was originated in June 2006. The loan has a total facility of
      $1,400,000 and bears interest at nine percent. As of September 30, 2006, the
      Company has taken only a partial draw of $418,670 on the facility and the
      remaining facility of $981,330 is available to use to purchase equipment. The
      principal balance owed on the loan as of September 30, 2006 was $414,327. This
      loan is secured by receivables, equipment, materials and inventory of IsoRay,
      and certain life insurance policies.





The
      Company has certain capital leases for production and office equipment that
      expire at various times from March 2008 to April 2009. These leases currently
      call for total monthly payments of $19,361. The total of capital lease
      obligations at September 30, 2006 was $352,908.





At
      September 30, 2006, the Company had outstanding $455,000 of convertible
      debentures. These debentures could be converted into 109,639 shares of common
      stock at a conversion rate of $4.15 per share. Each debenture bears interest
      at
      an annual rate of eight percent (not compounded) with accrued interest paid
      quarterly. The debentures mature at various times from February 2007 to June
      2007.





In
      February 2006, the Company signed a license agreement with International
      Brachytherapy s.a. (“IBt”) covering North America and providing the Company with
      access to IBt’s Ink Jet production process and its proprietary polymer seed
      technology for use in brachytherapy procedures using Cesium-131. The Company
      paid license fees of $275,000 during 2006 and another payment of $225,000 was
      to
      be made in August 2006 pursuant to the license agreement. Royalty payments
      based
      on net sales revenue are also required, with minimum quarterly royalties ranging
      from $100,000 to $200,000 and minimum annual royalties ranging from $400,000
      to
      $800,000 over the term of the agreement. Management is engaged in further
      negotiations with IBt and may ultimately terminate this agreement, although
      management has not yet decided on a course of action.





As
      of the
      date of this report, the payment due in August 2006 has not been made as the
      Company has been in continued negotiations with IBt concerning the amount and
      timing of future royalty payments due to the low market acceptance of the
      polymer seed technology.





In
      September 2006, the Company entered into a settlement agreement with a former
      executive. As part of the settlement the Company agreed to pay the former
      executive $100,000 in September 2006 and $215,000 in January 2007. As of
      September 30, 2006 the remaining payment of $215,000 is accrued in accrued
      payroll.





13


Also
      in
      September 2006, the Company reached a preliminary settlement agreement, subject
      to approval of the Board of Directors, with its former Chief Financial Officer.
      The preliminary settlement calls for payments totaling $288,000, with the timing
      of these payments under negotiation.





The
      industry that the Company operates in is subject to product liability
      litigation. Through its production and quality assurance procedures, the Company
      works to mitigate the risk of any lawsuits concerning its product. The Company
      also carries product liability insurance to help protect it from this
      risk.





The
      Company expects to finance its future cash needs through the sale of equity
      securities, solicitation to warrant holders to exercise their warrants, and
      possibly strategic collaborations or debt financing or through other sources
      that may be dilutive to existing shareholders. If the Company needs to raise
      additional money to fund its operations, funding may not be available to it
      on
      acceptable terms, or at all. If the Company is unable to raise additional funds
      when needed, it may not be able to market its products as planned or continue
      development and regulatory approval of its future products. If the Company
      raises additional funds through equity sales, these sales may be dilutive to
      existing investors.





The
      Company has no off-balance sheet arrangements.





**Going
      Concern Issues**




Our
      financial statements have been prepared assuming we will continue as a going
      concern. We had net losses of $8,218,130 and $4,269,188 for the years ended
      June
      30, 2006 and 2005 and an accumulated deficit of $13,546,261 at June 30, 2006.
      Our accumulated deficit at September 30, 2006 was $16,473,696. These factors,
      among others, raise substantial doubt about our ability to continue as a going
      concern. Our financial statements do not include any adjustment that might
      result from the outcome of this uncertainty. Management plans to obtain the
      necessary financing and to continue to grow revenues in order to achieve
      profitability but no assurances can be given that management will be able to
      obtain additional financing or grow revenues to a profitable level.





If
      we are
      unable to generate profits and unable to obtain additional financing to meet
      our
      working capital requirements, we may have to curtail our business or cease
      operations. Our continuation as a going concern is dependent upon our ability
      to
      generate sufficient cash flow to meet our obligations on a timely basis, to
      obtain additional financing, and, ultimately, to attain profitability. Should
      any of these events not occur, the accompanying financial statements will be
      adversely effected and we may have to cease operations.




**Risk
      Factors**





**You
      should consider the following discussion of risks as well as other information
      regarding our operations. The risks and uncertainties described below are not
      the only ones. Additional risks and uncertainties not presently known to us
      or
      that we currently deem immaterial also may impair our business operations.
      For a
      more detailed discussion of the risks facing us, you should review the "Risk
      Factors" sections contained in our Form 10-KSB for the fiscal year ended June
      30, 2006, and our amended Registration Statement on Form SB-2 originally filed
      with the SEC on November 10, 2005 and amended on October 24,
      2006.**





·
            Our
                independent accountants have expressed uncertainty about our ability
                to
                continue as a going concern.




14




·
            Our
                revenues depend upon one product, our131Cs
                brachytherapy seed, which is used to treat only one type of cancer
                as of
                the date of this report, although it is approved to treat any malignant
                tissue.




·
            We
                have limited data on the clinical performance of the131Cs
                seed.




·
            We
                will need to raise additional capital to fund our operations until
                we
                reach profitability.




·
            The
                passage of Initiative 297, which may in the future impose restrictions
                on
                sites generating certain types of radioactive wastes in Washington,
                may
                result in the relocation of our manufacturing
                operations.




·
            We
                have limited manufacturing experience and may not be able to meet
                future
                demand without increasing our supply of the isotopes used to manufacture
                our product and also increasing our level of
                staffing.




·
            We
                have limited specific experience with the sales and marketing of
                the131Cs
                seed.




·
            We
                are subject to the risk that certain third parties may mishandle
                our
                product.




·
            Our
                quarterly operating results will be subject to significant
                fluctuations.




·
            We
                rely heavily on a limited number of suppliers, particularly on our
                Russian
                suppliers of Barium and Cesium which amount to well over 50% of the
                raw
                materials needed for our
                production.




·
            We
                are subject to uncertainties regarding reimbursement for use of our
                product.




·
            It
                is possible that other treatments may be deemed superior to brachytherapy
                for the treatment of cancer and if this were to occur, demand for
                our
                product would decline.




·
            Our
                industry is intensely competitive, and many of our competitors are
                larger
                than we are and possess greater
                resources.




·
            We
                may be unable to adequately protect or enforce our intellectual property
                rights or secure rights to third-party patents, the value of our
                granted
                patent and our patents pending is uncertain, and one of our licensed
                patents may be terminated under certain
                conditions.




·
            Failure
                to comply with government regulations, which are quite complex, could
                harm
                our business.




·
            Our
                business exposes us to product liability claims and also involves
                environmental risks.




·
            We
                rely heavily upon our executive officers and key scientific
                personnel.




·
            Our
                ability to expand into foreign markets is
                uncertain.




·
            Our
                ability to successfully commercialize our product is
                uncertain.




·
            Our
                reporting obligations as a public company are
                costly.




·
            There
                is a limited market for our common stock, and our stock price is
                likely to
                be volatile.




·
            Our
                common stock may be subject to penny stock regulation.




·
            Future
                sales by shareholders of the shares available for sale in the public
                market, or the perception that such sales may occur, may depress
                the price
                of our common stock.




15


**ITEM
      3.**  **CONTROLS
      AND PROCEDURES**




(a)  Under
      the
      supervision and with the participation of our management, including our
      principal executive officer and principal financial officer, we conducted an
      evaluation of the design and operation of our disclosure controls and
      procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)
      promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
      Act"), as of September 30, 2006. Based on that evaluation, our principal
      executive officer and our principal financial officer concluded that the design
      and operation of our disclosure controls and procedures were effective in timely
      alerting them to material information required to be included in the Company's
      periodic reports filed with the SEC under the Exchange Act. The design of any
      system of controls is based in part upon certain assumptions about the
      likelihood of future events, and there can be no assurance that any design
      will
      succeed in achieving its stated goals under all potential future conditions,
      regardless of how remote. However, management believes that our system of
      disclosure controls and procedures is designed to provide a reasonable level
      of
      assurance that the objectives of the system will be met.




(b)  In
      connection with the review of our consolidated financial statements for the
      period ended September 30, 2005, our independent registered public accounting
      firm advised the Board of Directors and management of certain significant
      internal control deficiencies that they considered to be, in the aggregate,
      a
      material weakness. In particular, our independent registered public accounting
      firm identified the following weaknesses in our internal control system: (1)
      a
      lack of segregation of duties and (2) a lack of formal procedures relating
      to
      all areas of financial reporting. The independent registered public accounting
      firm indicated that they considered these deficiencies to be reportable
      conditions as that term is defined under standards established by the American
      Institute of Certified Public Accountants. A material weakness is a significant
      deficiency in one or more of the internal control components that alone or
      in
      the aggregate precludes our internal controls from reducing to an appropriately
      low level of risk that material misstatements in our financial statements will
      not be prevented or detected on a timely basis. The Company considered these
      matters in connection with the period end closing of accounts and preparation
      of
      the related consolidated financial statements and determined that no prior
      period financial statements were materially affected by such matters.
      Notwithstanding the material weaknesses identified by our independent registered
      public accountants, we believe that the financial statements, and other
      financial information included in this report, fairly present in all material
      respects, the financial condition, results of operation and cash flows of the
      Company as of, and for, the periods represented in this report.





The
      size
      of the Company has previously prevented us from being able to employ sufficient
      resources at this time to enable us to have an adequate level of supervision
      and
      segregation of duties within our internal control system. Set forth below is
      a
      discussion of the significant internal control deficiencies that had not been
      remediated as of the end of the period covered by this report.





*Lack
      of segregation of duties.* Our size
      has prevented us from being able to employ sufficient resources to enable us
      to
      have an adequate level of segregation of duties within our internal control
      system. There are two dedicated employees and three employees that work in
      accounting and other departments who are involved in the processing of
      transactions. Due to the small employee base it is difficult to effectively
      segregate accounting duties. While we strive to segregate duties as much as
      practicable, budgetary considerations have not previously allowed the addition
      of full time staff. We are currently reorganizing the accounting department
      to
      more effectively segregate duties but we believe additional staff is still
      needed. We will continue in our attempt to add staff to allow for fuller
      segregation of duties, although there is no certainty additional staff can
      be
      successfully hired. As a result, this significant internal control deficiency
      has not been remediated as of the end of the period covered by this report,
      nor
      do we know if we will be able to remediate this weakness during the upcoming
      quarter.





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*Lack
      of formal procedures relating to all areas of financial reporting including
      a
      lack of review by management* .
      Due to
      the size of our Company, and as a consequence of the lack segregation of duties,
      we historically have not previously had formal month-end close procedures.
      As a
      result, historically there has been a lack of timely review of the financial
      statements. However, near the end of fiscal year 2006 we began developing
      monthly close procedures. These procedures were partially implemented at
      September 30, 2006 and the Company is completing the documented monthly close
      process to ensure that monthly financial results are communicated to management
      in a timely manner. This significant internal control deficiency has not been
      fully remediated as of the end of the period covered by this report but we
      anticipate that it will be fully remediated by the end of the second quarter
      of
      fiscal year 2007 which ends on December 31, 2006.




If
      we are
      unable to remediate the identified material weaknesses, there is a more than
      remote likelihood that a material misstatement to our SEC reports will not
      be
      prevented or detected, in which case investors could lose confidence in the
      accuracy and completeness of our financial reports, which could have an adverse
      effect on our ability to raise additional capital and could also have an adverse
      effect on our stock price.




**PART
      II - OTHER INFORMATION**




**ITEM
      6. EXHIBITS AND REPORTS ON FORM 8-K**




(a)  Exhibits:




31.1
            Rule
                13a-14(a)/15d-14(a) Certification of Principal Executive
                Officer31.2
            Rule
                13a-14(a)/15d-14(a) Certification of Principal Financial
                Officer32
            Section
                1350 Certifications




(b)  Reports
      on Form 8-K:




On
      August
      10, 2006, the Company filed a Current Report on Form 8-K announcing the return
      of the Mercatus shares and their cancellation.





On
      August
      18, 2006, the Company filed a Current Report on Form 8-K announcing the sale
      of
      unregistered common stock and warrants pursuant to a Common Stock and Warrant
      Purchase Agreement.





On
      September 8, 2006, the Company filed a Current Report on Form 8-K announcing
      a
      press release of the Company’s preliminary financial results for the year ended
      June 30, 2006 and anticipated first quarter of fiscal year 2007.




On
      September 11, 2006, the Company filed a Current Report on Form 8-K announcing
      the resignation of the Company’s Chief Financial Officer, the appointment of a
      new Chief Financial Officer, and the transcript from the Company’s presentation
      at the Roth Capital Conference.





On
      November 6, 2006, the Company filed a Current Report on Form 8-K announcing
      its
      subsidiary’s entry into two contracts for the supply of Cesium-131 with RIAR in
      Russia.




17


SIGNATURES





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.




Dated:
                November 13, 2006ISORAY,
                INC., a Minnesota corporationBy
            /s/ Roger
                E. GirardRoger
                E. Girard, Chief Executive Officer





By
            /s/ Jonathan
                R. HuntJonathan
                R. Hunt, Chief Financial Officer








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