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

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# FORM 10-KSB

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|x |  | Annual Report
Under Section 13 or 15(d) of the Securities Exchange Act of 1934
|- |  | ------------------------------------------------------------------------------

For the fiscal year
ended December 31, 2005

|o |  | Transition Report
Under Section 13 or 15(d) of the Securities Exchange Act of 1934
|- |  | ----------------------------------------------------------------------------------

For the transition
period from __________ to __________

Commission file number   
0-26056

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Image Sensing
Systems, Inc.(Name of small business
issuer 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 WestSt. Paul, MN 55104 | (651) 603-7700             
|-------------------------------------------------------------------- | ---------------------------
|(Address of principal executive offices, including zip code)         | (Issuers telephone number)

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

None

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

Common Stock, $.01 par
value(Title of class)

Check
whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the
Exchange Act.o

Check
whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of
the Exchange Act during the past 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing requirements
for the past 90 days.   Yesx
Noo

Check
if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B
contained in this form, and no disclosure will 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-KSB or any amendment to this
Form 10-KSB.x

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

The
issuers revenues for the fiscal year ended December 31, 2005 totaled $11,002,000.

Based
on the closing price at March 9, 2006, the aggregate market value of the voting and
non-voting stock held by nonaffiliates of the registrant was $36,823,711.

The
number of shares outstanding of the registrants $.01 par value common stock, as of
March 9, 2006, was 3,706,405 shares.

DOCUMENTS INCORPORATED
BY REFERENCE

Portions
of the registrants proxy statement for its May 17, 2006 annual meeting of
shareholders, which will be filed on or prior to April 30, 2006, are incorporated by
reference into Part III of this Form 10-KSB.

Transitional Small
Business Issuer Format:   Yeso
Nox





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# PART I

# Item 1.   Description
of Business

Image
Sensing Systems, Inc. (referred to in this report as we, us,
our and the Company) develops and markets machine vision products
for use in traffic applications such as intersection control, highway and tunnel traffic
management and traffic data collection. We use a 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 implemented on commercially available computer hardware and video cameras to
create our core family of products, the Autoscope® Wide Area 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 has a variety of traffic
control and monitoring applications such as intersection control, highway and tunnel
traffic management and traffic data collection. The system can also be used by traffic
managers for research and other applications, such as transportation security, and
ultimately can help improve traffic flow 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
have strategic distribution agreements with several traffic control companies in the
United States and abroad for the manufacturing and distribution of our products. We
currently have the Autoscope family of products manufactured through an agreement with
Econolite Control Products Inc. (Econolite) and Wireless Technology Inc. (WTI). We sell
the Autoscope system in North America, the Caribbean and Latin America through a long-term
agreement with Econolite. In Europe, we sell the Autoscope system through our wholly-owned
subsidiary, Image Sensing Systems Europe Ltd. In Asia, we sell the Autoscope system
through our wholly-owned subsidiary, Flow Traffic Ltd. Both subsidiaries offer additional
traffic management equipment complementary to the Autoscope system.

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 sublicense 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 branch office in
Poland.

Industry Background

Automated
vehicle detection for traffic management and control has traditionally been performed with
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

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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 in-pavement loop detectors.

Strategy

Our
strategy is to remain the 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 processor called the Autoscope machine vision processor
(MVP). The Autoscope MVP is configured by defining detection zones on a monitor displaying
the traffic view as seen by each camera, as opposed to saw-cutting and placing detector
loops in the pavement. The 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, allowing a traffic
engineer to replace a like number, or more, of in-pavement loops.

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 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 or 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, AutoscopeRackVision System 1, 4
& 16, Autoscope 2020and the Autoscope AtlasJunction
Detection System (JDS). 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 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. Finally, an optional Autoscope Software
Developers Kit is available at added cost for large projects that require integrated
communications for real-time operation and data retrieval.

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

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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 4 cameras. Both products provide a replacement
for the many existing Autoscope 2004 MVPs installed between 1995 and 2002. 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 4 and 16 cameras
respectively. The Autoscope RackVision System 1 was developed in 2004 specifically for
highway projects in Korea and will replace the Autoscope Solo Pro NC product. The
Autoscope Atlas JDS 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 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 speed 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 2005, we increased our research and development
investing by adding and enhancing features that we believe will give us competitive
advantages and meet customer needs for new applications. A new version 8.30 of our
software, containing the enhancements made in 2005, is currently in preparation for
release. For competitive reasons, we do not disclose the technical details of new
development and enhancement efforts.

Research
and development expense increased 35% to $1,516,000 in 2005 from $1,126,000 in 2004.

Manufacturing

We
currently have the Autoscope family of products manufactured through agreements with
Econolite and WTI. We are currently working to have Autoscope products that meet the new
European directive on the restriction of the use of certain hazardous substances in
electrical and electronic equipment manufactured overseas. In 1991, we appointed Econolite
as our licensee to make and have made 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. The manufacturers we select
overseas will 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.

Sales and Marketing

We
market and sell our products to global customers. As of year end, we have supplied
Autoscope systems to support over 40,000 cameras worldwide in more than 50 countries.
Together, we and our partners offer a combination of high-performance video detection
technology and experienced local support.

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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 their sales of the Autoscope system. Royalty income from Econolite comprised
78% of our revenue in 2005, up from 69% in 2004. We coordinate the marketing of Autoscope
products with Econolite for North America, the Caribbean and Latin America and provide
second tier technical support.

We
may terminate our agreement with Econolite if a minimum annual sales level is not met 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 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 subsidiary, Image Sensing Systems Europe Ltd.,
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. Flow
Traffic Ltd. and Image Sensing Systems Europe Ltd. also sell other traffic management
products and systems.

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. 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.

Other
potential competitors we are aware of include Siemens AG, Cognex Corp., Panasonic,
Sumitomo, Omron and 3M, 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 computer hardware
products that are available from multiple sources. To date, our current vendors 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,
efforts with our manufacturing and component suppliers are underway to convert our
products to meet the new European directive on the restriction of the use of certain
hazardous substances in electrical and electronic equipment. Shortages of compliant parts,
the need to change suppliers or difficulties in the

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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,
2005. 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 have been granted an exclusive, worldwide license, with a
right to grant sublicenses, to make, have made, use, sell and lease any product that
incorporates knowledge, information, know-how, software and devices, whether patentable or
not, in the possession of the University and related to a video vehicle detection system
developed by the University, solely or jointly with us, including certain improvements
made to this technology. In exchange for our license, we pay a royalty to the University
which is based on net sales of licensed products and sublicensing revenue. The license
agreement terminates upon the termination of the patent covering the technology. The
patent terminates on July 11, 2006. The University may terminate the license agreement if
the royalties are not paid, if there is a material breach of the agreement by us, or if we
fail to use our best efforts to effect commercial sales of the licensed products. We have
agreed to indemnify the University against all liabilities or losses arising from (1) the
manufacture, use, lease or sale of a licensed product by us or a sublicensee of us, (2) a
third partys use of a licensed product purchased from us or a sublicensee of us, and
(3) a third partys manufacture of a licensed product at our request.

We
have sublicensed some of our rights in the University technology and our technology to
Econolite pursuant to our manufacturing, distribution and technology agreement with
Econolite. (See Manufacturing above.)

The
expiration of the University of Minnesota patent will make the University technology
available to the public, and competing businesses may 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 including our own intellectual property
independent of the University technology, and have made extensive modifications 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 actively 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 patents, trademarks 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 6, 2006, we had 49 employees, 46 of whom were full-time and three of whom were
part-time. Seventeen of these employees were employed by our wholly-owned subsidiaries in
Hong Kong and the United Kingdom and our branch office in Poland. None of our employees is
represented by a union. We believe our employee relations are good.

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Cautionary Statement

This
Annual Report on Form 10-KSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange 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.

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.

More
than 90% of our revenue since inception has been generated from sales of, or royalties
from the sales of, the Autoscope® system vehicle detection system. 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 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, 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.

We
sell the Autoscope system 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. 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. 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 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 1991, more than 60% of our revenue has consisted
of royalties resulting from sales made by Econolite. A failure by Econolite to make
royalty payments to us in a timely manner or at all will significantly reduce our revenues
and harm our financial condition.

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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 plan 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 are working 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.

Our exclusive North American
manufacturer and distributor, Econolite, has filed a complaint against us, and the cost to
defend against the claim, or to settle the claim, or our inability to prevail against the
claim, may result in reduced profitability.

Econolite
has filed a claim against us for at least $684,000, and we are incurring legal costs to
defend ourselves against the claim. Although we believe we will be successful in defending
against the claim, we will continue to incur legal defense costs, which reduce
profitability, and we cannot be absolutely sure that we will prevail in our defense, which
would further reduce profitability.

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 computer
hardware products 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, patents 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, or that the
current patent on the technology underlying the Autoscope system will be held valid if
challenged. We also cannot assure you that others have not developed or will not develop
similar products, duplicate any of our products or design around our patents. 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. 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 foreign countries in which we may market and
sell the Autoscope system. Consequently, our proprietary rights in the technology
underlying the Autoscope system will be protected only to the extent that trade secret,
copyright or other non-patent protection is available in other countries and to the extent
we are able to enforce our rights in those countries. The laws of other countries in which
we market our products may afford little or no effective protection of our proprietary
technology.

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The
United States and foreign patents for certain aspects of the underlying technology for the
Autoscope system are owned by the University of Minnesota. We have entered into a license
agreement with the University, pursuant to which we have been granted an exclusive,
worldwide license, with a right to grant sublicenses, to make, have made, use, sell and
lease products incorporating the University technology, and we pay royalties to the
University for this license. The University of Minnesota may terminate the license only in
limited circumstances, but any termination would prevent us from developing and selling
our products and therefore would severely disrupt our business operations.

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
are owned by the University of Minnesota. The patent expires in July 2006, and the
University technology will then become available to the public. Other businesses could use
the University 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 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 adaptive technology 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 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 home-grown local competitors in Asia, and our inability to do
so could affect revenue and profitability.

The
transportation market in China is growing at a rapid rate and is likely to continue to
grow. Local competing low-cost developers of machine vision products for traffic 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 slow down and erode sales revenue in Asia and affect
profitability.

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.

8

---

The significant control over
shareholder voting matters that may be exercised by our directors and officers may deprive
other shareholders of the ability to influence corporate actions.

As
of March 1, 2006, our directors and officers owned beneficially approximately 18% 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
significant 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.

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 with the second and third quarters being the strongest and the
first and fourth quarters being the weakest generally due to weather conditions that make
roadway construction more difficult. We expect such seasonality to continue for the
foreseeable future. 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 cycles, 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 3,038,260 shares held by nonaffiliates as of March 9,
2006. Based on this fact, 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 or our competitors and
consolidation among our competitors.

9

---

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 and testing 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. 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. Failure to achieve and maintain an effective internal control
environment could have a material adverse effect on our stock price.

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 chromium. We expect that we will be able to have
our product in compliance with the RoHS directive in time, but 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 the customer, thereby adversely impacting revenue and profitability.

Various
Asian governments could adopt their own versions of environment-friendly electronics
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.

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

Terrorists
attacks against Econolite, WTI or our overseas suppliers would adversely effect
manufacture of our Autoscope products and delay the delivery of sales orders. War and the
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.

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 customers, there
is no guarantee that the new products, features or functions we introduce to any of
several market niches will gain market acceptance in that niche or broader market place.
The lack of market acceptance in one or more of our market segments could hurt our
reputation and decrease our revenues and earnings.

10

---

# Item 2.   Description of
Property

We
currently lease approximately 8,825 and 784 square feet of office space in St. Paul,
Minnesota, and Fullerton, California, pursuant to operating leases that expire in May 2008
and June 2006, respectively. Our subsidiaries in Hong Kong and the United Kingdom and our
branch offices in Poland and Spain rent office and storage space totaling 2,439 square
feet, pursuant to operating leases that expire in 2006 and 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 September
15, 2005, Econolite, our exclusive North American manufacturer and distributor, filed a
complaint against us in the United States District Court for the Central District of
California. Econolite has asserted claims for breach of contract and unjust enrichment and
claims damages of at least $684,000. Econolites claims are based on its theory that
it has overpaid royalties due to us under our agreement with Econolite and that it is
entitled to take into account allegedly higher costs it has incurred. We deny
Econolites claims and believe that royalties have been correctly calculated under
the specific formula set forth in the agreement, and we plan to defend the case
vigorously. The case is at the beginning stages of discovery.

# Item 4.   Submission of
Matters to a Vote of Security Holders

None

11

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# PART II

# Item 5.   Market for
Common Equity, Related Shareholder Matters and Small Business IssuerPurchases of
Equity Securities

Market Information

Our
common stock is traded on the NASDAQ Small Cap 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 2005 |   | FY 2004
|------ |  | ------- | - | -------
|
|       |  |         |   |        
|First  |  |         | $ | 16.93  
|Second |  |         |   | 13.39  
|Third  |  |         |   | 13.00  
|Fourth |  |         |   | 13.34  

Shareholders

As
of March 9, 2006, there were 24 holders of record of our common stock and 2,051 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,
do not anticipate paying any dividends in the foreseeable future.

# Item 6.   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 have applied it to traffic
management problems. Our technology uses standard video and computer equipment, combined
with proprietary technology, including complex detection algorithms, computer software,
special purpose hardware, and a Microsoft Windows®-based graphical user
interface that enables standard video cameras to work with the Autoscope system.

Autoscope
systems are sold to distributors and end users of traffic management products in North
America, the Caribbean and Latin America by Econolite, our master distributor 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 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. Flow Traffic
Ltd. and Image Sensing Systems Europe Ltd. also sell other traffic management products and
systems.

The
majority of our revenue is derived from royalties received from Econolite, with a second
primary source of revenue produced from direct 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 (1) continued governmental funding of
Intelligent Transportation Systems, such as machine vision for traffic
control; (2) our ability through Econolite and our sales representatives in Europe and
Asia, to successfully market the Autoscope System to individual traffic managers and (3)
our ability to develop new machine vision products and applications that enhance the
traffic managers ability to cost- effectively improve traffic flow and safety.

12

---

Our
quarterly revenues and operating results have varied significantly in the past due to the
seasonality of our business with the second and third quarters being the strongest and the
first and fourth quarters being the weakest generally due to weather conditions that make
roadway construction more difficult. We expect such seasonality to continue for the
foreseeable future. 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, (1) certain statements of income
data as a percent of total revenue, (2) gross profit on product sales and royalties as a
percentage of product sales and royalties, respectively and (3) year to year changes of
items in the consolidated statement of income from 2004 to 2005:

|                                       |  | Year Ended
December 31 |  | Year toYear
% Change
|-------------------------------------- |  | ---------------------- |  | --------------------
|
|
|                                       |  |                        |  |                     
|International sales                    |  |                        |  | 21.9                
|Royalties                              |  |                        |  | 78.1                
|Total revenue                          |  |                        |  | 100.0               
|Gross profit - International sales     |  |                        |  | 56.7                
|Gross profit - royalties               |  |                        |  | 95.5                
|Selling, marketing and product support |  |                        |  | 23.3                
|General and administrative             |  |                        |  | 12.7                
|Research and development               |  |                        |  | 13.8                
|Income from operations                 |  |                        |  | 37.2                
|Income taxes                           |  |                        |  | 13.7                
|Net income                             |  |                        |  | 25.8                

Total
revenue increased to $11,002,000 in 2005 from $10,830,000 in 2004, an increase of 1.6%.
Royalty income for 2005 increased to $8,595,000, or 78.1% of revenue, from $7,521,000, 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 $2,407,000, or 21.9% of revenue, from $3,309,000, 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. We continue to work on resolving technical issues with
this product, but even if we do so, there is no assurance that we can successfully reenter
the loop detector market. 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.

Total
gross profit was $9,577,000, or 87% of revenue, in 2005, compared to $8,910,000, 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 $2,567,000, or 23.3% of revenue, in 2005,
compared to $2,523,000, or 23.3% of revenue, in 2004. The small increase in total dollars
expended resulted primarily from adding sales and support staff in Europe. We anticipate
adding sales and product support personnel and increasing our marketing efforts in Europe
in 2006. As a result, we expect selling, marketing and product support expenses to
increase in real terms and as a percentage of revenue. General and administrative expenses
were $1,400,000, or 12.7% of revenue, in 2005, compared to $1,317,000, or 12.2% of
revenue, in 2004. The small increase was due

13

---

primarily to added professional fees
and depreciation. We expect these expenses to increase in 2006 as we incur added
professional fees associated with strategic and succession planning and expensing of stock
options to comply with Financial Accounting Standards Statement No. 123 (R). Research and
development expenses totaled $1,516,000, or 13.8% of revenue, in 2005, compared to
$1,126,000, 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.
We expect research and development expenses to increase by over 30% in 2006 as we complete
or advance the development of several new products.

Income
taxes were $1,505,000, or 34.6% of pretax income, in 2005, compared to $1,352,000, 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. If we are profitable in Asia in
2006, we have approximately $368,000 in loss carryover available as an offset. In
addition, we expect to earn more research and experimental credit in 2006. We therefore
believe our effective tax rate will decrease to approximately 32% of pretax income in
2006.

Net
income was $2,841,000 in 2005, compared to $2,694,000 in 2004 due to the factors discussed
above.

Liquidity and Capital
Resources

At
December 31, 2005, we had $9,006,000 in cash and cash equivalents, compared to $1,262,000
at December 31, 2004. Included in cash equivalents at December 31, 2005 was $7.9 million
in a tax-exempt money market fund. Net cash provided by operating activities was
$2,410,000 in 2005, compared to $2,563,000 in 2004. The decrease was due primarily to
increased 2005 fourth quarter royalty income compared to 2004 which was not collected by
December 31, 2005. This more than offset increased cash flow from increased profitability
in 2005, compared to 2004, and utilization of an overpayment of income taxes in 2004
against our 2005 estimated income tax liability. The only other significant source of cash
in 2005 was from selling $5,000,000 in short-term investments. The callable AAA rated
Federal Home Loan Bank bonds are classified as current assets since they may be called
every six months.

We
have a credit agreement with Wells Fargo Bank Minnesota, N. A. that provides up to
$1,000,000 in short-term borrowings at .5% over the prime rate (effective rate of 7.75% at
December 31, 2005), expiring May 31, 2006. 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 2005 or 2004. We expect to renew the agreement at substantially
the same terms and conditions prior to expiration.

We
believe that cash and cash equivalents on hand at December 31, 2005, our $1,000,000
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, which include 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 this fair value to
the carrying value of the subsidiary. If 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

14

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31, 2005 and 2004. 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, 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 international sales at the time of delivery and acceptance, the selling price
is fixed or determinable and collectibility is reasonably assured. Consulting fees are
recorded as earned. 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 SFAS 151,
Inventory Costs. The provisions of this statement become effective for us in
fiscal 2006. SFAS 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 151
requires that those items be recognized as current period charges regardless of whether
they meet the criterion of so abnormal. In addition, SFAS 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 is not expected to
have a material impact on our valuation of inventory or operating results.

In
December 2004, the FASB issued SFAS 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. We will adopt this standard January 1, 2006, and it is not expected
to have a material impact on our operating results.

In
December 2004, the FASB issued SFAS 153, Exchanges of Nonmonetary Assets. This
statement addresses the fair value concepts contained in Opinion 29, Accounting for
Nonmonetary Transactions, which included certain exceptions to the concept that
exchanges of similar productive assets should be recorded at the carrying value of the
asset relinquished. SFAS 153 eliminates that exception and replaces it with a general
exception for exchanges of nonmonetary assets that lack commercial substance. Only
nonmonetary exchanges in which an entitys future cash flows are expected to
significantly change as a result of the exchange will be considered to have commercial
substance. SFAS 153 must be applied to nonmonetary asset exchanges occurring in fiscal
periods beginning after June 15, 2005. The adoption of this statement is not expected to
have a material impact on our operating results.

15

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# Item 7.   Financial
Statements

# IMAGE SENSING SYSTEMS,
INC.CONSOLIDATED BALANCE SHEETS

|                                                               |  | December 31
|-------------------------------------------------------------- |  | -----------
|Assets                                                         | 
|                                                               |  |            
|Current assets:                                                |  |            
|Cash and cash equivalents                                      |  |            
|Short-term investments                                         |  |            
|Accounts receivable, net of allowance for returns and doubtful |  |            
|accounts of $39,000 in 2005 and 2004                           |  |            
|Inventories                                                    |  |            
|Investment in callable FHLB bonds                              |  |            
|Prepaid expenses                                               |  |            
|Deferred income taxes                                          |  |            
|                                                               |  |            
|Total current assets                                           |  |            
|                                                              
|Property and equipment:                                        |  |            
|Furniture and fixtures                                         |  |            
|Leasehold improvements                                         |  |            
|Equipment                                                      |  |            
|                                                               |  |            
|                                                               |  |            
|Accumulated depreciation                                       |  |            
|                                                               |  |            
|                                                               |  |            
|                                                              
|Goodwill                                                       |  |            
|Capitalized software development costs, net of accumulated     |  |            
|amortization of $1,641,000 ($1,383,000 in 2004)                |  |            
|                                                               |  |            
|Total Assets                                                   |  |            
|                                                               |  |            
|                                                              
|Liabilities and Shareholders Equity                           |  |            
|Current liabilities:                                           |  |            
|Accounts payable                                               |  |            
|Accrued compensation                                           |  |            
|Income taxes payable                                           |  |            
|                                                               |  |            
|Total current liabilities                                      |  |            
|                                                              
|Deferred income taxes                                          |  |            
|                                                              
|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,    |  |            
|3,702,005 issued and outstanding (3,537,222 in 2004)           |  |            
|Additional paid-in capital                                     |  |            
|Retained earnings                                              |  |            
|                                                               |  |            
|Total shareholders equity                                     |  |            
|                                                               |  |            
|Total Liabilities and Shareholders Equity                     |  |            
|                                                               |  |            

See accompanying notes.

16

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# IMAGE SENSING SYSTEMS,
INC.CONSOLIDATED STATEMENTS OF INCOME

|                                                      |  | Year ended December 31
|----------------------------------------------------- |  | ----------------------
|
|                                                      |  |                       
|Revenue:                                              |  |                       
|International sales                                   |  |                       
|Royalties                                             |  |                       
|                                                      |  |                       
|                                                      |  |                       
|Cost of revenue:                                      |  |                       
|International sales                                   |  |                       
|Royalties                                             |  |                       
|                                                      |  |                       
|                                                      |  |                       
|                                                      |  |                       
|Gross profit                                          |  |                       
|                                                     
|Operating expenses:                                   |  |                       
|Selling, marketing and product support                |  |                       
|General and administrative                            |  |                       
|Research and development                              |  |                       
|                                                      |  |                       
|                                                      |  |                       
|                                                      |  |                       
|Income from operations                                |  |                       
|                                                     
|Other income                                          |  |                       
|                                                      |  |                       
|Income before income taxes                            |  |                       
|Income taxes                                          |  |                       
|                                                      |  |                       
|Net income                                            |  |                       
|                                                      |  |                       
|                                                     
|Net income per share:                                 |  |                       
|Basic                                                 |  |                       
|Diluted                                               |  |                       
|                                                     
|Weighted average number of common shares outstanding: |  |                       
|Basic                                                 |  |                       
|Diluted                                               |  |                       

See accompanying notes.

17

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# IMAGE SENSING SYSTEMS,
INC.CONSOLIDATED STATEMENTS OF CASH FLOW

|                                                                                  |  | Year ended December 31
|--------------------------------------------------------------------------------- |  | ----------------------
|
|                                                                                  |  |                       
|Operating activities:                                                             |  |                       
|Net income                                                                        |  |                       
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                       
|Depreciation                                                                      |  |                       
|Amortization                                                                      |  |                       
|Tax benefit from disqualifying disposition                                        |  |                       
|Compensation expense for performance-based stock option                           |  |                       
|Deferred income taxes                                                             |  |                       
|Changes in operating assets and liabilities:                                      |  |                       
|Receivables                                                                       |  |                       
|Inventories                                                                       |  |                       
|Prepaid expenses                                                                  |  |                       
|Accounts payable                                                                  |  |                       
|Accrued compensation                                                              |  |                       
|Income taxes payable                                                              |  |                       
|                                                                                  |  |                       
|Net cash provided by operating activities                                         |  |                       
|                                                                                 
|Investing activities:                                                             |  |                       
|Purchase of short-term investments                                                |  |                       
|Sale of short-term investments                                                    |  |                       
|Purchase of Federal Home Loan Bank Bonds                                          |  |                       
|Purchases of property and equipment                                               |  |                       
|Proceeds from sale of other asset                                                 |  |                       
|                                                                                  |  |                       
|Net cash provided by (used in) investing activities                               |  |                       
|                                                                                 
|Financing activities:                                                             |  |                       
|Proceeds from exercise of stock options                                           |  |                       
|                                                                                  |  |                       
|Net cash provided by financing activities                                         |  |                       
|                                                                                  |  |                       
|Increase (decrease) in cash and cash equivalents                                  |  |                       
|                                                                                 
|Cash and cash equivalents at beginning of year                                    |  |                       
|                                                                                  |  |                       
|Cash and cash equivalents at end of year                                          |  |                       
|                                                                                  |  |                       
|                                                                                 
|Supplemental disclosure:                                                          |  |                       
|Income taxes paid                                                                 |  |                       

See accompanying notes.

18

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# IMAGE SENSING SYSTEMS,
INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

|                                           |  | SharesIssued |  | CommonStock |  | Additional
Paid-InCapital |        | RetainedEarnings |   | Total    
|------------------------------------------ |  | ------------ |  | ----------- |  | ------------------------- | ------ | ---------------- | - | ---------
|                                           |  |              |  |             |  |                           |        |                  |   |          
|                                          
|Balance at December 31, 2003               |  |              |  | 3,288,177   |  | $                         | 33,000 |                  | $ | 5,218,000
|                                          
|Tax benefit from disqualifying disposition |  |              |  |             |  |                           |        |                  |   | 653,000  
|Common stock issued for options exercised  |  |              |  | 249,045     |  |                           | 2,000  |                  |   | 670,000  
|Net income                                 |  |              |  |             |  |                           |        |                  |   |          
|                                           |  |              |  |             |  |                           |        |                  |   |          
|Balance at December 31, 2004               |  |              |  | 3,537,222   |  |                           | 35,000 |                  |   | 6,541,000
|                                          
|Tax benefit from disqualifying disposition |  |              |  |             |  |                           |        |                  |   | 377,000  
|Common stock issued for options exercised  |  |              |  | 164,783     |  |                           | 2,000  |                  |   | 655,000  
|Compensation in the form of stock options  |  |              |  |             |  |                           |        |                  |   | 68,000   
|Net income                                 |  |              |  |             |  |                           |        |                  |   |          
|                                           |  |              |  |             |  |                           |        |                  |   |          
|Balance at December 31, 2005               |  |              |  | 3,702,005   |  | $                         | 37,000 |                  | $ | 7,641,000
|                                           |  |              |  |             |  |                           |        |                  |   |          

See accompanying notes.

19

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# Notes to Consolidated
Financial Statements

December 31, 2005

# 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, and
Image Sensing Systems Europe Ltd. (ISS/Europe), located in the United Kingdom. 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 2006 and 2007 but are callable either
quarterly or semi-annually. At December 31, 2005 and 2004, 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. 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.

20

---

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 four-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 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, 2005 or 2004.

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 2005 or
2004.

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 2005 or 2004.

21

---

Foreign Currency

All
assets and liabilities of Flow Traffic and ISS/Europe 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 not material.

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, 2005 and 2004, respectively, 266,000 and 401,000 common share
equivalents were included in the computation of diluted net income per share. There were
no anti-dilutive options at December 31, 2005 or 2004.

At
December 31, 2005, the exercise prices of all outstanding options were less than the
average market price of the common shares during the period.

Stock Options

Stock
options issued to employees are accounted for under the intrinsic value method as
prescribed by Accounting Principles Bulletin Opinion No. 25, Accounting for Stock
Issued to Employees. No stock-based employee compensation cost is 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, using the
assumptions described in Note 8.

|                                          |  | Year Ended December 31
|----------------------------------------- |  | ----------------------
|
|                                          |  |                       
|Net income , as reported                  |  |                       
|Deduct:  Total stock-based employee       |  |                       
|compensation expense determined under     |  |                       
|the fair value method for all awards, net |  |                       
|of related tax effects                    |  |                       
|                                          |  |                       
|Pro-forma net income                      |  |                       
|                                          |  |                       
|                                         
|Income  per share:                        |  |                       
|Basic - as reported                       |  |                       
|Basic - pro forma                         |  |                       
|                                         
|Diluted - as reported                     |  |                       
|Diluted - pro forma                       |  |                       

New Accounting
Pronouncements

In
November 2004, the Financial Accounting Standards Board (FASB) issued SFAS 151,
Inventory Costs. The provisions of this statement become effective for us in
fiscal 2006. SFAS 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

22

---

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 151 requires that
those items be recognized as current period charges regardless of whether they meet the
criterion of so abnormal. In addition, SFAS 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 is not expected to have a
material impact on our valuation of inventory or operating results.

In
December 2004, the FASB issued SFAS 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. We will adopt this standard January 1, 2006, and it is not expected
to have a material impact on our operating results.

In
December 2004, the FASB issued SFAS 153, Exchanges of Nonmonetary Assets. This
statement addresses the fair value concepts contained in Opinion 29, Accounting for
Nonmonetary Transactions, which included certain exceptions to the concept that
exchanges of similar productive assets should be recorded at the carrying value of the
asset relinquished. SFAS 153 eliminates that exception and replaces it with a general
exception for exchanges of nonmonetary assets that lack commercial substance. Only
nonmonetary exchanges in which an entitys future cash flows are expected to
significantly change as a result of the exchange will be considered to have commercial
substance. SFAS 153 must be applied to nonmonetary asset exchanges occurring in fiscal
periods beginning after June 15, 2005. The adoption of this statement is not expected to
have a material impact on our operating results.

Reclassifications

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

# 2.   Credit
Facility

We
have a credit agreement that provides up to $1,000,000 in short-term borrowings at .5%
over the prime rate (effective rate of 7.75% at December 31, 2005), expiring May 31,
2006. 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 2005 or 2004. 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 at December 31, 2005 and 2004:

|                                                 |  | 2005 |   | 2004     
|------------------------------------------------ |  | ---- | - | ---------
|                                                 |  |      |   |          
|Callable Federal Home Loan Bonds                 |  |      | $ | 2,300,000
|Short-term investments - Auction Rate Securities |  |      |   |         
|                                                 |  |      |   |          
|                                                
|Total                                            |  |      | $ | 2,300,000
|                                                 |  |      |   |          

As
of December 31, 2005 and 2004, investments are classified as available-for-sale. The cost
of investments approximate 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.

23

---

Proceeds
from maturities and sales of investments totaled $5,000,000 for the year ended December
31, 2005. There were no sales or maturities in 2004. There were no realized gains or
losses related to sales or unrealized gains and losses during the years ended December 31,
2005 and 2004.

# 4.   Lease Commitment

We
rent office space and equipment under operating lease agreements expiring at various dates
through May 2008. The leases provide for monthly payments of $23,000, and we are
responsible for our proportionate share of increases in operating expenses that exceed a
base rent factor. Rent expense amounted to $221,000 in 2005 and $217,000 in 2004.

Future
minimum annual lease payments under noncancelable operating leases for the years ending
December 31, 2006, 2007 and 2008 are $232,000, $151,000 and $59,000, respectively.

# 5. Income   Taxes

Our
deferred tax assets and liabilities are as follows:

|                                       |  | December 31
|-------------------------------------- |  | -----------
|
|                                       |  |            
|Deferred tax assets:                   |  |            
|Accrued compensation                   |  |            
|Allowance for returns and bad debts    |  |            
|Alternative minimum tax credits        |  |            
|Prepaid expenses                       |  |            
|Other                                  |  |            
|Less valuation allowance               |  |            
|                                       |  |            
|                                       |  |            
|Deferred tax liabilities:              |  |            
|Capitalized software development costs |  |            
|                                       |  |            
|Net deferred liabilities               |  |            
|                                       |  |            

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 $270,000 and $500,000 in undistributed earnings of our wholly-owned foreign
subsidiaries at December 31, 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 of approximately $268,000
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.

24

---

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

|             |  | Year Ended December 31
|------------ |  | ----------------------
|
|             |  |                       
|Current:     |  |                       
|Federal      |  |                       
|State        |  |                       
|Foreign      |  |                       
|             |  |                       
|             |  |                       
|Deferred:    |  |                       
|Federal      |  |                       
|State        |  |                       
|Foreign      |  |                       
|             |  |                       
|             |  |                       
|             |  |                       
|            
|Income taxes |  |                       
|             |  |                       

A
reconciliation of income taxes to the statutory federal rate is as follows:

|                                                 |  | December 31 |   |          
|------------------------------------------------ |  | ----------- | - | ---------
|
|                                                 |  |             |   |          
|Federal tax statutory rate                       |  |             | $ | 1,477,000
|State taxes, net of federal benefit              |  |             |   | 72,000   
|Tax exempt interest                              |  |             |   | (53,000  
|Research and development tax credits             |  |             |   | (80,000  
|Domestic production activity deduction           |  |             |   | (45,000  
|Effect of higher (lower) rates on foreign income |  |             |   | 115,000  
|Other                                            |  |             |   | 19,000   
|                                                 |  |             |   |          
|                                                
|Income taxes                                     |  |             | $ | 1,505,000
|                                                 |  |             |   |          

# 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 have an exclusive worldwide license
from the University of Minnesota for that technology and pay royalties to the University
of Minnesota in exchange for such license. Royalty expense under the agreement was
$383,000 in 2005 and $321,000 in 2004.

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, 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 term to 2011.

We
recognized royalty income from this agreement of $8,595,000 in 2005 and $7,521,000 in
2004. Accounts receivable from Econolite were $3,102,000 and $1,984,000 at December 31,
2005 and 2004, respectively.

25

---

# 7.   Significant Customers
and Concentration of Credit Risk

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

|              |  | 2005 |  | 2004
|------------- |  | ---- |  | ----
|              |  |      |  |     
|Asia Pacific  |  |      |  | 6%  
|Europe        |  |      |  | 16% 
|North America |  |      |  | 78% 

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

# 8.   Retirement Plan

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 Ltd. is obligated to contribute to an employee
pension plan. The Company made contributions totaling $60,000 and $50,000 to the plans for
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-incentive (NSO) 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. The following table summarizes stock option activity for 2005 and 2004:

|                             |  | Plan
OptionsAvailableFor Grant |  | Plan Options
Outstanding |   | Non-Plan
Options
Outstanding |          | Weighted Average
Exercise Price
Per Share
|---------------------------- |  | ------------------------------ |  | ------------------------ | - | ---------------------------- | -------- | -----------------------------------------
|
|
|                            
|Balance at December 31, 2003 |  |                                |  | 312,200                  |   |                              | 208,100  |                                          
|Granted                      |  |                                |  | (16,000                  | ) |                              |         |                                          
|Exercised                    |  |                                |  |                         |   |                              | (112,950 | )                                        
|                             |  |                                |  |                          |   |                              |          |                                          
|Balance at December 31, 2004 |  |                                |  | 296,200                  |   |                              | 95,150   |                                          
|Plan terminated              |  |                                |  | (296,200                 | ) |                              |         |                                          
|Reserved for new plan        |  |                                |  | 281,200                  |   |                              |         |                                          
|Exercised                    |  |                                |  |                         |   |                              | (15,550  | )                                        
|Cancelled                    |  |                                |  |                         |   |                              | (1,200   | )                                        
|                             |  |                                |  |                          |   |                              |          |                                          
|Balance at December 31, 2005 |  |                                |  | 281,200                  |   |                              | 78,400   |                                          
|                             |  |                                |  |                          |   |                              |          |                                          

26

---

The
following table summarizes information about the stock options outstanding at December 31,
2005.

|  |           | Options Outstanding |  | Options Exercisable
|- | --------- | ------------------- |  | -------------------
|
|  |           |                     |  |                    
|$ | 1.30-1.99 |                     |  | 100,700            
|  | 2.00-2.99 |                     |  | 84,400             
|  | 3.00-3.99 |                     |  | 43,132             
|  | 7.00-7.93 |                     |  | 28,600             
|  |           |                     |  |                    
|  |           |                     |  | 256,832            

No
options were granted in 2005. The weighted average fair value of the options granted
during 2004 was $56,000. The fair value of each option granted was 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 127%; risk-free interest rate
of 4.27%; and expected life of 10 years. Options exercisable at December 31, 2004 were
293,683 and had a weighted average exercise price of $3.28.

# 10.   Contingency

On
September 15, 2005, Econolite, our exclusive North American manufacturer and distributor,
filed a complaint against us asserting breach of contract and unjust enrichment and claims
damages of at least $684,000. We deny Econolites claims and believe that royalties
have been correctly calculated under the specific formula set forth in the agreement we
have with them, and we plan to defend the case vigorously. The case is at the beginning
stages of discovery.

27

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Report of
Independent Registered Public Accounting Firm

Shareholders and Board of
Directors

# 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, 2005 and 2004, and the related
consolidated statements of income, shareholders equity, and cash flows for each of
the two years then ended. 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 purpose 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 its subsidiaries at December 31, 2005 and 2004, and the consolidated results of their
operations and their consolidated cash flows for each of the two years in the period ended
December 31, 2005 in conformity with accounting principles generally accepted in the
United States of America.

| | /s/Grant
Thornton LLP
| | ---------------------

Minneapolis, MinnesotaFebruary
17, 2006

28

---

# Item 8.    Changes in
and Disagreements with Accountants on Accounting and Financial Disclosure

None

# Item 8A.   Controls and
Procedures

Evaluation of disclosure
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 (as defined in Rule
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)).
Based upon that evaluation, our 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 8B.   Other
Information

None

# PART III

# Item 9.   Directors,
Executive Officers, Promoters and Control Persons; Compliance with Section16(a) of the
Exchange Act

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 or financial officers will be published on
our website.

The
sections entitled Proposal 1  Election of Directors, Audit
Committee and Section 16(a) Beneficial Ownership Reporting Compliance in
our definitive proxy statement for our 2006 annual meeting of shareholders are
incorporated into this Form 10-KSB by reference.

# Item 10.   Executive
Compensation

The
sections entitled Executive Compensation and Compensation of
Directors in our definitive proxy statement for the 2006 annual meeting of
shareholders are incorporated into this Form 10-KSB by reference.

29

---

# Item 11.   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, 2005, 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 exerciseof outstanding options,warrants and rights | Weighted-average exercise
price of outstandingoptions, warrants andrights | Number of securities remainingavailable for future issuance
under equity compensation plans(excluding securities reflectedin the first column)(2)
|------------------------------------------------------ | ----------------------------------------------------------------------------------------- | ------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------
|Equity compensation plans
approved by shareholders(1)  | 256,832                                                                                   | $2.72                                                                     | 281,200                                                                                                                                          
|Equity compensation plans not
approved by shareholders |                                                                                          |                                                                          |                                                                                                                                                 
|Total                                                  | 256,832                                                                                   | $2.72                                                                     | 281,200                                                                                                                                          

(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
281,200 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 2006 annual meeting of
shareholders is incorporated into this Form 10-KSB by reference.

# Item 12.   Certain
Relationships and Related Transactions

The
section entitled Certain Relationships and Related Transactions in our
definitive proxy statement for the 2006 annual meeting of shareholders is incorporated
into this Form 10-KSB by reference.

# Item 13.   Exhibits

The
following documents are filed as exhibits to this report:

|Exhibit No. |  | Description
|----------- |  | -----------

|3.1 |  | Restated
Articles of Incorporation of ISS, incorporated by reference to ISSs registration
                  statement on Form SB-2 (Registration No. 90298C) filed on March 14,
1995.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.2 |  | Articles
of Amendment to Articles of Incorporation of ISS, incorporated by reference to ISSs
quarterly report on Form 10-QSB for the quarter ended June 30, 2001.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

30

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|3.3 |  | Bylaws
of ISS, incorporated by reference to ISSs registration statement on Form SB-2
(Registration No. 90298C) filed on March 14, 1995.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------

|4.1 |  | Specimen
form of ISSs common stock certificate, incorporated by reference to
ISSs registration statement on Form SB-2 (Registration No. 90298C) filed
on March 14, 1995.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.1 |  | Manufacturing,
Distributing and Technology License Agreement dated June 11, 1991, as amended on December
15, 1992, between Econolite Control Products, Inc. and ISS, incorporated by reference to
ISSs registration statement on Form SB-2 (Registration No. 90298C) filed on March
14, 1995.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.2 |  | License
Agreement dated June 10, 1991, between the University of Minnesota and ISS, incorporated
by reference to ISSs registration statement on Form SB-2 (Registration No. 90298C)
filed on March 14, 1995.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.3 |  | Form
of Distributor Agreement, incorporated by reference to ISSs registration
statement on Form SB-2 (Registration No. 90298C) filed on March 14, 1995.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|10.4 |  | Assignment
from Panos G. Michalopoulos to ISS dated January 19, 1985, incorporated by
reference to ISSs registration statement on Form SB-2 (Registration No.
90298C) filed on March 14, 1995.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.5 |  | Production
Agreement dated July 8, 1997, between ISS, Cohu, Inc., and Econolite Control
Products, Inc., incorporated by reference to Exhibit 10.14 to ISSs annual
report on Form 10-KSB for the year ended December 31, 1997.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.6 |  | Conditional
Credit Line Letter Agreement with Wells Fargo Bank Minnesota, N.A. dated
September 14, 1998, incorporated by reference to Exhibit 10.17 to ISSs
annual report on Form 10-KSB for the year ended December 31, 1998.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.7 |  | Office
Lease Agreement by and between Spruce Tree Centre L.L.P. and ISS, dated November
24, 1998, incorporated by reference to Exhibit 10.18 to ISSs annual report
on Form 10-KSB for the year ended December 31, 1998.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.8* |  | 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.
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.9 |  | Distribution
Agreement dated April 20, 2001, between ISS and Wireless Technology, Inc., incorporated
by reference to ISSs quarterly report on Form 10-QSB for the quarter ended June 30,
2001.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.10 |  | Extension
and Second Modification dated July 13, 2001, to Manufacturing, Distributing and
Technology License Agreement dated June 11, 1991, between ISS and Econolite Control
Products, Inc., incorporated by reference to Exhibit 10.12 to ISSs annual report on
Form 10-KSB for the year ended December 31, 2001.
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.11 |  | Definitive
Agreement dated July 20, 2001, between ISS and Detector Electronics Corporation,
incorporated by reference to ISSs quarterly report on Form 10-QSB for the quarter
ended September 30, 2001.
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.12 |  | Shares
Sale and Purchase Agreement dated November 28, 2001, among ISS and Berkeley Development
Limited, Mats Johan Billow and Grove Place Limited, incorporated by reference to Exhibit
10.10 to ISSs annual report on Form 10-KSB for the year ended December 31, 2001.
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.13 |  | Amendment
No. 1 dated as of December 31, 2001, to Shares Sale and Purchase Agreement dated November
28, 2001, among ISS and Berkeley Development Limited, Mats Johan Billow and Grove Place
Limited, incorporated by reference to Exhibit 10.15 to ISSs annual report on Form
10-KSB for the year ended December 31, 2001.
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

31

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|10.14* |  | Employment
Arrangement between ISS and Anthony H. Gould, incorporated by reference to Exhibit 10.19
to ISSs annual report on Form 10-KSB for the year ended December 31, 2001.
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.15 |  | Production
Agreement dated February 14, 2002, among ISS, Wireless Technology, Inc. and Econolite
Control Products, Inc., incorporated by reference to Exhibit 10.20 to ISSs annual
report on Form 10-KSB for the year ended December 31, 2001.
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.16* |  | Consultant
Agreement effective May 1, 2003 between ISS and Art Bourgeois, incorporated by reference
to Exhibit 10.1 to ISSs quarterly report on Form 10-QSB for the quarter ended March
31, 2002.
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.17* |  | Employment
Agreement effective June 14, 2002 between ISS, Flow Traffic Ltd. and Mats Johan Billow,
incorporated by reference to Exhibit 10.1 to ISSs quarterly report on Form 10-QSB
for the quarter ended June 30, 2002.
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.18 |  | Amendment
No. 3, dated June 14, 2002, to share Sale and Purchase Agreement dated November 28, 2001
among ISS and Berkeley Development Limited, Mats Johan Billow and Grove Place Limited,
incorporated by reference to Exhibit 10.2 to ISSs quarterly report on Form 10-QSB
for the quarter ended June 30, 2002.
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.19* |  | Addendum
to Consultant Agreement Between Image Sensing Systems, Inc. and Arthur J.
Bourgeois, dated September 11, 2003, incorporated by reference to Exhibit 10.1
to ISSs quarterly report on Form 10-QSB for the quarter ended September
30, 2003.
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.20* |  | Consultant
Agreement between Image Sensing Systems, Inc. and James Murdakes, dated March 23, 2004.
|------ |  | --------------------------------------------------------------------------------------------------

|10.21* |  | Employment
Agreement between Image Sensing Systems, Inc. and Arthur Bourgeois
|------ |  | -----------------------------------------------------------------------------

|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.

# 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 2006 annual meeting of
shareholders are incorporated into this Form 10-KSB by reference.

32

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# SIGNATURES

In
accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized:

Image Sensing Systems,
Inc. By:


|/s/ James Murdakes                                   |  | Date: March 24, 2006 | 
|---------------------------------------------------- |  | -------------------- | 
|James Murdakes
President and Chief Executive Officer

Each
person whose signature to this report on Form 10-KSB appears below hereby constitutes and
appoints James Murdakes and Arthur J. Bourgeois, and each of them, as his or her true and
lawful attorney-in-fact and agent, with full power of substitution, to sign on his or her
behalf individually and in the capacity stated below and to perform any acts necessary to
be done in order to file all amendments to this report on Form 10-KSB, and any and all
instruments or documents filed as part of or in connection with this report on Form 10-KSB
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 24, 2006 | 
|---------------------------------------------------------------------------------------------------------------------- |  | -------------------- | 
|James Murdakes
President and Chief Executive Officer, Chairman of the Board of Directors (Principal Executive Officer)

|/s/ Arthur J. Bourgeois                                                                |  | Date: March 24, 2006 | 
|-------------------------------------------------------------------------------------- |  | -------------------- | 
|Arthur J. Bourgeois
Chief Financial Officer (Principal Financial & Accounting Officer)

|/s/ Panos G. Michalopoulos      |  | Date: March 24, 2006 | 
|------------------------------- |  | -------------------- | 
|Panos G. Michalopoulos
Director

|/s/ Richard P. Braun      |  | Date: March 24, 2006 | 
|------------------------- |  | -------------------- | 
|Richard P. Braun
Director

|/s/ Richard C. Magnuson      |  | Date: March 24, 2006 | 
|---------------------------- |  | -------------------- | 
|Richard C. Magnuson
Director

|/s/ Michael Eleftheriou      |  | Date: March 24, 2006 | 
|---------------------------- |  | -------------------- | 
|Michael Eleftheriou
Director

33

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