---

---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

FORM 10-K

|  |                                                                                            | 
|- | ------------------------------------------------------------------------------------------ | 
|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
  SECURITIES EXCHANGE ACT OF 1934    
|  |                                                                                           
|  | For the fiscal year ended December 31, 2006                                               
|  | OR                                                                                        
|  |                                                                                           
|o | TRANSITION REPORT PURSUANT TO 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.(Exact name of
registrant as specified in its charter)

|                                                                 |  |                                     
|---------------------------------------------------------------- |  | ------------------------------------
|Minnesota                                                        |  | 41-1519168                          
|(State or other jurisdiction of
  incorporation or organization) |  | (I.R.S. Employer Identification No.)

|                                                                    |  |           
|------------------------------------------------------------------- |  | ----------
|500 Spruce Tree Centre, 1600 University
  Avenue West, St. Paul, MN |  | 55104     
|(Address of principal executive offices)                            |  | (Zip Code)

(651) 603-7700(Registrants telephone number, including area code)

Not applicable.(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:

|                              |  |                                          
|----------------------------- |  | -----------------------------------------
|Title of each class           |  | Name of each exchange on which registered
|                              |  |                                          
|Common Stock, $0.01 par value |  | The NASDAQ Capital Market                

Securities registered pursuant to Section 12(g) of the
Act: None.

|                                                                                                                                       | 
|-------------------------------------------------------------------------------------------------------------------------------------- | 
|Indicate by check mark if the registrant is a
well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o     No x
|                                                                                                                                       | 
|Indicate by check mark if the registrant is not
required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No x  

|                                                                                                                                                                                                                                                                                                                                                        |               
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------
|Indicate by check mark whether the registrant (1) has
filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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.
|                                                                                                                                                                                                                                                                                                                                                        | Yes x     No o

Indicate by check mark if disclosure of delinquent
filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants
knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment
to this Form 10-K.  o

Indicate by check mark whether the registrant is a
large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large
accelerated filer in Rule 12b-2 of the Exchange Act.

|                            |                     |                        
|--------------------------- | ------------------- | -----------------------
|Large
  accelerated filer o | Accelerated filer o | Non-accelerated filer x

Indicate
by check mark whether the registrant is a shell company (as defined in Exchange
Act Rule 12b-2).

Yes
o     No x

As of March 8, 2007, the aggregate
market value of the registrants common stock held by non-affiliates of the registrant was $61,933,957 based on the closing
sale price as reported on The NASDAQ Capital Market.

The number of shares outstanding of
the registrants $0.01 par value common stock as of March 8, 2007 was 3,777,004 shares.

---

---



DOCUMENTS INCORPORATED BY REFERENCE

|                                                                                                      |  |                                
|----------------------------------------------------------------------------------------------------- |  | -------------------------------
|Document                                                                                              |  | Parts
  Into Which Incorporated
|                                                                                                      |  |                                
|Proxy
  Statement for the Annual Meeting of Shareholders to be held 
  May 31, 2007 (Proxy Statement) |  | Part III                       

---



PART I

|        |         
|------- | --------
|Item 1. | Business

Image
Sensing Systems, Inc. (referred to in this report as we, us, our and the
Company) develops and markets video image processing products for use in
traffic applications such as intersection control, highway, bridge and tunnel
traffic management and traffic data collection. We use video image processing
technology, which captures video images and analyzes the captured images
through the use of sophisticated algorithms and computer software resident on
special purpose hardware. Machine vision technology uses video cameras to
emulate the function of the human eye and is used in a variety of applications
such as industrial quality control, manufacturing automation, health care,
robotic guidance and defense. We use a proprietary version of machine vision
technology using commercially available components and video cameras along with
our video image processing technology to create the Companys core family of
products, the Autoscope® Video Vehicle Detection System.

The
Autoscope system converts video images of a traffic scene into traffic
information and data that may be transmitted to local or remote locations for
real-time traffic management and control. The Autoscope system is modular and
expandable and provides information to a variety of applications in traffic
control data collection. The system can also be used by traffic managers for
research and other applications, such as transportation security and
surveillance, and ultimately can help improve traffic flow and safety and
reduce travel time, traffic accidents, delays, congestion, air pollution and
fuel consumption and can improve roadway planning and cost efficiencies in
traffic management and control. Products are sold globally to city, county,
state, federal and private transportation professionals.

We
sell the Autoscope system in North America, the Caribbean and Latin America
through a long-term agreement with Econolite Control Products Inc. (Econolite).
In Europe, we sell the Autoscope system through our wholly-owned subsidiaries,
Image Sensing Systems Europe Ltd. (ISS/Europe) and Image Sensing Systems Europe
Limited SP.Z.O.O (ISS/Poland). In Asia, we sell the Autoscope system through
our wholly-owned subsidiary, Flow Traffic Ltd. (Flow Traffic).

History

We
were incorporated in the state of Minnesota in December 1984 and began
operations by pioneering the commercial application of wide-area video vehicle
detection for traffic management. The technology underlying the Autoscope system
was initially developed at the University of Minnesota under the direction of
the Companys founder, Dr. Panos Michalopoulos, a professor at the University.
In 1989, the University was awarded a patent for that technology. In 1991, the
University awarded us an exclusive license of the technology. In 1991, we
granted a sub-license to Econolite, a leading manufacturer and seller of
traffic control products in North America, to manufacture and distribute the
licensed technology. In 1995, we raised $3.9 million in a public offering of
990,000 shares of common stock. Some of the proceeds of the public offering
were used to advance the technology of our products and to expand our
distribution network to Europe and Asia. In 1999, we acquired 60% ownership of
Flow Traffic Ltd., a distributor of traffic products in Asia, located in Hong
Kong. In 2002, we acquired the remaining 40% ownership of Flow Traffic. In
2004, we formed a wholly-owned subsidiary, Image Sensing Systems Europe Ltd.
with offices in the United Kingdom and Spain. In 2005, we formed a wholly-owned
subsidiary, Image Sensing Systems Europe Limited SP.Z.O.O. in Poland.

Industry Background

Automated
vehicle detection for traffic management and control has traditionally been
performed using inductive wire loops buried in the pavement. Typically, the
road surfaces are saw-cut with a specific shaped cut; specified metallic wires
are bent into the same shape as the saw-cut and placed into the saw-cut with a
sealant material subsequently covering up the saw-cut opening. However,
in-pavement loop detectors are costly to install and difficult to maintain, are
destructive to road surfaces and are not capable of wide-area vehicle detection
without the use of many loops. By contrast, the Autoscope system is easier to
install and maintain than loop 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 Autoscope systems range
of applications and its ability to support new applications for advanced
technology solutions to traffic management problems make it superior to the
in-pavement loop detectors.

1

---



Strategy

Our
strategy is to remain a global leader in machine vision technology for advanced
traffic management while continuing to improve profitability and provide value
for our customers. To achieve our objectives, we will continue to develop new
hardware and software products and applications for use by traffic managers
worldwide in order to improve traffic flow, traffic safety and roadway
planning, and to reduce travel time, traffic accidents, delays, congestion, air
pollution and fuel consumption and ultimately provide increased cost
efficiencies in traffic management and control. We will continue efforts to (1)
expand and improve our distribution network in other parts of Europe and
Asia-Pacific that can grow our market base; (2) seek out partners within the
industry that bring synergistic technologies to our current products and
markets; and (3) seek out partners outside of the traffic management industry
that leverage our technology that can result in profitable business.

The Autoscope System

In
the Autoscope system, a camera is used to view the roadway traffic scene. The
camera video is input to a special purpose computer called the Autoscope
machine vision processor (MVP). A monitor displays the cameras field-of-view
and, using software provided with the Autoscope system, the user defines the
detection zones using a computer mouse. Configuring the detection zones allows
the user to specify where and what type of traffic data needs to be collected.
Numerous detection zones can be programmed per camera. These detection zones
are then stored in the memory of the Autoscope MVP, which analyzes the camera
view in real-time and extracts the required traffic data. A single Autoscope
unit can be configured to include numerous detection zones.

The
Autoscope system is capable of measuring traffic data such as: vehicle
presence, counts, speed and length, time occupancy (percent of time the
detection zone is occupied), average headway (time interval between vehicles),
flow rate (vehicles per hour per lane) and more. The Autoscope system output
can be routed to the intersection signal controller which actuates the traffic
light. In tunnel safety applications, the Autoscope system can provide alerts
to operators upon detecting stopped, wrong direction or slow moving vehicles
and upon detecting pedestrians, debris or smoke. The traffic data and alerts
may also be transmitted to another host computer via public dial-up telephone
lines, private twisted-pair copper wires, fiber optic network or various
wireless communications media. Typically, the data is transmitted to a central
computer at a traffic management center (TMC). If desired, video can also be
transmitted to the same destination as the data. Data from the Autoscope system
can be processed in real-time to manage traffic and stored for later analysis
for traffic planning purposes.

Current Products

The
original Autoscope 2002 system was introduced in 1989 and was based on an
industrial computer. Since that time, we have developed a number of Autoscope
products, which currently include: Autoscope Solo® Pro, Autoscope
RackVision, Autoscope
RackVision System 1,4 &16, Autoscope 2020 ,
Autoscope Atlas Junction
Detection System (JDS), Autoscope Solo Terra and Autoscope RackVision Terra.
We also supply the Autoscope® Image Sensor Camera (AIS Camera)
for use with our Autoscope MVP products.

All
systems come with the latest Autoscope Software Suite which provides a robust
communications server and applications software for configuring, monitoring and
maintaining small to large system installations. The applications software
graphical user interface (GUI) is currently available in 15 languages, which is
vital to many of our markets where English may not be used by those who use our
products. A Translation Kit is available to translate the GUI into further local
languages as may be necessary or desired.

The
Autoscope Solo Pro is a smart camera consisting of an integrated color zoom
camera and MVP contained in one compact housing unit. The Solo Pro provides the
best performance of our product line due to the guaranteed, high-quality video
resulting from the integration of camera and processor. The Autoscope
RackVision, introduced in 2003, and Autoscope 2020 were developed to allow
customers to use standard video cameras with Autoscope technology. The
Autoscope RackVision processes one camera, while the Autoscope 2020 processes
up to four cameras. The AIS Camera is our stand-alone specialized camera that
promotes optimal use of the Autoscope RackVision products and the Autoscope
2020.

The
Autoscope RackVision System 4 and 16 products were introduced in 2004 to
provide a turn-key solution, primarily for our Asian market, to process up to
four and 16 cameras, respectively. The Autoscope RackVision System 1 was
developed in 2004 specifically for highway projects in Korea. The Autoscope
Atlas JDS

2

---



is a single
board, two-camera MVP for processing two cameras which was developed in 2004 to
provide a cost-effective solution for intersection control in Europe. All our
products are designed to meet both United States Federal Communications
Commission and European regulatory standards.

The
Autoscope Terra product line was developed in 2006 and includes enhancements to
provide broadband connections, streaming digital video, internet web browser
maintenance and three times the processing power of the previous Autoscope
systems.

The
Autoscope Software Developers Kit provides system integrators and software
developers the means to fully integrate many Autoscope vehicle detection systems
within their overall traffic management system. This kit provides tools for
high level software programming and trouble shooting. The communications
software supplied with the kit has extensive built-in error correction, with
useful error and data logging capabilities which greatly speeds up the
integration process.

Product
Development

We
continually work on product development and enhancements that expand our
applications, reduce costs, improve performance, make the product more
user-friendly and provide other beneficial features to the user. In 2006, we
again increased our research and development investment by adding and enhancing
features we believe will give us competitive advantages and meet customer needs
for new applications. A new version of our software, containing the
enhancements made in 2006, is expected to be released in the first half of
2007. For competitive reasons, we do not disclose the technical details of new
development and enhancement efforts.

Manufacturing

We
currently have the Autoscope family of products for sale in North America
manufactured through agreements with Econolite and Wireless Technology, Inc.
(WTI). In 1991, we appointed Econolite as our exclusive licensee to manufacture
the Autoscope system and related technology and to sell the products in North
America, the Caribbean and Latin America (see Sales and Marketing below). In
2002, we granted WTI a non-transferable license to use any of our intellectual
property as needed to manufacture Autoscope Solo Pro and AIS camera products
for our and Econolites use. WTI has no right, title or interest in or to our
intellectual property other than the foregoing limited license, nor does WTI
have the right or authority to sublicense our intellectual property. Our manufacturers
overseas have no right, title or interest in our intellectual property other
than our permission to use the documents we provide to manufacture products for
us as directed by us. Econolite provides a two-year warranty on the current
Autoscope system and must provide all service required under this warranty. WTI
provides a two-year warranty to us on the Autoscope Solo Pro and AIS camera
products it manufactures. The terms of the warranties vary for overseas
manufacturers.

Sales and Marketing

We
market and sell our products globally to customers. As of December 31, 2006, we
had supplied Autoscope
systems for over 50,000 cameras worldwide in more than 55 countries. Together,
we and our partners offer a combination of high-performance video detection
technology and experienced local support.

Our
customers primarily consist of federal, state, city and county departments of
transportation, road commissions and port, highway, tunnel and other
transportation authorities. The decision-makers within these governmental
entities typically are traffic planners and government engineers, who in turn
often rely on consulting firms that perform planning and feasibility studies
for the governmental entities. Our products sometimes are sold directly to
system integrators or other suppliers of systems and services who are operating
under subcontracts in connection with major road construction contracts.

We
have granted Econolite an exclusive right to market and distribute the
Autoscope system and related technology which it manufactures (see
Manufacturing above) in North America, the Caribbean and Latin America.
Econolite provides the marketing and technical support needed for its sales in
these territories. Econolite pays us a royalty on the revenue derived from its
sales of the Autoscope system. Royalty income from Econolite comprised 77% of
our revenue in 2006, 78% in 2005 and 69% in 2004. We cooperate and share in the
marketing of Autoscope products with Econolite for North America, the Caribbean
and Latin America and provide second tier technical support.

3

---



We
may terminate our agreement with Econolite if it does not meet minimum annual
sales level or Econolite fails to make payments as required by the agreement.
The initial term of the agreement was 15 years, ending in 2006, and was
automatically renewable thereafter for additional one-year periods unless
terminated by either party upon 60 days notice prior to the end of the initial
term or any extension term. In 2001, we signed a five-year extension of our
agreement with Econolite, thereby extending its original term to 2011.

We
market the Autoscope system to a network of distributors covering countries in
Europe and the Middle East through our wholly-owned subsidiaries, Image Sensing
Systems Europe Ltd. and Image Sensing Systems Europe Limited SP.Z.O.O., and in
Asia through our wholly-owned Asian subsidiary, Flow Traffic Ltd. Technical
support to these distributors is provided by Autoscope experts residing in Europe
and Asia, with second tier support provided from our corporate headquarters in
St. Paul, Minnesota.

Competition

We
are aware of several companies that develop, manufacture and sell traffic
management devices using machine vision technology or other advanced
technology. Among the companies that provide direct competition to the
Autoscope system worldwide are Traficon N.V., Quixote Corporation, Iteris, Inc.
and Citilog S.A. They all have working installations of their machine vision
systems in the United States and other parts of the world. To our knowledge,
however, these companies do not have as many installations as we have. In
addition, there are local companies providing direct competition in specific
markets such as Korea, China and Japan. We are 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 Autoscope systems.

Other
potential competitors of which we are aware include Siemens AG, Cognex Corp.,
Matsushita Electric Industrial Co., Ltd. (Panasonic), Sumitomo Corporation,
Omron Electronics LLC and 3M Corp., which are companies that have machine
vision capabilities and have substantially more financial, technological,
marketing, personnel and research and development resources than we have. We
estimate that more than 90% of the detector systems currently in use in the
United States use competing in-pavement loop detectors. Other technologies that
compete with video and loops for traffic sensing are radar, laser, infrared and
acoustics.

Suppliers

The
hardware components incorporated into Autoscope products are standard
electronics components that are available from multiple sources. To date, our
current manufacturers of these components have met our quality and performance
expectations. However, we believe alternative component vendors are available
should the necessity arise. Nevertheless, shortages of parts or the need to
change vendors could hinder our ability to manufacture our products, which
could, in turn, decrease our revenues and harm our business.

Additionally,
our manufacturing and component suppliers responded to comply with the European
directive on the restriction of the use of certain hazardous substances (RoHS)
in electrical and electronic equipment. Shortages of compliant parts, the need
to change vendors or difficulties in the new manufacturing processes required
could hinder the ability of our selected overseas suppliers to manufacture our
products on time, which could, in turn, decrease our revenues and harm our
business.

Backlog

Our
backlog of unfulfilled firm orders from distributors was not material as of
December 31, 2006. Terms of agreements between distributors of our products and
government contractors and other customers generally provide for cancellation
or rescheduling of delivery in the case of backlogs. A backlog in our orders as
of a particular date may not be a relevant factor in predicting our future
revenue.

Intellectual Property

We
entered into a license agreement with the University of Minnesota (the
University) in 1991. Under the agreement, we were 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, solely or jointly with us, including certain improvements made to
this technology.

4

---



The
expiration of the University of Minnesota patent in July 2006 made the
University technology available to the public and allows competing businesses
to take advantage of this availability to design, manufacture and sell a
product which competes with our Autoscope product, which in turn could
adversely affect our revenues and profits. However, since 1991, we have
extensively added to our product design, to include our own intellectual
property independent of the University technology, and we have made extensive
moderations and revisions to the University technology. Furthermore, flaws in
the original licensed technology required us to develop our own techniques in
order to make the technology commercially feasible. Consequently, we do not
foresee the expiration of the University patent as an immediate threat to our
business.

Our
technology is dependent upon the knowledge, experience and skills of our key
scientific and technical personnel. To protect our rights to our proprietary
know-how and technology, we require all employees and consultants to execute
confidentiality agreements that prohibit the disclosure of confidential
information to any third parties. These agreements also require disclosure and
assignment to us of any discoveries and inventions made by employees and
consultants while they are devoted to our business activities.

We
intend to protect our intellectual property assets and will actively seek, when
appropriate, protection for owned or licensed products and proprietary
information by means of United States and foreign copyrights, trademarks,
patents and contractual arrangements. In addition, we rely upon trade secrets
and contractual arrangements to protect some of our proprietary information. We
have registered trademark rights to Autoscope and Autoscope Solo. U.S.
trademark registrations are generally for a term of 10 years, renewable every
10 years as long as the trademark is used in the regular course of trade.

Employees

As
of March 5, 2007, we had 53 employees, 50 of whom were full-time and three of
whom were part-time. Sixteen of these employees were employed by our wholly-owned
subsidiaries in Hong Kong, the United Kingdom and Poland. None of our employees
is represented by a union. We believe our employee relations are good.

Cautionary Statement

This Annual
Report on Form 10-K 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 of 1934, as amended. Forward-looking statements represent
our expectations or beliefs concerning future events and can be identified by
the use of forward-looking words such as believes, may, will, should,
intends, plans, estimates, or anticipates or other comparable
terminology. Forward-looking statements are subject to risks and uncertainties
that may cause our actual results to differ materially from the results
discussed in the forward-looking statements. Some factors that might cause
these differences include the factors listed below. Although we have attempted
to list these factors comprehensively, we wish to caution investors that other
factors may prove to be important in the future and may affect our operating
results. New factors may emerge from time to time, and it is not possible to
predict all of these factors, nor can we assess the affect each factor or
combination of factors may have on our business.

We
further caution you not to unduly rely on any forward-looking statements,
because they reflect our views only as of the date the statements were made. We
undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.

|         |             
|-------- | ------------
|Item 1A. | Risk Factors

We are dependent on a single family of
products for most of our revenue, and if we do not maintain the market for
these products, we will be unable to be profitable and our business will be
harmed.

Substantially
all of our revenue since inception has been generated from sales of, or
royalties from the sales of, the AutoscopeÒ
vehicle detection system. We anticipate that revenue from the sale of the
Autoscope system will continue to account for a substantial portion of our
revenue for the foreseeable future. As such, any decline in sales of our
Autoscope system would have a material adverse impact on our business,
financial condition and results of operations. The application of machine
vision technology to traffic management is a relatively new concept in the
traffic management industry. Our financial success and prospects for growth
will depend in large part on the

5

---



continued
development of the market for advanced technology solutions for traffic
management and the acceptance of the Autoscope system as a reliable,
cost-effective alternative to traditional vehicle detection systems. We cannot
assure you that we will be able to utilize our technology profitably in other
products or markets. If the Autoscope system does not continue to gain greater
market acceptance and if we are unable to increase awareness of our product and
expand our customer base, or if revenue from the Autoscope system declines for
any reason, sales of our products will suffer, and we may be unable to sustain
our business.

If governmental entities elect not to use our
product due to budgetary constraints, project delays or other reasons, our
revenues may fluctuate severely or be substantially diminished.

The
Autoscope system is sold primarily to governmental entities for use in large
traffic control projects using advanced traffic control technologies. Unless
and until broader market acceptance of the Autoscope system is achieved, we
will continue to rely substantially on revenues and royalties from sales of the
Autoscope system to governmental entities. In addition to normal business
risks, it often takes considerable time before governmental traffic control
projects are developed to the point where a purchase of the Autoscope system is
made, and a purchase of our product also may be subject to a time-consuming
approval process. Additionally, governmental budgets and plans may change
without warning. Other risks of selling to governmental entities include
dependence on appropriations and administrative allocation of funds, changes in
governmental procurement legislation and regulations and other policies that
may reflect political developments, significant changes in contract scheduling,
intense competition for government business and termination of purchase
decisions for the convenience of the governmental entity. Substantial delays in
purchase decisions by governmental entities, or governmental budgetary constraints,
could cause our revenues and income to drop substantially or to fluctuate
significantly between fiscal periods.

If our primary distributors sales volume
decreases or if it fails to pay royalties to us in a timely manner or at all,
our financial results will suffer.

We
have entered into an agreement with Econolite, pursuant to which Econolite is
the exclusive distributor of the Autoscope system in North America, the
Caribbean and Latin America. In exchange for its right to distribute our product,
Econolite pays us royalties for sales of the Autoscope system. Since 2002, more
than 60% of our revenue has consisted of royalties resulting from sales made by
Econolite, including 77% in 2006, 78% in 2005 and 69% in 2004. Econolites
account receivable represented 69% of our accounts receivable at December 31,
2006 and 88% of our accounts receivable at December 31, 2005. We expect that
Econolite will continue to account for a significant portion of our revenue for
the foreseeable future. Any decrease in Econolites sales volume could
significantly reduce our royalty revenue and adversely impact earnings. A
failure by Econolite to make royalty payments to us in a timely manner or at
all will harm our financial condition.

Our dependence on third parties for
manufacturing and marketing our product may prevent us from meeting customers
needs in a timely manner.

We
do not have, and do not intend to develop in the near future, internal
capabilities to manufacture our products. We have entered into agreements with
Econolite and WTI to manufacture the Autoscope system and related products. In
addition, we work with suppliers overseas to manufacture Autoscope products
that need to comply with the European Unions regulatory directive on the restriction
of the use of certain hazardous substances in electrical and electronic
equipment. If Econolite, WTI and our overseas suppliers are unable to
manufacture our products in the future, we may be unable to identify other
manufacturers able to meet product and quality demands in a timely manner or at
all. Our inability to find suitable manufacturers for our products could result
in delays or reductions in product shipments, which in turn may harm our
business reputation and results of operations. In addition, we have granted
Econolite the exclusive right to market the Autoscope system and related
products in North America, the Caribbean and Latin America. Consequently, our
revenues depend to a significant extent on Econolites marketing efforts.
Econolites inability to effectively market the Autoscope system, or the
disruption or termination of that relationship, could result in reduced
revenues and market share for our products.

6

---



Our dependence on single-source suppliers may
prevent us from meeting customers needs in a timely manner.

All
of the hardware components incorporated into the Autoscope system are standard
electronics components that are available from multiple sources. If current
vendors of components for the Autoscope system fail to meet quality and
performance expectations, and if alternative component vendors are unavailable,
shortages of parts or the need to change vendors could limit our ability to
manufacture the Autoscope system, which would harm our business reputation and
financial results.

We may face increased competition if we fail
to adequately protect our intellectual property rights, and efforts to protect
our intellectual property rights may result in costly litigation.

Our
success depends in large measure on the protection of our proprietary
technology rights. We rely on trade secret, copyright and trademark laws, and
confidentiality agreements with employees and third parties, all of which offer
only limited protection. We cannot assure you that the scope of any current or
future patents relating to our products will exclude competitors or provide
competitive advantages to us. We also cannot assure you that others have not
developed or will not develop similar products, duplicate any of our products
or design products similar to ours. The reverse engineering, unauthorized
copying or other misappropriation of our proprietary technology could enable
third parties to benefit from our technology without paying us for it. This
could adversely affect our business and financial results. Litigation may be
necessary in the future to enforce our intellectual property rights, to protect
our trade secrets or to determine the validity and scope of the proprietary
rights of others. In addition, we may be the subject of lawsuits by others who
claim we violate their intellectual property rights. Litigation could result in
substantial costs and the diversion of management resources, either of which
could harm our business.

We
have not applied for patent protection in all countries in which we market and
sell the Autoscope system. Consequently, our proprietary rights in the
technology underlying the Autoscope system in these countries will be protected
only to the extent that trade secret, copyright or other non-patent protection
is available and to the extent we are able to enforce our rights. The laws of
other countries in which we market our products may afford little or no
effective protection of our proprietary technology.

Expiration of the University of Minnesota
patent for certain aspects of our Autoscope system may result in additional
competition.

The patent
rights for certain aspects of the underlying technology for the Autoscope
system previously owned by the University of Minnesota expired as of July 2006.
Other businesses may choose to use the University patent technology to develop
a product which competes with the Autoscope system, and this competition could
adversely impact our revenues and earnings.

Increased competition may make it difficult
for us to acquire and retain customers, and if we are unsuccessful in
developing new applications and product enhancements, our products may become
noncompetitive or obsolete.

Competition
in the area of advanced traffic management and surveillance is growing. Some of
the companies that may compete with us in the business of developing and
implementing traffic control systems have substantially more financial,
technological, marketing, personnel and research and development resources than
we have. Therefore, they may be able to respond more quickly than we can to new
or changing opportunities, technologies, standards or customer requirements. If
we are unable to compete successfully with these companies, the market share
for our products will decrease, and competitive pressures may seriously harm
our business.

Additionally,
the market for vehicle detection is continuously seeking more advanced
technological solutions to traffic management and control problems.
Technologies such as embedded loop detectors, pressure plates, pneumatic tubes,
radars, lasers, magnetometers, acoustics, and microwaves that have been used as
traffic sensing devices in the past will be enhanced for use in the traffic
management industry, and new technologies may be developed. We are aware of
several companies that are developing traffic management devices using machine

7

---



vision
technology or other advanced technology. We expect that we increasingly will
face competitive product developments, applications and enhancements. New
technologies or applications in traffic control systems may provide our
customers with alternatives to the Autoscope system and could render our
products or technologies noncompetitive or obsolete. If we are unable to
increase the number of our applications and develop and commercialize product
enhancements and applications in a timely manner that respond to changing
technology and satisfy the needs of our customers, our business and financial
results will suffer. We cannot be certain that we will be successful in
developing and marketing product enhancements or new products on a timely or
cost-effective basis or that these products, if developed, will achieve market
acceptance.

We may not be able to quickly respond to
emerging low-cost local competitors, and our inability to do so could affect
revenue and profitability.

Local
competing low-cost developers of machine vision products for traffic in our
international markets are likely to emerge and grow stronger, especially since
it appears that local officials that purchase traffic management products favor
products that are developed and manufactured locally. This bias could erode
revenue in Europe and Asia and affect profitability.

Lack of market
acceptance of new products or new features in one or more of our market
segments could adversely affect revenues and profitability.

Even
though we diligently seek out new product requirements by talking to our
distributors and customers, there is no guarantee that our new products,
including our new Autoscope Terra product line, or product features or
functions we introduce will gain market acceptance. The lack of market
acceptance in one or more of our markets could hurt our reputation and decrease
our revenues and earnings.

Our inability to manage growth effectively
could seriously harm our business.

Growth
and expansion of our business could significantly strain our capital resources
as well as the time and abilities of our management personnel. Our ability to
manage growth effectively will require continued improvement of our
operational, financial and management systems, and successful training,
motivation and management of our employees. If we are unable to manage growth
successfully, our business and operating results will suffer.

Our officers and directors beneficially own
approximately 9% of our common stock, and they have influence over shareholder
voting matters, which may deprive other shareholders of the ability to
influence corporate actions.

As
of March 8, 2007, our directors and officers owned beneficially approximately
9% of our outstanding common stock. Accordingly, these shareholders may be able
to influence the outcome of shareholder votes, including votes concerning the
election of directors and the outcome of corporate actions requiring
shareholder approval, such as mergers and acquisitions, regardless of how other
shareholders may vote. This concentration of voting control among our officers
and directors may result in the deferral, prevention or delay in a change in
management or change in control of the Company and may constrain the voting or
other rights of other holders of our common stock.

Our business operations will be severely
disrupted if we lose key personnel or if we fail to attract and retain qualified
personnel.

Our
technology is dependent upon the knowledge, experience, and skills of key
scientific and technical personnel. Additionally, our ability to continue
technological developments and to market our products, and thereby develop a
competitive edge in the marketplace, depends in large part on our ability to
attract and retain qualified scientific and technical personnel. Competition
for qualified personnel is intense, and we cannot assure you that we will be
able to attract and retain the individuals we need. The loss of key personnel,
or our inability to hire and retain qualified personnel, will harm our
business.

8

---



Our business tends to
be seasonal, with results in revenue and operating results varying from quarter
to quarter.

Our
quarterly revenues and operating results have varied significantly in the past
due to the seasonality of our business. The second and third quarters are the
strongest, and the first and fourth quarters are the weakest, generally due to
weather conditions in North America and Europe that make roadway construction
more difficult. We expect such seasonality to continue for the foreseeable
future. Additionally, our international revenues have a significant large
project component, resulting in a varying revenue stream. Accordingly, we
believe that quarter-to-quarter comparisons of our financial results should not
be relied upon as an indication of our future performance. No assurance can be
given that we will be able to achieve or maintain profitability on a quarterly
or annual basis in the future.

Our operating costs
tend to be fixed, while our revenue tends to be seasonal, thereby resulting in
operating results that fluctuate from quarter to quarter.

Our
expense levels are based in part on our product development efforts and our
expectations regarding future revenues and, in the short-term, are generally
fixed. Therefore, we may be unable to adjust our spending in a timely manner to
compensate for any unexpected revenue shortfall. As a result, if anticipated
revenues in any quarter do not occur or are delayed, our operating results for
the quarter would be disproportionately affected. Operating results also may
fluctuate due to factors such as the demand for our products, product life cycle,
the development, introduction and acceptance of new products and product
enhancements by us or our competitors, changes in the mix of distribution
channels through which our products are offered, changes in the level of
operating expenses, customer order deferrals in anticipation of new products,
competitive conditions in the industry and economic conditions generally.

Our stock price is
volatile.

Our
common stock is thinly traded, with 3,452,283 shares of our 3,777,004
outstanding shares held by non-affiliates as of March 8, 2007. Based on the
trading history of our common stock and the nature of the market for publicly
traded securities of companies in evolving high-tech industries, we believe
there are several factors that have caused and are likely to continue to cause
the market price of our common stock to fluctuate substantially. The
fluctuations may occur on a day-to-day basis or over a longer period of time.
Factors that may cause fluctuations in our stock price include: announcements of
large orders obtained by us or our competitors, substantial cutbacks in
government funding of highway projects or of the potential availability of
alternative technologies for use in traffic control and safety, quarterly
fluctuation in our financial results or the financial results of our
competitors and consolidation among our competitors.

Failure to achieve
and maintain effective internal controls in accordance with Section 404 of the
Sarbanes-Oxley Act could have a material adverse effect on our business and
stock price.

We
are in the process of documenting our internal control procedures in order to
satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which
requires annual assessments of the effectiveness of our internal controls over
financial reporting. Section 404 will be effective for us for the year ending
December 31, 2007. During the course of our testing, we may identify
deficiencies which we may not be able to remedy in time to meet the deadline
imposed by the Sarbanes-Oxley Act for compliance with the requirements of
Section 404. In addition, if we fail to maintain the adequacy of our internal
controls, as such standards are modified, supplemented or amended from time to
time; we may not be able to ensure that we can conclude on an ongoing basis
that we have effective internal controls over financial reporting in accordance
with Section 404 of the Sarbanes-Oxley Act. If we are not able to implement the
requirements of Section 404 in a timely manner or with adequate compliance,
we may be subject to sanctions or investigation by regulatory authorities,
including the SEC or The Nasdaq Stock Market. This type of action could
adversely affect our financial results, investors confidence in our Company
and our ability to access capital markets and could cause our stock price to
decline. In addition, the controls and procedures that we will implement may
not comply with all of the relevant rules and regulations of the SEC and
The Nasdaq Stock Market. If we fail to develop and maintain effective controls
and procedures, we may be unable to provide the required financial information
in a timely and reliable manner.

9

---



We sell our products
internationally and are subject to various risks relating to such international
activities, which could harm our international sales and profitability.

During
the years ended December 31, 2006, December 31, 2005 and December 31, 2004,
23%, 22% and 31% of our total revenues were attributable to international
sales. We sell outside of the United States through our agreement with
Econolite and through our subsidiaries, Flow Traffic, ISS/Europe and
ISS/Poland. By doing business in international markets, we are exposed to risks
separate and distinct from those we face in our domestic operations. Our
international business may be adversely affected by changing economic
conditions in foreign countries. Because most of our sales are currently
denominated in U.S. dollars, if the value of the U.S. dollar increases relative
to foreign currencies, our products could become more costly to the
international consumer and therefore less competitive in international markets,
which could adversely affect our profitability. Furthermore, although currently
only a small percentage of our sales are denominated in non-U.S. currency, this
percentage may increase in the future, in which case fluctuations in exchange
rates could affect demand for our products. Engaging in international business
inherently involves a number of other difficulties and risks, including:

|  |                                                                                                   
|- | --------------------------------------------------------------------------------------------------
| | export
  restrictions and controls relating to technology;                                        
|  |                                                                                                   
| | pricing
  pressure that we may experience internationally;                                        
|  |                                                                                                   
| | required
  compliance with existing and new foreign regulatory requirements and laws;             
|  |                                                                                                   
| | laws and
  business practices favoring local companies;                                           
|  |                                                                                                   
| | longer
  payment cycles;                                                                          
|  |                                                                                                   
| | difficulties
  in enforcing agreements and collecting receivables through foreign legal
  systems;
|  |                                                                                                   
| | political
  and economic instability;                                                             
|  |                                                                                                   
| | potentially
  adverse tax consequences, tariffs and other trade barriers;                         
|  |                                                                                                   
| | international
  terrorism and anti-American sentiment;                                            
|  |                                                                                                   
| | difficulties
  and costs of staffing and managing foreign operations;                             
|  |                                                                                                   
| | changes in
  currency exchange rates; and                                                         
|  |                                                                                                   
| | difficulties
  in enforcing intellectual property rights.                                         

Our
exposure to each of these risks may increase our costs, lengthen our sales
cycle and require significant management attention. We cannot assure you that
one or more of these factors will not harm our business.

Our inability to
comply with European regulatory restrictions over hazardous substances and
electronic waste could restrict product sales in those markets and reduce
profitability in the future.

The
European Union has finalized the Waste Electrical and Electronic Equipment
(WEEE) directive, which makes producers of electrical goods financially
responsible for specified collection, recycling, treatment and disposal of past
and future covered products. This directive must now be enacted and implemented
by individual European Union governments (such legislation together with the
directive, the WEEE Legislation), and certain producers are to be financially
responsible under the WEEE Legislation. This may impose on us requirements,
which, if we are unable to meet, could adversely affect our ability to market
our products in European Union countries, and sales revenues and profitability
would suffer as a consequence. In addition, the European Parliament has enacted
a directive for the restriction of the use of certain hazardous substances in
electrical and electronic equipment (RoHS). This legislation governs
restriction of the use of such substances as mercury, lead, cadmium, and
hexavalent cadmium. We expect that we will continue to have our product
manufactured in compliance with the RoHS directive. However, if we are unable
to do so we would be unable to market our products in European Union countries,
and sales revenues and profitability would suffer as a consequence.

New Asian
requirements for electronic products could increase our cost of production and
delay delivery of our product to our customers, thereby adversely impacting
revenue and profitability.

Various
Asian governments could adopt their own versions of environment-friendly
electronic regulations, similar to the European directives, RoHS and WEEE. This
could require new and unanticipated manufacturing changes, product testing and
certification requirements, thereby increasing cost, delaying sales, and
lowering revenue and profitability.

10

---



Our ability to comply
with the conditions beyond our control could seriously harm our business.

Terrorists
attacks against and natural disaster affecting Econolite, WTI or our overseas
suppliers would adversely affect manufacture of our Autoscope products and
delay the delivery of sales orders. War and severe acute respiratory syndrome,
or SARS, bird flu or similar epidemics could affect our ability to travel and
sell products internationally and to deliver product in a timely manner.
Economic recession or depression could also affect government entities and
their ability to expend funds for transportation improvements. These and other
factors beyond our control could seriously reduce our revenues and earnings.

Changes in
accounting principles, including changes in employee stock option accounting
rules, may adversely affect our reported operating results and our efforts and
success in recruiting and retaining employees.

Technology
companies, including our Company, have a history of using stock programs to
hire, incentivize and retain employees and directors in a competitive
marketplace. In December 2004, the Financial Accounting Standards Board,
or FASB, adopted SFAS No. 123(R), Share-Based
Payment, which was effective for us on January 1, 2006. SFAS
No. 123(R) requires companies, including our Company, to record
equity-based compensation expense for stock options and any employee stock
purchase plan rights granted to employees based on the fair value of the equity
instrument at the time of grant. We began to record these expenses on
January 1, 2006. We apply the modified prospective method and have not
restated prior year results. The actual amount of expense that we recognize
will depend on the value of our common stock at the time of any grants of
options and other stock awards to employees. The change in accounting
rules may lead to an increased loss, if we recognize a net loss, or a
decrease in reported earnings, if we have earnings. This could also adversely
affect our ability to use stock plans to attract and reward employees and
directors and could result in a competitive disadvantage to us in the
marketplace. Our financial results could be adversely affected by other changes
in accounting principles by FASB, the American Institute of Certified Public
Accountants, the SEC, or various other bodies formed to promulgate and
interpret accounting principles which have not yet been announced or adopted.

|         |                          
|-------- | -------------------------
|Item 1B. | Unresolved Staff Comments

None.

|        |           
|------- | ----------
|Item 2. | Properties

We
currently lease approximately 10,457 and 784 square feet of office space in St.
Paul, Minnesota, and Fullerton, California, pursuant to operating leases that
expire in May 2010 and June 2007, respectively. Our subsidiaries in Hong Kong,
the United Kingdom and Poland and our branch office in Spain rent office and
storage space totaling 2,439 square
feet under operating leases that expire in 2007.

We
believe that our current space is adequate in the United States, Asia and
Europe and do not intend to lease significantly more space in the near-future.

We do not
otherwise invest in real estate in any manner.

|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

On
August 3, 2006, we entered into a Settlement Agreement, Contract Modification
and Mutual Release (the Agreement) with Econolite Control Products, Inc.
(Econolite) relating to the action filed by Econolite against us in September
2005. Under the Agreement, we agreed to pay Econolite $200,000 within ten days
of execution of the Agreement and an additional $175,000 if Econolite achieved
sales of Autoscope products of $33 million in calendar year 2006. In addition,
we agreed to modify the royalty calculation set forth in our Manufacturing,
Distributing and Technology License Agreement with Econolite to take into
account additional overhead expenses that Econolite incurs. Under the
Agreement, beginning as of July 1, 2006, Econolite will calculate and pay
royalties to us on Solo Pro products so as to split 50/50 net profit on sales
of Solo Pro between Econolite and us. Net profit on sales is defined in the
Agreement as sales price to the end user less distribution commission (if any)
and Solo Pro purchase

11

---



price plus 15%
of purchase price overhead. Under an oral agreement we entered into with
Econolite in 2003, we were already taking into account in the royalty
calculation 10% of the purchase price for overhead. Thus, the Amendment in
effect increased the percentage of purchase price for overhead by 5%. We paid
Econolite $200,000 in August as part of the Agreement and $175,000 in December
2006. We accrued $200,000 and $175,000 as charges to Other Income (Expense),
Net in the second quarter and third quarter of 2006, respectively.

|        |                                                    
|------- | ---------------------------------------------------
|Item 4. | Submission of Matters to a Vote of
Security Holders

None.

12

---



PART
II

|        |                                                                                                               
|------- | --------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common
  Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market
Information

Our
common stock is traded on the NASDAQ Capital Market under the symbol ISNS.
The quarterly high and low sales prices for our common stock for our last two
fiscal years are set forth below.

|        |  |         |       |         |   |       |  |     |       |  |   |       | 
|------- |  | ------- | ----- | ------- | - | ----- |  | --- | ----- |  | - | ----- | 
|        |  | FY 2006 |       | FY 2005 |  
|        |  |         |       |         |  
|Quarter |  | High    |       | Low     |   | High  |  | Low |      
|        |  |         |       |         |   |       |  |     |      
|First   |  | $       | 13.50 |         | $ | 11.44 |  | $   | 16.93 |  | $ | 12.76 | 
|Second  |  |         | 14.92 |         |   | 11.50 |  |     | 13.39 |  |   | 11.54 | 
|Third   |  |         | 14.25 |         |   | 11.25 |  |     | 13.00 |  |   | 10.76 | 
|Fourth  |  |         | 14.57 |         |   | 12.50 |  |     | 13.34 |  |   | 10.75 | 

Shareholders

As
of March 8, 2007, there were 24 holders of record of our common stock and
approximately 2,031 beneficial holders of our common stock.

Dividends

We
have never declared or paid a cash dividend on our common stock. We currently
intend to retain earnings for use in the operation and expansion of our
business, and, consequently, we do not anticipate paying any dividends in the
foreseeable future.

13

---



Comparative
Stock Performance Graph

The
graph below compares the cumulative total stockholder return on our common
stock with the cumulative total stockholder return of (i) the Dow Jones
Wilshire 5000 Index, and (ii) the DJ Wilshire Electronic Equipment Index,
assuming an investment of $100 on December 31, 2001.

Notwithstanding
anything to the contrary set forth in any of our previous or future filings
under the Securities Act of 1933 or the Securities Exchange Act of 1934 that
might incorporate future filings by reference, including this Annual
Report on Form 10-K, in whole or in part, the following performance graph
and accompanying data shall not be deemed to be incorporated by reference into
any such filings and shall not otherwise be deemed filed under such acts.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*Among Image Sensing Systems, Inc, The
Dow Jones Wilshire 5000 IndexAnd The DJ Wilshire Electronic Equipment Index

(LINE GRAPH)

* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends.Fiscal year ending December 31.

|                                   |  |  |        |  |  |        |  |  |        |  |  |        |  |  |        |  |  |        | 
|---------------------------------- |  |  | ------ |  |  | ------ |  |  | ------ |  |  | ------ |  |  | ------ |  |  | ------ | 
|                                   |  |  |        |  |  |        |  |  |        |  |  |        | 
|                                   |  |  | 12/01  |  |  | 12/02  |  |  | 12/03  |  |  | 12/04  |  |  | 12/05  |  |  | 12/06  | 
|                                   |  |  |        |  |  |        |  |  |        |  |  |        |  |  |        |  |  |        | 
|                                  
|Image
  Sensing Systems, Inc       |  |  | 100.00 |  |  | 199.55 |  |  | 459.09 |  |  | 768.18 |  |  | 606.36 |  |  | 650.91 | 
|Dow
  Jones Wilshire 5000          |  |  | 100.00 |  |  | 79.14  |  |  | 104.18 |  |  | 117.33 |  |  | 124.75 |  |  | 144.56 | 
|DJ
  Wilshire Electronic Equipment |  |  | 100.00 |  |  | 59.96  |  |  | 99.14  |  |  | 106.02 |  |  | 111.77 |  |  | 128.80 | 

14

---



|        |                         
|------- | ------------------------
|Item 6. | Selected  Financial Data

The
following table sets forth selected consolidated financial data for each of the
five fiscal years ended December 31, 2006. The statement of income and balance
sheet data for the years ended and as of December 31, 2006, 2005, 2004, 2003
and 2002 are derived from our audited consolidated financial statements. The
following information should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations and
with our consolidated financial statements and the related notes thereto
included elsewhere in this report.

|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|------------------------------------------------------- |  | --------------------------------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ----- |  | - | ----- | 
|                                                        |  | Fiscal
  Year Ended December 31         |       
|                                                        |  |                                         |       
|                                                        |  | 2006                                    |        | 2005 |   | 2004   |  | 2003 |        | 2002 |  
|                                                        |  |                                         |        |      |   |        |  |      |        |      |  
|                                                        |  | (in
  thousands, except per share data) |       
|                                                       
|Consolidated Statement of Income
  Data:                |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Revenue:                                                |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|International
  sales                                   |  | $                                       | 2,980  |      | $ | 2,407  |  | $    | 3,309  |      | $ | 3,334 |  | $ | 2,981 | 
|Royalties                                               |  |                                         | 10,136 |      |   | 8,595  |  |      | 7,521  |      |   | 5,920 |  |   | 4,992 | 
|Consulting
  services                                   |  |                                         |       |      |   |       |  |      |       |      |   | 5     |  |   | 112   | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Total revenue                                           |  |                                         | 13,116 |      |   | 11,002 |  |      | 10,830 |      |   | 9,259 |  |   | 8,085 | 
|Cost of revenue:                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|International
  sales                                   |  |                                         | 1,501  |      |   | 1,042  |  |      | 1,599  |      |   | 1,531 |  |   | 1,514 | 
|Royalties                                               |  |                                         | 220    |      |   | 383    |  |      | 321    |      |   | 277   |  |   | 368   | 
|Consulting
  services                                   |  |                                         |       |      |   |       |  |      |       |      |   | 2     |  |   | 107   | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Total cost of
  revenue                                 |  |                                         | 1,721  |      |   | 1,425  |  |      | 1,920  |      |   | 1,810 |  |   | 1,891 | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Gross profit                                            |  |                                         | 11,395 |      |   | 9,577  |  |      | 8,910  |      |   | 7,449 |  |   | 6,194 | 
|Operating
  expenses:                                   |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Selling,
  marketing and product support                |  |                                         | 2,850  |      |   | 2,567  |  |      | 2,523  |      |   | 2,536 |  |   | 2,678 | 
|General and
  administrative                            |  |                                         | 2,007  |      |   | 1,400  |  |      | 1,317  |      |   | 1,235 |  |   | 1,100 | 
|Research and
  development                              |  |                                         | 2,639  |      |   | 1,516  |  |      | 1,126  |      |   | 730   |  |   | 602   | 
|Restructuring
  costs                                   |  |                                         |       |      |   |       |  |      |       |      |   |      |  |   | 474   | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|                                                        |  |                                         | 7,496  |      |   | 5,483  |  |      | 4,966  |      |   | 4,501 |  |   | 4,854 | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Income from
  operations                                |  |                                         | 3,899  |      |   | 4,094  |  |      | 3,944  |      |   | 2,948 |  |   | 1,340 | 
|Other income,
  net                                     |  |                                         | 148    |      |   | 252    |  |      | 102    |      |   | 23    |  |   | 26    | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Income before
  income taxes                            |  |                                         | 4,047  |      |   | 4,346  |  |      | 4,046  |      |   | 2,971 |  |   | 1,366 | 
|Income taxes                                            |  |                                         | 942    |      |   | 1,505  |  |      | 1,352  |      |   | 836   |  |   | 174   | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Net income                                              |  | $                                       | 3,105  |      | $ | 2,841  |  | $    | 2,694  |      | $ | 2,135 |  | $ | 1,192 | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Net income per
  share:                                 |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Basic                                                   |  | $                                       | 0.83   |      | $ | 0.79   |  | $    | 0.79   |      | $ | 0.66  |  | $ | 0.38  | 
|Diluted                                                 |  |                                         | 0.80   |      |   | 0.73   |  |      | 0.71   |      |   | 0.60  |  |   | 0.37  | 
|                                                        |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Weighted average
  number of common shares outstanding: |  |                                         |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Basic                                                   |  |                                         | 3,725  |      |   | 3,602  |  |      | 3,409  |      |   | 3,215 |  |   | 3,155 | 
|Diluted                                                 |  |                                         | 3,891  |      |   | 3,868  |  |      | 3,810  |      |   | 3,598 |  |   | 3,252 | 

|                                 |  |                 |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|-------------------------------- |  | --------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ----- |  | - | ----- | 
|                                 |  | At December 31, |       
|                                 |  |                 |       
|                                 |  | 2006            |        | 2005 |   | 2004   |  | 2003 |        | 2002 |  
|                                 |  |                 |        |      |   |        |  |      |        |      |  
|                                 |  | (in thousands)  |       
|                                
|Consolidated Balance Sheet Data: |  |                 |        |      |   |        |  |      |        |      |   |       |  |   |       | 
|Total assets                     |  | $               | 21,224 |      | $ | 16,791 |  | $    | 13,063 |      | $ | 9,587 |  | $ | 6,789 | 
|Total
  shareholders equity     |  |                 | 19,333 |      |   | 15,722 |  |      | 11,779 |      |   | 7,760 |  |   | 5,123 | 

15

---



|        |                                                                                      
|------- | -------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
of Financial Condition and Results of Operations

Overview

We
have developed proprietary machine vision technology that converts real world
information into digital electronic signals for processing by computer and
applies it to traffic management problems. The machine vision technology uses
commercially available components and video cameras in conjunction with our
proprietary software to create our core family of products, the Autoscope®
Video Vehicle Detection System. The Autoscope system is used by traffic
managers primarily to improve the flow of vehicle traffic and to enhance safety
at intersections, main thoroughfares, freeways and tunnels.

Autoscope
systems are sold to distributors and end users of traffic management products
in North America, the Caribbean and Latin America by Econolite, our licensee in
those locations. We also sell Autoscope products to distributors and end users
in Europe and Asia through our European and Hong Kong subsidiaries,
respectively.

The
majority of our revenue is derived from royalties received from Econolite, with
a second primary source of revenue received from product sales in Europe and
Asia. End users of the Autoscope system throughout the world are generally
funded by government agencies responsible for traffic management and/or traffic
law enforcement.

Our
success is primarily dependent upon continued governmental funding of
Intelligent Transportation Systems, such as machine vision, for traffic
control; our ability, through Econolite and our sales representatives in Europe
and Asia, to successfully market the Autoscope System to individual traffic
managers; and our ability to develop new machine vision products and
applications that enhance the traffic managers ability to cost-effectively
improve traffic flow, safety and security.

Our
quarterly revenues and operating results have varied significantly in the past
due to the seasonality of our business. Our second and third quarters are the
strongest and the first and fourth quarters are the weakest generally due to
weather conditions that make roadway construction more difficult in North
America and Europe. We expect such seasonality to continue for the foreseeable
future. Additionally, our international revenues have a significant large
project component, resulting in a varying revenue stream. Accordingly, we
believe that quarter-to-quarter comparisons of our financial results should not
be relied upon as an indication of our future performance. No assurance can be
given that we will be able to achieve or maintain profitability on a quarterly
or annual basis in the future.

Results of Operations

The
following table sets forth, for the periods indicated, certain statements of
income data as a percent of total revenue and gross margin on international
sales and royalties as a percentage of international sales and royalties,
respectively:

|                                       |  |                           |       |      |  |       |      |  |       |   | 
|-------------------------------------- |  | ------------------------- | ----- | ---- |  | ----- | ---- |  | ----- | - | 
|                                       |  | Year Ended
  December 31, |      
|                                       |  |                           |      
|                                       |  | 2006                      |       | 2005 |  |       | 2004 |  |      
|                                       |  |                           |       |      |  |       |      | 
|International sales                    |  |                           | 22.7  | %    |  | 21.9  | %    |  | 30.6  | % | 
|Royalties                              |  |                           | 77.3  |      |  | 78.1  |      |  | 69.4  |   | 
|                                       |  |                           |       |      |  |       |      |  |       |   | 
|Total revenue                          |  |                           | 100.0 |      |  | 100.0 |      |  | 100.0 |   | 
|Gross margin - International sales     |  |                           | 49.6  |      |  | 56.7  |      |  | 51.7  |   | 
|Gross margin - royalties               |  |                           | 97.8  |      |  | 95.5  |      |  | 95.7  |   | 
|Selling, marketing and product support |  |                           | 21.7  |      |  | 23.3  |      |  | 23.3  |   | 
|General and administrative             |  |                           | 15.3  |      |  | 12.7  |      |  | 12.2  |   | 
|Research and development               |  |                           | 20.1  |      |  | 13.8  |      |  | 10.4  |   | 
|Income from operations                 |  |                           | 29.7  |      |  | 37.2  |      |  | 36.4  |   | 
|Income taxes                           |  |                           | 7.2   |      |  | 13.7  |      |  | 12.5  |   | 
|Net income                             |  |                           | 23.7  |      |  | 25.8  |      |  | 24.9  |   | 

16

---



2006 Compared to 2005

Total
revenue increased to $13.1 million in 2006 from $11.0 million in 2005, an
increase of 19.2%. International sales increased to $3.0 million in 2006 from
$2.4 million in 2005, an increase of 25%. Royalty income increased to $10.1
million in 2006 from $8.6 million in 2005, an increase of 17.4%. The increase
in international sales was a result of better performance in our Asian
subsidiary, including a significant fourth quarter tunnel installation in
China. The increase in royalty income reflects the continued success of
Econolites distribution of Autoscope in the North American market, including
an unexpectedly strong fourth quarter in 2006.

Gross
margins for international sales decreased to 49.6% in 2006 from 56.7% in 2005.
Gross margins on royalty income increased to 97.8% in 2006 up from 95.5% in
2005. International gross margins were negatively impacted by slightly higher
manufacturing costs and higher warranty reserves in 2006 versus 2005. Royalty
gross margins were positively impacted by the patent royalty we owed to the
University of Minnesota ending in the third quarter of 2006. We anticipate that
gross margins for our international sales will be in the range of 50 to 55% in
2007, while we expect royalty gross margins will approach 100% in 2007.

Selling,
marketing and product support expense increased to $2.9 million or 21.7% of
total revenue in 2006, up from $2.6 million or 23.3% of total revenue in 2005.
The change related mostly to headcount additions. We anticipate that selling,
marketing and product support expense will increase both in terms of actual
expense and as a percentage of total revenue in 2007 when compared to 2006.

General
and administrative expense increased to $2.0 million or 15.3% of total revenue
in 2006 up from $1.4 million or 12.7% of total revenue in 2005. The 2006
increase resulted mainly from a combination of headcount additions, stock
option expense recognition, and increased audit, tax, legal and consulting
fees. We anticipate that general and administrative expense will increase in
2007 both in terms of actual expense and as a percentage of total revenue when
compared to 2006.

Research
and development expense increased to $2.6 million or 20.1% of total revenue in
2006, up from $1.5 million or 13.8% of total revenue in 2005. The increase was
directly related to headcount additions and significant prototype material and
consulting expenses incurred in accelerating technical efforts on our next
generation Autoscope Terra product line. We anticipate that research and
development expense will increase in 2007 both in terms of actual expense and
as a percentage of total revenue when compared to 2006.

Other
income decreased to $148,000 in 2006 from $252,000 in 2005. Increased interest
income was offset by a $375,000 legal settlement with Econolite. We anticipate
other income will increase in 2007.

Our
income tax effective rate decreased to 23.3% of pretax income in 2006 from
34.6% in 2005. The decrease was due to a number of federal and state
adjustments and increased research and development credits. We expect the
effective rate in 2007 to return to our historical range of 30 to 35%.

Net
income was $3.1 million in 2006 compared to $2.8 million in 2005 due to the
factors mentioned above.

2005 Compared to 2004

Total
revenue increased to $11.0 million in 2005 from $10.8 million in 2004, an
increase of 1.6%. Royalty income for 2005 increased to $8.6 million, or 78.1%
of revenue, from $7.5 million, or 69.4% of revenue, in 2004. The 14.3% increase
in royalty income in 2005 resulted primarily from increased sales volume of the
Autoscope Solo Pro product by Econolite. International sales for 2005 decreased
to $2.4 million, or 21.9% of revenue, from $3.3 million, or 30.6% of revenue,
in 2004. The 27.3% decrease from 2004 was due to lower sales in Asia, which
more than offset higher sales of Autoscope systems in Europe. The decline in
sales in Asia was primarily due to our inability to repeat a large 2004 sale in
Korea in 2005 and to sell a newly developed loop detector product which was to
replace a similar product that we previously distributed in Asia. Autoscope
product sales in Europe increased by over 70% compared to 2004 primarily due to
the successful expansion into Eastern Europe and continued acceptance of the
RackVision product introduced into Europe in 2003.

17

---



Total
gross profit was $9.6 million, or 87% of revenue, in 2005, compared to $8.9
million, or 82.3% of revenue, in 2004. The increase in our total gross profit
margin percentage was primarily due to revenue mix, with higher margin royalty
income increasing as a percentage of total revenue. Gross profit margin on
international sales increased to 56.7% of sales in 2005 from 51.7% of sales in
2004. The increase was due primarily to selling more products directly to the
end user in Eastern Europe, instead of through a distributor, and we did not
repeat an unusually large non-recurring sale of low margin cameras in 2005 that
occurred in January 2004. Margins on sales of the Autoscope products were
stable in 2005.

Selling,
marketing and product support expenses were $2.6 million, or 23.3% of revenue,
in 2005, compared to $2.5 million, or 23.3% of revenue, in 2004. The small
increase in total dollars expended resulted primarily from adding sales and
support staff in Europe. General and administrative expenses were $1.4 million,
or 12.7% of revenue, in 2005, compared to $1.3 million, or 12.2% of revenue, in
2004. The small increase was due primarily to added professional fees and
depreciation. Research and development expenses totaled $1.5 million, or 13.8%
of revenue, in 2005, compared to $1.1 million, or 10.4% of revenue, in 2004.
The increase resulted primarily from adding engineering staff and assigning
them to development projects and annual pay adjustments.

Income
taxes were $1.5 million, or 34.6% of pretax income, in 2005, compared to $1.4
million, or 33.4% of pretax income, in 2004. The increase in income taxes was
due primarily to more taxable income, while the increase in income taxes as a
percentage of pretax income was due primarily to a higher effective tax rates
on foreign earnings than the previous year as we were not able to benefit from
the taxable loss in Asia.

Net
income was $2.8 million in 2005 compared to $2.7 million in 2004 due to the
factors discussed above.

Liquidity and Capital Resources

At
December 31, 2006, we had $11.6 million in cash and cash equivalents, compared
to $9.0 million at December 31, 2005. Net cash provided by operating activities
was $4.6 million in 2006, compared to $2.4 and $2.6 million in 2005 and 2004,
respectively. The primary reasons for the increase include unusually high
accounts receivables at the end of 2005 that were received early in 2006;
payables were higher in 2006 due to increased employee compensation and
warranty reserves; and we had a higher non-cash charge for stock option expense
in 2006. The only significant use of cash in 2006 was investing $1.8 million in
short-term investments. The short-term investments are AAA rated tax-exempt
auction rate securities that can be either rolled over or cashed out every 35
days with interest rates reset every 35 days based on auction bidding.

We
have a credit agreement with Wells Fargo Bank Minnesota, N.A. that provides up
to $1.0 million in short-term borrowings at .5% over the prime rate (effective
rate of 8.75% at December 31, 2006) expiring May 31, 2008. Any loans would be
secured by inventories, accounts receivable and equipment and the bank would
have the right of setoff against checking, savings and other accounts we have
with the bank. We had no outstanding borrowings under the credit agreement in
2006 or 2005.

We
believe that cash and cash equivalents on hand at December 31, 2006, our $1.0
million revolving line of credit with Wells Fargo Bank Minnesota, N.A. and cash
provided by operating activities will satisfy our projected working capital
needs, investing activities and other cash requirements for the foreseeable
future.

Off-Balance Sheet Arrangements

We
do not participate in transactions or have relationships or other arrangements
with an unconsolidated entity, including special purpose and similar entities
or other off-balance sheet arrangements.

Critical Accounting Policies

Goodwill.Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or
whenever an impairment indicator arises. Our recorded goodwill relates to our Flow Traffic subsidiary and is tested for impairment
on December 31 of each year. The impairment test requires us to estimate the fair value of our subsidiary and then compare it to
the carrying value of the subsidiary. If the carrying value exceeds the fair value, further analysis is performed to determine if
there is an impairment loss. We estimate the fair value by using the income approach, where fair value is dependent on the present
value of future economic benefits to be derived from ownership of Flow Traffic. No impairment of goodwill was recorded as of
December 31, 2006

18

---



and 2005. If
Flow Traffic does not provide the future economic benefits we project, the fair
value of this subsidiary may become impaired, and we would need to record an
impairment loss.

Revenue
recognition.Royalty income is recognized based upon a
monthly royalty report provided to us by Econolite. This report is prepared by
Econolite based on its sales of products we developed and is based on sales
delivered and accepted by its customers. We recognize revenue from
international sales at the time of delivery and acceptance, the selling price
is fixed or determinable and collectibility is reasonably assured. We record
provisions against sales revenue for estimated returns and allowances in the
period when the related revenue is recorded based upon historical sales returns
and changes in customer demands.

Income
taxes.Income taxes are accounted for under the
liability method. Deferred income taxes reflect the effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and amounts used for income tax purposes. Deferred
tax assets are offset by a valuation allowance as deemed necessary based on our
estimate of our future sources of taxable income and the expected timing of
temporary difference reversals.

New Accounting Pronouncements

In
November 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 151, Inventory Costs. The
provisions of this statement become effective for us in fiscal 2006. SFAS No.
151 amends the existing guidance on the recognition of inventory costs to
clarify the accounting for abnormal amounts of idle expense, freight, handling
costs, and wasted material (spoilage). Existing rules indicate that under some
circumstances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment as
current period charges. SFAS No. 151 requires that those items be recognized as
current period charges regardless of whether they meet the criterion of so
abnormal. In addition, SFAS No. 151 requires that allocation of fixed
production overheads to the costs of conversion be based on the normal capacity
of the production facilities. The adoption of this statement did not have a
material impact on our valuation of inventory or operating results.

In
December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This
revised standard addresses the accounting for share-based payment transactions
in which a company receives employee services in exchange for either equity
instruments of the company or that are based on the fair value of the companys
equity instruments or that may be settled by the issuance of such equity
instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in
accordance with APB 25. Instead, companies will be required to account for such
transactions using a fair-value method and recognize the expense in the
consolidated statement of income. SFAS No. 123R was effective for all interim
and annual periods beginning after December 15, 2005. The Company adopted this
standard in 2006 and recorded an expense of $177,000.

In
June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes - an interpretation of SFAS No. 109, Accounting for Income
Taxes (FIN 48), which clarifies the accounting for uncertainty in income
taxes. FIN 48 prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. The interpretation requires that we
recognize in the financial statements the impact of a tax position. Recognition
is allowed if the tax position is more likely than not of being sustained on
audit, based on the technical merits of the position. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting
in interim periods and disclosure. The provisions of FIN 48 are effective for
fiscal years beginning after December 15, 2006, with the cumulative effect of
the change in accounting principle recorded as an adjustment to opening
retained earnings. We do not expect the new standard to materially affect our
financial position or results of operations.

In
September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements. SAB No. 108 was issued to
provide consistency between how registrants quantify financial statement
misstatements. Historically, there have been two widely-used methods for
quantifying the effects of financial statement misstatements. These methods are
referred to as the roll-over and iron curtain method. The roll-over method
quantifies the amount by that the current year income statement is misstated.
Exclusive reliance on an income

19

---



statement
approach can result in the accumulation of errors on the balance sheet that may
not have been material to any individual income statement, but which may
misstate one or more balance sheet accounts. The iron curtain method quantifies
the error as the cumulative amount by which the current year balance sheet is
misstated. Exclusive reliance on a balance sheet approach can result in
disregarding the effects of errors in the current year income statement that
results from the correction of an error existing in previously issued financial
statements. We currently use the roll-over method for quantifying identified
financial statement misstatements. SAB No. 108 established an approach that
requires quantification of financial statement misstatements based on the
effects of the misstatement on each of the companys financial statements and
the related financial statement disclosures. This approach is commonly referred
to as the dual approach because it requires quantification of errors under
both the roll-over and iron curtain methods. SAB No. 108 allows registrants to
initially apply the dual approach either by (1) retroactively adjusting prior
financial statements as if the dual approach had always been used or by (2)
recording the cumulative effect of initially applying the dual approach as
adjustments to the carrying value of assets and liabilities as of January 1,
2006 with an offsetting adjustment recorded to the opening balance of retained
earnings. Use of this cumulative effect transition method requires detailed
disclosure of the nature and amount of each individual error being corrected
through the cumulative adjustment and how and when it arose. We have initially
applied SAB No. 108 using the cumulative effect transition method in connection
with the preparation of our annual financial statements for the year ending
December 31, 2006. The implementation of the new standard did not materially
affect our financial position or results of operations.

In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS
No. 157 defines fair value, establishes a framework for measuring fair value
and expands disclosures about fair value measurement but does not require any
new fair value measurements. SFAS No. 157 is effective for financial statement
issued for fiscal years beginning after November 15, 2007 and interim periods
within those fiscal years. We have not evaluated the impact of this standard.

|         |                                                             
|-------- | ------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures About Market Risks.

The
Companys foreign sales and results of operations are subject to the impact of
foreign currency fluctuations. The Company has not hedged its exposure to
translation gains and losses. A 10% adverse change in foreign currency rates
would not have a material effect on the Companys results of operations or
financial position.

20

---



|        |                                            
|------- | -------------------------------------------
|Item 8. | Financial Statements and Supplementary Data

IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS(in thousands except share
data)

|                                                                                                                     |  |               |        |      |   |        | 
|-------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------ | ---- | - | ------ | 
|                                                                                                                     |  | December
  31 |       
|                                                                                                                     |  |               |       
|                                                                                                                     |  | 2006          |        | 2005 |  
|                                                                                                                     |  |               |        |      |  
|ASSETS                                                                                                               |  |               |        |      |   |        | 
|Current assets:                                                                                                      |  |               |        |      |   |        | 
|Cash and cash
  equivalents                                                                                          |  | $             | 11,626 |      | $ | 9,006  | 
|Short-term
  investments                                                                                             |  |               | 1,800  |      |   |       | 
|Investment in
  callable FHLB bonds                                                                                  |  |               | 2,300  |      |   | 2,300  | 
|Accounts
  receivable, net of allowance for returns and doubtful accounts of $98 ($39 in
  2005)                     |  |               | 2,957  |      |   | 3,514  | 
|Inventories                                                                                                          |  |               | 670    |      |   | 312    | 
|                                                                                                                     |  |               |        |      |   |        | 
|Prepaid expenses                                                                                                     |  |               | 126    |      |   | 104    | 
|Deferred income
  taxes                                                                                              |  |               | 173    |      |   | 14     | 
|                                                                                                                     |  |               |        |      |   |        | 
|                                                                                                                    
|Total current
  assets                                                                                               |  |               | 19,652 |      |   | 15,250 | 
|                                                                                                                     |  |               |        |      |   |        | 
|Property and
  equipment:                                                                                            |  |               |        |      |   |        | 
|Furniture and
  fixtures                                                                                             |  |               | 293    |      |   | 309    | 
|Leasehold
  improvements                                                                                             |  |               | 44     |      |   | 22     | 
|Equipment                                                                                                            |  |               | 834    |      |   | 970    | 
|                                                                                                                     |  |               |        |      |   |        | 
|                                                                                                                     |  |               | 1,171  |      |   | 1,301  | 
|Accumulated
  depreciation                                                                                           |  |               | 649    |      |   | 972    | 
|                                                                                                                     |  |               |        |      |   |        | 
|                                                                                                                     |  |               | 522    |      |   | 329    | 
|                                                                                                                    
|Goodwill                                                                                                             |  |               | 1,050  |      |   | 1,050  | 
|Capitalized
  software development costs, net of accumulated amortization of $1,641 in 2005                          |  |               |       |      |   | 162    | 
|                                                                                                                     |  |               |        |      |   |        | 
|TOTAL ASSETS                                                                                                         |  | $             | 21,224 |      | $ | 16,791 | 
|                                                                                                                     |  |               |        |      |   |        | 
|                                                                                                                     |  |               |        |      |   |        | 
|LIABILITIES AND
SHAREHOLDERS
  EQUITY                                                                               |  |               |        |      |   |        | 
|Current
  liabilities:                                                                                               |  |               |        |      |   |        | 
|Accounts payable                                                                                                     |  | $             | 616    |      | $ | 398    | 
|Accrued
  compensation                                                                                               |  |               | 587    |      |   | 329    | 
|Accrued warranty
  and other                                                                                         |  |               | 449    |      |   | 196    | 
|Income taxes
  payable                                                                                               |  |               | 231    |      |   | 94     | 
|                                                                                                                     |  |               |        |      |   |        | 
|Total current
  liabilities                                                                                          |  |               | 1,883  |      |   | 1,017  | 
|                                                                                                                     |  |               |        |      |   |        | 
|Deferred income
  taxes                                                                                              |  |               | 8      |      |   | 52     | 
|                                                                                                                     |  |               |        |      |   |        | 
|Shareholders
  equity:                                                                                              |  |               |        |      |   |        | 
|Preferred stock,
  $.01 par value; 5,000,000 shares authorized, none issued or outstanding                           |  |               |       |      |   |       | 
|Common stock,
  $.01 par value; 20,000,000 shares authorized, 3,761,804 issued and
  outstanding (3,702,005 in 2005) |  |               | 38     |      |   | 37     | 
|Additional
  paid-in capital                                                                                         |  |               | 8,130  |      |   | 7,641  | 
|Accumulated
  other comprehensive income                                                                             |  |               | 16     |      |   |       | 
|Retained
  earnings                                                                                                  |  |               | 11,149 |      |   | 8,044  | 
|                                                                                                                     |  |               |        |      |   |        | 
|Total
  shareholders equity                                                                                         |  |               | 19,333 |      |   | 15,722 | 
|                                                                                                                     |  |               |        |      |   |        | 
|TOTAL
  LIABILITIES AND SHAREHOLDERS EQUITY                                                                         |  | $             | 21,224 |      | $ | 16,791 | 
|                                                                                                                     |  |               |        |      |   |        | 

See accompanying notes.

21

---



IMAGE
SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME(in thousands, except share
data)

|                                                        |  |                          |        |      |   |        |  |   |        | 
|------------------------------------------------------- |  | ------------------------ | ------ | ---- | - | ------ |  | - | ------ | 
|                                                        |  | Year ended
  December 31 |       
|                                                        |  |                          |       
|                                                        |  | 2006                     |        | 2005 |   | 2004   | 
|                                                        |  |                          |        |      |   |        | 
|                                                        |  |                          |        |      |   |        | 
|Revenue:                                                |  |                          |        |      |   |        |  |   |        | 
|International
  sales                                   |  | $                        | 2,980  |      | $ | 2,407  |  | $ | 3,309  | 
|Royalties                                               |  |                          | 10,136 |      |   | 8,595  |  |   | 7,521  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|                                                        |  |                          | 13,116 |      |   | 11,002 |  |   | 10,830 | 
|                                                        |  |                          |       
|Cost of revenue:                                        |  |                          |        |      |   |        |  |   |        | 
|International
  sales                                   |  |                          | 1,501  |      |   | 1,042  |  |   | 1,599  | 
|Royalties                                               |  |                          | 220    |      |   | 383    |  |   | 321    | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|                                                        |  |                          | 1,721  |      |   | 1,425  |  |   | 1,920  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Gross profit                                            |  |                          | 11,395 |      |   | 9,577  |  |   | 8,910  | 
|                                                        |  |                          |       
|Operating
  expenses:                                   |  |                          |        |      |   |        |  |   |        | 
|Selling,
  marketing and product support                |  |                          | 2,850  |      |   | 2,567  |  |   | 2,523  | 
|General and
  administrative                            |  |                          | 2,007  |      |   | 1,400  |  |   | 1,317  | 
|Research and
  development                              |  |                          | 2,639  |      |   | 1,516  |  |   | 1,126  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|                                                        |  |                          | 7,496  |      |   | 5,483  |  |   | 4,966  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Income from
  operations                                |  |                          | 3,899  |      |   | 4,094  |  |   | 3,944  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Other income                                            |  |                          | 148    |      |   | 252    |  |   | 102    | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Income before income
  taxes                            |  |                          | 4,047  |      |   | 4,346  |  |   | 4,046  | 
|Income taxes                                            |  |                          | 942    |      |   | 1,505  |  |   | 1,352  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Net income                                              |  | $                        | 3,105  |      | $ | 2,841  |  | $ | 2,694  | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Net income per
  share:                                 |  |                          |        |      |   |        |  |   |        | 
|Basic                                                   |  | $                        | 0.83   |      | $ | 0.79   |  | $ | 0.79   | 
|Diluted                                                 |  |                          | 0.80   |      |   | 0.73   |  |   | 0.71   | 
|                                                        |  |                          |        |      |   |        |  |   |        | 
|Weighted average
  number of common shares outstanding: |  |                          |        |      |   |        |  |   |        | 
|Basic                                                   |  |                          | 3,725  |      |   | 3,602  |  |   | 3,409  | 
|Diluted                                                 |  |                          | 3,891  |      |   | 3,868  |  |   | 3,810  | 

See accompanying notes.

22

---



IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW(in thousands)

|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|----------------------------------------------------------------------------------- |  | ------------------------ | ------ | ---- | - | ------ | - | - | ------ | -
|                                                                                    |  | Year ended
  December 31 |       
|                                                                                    |  |                          |       
|                                                                                    |  | 2006                     |        | 2005 |   | 2004   |  
|                                                                                    |  |                          |        |      |   |        |  
|Operating activities:                                                               |  |                          |        |      |   |        |   |   |        |  
|Net income                                                                          |  | $                        | 3,105  |      | $ | 2,841  |   | $ | 2,694  |  
|Adjustments to reconcile net income to net
  cash provided by operating activities: |  |                          |        |      |   |        |   |   |        |  
|Depreciation                                                                        |  |                          | 226    |      |   | 121    |   |   | 85     |  
|Amortization                                                                        |  |                          | 162    |      |   | 258    |   |   | 259    |  
|Tax
  benefit from disqualifying disposition                                        |  |                          | 113    |      |   | 377    |   |   | 653    |  
|Stock option expense                                                                |  |                          | 177    |      |   | 68     |   |   |       |  
|Deferred income taxes                                                               |  |                          | (203   | )    |   | (57    | ) |   | (73    | )
|Changes in operating assets and
liabilities:                                        |  |                          |        |      |   |        |   |   |        |  
|Accounts receivable                                                                 |  |                          | 557    |      |   | (1,338 | ) |   | (341   | )
|Inventories                                                                         |  |                          | (358   | )    |   | 92     |   |   | (81    | )
|Prepaid expenses                                                                    |  |                          | (22    | )    |   | 41     |   |   | (175   | )
|Accounts payable                                                                    |  |                          | 218    |      |   | (4     | ) |   | (177   | )
|Accrued
  liabilities                                                               |  |                          | 511    |      |   | (183   | ) |   | 147    |  
|Income taxes payable                                                                |  |                          | 137    |      |   | 194    |   |   | (428   | )
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Net cash provided by operating activities                                           |  |                          | 4,623  |      |   | 2,410  |   |   | 2,563  |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Investing activities:                                                               |  |                          |        |      |   |        |   |   |        |  
|Purchase of short-term investments                                                  |  |                          | (1,800 | )    |   |       |   |   | (2,250 | )
|Sale of short-term investments                                                      |  |                          |       |      |   | 5,000  |   |   | 600    |  
|Purchase of callable FHLB bonds                                                     |  |                          |       |      |   |       |   |   | (2,300 | )
|Purchases of property and equipment                                                 |  |                          | (419   | )    |   | (323   | ) |   | (86    | )
|Proceeds from sale of other asset                                                   |  |                          |       |      |   |       |   |   | 29     |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Net cash provided by (used in) investing
  activities                               |  |                          | (2,219 | )    |   | 4,677  |   |   | (4,007 | )
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Financing activities:                                                               |  |                          |        |      |   |        |   |   |        |  
|Proceeds from exercise of stock options                                             |  |                          | 200    |      |   | 657    |   |   | 672    |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Net cash provided by financing activities                                           |  |                          | 200    |      |   | 657    |   |   | 672    |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Effect of exchange rate changes on cash                                             |  |                          | 16     |      |   |       |   |   |       |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Increase (decrease) in cash and cash
  equivalents                                  |  |                          | 2,620  |      |   | 7,744  |   |   | (772   | )
|                                                                                   
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Cash and cash equivalents at beginning of
  year                                    |  |                          | 9,006  |      |   | 1,262  |   |   | 2,034  |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Cash and cash equivalents at end of year                                            |  | $                        | 11,626 |      | $ | 9,006  |   | $ | 1,262  |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  
|Supplemental disclosure:                                                            |  |                          |        |      |   |        |   |   |        |  
|Income taxes paid                                                                   |  | $                        | 1,025  |      | $ | 933    |   | $ | 1,362  |  
|                                                                                    |  |                          |        |      |   |        |   |   |        |  

See accompanying notes.

23

---



IMAGE SENSING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY(in thousands, except per share data)

|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|---------------------------------------------- |  | --------------- | --------- | -------------- | - | ------------------------------ |  | --------------------------------------------- | ----- | ----------------- |  | ----- | -- |  |  | - | ------ |  | - | ------ | 
|                                               |  | Shares
  Issued |           | Common
  Stock |   | Additional
  Paid-In
  Capital |  | Accumulated Other Comprehensive Income (Loss) |       | Retained Earnings |  | Total |   
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |   
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Balance at December 31, 2003                   |  |                 | 3,288,177 |                | $ | 33                             |  | $                                             | 5,218 |                   |  |       |   |  |  | $ | 2,509  |  | $ | 7,760  | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Tax benefit from disqualifying  disposition    |  |                 |           |                |   |                                |  |                                               | 653   |                   |  |       |    |  |  |   |        |  |   | 653    | 
|Common stock issued for  options exercised     |  |                 | 249,045   |                |   | 2                              |  |                                               | 670   |                   |  |       |    |  |  |   |        |  |   | 672    | 
|Net income                                     |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   | 2,694  |  |   | 2,694  | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Balance at December 31, 2004                   |  |                 | 3,537,222 |                |   | 35                             |  |                                               | 6,541 |                   |  |       |   |  |  |   | 5,203  |  |   | 11,779 | 
|                                              
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Tax
  benefit from disqualifying
  disposition |  |                 |           |                |   |                                |  |                                               | 377   |                   |  |       |    |  |  |   |        |  |   | 377    | 
|Common stock issued for  options exercised     |  |                 | 164,783   |                |   | 2                              |  |                                               | 655   |                   |  |       |    |  |  |   |        |  |   | 657    | 
|Stock option expense                           |  |                 |           |                |   |                                |  |                                               | 68    |                   |  |       |    |  |  |   |        |  |   | 68     | 
|Net income                                     |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   | 2,841  |  |   | 2,841  | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Balance at December 31, 2005                   |  |                 | 3,702,005 |                |   | 37                             |  |                                               | 7,641 |                   |  |       |   |  |  |   | 8,044  |  |   | 15,722 | 
|                                              
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Tax benefit from disqualifying disposition     |  |                 |           |                |   |                                |  |                                               | 113   |                   |  |       |    |  |  |   |        |  |   | 113    | 
|Common stock issued for  options exercised     |  |                 | 59,799    |                |   | 1                              |  |                                               | 199   |                   |  |       |    |  |  |   |        |  |   | 200    | 
|Stock option expense                           |  |                 |           |                |   |                                |  |                                               | 177   |                   |  |       |    |  |  |   |        |  |   | 177    | 
|Foreign currency translation adjustment        |  |                 |           |                |   |                                |  |                                               |       |                   |  |       | 16 |  |  |   |        |  |   | 16     | 
|Net income                                     |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   | 3,105  |  |   | 3,105  | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Comprehensive income                           |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   | 3,121  | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 
|Balance at December 31, 2006                   |  |                 | 3,761,804 |                | $ | 38                             |  | $                                             | 8,130 |                   |  | $     | 16 |  |  | $ | 11,149 |  | $ | 19,333 | 
|                                               |  |                 |           |                |   |                                |  |                                               |       |                   |  |       |    |  |  |   |        |  |   |        | 

See accompanying notes.

24

---



Notes to Consolidated Financial Statements

December 31,
2006

1. DESCRIPTION OF BUSINESS AND SIGNIFICANT
ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

Image Sensing
Systems, Inc. (referred to herein as we, us, our and the Company)
develops and markets video image processing technology and products for use in
advanced traffic management systems and traffic data collection. We sell our
products primarily to foreign distributors and also receive a royalty for sales
made by a sublicensee to North American and Latin American distributors and end
users. Our products are used primarily by governmental entities.

PRINCIPLES OF CONSOLIDATION

The consolidated
financial statements include the accounts of Image Sensing Systems, Inc. and
its wholly-owned subsidiaries: Flow Traffic Ltd. (Flow Traffic) located in Hong
Kong, Image Sensing Systems Europe Ltd. (ISS/Europe), located in the United
Kingdom, and Image Sensing Systems Europe Limited SP.Z.O.O., located in Poland.
All significant inter-company transactions and accounts have been eliminated in
consolidation.

REVENUE RECOGNITION

Royalty income is
recognized based upon a monthly royalty report provided to us by Econolite
Control Products, Inc. (Econolite), a sublicensee that sells our product in
North America, the Caribbean and Latin America. This report is prepared by
Econolite based on its sales of products we developed and is based on sales
delivered and accepted by its customers. We recognize revenue from product
sales at the time of delivery and acceptance, the selling price is fixed or
determinable and collectibility is reasonably assured. We record provisions
against sales revenue for estimated returns and allowances in the period when
the related revenue is recorded based upon historical sales returns and changes
in customer demands.

CASH AND CASH EQUIVALENTS

We consider all
highly liquid investments with an original maturity of three months or less to
be cash equivalents. Cash equivalents consist of money market funds.

INVESTMENTS

Investments in
callable Federal Home Loan Bank bonds mature in 2007 but are callable either
quarterly or semi-annually. At December 31, 2006 and 2005, cost was equal to
fair value, and no amount was included as a separate component of shareholders
equity. We consider short-term investments as available-for-sale.

ACCOUNTS RECEIVABLE

We grant credit to
customers in the normal course of business and generally do not require
collateral. Management performs on-going credit evaluations of customers. We
determine an allowance for returns and doubtful accounts by considering a
number of factors, including any on-going technical problems with product in
the field, the length of time trade accounts receivable are past due, our
previous loss history with the customer and the customers current ability to
pay. We write-off accounts receivable when they become uncollectible, and
payments subsequently received on such receivables are credited to the
allowance for doubtful accounts.

INVENTORIES

Inventories are
primarily finished goods and are valued at the lower of cost or market on the
first-in, first-out (FIFO) method.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost. Depreciation is computed by the
straight-line method over a three- to seven-year period for financial reporting
purposes and by accelerated methods for income tax purposes.

INCOME TAXES

Income taxes are
accounted for under the liability method. Deferred income taxes are provided
for temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and

25

---



amounts used
for income tax purposes. Deferred taxes are reduced by a valuation allowance
when, in the opinion of management, it is more likely than not that some
portion or the entire deferred tax asset will not be realized. Deferred tax
assets and liabilities are adjusted for the effects of changes in tax laws and
rates on the date of the enactment.

USE OF
ESTIMATES
          Preparing financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the consolidated financial
statements and reported amounts of revenues and expenses during the reporting
periods. Actual results could differ from the estimates.

GOODWILL
          Goodwill and other
intangible assets with indefinite lives are not amortized but are tested for
impairment annually or whenever an impairment indicator arises. Our goodwill
relates to our Flow Traffic subsidiary and is tested for impairment on December
31 of each year. No impairment of goodwill was recorded as of December 31, 2006
or 2005.

IMPAIRMENT OF
LONG-LIVED ASSETS
          Long-lived assets
are reviewed for impairment when indicators of impairment are present.
Impairment is recognized when the undiscounted cash flows estimated to be
generated by those assets are less than the assets carrying amount. No such
losses were recorded in 2006 or 2005.

RESEARCH AND
DEVELOPMENT
          Research and
development costs are charged to operations in the period incurred.

SOFTWARE
DEVELOPMENT COSTS
          We capitalize
software development costs, including significant product enhancements
beginning upon the establishment of technological feasibility for the product
and concluding when the product is available for release to distributors. The
establishment of technological feasibility and the ongoing assessment of the
recoverability of these costs require considerable judgment by management with
respect to certain external factors, including, but not limited to, anticipated
future gross product revenue or royalties, estimated economic life, and changes
in software and hardware technology. We amortize software development costs
based on projected revenue, with minimum annual amortization based on a
seven-year life using the straight-line method. No software development cost
was capitalized in 2006 or 2005.

FOREIGN
CURRENCY
          All assets and
liabilities of Flow Traffic, ISS/Europe and ISS/Poland are translated from the
foreign currency to United States dollars at period-end rates of exchange,
while the statement of income is translated at the average exchange rates
during the period. Accumulated translation adjustments are shown in equity
under Accumulated Other Comprehensive Income (Loss).

NET INCOME PER SHARE
          Our basic net
income per share amounts have been computed by dividing net income by the
weighted average number of outstanding common shares. Diluted net income per
share amounts have been computed by dividing net income by the weighted average
number of outstanding common shares and common share equivalents relating to
stock options, when dilutive.

For the
years ended December 31, 2006 and 2005, respectively, 166,000 and 266,000
common share equivalents were included in the computation of diluted net income
per share. There were no anti-dilutive options at December 31, 2006 or 2005.

At December 31, 2006,
the exercise prices of all outstanding options
were less than the average market price of the common shares during the period.

26

---



STOCK OPTIONS
          In 2006, the
Company adopted Statement of Financial Accounting Standard No.
123R, Share-Based Payment (SFAS No. 123R). This revised standard addresses
the accounting for share-based payment transactions in which a company receives
services in exchange for either equity instruments of the company or that are
based on the fair value of the companys equity instruments or that may be
settled by the issuance of such equity instruments. Under the new standard,
companies no longer are able to account for share-based compensation
transactions using the intrinsic value method in accordance with Accounting
Principles Bulletin No. 25, Accounting for Stock Issued to Employees (APB
25). Instead, companies are required to account for such transactions using a
fair-value method and recognize the expense in the consolidated statement of
income. As a result of adopting this standard in 2006, the Company recorded an
option expense of $177,000, or $0.05 per diluted share, to General and Administrative operating expense.

Prior to
2006, stock options were accounted for under the intrinsic value method as
prescribed by APB 25. No stock-based employee compensation cost was reflected
in net income, except for costs related to performance based options, because
all options granted had an exercise price equal to the market value of the
underlying common stock on the date of grant.

The
following table illustrates the effect on net income and net income per share
if we had applied the fair value method of accounting for stock-based
compensation plans under the provisions of SFAS No. 123, Accounting for
Stock-Based Compensation for 2005 and 2004, using the assumptions described in
Note 9.

|                                                                                                                                     |  |                          |           |      |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------ | --------- | ---- | - | --------- | -
|                                                                                                                                     |  | Year Ended
  December 31 |          
|                                                                                                                                     |  |                          |          
|                                                                                                                                     |  | 2005                     |           | 2004 |  
|                                                                                                                                     |  |                          |           |      |  
|Net income, as reported                                                                                                              |  | $                        | 2,841,000 |      | $ | 2,694,000 |  
|Deduct: Total stock-based compensation
  expense determined under the fair value method for all awards, net of related
  tax effects |  |                          | (210,000  | )    |   | (229,000  | )
|                                                                                                                                     |  |                          |           |      |   |           |  
|Pro-forma net income                                                                                                                 |  | $                        | 2,631,000 |      | $ | 2,465,000 |  
|                                                                                                                                     |  |                          |           |      |   |           |  
|                                                                                                                                     |  |                          |           |      |   |           |  
|Income per share:                                                                                                                    |  |                          |           |      |   |           |  
|Basic - as reported                                                                                                                  |  | $                        | .79       |      | $ | .79       |  
|Basic - pro forma                                                                                                                    |  |                          | .73       |      |   | .72       |  
|                                                                                                                                     |  |                          |           |      |   |           |  
|Diluted - as reported                                                                                                                |  | $                        | .73       |      | $ | .71       |  
|Diluted - pro forma                                                                                                                  |  |                          | .68       |      |   | .65       |  

Unrecognized
compensation costs are $68,214 at December 31, 2006, with a weighted average
remaining life of 2.8 years.

NEW ACCOUNTING PRONOUNCEMENTS
          In
November 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 151, Inventory Costs. The
provisions of this statement become effective for us in fiscal 2006. SFAS No.
151 amends the existing guidance on the recognition of inventory costs to
clarify the accounting for abnormal amounts of idle expense, freight, handling
costs, and wasted material (spoilage). Existing rules indicate that under some
circumstances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment as
current period charges. SFAS No. 151 requires that those items be recognized as
current period charges regardless of whether they meet the criterion of so
abnormal. In addition, SFAS No. 151 requires that allocation of fixed
production overheads to the costs of conversion be based on the normal capacity
of the production facilities. The adoption of this statement did not have a
material impact on our valuation of inventory or operating results.

In
December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This
revised standard addresses the accounting for share-based payment transactions
in which a company receives employee services in

27

---



exchange for
either equity instruments of the company or that are based on the fair value of
the companys equity instruments or that may be settled by the issuance of such
equity instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in
accordance with APB 25. Instead, companies will be required to account for such
transactions using a fair-value method and recognize the expense in the
consolidated statement of income. SFAS No. 123R was effective for all interim
and annual periods beginning after December 15, 2005. The Company adopted this
standard in 2006 and recorded an expense of $177,000.

In
June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes - an interpretation of SFAS No. 109, Accounting for Income
Taxes (FIN 48), which clarifies the accounting for uncertainty in income
taxes. FIN 48 prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. The interpretation requires that we
recognize in the financial statements the impact of a tax position. Recognition
is allowed if the tax position is more likely than not of being sustained on
audit, based on the technical merits of the position. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting
in interim periods and disclosure. The provisions of FIN 48 are effective for
fiscal years beginning after December 15, 2006, with the cumulative effect of
the change in accounting principle recorded as an adjustment to opening
retained earnings. We do not expect the new standard to materially affect our financial
position or results of operations.

In
September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements. SAB No. 108 was issued to
provide consistency between how registrants quantify financial statement
misstatements. Historically, there have been two widely-used methods for
quantifying the effects of financial statement misstatements. These methods are
referred to as the roll-over and iron curtain method. The roll-over method
quantifies the amount by that the current year income statement is misstated.
Exclusive reliance on an income statement approach can result in the
accumulation of errors on the balance sheet that may not have been material to
any individual income statement, but which may misstate one or more balance
sheet accounts. The iron curtain method quantifies the error as the cumulative
amount by which the current year balance sheet is misstated. Exclusive reliance
on a balance sheet approach can result in disregarding the effects of errors in
the current year income statement that results from the correction of an error
existing in previously issued financial statements. We currently use the
roll-over method for quantifying identified financial statement misstatements.
SAB No. 108 established an approach that requires quantification of financial
statement misstatements based on the effects of the misstatement on each of the
companys financial statements and the related financial statement disclosures.
This approach is commonly referred to as the dual approach because it
requires quantification of errors under both the roll-over and iron curtain
methods. SAB No. 108 allows registrants to initially apply the dual approach
either by (1) retroactively adjusting prior financial statements as if the dual
approach had always been used or by (2) recording the cumulative effect of
initially applying the dual approach as adjustments to the carrying value of assets
and liabilities as of January 1, 2006 with an offsetting adjustment recorded to
the opening balance of retained earnings. Use of this cumulative effect
transition method requires detailed disclosure of the nature and amount of each
individual error being corrected through the cumulative adjustment and how and
when it arose. We have initially applied SAB No. 108 using the cumulative
effect transition method in connection with the preparation of our annual
financial statements for the year ending December 31, 2006. The implementation
of the new standard did not materially affect our financial position or results
of operations.

In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS
No. 157 defines fair value, establishes a framework for measuring fair value
and expands disclosures about fair value measurement but does not require any
new fair value measurements. SFAS No. 157 is effective for financial statement
issued for fiscal years beginning after November 15, 2007 and interim periods
within those fiscal years. We have not evaluated the impact of this standard.

RECLASSIFICATIONS
          Certain prior year
amounts have been reclassified to conform to the current year presentation.

28

---



2. CREDIT FACILITY

We
have a credit agreement that provides up to $1.0 million in short-term
borrowings at .5% over the prime rate (effective rate of 8.75% at December 31,
2006), expiring May 31, 2007. Loans would be secured by inventories, accounts
receivable and equipment and the bank would have the right of setoff against
checking, savings and other accounts we have with the bank. We had no
outstanding borrowings in 2006 or 2005. We expect to renew the agreement at
substantially the same terms and conditions prior to expiration.

3. INVESTMENTS

Investments,
at cost, consisted of the following (in thousands):

|                                                   |  |                |       |      |   |       | 
|-------------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                                   |  | December
  31, |      
|                                                   |  |                |      
|                                                   |  | 2006           |       | 2005 |  
|                                                   |  |                |       |      |  
|Callable
  Federal Home Loan Bonds                 |  | $              | 2,300 |      | $ | 2,300 | 
|Short-term
  investments - Auction Rate Securities |  |                | 1,800 |      |   |      | 
|                                                   |  |                |       |      |   |       | 
|Total                                              |  | $              | 4,100 |      | $ | 2,300 | 
|                                                   |  |                |       |      |   |       | 

As
of December 31, 2006 and 2005, investments are classified as
available-for-sale. The cost of investments approximates market value and
therefore no amount is recorded in accumulated other comprehensive income. The
cost of securities sold is based on the specific identification method.

Proceeds
from maturities and sales of investments totaled $ - , $5.0 million and
$600,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
There were no realized gains or losses related to sales or unrealized gains or
losses during the years ended December 31, 2006, 2005 and 2004.

4. LEASE COMMITMENTS

We
rent office space and equipment under operating lease agreements expiring at
various dates through May 2010. The leases provide for monthly payments of
$25,000, and we are responsible for our proportionate share of increases in
operating expenses that exceed a base rent factor. Rent expense amounted to
$261,000 in 2006, $221,000 in 2005 and $217,000 in 2004.

Future
minimum annual lease payments under noncancelable operating leases for the
years ending December 31, 2007, 2008, 2009 and 2010 are $207,000, $183,000,
$186,000 and $78,000, respectively.

5. INCOME TAXES

Our
deferred tax assets (liabilities) are as follows (in thousands):

|                                                 |  |               |      |   |   |      |  
|------------------------------------------------ |  | ------------- | ---- | - | - | ---- | -
|                                                 |  | December
  31 |     
|                                                 |  |               |     
|                                                 |  |               | 2006 |   |   | 2005 |  
|                                                 |  |               |      |   |   |     
|Current
  deferred tax assets (liabilities):     |  |               |      |   |   |     
|Accrued compensation                             |  | $             | 20   |   | $ | 18   |  
|Allowance for returns and bad debts              |  |               | 131  |   |   | 25   |  
|Prepaid expenses                                 |  |               | (28  | ) |   | (29  | )
|State tax credits                                |  |               | 50   |   |   |     |  
|Alternative minimum tax credits                  |  |               | 50   |   |   | 50   |  
|Less valuation allowance                         |  |               | (50  | ) |   | (50  | )
|                                                 |  |               |      |   |   |      |  
|                                                 |  |               | 173  |   |   | 14   |  
|Non-current
  deferred tax assets (liabilities): |  |               |      |   |   |      |  
|Capitalized software development costs           |  |               |     |   |   | (60  | )
|Other                                            |  |               | (8   | ) |   | 8    |  
|                                                 |  |               |      |   |   |      |  
|                                                 |  |               | (8   | ) |   | (52  | )
|                                                 |  |               |      |   |   |      |  
|Net deferred tax assets (liabilities)            |  | $             | 165  |   | $ | (38  | )
|                                                 |  |               |      |   |   |      |  

29

---



Deferred
tax assets have been offset by a valuation allowance as deemed necessary based
on our estimates of future sources of taxable income and the expected timing of
temporary difference reversals.

There
is $449,000, $270,000 and $500,000 in undistributed earnings of our
wholly-owned foreign subsidiaries at December 31, 2006, 2005 and 2004,
respectively.

We
realize an income tax benefit from the exercise or early disposition of certain
stock options. This benefit results in a decrease in current income taxes
payable and an increase in additional paid-in capital.

Our
wholly-owned subsidiary in Hong Kong has unused tax losses which do not expire of approximately
$407,000 available for offset against future taxable income. No deferred income
tax asset has been recognized since we have no assurance that taxable income
will be earned in the future.

The
components of income tax expense are as follows for the years ended December
31, 2006, 2005 and 2004 (in thousands):

|                         |  |                          |       |      |   |       |   |   |       |  
|------------------------ |  | ------------------------ | ----- | ---- | - | ----- | - | - | ----- | -
|                         |  | Year Ended
  December 31 |      
|                         |  |                         
|                         |  | 2006                     |       | 2005 |   | 2004  |  
|                         |  |                          |       |      |   |       |  
|Current:                 |  |                          |       |      |   |       |   |   |       |  
|Federal                  |  | $                        | 1,039 |      | $ | 1,411 |   | $ | 1,340 |  
|State                    |  |                          | 49    |      |   | 114   |   |   | 53    |  
|Foreign                  |  |                          | 57    |      |   | 37    |   |   | 32    |  
|                         |  |                          |       |      |   |       |   |   |       |  
|                         |  |                          | 1,145 |      |   | 1,562 |   |   | 1,425 |  
|                         |  |                          |       |      |   |       |   |   |       |  
|Deferred:                |  |                          |       |      |   |       |   |   |       |  
|Federal                  |  |                          | (173  | )    |   | (52   | ) |   | (66   | )
|State                    |  |                          | (30   | )    |   | (5    | ) |   | (7    | )
|Foreign                  |  |                          |      |      |   |      |   |   |      |  
|                         |  |                          |       |      |   |       |   |   |       |  
|                         |  |                          | (203  | )    |   | (57   | ) |   | (73   | )
|                         |  |                          |       |      |   |       |   |   |       |  
|                        
|Total income tax expense |  | $                        | 942   |      | $ | 1,505 |   | $ | 1,352 |  
|                         |  |                          |       |      |   |       |   |   |       |  

Income
before taxes for the foreign operations were $236,000, $(230,000) and $126,000 for the years ended December 31, 2006, 2005 and
2004.

A
reconciliation of income taxes to the statutory federal rate is as follows (in
thousands):

|                                                   |  |               |       |      |   |       |   |   |       |  
|-------------------------------------------------- |  | ------------- | ----- | ---- | - | ----- | - | - | ----- | -
|                                                   |  | December
  31 |      
|                                                   |  |              
|                                                   |  | 2006          |       | 2005 |   | 2004  |  
|                                                   |  |              
|Federal tax
  statutory rate                       |  | $             | 1,382 |      | $ | 1,477 |   | $ | 1,376 |  
|State taxes, net
  of federal benefit              |  |               | 13    |      |   | 72    |   |   | 31    |  
|Tax exempt interest                                |  |               | (124  | )    |   | (53   | ) |   |      |  
|Research and
  development tax credits             |  |               | (135  | )    |   | (80   | ) |   | (60   | )
|Domestic
  production activity deduction           |  |               | (39   | )    |   | (45   | ) |   |      |  
|Effect of higher
  (lower) rates on foreign income |  |               | (23   | )    |   | 115   |   |   | (23   | )
|Stock option
  expense                             |  |               | 60    |      |   | 23    |   |   |      |  
|Adjustment of
  prior year tax credits and refunds |  |               | (202  | )    |   |      |   |   |      |  
|Other                                              |  |               | 10    |      |   | (4    | ) |   | 28    |  
|                                                   |  |               |       |      |   |       |   |   |       |  
|                                                  
|Income taxes                                       |  | $             | 942   |      | $ | 1,505 |   | $ | 1,352 |  
|                                                   |  |               |       |      |   |       |   |   |       |  

6.
LICENSING

The
United States patent for some aspects of the technology underlying our
Autoscope system was issued in 1989 to the University of Minnesota. We had an
exclusive worldwide license from the University of Minnesota for that
technology and paid royalties to the University of Minnesota in exchange for
such license. Royalty expense

30

---



under the agreement was $220,000, $383,000 and
$321,000, in 2006, 2005 and 2004, respectively. Our exclusive license, and all
related royalty obligations, expired July 2006.

We
have sublicensed the right to manufacture and market the Autoscope technology
in North America, the Caribbean and Latin America to Econolite and receive
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 us outside of North America, the Caribbean and Latin America.
We may terminate our agreement with Econolite if a minimum annual sales level
is not met or Econolite fails to make royalty payments as required by the
agreement. The initial term of the agreement was 15 years, ended in 2006, and
was automatically renewable thereafter for additional one-year periods unless
terminated by either party upon 60 days notice prior to the end of the initial
term or any extension term. In 2001, we signed a five-year extension of our
agreement with Econolite, thereby extending its original term to 2011.

We
recognized royalty income from this agreement of $10.1 million, $8.6 million
and $7.5 million in 2006, 2005 and 2004, respectively. Accounts receivable from
Econolite were $2.1 million and $3.1 million at December 31, 2006 and 2005,
respectively.

7.
SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK

We
derived the following percentages of our net revenues from the following geographic
regions:

|              |  |      |   |      |    |      |  |    |   | 
|------------- |  | ---- | - | ---- | -- | ---- |  | -- | - | 
|              |  | 2006 |   | 2005 |    | 2004 | 
|              |  |      |   |      |    |      | 
|Asia Pacific  |  | 10   | % |      | 6  | %    |  | 21 | % | 
|Europe        |  | 13   | % |      | 16 | %    |  | 10 | % | 
|North America |  | 77   | % |      | 78 | %    |  | 69 | % | 
|              |  |      |   |      |    |      |  |    |   | 

Royalty
income from Econolite comprised 77%, 78% and 69% of revenues in 2006, 2005 and
2004, respectively.

8.
RETIREMENT PLANS

Substantially
all of our employees in the United States are eligible to participate in a
qualified defined contribution 401(k) plan in which participants may elect to
have a specified portion of their salary contributed to the plan and we may
make discretionary contributions to the plan. Flow Traffic is obligated to
contribute to an employee pension plan. The Company made contributions totaling
$87,000, $60,000 and $50,000 to the plans for 2006, 2005 and 2004,
respectively.

9. STOCK
OPTIONS

In
February 1995 and April 2005, we adopted the 1995 Long-Term Incentive and Stock Option Plan (the 1995 Plan) and the 2005 Stock
Incentive Plan (the 2005 Plan), respectively, which provide for the granting of incentive (ISO) and non-qualified (NQO) stock
options, stock appreciation rights, restricted stock awards and performance awards to our officers, directors, employees,
consultants and independent contractors. The 1995 Plan terminated in February 2005. Options granted under the Plans generally vest
over three to five years based on service and have a contractual term of six to ten years and are amortized to expense on a straight-line basis. The following table summarizes stock
option activity for 2006 and 2005:

|                             |  |                                        |                            |                                  |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 
|---------------------------- |  | -------------------------------------- | -------------------------- | -------------------------------- | --- | ------------------------------------------- | - |  | ------- | - | -------- | - |  |  | - | ----- |  | 
|                             |  | Plan
  Options
  Available
  For Grant | Plan Options
  Outstanding | Non-Plan
  Options
  Outstanding |     | Weighted Average Exercise Price
  Per Share |  
|                             |  |                                        |                            |                                  |     |                                             |   |  |        
|                             |  |                                        |                            |                                  | ISO | NQO                                         |   |  |         |   |          |  
|                             |  |                                        |                            |                                  |     |                                             |   |  |         |   |          |   |  | 
|Balance at December 31, 2004 |  |                                        | 296,200                    |                                  |     | 95,150                                      |   |  | 196,665 |   | 156,000  |   |  |  | $ | 3.13  |  | 
|Plan terminated              |  |                                        | (296,200                   | )                                |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 
|Reserve for new plan         |  |                                        | 281,200                    |                                  |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 
|Exercised                    |  |                                        |                            |                                  |     | (15,550                                     | ) |  | (35,233 | ) | (114,000 | ) |  |  |   | 3.99  |  | 
|Cancelled                    |  |                                        |                            |                                  |     | (1,200                                      | ) |  | (25,000 | ) |          |   |  |  |   | 1.69  |  | 
|                             |  |                                        |                            |                                  |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 
|Balance at December 31, 2005 |  |                                        | 281,200                    |                                  |     | 78,400                                      |   |  | 136,432 |   | 42,000   |   |  |  | $ | 2.72  |  | 
|Granted                      |  |                                        | (18,000                    | )                                |     |                                             |   |  | 18,000  |   |          |   |  |  |   | 12.61 |  | 
|Exercised                    |  |                                        |                            |                                  |     | (7,700                                      | ) |  | (52,099 | ) |          |   |  |  |   | 3.33  |  | 
|                             |  |                                        |                            |                                  |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 
|Balance at December 31, 2006 |  |                                        | 263,200                    |                                  |     | 70,700                                      |   |  | 102,333 |   | 42,000   |   |  |  | $ | 3.38  |  | 
|                             |  |                                        |                            |                                  |     |                                             |   |  |         |   |          |   |  |  |   |       |  | 

31

---

The
following table summarizes information about the stock options outstanding at
December 31, 2006.

Options Outstanding
        
        Options ExercisableRange ofExercise Price
        
        NumberOutstanding
        
        WeightedAverageRemainingContractual Life
        
        WeightedAverageExercise Price
        
        AggregateIntrinsicValue
        
        NumberExercisable
        
        WeightedAverageExercise Price
        
        AggregateIntrinsicValue$1.30-1.99
        
        81,100
        
        5.5 years
        
        $
        1.33
        
        1,053,489
        
        81,100
        
        $
        1.33
        
        1,053,4892.00-2.99
        
        60,400
        
        3.2 years
        
        
        2.38
        
        721,176
        
        60,400
        
        
        2.38
        
        721,1763.00-3.99
        
        39,533
        
        5.8 years
        
        
        3.16
        
        441,188
        
        38,333
        
        
        3.13
        
        428,9467.00-7.93
        
        16,000
        
        2.4 years
        
        
        7.77
        
        104,800
        
        16,000
        
        
        7.77
        
        104,80012.00-12.99
        
        18,000
        
        9.8 years
        
        
        12.61
        
        30,780
        
        
        
        
        
        
        215,033
        
        
        
        $
        3.38
        
        2,351,433
        
        195,833
        
        $
        2.53
        
        2,308,411


The
weighted average fair value of the 18,000 options granted during 2006 was
$74,340. There were no options granted in 2005 or 2004.

The total intrinsic value of options exercised during
2006, 2005 and 2004 was $607,000, $1.3 million and $2.5 million. The total fair value of shares vested during 2006, 2005 and 2004 was
$170,000, $15,000 and $7,000. The fair value of each option granted is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions used: zero dividend yield; expected volatility of 127%;
risk-free interest rate of 4.27%; and expected life of 3 years. The expected life of the options is based on evaluations of
historical and expected future exercise behavior. The risk-free interest rate is based on the US Treasury rates at the date of
grant with maturity dates approximately equal to the expected life at the grant date. Volatility is based on historical volatility
of the Companys stock over the past three years. The Company has not historically issued any dividends and does not expect
to in the foreseeable future.

There
were 213,767 and 293,683 options exercisable at December 31, 2005 and 2004,
respectively. The weighted average exercise price of these options was $2.52
and $3.28 at December 31, 2005 and 2004, respectively.

32

---



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
Image Sensing Systems, Inc.

We have audited the accompanying consolidated balance
sheets of Image Sensing Systems, Inc. and subsidiaries (the Company) as of
December 31, 2006 and 2005, and the related consoli­dated state­ments of
income, shareholders equity, and cash flows for each of the three years in the
period ended December 31, 2006. These consolidated financial statements are the
responsibility of the Companys man­agement. Our responsibility is to express
an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of mate­rial mis­statement.
The Company is not required to have, nor were we engaged to perform an audit of
its internal control over financial reporting. Our audit included consideration
of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purposes
of expressing an opinion on the effectiveness of the Companys internal control
over financial reporting. Accordingly, we express no such opinion. An audit
also includes examining, on a test basis, evidence supporting the amounts and
disclo­sures in the consolidated financial statements, assessing the accounting
prin­ciples used and significant estimates made by management, as well as evaluating
the overall financial statement pres­entation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements
referred to above, present fairly, in all material respects, the consolidated
financial position of Image Sensing Systems, Inc. and subsidi­aries as of
December 31, 2006 and 2005, and the consolidated results of their
operations and their consolidated cash flows for the each of the three years in
the period ended December 31, 2006, in con­formity with accounting
principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financial
statements, the Company changed its method of accounting for share-based
payments to adopt Financial Accounting Standards No. 123(R), Share-Based Payment effective
January 1, 2006.

/s/ Grant Thornton LLP

Minneapolis,
Minnesota
March 23, 2007

33

---



|        |                                                                                     
|------- | ------------------------------------------------------------------------------------
|Item 9. | Changes
in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Evaluation of disclosure controls and procedures

We
maintain disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934, as amended (Exchange Act)) that are designed to reasonably ensure that
information required to be disclosed by us in the reports we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SECs rules and forms and that such
information is accumulated and communicated to our management, including our
principal executive officer and principal financial officer, or persons
performing similar functions, as appropriate to allow timely decisions
regarding required disclosure. In designing and evaluating our disclosure
controls and procedures, we recognize that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, and we necessarily are required to
apply our judgment in evaluating the cost-benefit relationship of possible
controls and procedures. Under the supervision and with the participation of
our management, including our Chief Executive Officer and Chief Financial
Officer, we evaluated the effectiveness of the design and operation of our
disclosure controls and procedures. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that, as of the end of
the period covered by this report, our disclosure controls and procedures were
effective.

Changes in internal control over financial reporting

During
the most recent fiscal quarter covered by this report, there has been no change
in our internal control over financial reporting (as defined in Rule 13a-15(f)
and 15d-15(f) under the Exchange Act) that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.

|         |                  
|-------- | -----------------
|Item 9B. | Other Information

On
December 8, 2006, the Company appointed Gregory R.L. Smith as the Companys
Chief Financial Officer. Mr. Smith began serving as the Companys Chief
Financial Officer on January 15, 2007. Mr. Smith, 40 years old, previously
served as Chief Financial Officer and Treasurer of MQSoftware, Inc., a
privately-held developer of systems management software, since May 2002. Mr.
Smith holds a Bachelor of Science degree in Accounting from the University of
South Carolina and is a Certified Public Accountant.

On
December 21, 2006, the Company announced the appointment of Kenneth R. Aubrey
to serve as the Companys President, effective February 1, 2007, and as the
Companys Chief Executive Officer, effective on June 1, 2007. Mr. Aubrey, 57
years old, previously served since 1995 in various positions with Siemens AG,
one of the worlds largest electrical engineering and electronics companies,
most recently as a business unit vice president of Siemens ITS (Intelligent
Transportation Systems) Division, Industrial Solutions & Services Group. He
concurrently managed Strategic Projects for the ITS Division.

34

---



PART
III

|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors, Executive Officers and Corporate Governance

We
have adopted a Code of Ethics which applies to our principal executive,
accounting and financial officers. The Code of Ethics is published on our
website at www.imagesensing.com.  Any
amendments to the Code of Ethics and waivers of the Code of Ethics for our principal
executive, accounting and financial officers will be published on our website.

The sections entitled Proposal I - Election of
Directors, Audit Committee and Section 16(a) Beneficial Ownership Reporting
Compliance in our definitive proxy statement for our 2007 annual meeting of shareholders
are incorporated into this Form 10-K by reference.

|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The
sections entitled Executive Compensation and Compensation of Directors in
our definitive proxy statement for the 2007 annual meeting of shareholders are incorporated
into this Form 10-K by reference.

|         |                                                                                               
|-------- | ----------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters

Equity Compensation
Plan Information

The
following table provides information as of December 31, 2006, about our shares
of common stock subject to outstanding awards or available for future awards
under our equity compensation plans and arrangements.

|                                                       |  |  |                                                                                             |  |                                                                             |   |                                                                                                                                                      |  |  |         | 
|------------------------------------------------------ |  |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | - | ---------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ------- | 
|Plan
  Category                                        |  |  | Number of securities to be issued upon exercise of outstanding options, warrants and rights |  | Weighted-average exercise price of outstanding options, warrants and rights |   | Number of securities remaining available for future issuance under equity compensation plans (excluding
securities reflected in the first column)(2)
|                                                       |  |  |                                                                                             |  |                                                                             |   |                                                                                                                                                     
|Equity compensation plans approved by shareholders(1)  |  |  | 173,033                                                                                     |  |                                                                             | $ | 3.45                                                                                                                                                 |  |  | 263,200 | 
|                                                       |  |  |                                                                                             |  |                                                                             |   |                                                                                                                                                      |  |  |         | 
|Equity compensation plans not approved by shareholders |  |  | 42,000                                                                                      |  |                                                                             |   | 3.13                                                                                                                                                 |  |  |        | 
|                                                      
|Total                                                  |  |  | 215,033                                                                                     |  |                                                                             | $ | 3.38                                                                                                                                                 |  |  | 263,200 | 

(1)Includes shares underlying stock options under the Image Sensing Systems,
Inc. 1995 Long-Term Incentive and Stock Option Plan and non-qualified stock
options granted outside the 1995 Plan between 1996 and 2000 to current and
former members of the Board of Directors.

(2)The 263,200 shares available for grant under the 2005 Stock Incentive
Plan may become the subject of future awards in the form of stock options,
stock appreciation rights, restricted stock, performance awards or other
stock-based awards.

The
section entitled Security Ownership of Certain Beneficial Owners and
Management in our definitive proxy statement for the 2007 annual meeting of
shareholders is incorporated into this Form 10-K by reference.

35

---



|         |                                                                          
|-------- | -------------------------------------------------------------------------
|Item 13. | Certain Relationships and Related Transactions, and Director Independence

The
section entitled Certain Relationships and Related Transactions in our
definitive proxy statement for the 2007 annual meeting of shareholders is
incorporated into this Form 10-K by reference.

|         |                                       
|-------- | --------------------------------------
|Item 14. | Principal Accountant Fees and
Services

The sections entitled Audit Fees,
Audit-Related Fees, Tax Fees, All Other Fees and Policy on Audit Committee Pre-Approval
of Audit and Permissible Non-Audit Services Provided by Our Independent Registered Public Accounting Firm in our definitive
proxy statement for our 2007 annual meeting of shareholders are incorporated into this Form 10-K by reference.

36

---



PART IV

|         |                                           
|-------- | ------------------------------------------
|Item 15. | Exhibits and Financial Statement Schedules

(b)   The following documents are filed
as exhibits to this report:

|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|----------- | ----- | ----------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |       | Description
|            |       |            
|           
|            | 3.1   |             | Restated Articles of Incorporation of Image Sensing Systems, Inc. (ISS), incorporated by reference to
Exhibit 3.1 to ISSs registration statement on Form SB-2 (Registration No. 90298C) filed on March 14, 1995 (Registration
Statement).                                                                                                                      
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 3.2   |             | Articles of Amendment to Articles of Incorporation of ISS, incorporated by reference to Exhibit 3.2 to
ISSs quarterly report on Form 10-QSB for the quarter ended June 30, 2001.                                                                                                                                                                               
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 3.3   |             | Bylaws of ISS, incorporated by reference to Exhibit 3.3 to ISSs Registration Statement.                                                                                                                                                                                                                                                                        
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 4.1   |             | Specimen form of ISSs common stock certificate, incorporated by reference to Exhibit 4.1 to ISSs
Registration Statement.                                                                                                                                                                                                                                      
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.1  |             | Form of Distributor Agreement, incorporated by reference to Exhibit 10.1 to ISSs Registration
Statement.                                                                                                                                                                                                                                                       
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.2* |             | 1995 Long-Term Incentive and Stock Option Plan, amended and restated through May 17, 2001, incorporated by
reference to Exhibit 10.10 to ISSs annual report on Form 10-KSB for the year ended December 31, 2001.                                                                                                                                               
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.3* |             | Consulting Agreement
  between ISS and Arthur Bourgeois, dated December 13, 2006, incorporated
  by reference to Exhibit 10.2 to ISSs current report on Form 8-K dated
  December 8, 2006.                                                                                                                                                                     
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.4* |             | Employment Agreement between ISS and Kenneth R.
  Aubrey, dated December 12, 2006, effective on or about January 15, 2007 (in
  capacity as President) and effective on or about June 1, 2007 (in capacity of
  President and Chief Executive Officer), incorporated by reference to Exhibit
  10.1 to ISSs current report on Form 8-K dated December 14, 2006.
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.5* |             | Employment Agreement between ISS and Gregory R.L.
  Smith, dated December 8, 2006, incorporated by reference to Exhibit 10.1 to
  ISSs current report on Form 8-K dated December 8, 2006.                                                                                                                                                                      
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 10.6* |             | Employment Agreement between ISS and James Murdakes,
  dated March 9, 2007, incorporated by reference to Exhibit 10.1 to ISSs
  current report on Form 8-K dated March 13, 2007.                                                                                                                                                                               
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 21    |             | List of Subsidiaries of ISS.                                                                                                                                                                                                                                                                                                                                    
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 23    |             | Consent of Independent Registered Public Accounting
  Firm.                                                                                                                                                                                                                                                                                                     
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 24    |             | Power of Attorney (included on signature page).                                                                                                                                                                                                                                                                                                                 
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 31.1  |             | Certification of Chief Executive Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                           
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 31.2  |             | Certification of Chief Financial Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                           
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 32.1  |             | Certification of Chief Executive Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                           
|            |       |             |                                                                                                                                                                                                                                                                                                                                                                 
|            | 32.2  |             | Certification of Chief Financial Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                           

---

*          Management contract or compensatory plan or arrangement.

37

---



SIGNATURES

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

Image Sensing Systems, Inc.

|                        |  |                       
|----------------------- |  | ----------------------
|/s/ James Murdakes      |  | Date:   March 29, 2007
|                        |  |                       
|James Murdakes          |  |                       
|Chief Executive Officer |  |                       

Each
person whose signature to this report on Form 10-K appears below hereby
constitutes and appoints James Murdakes and Gregory R.L. Smith, 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-K, and any and all instruments or
documents filed as part of or in connection with this report on Form 10-K or
the amendments hereto, 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.

In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated:

|                                                                                               |  |                       
|---------------------------------------------------------------------------------------------- |  | ----------------------
|/s/ James Murdakes                                                                             |  | Date:   March 29, 2007
|                                                                                               |  |                       
|James Murdakes                                                                                 |  |                       
|Chief Executive Officer and Chairman of the Board of
  Directors (Principal Executive Officer)
|                                                                                               |  |                       
|/s/ Gregory R.L. Smith                                                                         |  | Date:   March 29, 2007
|                                                                                               |  |                       
|Gregory R.L. Smith                                                                             |  |                       
|Chief Financial Officer (Principal Financial &
  Accounting Officer)                          
|                                                                                               |  |                       
|/s/ Panos G. Michalopoulos                                                                     |  | Date:   March 29, 2007
|                                                                                               |  |                       
|Panos G. Michalopoulos                                                                         |  |                       
|Director                                                                                       |  |                       
|                                                                                               |  |                       
|/s/ Richard C. Magnuson                                                                        |  | Date:   March 29, 2007
|                                                                                               |  |                       
|Richard C. Magnuson                                                                            |  |                       
|Director                                                                                       |  |                       
|                                                                                               |  |                       
|/s/ Michael G. Eleftheriou                                                                     |  | Date:   March 29, 2007
|                                                                                               |  |                       
|Michael G. Eleftheriou                                                                         |  |                       
|Director                                                                                       |  |                       
|                                                                                               |  |                       
|/s/ Sven A. Wehrwein                                                                           |  | Date:   March 29, 2007
|                                                                                               |  |                       
|Sven A. Wehrwein                                                                               |  |                       
|Director                                                                                       |  |                       

38

---