UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

[X]  ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 
     ACT OF 1934

                   For the fiscal year ended December 31, 1998

     TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 
     ACT OF 1934

             For the transition period from __________ to __________

                         Commission file number 0-26056

                           IMAGE SENSING SYSTEMS, INC.
                 (Name of small business issuer in its charter)

          MINNESOTA                                        41-1519168
State or other jurisdiction of                I.R.S. Employer Identification No.
incorporation of organization

1600 UNIVERSITY AVE. W., #500, ST. PAUL, MN 55104           (651) 603-7700
Address of principal executive offices                 Issuer's telephone number

         Securities registered under Section 12(b) of the Exchange act:

                                      NONE
                               Title of each class

         Securities registered under Section 12(g) of the Exchange Act:

                          COMMON STOCK, $.01 PAR VALUE
                               Title of each class

         Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. [X] Yes  No [ ] 

         Check if there is no disclosure of delinquent filers in response to
Items 405 of Regulation S-B in this form, and no disclosure will be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form-10-KSB. [X]

         The registrant's revenues for the fiscal year ended December 31, 1998
totaled $3,368,000.

         Based on the closing bid price at March 23, 1999, the aggregate market
value of the voting stock held by nonaffiliates of the registrant was
$4,015,650.

         The number of shares outstanding of the registrant's $.01 par value
common stock, as of March 23, 1999, was 2,479,200 shares.

         Transitional Small Business Issuer Format:  Yes [ ] No [X]

                      DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the registrant's Annual Report to Shareholders for the year ended
December 31, 1998, which was filed as an exhibit hereto, are incorporated by
reference into Parts I and II.

Portions of the registrant's Proxy Statement for its May 11, 1999 Annual
Meeting, which will be filed prior to April 30, 1999, are incorporated by
reference in Part III.


<PAGE>


                         SAFE HARBOR STATEMENT UNDER THE
                     PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

         This Annual Report on Form 10-KSB contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements involve risks and uncertainties that may cause the
Company's actual results to differ materially from the results discussed in the
forward-looking statements. Factors that might cause such differences include,
but are not limited to, lack of market acceptance of the Company's products;
dependence on third parties for manufacturing and marketing capabilities and
continuing ability to pay royalties owed; inability of the Company to diversify
its product offerings; revenue fluctuations caused by the Company's dependence
on sales to governmental entities; failure of the Company to secure adequate
protection for the Company's intellectual property rights; failure of the
Company to respond to evolving industry standards and technological changes;
inability of the Company to properly manage growth in revenues and/or production
requirements; inability of the Company to meet its future additional capital
requirements; and control of the voting stock by insiders. The forward-looking
statements are qualified in their entirety by the cautions and risk factors set
forth in Exhibit 99, under the caption "Cautionary Statement," to this Annual
Report on Form 10-KSB for the year ended December 31, 1998.


                                     PART I

ITEM 1.           DESCRIPTION OF BUSINESS

GENERAL

         ISS was founded in 1984 to develop and market products using video
image processing technology for use in advanced traffic management systems and
traffic data collection. Video image processing, also known as machine vision or
artificial vision, is a technology that analyzes video images through computer
programs and special purpose hardware. By using video cameras and computers to
emulate the function of the human eye, machine vision has been used in a variety
of industrial applications. ISS has combined its proprietary machine vision
technology, consisting of complex algorithms, software, and special purpose
hardware with commercially available computer hardware and video cameras, to
create a system that collects, processes, and analyzes video images.

         The Company's first product, the Autoscope(R) Wide Area Video Vehicle
Detection System, converts video images of a traffic scene into digitized
traffic data that may be transmitted to local or remote locations for real-time
traffic management or stored for later analysis. The Autoscope system is
modular, flexible, and expandable and has a variety of current and potential
applications in intersection control, freeway traffic management, and traffic
data collection. Automated vehicle detection for traffic management has
traditionally been performed with inductive wire loops buried in the pavement.
The Autoscope system is easier to install and maintain than these embedded loop

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detectors; is non-destructive to road surfaces; and is capable of wide-area
vehicle detection with a single camera, thus enabling one camera to do the work
of many loops. The Company believes that the Autoscope system is superior to
loop detectors or most other commercially available vehicle detection systems in
its current range of applications and its ability to support new applications
for advanced technology solutions to traffic management problems.

         In 1987, the University of Minnesota, utilizing the technology
underlying the Autoscope system, demonstrated the first working traffic
application of image processing technology. The U.S. patent for certain aspects
of the technology underlying the Autoscope system was issued in 1989 to the
University of Minnesota. The Company has an exclusive worldwide license from the
University of Minnesota for that technology and the patent and pays royalties to
the University of Minnesota in exchange for such license. The Company has
sublicensed the exclusive right to manufacture and market the Autoscope system
in North America and the Caribbean to Econolite Control Products, Inc.
(Econolite) of Anaheim, California and receives royalties from Econolite on
sales of the Autoscope system in those territories. Econolite also manufactures
the Autoscope system on a non-exclusive basis for direct sales by the Company
outside of North America and the Caribbean. In 1997, ISS and Econolite jointly
entered into a Production Agreement with Cohu, Inc., Electronic Division (Cohu),
wherein ISS and Econolite each granted to Cohu a non-exclusive right to
manufacture the Autoscope Solo product solely for sale to ISS and Econolite.

         The Autoscope system was first marketed and sold commercially in 1991.
In 1993, the Company began to market the Autoscope system outside of North
America through distributor arrangements, and the Company intends to continue to
increase its marketing efforts in foreign countries. The Company currently has
twenty-one distributors covering countries primarily in Europe, Asia, and South
America.

 TECHNOLOGY

         The machine vision industry utilizes technology that converts real
world "scenic" information into digital electronic signals for processing by
computer. Machine vision has a number of industrial applications. For example,
machine vision technology is used for quality control in manufacturing
processes. An image of a manufactured product can be fed by video into a
computer and analyzed to determine if that finished product satisfies production
standards that have been programmed into the computer. The defense industry has
used machine vision in a number of applications. For example, "smart" bombs use
video imaging technology to identify targets through the use of special optic
sensors that feed scenic information into sophisticated computer programs that
process the scenic information into target location coordinates.

         Through the use of its sophisticated proprietary technology, the
Company has been able to apply machine vision technology to traffic management
problems. The Company's technology was initially developed by Dr. Panos
Michalopoulos, Chairman of the Board and Chief Scientific Advisor of ISS and a
Professor at the University of Minnesota, and was further developed at the
University of Minnesota from 1985 to 1991 with involvement by Dr. Michalopoulos.
The technology uses standard video and computer equipment, combined with
proprietary technology, including complex detection algorithms, computer
software, special purpose hardware, and a Microsoft Windows(R)-based graphical
user interface that enables standard video cameras to work with the Autoscope
system.



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<PAGE>

THE AUTOSCOPE SYSTEM

         The Autoscope 2004 system generally consists of one to four video
cameras, a flexible modular microprocessor with specialized software and
circuitry, and a supervisor computer with a video monitor, keyboard, and mouse.
The Autoscope Solo system (Solo) incorporates the microprocessor and circuitry
into a single video camera. The Autoscope microprocessor in both the 2004 and
Solo systems accepts scenic input from the video cameras and, through a series
of complex algorithms and computer software, converts the scenic data into
digitized data. This data can then be used for traffic control, research,
management, and planning purposes. Most brands of commercially available
personal computers with standard configurations can be used as the supervisor
computer in the system.

         The Autoscope system permits a user to draw detection zones on a video
screen displaying the traffic scene and derive traffic data from the portion of
the image specified by the detection zones displayed on the screen. The system
analyzes virtual detection zones that appear only on the video screen, not on
the roadway. Each detection zone represents an area in the field of view of the
camera that the system user wishes to analyze for determining the presence of
vehicles or extracting other pertinent traffic data. Over 100 detection zones
can be programmed into multi-camera systems. The system user determines the
detection zones by drawing them on a video monitor with a mouse. Different types
of detection zones can be selected and may be placed anywhere in any orientation
within the field of view of the cameras using the system's unique interactive
graphics. The detection zones can be changed simply by using the mouse to
resize, reshape, or relocate the detection zones on the video monitor. Once a
new detection configuration has been created, the supervisor computer system can
display the detection zones on its own video monitor, together with the live
video image, to monitor the system in operation. When a vehicle is under the
detection zone, the detection zone changes in color or intensity, thereby
providing visual verification of correct system operation. Measured traffic data
may be displayed on the video monitor of the supervisor computer in numeric
format. The traffic data may be transmitted to another host computer via modem
and dial-up telephone lines, private cable, fiber optic network, direct cable
connection, or various other wireless communications equipment. Vehicle
detection output can also be routed to intersection signal controllers. A
detection signal is generated each time a vehicle crosses one of the virtual
detection zones, thus enabling the system to accumulate measured traffic data in
user-selected categories, such as volume, average speed, time occupancy (percent
of time the detection zone is occupied), headways (time interval between
vehicles), flow rate (vehicles per hour per lane), and vehicle length.
Information from the system can be processed in real-time or stored for later
analysis.

         The Autoscope system is modular, flexible, and expandable. The
Autoscope supervisor computer and video monitor may be disconnected once the
detection zone configuration has been transferred to the microprocessor. The
system can then operate independently, providing detection zone outputs and
storing traffic data in the microprocessor's internal memory. The same portable
supervisor computer and video monitor may be used with multiple Autoscope
systems. New detection zone configurations can be saved to diskette, and
previously saved detection zone configurations can be retrieved from diskette
for downloading into each system. The same Autoscope microprocessor can be used
with multiple cameras, each with its own detection zone configuration.



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<PAGE>

         The Company introduced its new product, Autoscope Solo, in October
1998. The Solo, which integrates the video image processor camera and
peripherals, was developed over the last two years and has now been deployed in
two large projects in Minneapolis and St. Paul, Minnesota.

CURRENT APPLICATIONS AND INSTALLATIONS

         The current Autoscope system may be used in a number of applications,
primarily for intersections, freeways, tunnels, and traffic count stations. In
addition, the Company has identified additional potential traffic and
non-traffic related applications for the system that it intends to pursue.

INTERSECTION APPLICATIONS. The Autoscope system can be installed at an
intersection to provide traffic detection information as required by an
intersection signal controller. An intersection signal controller is essentially
a device that contains a set of sophisticated computer programs, separate from
the vehicle detection system, that uses the traffic detection information to
control the green, yellow, and red lights for each of the turning or through
lanes to provide for safe and efficient movement of vehicles through the
intersection. More sophisticated intersection signal controllers use detection
information to maximize the efficient flow of traffic through one or more
intersections. The extent to which a signal controller is successful is
dependent not only on the level of sophistication of the controller but also on
the quality and reliability of the detection system and the type of traffic data
provided.

         The Autoscope system can be programmed to provide data with respect to
vehicle presence, traffic volume, time occupancy (percent of time the detection
zone is occupied), vehicle speed, turning movements, queue lengths, stopped
vehicles, vehicle direction, and vehicle length. This information is then routed
to the intersection signal controller to control the flow of traffic at the
intersection or provide alarms at centralized traffic control centers. For
example, the Autoscope system can determine that a queue has developed at a
stoplight and route that information to the intersection controller so that the
signal times can be adjusted appropriately or a left turn signal phase can be
engaged if a line develops at the left turn lane. In addition, selected
detection zones in the Autoscope system can be programmed so that they only
detect cars moving in one direction. This capability can be used to prevent
undesired detections, such as a left turning vehicle that has turned too sharply
and is momentarily driving in the wrong lane. This capability can also be used
to detect cars going the wrong way on a one way street or the wrong way on a
freeway exit-ramp. A majority of all commercially installed Autoscope systems
are currently being used for intersection control applications.

FREEWAY APPLICATIONS. For freeway applications, Autoscope provides information
for traffic management analysis, ramp control, incident detection, and automated
surveillance. Typical traffic information provided by the system includes
traffic volumes, time occupancy, vehicle speeds and vehicle counts of three
different vehicle classes based on length. The system is also used to signal an
alarm if it detects stopped vehicles or the sudden onset of congestion in a
detection zone indicating a traffic incident on the highway. Using a video
camera next to a freeway on-ramp, the Autoscope system detects traffic movement
on a freeway on-ramp or in the 



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<PAGE>

merging area on the freeway, and the resulting data is used to prevent a queue
from developing on a side street, to control on-ramp traffic signals, or to
determine the capacity of a merge area for planning and control purposes.

TRAFFIC INFORMATION GATHERING AND ANALYSIS. The Autoscope system is also used
for basic traffic information gathering and analysis on intersections, freeways,
and other roadways. Traffic planners use the traffic data collected by the
Autoscope system to design roadway changes, define signal timing plans, approve
commercial development plans, and define the environmental impact of traffic
congestion. The Autoscope system has been deployed in temporary or
semi-permanent configurations as a portable detection system during road
repairs, construction, or resurfacing and for special studies, such as traffic
data collection by a planning department, a traffic consultant or a university.
The Autoscope system captures vast amounts of traffic data in its own memory or
on a hard disk of the supervisor computer for later off-line graphing and
analysis. Further flexibility is gained with the ability to videotape a section
of roadway with a portable video camera and measure the traffic data off-line
with the Autoscope processor.

POTENTIAL PRODUCT APPLICATIONS AND ENHANCEMENTS. The Company is engaged in a
continuous effort to increase the number of applications and develop
enhancements for the Autoscope system. Enhancements to the system are often a
result of responses to needs identified by customers in the field. The Company
has been involved in a number of consulting arrangements in which the Company
has been engaged to manage the deployment of custom applications of the
Autoscope system.

         While the Company believes that it will be able to develop and
commercialize these product enhancements and applications, there can be no
assurance that it will be able to do so or that offering such enhancements or
applications will provide the Company any unique competitive advantage over
existing or developed technology.

RESEARCH AND DEVELOPMENT

         The Company is engaged in continued research and development in order
to lower manufacturing unit costs, develop less expensive system configurations,
and improve product quality. The Company's research and development activities
also are focused on broadening the applications of the Company's system and
developing product enhancements. New applications and product enhancements are
often a result of research and development in response to needs identified by
customers in the field.

         The size of the Company's research and development staff varies in
numbers depending on the allocation of engineering resources to outside projects
and product support. Generally eleven individuals, of whom four hold advanced
degrees, are presently involved in research and development. The Company's
research and development expenditures totaled approximately $203,000 in 1998 and
$643,000 in 1997. In addition, the Company capitalized software development
costs during the application development stage for the Solo product totaling
$825,000 in 1998 and $75,000 in 1997. The combination of capitalized software
development costs and research and development costs was $1,028,000 in 1998 and
$718,000 in 1997. The 



                                       6
<PAGE>

Company expects its research and development costs in 1999 to be comparable to
the combined capitalized software development and research and development costs
incurred in 1998.

MARKETS

         Urban traffic congestion is a major global problem. Consequently, in
the United States and in many developed countries throughout the world, there is
a growing demand for traffic management and control technology. In the U.S.
local and national government agencies continuously seek new solutions to
traffic congestion. Traffic planners can build new roads or develop mass
transit. However, both of these options are expensive, time consuming, and in
many situations not feasible. In this era of governmental budgetary constraints,
traffic planners are increasingly seeking solutions that will maximize the
efficiency and utilization of the existing roadways.

         The costs due to congestion, including wasted fuel, increased
accidents, and time lost, are substantial. In a report to Congress, the U.S.
Secretary of Transportation estimated that lost productivity due to urban
traffic congestion for the twenty-five largest U.S. metropolitan areas is
approximately $34 billion per year and approximately $100 billion per year for
the entire country. In an effort to reduce these costs, the U.S. Congress, in
1991, enacted the Intermodal Surface Transportation Efficiency Act (ISTEA), the
purpose of which is to develop economically efficient and environmentally sound
solutions to transportation system problems in the U.S. As part of ISTEA
Congress endorsed a national transportation initiative known as Intelligent
Transportation Systems (ITS) and appropriated substantial funding for ITS
projects. Under ISTEA the U.S. Department of Transportation must report to
Congress periodically regarding the progress of ITS projects.

         ITS represents a new and growing area of interest within the
transportation industry, dedicated to the application of advanced technology to
meet the increased demands on the nation's transportation systems. One central
principle of the ITS program is that solutions to transportation problems in the
U.S. should focus on more efficient use of the current roads and systems, rather
than merely increasing the quantity of roads and systems. ITS encourages
technological developments that will improve highway safety, system operating
efficiency, environmental quality, or energy utilization in transportation
through improved interactions between roads, vehicles, and their drivers. ITS is
an interdisciplinary initiative composed of a number of technologies, including
those developed and used in the defense industry, information processing,
communications, control, and electronics. With funding and oversight from the
U.S. Department of Transportation, the Federal Highway Administration, and the
state departments of transportation, the ITS program seeks to develop and
implement a variety of transportation user services.

         On June 9, 1998, the Transportation Equity Act for the 21st Century
(TEA-21) was signed into law by the President of the United States. This law
authorizes $198 billion in spending for highways, highway safety, transit and
other surface transportation programs over the next five years. Over $10 billion
is earmarked for mitigation of congestion and air quality improvement, to
develop and deploy advanced intelligent transportation system technologies and
for transportation research and technology deployment. TEA-21 will provide
transportation 



                                       7
<PAGE>

managers with increased funding over the next five years to enable more
deployment of machine vision technology.

         The Company believes that implementation of advanced traffic management
schemes envisioned by ITS requires collection of real-time traffic conditions
including traffic volume, roadway occupancy, traffic speed, stopped vehicles,
vehicle direction, vehicle length, and traffic incidents. Loop detectors are
generally too expensive to install and maintain in the large quantities required
for implementing some of the more aggressive ITS programs.

         While the Company is optimistic that its Autoscope machine vision
technology will be selected for deployment in the United States with increasing
frequency, there can be no assurance that traffic managers responsible for
selecting Intelligent Transportation Systems will choose machine vision
technology over embedded loop detectors, pressure plates, radar, microwave or
other competing technologies or will choose the Autoscope system over competing
machine vision products.

         The Company is aware that other countries are initiating or
contemplating initiating programs similar to ITS. For example, the European
Community has a program called ERTICO, which is attempting to manage traffic
with advanced technology. The Company believes that as market acceptance
increases in such countries, the utilization of the Autoscope system for freeway
applications in such programs may increase. To date the Company has generated
revenues from involvement in an ITS-type program in South Korea.

CUSTOMERS

         The customers for Autoscope are primarily federal, state, city, and
county departments of transportation; road commissions; and port, turnpike,
tunnel, and other transportation authorities. The decision makers within these
government entities are typically traffic planners and government engineers, who
in turn often rely on consulting firms that perform planning and feasibility
studies for those entities. Most Autoscope systems deployed as part of an ITS
program are ordered as components of major construction contracts, under
subcontracts to system integrators or other suppliers of systems and services.
Otherwise, state and local government agencies often install and maintain their
own equipment. In order to increase sales of the Autoscope system, the Company
must continue to increase product and technology awareness within these customer
groups.

BACKLOG

         The Company's backlog of unfulfilled firm orders from distributors was
approximately $288,000 as of December 31, 1998 and was not material as of
December 31, 1997. Terms of agreements between distributors of the Company's
products and government contractors and other customers generally provide for
cancellation or rescheduling of delivery. Accordingly, the Company's backlog at
a particular date may not be indicative of its future revenue.





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<PAGE>

COMPETITION

         Competition in the area of advanced traffic management and surveillance
is growing, due in part to the increased federal funding of advanced
technologies under the ITS program. Some of the companies that may compete with
the Company in the business of developing and implementing traffic control
systems include companies that have substantially more financial, technological,
marketing, personnel, and research and development resources than the Company.
The Company's products will compete not only with conventional methods of
vehicle detection and traffic control, such as embedded loop detectors, but also
with new technologies that may be applied to problems of urban traffic
congestion. New technologies or applications in traffic control systems may
provide the Company's customers with alternatives to the Autoscope system.
Various technologies have been used as traffic sensing devices in the past and
will continue to be developed for application to traffic management. These
technologies include embedded loop detectors, pressure plates, pneumatic tubes,
radars, lasers, magnetometers, acoustics, and microwaves. The Company estimates
that over 95% of the detector systems currently in use in the U.S. are embedded
loop detectors. Embedded loop detectors are relatively easy to manufacture and
are currently manufactured by numerous companies throughout the world.

         The Company is aware of several companies that are developing traffic
management devices using machine vision technology or other advanced technology.
Among the companies that are expected to provide direct competition to the
Company's Autoscope system in the use of machine vision technology in traffic
management are Traficon N.V. (Traficon), Peek business unit of Thermo Power
Corp. (Peek), Nestor, Inc., and Odetics, Inc., (Odetics). To the Company's
knowledge, Traficon, Odetics, and Peek have working installations of their
machine vision systems in the U.S. and other parts of the world. However, these
companies do not have as many installations as ISS. To the Company's knowledge,
machine vision systems are also being developed by Nestor, Inc. The Company is
aware that these and other companies will continue to develop technologies for
use in traffic management and surveillance. One or more of these technologies
could in the future provide increased competition for the Autoscope system.
Nevertheless, the Company believes that its products have undergone more
extensive field-testing and are at a more advanced stage of development than any
of its competitors' products.

MARKETING AND MANUFACTURING

         Marketing and manufacturing of the Autoscope system in North America
and the Caribbean (the Econolite Territory) has been performed by Econolite
Control Products, Inc. of Anaheim, California pursuant to a Manufacturing,
Distributing and Technology License Agreement (the Econolite Agreement).
Pursuant to that agreement, ISS has appointed Econolite as its licensee to make,
have made, use, license, distribute and sell the Autoscope system and related
technology in the Econolite Territory. Econolite has agreed to use its best
efforts to promote the sale of the Autoscope system and not to distribute
products that compete with the Autoscope system. Econolite pays ISS a royalty on
all revenue derived by Econolite from sales of the Autoscope system. Econolite
has over 64 years of experience in the traditional traffic intersection control
industry.



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         In January 1998, Econolite was certified as to ISO 9002 standards in
its manufacture of machine vision products for the transportation management
industry.

         The Company also obtained Conformite Europeenne (CE) Mark approval in
1998 for its Autoscope technology. The CE Mark is a worldwide standard for
safety and quality assurance.

         ISS may terminate the Econolite Agreement if a minimum annual sales
level is not met. The initial term of the Econolite Agreement is 15 years,
ending in 2007, automatically renewable thereafter for additional one-year
periods unless terminated by either party on 60 days notice prior to the end of
the initial term or any extension term.

         The Econolite Agreement grants a license to Econolite that encompasses
any knowledge, information, know-how, software or devices relating to vehicle
detection, whether patentable or not, that is licensed to ISS pursuant to the
License Agreement with the University of Minnesota described below under
"Patents and Proprietary Rights," and any knowledge, information, know-how,
software or devices relating to vehicle detection owned or licensable by ISS.
Econolite has a first negotiation right for extension of the license granted in
the Econolite Agreement to include rights in countries outside the Econolite
Territory. Currently, Econolite has agreed to manufacture, on a non-exclusive
basis, the Autoscope systems sold outside the Econolite Territory.

         In 1997, ISS and Econolite jointly entered into a Production Agreement
with Cohu, Inc., Electronic Division (Cohu), wherein ISS and Econolite each
granted to Cohu a non-exclusive, non-transferable, non-assignable, royalty-free
right and license to use such of the Company's Intellectual Property and
Econolite Intellectual Property as may be necessary to make, design, develop,
assemble, manufacture, and repair the Solo product solely for sale to ISS and
Econolite. Cohu acquired no right, title, or interest in or to the Company's
Intellectual Property or the Econolite Intellectual Property other than the
foregoing limited license, nor does Cohu have the right or authority to
sublicense all or any portion of the Company's Intellectual Property or
Econolite Intellectual Property.

         Cohu agreed to manufacture and sell exclusively to ISS and Econolite so
many units of the Solo product as ISS and Econolite may order from time to time.
ISS and Econolite each agreed to purchase from Cohu all of their respective
requirements for the Solo product for sale to end users in the Company's and
Econolite's territories until such time as ISS and/or Econolite have purchased
5,000 units in the aggregate. Econolite agreed to continue to purchase all of
its requirements for the Solo product thereafter, subject to Econolite's option
to manufacture the Solo product and the Company's right of termination.
Notwithstanding the foregoing, nothing in the Production Agreement requires
either ISS or Econolite to purchase a minimum number of units from Cohu.

         ISS may terminate the Production Agreement, with or without cause, upon
sixty days' prior written notice. Cohu may terminate the Production Agreement,
with or without cause, upon twelve months' prior written notice. In the event
ISS terminates the Production Agreement with cause, Cohu shall promptly deliver
to ISS all tooling specific to production of the Solo product, and Cohu shall
not be entitled to any further payment for development services. 



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<PAGE>

          In the event ISS terminates the Production Agreement without cause as
provided in the agreement, ISS will purchase from Cohu all of Cohu's inventory
related solely to the manufacture or sale, including raw materials, unique
parts, work in process, and finished goods up to a maximum purchase price of
$90,000. The purchase price of such inventory would be at Cohu's cost.

         Econolite provides a two-year warranty on the current Autoscope system
and must provide all service required under such warranties. Cohu provides a
two-year warranty to ISS and Econolite on the Solo product. Some of the
component hardware incorporated into the Autoscope system, such as the
supervisor computer and the video monitor, are standard computer hardware
products that are available from multiple sources. Other parts, such as the
microprocessor and digitizer are manufactured to certain specifications by third
party vendors for integration into the system. While current vendors of
components for the Autoscope system are meeting Econolite's, Cohu's and the
Company's quality and performance expectations, the Company believes alternative
component vendors are available should the necessity arise. Nevertheless,
shortages of parts or the need to change vendors could adversely affect
Econolite's or Cohu's ability to manufacture the Autoscope system, which could,
in turn, adversely affect the Company's business.

         The Company continues to strengthen its sales and marketing effort by
investing in promotional activities to support Econolite's marketing efforts in
the Econolite Territory. As part of this effort, ISS and Econolite have an
integrated marketing communications program. This program attempts to increase
market awareness of the Company's technology and its product. ISS and Econolite
have engaged in direct mailings of Autoscope brochures, manuals and videos to
potential customers.

         ISS has established a sales and marketing capability in countries
outside the Econolite Territory. In November 1998, the Company employed a
Director of Asian Operations to be responsible for sales and marketing efforts,
including revitalization and growth of distributors in this market. In addition,
on February 1, 1999, the Company acquired a sixty- percent equity interest in a
sales organization in Hong Kong. This affiliate, under the direction of the
Director of Asian Operations, will market the Company's products as well as
related traffic control products in Asia.

         The Company also employs a business development manager to expand the
distribution network in Europe and Latin America. The Company currently has
distributor agreements with twenty-one distributors covering countries primarily
in Europe, Asia, and South America. Under the distributor agreements each
distributor agrees to use its best efforts to market and sell the Autoscope
system and to purchase one demonstration system of the Autoscope for use in its
marketing efforts.

PATENTS AND PROPRIETARY RIGHTS

         The Company intends to actively protect its intellectual property
assets and will actively seek, when appropriate, protection for owned or
licensed products and proprietary information by means of U.S. and foreign
patents, trademarks, and contractual arrangements. In addition, the 



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<PAGE>

Company relies upon trade secrets and contractual arrangements to protect
certain of its proprietary information. The Company has a federally registered
trademark right to "Autoscope."

         The technology underlying the Autoscope system was initially developed
by Dr. Panos Michalopoulos, Chairman of the Board and Chief Scientific Advisor
of ISS and a Professor at the University of Minnesota, and was further developed
at the University of Minnesota from 1985 to 1991 with involvement by Dr.
Michalopoulos. Additional system developments were funded, in part, by the
Minnesota Department of Transportation and the Federal Highway Administration
from 1985 to 1989. The U.S. patent for certain aspects of the technology
underlying the Autoscope system was issued in 1989 to the University of
Minnesota. The University of Minnesota has filed to perfect related patents in
France, Germany, the United Kingdom, and Japan. Dr. Michalopoulos has assigned
all of his rights in such technology to the Company or to the University of
Minnesota. The Company entered into a License Agreement (the License Agreement)
with the University of Minnesota in 1991.

         Under the License Agreement, the Company has been granted an exclusive,
worldwide license, with a right to grant sublicenses, to make, have made, use,
sell, and lease any product that incorporates knowledge, information, know-how,
software and devices, whether patentable or not, in the possession of the
University and related to a video vehicle detection system developed by the
University of Minnesota, solely or jointly with the Company, including certain
improvements made to such technology. In exchange for that license, the Company
pays to the University of Minnesota (i) a royalty of 3% of the net sales of
licensed products, (ii) 50% of all site license revenue, and (iii) 10% of all
sublicensing revenue. For purposes of the License Agreement, net sales means the
gross amount collected for sales, leases or licenses of licensed products.
Licensed products include any manufactured product that incorporates the
technology or improvements covered by the License Agreement. Site license
revenue equals all revenue collected by the Company and specifically allocable
to the Company for granting a license to use the licensed products at a specific
location or by a specific user. Sublicensing revenue equals all revenue
collected by the Company from parties to whom the Company grants sublicense
rights to make or sell the licensed products. The University of Minnesota has
retained a nonexclusive and nontransferable right to use the licensed technology
for educational and research purposes. The License Agreement terminates at the
termination of the patent covering the technology. The University of Minnesota
may terminate the License Agreement if the royalties due thereunder are unpaid,
if there is a material breach of the agreement by the Company or if the Company
fails to use best efforts to effect commercial sales of the licensed products.
The Company has agreed to indemnify the University of Minnesota against all
liabilities or losses arising from (i) manufacture, use, lease or sale of a
licensed product by the Company or a sublicensee of the Company, or (ii) a third
party's use of a licensed product purchased from the Company or a sublicensee of
the Company or (iii) a third party's manufacture of a licensed product at the
request of the Company.

         The Company has sublicensed certain of its rights in the Autoscope
technology to Econolite pursuant to the Econolite Agreement. See "Marketing and
Manufacturing" above.



                                       12
<PAGE>

         The Company's technology is dependent upon the knowledge, experience,
and skills of its key scientific and technical personnel. To protect its rights
to its proprietary know-how and technology, Company policy requires all
employees and consultants to execute confidentiality agreements that prohibit
the disclosure of confidential information to anyone outside the Company. These
agreements also require disclosure and assignment to the Company of any
discoveries and inventions made by such persons while devoted to Company
activities.

EMPLOYEES

         As of March 18, 1999, the Company had 23 full time employees, of which
11 were engaged in research and development; 5 in product and customer support;
2 in sales and marketing; and 5 in management, administration, finance, and
human resources. No employee is represented by a union. The Company believes its
employee relations are good.

LIABILITY INSURANCE

         Econolite currently maintains $15,000,000 of product liability
insurance, and ISS maintains $2,000,000 of product liability insurance. In
addition, Econolite has agreed to indemnify and hold harmless ISS from and
against any losses, damages, or expenses arising out of the products made or
sold by Econolite pursuant to the Econolite Agreement. There can be no assurance
that the Company will be able to obtain adequate insurance in the future or that
claims will not be made in excess of any insurance coverage obtained.


 ITEM 2.          DESCRIPTION OF PROPERTY

                  The Company currently leases approximately 10,000 square feet
                  of office space in St. Paul, Minnesota. The lease expires in
                  November 2001, with an option to extend the lease through
                  November 2004. Aggregate annual lease payments under the lease
                  are approximately $138,000. The Company believes its
                  facilities are sufficient for its current needs.

ITEM 3.           LEGAL PROCEEDINGS

                  During 1998, the Company was not involved in any legal
                  proceedings.

ITEM 4.           SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

                  There were no matters submitted to a vote of security holders
                  during the fourth quarter of the calendar year covered by this
                  report.





                                       13
<PAGE>


                                     PART II

ITEM 5.           MARKET PRICE OF COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

                  MARKET INFORMATION

                  Price Range of Common Stock on page 21 of the Annual Report to
                  Shareholders for the year ended December 31, 1998, is
                  incorporated herein by reference.

                  HOLDERS

                  As of March 23, 1999, the Company had approximately 36 holders
                  of record of its Common Stock and approximately 650
                  shareholders.

                  DIVIDENDS

                  The Company has never declared or paid a cash dividend on its
                  Common Stock. The Company currently intends to retain earnings
                  for use in the operation and expansion of its business; and
                  therefore, it does not anticipate paying any dividends in the
                  foreseeable future.

ITEM 6.           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 
                  AND RESULTS OF OPERATIONS

                  Management's Discussion and Analysis of Financial Condition
                  and Results of Operations on pages 10 and 11 of the Annual
                  Report to Shareholders for the year ended December 31, 1998
                  are incorporated herein by reference.

ITEM 7.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                  The financial statements and report of independent auditors
                  included on pages 12 through 20 of the Annual Report to
                  Shareholders for the year ended December 31, 1998 are
                  incorporated herein by reference.

ITEM 8.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                  AND FINANCIAL DISCLOSURE

                  None




                                       14
<PAGE>


                                    PART III

ITEM 9.           DIRECTORS AND OFFICERS OF THE REGISTRANT

                  The information contained on pages 2 and 3 of Image Sensing
                  Systems, Inc.'s Proxy Statement dated April 5, 1999, with
                  respect to directors and executive officers of the Company, is
                  incorporated herein by reference in response to this item.

ITEM 10.          EXECUTIVE COMPENSATION

                  The information contained on pages 4 and 5 of Image Sensing
                  Systems, Inc.'s Proxy Statement dated April 5, 1999, with
                  respect to executive compensation and transactions, is
                  incorporated herein by reference in response to this item.

ITEM 11.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

                  The information contained on page 7 of Image Sensing Systems,
                  Inc.'s Proxy Statement dated April 5, 1999, with respect to
                  security ownership or certain beneficial owners and
                  management, is incorporated herein by reference in response to
                  this item.

ITEM 12.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

                  None.



                                       15
<PAGE>


                                    PART III

ITEM 13. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)      LIST OF DOCUMENTS FILED AS PART OF THE REPORT:  
         1.   Financial statements referenced in Item 7
         2.   Exhibits:

         EXHIBIT NO.       DESCRIPTION
         -----------       -----------
         3.1               Restated Articles of Incorporation of the Company,
                           incorporated by reference to the Company's
                           registration statement on Form SB-2 (Registration No.
                           90298C) filed with the Commission on March 14, 1995.
         3.3               Bylaws of the Company, incorporated by reference to
                           the Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         4.1               Specimen form of the Company's Common Stock
                           Certificate, incorporated by reference to the
                           Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         4.2               1995 Long-Term Incentive and Stock Option Plan and
                           form of Option Agreement, incorporated by reference
                           to the Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         10.1              Manufacturing Distributing and Technology License
                           Agreement dated June 11, 1991, as amended December
                           15, 1992, between Econolite Control Products, Inc.
                           and the Company, incorporated by reference to the
                           Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         10.2              License Agreement dated June 10, 1991 between the
                           University of Minnesota and the Company, incorporated
                           by reference to the Company's registration statement
                           on Form SB-2 (Registration No. 90298C) filed with the
                           Commission on March 14, 1995.
         10.3              Form of Distributor Agreement, incorporated by
                           reference to the Company's registration statement on
                           Form SB-2 (Registration No. 90298C) filed with the
                           Commission on March 14, 1995.
         10.4              Employment Agreement dated January 3, 1995 between
                           the Company and Panos G. Michalopoulos, incorporated
                           by reference to the Company's registration statement
                           on Form SB-2 (Registration No. 90298C) filed with the
                           Commission on March 14, 1995.
         10.5              Employment Agreement dated January 3, 1995 between
                           the Company and Spiro G. Voglis, incorporated by
                           reference to the Company's registration statement on
                           Form SB-2 (Registration No. 90298C) filed with the
                           Commission on March 14, 1995.
         10.6              Commercial Note with Norwest Bank Minnesota, N.A.
                           dated February 16, 1995, incorporated by reference to
                           the Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         10.7              Form of Data Exchange and Disclosure Agreement,
                           incorporated by reference to the Company's
                           registration statement on Form SB-2 (Registration No.
                           90298C) filed with the Commission on March 14, 1995.
         10.8              Lease Agreement dated January 14, 1994 between the
                           Company and Bradley Real Estate Trust, incorporated
                           by reference to the Company's registration statement
                           on Form SB-2 (Registration No. 90298C) filed with the
                           Commission on March 14, 1995.
         10.9              Assignment from Panos G. Michalopoulos to the Company
                           dated January 19, 1985, incorporated by reference to
                           the Company's registration statement on Form SB-2
                           (Registration No. 90298C) filed with the Commission
                           on March 14, 1995.
         10.10             Office Lease Amendment I dated June 8, 1995, by and
                           between Spruce Tree Centre L.L.P. and Image Sensing
                           Systems, Inc., filed as Exhibit 10.10 to the
                           Company's Form 10-KSB for the year ended December 31,
                           1995 and incorporated herein by reference.


                                       16
<PAGE>

         10.11             Second Lease Amendment dated October 13, 1995, by and
                           between Spruce Tree Centre L.L.P. and Image Sensing
                           Systems, Inc. filed as Exhibit 10.11 to the Company's
                           Form 10-KSB for the year ended December 31, 1995 and
                           incorporated herein by reference.
         10.12             Extension of Spiro Voglis's employment agreement,
                           filed as Exhibit 10.12 to the Company's Form 10-KSB
                           for the year ended December 31, 1995 and incorporated
                           herein by reference.
         10.13             Consulting Agreement dated February 24, 1997, by and
                           between Arthur J. Bourgeois and Image Sensing
                           Systems, Inc., filed as Exhibit 10.13 to the
                           Company's Form 10-KSB for the year ended December 31,
                           1995 and incorporated herein by reference.
         10.14             Production Agreement dated July 8, 1997, between the
                           Company, Cohu, Inc., and Econolite Control Products,
                           Inc., filed as Exhibit 10.14 to the Company's Form
                           10-KSB for the year ended December 31, 1997 and
                           incorporated herein by reference.
         10.15             Extension of Mr. Bourgeois's consulting agreement,
                           filed as Exhibit 10.15 to the Company's Form 10-KSB
                           for the year ended December 31, 1997 and incorporated
                           herein by reference.
         10.16             Executive Employment Agreement between the Company
                           and William L. Russell, dated June 10, 1998, filed as
                           Exhibit 10 to the Company's Form 10-QSB for the
                           quarter ended June 30, 1998 and incorporated herein
                           by reference.
         10.17             Conditional Credit Line Letter Agreement with Norwest
                           Bank Minnesota, N.A. dated September 14, 1998
         10.18             Office Lease Agreement by and between Spruce Tree
                           Centre L.L.P and the Company, dated November 24, 1998
         13                Annual Report of the Company for the year ended
                           December 31, 1998, certain portions of which are
                           incorporated by reference into this Annual Report on
                           Form 10-KSB.
         23                Consent of Ernst & Young LLP
         99                Cautionary Statement
         27                Financial data schedule

b)       REPORTS ON FORM 8-K FILED DURING FOURTH QUARTER OF 1998: NONE




                                       17
<PAGE>



                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Image Sensing Systems, Inc. has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized:

                           IMAGE SENSING SYSTEMS, INC.

    /s/ William L. Russell                                 Date:  March 30, 1999
    ----------------------                                 ---------------------
By: William L. Russell, President and CEO

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated. Each person whose
signature to this report on Form 10-KSB appears below hereby constitutes and
appoints William L. Russell and Arthur J. Bourgeois, and each of them, as his or
her true and lawful attorney-in-fact and agent, with full power of substitution,
to sign on his or her behalf individually and in the capacity stated below and
to perform any acts necessary to be done in order to file all amendments to this
report on Form 10-KSB, and any and all instruments or documents filed as part of
or in connections with this report on Form 10-KSB or the amendments thereto and
each of the undersigned does hereby ratify and confirm all that said
attorney-in-fact and agent, or his substitutes, shall do or cause to be done by
virtue hereof.


    /s/ Panos G. Michalopoulo                              Date:  March 30, 1999
--------------------------------------------------------
By:     Panos G. Michalopoulos
        Chairman of the Board & Director

    /s/ William L. Russel                                  Date:  March 30, 1999
--------------------------------------------------------
By:     William L. Russell
        President & Director  (Chief Executive Officer)

    /s/ Richard P. Braun                                   Date:  March 30, 1999
--------------------------------------------------------
By:     Richard P. Braun
        Director

    /s/ Richard C. Magnuson                                Date:  March 30, 1999
--------------------------------------------------------
By:     Richard C. Magnuson
        Director

    /s/ James Murdakes                                     Date:  March 30, 1999
--------------------------------------------------------
By:     James Murdakes
        Director

    /s/ C. (Dino) Xykis                                    Date:  March 30, 1999
--------------------------------------------------------
By:     C. (Dino) Xykis
        Director

    /s/ Arthur J. Bourgeois                                Date:  March 30, 1999
--------------------------------------------------------
By:     Arthur J. Bourgeois
        Chief Financial Officer


                                       18