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

# FORM 10-KSB

# [X]     Annual
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year
ended December 31, 2004

# [_]     Transition
Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition
period from _________________ to  _________________

Commission file number   0-26056

|Image Sensing Systems, Inc.                                    
|---------------------------------------------------------------
|                                                               
|(Name of small business issuer in its charter)                 
|                                                               
|Minnesota                                                      
|                                                               
|(State or other jurisdiction of                                
|incorporation or organization)                                 
|                                                               
|500 Spruce Tree Centre1600 University Ave. W.St. Paul, MN 55104
|                                                               
|(Address of principal executive offices, including zip code)   

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 (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.   [X]  Yes     [_]  No

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

The
registrants revenues for the fiscal year ended December 31, 2004 totaled $10,830,000.

Based
on the closing price at March 14, 2005, the aggregate market value of the voting and
non-voting stock held by nonaffiliates of the registrant was $38,308,277.

The
number of shares outstanding of the registrants $.01 par value common stock, as of
March 14, 2005, was 3,546,322 shares.

# DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statement for
our May 18, 2005 annual meeting of shareholders, which will be filed on or
prior to May 2, 2005, are incorporated by reference into Part III of
this Form 10-KSB.

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

---

# 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 video image processing
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, also known as machine vision, 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 the machine vision technology implemented on commercially
available computer hardware and video cameras to create the companys 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
applications in 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
manufacture the Autoscope family of products through an agreement with Econolite Control
Products Inc. and Wireless Technology Inc. We sell the Autoscope system in North America
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 and a non-Autoscope loop detection product to
distributors through our wholly-owned subsidiary, Flow Traffic Ltd.

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 exclusive license of the Autoscope
technology. In 1991 we also granted a sub-license to Econolite Control Products, Inc., 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 sixty percent ownership of
Flow Traffic Ltd., a distributor of traffic products in Asia, located in Hong Kong. In
2002, we acquired the remaining forty percent 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.

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 one camera to
do the work of many loops. The Autoscope systems range of applications and its
ability to support

1

---

new applications for advanced
technology solutions to traffic management problems make it superior to the 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 that they may improve
traffic flow, traffic safety and roadway planning, and that they may reduce travel time,
traffic accidents, delays, congestion, air pollution and fuel consumption and ultimately
provide increased cost efficiencies in traffic management and control. We will continue
efforts to (1) expand and improve our distribution network in other parts of Europe and
Asia-Pacific that can grow our market base; (2) seek out partners within the industry that
bring synergistic technologies to our current products and markets; and (3) seek out
partners outside of the traffic management industry that leverage our technology that can
result in profitable business.

The Autoscope System

In
the Autoscope system a camera is used to view the roadway traffic scene. The camera video
is input to a special purpose computer called the Autoscope machine vision processor
(MVP). The Autoscope system 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. 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 Solo® Pro
NC, Autoscope 2020, Autoscope RackVision, Autoscope
RackVision System 4, Autoscope RackVision System
16, and most recently, 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 large or small 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 requiring integrated communications for
real-time operation and data retrieval.

Autoscope
Solo Pro is an integrated color zoom camera and machine vision processor contained in one
compact housing unit. The Solo Pro provides the best performance of our product line due
to the guaranteed, high-

2

---

quality video resulting from the
integration of camera and processor. The Autoscope Solo Pro NC, introduced in 2002, and
Autoscope 2020 and Autoscope RackVision, introduced in 2003, were developed to allow
customers to use standard video cameras with Autoscope technology. The AIS Camera is our
stand-alone specialized camera that promotes optimal use of Autoscope Solo Pro NC,
Autoscope 2020 and the Autoscope RackVision products. The Autoscope RackVision System
products were introduced this past year to provide a turn-key solution, primarily for our
Asian market. The Autoscope Atlas JDS is a single board, two-camera processor bundled with
two cameras, developed this past year 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 speeds up the integration process.

Product Development

We
continually work on product development and enhancements that expand our applications,
reduce costs, improve performance, make the product more user-friendly and provide other
beneficial features to the user. Product development efforts in 2004 included the
following:

| | Autoscope
Wizardthis highly successful software component was introduced in
2003 to automate setup and configuration for signalized intersection applications in our
North American market. The scope of the Wizard was expanded in 2004 and ported, in part,
to the Autoscope MVP itself, so that the MVP could be configured without a Windows PC,
using only a mouse and video monitor, for ease of use.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Autoscope
RackVision System-4 & -16 these products leverage the highly
successful RackVision Euro card by providing an integrated power supply and video
multiplexer in standard VME rack size for up to four and sixteen processors,
respectively.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Autoscope
Atlas JDS the Atlas system was developed as a lower-cost, two-camera
system for vehicle presence detection for European signalized intersections. It is hoped
that introduction of this product will accelerate the acceptance and adoption of video
detection in Europe to similar levels of widespread acceptance we are now enjoying in the
North American market.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Korean
Communications Protocol Similar to the TLS protocol, a standard
communications protocol for German highways, a similar standard communications protocol
for Korean highways was added to the Autoscope product. Transportation authorities and
system integrators in Korea will now find it easier to integrate the Autoscope system
with their highways transportation system.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Research
and development expense increased 38% from $814,000 in 2003 to $1,126,000 in 2004.

Manufacturing

We
manufacture the Autoscope family of products through agreements with Econolite Control
Products Inc. (Econolite) and Wireless Technology Inc. (WTI). 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 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.

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.

3

---

Sales and Marketing

We
market and sell our products to global customers. We have supplied Autoscope systems for
over 33,000 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.

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 they manufacture (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
69% and 64% of our revenue in 2004 and 2003, respectively. We coordinate the marketing of
Autoscope products with Econolite for North America 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 principal executive offices in St. Paul, Minnesota.
Flow Traffic Ltd. also sells other traffic management products and systems in Asia.

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 are Traficon N.V., Quixote
Corporation, Nestor, Inc., 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. 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., NEC 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 Econolites and
WTIs ability to manufacture our products, which could, in turn, decrease our
revenues and harm our business.

4

---

Additionally,
efforts with our manufacturing and component suppliers are underway to convert all of our
products to meet the new European directive for Reduction of Hazardous Substances (RoHS)
which takes effect on July 1, 2006. Shortages of compliant parts, the need to change
vendors or difficulties in the new manufacturing processes required could hinder
Econolites and WTIs ability to manufacture our products in time for the July
2006 deadline, 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,
2004. 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 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 of Minnesota 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 Autoscope technology to Econolite pursuant to
our manufacturing, distribution and technology agreement with Econolite. (See
Manufacturing above.)

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.

Employees

As
of February 28, 2005, we had 38 employees, 36 of whom were full-time and two of whom were
part-time. Thirteen of these employees are employed by our wholly-owned subsidiaries in
Hong Kong and the United Kingdom. None of our employees is represented by a union. We
believe our employee relations are good.

5

---

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
product for most of our revenue, and if we do not maintain the market for our product, 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, and the Autoscope
system currently is our only product sold commercially. 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 Control Products, Inc., pursuant to which
Econolite is the exclusive distributor of the Autoscope system in North America 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.

6

---

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

We
do not have, and do not intend to develop in the near future, the capability to
manufacture our products. We have entered into agreements with Econolite Control Products,
Inc. and Wireless Technology Inc. (WTI) to manufacture the Autoscope system and related
technology. If Econolite and WTI 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 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 dependence on single-source
suppliers may prevent us from meeting customers needs in a timely manner.

All
of the component hardware 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.

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 sub-licenses, to make, have made, use, sell and
lease products incorporating the Autoscope 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.

7

---

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.

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.

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, 2005, 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 Image Sensing Systems
and may constrain the voting or other rights of other holders of our common stock.

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

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

8

---

Our stock price is
volatile.

Our common
stock is thinly traded with approximately 2.9 million shares held by nonaffiliates. 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.

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
management assessments of the effectiveness of our internal controls over financial
reporting and a report by our Independent Auditors addressing these assessments. 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 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 beginning in August
2005. In addition, the European Parliament has enacted a requirement for the elimination
or reduction of hazardous substances (RoHS). This legislation governs the recovery of such
substances as mercury, lead, cadmium, and hexavalent cadmium. We are currently reviewing
the applicability of WEEE and RoHS Legislation to our electronic products. Accordingly, we
cannot currently estimate the extent of increased costs resulting from the WEEE and RoHS
Legislation. Similar legislation may be enacted in other geographies, including federal
and state legislation in the United States, the cumulative impact of which could be
significant costs. . We expect that we will be able to have our product in compliance with
the directives and a waste disposal program in place by the respective deadlines, 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.

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

Terrorists
attacks against Econolite or WTI would adversely effect manufacture of our Autoscope
products and delay the delivery of sales orders. War and the SARS or similar epidemic
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.

9

---

# Item
2.     Description of Property

We
currently lease approximately 7,600 square feet of office space in St. Paul, Minnesota,
pursuant to an operating lease that expires in May 2005. The lease provides for monthly
payments of $11,000, and we are responsible for our proportionate share of increases in
operating expenses that exceed a base rent factor. We are currently negotiating renewal of
this lease with the intention of adding approximately 500 square feet. Our subsidiaries in
Honk Kong and the United Kingdom rent office and storage space of 930 square feet and 525
square feet for $3,000 and $2,000 per month, respectively, pursuant to operating leases
that expire in April 2006 and December 2005, respectively.

Rent
expense for all locations amounted to $187,000 in 2004 and $182, 000 in 2003. At December
31, 2004, future minimum annual lease payments payable through 2005 total $95,000.

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

During
2004, we were not involved in any legal proceedings, and we currently are not a party to
any legal proceedings.

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

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

10

---

# PART II

# Item 5.     Market for
Common Equity, Related Shareholder Matters and Small Business Issuer Purchases 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 2004 |  | FY 2003
|------ | ------- |  | -------
|       |         |  |        
|
|       |         |  |        
|First  |         |  | $      
|Second |         |  |        
|Third  |         |  |        
|Fourth |         |  |        

Shareholders

As
of March 10, 2005, there were 28 holders of record of our common stock and approximately
1,675 beneficial holders of our common stock.

Dividends

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

# 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 and Latin America by Econolite Control Products, Inc. (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., our Asian subsidiary, also sells other traffic management products and
systems in Asia.

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.

11

---

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 2003 to 2004:

|                                       | Year Ended
December 31 |  | Year to Year
% Change
|-------------------------------------- | ---------------------- |  | ---------------------
|                                       |                        |  |                      
|
|                                       |                        |  |                      
|Product sales                          |                        |  |                      
|Royalties                              |                        |  |                      
|                                       |                        |  |                      
|Total revenue                          |                        |  |                      
|Gross profit - product sales           |                        |  |                      
|Gross profit - royalties               |                        |  |                      
|Selling, marketing and product support |                        |  |                      
|General administrative                 |                        |  |                      
|Research and development               |                        |  |                      
|Income from operations                 |                        |  |                      
|Income taxes                           |                        |  |                      
|Net income                             |                        |  |                      

Total
revenue increased to $10,830,000 in 2004 from $9,259,000 in 2003, an increase of 17.0%.
Product sales for 2004 decreased to $3,309,000, or 30.6% of revenue, from $3,339,000, or
36.1% of revenue, in 2003. The .9% decrease from 2003 was due to $611,000 in lower sales
of non-Autoscope products in Asia which more than offset $581,000 in higher sales of
Autoscope systems by both our wholly-owned subsidiaries in Hong Kong and Europe. Our Hong
Kong subsidiary had an exclusive distribution agreement to sell a non-Autoscope product
line through December 31, 2004. Because of quality issues and delivery schedule problems
for the products, sales declined throughout 2004, particularly in the fourth quarter, and
we allowed the agreement to expire. We have transitioned to a new supplier and expect
sales of new non-Autoscope products to begin in the second quarter of 2005. Sales
increases for Autoscope products in both Asia and Europe were primarily attributable to
continued acceptance of the RackVision and NC products introduced into Asia and Europe
during the past three years. Royalty income for 2004 increased to $7,521,000, or 69.4% of
revenue, from $5,920,000, or 63.9% of revenue, in 2003. The 27.0% increase in royalty
income in 2004 resulted from increased sales volume of the Autoscope Solo Pro product by
Econolite.

Total
gross profit was $8,910,000, or 82.3% of revenue, in 2004, compared to $7,449,000, or
80.5% of revenue, in 2003. 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 product sales decreased to 51.7% of sales in 2004
from 54.1% of sales in 2003. The decrease was due primarily to an unusually large
non-recurring sale of low margin cameras in January 2004 and discounting of the
non-Autoscope product by our Asian subsidiary in the second half of 2004 in order to sell
out inventory of a product we no longer planned on carrying. Margins on sales of the Solo
Pros, RackVision and Autoscope NC, were stable in 2004. We expect the revenue mix to
change marginally in 2005 if we increase product sales in Asia and Europe faster than
Econolite increases royalty-generating sales in North America and Latin America. In this
case, our gross profit margins will decrease since the margin on royalty income (95.7%) is
significantly greater than on product sales (51.7%).

Selling,
marketing and product support expenses were $2,523,000, or 23.3% of revenue, in 2004,
compared to $2,452,000, or 26.5% of revenue, in 2003. The small increase in total dollars
expended resulted primarily from annual pay adjustments and adding one support person in
Europe. We anticipate adding sales and product support personnel and increasing our
marketing efforts in Europe in 2005. As a result, we expect selling and marketing expenses
to increase in real terms in 2005, but we do not expect these expenses to increase as a
percentage of revenue. General and administrative expenses were $1,317,000, or 12.2% of
revenue, in 2004, compared to $1,235,000, or 13.3% of revenue, in 2003. The increase was
due primarily to annual pay adjustments. We expect these expenses to increase in 2005 as
we incur added audit and other professional fees associated with expansion in

12

---

Europe and planning for
Sarbanes-Oxley compliance in 2006, but we do not expect these expenses to increase as a
percentage of revenue. Research and development expenses totaled $1,126,000, or 10.4% of
revenue, in 2004, compared to $814,000, or 8.8% of revenue, in 2003. 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
approximately 29% in 2005 as we complete or advance the development of several new
products.

Income
taxes were $1,352,000 or 33.4% of pretax income in 2004, compared to $836,000 or 28.1% of
pretax income in 2003. 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 less benefit from tax credit carryforwards and higher effective tax rates on
foreign earnings than the previous year.

Net
income was $2,694,000 in 2004, compared to $2,135,000 in 2003 due to the factors discussed
above.

Liquidity and Capital
Resources

At
December 31, 2004, we had $1,262,000 in cash and cash equivalents, compared to $2,034,000
at December 31, 2003. Net cash provided by operating activities was $2,563,000 in 2004,
compared to $3,014,000 in 2003. The decrease was due primarily to (1) increased payments
of income taxes due for 2003 and estimated income taxes for 2004, included in prepaid
expenses, and (2) increased 2004 fourth quarter royalty income compared to 2003 which was
not collected by December 31, 2004, which more than offset increased cash flow from
increased profitability in 2004, compared to 2003. Another significant source of cash was
proceeds from issuance of common stock as employees exercised stock options in 2004. The
only other significant use of cash in 2004 was investing $2,300,000 in callable Federal
Home Loan bonds and $1,650,000 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. The short-term investments are AAA rated tax-exempt government-backed student loan
bonds that can either be rolled over or cashed out every 35 days with interest rates reset
every 35 days based on auction bidding.

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 5.75% at December 31, 2004). Loans would be
unsecured except for the banks right of setoff against checking, savings and other
accounts we have with the bank. We had no outstanding borrowings under the credit
agreement in 2004 or 2003.

We
believe that cash and cash equivalents on hand at December 31, 2004, 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. If carrying value exceeds fair value, the
          excess is recorded as an impairment loss. We estimate the fair value by using
          the income approach, where fair value is dependent on the present value of
          future economic benefits to be derived from ownership of Flow Traffic. No
          impairment of goodwill was recorded as of December 31, 2004 and 2003.

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 and Latin America. This report is prepared by Econolite based on
its sales of products we developed and is based on sales

13

---

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.
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. SFAS 123R for Small Business Issuers will be effective
for all interim and annual periods beginning after December 15, 2005. The Company will
adopt this standard January 1, 2006 and it is not expected to have a material impact on
its 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.

14

---

# 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 ($98,000 in 2003) |            
|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 $1,383,000 ($1,125,000 in 2003)                                                            |            
|Other assets                                                                                               |            
|                                                                                                           |            
|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,                                                |            
|3,537,222 issued and outstanding (3,288,177 in 2003)                                                       |            
|Additional paid-in capital                                                                                 |            
|Retained earnings                                                                                          |            
|                                                                                                           |            
|Total shareholders equity                                                                                 |            
|                                                                                                           |            
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                 |            
|                                                                                                           |            

See accompanying
notes.

15

---

# IMAGE SENSING SYSTEMS,
INC.CONSOLIDATED STATEMENTS OF INCOME

|                                                      | Year ended December 31
|----------------------------------------------------- | ----------------------
|
|Revenue:                                              |                       
|Product sales                                         |                       
|Royalties                                             |                       
|                                                      |                       
|                                                      |                       
|Cost of revenue:                                      |                       
|Product 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.

16

---

# 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 Federal Home Loan Bank Bonds                              |                       
|Purchase of short-term investments                                    |                       
|Sale of short-term investments                                        |                       
|Purchases of property and equipment                                   |                       
|Proceeds from sale of other asset                                     |                       
|                                                                      |                       
|Net cash used in investing activities                                 |                       
|                                                                     
|Financing activities:                                                 |                       
|Payment to former shareholders of subsidiary                          |                       
|Proceeds from exercise of stock options                               |                       
|                                                                      |                       
|Net cash provided by (used in) 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.

17

---

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

|                               | SharesIssued | CommonStock | AdditionalPaid-InCapital | RetainedEarnings | Total
|------------------------------ | ------------ | ----------- | ------------------------ | ---------------- | -----
|                               |              |             |                          |                  |      
|Balance at December 31, 2002   |              |             |                          | 3,175,777        |      
|                              
|Tax benefit from disqualifying |              |            
|disposition                    |              |             |                          |                  |      
|Common stock issued for        |              |            
|options exercised              |              |             |                          | 112,400          |      
|Compensation in the form of    |              |            
|performance based options      |              |             |                          |                  |      
|Net income                     |              |             |                          |                  |      
|                               |              |             |                          |                  |      
|Balance at December 31, 2003   |              |             |                          | 3,288,177        |      
|                              
|Tax benefit from disqualifying |              |            
|disposition                    |              |             |                          |                  |      
|Common stock issued for        |              |            
|options exercised              |              |             |                          | 249,045          |      
|Net income                     |              |             |                          |                  |      
|                               |              |             |                          |                  |      
|Balance at December 31, 2004   |              |             |                          | 3,537,222        |      
|                               |              |             |                          |                  |      

See accompanying notes.

18

---

Notes to Consolidated Financial
Statements

---

December 31, 2004

# 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 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 Short-term investments
consist of a diversified portfolio of auction rate securities which have maturity dates
through 2038, but which are all callable in 2005.  We consider short-term investments as
available-for-sale.  Investments in callable Federal Home Loan Bank bonds mature in
2006 and 2007, but are callable either quarterly or semi-annually.  At December 31, 2004
and 2003, cost was equal to fair value and no amount was included as a separate component
of shareholders equity.

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.

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

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

19

---

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 all of the 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 The preparation of
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, 2004 or 2003.

IMPAIRMENT OF LONG-LIVED ASSETS We
determine losses on long-lived assets used in operations when indicators of impairment
are present and the undiscounted cash flows estimated to be generated by those assets are
less than the assets carrying amount.  No such losses were recorded in 2004 or 2003.

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 requires 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 were capitalized in 2004 or 2003.

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,
2004 and 2003, respectively, 401,000 and 383,000 common share equivalents were included
in the computation of diluted net income per share.  There were no anti-dilutive options
at December 31, 2004 or 2003.

20

---

At December 31, 2004, 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 9.

|                                          | Year Ended December 31
|----------------------------------------- | ----------------------
|2003                                     
|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 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. SFAS
123R for Small Business Issuers will be effective for all interim and annual
periods beginning after December 15, 2005. The Company will adopt this standard January 1,
2006 and it is not expected to have a material impact on its operating results.

21

---

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.     ACQUISITION
On January 7, 2002, we acquired the remaining 40% of Flow Traffic Ltd. from minority shareholders. The acquisition included
additional future cash payments totaling $450,000, secured by letters of credit. The
additional payments of $450,000 were paid in April 2003 and the letters of credit expired
on April 30, 2003.

3.     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 5.75% at December 31, 2004), expiring May 31, 2005. Loans would be unsecured
except for the banks right of setoff against checking, savings and other accounts we
have with the bank. We had no outstanding borrowings in 2004 or 2003. We expect to renew
the agreement at substantially the same terms and conditions prior to expiration.

4.     LEASE COMMITMENT
We rent office space and equipment under operating lease agreements expiring at various dates through April 2006. The leases
provide for monthly payments of $19,000 and we are responsible for our proportionate share
of increases in operating expenses that exceed a base rent factor. Rent expense amounted
to $217,000 in 2004 and $212,000 in 2003.

Future minimum annual lease payments
under noncancelable operating leases for the years ending December 31, 2005 and 2006 are
$125,000 and $8,000, 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        |            
|Less valuation allowance               |            
|Other                                  |            
|                                       |            
|                                       |            
|Deferred tax liabilities:              |            
|Capitalized software development costs |            
|                                       |            
|Net deferred taxes                     |            
|                                       |            

22

---

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 $534,000 in undistributed
earnings of our wholly-owned foreign subsidiaries at December 31, 2004.

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.

The components of income tax expense
are as follows for the years ended December 31, 2004 and 2003:

|                         | Year Ended December 31
|------------------------ | ----------------------
|                         | 2003                  
|Current:                 |                       
|Federal                  |                       
|State                    |                       
|Foreign                  |                       
|                         |                       
|                         |                       
|                         |                       
|Deferred:                |                       
|Federal                  |                       
|State                    |                       
|Foreign                  |                       
|                         |                       
|                         |                       
|                         |                       
|Total income tax expense |                       
|                         |                       

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

|                                        | December 31
|--------------------------------------- | -----------
|
|Federal tax statutory rate              |            
|State taxes, net of federal benefit     |            
|Research and development tax credits    |            
|Effect of lower rates on foreign income |            
|Change in valuation allowance           |            
|Adjustment of prior year tax credits    |            
|Other                                   |            
|                                        |            
|Income taxes                            |            
|                                        |            

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 $321,000 in 2004 and $277,000 in
2003.



We have sublicensed the right to
manufacture and market the Autoscope technology in North America 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 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 $7,521,000 in 2004 and $5,920,000 in 2003. Accounts receivable from
Econolite were $1,984,000 and $1,430,000 at December 31, 2004 and 2003, respectively.

23

---

7.     SIGNIFICANT CUSTOMERS
AND CONCENTRATION OF CREDIT RISK
We derived the following percentages of our net revenues from the following geographic regions:

|              |  | 2004
|------------- |  | ----
|Asia Pacific  |  |     
|Europe        |  |     
|North America |  |     

Royalty income from Econolite
comprised 69% and 64% of revenues in 2004 and 2003, 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.
Discretionary contributions of $50,000 and $42,000 were made to the plan for 2004 and
2003, respectively.

9.     STOCK OPTIONS
In February 1995, we adopted the 1995 Long-Term Incentive and Stock Option Plan (the 1995 Plan),
which provides 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 was amended and restated effective
May 17, 2001. The following table summarizes stock option activity for 2004 and 2003:



|                             |  | PlanOptionsAvailableFor Grant |  | Plan OptionsOutstanding | Non-PlanOptionsOutstanding |  | Weighted AverageExercise PricePer Share
|---------------------------- |  | ----------------------------- |  | ----------------------- | -------------------------- |  | ---------------------------------------
|                             | 
|
|Balance at December 31, 2002 |  |                               |  | 355,200                 |                            |  | 248,500                                
|Granted                      |  |                               |  | (43,000                 | )                          |  | 3,000                                  
|Exercised                    |  |                               |  |                         |                            |  | (40,400                                
|Expired                      |  |                               |  |                         |                            |  | (3,000                                 
|                             | 
|Balance at December 31, 2003 |  |                               |  | 312,200                 |                            |  | 208,100                                
|Granted                      |  |                               |  | (16,000                 | )                          |  |                                        
|Exercised                    |  |                               |  |                         |                            |  | (112,950                               
|                             | 
|Balance at December 31, 2004 |  |                               |  | 296,200                 |                            |  | 95,150                                 
|                             | 

The following table summarizes
information about the stock options outstanding at December 31, 2004.

|           | Options Outstanding |  | Options Exercisable
|---------- | ------------------- |  | -------------------
|           |                     |  |                    
|
|           |                     |  |                    
|$1.30-1.99 |                     |  |                    
|2.00-2.99  |                     |  |                    
|3.00-3.99  |                     |  |                    
|7.00-7.93  |                     |  |                    
|           |                     |  |                    
|           |                     |  |                    
|           |                     |  |                    

24

---

The weighted average fair value of
the options granted during 2004 and 2003 amounted to $56,000 and $291,000, respectively.
The fair value of each option granted is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average assumptions used:
zero dividend yield; expected volatility of 127% in 2004 and 137% in 2003; risk-free
interest rate of 4.27% in 2004 and 2.97% in 2003; and expected life of 10 years for 2004
and 5 years for 2003.

25

---

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 as of December
31, 2004 and 2003, and the related consolidated statements of income, shareholders
equity, and cash flows for each of the two years in the period ended December 31, 2004.
These financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these 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 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 financial
statements referred to above present fairly, in all material respects, the consolidated
financial position of Image Sensing Systems, Inc. and subsidiaries at December 31, 2004
and 2003, and the consolidated results of their operations and their consolidated cash
flows for each of the two years in the period ended December 31, 2004 in conformity with
accounting principles generally accepted in the United States of America.

/s/Grant Thornton LLP

Minneapolis, Minnesota
February 23, 2005

26

---

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

No
additional disclosure is required regarding our change in independent accountants, as
disclosed in our Form 8-K filed on January 9, 2003.

# 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, the Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, our disclosure
controls and procedures were adequately designed to ensure that information required to be
disclosed by us in the reports we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in applicable rules
and forms.

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

No
information was required to be disclosed in a report on Form 8-K in the fourth quarter
that was not so disclosed.

# PART III

# Item 9.     Directors,
Executive Officers, Promoters and Control Persons; Compliance with Section 16(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 Chief Executive Officer or Chief Financial Officer will be published on our
website.

The
sections entitled Item 1, Election of Directors, Report of the Audit
Committee and Section 16(a) Beneficial Ownership Reporting Compliance in
our definitive proxy statement for our 2005 annual meeting of shareholders to be filed on
or before May 2, 2005, 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 2005 annual meeting of
shareholders are incorporated into this Form 10-KSB by reference.

# Item 11.     Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Equity
Compensation Plan Information

27

---

The
following table provides information as of December 31, 2004, about our shares of common
stock subject to outstanding awards or available for future awards under our equity
compensation plans and arrangements.

|Plan Category                                          | Number of securities to be issued upon exercise of outstanding options,warrants and rights | Weighted-average exercise price of outstanding
                options, warrants and rights | Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected
in the first column)(2)
|------------------------------------------------------ | ------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------
|Equity compensation plans approved by shareholders(1)  | 447,815                                                                                    | $3.13                                                                                       | 296,200                                                                                                                                             
|Equity compensation plans not approved by shareholders |                                                                                           |                                                                                            |                                                                                                                                                    
|Total                                                  | 447,815                                                                                    | $3.13                                                                                       | 296,200                                                                                                                                             

(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 296,200 shares available for grant under the 1995 Long-Term Incentive and
          Stock Option 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 2005 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 2005 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

28

---

|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.
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

29

---

|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.
|------ |  | --------------------------------------------------------------------------------------------------

|21 |  | List
of Subsidiaries of ISS.
|-- |  | ----------------------------

|23.1 |  | Consent
of Grant Thornton LLP.
|---- |  | ------------------------------

|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 Fees Paid to Independent Auditors and Policy on Audit
Committee Pre-Approval of Audit and Permissible Non-Audit Services Provided by Our
Independent Auditors in our definitive proxy statement for our 2005 annual meeting
of shareholders are incorporated into this Form 10-KSB by reference.

30

---

# 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.

|/s/   James Murdakes                                        |  | Date:   March 29, 2005 | 
|----------------------------------------------------------- |  | ---------------------- | 
|                                                            |  |                       
|By:   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 29, 2005 | 
|---------------------------------------------------------------------------------------------------------------- |  | ---------------------- | 
|                                                                                                                 |  |                       
|James Murdakes                                                                                                   | 
|President and Chief Executive Officer, Chairman of the Board of          Directors (Principal Executive Officer) | 
|                                                                                                                
|/s/   Arthur J. Bourgeois                                                                                        |  | Date:   March 29, 2005 | 
|                                                                                                                 |  |                       
|Arthur J. Bourgeois                                                                                              | 
|Chief Financial Officer          (Principal Financial & Accounting Officer)                                      | 
|                                                                                                                
|/s/   Panos G. Michalopoulos                                                                                     |  | Date:   March 29, 2005 | 
|                                                                                                                 |  |                       
|Panos G. Michalopoulos                                                                                           | 
|Director                                                                                                         | 
|                                                                                                                
|/s/   Richard P. Braun                                                                                           |  | Date:   March 29, 2005 | 
|                                                                                                                 |  |                       
|Richard P. Braun                                                                                                 | 
|Director                                                                                                         | 
|                                                                                                                
|/s/   Richard C. Magnuson                                                                                        |  | Date:   March 29, 2005 | 
|                                                                                                                 |  |                       
|Richard C. Magnuson                                                                                              | 
|Director                                                                                                         | 
|                                                                                                                
|/s/   Michael Eleftheriou                                                                                        |  | Date:   March 29, 2005 | 
|                                                                                                                 |  |                       
|Michael Eleftheriou                                                                                              | 
|Director                                                                                                         | 

31

---