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




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FORM 10-K





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|- | --------------------------------------------------------------------------------------
|x | ANNUAL
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008

OR

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|- | ------------------------------------------------------------------------------------------
|o | TRANSITION
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________
to ____________

Commission file number: 0-26056

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Image Sensing Systems, Inc.

(Exact name of registrant as specified in its charter)



|                                                                   |                                     
|------------------------------------------------------------------ | ------------------------------------
|Minnesota                                                          | 41-1519168                          
|(State or other jurisdiction of                                    | (I.R.S. Employer Identification No.)
|incorporation or organization)                                     |                                     
|                                                                   |                                     
|500 Spruce Tree Centre, 1600 University
 Avenue West, St. Paul, MN | 55104                               
|(Address of principal executive offices)                           | (Zip Code)                          

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

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

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

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

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

Indicate by
check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes o No x


Indicate by
check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.


Yes o No x


Indicate by
check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days.
                              Yes
x
No o

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

Indicate
by check mark whether the registrant is a large accelerated filer, an accelerated
filer, a non-accelerated filer or a smaller reporting company. See the
definitions of large accelerated filer, and accelerated filer, and smaller
reporting company in Rule 12b-2 of the Exchange Act. (Check one):

| |                                                 |  |                             
| | ----------------------------------------------- |  | ----------------------------
| | Large
 accelerated filer o                      |  | Accelerated
 filer o        
| |                                                 |  |                             
| | Non-accelerated
 filer o                        |  | Smaller
 reporting company x
| | (Do not
 check if a smaller reporting company.) |  |                             

Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Act).          Yes o No x

As of June 30,
2008, the aggregate market value of the registrants common stock held by
non-affiliates of the registrant was $46,705,011 based on the closing sale
price as reported on The NASDAQ Capital Market. The number of shares
outstanding of the registrants $0.01 par value common stock as of February 28,
2009 was 3,985,219 shares.







DOCUMENTS INCORPORATED BY REFERENCE

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|-------------------------------------------------------------------------------------------------- |  | -----------------------------
|Document                                                                                           |  | Parts Into Which Incorporated
|                                                                                                   |  |                              
|                                                                                                   |  |                              
|Proxy
 Statement for the Annual Meeting of Shareholders to be held
 May 20, 2009 (Proxy Statement) |  | Part III                     

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PART I

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|Item 1. | Business

Image
Sensing Systems, Inc. (referred to in this report as we, us, our and the
Company) develops and markets video and radar image processing products for
use in traffic applications such as intersection control, highway, bridge and
tunnel traffic management and traffic data collection.

We
are the leading provider of software-based computer enabled detection, or CED,
products and solutions for the intelligent transportation systems, or ITS,
industry. Our family of products, which we market as Autoscope® and RTMS®,
provides end users with the tools needed to optimize traffic flow, enhance
driver safety, regulate air quality and address emerging security/surveillance
concerns. Our technology analyzes signals from sophisticated sensors and
transmits the information to management systems and controllers or directly to
users.

CED
is a process in which software rather than humans examines outputs from various
types of sophisticated sensors to determine what is happening in a field of
view. In the ITS industry, CED is a critical component of managing congestion
and traffic flow. In many markets, it is not possible to build roads, bridges
and highways quickly enough to accommodate increasing automobile ownership. For
example, in 2007 there were approximately 3.0 million vehicles in Moscow, and
the number of vehicles is expected to increase by 50% to 4.5 million vehicles
by 2012. In China, 7.0 million vehicles were introduced in 2006, with this
figure increasing by 133% to 16.3 million additional vehicles expected in 2014.
We believe this growing use of vehicles worldwide will make CED-based ITS
solutions increasingly necessary to complement existing and new roadway
infrastructure to manage traffic flow and optimize throughput.

We
believe our CED solutions are technically superior to those of our competitors
because they have a higher level of accuracy, limit the occurrence of false
detection, are generally easier to install with lower costs of ownership, work
effectively in a multitude of light and weather conditions, and provide end
users the ability to manage inputs from a variety of sensors for a number of
tasks. It is our view that the technical advantages of our products make our
solutions ideally suited for use in ITS as well as adjacent markets. We believe
that the market for CED is increasingly favoring converged solutions that
include ITS, security/surveillance and environmental management, which we
expect to increase demand for CED products such as ours.

We
believe the strength of our distribution channels positions us to increase the
penetration of our technology-driven solutions in the marketplace. We market
our Autoscope products in North America, the Caribbean and Latin America
through an exclusive agreement with Econolite Control Products, Inc., or
Econolite, which we believe is the leading distributor of ITS intersection
control products in North America and the Caribbean. We market our Autoscope
products outside of North America, the Caribbean and Latin America and our RTMS
products through a combination of distribution and direct sales channels,
including our wholly-owned subsidiaries in Hong Kong, Poland and the United
Kingdom. Our end users primarily include governmental agencies and
municipalities, and, as of December 31, 2008, we had sold over 90,000 instances
in more than 60 countries.

In
December 2007, we completed our purchase of certain assets of EIS Electronic
Integrated Systems, Inc., or EIS. EIS was a leading provider of radar-based
detection solutions. In addition to the increased scale we gained through the
EIS asset purchase, the addition of EIS RTMS radar products enables us to
provide a wider array of CED products to our end users and support the
introduction of hybrid product offerings to help drive market demand. We
operate the EIS asset purchase business through ISS Image Sensing Systems
Canada Ltd., our wholly-owned subsidiary in Toronto, Ontario, Canada.

Industry Overview

The Intelligent Transportation Systems
Market. The market for ITS is large and growing.
According to a December 2007 report by Global Industry Analysts, Inc., total
ITS sales in the United States and Europe for 2007 were approximately $3.4
billion and $2.8 billion, respectively, and total global ITS sales were approximately
$8.7 billion. Global Industry Analysts expects total global ITS sales to reach
$12.5 billion by the end of 2010, representing a compound annual growth rate of
11.6% for the period from 2000 to 2010.

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ITS
encompasses a broad range of information processing and control electronics
technologies that, when integrated into roadway infrastructure, help monitor
and manage traffic flow, reduce congestion and enhance driver safety. The ITS market has been built around
the detection of conditions that impact the proper operation of roadway
infrastructure. ITS applications include a wide array of traffic management
systems, such as traffic signal control, automatic number plate recognition and
variable messaging signs. ITS technologies include video vehicle detection,
inductive loop detection, sensing technologies (such as radars), floating
cellular data, computational technologies and wireless communications.

In
traffic management applications, CED products are used for automated vehicle
detection and are a primary data source upon which ITS solutions are built.
Traditionally, automated vehicle detection is performed using inductive wire
loops buried in the pavement. However, in-pavement loop detectors are costly to
install, difficult to maintain, expensive to repair and not capable of
wide-area vehicle detection without installations of multiple loops.

Above-ground
CED solutions for ITS offer several advantages to in-pavement loop detectors.
Above-ground CED solutions tend to have lower total cost of ownership than
in-pavement loop detectors because above-ground CED solutions are
non-destructive to road surfaces, do not require closing roadways to install or
repair, and are capable of wide-area vehicle detection with a single device,
thus enabling one input device to do the work of many in-pavement loops. Due to
their location above ground, CED solutions have no exposure to the wear and
tear associated with expanding and contracting pavement and generally less
exposure to the vibration and compaction caused by traffic. Furthermore, in the
event of malfunction or product failure, above-ground CED solutions can be
serviced and repaired without shutting down the roadway. Each of these factors
results in greater up-time and increased reliability of above-ground CED
solutions compared to in-pavement loop detectors. Above-ground CED solutions
also tend to offer a broader set of detection capabilities and a wider field of
view than in-pavement loop detectors. For example, unlike in-pavement loops,
above-ground CED solutions can detect smoke and debris. In addition, a single
unit video- or radar-based CED system can detect and measure a variety of data
points, including vehicle presence, counts, speed, length, time occupancy,
headway and flow rate as well as environmental factors and obstructions to the
roadway. An equivalent installation using loops would require many
installations per lane.

We
believe our Autoscope and RTMS products are competitive with and can take
market share from in-pavement loop detectors. We believe the U.S. ITS video
detection market sales in 2007 were approximately $110 to $130 million and
growing at approximately 20% per year. We believe that we are the leader in the
U.S. video detection market in terms of unit sales, and we estimate that U.S.
sales of the in-pavement loop detectors our products can supplant were
approximately $500 million in 2007.

We
believe that several trends are driving the growth in ITS and adjacent market
segments:

Proliferation
of Traffic.In many
countries, there has been a surge in the number of vehicles on roadways. Due to
the growth of emerging economies and elevated standards of living, more people
desire and are able to afford automobiles. For example, in 2006 there were 7.0
million new vehicles introduced in China, and the number is expected to be 7.5
million in 2007 and 16.3 million by 2014. The number of vehicles utilizing the
worlds roadway infrastructure is growing at a quicker pace than new roads,
bridges and highways are being constructed. The population of the United States
has grown by about 30% or 70 million from 1982 to 2007, while highway miles
have increased by approximately 5% in the same period. Between 1970 and 2005,
the number of registered highway vehicles in the U.S. increased from 111
million to 247 million. Overall, the growth in roadway infrastructure is
failing to match the surge in the number of vehicles using it. CED-based
traffic management and control systems attempt to solve the problem by
monitoring high traffic areas and analyzing data that can be used to mitigate
traffic problems.

The
Demographics of Urbanization. Accelerated worldwide urbanization drives the creation and expansion
of middle classes and produces heightened demand for automobiles. Currently,
there are over 400 cities in the world with over 1 million people. Since
automobiles can be introduced to a metropolitan area faster than roadway
infrastructure can be constructed, the result is continuously worsening
traffic. Because expanding the roadway infrastructure is slow and costly to
implement, and often environmentally undesirable, government agencies are
increasingly turning to technology-based congestion solutions that optimize
performance and throughput of existing and new roadway infrastructure.
Detection is the requisite common denominator for any technology-based
solution.

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The
Melding of Large City Service Domains.Large cities require a wide range of service
domains, including traffic, security/surveillance and environmental protection.
These cities are increasingly turning to centralized management of these
service domains, employing a command and control model that requires sharing
and integrating data across service domains to operate effectively. For
example, data collected for the traffic management service domain is relevant
to all of the other service domains. This means that each CED sensor can supply
information to multiple domain services. In turn, we believe the sharing of
detection information across service domains will increase the level of
sophistication required to process and interpret that information.

Advances
in Wireless Technology Create the Ubiquitous Network.Businesses and government entities, motivated
by the need for improved productivity and functionality, are increasingly
adopting pervasive, networked information systems. The internet and widely
available broadband networks, including recent advances in wireless
technologies such as mesh networks, have greatly reduced the deployment costs
of adding broadly distributed CED solutions to existing information systems. We
believe that lower cost of deployment will increase demand for CED.

The
Ascendancy of CED.
Electronics of all sorts are becoming smaller and less costly to manufacture,
while becoming more capable of performing certain complicated tasks than
humans. CED solutions benefit from these trends. Of particular significance is
the evolving concept of hybrid detection in which two or more sensing types
such as radar and video are combined in a common CED device in which the
weaknesses of each are synergistically offset by the strengths of the other. By
leveraging a common digital signal processor and network interface, we believe
the incremental cost of a hybrid device will be significantly lower than
deploying multiple, single-sensor CED devices. This makes the concepts of rich
sensing and instrumenting the city through CED solutions cost effective,
which we believe will result in extensive proliferation of sophisticated
sensors and detection devices.

Solutions for Adjacent Markets. We believe
that the adjacent markets of ITS,
security/surveillance and environmental management are converging, and that
this convergence will accelerate as CED systems become more cost-effective when
a single CED unit can be used for multiple purposes. Because the CED
technologies involved are closely related, we believe our CED technology can be
adapted to or is already capable of addressing these adjacent markets.
According to Civitas Group, the global market for homeland security is
estimated in 2006 to have been approximately $55.0 billion; whereas
National Defense Magazine states that the environmental management market was
$520.0 billion in 2002. Both are growing.

We
believe that environmental management systems will become a necessity,
especially in large cities where the costs of air pollution are being
increasingly borne by city residents. Long traffic delays ensure that idling
vehicles have adverse effects on urban areas. In conjunction with video
detection for ITS, CED products can help governmental agencies reduce air
pollution and energy consumption by controlling traffic flow and reducing
travel time, accidents and delays. We believe that the convergence of traffic,
security/surveillance and environmental management should drive significant continued
CED demand growth.

Our Competitive Strengths

We
are the leading provider of software-based CED products and solutions for the
ITS industry. We have the following competitive strengths that we expect
will continue to enhance our leadership position in ITS and
adjacent industries:

Leading Proprietary Technologies. Over the
last two decades, we have developed
a proprietary portfolio of complex software algorithms and applications that we
have continuously enhanced and refined. These algorithms, which include our
advanced signal processing technologies, allow our video and radar detection
products to capture and analyze objects in diverse weather and lighting
conditions and to balance the accuracy of positive detection and the avoidance
of false detections. Due to the strength of these proprietary technologies, we
believe we command premium pricing and, as a result, have achieved, on average,
annual double-digit revenue growth over the last five years. CED technologies
similar to ours are also difficult to develop and refine in a commercially
viable manner. We therefore believe we are well positioned to quickly introduce
next-generation products to market and continue our historically strong growth.

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Proven Ability to Develop, Enhance and Market New
Products.
We are developing and enhancing our product offerings. Over the last two
decades, we have demonstrated the ability to lead the market with new products
and product enhancements. For example, we were the first company to provide our
end users with a fully integrated color camera, zoom lens and machine vision
processor in our Autoscope Solo system. Additionally, EIS was one of the first
companies to introduce radar-based technology solutions for ITS applications,
and it has continued to lead the market with technology enhancements and new
products, such as RTMS. We have successfully collaborated with our long-term
channel partners to market these new products. We believe that developing,
enhancing and marketing new products with our partners translates into strong
organic revenue growth and high levels of profitability.

Leading Distribution Channel. We have
maintained a relationship with
Econolite for the distribution of our Autoscope products in North America and
the Caribbean since 1991 and in Latin America since 2002. We believe that
Econolite is the leading distributor of ITS control products in North America
and the Caribbean. In our view, this relationship enhances our ability to
commercialize and market new products and allows us to focus on our core
business of advanced signal processing software algorithms. Although we expect
our percentage of revenue attributable to Econolite to somewhat lessen over the
next few years due to international diversification, we expect that our revenue
dollars attributable to Econolite will continue to grow.

Broad Product Portfolio. Our product
portfolio leverages our core
software-based algorithms for CED to enable end users to detect and monitor
objects in a designated field of view. We believe that our family of Autoscope
and RTMS products allows us to offer a broad product portfolio that meets the
needs of our end users. Additionally, our intention is to use our broad product
portfolio to offer hybrid products that satisfy traffic, security/surveillance
and environmental management requirements.

Experienced Management Team and Engineering
Staff. We transitioned to a new management team in
2007 charged with executing our growth strategy. Our management team is highly
experienced in the ITS and software industries. Additionally, we believe that
the continuity of our engineering staff allows us to continuously develop
improved products.

Strong Financial Performance. Over the past
five years, we have grown our
revenue organically at an average double-digit compound annual growth rate.
During this time, we maintained average net margins approaching 25%. As of
December 31, 2008, we had $28.5 million in shareholders equity. Our financial
performance and strength gives us the ability to take advantage of favorable
market trends without the restrictions that often handicap other nimble,
leading-edge technology companies similar to us in size.

Our Growth Strategy

As
part of our growth strategy, we seek to:

Enhance and Extend Our Technology Leadership in
ITS. We believe we have established ourselves as
the leading provider of CED in the ITS market segment. We believe that we now
have an opportunity to accelerate our growth while maintaining our
traditionally high level of profitability. We believe we will do this by improving
the accuracy and functionality of our products, opportunistically expanding our
product offering into adjacent markets, as well as expanding our portfolio and
channels through licensing or selected acquisitions. We intend to develop and
introduce hybrid CED products, which we believe will take advantage of our
technical leadership in ITS and further differentiate us from
our competitors.

Expand into Adjacent Markets. Our core
skill is the implementation of
software-based CED products and solutions. Over the past two decades, we have
been developing and refining our complex signal processing software algorithms.
We believe that our core software skills can be effectively utilized more
broadly as markets, including security/surveillance and environmental management
systems, converge. We believe that a driver of this convergence is that CED
systems will become more cost-effective when a single CED unit can be used for
multiple purposes. As a result, our objective is to become the leading supplier
of critical CED components to third party management systems, particularly
those that exploit the convergence of traffic, security/surveillance and
environmental management systems. To do this, we are integrating this concept
into our long-range engineering development road-map and will evaluate the use
of technology licensing, acquisition and channel strategies that support this
vision.

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Increase the Scope of Our Distribution and Direct
Sales. We
have made substantial investments in product adjustments to tailor our solutions
to the differing needs of our international end users. We have also invested in
the expansion of our European and Asian subsidiaries. We believe that markets
in Eastern Europe, the Asia/Pacific region, the Middle East, Africa and South
America, which have historically lagged North America and Western Europe in
their use of CED, have recently begun to increase the adoption of CED in their
traffic, security/surveillance and environmental management systems. We intend
to continue to refine our product offerings through engineering development,
technology licensing and/or acquisitions to take advantage of the accelerated
pace of adoption of CED throughout the developing world.

Grow Through Complementary Acquisitions. We
intend to pursue strategic acquisitions
that extend our technology leadership, breadth of product offerings and market
share in ITS and adjacent market segments. We expect to target acquisitions
that will serve as a platform for additional growth opportunities, including
new product offerings, technology enhancements and the introduction of new
sales and distribution channels. We intend to employ a selective and
disciplined approach when evaluating acquisition opportunities.

Our Products and Solutions

Our vehicle and traffic detection products are critical components of many ITS
applications, including intersection control, highway management and tunnel
safety. Our Autoscope video systems and RTMS radar systems convert sensory
input collected by video cameras and radar units into vehicle detection and
traffic data used to operate, monitor and improve the efficiency of roadway
infrastructure. At the core of each product line are proprietary digital signal
processing algorithms and sophisticated embedded software that analyze sensory
input and deliver actionable data to integrated ITS applications. Between ISS
and EIS, we spent approximately $2.9 million, $2.8 million, and $3.3 million on
research and development in 2008, 2007 and 2006, respectively, to develop and
enhance our Autoscope and RTMS technology. We believe our digital signal
processing software algorithms represent a foundation on which support for
additional sensory inputs such as audio, chemical, smoke, weather and vibration
sensors may be added in the future. A diagram displaying our fundamental
product architecture is shown below.

The Image Sensing Product Architecture

(FLOW CHART)

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Autoscope. Our Autoscope system
processes video input
from a traffic scene in real time and extracts the required traffic data,
including vehicle presence, counts, speed, length, time occupancy (percent of
time the detection zone is occupied), average headway (time interval between
vehicles) and flow rate (vehicles per hour per lane). Autoscope supports a
variety of standard video cameras or can be purchased with an integrated video
camera. For intersections, the system communicates with the intersection signal
controller, which changes the traffic lights based on the data provided. In
highway applications, the system gathers vehicle count and flow rates and
detects anomalous incidents, such as stopped or wrong-way vehicles. In tunnel
safety applications, Autoscope provides alerts to operators upon detecting
stopped, wrong-way or slow moving vehicles and upon detecting pedestrians,
debris or smoke. In any application, the data may also be transmitted to a
traffic management center via the internet or other standard communication
means and processed in real time to assist in traffic management and stored for
later analysis for traffic planning purposes.

All
systems come with the latest Autoscope software suite, which provides a
communications server and applications software for configuring, monitoring and
maintaining system installations. Using a computer mouse, desired detection
zones within a cameras field of view are programmed to specify where and what
type of traffic data is collected. The applications software graphical user
interface is currently available in 15 languages. A translation kit is
available to translate the graphical user interface into other local languages
as may be necessary or desired.

The
Autoscope system runs on our Terra platform, which we introduced in April 2007.
Enhancements to the Terra platform include the use of the Texas Instruments
DaVinci dual core advanced RISCTM machine and digital signal
processor, digital MPEG-4 streaming, high speed Ethernet interface, web browser
maintenance and data and video over power line communications.

The
Terra platform comes in the following two varieties:

Autoscope
Solo Terra. The
Autoscope Solo Terra is an integrated color zoom camera and machine vision
processing computer contained in one compact housing unit that is situated on
roadway infrastructure overlooking the traffic scene. The Solo Terra provides
the best performance of our platforms due to the high-quality video resulting
from the integration of camera and processor. The Solo Terra is our leading
Autoscope offering in the North American market.

Autoscope
RackVision Terra. The
Autoscope RackVision Terra allows end users to use standard video cameras (both
new or previously installed) with Autoscope technology. The RackVision Terra
consists of a machine vision processing computer that is located in an
intersection signal controller, control hub, incident management center or traffic
management center that receives video from a separate camera. The RackVision
Terra is our top selling Autoscope product in international markets.

RTMS. Our RTMS systems use radar to
measure
vehicle presence, volume, occupancy, speed and classification information for
roadway monitoring applications. Data is transmitted to a central computer at a
traffic management center via the internet or other standard communication
means, including wireless. Data can be processed in real-time to assist in
traffic management and stored for later analysis for traffic planning purposes.

RTMS
is an integrated radar transmitter/receiver and special purpose computer
contained in a compact, self-contained unit. The unit is typically situated on
roadway poles and side-fired, making it especially well suited for highway
detection applications.

Comparison of Video and Radar Detection.Video detection is best suited to
applications in which the ability to act on complex and detailed information is
desired. However, video can encounter difficulties in poorly-lit environments,
adverse weather conditions (such as fog or driving snow), in situations in
which vehicles are obscured (for example, by other vehicles), or in
extraordinarily dirty environments in which airborne particulates obscure the
view. Also, despite the compensating factors of using high-quality color
video, video can be susceptible to false detections due to shadows
or reflections. Radar is less able to distinguish fine details than video
but is considerably less affected by adverse environmental conditions and to
some degree can see through certain kinds of obstructions. It also does not
recognize shadows or visual reflections.

We
believe that by combining video and radar sensors and algorithmically comparing
their outputs, we will be able to offer our end users products that provide
superior accuracy. Hybrid CED detectors should be able to coalesce the
strengths of each type of sensor to overcome the others limitations. The
result will be improved overall performance in a broader range
of circumstances.

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Distribution, Sales and Marketing

We
market and sell our products globally. As of December 31, 2008, we had supplied
systems for more than 90,000 instances in more than 60 countries. Together with
our partners, we offer a combination of high-performance CED technology and
experienced local support. Our end users 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.

Autoscope North American, Caribbean and Latin
American
Sales.We
have granted Econolite an exclusive right to market and distribute the
Autoscope system in North America, the Caribbean and Latin America. The
agreement with Econolite grants it a first refusal right that arises when we
make a proposal to Econolite to extend the license to additional products in
North America, the Caribbean and Latin America and a first negotiation right
that arises when we make a proposal to Econolite to include rights
corresponding to Econolites rights under our current agreement in countries not
in these territories. Econolite provides the marketing and technical support
needed for its sales in these territories. Econolite pays us a royalty on the
revenue derived from its sales of the Autoscope system. We cooperate in
marketing Autoscope products with Econolite for North America, the Caribbean
and Latin America and provide second-tier technical support. We have the right
to terminate our agreement with Econolite if it does not meet minimum annual
sales levels or if Econolite fails to make payments as required by the
agreement. In 2008, the term of the agreement was extended to 2028. The
agreement can be terminated by either party upon three years notice.

RTMS North American, Caribbean and Latin American
Sales.We
market the RTMS system to a network of distributors covering countries in North
America, the Caribbean and Latin America. We provide technical support to these
distributors from our office in Toronto, Ontario, Canada.

European and Asian Sales.We market
Autoscope and RTMS to a network of
distributors covering countries in Europe, the Middle East, Africa and Asia
through wholly-owned subsidiaries that have offices in Hong Kong, Poland and
the United Kingdom. Technical support to these distributors is provided by our
wholly-owned subsidiaries in Europe and Asia, with second-tier support provided
by our Toronto office or our corporate headquarters in St. Paul, Minnesota.

Competition

We
compete with companies that develop, manufacture and sell traffic management
devices using machine vision and radar sensing technologies as well as other
above-ground CED technologies based on laser, infrared and acoustic sensors. We
also compete with providers of in-pavement loop detectors and estimate that
more than 80% of the traffic management systems currently in use in the U.S.
use in-pavement loop detectors. For competition with other above-ground CED
products, we typically compete on performance and functionality, and to a
lesser extent on price. When competing against providers of loop detectors, we
compete principally on ease of installation and the total cost of ownership
over a multi-year period, and to a lesser extent on functionality.

Among
the companies that provide direct competition to the Autoscope system worldwide
are Traficon N.V., Signal Group Inc. (Semex), Iteris, Inc. and Citilog S.A. Among the
companies that provide direct competition to RTMS worldwide are Wavetronix, LLC
and Xtralis, LLC. All of these companies have working installations of their
machine vision or radar systems in the U.S. and other parts of the world. To
our knowledge, however, these companies do not have as many installations as we
have. In addition, there are local companies providing direct competition in
specific markets such as Korea, China and Japan. We are aware that these and
other companies will continue to develop technologies for use in traffic
management and surveillance. One or more of these technologies could in the
future provide increased competition for our Autoscope and RTMS systems.

Other
potential competitors of which we are aware include Siemens AG, Cognex Corp.,
Matsushita Electric Industrial Co., Ltd. (Panasonic), Sumitomo Corporation,
Omron Electronics LLC and 3M Company. These companies have machine vision or
radar capabilities and have substantially more financial, technological,
marketing, personnel and research and development resources than we have.

7

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Manufacturing

We
currently have the Autoscope family of products for sale in North America, the
Caribbean and Latin America manufactured through agreements with Econolite and
Wireless Technology, Inc., or WTI. In 1991, we appointed Econolite as our
exclusive licensee to manufacture and sell the Autoscope system and related
technology and to sell the products in North America and the Caribbean. In
2002, we granted Econolite an exclusive license to sell Autoscope products in
Latin America, and we granted WTI a non-transferable license to use any of our
intellectual property as needed to manufacture Autoscope products for our use
and Econolites use. In Europe and Asia, we engage contract manufacturers to
manufacture the Autoscope family of products. Econolite provides a one-year
warranty on the Autoscope system and must provide all service required under
this warranty. WTI provides Econolite a limited two-year warranty on material
and workmanship on the products it manufactures. The terms of the warranties
vary for overseas manufacturers.

For
RTMS products, we engage contract manufacturers to produce subassemblies based
on our designs. These subassemblies are then shipped to our facilities in
Toronto, where we perform final assembly, testing and calibration and packaging
of finished units for shipment. For most RTMS products, we provide a two-year
warranty. We also perform warranty and post-warranty repairs of RTMS units in
Toronto.

Most
of the hardware components used to manufacture our products are standard
electronics components that are available from multiple sources. Although some
of the components used in our products are obtained from single-source
suppliers, we believe other component vendors are available should the necessity
arise. To our knowledge, our contract manufacturing and component vendors in
Europe and Asia comply with the European directive on RoHS, which is the
restriction of the use of certain hazardous substances in electrical and
electronic equipment.

Intellectual
Property

To
protect our rights to our proprietary know-how, technology and other
intellectual property, it is our policy to require all employees and
consultants to sign 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. In
addition, in the EIS asset purchase, we acquired six patent applications on
file with the U.S. Patent and Trademark Office relating to the RTMS products.
We have been issued patents on two of these applications and a notice of
allowance on one application (meaning that it appears we are entitled to a
patent under the law), and the remaining three applications are pending. We
also rely on trade secret, copyright and trademark laws to protect our
intellectual property.

We
intend to protect our intellectual property assets and will actively seek, when
appropriate, protection for owned or licensed products and proprietary
information by means of U.S. and foreign copyrights, trademarks, patents and
contractual arrangements. We have registered trademark rights to Autoscope and
Autoscope Solo in 29 countries, including the U.S. and most European
countries, and we also have registered RTMS in the U.S.

We
entered into a license agreement with the University of Minnesota in 1991.
Under the agreement, the University granted us the exclusive right to make,
have made, use, sell and lease any product that incorporated knowledge,
information, know-how, software and devices in the possession of the
University, including a patent held by the University, related to a video vehicle
detection system developed by the University, including improvements to the
technology. The patent expired in July 2006. The expiration of the University
patent in July 2006 made the technology covered by the patent available to the
public, allowing others to use the technology to design, manufacture and sell a
product which could compete with our Autoscope product. However, since 1991, we
have extensively added to the technology and product design to include our own
intellectual property, and we have made extensive moderations and revisions to
the University technology. We also developed our own techniques to made the
technology commercially feasible. Consequently, we believe that the expiration
of the University patent is not a threat to our business.

Employees

As
of February 28, 2009, we had 97 employees. We have 73 employees in our main
offices in St. Paul and Toronto and 24 employees in our overseas subsidiaries
in Hong Kong, the United Kingdom and Poland. None of our employees is represented
by a union. We believe our employee relations are good.

8

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Cautionary Statement

This
Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange of 1934, as amended. Forward-looking statements
represent our expectations or beliefs concerning future events and can be
identified by the use of forward-looking words such as believes, may,
will, should, intends, plans, estimates, or anticipates or
other
comparable terminology. Forward-looking statements are subject to risks and
uncertainties that may cause our actual results to differ materially from the
results discussed in the forward-looking statements. Some factors that might
cause these differences include the factors listed below. Although we have
attempted to list these factors comprehensively, we wish to caution investors
that other factors may prove to be important in the future and may affect our operating
results. New factors may emerge from time to time, and it is not possible to
predict all of these factors, nor can we assess the affect each factor or
combination of factors may have on our business.

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

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

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

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

A majority of our
revenue has been generated from sales of our Autoscope family of products, and
if we do not maintain the market for these products, our business will be
harmed.

Historically,
a majority of our revenue has been generated from sales of, or royalties from
the sales of, the Autoscope Vehicle Detection System. We anticipate that
revenue from the sale of the Autoscope system will continue to account for a
substantial portion of our revenue for the foreseeable future. As such, any
decline in sales of our Autoscope system would have a material adverse impact
on our business, financial condition and results of operations.

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

We
have an agreement with Econolite under which Econolite is the exclusive
distributor of the Autoscope system in North America, the Caribbean and Latin
America. The agreement also grants Econolite a first refusal right that arises
when we make a proposal to Econolite to extend the license to additional
products in North America, the Caribbean and Latin America and a first
negotiation right that arises when we make a proposal to Econolite to include
rights corresponding to Econolites rights under our current agreement in
countries not in these territories. In exchange for its rights under the
agreement, Econolite pays us royalties for sales of the Autoscope system. Since
2002, at least 50% of our revenue has consisted of royalties resulting from
sales made by Econolite, including 50% in 2008, 71% in 2007, and 77% in 2006.
Econolites account receivable represented 44% of our accounts receivable at
December 31, 2008 and 71% of our accounts receivable at December 31, 2007. We
expect that Econolite will continue to account for a significant portion of our
revenue for the foreseeable future. Any decrease in Econolites sales volume
could significantly reduce our royalty revenue and adversely impact earnings. A
failure by Econolite to make royalty payments to us in a timely manner or at
all will harm our financial condition. In addition, we believe sales of our
products are a material part of Econolites business, and any significant
decrease in Econolites sales of the other products it sells could harm
Econolite, which could have a material adverse effect on our business and
prospects.

9

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The features and
functions in our products have not been as widely utilized as traditional
products offered by our competitors, and the failure of our end users to
provide greater demand for the features and functions in our products could
adversely affect our business and growth prospects.

Machine
vision and radar technologies have not been utilized in the traffic management
industry as extensively as other more traditional technologies, mainly
in-pavement loop detectors. Our financial success and growth prospects depend
on the continued development of the market for advanced technology solutions
for traffic management and the acceptance of our Autoscope and RTMS systems,
and future systems we may develop, as reliable, cost-effective alternatives 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
our end users do not continue to increase their demand for the features and
functions provided by our Autoscope and RTMS systems, or hybrid or other
systems we may develop, our business and growth prospects could be adversely
affected.

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

Our
expense levels are based in part on our product development efforts and our
expectations regarding future revenues and, in the short-term, are generally
fixed. Our quarterly revenues, however, have varied significantly in the past,
with our first quarter historically being the weakest due to weather conditions
in North America, Europe and northern Asia that make roadway construction more
difficult. Additionally, our international revenues have a significant large
project component, resulting in a varying revenue stream. We expect the
seasonality of our revenue and the fixed nature of our operating costs to
continue in the foreseeable future. Therefore, we may be unable to adjust our
spending in a timely manner to compensate for any unexpected revenue shortfall.
As a result, if anticipated revenues in any quarter do not occur or are
delayed, our operating results for the quarter would be disproportionately
affected. Operating results also may fluctuate due to factors such as the
demand for our products, product life cycle, the development, introduction and
acceptance of new products and product enhancements by us or our competitors,
changes in the mix of distribution channels through which our products are
offered, changes in the level of operating expenses, end user order deferrals
in anticipation of new products, competitive conditions in the industry, and
economic conditions generally. No assurance can be given that we will be able
to achieve or maintain profitability on a quarterly or annual basis in the
future.

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

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

Additionally,
the market for vehicle detection is continuously seeking more advanced
technological solutions to traffic management and control problems.
Technologies such as embedded loop detectors, pressure plates, pneumatic tubes,
radars, lasers, magnetometers, acoustics and microwaves that have been used as
traffic sensing devices in the past will be enhanced for use in the traffic
management industry, and new technologies may be developed. We are aware of several
companies that are developing traffic management devices using machine vision
technology or other advanced technology. We expect to face increasingly
competitive product developments, applications and enhancements. New
technologies or applications in traffic control systems may provide our end
users with alternatives to the Autoscope and RTMS systems and could render our
solutions 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 end users, our business and financial results will suffer.

10

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

We
do not have, and do not intend to develop in the near future, internal
capabilities to manufacture our products. We have entered into agreements with
Econolite and Wireless Technology, Inc., or WTI, to manufacture the Autoscope
system and related products for sales in North America, the Caribbean and Latin
America. The hardware components for our RTMS products are made by
manufacturers in Taiwan and Canada, and the components are assembled and tested
in Canada. In addition, we work with suppliers, some of whom are overseas, to
manufacture Autoscope and RTMS products that need to comply with the European
Unions regulatory RoHS directive on the restriction of the use of certain
hazardous substances in electrical and electronic equipment. If Econolite, WTI
and our suppliers are unable to manufacture our products in the future, we may
be unable to identify other manufacturers able to meet product and quality
demands in a timely manner or at all. Our inability to find suitable
manufacturers for our products could result in delays or reductions in product
shipments, which in turn may harm our business reputation and results of
operations. In addition, we have granted Econolite the exclusive right to
market the Autoscope system and related products in North America, the
Caribbean and Latin America. Consequently, our revenue depends 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 revenue and market share for our
products.

We and our third
party manufacturers obtain some of the components of our products from a single
source, and an interruption in the supply of those components may prevent us
from meeting customers needs in a timely manner and could therefore reduce our
sales.

Although
substantially all of the hardware components incorporated into the Autoscope
and RTMS systems are standard electronics components that are available from
multiple sources, we and our third party manufacturers obtain some of the
components from a single source. The loss or interruption of any of these
supply sources could force us or our manufacturers to identify new suppliers,
which could increase our costs, reduce our sales and profitability, or harm our
customer relations by delaying product deliveries.

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

Our
success depends in large measure on the protection of our proprietary
technology rights. We rely on trade secret, copyright and trademark laws, and
confidentiality agreements with employees and third parties, all of which offer
only limited protection. We acquired six patent applications filed with the
U.S. Patent and Trademark Office, or USPTO, in the EIS asset purchase. We have
been issued patents on two of these applications and a notice of allowance on
one application (meaning that it appears we are entitled to a patent under the
law), and the remaining three applications are pending. However, we cannot
assure you that the scope of these or any future patents relating to our
products will exclude competitors or provide competitive advantages to us. We
also cannot assure you that we will become aware of all instances in which
others develop similar products, duplicate any of our products, reverse
engineer or misappropriate our proprietary technology. If our proprietary
technology is misappropriated, our business and financial results could be
adversely affected. Litigation may be necessary in the future to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. In addition, we may be
the subject of lawsuits by others who claim we violate their intellectual
property rights. Even if the result is favorable, litigation could result in
substantial costs and the diversion of management resources, either of which
could harm our business.

As
described above, although we have acquired six patent applications filed with
the USPTO, we have not applied for patent protection in all countries in which
we market and sell the Autoscope and RTMS systems. Consequently, our
proprietary rights in the technology underlying the Autoscope and RTMS systems
in countries other than the U.S. will be protected only to the extent that
trade secret, copyright or other non-patent protection is available and to the
extent we are able to enforce our rights. The laws of other countries in which
we market our products may afford little or no effective protection of our
proprietary technology, which could harm our business.

The expiration of
the University of Minnesota patent for certain aspects of our Autoscope system
may result in additional competition, which could adversely affect our revenue
and earnings.

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

11

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We plan to continue
introducing new products and technologies and may not realize the degree or
timing of benefits we initially anticipated, which could adversely affect our
business and results of operations.

We
regularly invest substantial amounts in research and development efforts that
pursue advancements in a range of technologies, products and services. Our
ability to realize the anticipated benefits of these advancements depends on a
variety of factors, including meeting development, production, certification
and regulatory approval schedules; execution of internal and external
performance plans; availability of supplier-produced parts and materials;
performance of suppliers and vendors; achieving cost efficiencies; validation
of innovative technologies; and the level of end user interest in new
technologies and products. These factors involve significant risks and
uncertainties. We may encounter difficulties in developing and producing these
new products and may not realize the degree or timing of benefits initially
anticipated. In particular, we cannot predict with certainty whether, when or
in what quantities our current or potential end users will have a demand for
products currently in development or pending release. Moreover, as new products
are announced, sales of current products may decrease as end users delay making
purchases until such new products are available. Any of the foregoing could
adversely affect our business and results of operations.

We price our
products at a premium compared to other technologies. As such, we may not be
able to quickly respond to emerging low-cost competitors, and our inability to
do so could adversely affect revenue and profitability.

We
price our products at a premium as compared to less sophisticated technologies.
As the technological sophistication of our competitors and the size of the
market increases, competing low-cost developers of machine vision products for
traffic are likely to emerge and grow stronger. If end users prefer low-cost
alternatives over our products, our revenue and profitability could be
adversely affected.

Our revenue could be
adversely affected by the emergence of local competitors and local biases in
international markets.

Our
experience indicates that local officials that purchase traffic management
products in the international markets we serve favor products that are
developed and manufactured locally. As local competitors to our products
emerge, local biases could erode our revenue in Europe and Asia and adversely
affect our sales and revenue in those markets.

Failure to predict
technological convergence could harm our business and could reduce our sales.

With
our Autoscope and RTMS product families, we currently utilize only certain
detection technologies available in the ITS field. If we fail to predict
convergence of technology preferences in the market for ITS, or fail to acquire
complementary businesses or products that broaden our current product
offerings, we may fail to capture certain segments of the market, which could
harm our business and reduce our sales.

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

During
2008, 2007 and 2006, 28%, 27% and 23% of our total revenue, respectively, was
attributable to international sales. We sell outside of the U.S. through our
agreement with Econolite, through our wholly-owned subsidiaries and through our
distributor network. By doing business in international markets, including
Canada, we are exposed to risks separate and distinct from those we face in our
domestic operations. Our international business may be adversely affected by
changing economic conditions in foreign countries. Because most of our sales
are currently denominated in U.S. dollars, if the value of the U.S. dollar
increases relative to foreign currencies, our products could become more costly
to the international consumer and therefore less competitive in international
markets, which could adversely affect our profitability. Furthermore, although
currently only a small percentage of our sales are denominated in non-U.S.
currency, this percentage may increase in the future, in which case
fluctuations in exchange rates could affect demand for our products. Engaging
in international business inherently involves a number of other difficulties
and risks, including:

| |   |                                                          
| | - | ---------------------------------------------------------
| |  | export
 restrictions and controls relating to technology;
| |   |                                                          
| |  | pricing
 pressure that we may experience internationally;

12

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

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

Our inability to
comply with European and Asian 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, or
WEEE, directive, which makes producers of electrical goods financially
responsible for specified collection, recycling, treatment and disposal of past
and future covered products. This directive must now be enacted and implemented
by individual European Union governments, and certain producers are to be
financially responsible under the WEEE legislation. This may impose on us
requirements, which, if we are unable to meet them, could adversely affect our
ability to market our products in European Union countries, and sales revenues
and profitability would suffer as a consequence. In addition, the European
Parliament has enacted a directive for the restriction of the use of certain
hazardous substances in electrical and electronic equipment, or RoHS. This
legislation governs restriction of the use of such substances as mercury, lead,
cadmium and hexavalent cadmium. If we are unable to have our product
manufactured in compliance with the RoHS directive, we would be unable to
market our products in European Union countries, and sales revenues and
profitability would suffer. In addition, various Asian governments could adopt
their own versions of environment-friendly electronic regulations similar to
the European directives, RoHS and WEEE. This could require new and
unanticipated manufacturing changes, product testing and certification
requirements, thereby increasing cost, delaying sales and lowering revenue and
profitability.

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 the successful training,
motivation and management of our employees. If we are unable to manage growth
successfully, our business and operating results will suffer.

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

Our
technology depends upon the knowledge, experience and skills of our key
management and 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, especially if
our business expands and requires us to employ additional personnel. In
addition, the loss of personnel or our failure to hire additional personnel
could materially and adversely affect our business, operating results and
ability to expand. The loss of key personnel, including Kenneth R. Aubrey, our
President and Chief
Executive Officer, and Dan Manor, the Managing Director of ISS Image Sensing
Systems Canada Ltd., or our inability to hire and retain qualified personnel,
will harm our business.

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EIS is party to a
lawsuit involving assets that we acquired from EIS in December 2007. If the
assets are determined to infringe a third partys patent and EIS and its
affiliates fail to fulfill their obligation to indemnify us or our affiliates,
or if our losses from the allegedly infringing technology exceed the
obligations of EIS and its affiliates to indemnify us, our business could
suffer.

In
2005, a third party sued EIS for patent infringement alleging infringement of
the patent held by the third party on automatic lane calibration. The allegedly
infringing technology is part of the assets we purchased in the EIS asset
purchase. In October 2007, the court entered a final judgment dismissing the
third partys claim of patent infringement, but the third party appealed the
courts order. Under the EIS asset purchase agreement, EIS agreed to defend
this litigation at its own expense, we are not responsible for any liabilities
of EIS or its affiliates arising before the closing of the EIS asset purchase
on December 6, 2007, and EIS and its affiliates are obligated to indemnify
us and our affiliates for any losses we or our affiliates incur in connection
with the litigation or disputed technology. However, if the EIS technology we
acquired is finally determined to infringe the third party patent and EIS and
its affiliates fail to satisfy their indemnification obligations to us or our
affiliates, or if our losses from the allegedly infringing technology exceed
the obligation of EIS or its affiliates to indemnify us, our business could
suffer.

Our stock is thinly
traded and our stock price is volatile.

Our
common stock is thinly traded, with 3,628,983 shares of our 3,985,219
outstanding shares held by non-affiliates as of February 28, 2009. Based on the
trading history of our common stock and the nature of the market for publicly
traded securities of companies in evolving high-tech industries, we believe
there are several factors that have caused and are likely to continue to cause
the market price of our common stock to fluctuate substantially. The
fluctuations may occur on a day-to-day basis or over a longer period of time.
Factors that may cause fluctuations in our stock price include announcements of
large orders obtained by us or our competitors, substantial cutbacks in
government funding of highway projects or of the potential availability of
alternative technologies for use in traffic control and safety, quarterly
fluctuation in our financial results or the financial results of our
competitors, consolidation among our competitors, fluctuations in stock market
prices and volumes, and the volatility of the stock market.

We may not be
successful in implementing our acquisition strategy. Future acquisitions could
result in disruptions to our business by, among other things, distracting
management time and diverting financial resources. Further, if we are unsuccessful
in integrating acquired companies into our business, it could materially and
adversely affect our financial condition and operating results.

Part
of our continuing business strategy is to acquire or invest in companies,
products or technologies that complement our current products, enhance our
market coverage or technical capabilities or offer growth opportunities. As
part of this strategy, in December 2007, we completed the EIS asset purchase.
We may not be able to identify suitable acquisition candidates or investment
partners or products in the future or, if we do, we may not be able to make
such acquisitions on commercially acceptable terms or at all. For any
acquisitions, including the EIS asset purchase, a significant amount of managements
time and financial resources may be required to complete the acquisition and
integrate the acquired business into our existing operations. Even with this
investment of management time and financial resources, an acquisition,
including the EIS asset purchase, may not produce the revenue, earnings or
business synergies anticipated. Acquisitions involve numerous other risks,
including assumption of unanticipated operating problems or legal liabilities,
problems integrating the purchased operations, technologies or products,
diversion of managements attention from our core businesses, restrictions on
the manner in which we may use purchased companies or assets imposed by
acquisition agreements, adverse effects on existing business relationships with
suppliers and customers, incorrect estimates made in the accounting for
acquisitions and amortization of acquired intangible assets that would reduce
future reported earnings (such as goodwill impairments), ensuring acquired
companies compliance with the requirements of the Sarbanes-Oxley Act,
and potential loss of customers or key employees of acquired businesses.
We cannot assure you that any acquisitions, investments, strategic alliances or
joint ventures, including the EIS asset purchase, will be completed in a timely
manner or achieve anticipated synergies, will be structured or financed in a
way that will enhance our business or creditworthiness, or will meet our
strategic objectives or otherwise be successful. In addition, we may not be
able to secure the financing necessary to consummate future acquisitions, and
future acquisitions and investments could involve the issuance of
additional equity securities or the incurrence of additional debt, which
could increase dilution or harm our financial condition or creditworthiness.

14

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Amounts recorded for goodwill could be
adversely impacted by current market conditions.

We
perform our annual impairment test of goodwill in December of each year or
whenever an impairment indicator arises, and we test our long-lived assets for
impairment when indicators of impairment are present. Our recorded goodwill
relates to our Hong Kong-based subsidiary, Flow Traffic Ltd., and certain
assets purchased from EIS. The impairment test requires us to estimate the fair
value of our reporting units and then compare it to the carrying value of the
reporting units. If the carrying value exceeds the fair value, further analysis
is performed to determine if there is an impairment loss. We estimate the fair
value primarily by using a combination of income and market approaches, where
fair value is dependent on the present value of future economic benefits to be
derived from ownership of Flow Traffic and the EIS assets. The future economic
benefits are significantly dependent on future revenue growth. If Flow Traffic
and the EIS assets do not provide the future economic benefits we project, the
fair value of these assets may become impaired, and we would need to record an
impairment loss. Fair market valuation requires assumptions and estimates of
many critical factors, including revenue and market growth, operating cash
flows, market multiples and discount rates. As general market conditions have
deteriorated, our Flow Traffic subsidiary and the EIS assets could experience a
decline in the fair market value, which could adversely affect the results of
the impairment testing that we perform in the future and could potentially lead
to a future impairment charge of some or all of our goodwill at one or both of
our reporting units, which totaled approximately $6,055,000 at December 31,
2008. In addition, the financial markets turmoil appears to be impacting common
stock trading prices for many companies, including ours. If our market
capitalization falls below our shareholders equity, it could trigger an
impairment of goodwill in the future.

Difficult and volatile conditions in the
capital, credit and commodities markets and in the overall economy could
materially adversely affect our financial position, results of operations and
cash flows, and we do not know if these conditions will improve in the near
future.

Our financial
position, results of operations and cash flows could be materially adversely
affected by difficult conditions and significant volatility in the capital,
credit and commodities markets and in the overall worldwide economy. These
factors, combined with declining business and consumer confidence and increased
unemployment, have precipitated a worldwide economic slowdown and fears of a
possible recession. The impact, if any, that these factors might have on us and
our business is uncertain and cannot be estimated at this time. Current
economic conditions have accentuated each of these risks and magnified their
potential effect on us and our business. The difficult conditions in these
markets and the overall economy affect our business in a number of ways. For
example:

|  |                                                                                                                                                                                                                                                                                                                                                                
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Although we
 believe we have sufficient liquidity under our financing arrangement with
 Associated Bank to run our business, under extreme market conditions, there
 can be no assurance that such funds would be available or sufficient, and, in
 such a case, we may not be able to successfully obtain additional financing
 on favorable terms, or at all.
|  |                                                                                                                                                                                                                                                                                                                                                                
| | Recent
 market volatility has exerted downward pressure on our stock price, which may
 make it more difficult for us to raise additional capital in the future.                                                                                                                                                                                                
|  |                                                                                                                                                                                                                                                                                                                                                                
| | Economic
 conditions could result in customers in our markets experiencing financial
 difficulties or electing to limit spending because of the declining economy
 which may result, for example, in declining tax revenue for our customers
 that are governmental entities, which in turn could result in decreased sales
 and earnings for us.              

Our directors and
executive officers have substantial control over us and could limit the ability
of our other shareholders to influence the outcome of key transactions,
including changes of control.

Our
executive officers and directors and entities affiliated with them, in the
aggregate, beneficially owned 15% of our outstanding common stock as of March
26, 2009, assuming the exercise by them of all of their options that were
currently exercisable or that vest within 60 days of March 26, 2009. Our
executive officers and directors and their affiliated entities, if acting
together, thus are able to control or influence significantly all matters
requiring approval by our shareholders, including the election of directors and
the approval of mergers or other significant corporate transactions. These
shareholders may have interests that differ from other shareholders, and they
may vote in a way with which other shareholders disagree and that may be
adverse to other shareholders interests. The concentration of ownership of our
common stock may have the effect of delaying, preventing or deterring a change
of control of our company, could deprive our shareholders of an opportunity to
receive a premium for their common stock as part of a sale of our company, and
may affect the market price of our common stock. This concentration of
ownership of our common stock may also have the effect of influencing the
completion of a change in control that may not necessarily be in the best
interests of all of our shareholders.

15

---



Our articles of
incorporation and bylaws, Minnesota law and the terms of the EIS asset purchase
agreement may inhibit a takeover that shareholders consider favorable.

Provisions
of our articles of incorporation and bylaws and applicable provisions of
Minnesota law may delay or discourage transactions involving an actual or
potential change in our control or change in our management, including
transactions in which shareholders might otherwise receive a premium for their
shares or transactions that our shareholders might otherwise deem to be in their
best interests. These provisions:

| |   |                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | permit our
 board of directors to issue up to 5,000,000 shares of preferred stock with
 any rights, preferences and privileges as it may designate, including the
 right to approve an acquisition or other change in our control;            
| |   |                                                                                                                                                                                                                                               
| |  | provide that
 the authorized number of directors may be changed by resolution of the board
 of directors;                                                                                                                                     
| |   |                                                                                                                                                                                                                                               
| |  | provide that
 all vacancies, including newly-created directorships, may, except as
 otherwise required by law, be filled by the affirmative vote of a majority of
 directors then in office, even if less than a quorum; and                  
| |   |                                                                                                                                                                                                                                               
| |  | eliminate
 cumulative voting rights, therefore allowing the holders of a majority of the
 shares of common stock entitled to vote in any election of directors to elect
 all of the directors standing for election, if they should so choose.

In
addition, Section 302A.671 of the Minnesota Business Corporation Act, or
MBCA, generally limits the voting rights of a shareholder acquiring a
substantial percentage of our voting shares in an attempted takeover or
otherwise becoming a substantial shareholder of our company unless holders of a
majority of the voting power of the disinterested shares approve full voting
rights for the substantial shareholder. Section 302A.673 of the MBCA
generally limits our ability to engage in any business combination with certain
persons who own 10% or more of our outstanding voting stock or any of our
associates or affiliates who at any time in the past four years have owned 10% or
more of our outstanding voting stock. These provisions may have the effect of
entrenching our management team and may deprive shareholders of the opportunity
to sell their shares to potential acquirers at a premium over prevailing
prices. This potential inability to obtain a control premium could reduce the
price of our common stock.

The
EIS asset purchase agreement also accelerates earn-out payments we must make to
EIS if we are acquired or sell substantially all of our assets before December
6, 2010. The required acceleration of these payments could negatively affect
the ability of our shareholders to obtain a premium over our prevailing stock
price and reduce our stock price generally.

We can issue shares
of preferred stock without shareholder approval, which could adversely affect
the rights of common shareholders.

Our
articles of incorporation permit our board of directors to establish the
rights, privileges, preferences and restrictions, including voting rights, of
future series of our preferred stock and to issue such stock without approval
from our shareholders. The rights of holders of our common stock may
suffer as a result of the rights granted to holders of preferred stock that may
be issued in the future. In addition, we could issue preferred stock to prevent
a change in control of our company, depriving common shareholders of an
opportunity to sell their stock at a price in excess of the prevailing market
price.

We do not intend to
declare dividends on our stock in the foreseeable future.

We
currently intend to retain all future earnings for the operation and expansion
of our business and, therefore, do not anticipate declaring or paying cash
dividends on our common stock in the foreseeable future. Any payment of cash
dividends on our common stock will be at the discretion of our board of
directors and will depend upon our operating results, earnings, current and
anticipated cash needs, capital requirements, financial condition, future
prospects, any contractual restrictions and any other factors deemed relevant
by our board of directors. Therefore, shareholders should not expect to receive
dividend income from shares of our common stock.

16

---



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

None.

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

We
currently lease and occupy 14,545 square feet in St. Paul, Minnesota for our
headquarters. This lease expires on May 31, 2010, and we have the right to
renew the lease for two additional three-year terms. Our office in Toronto,
Ontario, Canada consists of 6,227 square feet of space, and our lease for
this space expires in December 2010. We also lease smaller facilities in Hong
Kong, the United Kingdom and Poland. We believe that our facilities are
adequate to meet our current and expected needs.

We
believe that our current space is generally adequate in the United States, Asia
and Europe, and we do not intend to lease significantly more space in 2009.

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

We
are not currently a party to any material pending legal proceedings.

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

None.

17

---



PART II

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

Market Information

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

|        |  |      |       |      |   |       |  |     |       |  |   |       | 
|------- |  | ---- | ----- | ---- | - | ----- |  | --- | ----- |  | - | ----- | 
|        |  | 2008 |       | 2007 |  
|        |  |      |       |      |  
|        |  |      |       |      |   |       |  |     |       |  |   |       | 
|Quarter |  | High |       | Low  |   | High  |  | Low |      
|        |  |      |       |      |   |       |  |     |      
|        |  |      |       |      |   |       |  |     |       |  |   |       | 
|First   |  | $    | 17.50 |      | $ | 12.08 |  | $   | 18.90 |  | $ | 13.70 | 
|Second  |  |      | 16.40 |      |   | 11.37 |  |     | 19.70 |  |   | 14.86 | 
|Third   |  |      | 15.12 |      |   | 10.71 |  |     | 16.74 |  |   | 11.56 | 
|Fourth  |  |      | 12.00 |      |   | 6.12  |  |     | 18.54 |  |   | 11.65 | 

Shareholders

As
of March 22, 2009, there were 25 holders of record of our common stock and
approximately 1,708 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.

18

---



Comparative Stock Performance Graph

The
graph below compares the cumulative total stockholder return on our common
stock with the cumulative total stockholder return of (i) the Dow Jones
Wilshire 5000 Index, and (ii) the Dow Jones Wilshire Electronic Equipment
Index, assuming an investment of $100 on December 31, 2003, including
reinvestment of dividends.

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

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN

Among Image Sensing Systems, Inc., The Dow Jones Wilshire 5000 Index 
And The DJ Wilshire Electronic Equipment Index

(LINE GRAPH)

|                                         |  |       |        |       |   |        |  |       |        |       |   |        |  |   |        |  |   |       | 
|---------------------------------------- |  | ----- | ------ | ----- | - | ------ |  | ----- | ------ | ----- | - | ------ |  | - | ------ |  | - | ----- | 
|                                         |  |       |        |       |   |        |  |       |        |       |   |        | 
|                                         |  | 12/03 |        | 12/04 |   | 12/05  |  | 12/06 |        | 12/07 |   | 12/08  | 
|                                         |  |       |        |       |   |        |  |       |        |       |   |        | 
|Image
 Sensing Systems, Inc.             |  | $     | 100.00 |       | $ | 167.33 |  | $     | 132.08 |       | $ | 141.78 |  | $ | 172.08 |  | $ | 63.07 | 
|Dow Jones
 Wilshire 5000                 |  | $     | 100.00 |       | $ | 112.48 |  | $     | 119.65 |       | $ | 138.52 |  | $ | 146.30 |  | $ | 91.83 | 
|Dow Jones
 Wilshire Electronic Equipment |  | $     | 100.00 |       | $ | 106.94 |  | $     | 112.74 |       | $ | 129.91 |  | $ | 151.02 |  | $ | 88.80 | 

19

---



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

The
following table sets forth selected consolidated financial data for each of the
five fiscal years ended December 31, 2008. The statement of income and
balance sheet data for the years ended and as of December 31, 2008, 2007, 2006,
2005 and 2004 are derived from our audited consolidated financial statements.
The following information should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations and
with our consolidated financial statements and the related notes thereto
included elsewhere in this report.

|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|----------------------------------------------------- |  | -------------------------------------- | ------ | ---- | - | ------ | - | ---- | ------ | ---- | - | ------ |  | - | ------ | 
|                                                      |  | Fiscal
 Years Ended December 31,       |       
|                                                      |  |                                        |       
|                                                      |  | 2008                                   |        | 2007 |   | 2006   |   | 2005 |        | 2004 |  
|                                                      |  |                                        |       
|                                                      |  | (in
 thousands, except per share data) |       
|Consolidated
 Statement of Income Data:               |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Revenue:                                              |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|International sales                                   |  | $                                      | 7,455  |      | $ | 4,067  |   | $    | 2,980  |      | $ | 2,407  |  | $ | 3,309  | 
|North American sales                                  |  |                                        | 5,689  |      |   | 269    |   |      |       |      |   |       |  |   |       | 
|Royalties                                             |  |                                        | 13,321 |      |   | 10,747 |   |      | 10,136 |      |   | 8,595  |  |   | 7,521  | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Total revenue                                         |  |                                        | 26,465 |      |   | 15,083 |   |      | 13,116 |      |   | 11,002 |  |   | 10,830 | 
|Cost of revenue:                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|International sales                                   |  |                                        | 2,805  |      |   | 1,927  |   |      | 1,501  |      |   | 1,042  |  |   | 1,599  | 
|North American sales                                  |  |                                        | 2,107  |      |   | 60     |   |      |       |      |   |       |  |   |       | 
|Royalties                                             |  |                                        |       |      |   |       |   |      | 220    |      |   | 383    |  |   | 321    | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Total cost of revenue                                 |  |                                        | 4,912  |      |   | 1,987  |   |      | 1,721  |      |   | 1,425  |  |   | 1,920  | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Gross profit                                          |  |                                        | 21,553 |      |   | 13,096 |   |      | 11,395 |      |   | 9,577  |  |   | 8,910  | 
|Operating expenses:                                   |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Selling, marketing and product support                |  |                                        | 6,680  |      |   | 3,463  |   |      | 2,850  |      |   | 2,567  |  |   | 2,523  | 
|General and administrative                            |  |                                        | 4,069  |      |   | 2,653  |   |      | 2,383  |      |   | 1,400  |  |   | 1,317  | 
|Research and development                              |  |                                        | 2,908  |      |   | 2,299  |   |      | 2,639  |      |   | 1,516  |  |   | 1,126  | 
|Amortization of intangible assets                     |  |                                        | 768    |      |   | 51     |   |      |       |      |   |       |  |   |       | 
|In-process research and development                   |  |                                        |       |      |   | 4,500  |   |      |       |      |   |       |  |   |       | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|                                                      |  |                                        | 14,425 |      |   | 12,966 |   |      | 7,871  |      |   | 5,483  |  |   | 4,966  | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Income from operations                                |  |                                        | 7,128  |      |   | 130    |   |      | 3,524  |      |   | 4,094  |  |   | 3,944  | 
|Other income, net                                     |  |                                        | 43     |      |   | 543    |   |      | 523    |      |   | 252    |  |   | 102    | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Income before income taxes                            |  |                                        | 7,171  |      |   | 673    |   |      | 4,047  |      |   | 4,346  |  |   | 4,046  | 
|Income tax expense (benefit)                          |  |                                        | 2,207  |      |   | (199   | ) |      | 942    |      |   | 1,505  |  |   | 1,352  | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Net income                                            |  | $                                      | 4,964  |      | $ | 872    |   | $    | 3,105  |      | $ | 2,841  |  | $ | 2,694  | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Net income per share:                                 |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Basic                                                 |  | $                                      | 1.26   |      | $ | 0.23   |   | $    | 0.83   |      | $ | 0.79   |  | $ | 0.79   | 
|Diluted                                               |  |                                        | 1.24   |      |   | 0.22   |   |      | 0.80   |      |   | 0.73   |  |   | 0.71   | 
|                                                      |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Weighted average number of common shares
outstanding: |  |                                        |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Basic                                                 |  |                                        | 3,943  |      |   | 3,789  |   |      | 3,725  |      |   | 3,602  |  |   | 3,409  | 
|Diluted                                               |  |                                        | 4,001  |      |   | 3,881  |   |      | 3,891  |      |   | 3,868  |  |   | 3,810  | 

|                                  |  |                  |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|--------------------------------- |  | ---------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ | 
|                                  |  | At
 December 31, |       
|                                  |  |                  |       
|                                  |  | 2008             |        | 2007 |   | 2006   |  | 2005 |        | 2004 |  
|                                  |  |                  |        |      |   |        |  |      |        |      |  
|                                  |  | (in
 thousands)  |       
|Consolidated
 Balance Sheet Data: |  |                  |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Total assets                      |  | $                | 36,108 |      | $ | 30,388 |  | $    | 21,224 |      | $ | 16,791 |  | $ | 13,063 | 
|Bank debt                         |  |                  | 3,750  |      |   | 5,000  |  |      |       |      |   |       |  |   |       | 
|Total shareholders equity        |  |                  | 28,530 |      |   | 23,225 |  |      | 19,333 |      |   | 15,722 |  |   | 11,779 | 

20

---



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

The following discussion and
analysis of our
financial condition and results of operations should be read in conjunction
with the Selected Financial Data and our financial statements and the
accompanying notes. Our actual results could differ materially from those
anticipated in the forward-looking statements included in this discussion as a
result of certain factors, including, but not limited to, those discussed in
Risk Factors and Information Regarding Forward-Looking Statements included
elsewhere in this Annual Report.

Overview

General. We
provide software based computer enabled
detection, or CED, products and solutions that use advanced signal processing
software algorithms to detect and monitor objects in a designated field of
view. Our technology analyzes the signal from a sophisticated sensor and passes
the information along to management systems, controllers or directly to users. Our
core products, the Autoscope® Video Vehicle Detection System and the RTMS®
Radar Detection System, operate using our proprietary software in conjunction
with video cameras or radar and commonly available electronic components. Each
of these systems is used by traffic managers primarily to improve the flow of
vehicle traffic and to enhance safety at intersections, main thoroughfares,
freeways and tunnels.

Autoscope
systems are sold to distributors and end users of traffic management products
in North America, the Caribbean and Latin America by Econolite Control
Products, Inc., or Econolite, our exclusive licensee in these regions. We sell
RTMS systems to distributors and end users in North America. We also sell both
Autoscope and RTMS to distributors and end users in Europe and Asia through our
European and Hong Kong subsidiaries, respectively. End users of our products
throughout the world are generally funded by government agencies responsible
for traffic management or traffic law enforcement.

EIS Asset Purchase.
On December 6, 2007, we purchased certain assets from EIS Electronic Integrated
Systems Inc., or EIS, including its principal product line, the RTMS System. In
its fiscal year ended September 30, 2007, EIS had revenue of $8.7 million,
substantially all of which related to RTMS sales. Our consolidated financial
statements include revenue and expenses related to the operations of the former
EIS business from December 7, 2007 through December 31, 2008.

Trends and
 Challenges in Our Business

| | We believe
 recent growth in our business can be attributed primarily to the following
 global trends:
| | ------------------------------------------------------------------------------------------------------
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| | We believe
 our continued growth primarily depends upon:                                              
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| |                                                                                                      
| |                                                                                                       
| |                                                                                                      

21

---



| |   |                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our ability
 to develop new products, such as hybrid CED devices incorporating, for
 example, radar and video technologies, that provide increasingly accurate
 information and enhance the end users ability to cost-effectively manage
 traffic, security/surveillance and environmental issues.

Because
our principal end users are governmental entities, we are faced with challenges
related to potential delays in purchase decisions by those entities and changes
in budgetary constraints. These contingencies could result in significant
fluctuations in our revenue between periods. The current worldwide recession is
further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to
negatively affect 2009 revenue. We believe we may be a beneficiary of the
federal stimulus bill enacted early in 2009, but it is too early to determine
the level of impact to our operations.

Key Financial Terms and
Metrics

Revenue. Revenue historically
has been
derived from two sources: (1) royalties received from Econolite for sales of
the Autoscope system in North America, the Caribbean and Latin America and (2)
revenue received from direct sales of Autoscope systems in Europe and Asia.
Royalties from Econolite historically have provided the majority of our
revenue. We calculate the royalties using a profit sharing model where we split
the gross profit on sales of Autoscope product made through Econolite. This
royalty arrangement has the benefit of decreasing our cost of revenues and our
selling, marketing and product support expenses because these costs and
expenses are borne primarily by Econolite. Although this royalty model has a
positive impact on our gross margin, it also negatively impacts our total
revenue, which would be higher if all the sales made by Econolite were made
directly by us. The royalty arrangement is exclusive under a long-term
agreement. Our acquisition of the RTMS product line, which we assemble, gives
us an additional source of revenue that we expect will significantly increase
our overall revenue and lessen fluctuations in our revenue from period to
period due to our ownership of more than one product line and the higher
volumes it brings, notwithstanding normal seasonality.

Cost of Revenue. There is no
cost of
revenue related to royalties, as virtually all manufacturing, warranty and
related costs are incurred by Econolite. Cost of revenue related to direct
product sales consists primarily of the amount charged by our third party
contractors to manufacture the Autoscope and RTMS hardware platforms, which is
influenced mainly by the cost of electronic components. The cost of revenue
also includes logistics costs and estimated expenses for product warranties and
inventory reserves. The key metric that we follow is achieving certain gross
margin percentages by geographic region.

Operating Expenses. Our
operating expenses
fall into three categories: (1) selling, marketing and product support; (2)
general and administrative; and (3) research and development. Selling,
marketing and product support expenses consist of various costs related to
sales and support of our products, including salaries, benefits and commissions
paid to our personnel, commissions paid to third parties, travel, trade show
and advertising costs, second-tier technical support for Econolite, and general
product support, where applicable. General and administrative expenses consist
of certain corporate and administrative functions that support the development
and sales of our products and provide an infrastructure to support future
growth. General and administrative expenses reflect management, supervisory and
staff salaries and benefits, legal and auditing fees, travel, rent and costs
associated with being a public company, such as board of director fees,
Sarbanes-Oxley compliance, listing fees and annual reporting expenses. Research
and development expenses consist mainly of salaries and benefits for our
engineers and third party costs for consulting and prototyping. We measure all
operating expenses against our annually approved budget, which is developed
with achieving a certain operating margin as a key focus. Also included in
operating expenses is non-cash expense for intangible asset amortization.

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

22

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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 our
products was initially developed at the University of Minnesota. In 1989, the
University was awarded a patent for that technology, which it exclusively
licensed to us. In 1991, we sub-licensed this technology to Econolite, a
leading manufacturer and seller of traffic control products in North America
and the Caribbean, to manufacture and distribute products incorporating the
technology.

Segments. We currently operate
in two
reportable segments: Autoscope and RTMS. Autoscope is our machine-vision
product line, and revenue consists of royalties (all of which are received from
Econolite), as well as a portion of international sales. RTMS is our radar
product line acquired in the EIS asset purchase in December 2007, and revenue
consists of all North American sales and a portion of international sales. All
segment revenues are derived from external customers.

The
following table sets forth selected financial information for each of the
Companys reportable segments for the year ended December 31, 2008
(in thousands):

|                                   |  |           |        |      |   |        |  |   |        | 
|---------------------------------- |  | --------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                   |  | Autoscope |        | RTMS |   | Total  | 
|                                   |  |           |        |      |   |        | 
|Revenue                            |  | $         | 18,705 |      | $ | 7,760  |  | $ | 26,465 | 
|Depreciation                       |  |           | 242    |      |   | 115    |  |   | 357    | 
|Amortization
 of intangible assets |  |           |       |      |   | 768    |  |   | 768    | 
|Income
 before income taxes        |  |           | 5,939  |      |   | 1,232  |  |   | 7,171  | 
|Capital
 expenditures              |  |           | 273    |      |   | 112    |  |   | 385    | 
|Total assets                       |  |           | 24,135 |      |   | 11,973 |  |   | 36,108 | 

Results of Operations

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

|                                       |  |                         |       |      |  |       |   |  |       |  
|-------------------------------------- |  | ----------------------- | ----- | ---- |  | ----- | - |  | ----- | -
|                                       |  | Year
Ended December 31, |      
|                                       |  |                         |      
|                                       |  | 2008                    |       | 2007 |  | 2006  |  
|                                       |  |                         |       |      |  |       |  
|International sales                    |  |                         | 28.2  | %    |  | 27.0  | % |  | 22.7  | %
|North American sales                   |  |                         | 21.5  |      |  | 1.8   |   |  | ―     |  
|Royalties                              |  |                         | 50.3  |      |  | 71.2  |   |  | 77.3  |  
|                                       |  |                         |       |      |  |       |   |  |       |  
|Total revenue                          |  |                         | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|                                       |  |                         |       |      |  |       |   |  |       |  
|Gross margininternational sales       |  |                         | 62.4  |      |  | 52.4  |   |  | 49.6  |  
|Gross marginNorth American sales      |  |                         | 63.0  |      |  | 77.7  |   |  | ―     |  
|Gross marginroyalties                 |  |                         | 100.0 |      |  | 100.0 |   |  | 97.8  |  
|Selling, marketing and product support |  |                         | 25.2  |      |  | 23.0  |   |  | 21.7  |  
|General and administrative             |  |                         | 15.4  |      |  | 17.6  |   |  | 18.1  |  
|Research and development               |  |                         | 11.0  |      |  | 15.2  |   |  | 20.1  |  
|Amortization of intangibles            |  |                         | 2.9   |      |  | 0.3   |   |  | ―     |  
|In process research and development    |  |                         | ―     |      |  | 29.8  |   |  | ―     |  
|Income from operations                 |  |                         | 26.9  |      |  | 0.9   |   |  | 26.9  |  
|Income tax expense (benefit)           |  |                         | 8.3   |      |  | (1.3  | ) |  | 7.2   |  
|Net income                             |  |                         | 18.8  |      |  | 5.8   |   |  | 23.7  |  

Year Ended December 31, 2008
Compared to Year Ended
December 31, 2007.Total revenue increased
to $26.5 million in 2008 from $15.1 million in 2007, an increase of 75.5%.
Royalty income increased to $13.3 million in 2008 from $10.8 million in 2007,
an increase of 24.0%. The increase in royalty income reflects the continued
success of Econolites distribution of Autoscope in the North American market.
North American sales, which are sales of RTMS in North America, were $5.7
million in 2008. International sales, which include both Autoscope and RTMS
sales outside of North America, increased to $7.5 million in 2008 from $4.1
million in 2007, an increase of 83.3%. The increase in international sales was mainly
due to the addition of RTMS but also reflects market gains for Autoscope. We
acquired the RTMS family of products in December 2007.

23

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Gross
margins for international sales increased to 62.4% in 2008 from 52.4% in 2007.
The increase resulted mainly from the addition of RTMS, which typically earns
higher margins than Autoscope, and to a lesser extent by a revenue mix shift to
higher margin product in Autoscope. Gross margins on royalty income remained
consistent at 100.0% in 2008 and 2007. We anticipate that gross margins for our
international and North American sales will again be in the ranges of 60% to
65% in 2009, while we expect royalty gross margins will be 100% in 2009.

Selling,
marketing and product support expense increased to $6.7 million or 25.2% of
total revenue in 2008 from $3.5 million or 23.0% of total revenue in 2007. The
change related mostly to the addition of RTMS related expenses and to a lesser
extent to headcount additions in sales and product support. We anticipate that
selling, marketing and product support expense will increase both in terms of
actual expense and as a percentage of revenue in 2009 as compared to 2008 as we
invest in market expansion activities in Eastern Europe and Asia and realize
the impact of headcount additions made late in 2008.

General
and administrative expense increased to $4.1 million or 15.4% of total revenue
in 2008, up from $2.7 million or 17.6% of total revenue in 2007. The 2008
increase in costs resulted mainly from the addition of RTMS related expenses
and increased professional services expenses, including the costs of our
withdrawn follow-on offering. We anticipate that general and administrative
expense will be flat in terms of actual expense in 2009 as compared to 2008.

Research
and development expense increased to $2.9 million or 11.0% of total revenue in
2008, up from $2.3 million or 15.2% of total revenue in 2007. The increase was
directly related to the addition of RTMS related expenses and headcount
additions towards the end of the year. We anticipate that research and
development expense will increase both in terms of actual expense and as a
percentage of revenue in 2009 as compared to 2008 as we invest in video/radar
hybrid solutions and tailored international offerings and realize the impact
of headcount additions made late in 2008.

Amortization
of intangibles expense was $768,000 in 2008 and reflects the amortization of
intangible assets acquired in the EIS asset purchase. Assuming there are no
changes to our intangible assets, we anticipate amortization expense will be
$768,000 in 2009.

Other
income decreased to $43,000 in 2008 from $543,000 in 2007. In 2008, other
income fell due to lower cash and investment balances, lower interest rates and
interest expense on debt incurred for the EIS asset purchase. In 2007, other
income was mainly tax-exempt interest income, which was partially offset by
interest expense on bank debt incurred in December 2007.

Our
income tax effective rate was 30.8% in 2008. Our 2007 income tax effective rate
was not meaningful due to the significant in-process research and development
expense impact on pre-tax book income coupled with federal tax credits that
brought our position to a benefit. We expect the effective rate in 2009 to be
in the range of 30% to 35%.

Year Ended December 31, 2007
Compared to Year Ended
December 31, 2006.Total revenue increased
to $15.1 million in 2007 from $13.1 million in 2006, an increase of 15.0%.
International sales increased to $4.1 million in 2007 from $3.0 million in
2006, an increase of 36.7%. The increase was a result of growing acceptance of
Autoscope products in both Europe and Asia, resulting in new customers. Royalty
income increased to $10.7 million in 2007 from $10.1 million in 2006, an
increase of 6.0%. The increase in royalty income reflects the continued success
of Econolites distribution of Autoscope in the North American market. North
American sales were $269,000 in 2007. North American sales represent sales of
RTMS products from the date of the EIS asset purchase.

Gross
margins for international sales increased to 52.4% in 2007 from 49.6% in 2006.
Gross margins on royalty income increased to 100.0% in 2007 from 97.8% in 2006.
International gross margins were positively impacted by a shift in product
sales mix to higher margin products in 2007 versus 2006. Royalty gross margins
were positively impacted by the patent royalty we owed to the University of
Minnesota ending in the third quarter of 2006.

Selling,
marketing and product support expense increased to $3.5 million or 23.0% of
total revenue in 2007 from $2.9 million or 21.7% of total revenue in 2006. The
change related mostly to headcount additions and increased promotional expense
for the Autoscope Terra product line launch.

General
and administrative expense increased to $2.7 million or 17.6% of total revenue
in 2007, up from $2.4 million or 18.1% of total revenue in 2006. The 2007
increase resulted mainly from a combination of headcount additions, higher
stock option and bonus expenses and, to a lesser extent, increased audit, tax,
legal and consulting fees.

24

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Research
and development expense decreased to $2.3 million or 15.2% of total revenue in
2007, down from $2.6 million or 20.1% of total revenue in 2006. The decrease
was directly related to significant prototype material and consulting expenses
incurred in accelerating technical efforts on our next generation Autoscope
Terra product line in 2006 which did not carry into 2007.

Amortization
of intangibles expense was $51,000 in 2007 and reflects the amortization of
intangible assets acquired in the EIS asset purchase from December 7, 2007 to
December 31, 2007.

In-process
research and development expense was $4.5 million in 2007 ($3.0 million net of
tax). This expense was a result of a purchase price allocation component
related to the EIS asset purchase and is one-time in nature.

Other
income increased to $543,000 in 2007 from $523,000 in 2006. In 2007, other
income was mainly tax-exempt interest income which was partially offset by
interest expense on bank debt incurred in December 2007.

Our
income tax effective rate was not meaningful in 2007 due to the significant
in-process research and development expense impact on pre-tax book income
coupled with federal tax credits that brought our position to a benefit. Our
2006 income tax effective rate was unusually low due to a number of federal and
state adjustments.

Liquidity and Capital
Resources

At
December 31, 2008, we had $10.3 million in cash and cash equivalents and $4.0
million in restricted short-term investments, compared to $5.6 million in cash
and cash equivalents, $5.3 million in restricted cash and $-0- in investments
at December 31, 2007. As discussed below, our investments held at December 31,
2008 were auction rate securities that were redeemed or sold at par subsequent to
year-end.

Net
cash provided by operating activities was $5.2 million in 2008, compared to
$1.5 million and $4.6 million in 2007 and 2006, respectively. The primary
reasons for the 2008 change were the incremental net income increase in 2008,
significant increases in depreciation and amortization and stabilization of
working capital related to the EIS asset purchase. We purchased $4.0 million in
investments, net of redemptions, in 2008 as opposed to selling $4.1 million in
investments, net of purchases, in 2007. We also repaid $1.3 million in debt in
2008. We anticipate that average receivable collection days in 2009 will
increase over 2008 but that it will not have a material impact on our
liquidity. Our planned additions of property and equipment are discretionary,
and we do not expect them to exceed historical levels in 2009.

At
December 31, 2008, we held $4.0 million (par value) of investments comprised of
auction rate securities, or ARS. In January 2009, these ARS were redeemed at
par under a rights offering established in November 2008 by the broker/dealer.
Also in the fourth quarter of 2008, we sold $1.4 million of ARS at par held
through a different broker/dealer. After these two transactions, we no longer
hold any ARS.

In
May 2008, we entered into a financing arrangement with Associated Bank,
National Association, or Associated Bank, which replaced our loan agreements
with Wells Fargo Bank, N.A., including fully repaying those loans. Under the
arrangement with Associated Bank, we entered into a revolving line of credit
and a term loan. The revolving line of credit provides for up to
$5.0 million at an annual interest rate equal to the greater of 4.5% or
LIBOR plus 2.75%, as reset from time to time by Associated Bank. Advances on
the line of credit cannot exceed a borrowing base determined under a formula,
which is a percentage of the amounts of ARS and receivables. The line of credit
currently has $2.0 million in borrowings outstanding and matures on May 1,
2011. The term loan is for $3.0 million and has a fixed annual interest
rate of 6.75%. Repayment on the term loan is in equal monthly principal
installments over a 36-month period. As collateral, Associated Bank has a first
priority security interest in all of our assets, and we pledged all of our ARS.
As a result of the new financing arrangement with Associated Bank, ARS
investments were restricted as pledged to Associated Bank.

In
February 2009, we fully repaid the term loan and outstanding balances on the
revolving line of credit using the proceeds from our ARS redemption. We
believe, on an ongoing basis, we have regular availability to draw a minimum of
$3 million on our line of credit based on qualifying assets.

In
conjunction with our EIS asset purchase, the sellers have an earn-out
arrangement over approximately three years. The earn-out is based on earnings
from RTMS sales less related cost of revenue and operating expenses,
depreciation and amortization, and it is calculated annually. If the earnings
are at target levels, the sellers would receive $2.0 million annually, or $6.0
million in total. Superior performance of the assets could lead to an earn-out
in excess of $2 million, as the earn-out is not capped. Earn-out payments
generally are due within three months of the end of an earn-out period. The
first earn-out period ran from December 6, 2007 to December 31, 2008. Based on
the 2008 results for RTMS, the sellers of the RTMS business, also
known as the EIS assets, are entitled to receive a $1.2 million earnout
payment, which is expected be paid in March 2009. The liability has been
recorded on our balance sheet as of December 31, 2008, with an offsetting entry
to increase goodwill. If we are acquired or sell substantially all of our
assets before December 6, 2010, we must pay EIS $6.0 million less earn-out
amounts previously paid as an acceleration of potential earn-out payments under
the EIS asset purchase agreement.

25

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We
believe that cash and cash equivalents on hand at December 31, 2008, along with
our $5.0 million revolving line of credit and cash provided by operating
activities, will satisfy our projected working capital needs, payments under the
EIS earn-out, investing activities, and other cash requirements for the
foreseeable future

Off-Balance
Sheet Arrangements

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

Beginning
in 2009, we entered into a number of currency hedging arrangements. The purpose
of the hedging was to lock in what we believe to be favorable rates on certain
currencies and to increase our predictability on certain expenses at our
foreign subsidiaries. All hedging activity is intended to qualify for hedge
accounting under Statement of Financial Accounting Standard (SFAS) No. 133. We believe all contracts will be utilized to provide
funds to cover operating expenses.

Critical
Accounting Policies

Goodwill and Intangible
Assets.
Goodwill is not amortized but is tested for impairment annually or whenever an
impairment indicator arises. Our recorded goodwill relates to our Flow Traffic
subsidiary and assets purchased from EIS. Goodwill for the EIS asset purchase
was recorded in December 2007 and is tested for impairment annually on October
1, beginning in 2008. The Flow Traffic goodwill is tested for impairment on
December 31 of each year. We also reconcile the fair value of our business
segments to market capitalization on December 31 or during interim periods when
our consolidated shareholders equity is similar to or exceeds our market
capitalization. The impairment tests require us to estimate the fair value of
our subsidiary and then compare it to the carrying value of the subsidiary (or
the fair value of all business segments to shareholders equity for the entity
test). If the carrying value exceeds the fair value, further analysis is
performed to determine if there is an impairment loss.

For
Flow Traffic, we estimate the fair value by using a combination of the income
approach, where fair value is dependent on the present value of future economic
benefits to be derived from ownership of Flow Traffic, and the prior
transactions in company stock method. The future economic benefits are
significantly dependent on sustaining revenue growth in our Autoscope product
line. For the EIS assets, we estimate fair value by using a combination of the
income approach, where fair value is dependent on the present value of future
economic benefits to be derived from the RTMS product line, and the market
valuation approach, where the business was compared to guideline public company
price-earning multiples with a significant weighting to companies in the
traffic detection business. The future economic benefits are mainly dependent
on future revenue growth of the RTMS product line. No impairment of goodwill
was recorded as of December 31, 2008, 2007 and 2006. If Flow Traffic and/or the
EIS assets do not provide the future economic benefits we project, the fair
value of these assets may become impaired, and we would need to record an
impairment loss.

The
fair value of all combined business segments was estimated using a discounted
cash flow analysis of future income. The market value was determined by
multiplying the sum of common shares outstanding at December 31, 2008 and
outstanding in the money stock options (as reduced using the treasury stock
method), by our average share price in December 2008, in total, our market
capitalization, and adding to it a control premium. In most industries,
including ours, an acquiring entity typically is willing to pay more for a
controlling interest than an investor would pay for a fractional,
noncontrolling ownership interest. For purposes of this analysis, we used a
control premium of 30%. To determine the applicable control premium, we
observed data derived from acquisitions and trading multiples of companies in
our industry, in addition to overall data for companies operating in both the
software and manufacturing industries. We have concluded that the control
premium is reasonable and supports the differential between our market
capitalization and the estimated fair value of our combined business, and no
impairment was recorded. The analysis indicated the two values were close and
therefore if our market capitalization were to decrease in 2009 even slightly
from the level in December 2008 or if control premiums were to decrease, it is
likely that we would need to recognize some level of impairment loss. At
December 31, 2007 and 2006, our market capitalization exceeded our shareholders
equity by a significant margin, and the reconciliation process described above
was not performed for those years.

26

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Earn-outs
related to the EIS asset purchase are recorded as additional goodwill in the
year earned. Intangible assets are related to the EIS asset purchase for trade
names and technology and are amortized over their anticipated useful lives of
five to eight years.

Revenue Recognition.
Royalty income is recognized based upon a monthly royalty report provided to us
by Econolite. This report is prepared by Econolite based on its sales of
products we developed and is based on sales delivered and accepted by its
customers. We recognize revenue from North American and international sales at
the time of delivery and acceptance; the selling price is fixed or determinable;
and collectability 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 end user
demands. Sales returns and warranty allowances are estimated at the time of
sale based on historical experience.

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. Uncertain tax positions
are recognized if the tax position is more likely than not of being sustained
on audit based on the technical merits of the position.

Inventories.
Inventories are stated at the lower of cost (first-in, first-out method) or
market and allowances have been made for obsolete, excess or unmarketable
inventories based on estimated future usage or actual or anticipated product
line changes.

New and Recently Adopted
Accounting Pronouncements

In
September 2006, the Financial Accounting Standards Board (FASB) issued SFAS
No. 157, Fair Value Measurements.
SFAS No. 157 defines fair value, establishes a framework for measuring
fair value and expands disclosures about fair value measurement but does not
require any new fair value measurements. SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007
and interim periods within those fiscal years. However, on February 12, 2008,
the FASB issued proposed FASB Staff Position (FSP) FAS 157-2, which delayed the
effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually).
This FSP partially defers the effective date of SFAS No. 157 to fiscal
years beginning after November 15, 2008 and interim periods within those
fiscal years for items within the scope of this FSP. Effective for 2008, we
have adopted SFAS No. 157 except as it applies to those nonfinancial
assets and nonfinancial liabilities as noted in proposed FSP FAS 157-2. The
partial adoption of SFAS No. 157 impacted our disclosures surrounding our
restricted long-term investments. The adoption of the remaining portions of
SFAS No. 157 is not expected to have a material impact on our financial
statements.

On
February 15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities  Including an Amendment of FASB Statement No. 115.
This standard permits an entity to choose to measure many financial instruments
and certain other items at fair value. The fair value option established by
SFAS No. 159 permits all entities to choose to measure eligible items at
fair value at specified election dates. SFAS No. 159 is effective for the
Company as of January 1, 2008. The initial impact of adopting this
pronouncement had no effect on our consolidated financial statements because we
did not elect the fair value option for any financial assets or liabilities at
the beginning of 2008. During the year, SFAS No. 159 impacted our accounting
and disclosure of the put option received as part of our auction rate
securities settlement.

In
December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations. SFAS
No. 141(R) will significantly change the accounting for business
combinations. Under SFAS No. 141(R), an acquiring entity will be required
to recognize all the assets acquired and liabilities assumed in a transaction
at the acquisition-date fair value with limited exceptions. SFAS
No. 141(R) will change the accounting treatment for certain specific
items. SFAS No. 141(R) also includes a substantial number of new
disclosure requirements. SFAS No. 141(R) applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008. Earlier
adoption is prohibited. SFAS No. 141(R) will impact us if we complete an
acquisition after the effective date.

27

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In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial
Statements  An
Amendment of ARB No. 51. SFAS No. 160 establishes new
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 also
includes expanded disclosure requirements
regarding the interests of the parent and its noncontrolling interest. SFAS
No. 160 is effective for fiscal years, and interim periods with those
fiscal years, beginning on or after December 15, 2008. Earlier adoption is
prohibited. We are currently assessing the potential impact that the adoption
of SFAS No. 160 will have on our financial statements.

In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging
Activities  an
amendment of FASB Statement No. 133. SFAS No. 161 requires
enhanced disclosures about an entitys derivative and hedging activities and is
effective for financial statements issued for fiscal years beginning after
November 15, 2008. We are currently assessing the impact of SFAS
No. 161 on our disclosures.

In
April 2008, the FASB issued FSP FAS 142-3, Determination
of the Useful Life of Intangible Assets, to provide guidance for
determining the useful life of recognized intangible assets and to improve
consistency between the period of expected cash flows used to measure the fair
value of a recognized intangible asset and the useful life of the intangible
asset as determined under SFAS No. 142, Goodwill
and Other Intangible Assets. The FSP requires that an entity
consider its own historical experience in renewing or extending similar
arrangements. However, the entity must adjust that experience based on
entity-specific factors under FAS No. 142. FSP FAS 142-3 is effective for
fiscal years and interim periods that begin after November 15, 2008. The
Company intends to adopt FSP FAS 142-3 effective January 1, 2009 and to apply
its provisions prospectively to recognized intangible assets acquired after
that date. The Company has periodically purchased recognized intangible assets
and is in the process of evaluating the impact that the adoption of FSP FAS
142-3 will have on its financial statements.

In
May 2008, FASB issued SFAS No. 162, The
Hierarchy of Generally Accepted Accounting Principles. SFAS
No. 162 identifies the sources of accounting principles and the framework
for selecting the principles to be used in the preparation of financial
statements of nongovernmental entities that are presented in conformity with
generally accepted accounting principles. SFAS No. 162 is effective 60
days following the SECs approval of the Public Company Accounting Oversight
Board amendments to AU Section 411, The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles. We do not anticipate that the adoption of SFAS
No. 162 will materially impact the Company.

Item 7A. Quantitative
and Qualitative Disclosures About Market Risks

Our
foreign sales and results of operations are subject to the impact of foreign
currency fluctuations. We have not historically hedged our exposure to
translation gains and losses. A 10% adverse change in foreign currency rates
would not have a material effect on our results of operations or financial
position.

Beginning
in 2009, we entered into a number of currency hedging arrangements. The purpose
of the hedging was to lock in what we believe to be favorable rates on certain
currencies and to increase our predictability on certain expenses at our
foreign subsidiaries. All hedging activity is intended to qualify for hedge
accounting under SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities, as amended. We
believe all contracts will be utilized to provide funds to cover operating
expenses.

28

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

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

|                                                                                                                  |  |             |        |      |   |        | 
|----------------------------------------------------------------------------------------------------------------- |  | ----------- | ------ | ---- | - | ------ | 
|                                                                                                                  |  | December 31 |       
|                                                                                                                  |  |             |       
|                                                                                                                  |  | 2008        |        | 2007 |  
|                                                                                                                  |  |             |        |      |  
|ASSETS                                                                                                            |  |             |        |      |   |        | 
|Current
 assets:                                                                                                  |  |             |        |      |   |        | 
|Cash and cash equivalents                                                                                         |  | $           | 10,289 |      | $ | 5,613  | 
|Restricted cash                                                                                                   |  |             |       |      |   | 5,263  | 
|Restricted investments, net                                                                                       |  |             | 4,000  |      |   |       | 
|Accounts receivable, net of allowance for
 returns and doubtful accounts of $96 ($32 in 2007)                     |  |             | 6,620  |      |   | 4,997  | 
|Inventories                                                                                                       |  |             | 1,608  |      |   | 1,579  | 
|Prepaid expenses                                                                                                  |  |             | 376    |      |   | 228    | 
|Deferred income taxes                                                                                             |  |             | 376    |      |   | 142    | 
|                                                                                                                  |  |             |        |      |   |        | 
|Total current assets                                                                                              |  |             | 23,269 |      |   | 17,822 | 
|                                                                                                                  |  |             |        |      |   |        | 
|Property and equipment:                                                                                           |  |             |        |      |   |        | 
|Furniture and fixtures                                                                                            |  |             | 265    |      |   | 328    | 
|Leasehold improvements                                                                                            |  |             | 64     |      |   | 27     | 
|Equipment                                                                                                         |  |             | 1,631  |      |   | 1,220  | 
|                                                                                                                  |  |             |        |      |   |        | 
|                                                                                                                  |  |             | 1,960  |      |   | 1,575  | 
|Accumulated depreciation                                                                                          |  |             | 1,232  |      |   | 875    | 
|                                                                                                                  |  |             |        |      |   |        | 
|                                                                                                                  |  |             | 728    |      |   | 700    | 
|                                                                                                                  |  |             |        |      |   |        | 
|Deferred income taxes                                                                                             |  |             | 1,575  |      |   | 1,676  | 
|Intangible assets                                                                                                 |  |             | 4,481  |      |   | 5,249  | 
|Goodwill                                                                                                          |  |             | 6,055  |      |   | 4,891  | 
|                                                                                                                  |  |             |        |      |   |        | 
|TOTAL ASSETS                                                                                                      |  | $           | 36,108 |      | $ | 30,338 | 
|                                                                                                                  |  |             |        |      |   |        | 
|                                                                                                                  |  |             |        |      |   |        | 
|LIABILITIES AND SHAREHOLDERS
EQUITY                                                                              |  |             |        |      |   |        | 
|Current liabilities:                                                                                              |  |             |        |      |   |        | 
|Accounts payable                                                                                                  |  | $           | 251    |      | $ | 816    | 
|Current portion of bank debt                                                                                      |  |             | 1,000  |      |   | 5,000  | 
|Accrued compensation                                                                                              |  |             | 1,091  |      |   | 703    | 
|Accrued warranty and other                                                                                        |  |             | 793    |      |   | 510    | 
|EIS earnout payable                                                                                               |  |             | 1,164  |      |   |       | 
|Income taxes payable                                                                                              |  |             | 283    |      |   |       | 
|                                                                                                                  |  |             |        |      |   |        | 
|Total current liabilities                                                                                         |  |             | 4,582  |      |   | 7,029  | 
|                                                                                                                  |  |             |        |      |   |        | 
|Bank debt, less current portion                                                                                   |  |             | 2,750  |      |   |       | 
|Income taxes payable                                                                                              |  |             | 246    |      |   | 84     | 
|                                                                                                                  |  |             |        |      |   |        | 
|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, 3,985,219 issued and outstanding (3,927,806 in 2007) |  |             | 40     |      |   | 39     | 
|Additional paid-in capital                                                                                        |  |             | 11,652 |      |   | 11,004 | 
|Accumulated other comprehensive income
 (loss)                                                                    |  |             | (147   | )    |   | 161    | 
|Retained earnings                                                                                                 |  |             | 16,985 |      |   | 12,021 | 
|                                                                                                                  |  |             |        |      |   |        | 
|Total shareholders equity                                                                                        |  |             | 28,530 |      |   | 23,225 | 
|                                                                                                                  |  |             |        |      |   |        | 
|TOTAL LIABILITIES AND SHAREHOLDERS
EQUITY                                                                        |  | $           | 36,108 |      | $ | 30,338 | 
|                                                                                                                  |  |             |        |      |   |        | 

See accompanying notes to the consolidated
financial statements.

29

---



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

|                                                       |  |                          |        |      |   |        |   |   |        | 
|------------------------------------------------------ |  | ------------------------ | ------ | ---- | - | ------ | - | - | ------ | 
|                                                       |  | Years
 ended December 31 |       
|                                                       |  |                          |       
|                                                       |  | 2008                     |        | 2007 |   | 2006   |  
|                                                       |  |                          |        |      |   |        |  
|Revenue:                                               |  |                          |        |      |   |        |   |   |        | 
|International sales                                    |  | $                        | 7,455  |      | $ | 4,067  |   | $ | 2,980  | 
|North American sales                                   |  |                          | 5,689  |      |   | 269    |   |   |       | 
|Royalties                                              |  |                          | 13,321 |      |   | 10,747 |   |   | 10,136 | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|                                                       |  |                          | 26,465 |      |   | 15,083 |   |   | 13,116 | 
|Cost of revenue:                                       |  |                          |        |      |   |        |   |   |        | 
|International sales                                    |  |                          | 2,805  |      |   | 1,927  |   |   | 1,501  | 
|North American sales                                   |  |                          | 2,107  |      |   | 60     |   |   |       | 
|Royalties                                              |  |                          |       |      |   |       |   |   | 220    | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|                                                       |  |                          | 4,912  |      |   | 1,987  |   |   | 1,721  | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Gross profit                                           |  |                          | 21,553 |      |   | 13,096 |   |   | 11,395 | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Operating expenses:                                    |  |                          |        |      |   |        |   |   |        | 
|Selling, marketing and product support                 |  |                          | 6,680  |      |   | 3,463  |   |   | 2,850  | 
|General and administrative                             |  |                          | 4,069  |      |   | 2,653  |   |   | 2,382  | 
|Research and development                               |  |                          | 2,908  |      |   | 2,299  |   |   | 2,639  | 
|Amortization of intangible assets                      |  |                          | 768    |      |   | 51     |   |   |       | 
|In-process research and development                    |  |                          |       |      |   | 4,500  |   |   |       | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|                                                       |  |                          | 14,425 |      |   | 12,966 |   |   | 7,871  | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Income from operations                                 |  |                          | 7,128  |      |   | 130    |   |   | 3,524  | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Other income, net                                      |  |                          | 43     |      |   | 543    |   |   | 523    | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Income before income taxes                             |  |                          | 7,171  |      |   | 673    |   |   | 4,047  | 
|Income tax expense (benefit)                           |  |                          | 2,207  |      |   | (199   | ) |   | 942    | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Net income                                             |  | $                        | 4,964  |      | $ | 872    |   | $ | 3,105  | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Net income per share:                                  |  |                          |        |      |   |        |   |   |        | 
|Basic                                                  |  | $                        | 1.26   |      | $ | 0.23   |   | $ | 0.83   | 
|Diluted                                                |  |                          | 1.24   |      |   | 0.22   |   |   | 0.80   | 
|                                                       |  |                          |        |      |   |        |   |   |        | 
|Weighted average number of common shares
 outstanding: |  |                          |        |      |   |        |   |   |        | 
|Basic                                                  |  |                          | 3,943  |      |   | 3,789  |   |   | 3,725  | 
|Diluted                                                |  |                          | 4,001  |      |   | 3,881  |   |   | 3,891  | 

See accompanying notes to the consolidated
financial statements.

30

---



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

|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|---------------------------------------------------------------------------------- |  | ------------------------ | ------ | ---- | - | ------- | - | - | ------ | -
|                                                                                   |  | Years
 ended December 31 |       
|                                                                                   |  |                          |       
|                                                                                   |  | 2008                     |        | 2007 |   | 2006    |  
|                                                                                   |  |                          |        |      |   |         |  
|Operating activities:                                                              |  |                          |        |      |   |         |   |   |        |  
|Net income                                                                         |  | $                        | 4,964  |      | $ | 872     |   | $ | 3,105  |  
|Adjustments to reconcile net income to net
 cash provided by operating activities: |  |                          |        |      |   |         |   |   |        |  
|Depreciation                                                                       |  |                          | 357    |      |   | 226     |   |   | 226    |  
|Amortization                                                                       |  |                          | 768    |      |   | 51      |   |   | 162    |  
|In-process research and development                                                |  |                          |       |      |   | 4,500   |   |   |       |  
|Tax benefit from disqualifying
disposition                                         |  |                          | 137    |      |   | 112     |   |   | 113    |  
|Stock option expense                                                               |  |                          | 339    |      |   | 194     |   |   | 177    |  
|Deferred income taxes                                                              |  |                          | (133   | )    |   | (1,653  | ) |   | (203   | )
|Changes in operating assets and
 liabilities:                                      |  |                          |        |      |   |         |   |   |        |  
|Accounts receivable                                                                |  |                          | (1,623 | )    |   | (2,040  | ) |   | 557    |  
|Inventories                                                                        |  |                          | (29    | )    |   | (909    | ) |   | (358   | )
|Prepaid expenses                                                                   |  |                          | (148   | )    |   | (102    | ) |   | (22    | )
|Accounts payable                                                                   |  |                          | (565   | )    |   | 200     |   |   | 218    |  
|Accrued liabilities                                                                |  |                          | 671    |      |   | 177     |   |   | 511    |  
|Income taxes payable                                                               |  |                          | 445    |      |   | (147    | ) |   | 137    |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Net cash provided by operating
activities                                          |  |                          | 5,183  |      |   | 1,481   |   |   | 4,623  |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Investing activities:                                                              |  |                          |        |      |   |         |   |   |        |  
|Purchase of EIS assets                                                             |  |                          |       |      |   | (11,406 | ) |   |       |  
|Purchase of short-term investments                                                 |  |                          | (7,400 | )    |   |        |   |   | (1,800 | )
|Sale of short-term investments                                                     |  |                          | 3,400  |      |   | 1,800   |   |   |       |  
|Maturity of callable FHLB bonds                                                    |  |                          |       |      |   | 2,300   |   |   |       |  
|Purchases of property and equipment                                                |  |                          | (385   | )    |   | (104    | ) |   | (419   | )
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Net cash used in investing activities                                              |  |                          | (4,385 | )    |   | (7,410  | ) |   | (2,219 | )
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Financing activities:                                                              |  |                          |        |      |   |         |   |   |        |  
|Proceeds from exercise of stock options                                            |  |                          | 173    |      |   | 34      |   |   | 200    |  
|Proceeds from (repayment of) bank debt                                             |  |                          | (1,250 | )    |   | 5,000   |   |   |       |  
|Cash (restricted for) released from
 restriction on bank debt                      |  |                          | 5,263  |      |   | (5,263  | ) |   |       |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Net cash provided by (used in) financing
 activities                               |  |                          | 4,186  |      |   | (229    | ) |   | 200    |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Effect of exchange rate changes on cash                                            |  |                          | (308   | )    |   | 145     |   |   | 16     |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Increase (decrease) in cash and cash
 equivalents                                  |  |                          | 4,676  |      |   | (6,013  | ) |   | 2,620  |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Cash and cash equivalents at beginning of
 year                                    |  |                          | 5,613  |      |   | 11,626  |   |   | 9,006  |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Cash and cash equivalents at end of
year                                           |  | $                        | 10,289 |      | $ | 5,613   |   | $ | 11,626 |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Supplemental disclosure:                                                           |  |                          |        |      |   |         |   |   |        |  
|Income taxes paid                                                                  |  | $                        | 1,680  |      | $ | 1,352   |   | $ | 1,025  |  
|Interest expense paid                                                              |  | $                        | 278    |      | $ | 35      |   | $ |       |  
|                                                                                   |  |                          |        |      |   |         |   |   |        |  
|Supplemental non-cash disclosure:                                                  |  |                          |        |      |   |         |   |   |        |  
|Common stock issued in connection with EIS
 asset purchase                         |  | $                        |       |      | $ | 2,534   |   | $ |       |  
|EIS earnout payable recorded as additional
 goodwill                               |  | $                        | 1,164  |      | $ |        |   | $ |       |  

See accompanying notes to the consolidated financial statements.

31

---



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

|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|------------------------------------------ |  | -------------- | --------- | ------------- | - | ---------------------------- |  | ---------------------------------------------------- | ------ | ------------------ | - | ----- | - | - | ------ |  | - | ------ | -
|                                           |  | Shares
 Issued |           | Common
 Stock |   | Additional
 Paid-In
 Capital |  | Accumulated
 Other
 Compre-
 hensive
 Income
 (Loss) |        | Retained
 Earnings |   | Total |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |  
|Balance at December 31, 2005               |  |                | 3,702,005 |               | $ | 37                           |  | $                                                    | 7,641  |                    | $ |      |   | $ | 8,044  |  | $ | 15,722 |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Tax benefit from disqualifying disposition |  |                |          |               |   |                             |  |                                                      | 113    |                    |   |      |   |   |       |  |   | 113    |  
|Common stock issued for options exercised  |  |                | 59,799    |               |   | 1                            |  |                                                      | 199    |                    |   |      |   |   |       |  |   | 200    |  
|Stock option expense                       |  |                |          |               |   |                             |  |                                                      | 177    |                    |   |      |   |   |       |  |   | 177    |  
|Foreign currency translation adjustment    |  |                |          |               |   |                             |  |                                                      |       |                    |   | 16    |   |   |       |  |   | 16     |  
|Net income                                 |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   | 3,105  |  |   | 3,105  |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                       |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   |       |  |   | 3,121  |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2006               |  |                | 3,761,804 |               |   | 38                           |  |                                                      | 8,130  |                    |   | 16    |   |   | 11,149 |  |   | 19,333 |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Tax benefit from disqualifying disposition |  |                |          |               |   |                             |  |                                                      | 112    |                    |   |      |   |   |       |  |   | 112    |  
|Common stock issued for options exercised  |  |                | 18,800    |               |   |                             |  |                                                      | 34     |                    |   |      |   |   |       |  |   | 34     |  
|Common stock issued in EIS asset purchase  |  |                | 147,202   |               |   | 1                            |  |                                                      | 2,534  |                    |   |      |   |   |       |  |   | 2,535  |  
|Stock option expense                       |  |                |          |               |   |                             |  |                                                      | 194    |                    |   |      |   |   |       |  |   | 194    |  
|Foreign currency translation adjustment    |  |                |          |               |   |                             |  |                                                      |       |                    |   | 145   |   |   |       |  |   | 145    |  
|Net income                                 |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   | 872    |  |   | 872    |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                       |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   |       |  |   | 1,017  |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2007               |  |                | 3,927,806 |               |   | 39                           |  |                                                      | 11,004 |                    |   | 161   |   |   | 12,021 |  |   | 23,225 |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Tax benefit from disqualifying disposition |  |                |          |               |   |                             |  |                                                      | 137    |                    |   |      |   |   |       |  |   | 137    |  
|Common stock issued for options exercised  |  |                | 59,000    |               |   | 1                            |  |                                                      | 194    |                    |   |      |   |   |       |  |   | 195    |  
|Common stock retired                       |  |                | (1,587    | )             |   |                             |  |                                                      | (22    | )                  |   |      |   |   |       |  |   | (22    | )
|Stock option expense                       |  |                |          |               |   |                             |  |                                                      | 339    |                    |   |      |   |   |       |  |   | 339    |  
|Foreign currency translation adjustment    |  |                |          |               |   |                             |  |                                                      |       |                    |   | (308  | ) |   |       |  |   | (308   | )
|Net income                                 |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   | 4,964  |  |   | 4,964  |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                       |  |                |          |               |   |                             |  |                                                      |       |                    |   |      |   |   |       |  |   | 4,656  |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2008               |  |                | 3,985,219 |               | $ | 40                           |  | $                                                    | 11,652 |                    | $ | (147  | ) | $ | 16,985 |  | $ | 28,530 |  
|                                           |  |                |           |               |   |                              |  |                                                      |        |                    |   |       |   |   |        |  |   |        |  

See accompanying notes to the consolidated
financial statements.

32

---



Notes to Consolidated Financial Statements

December 31,
2008

|   |                                                            
|-- | -----------------------------------------------------------
|1. | DESCRIPTION
OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF
BUSINESS

Image
Sensing Systems, Inc. (referred to herein as we, the Company, us and our) develops and
markets software based computer enabled detection products for use in advanced
traffic management systems and traffic data collection. We sell our products
primarily to distributors and also receive royalties under a license agreement
with a manufacturer/distributor for one of our product lines. Our products are
used primarily by governmental entities.

PRINCIPLES OF
CONSOLIDATION

The
consolidated financial statements include the accounts of Image Sensing
Systems, Inc. and its wholly-owned subsidiaries: Flow Traffic Ltd. (Flow
Traffic) located in Hong Kong, Image Sensing Systems Europe Ltd. (ISS/Europe),
located in the United Kingdom, Image Sensing Systems Europe Limited SP.Z.O.O.
(ISS/Poland), located in Poland and ISS Image Sensing Systems Canada Ltd
(ISS/Canada) and ISS Canada Sales Corp. (Canada Sales Corp.), both located in
Ontario, Canada. 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 licensee that sells one of our
products in North America, the Caribbean and Latin America. The royalty is
calculated using a profit sharing model where we split evenly the gross profit
on sales of our Autoscope product made by Econolite. The royalty report is
prepared by Econolite based on its sales of licensed products delivered and accepted
by its customers. Payment of royalties is due after Econolite has received
payment from its customer.

We
recognize revenue from international and North American sales at the time of
shipment or delivery, the selling price is fixed or determinable and collection
of payment is reasonably assured. We record provisions against sales revenue
for estimated returns and allowances in the period when the related revenue is
recorded based on historical sales returns and changes in end user demand.

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. Cash located in foreign banks was $1.0 million and $1.2 million at
December 31, 2008 and 2007, respectively.

INVESTMENTS

Investments
and marketable securities that do not qualify as cash equivalents have been
designated as trading at December 31, 2008 in accordance with Statement of
Financial Accounting Standard (SFAS) No. 115, Accounting for Certain Investments in
Debt and Equity Securities. Prior to our fourth fiscal quarter of
2008, we designated investments as available-for-sale. The change in
designation was made in relation to our acceptance of a settlement offer
related to auction rate securities in November 2008 (see Note 2). Trading
securities are carried at fair value, with any unrealized gains or losses
reported as investment income/loss on the statement of income.
Available-for-sale securities are carried at fair value, with unrealized gains
and losses reported in Accumulated other comprehensive income, a component of
shareholders equity.

ACCOUNTS
RECEIVABLE

We
grant credit to customers in the normal course of business and generally do not
require collateral. Management performs on-going credit evaluations of
customers. We have fixed payment terms with each of our customers that vary in
length. Accounts receivable that are outstanding longer than the fixed payment
term are considered past due. We determine an allowance for 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.

33

---



INVENTORIES

Inventories
are primarily electronic components and finished goods and are valued at the
lower of cost or market on the first-in, first-out (FIFO) method. Adjustments
to record inventory at the lower of cost or market are charged to cost of
revenue in the period incurred and totaled $211,000, $253,000 and $70,000 for
the years ended December 31, 2008, 2007 and 2006, respectively.

PROPERTY AND
EQUIPMENT

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

INCOME TAXES

Income
taxes are accounted for under the liability method. Deferred income taxes are
provided for temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and amounts used for income tax
purposes. Deferred taxes are reduced by a valuation allowance when, in the
opinion of management, it is more likely than not that some portion or the
entire deferred tax asset will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on
the date of the enactment. We recognize tax benefits when we believe the benefit
is more likely than not to be sustained upon review from the relevant
authorities. We recognize penalties and interest expense related to
unrecognized tax benefits in income tax expense.

FAIR VALUE
MEASUREMENTS

SFAS
No. 157, Fair Value Measurement,
defines the meaning of the term fair value and provides a consistent
framework intended to reduce inconsistency and increase comparability in fair
value measurements for many different types of assets or liabilities.
Generally, the new framework requires fair value to be determined
on the exchange price which would be received for an asset or paid to transfer
a liability (an exit price) in the principal or most advantageous market for
the asset or liability in an orderly transaction between market participants.
SFAS No. 157 requires disclosure by each major asset and liability category
measured at fair value on either a recurring or nonrecurring basis and
establishes a three-tier fair value hierarchy which prioritizes the inputs used
in fair value measurements. The three-tier hierarchy for inputs used in
measuring fair value is as follows:

| |          |                                                                                                                                     
| | -------- | ------------------------------------------------------------------------------------------------------------------------------------
| | Level 1. | Observable
 inputs such as quoted prices in active markets;                                                                         
| |          |                                                                                                                                     
| | Level 2. | Inputs,
 other than the quoted prices in active markets, that are observable either
 directly or indirectly; and                    
| |          |                                                                                                                                     
| | Level 3. | Unobservable
 inputs in which there is little or no market data, which require the
 reporting entity to develop its own assumptions.

INTANGIBLE
ASSETS

Intangible
assets are stated at their estimated value at the time of acquisition.
Amortization is computed by the straight-line method over a five to eight-year
period for financial reporting purposes based on their estimated useful lives.

GOODWILL

Goodwill
is not amortized but is tested for impairment annually or whenever an
impairment indicator arises. Our goodwill related to our Flow Traffic
subsidiary is tested for impairment on December 31 of each year. EIS asset
purchase related goodwill is tested October 1 of each year. We also reconcile
the fair value of our business segments to market capitalization on December 31
or interim periods when our consolidated shareholders equity is similar to or
exceeds our market capitalization.

Because our
market capitalization was similar to or less than or consolidated shareholders
equity in and around December 31, 2008, we also reconciled our market value to
the estimated fair value of our business segments on a combined basis to ensure
our determinations of fair value at the business segment level were reasonable.
The fair value of the combined business was estimated using a discounted cash
flow analysis. The market value was determined by multiplying the sum of common
shares outstanding at December 31, 2008 and outstanding in the money stock
options (as reduced using the treasury stock method), by our average share
price in December 2008, in total, our market capitalization, and adding to it a
control premium. In most industries, including ours, an acquiring entity typically
is willing to pay more for a controlling interest than an investor would pay
for a fractional, noncontrolling ownership interest. For purposes of this
analysis, we used a control premium of 30%. To determine the applicable control
premium, we observed data derived from acquisitions and trading multiples of
companies in our industry, in addition to overall data for companies operating
in both the software and manufacturing industries. We have concluded that the
control premium is reasonable and supports the differential between our market
capitalization and the estimated fair value of our combined business. At
December 31, 2007 and 2006, our market capitalization exceeded our shareholders
equity by a significant margin, and the reconciliation process described above was not performed for those years. Based upon the
results of our testing, we determined that no impairment of goodwill existed at
December 31, 2008, 2007 and 2006.

34

---



IMPAIRMENT OF
LONG-LIVED ASSETS

Long-lived
assets are reviewed for impairment when indicators of impairment are present.
Impairment is recognized when the undiscounted cash flows estimated to be
generated by those assets are less than the assets carrying amount. No such
losses were recorded during the years ended December 31, 2008, 2007 or 2006,
respectively.

USE OF
ESTIMATES

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

RESEARCH AND
DEVELOPMENT

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

WARRANTY

We
provide a standard two-year warranty on international and North American
product sales. Warranty expense was $153,000, $44,000, and $190,000 for the
years ended December 31, 2008, 2007 and 2006, respectively, and our warranty
reserve was $217,000 and $157,000 at December 31, 2008 and 2007, respectively.

ADVERTISING

Advertising
costs are charged to operations in the period incurred and totaled $196,000,
$247,000 and $129,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.

FOREIGN
CURRENCY

All
assets and liabilities of Flow Traffic, ISS/Europe, ISS/Poland, ISS/Canada and
Canada Sales Corp. are translated from their respective foreign currency to
United States dollars at period-end rates of exchange, while the statement of
income is translated at the average exchange rates during the period. Accumulated
translation adjustments are shown in equity under Accumulated other
comprehensive income/loss.

NET INCOME PER SHARE

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

For the
years ended December 31, 2008, 2007 and 2006, respectively, 58,000, 92,000 and
166,000 common share equivalents were included in the computation of diluted
net income per share.

At December
31, 2008 and 2007, the exercise prices of 253,500 and 66,000 outstanding
options, respectively, were greater than the average market price of the common
shares during the period and were excluded from the calculation of diluted net
income per share. At December 31, 2006, no outstanding options
were excluded.

STOCK OPTIONS

In 2006,
the Company adopted SFAS No. 123R, Share-Based Payment (SFAS No. 123R). Prior to 2006, stock options were accounted for under the
intrinsic
value method as prescribed by APB 25. No stock-based employee compensation cost
was reflected in net income, except for costs related to performance based
options, because all options granted had an exercise price equal to the market
value of the underlying common stock on the date of grant. We use the
straight-line attribute method to recognize expense for unvested options. The
amount of share-based compensation recognized during a period is based on the
value of the awards that are ultimately expected to vest.

Unrecognized
compensation costs are $774,574 at December 31, 2008, with a weighted average
remaining life of 2.5 years.

35

---



NEW ACCOUNTING PRONOUNCEMENTS

In
September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No.
157, Fair
Value Measurements. SFAS No. 157 defines fair value, establishes a
framework for measuring fair value and expands disclosures about fair value
measurement but does not require any new fair value measurements. SFAS No. 157
is effective for financial statements issued for fiscal years beginning after
November 15, 2007 and interim periods within those fiscal years. However, on
February 12, 2008, the FASB issued proposed FASB Staff Position (FSP) FAS 157-2,
which delayed the effective date of SFAS No. 157 for all nonfinancial assets
and nonfinancial liabilities, except those that are recognized or disclosed at
fair value in the financial statements on a recurring basis (at least
annually). This FSP partially defers the effective date of SFAS No. 157 to
fiscal years beginning after November 15, 2008 and interim periods within
those fiscal years for items within the scope of this FSP. Effective for 2008,
we have adopted SFAS No. 157 except as it applies to those nonfinancial assets
and nonfinancial liabilities as noted in proposed FSP FAS 157-2. The partial
adoption of SFAS No. 157 impacted our disclosures surrounding our restricted
long-term investments. The adoption of the remaining portions of SFAS No. 157
is not expected to have a material impact on our financial statements.

On February
15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities  Including an Amendment of FASB Statement No. 115.
This standard permits an entity to choose to measure many financial instruments
and certain other items at fair value. The fair value option established by
SFAS No. 159 permits all entities to choose to measure eligible items at fair
value at specified election dates. SFAS No. 159 is effective for the Company as
of January 1, 2008. The initial impact of adopting this pronouncement had no
effect on our consolidated financial statements because we did not elect the
fair value option for any financial assets or liabilities at the beginning of
2008. During the year, SFAS No. 159 impacted our accounting and disclosure of
the put option received as part of our auction rate securities settlement as
further described in Note 2.

In December
2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations. SFAS
No. 141(R) will significantly change the accounting for business combinations.
Under SFAS No. 141(R), an acquiring entity will be required to recognize all
the assets acquired and liabilities assumed in a transaction at the
acquisition-date fair value with limited exceptions. SFAS No. 141(R) will
change the accounting treatment for certain specific items. SFAS No. 141(R)
also includes a substantial number of new disclosure requirements. SFAS No.
141(R) applies prospectively to business combinations for which the acquisition
date is on or after the beginning of the first annual reporting period
beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS
No. 141(R) will impact us if we complete an acquisition after the effective
date.

In December
2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial
Statements  An Amendment of ARB No. 51. SFAS No. 160 establishes
new accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 also
includes expanded disclosure requirements regarding the interests of the parent
and its noncontrolling interest. SFAS No. 160 is effective for fiscal years,
and interim periods with those fiscal years, beginning on or after December 15,
2008. Earlier adoption is prohibited. We are currently assessing the potential
impact that the adoption of SFAS No. 160 will have on our financial statements.

In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging
Activities  an amendment of FASB Statement No. 133. SFAS No. 161
requires enhanced disclosures about an entitys derivative and hedging
activities and is effective for financial statements issued for fiscal years
beginning after November 15, 2008. We are currently assessing the impact of
SFAS No. 161 on our disclosures.

In April
2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets,
to provide guidance for determining the useful life of recognized intangible
assets and to improve consistency between the period of expected cash flows
used to measure the fair value of a recognized intangible asset and the useful
life of the intangible asset as determined under SFAS No. 142, Goodwill and
Other Intangible Assets. The FSP requires that an entity consider
its own historical experience in renewing or extending similar arrangements.
However, the entity must adjust that experience based on entity-specific
factors under FAS No. 142. FSP FAS 142-3 is effective for fiscal years and
interim periods that begin after November 15, 2008. The Company intends to
adopt FSP FAS 142-3 effective January 1, 2009 and to apply its provisions
prospectively to recognized intangible assets acquired after that date. The
Company has periodically purchased recognized intangible assets and is in the
process of evaluating the impact that the adoption of FSP FAS 142-3 will have
on its financial statements.

In May
2008, FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting
Principles. SFAS No. 162 identifies the sources of accounting
principles and the framework for selecting the principles to be used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles. SFAS No.
162 is effective 60 days following the SECs approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. We do not
anticipate that the adoption of SFAS No. 162 will materially impact the
Company.

36

---



RECLASSIFICATIONS

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

|   |            
|-- | -----------
|2. | INVESTMENTS

At December
31, 2008, we held $4.0 million (par value) of investments comprised of auction
rate securities, or ARS. In January 2009, our ARS were purchased by our
broker/dealer at par.

The balance
of investments consists of the combination of the fair value of ARS as
determined under SFAS No. 157 and the fair value of the settlement rights that
we received from the broker/dealer under a settlement agreement reached in
November 2008. The settlement rights allowed us to put the ARS to the broker/dealer at par between the dates of January 2, 2009 and January 2,
2011.

The ARS was
valued at $3.3 million at December 31, 2008 based on an internal valuation of
the investment. As no level 1 or 2 valuation inputs were present, we determined
the valuation based upon a combination of level 3 valuation inputs, including
broker/dealer estimates, secondary market quotations of similar illiquid
securities, and a discounted cash flow estimate comparing the ARS to long-term
federal securities. The changing of the ARS status to trading resulted in the
reclassification of the unrealized loss shown under accumulated other
comprehensive income (loss) of our consolidated balance sheet to the
consolidated statement of operations. We adopted SFAS No. 159, The Fair
Value Option for Financial Assets and Financial Liabilities, in 2008
and selected the fair value option for the settlement right in our fiscal
quarter ending December 31, 2008. Management determined that the fair value option
was appropriate for this unusual transaction and that it reflected the most accurate
substance of the settlement right offering in conjunction with the ARS
valuation. The settlement right was valued at $700,000 at December 31, 2008 and
was also determined internally using a discounted cash flow analysis factoring
in a risk discount on the broker/dealers likelihood of meeting the obligation.
The valuation loss on the ARS and investment income from receiving the
settlement rights are recorded in the other income, net line of the
consolidated statements of income.

Proceeds
from maturities and sales of investments totaled $3.4 million, $4.1 million and
$ - for the years ended December 31, 2008, 2007 and 2006, respectively. As
described above, in the year ended December 31, 2008, we realized a $700,000
loss on our ARS and a $700,000 gain on the ARS settlement rights. There were no
realized gains or losses related to sales during the years ended December 31,
2007 and 2006.

|   |                                                                          
|-- | -------------------------------------------------------------------------
|3. | INVENTORIES                                                              
|   |                                                                          
|   | Inventories,
 net of reserves, consisted of the following (in thousands):

|                       |  |              |       |      |   |       | 
|---------------------- |  | ------------ | ----- | ---- | - | ----- | 
|                       |  | December 31, |      
|                       |  |              |      
|                       |  | 2008         |       | 2007 |  
|                       |  |              |      
|Electronic
 components |  | $            | 1,097 |      | $ | 1,092 | 
|Finished
 goods        |  |              | 511   |      |   | 487   | 
|                       |  |              |      
|                       |  |              |       |      |   |       | 
|Total                  |  | $            | 1,608 |      | $ | 1,579 | 
|                       |  |              |       |      |   |       | 

|   |             
|-- | ------------
|4. | ACQUISITIONS

On
December 6, 2007, we purchased certain assets of EIS Electronic Integrated
Systems, Inc. (EIS), including its RTMS radar product line. The purchase price
was $10.9 million in cash plus 147,202 shares of our common stock valued at
approximately $2.5 million. We borrowed $5.0 million from a bank to partially
finance the purchase. In addition to the purchase price, we incurred $506,000
in direct acquisition costs. As part of the purchase agreement, the sellers are
eligible to receive an earn-out based on the performance of the assets for the
next three years. Earn-outs will be calculated and paid annually. Based on
target achievement, the sellers would receive $2.0 million annually or a total
of $6.0 million. Superior performance of the assets could lead to an earn-out
in excess of $2 million, as the earn-out is not capped.

37

---



Following
the purchase, the former operations of EIS were split into two subsidiaries: ISS/Canada
and Canada Sales Corp. The purchase price plus direct acquisition costs were
allocated on the basis of estimated fair value at the date of the purchase. The
purchase price allocation is as follows (in thousands):

|                                                   |  |   |        |  
|-------------------------------------------------- |  | - | ------ | -
|Purchase
 price including direct acquisition costs |  | $ | 13,941 |  
|Less:                                              |  |   |        |  
|Fixed assets                                       |  |   | (300   | )
|In-process
 research and development expense       |  |   | (4,500 | )
|Developed
 technology                              |  |   | (3,900 | )
|Trade names                                        |  |   | (1,200 | )
|Other
 intangibles                                 |  |   | (200   | )
|                                                   |  |   |        |  
|Goodwill                                           |  | $ | 3,841  |  
|                                                   |  |   |        |  

Earn-out
payments related to the EIS asset purchase will be recorded as additional
goodwill when earned. In 2008, the sellers earned an earn-out of $1.2 million,
which is payable in March 2009.

Prior
to the asset purchase, EIS was engaged in research and development activity
into its next generation product line, known internally as G4. G4 research
activity began in 2006. Because G4 had not yet reached technological
feasibility, the value of the G4 program was expensed as in-process research
and development at the date of transaction. As of the date of the EIS asset
purchase, the program was estimated to be between 50% and 75% complete. G4,
when released, is expected to provide new features and functionality and avoid
existing patent claims of competitors based upon unique technology. The value
of the G4 program was appraised utilizing a multi-period excess earnings cash
flow analysis based upon facts and circumstances surrounding the in-process
development activities and the expected economic benefits to be derived from
the resulting products. Key assumptions for the analysis include revenue from
G4 products beginning in mid-2008, achievement of an efficient cost to
manufacture and a risk adjusted discount rate of 17.0% on cash flows. At the
date of acquisition, EIS was actively selling its G3 product, which has
provided the majority of its revenues in the last two years. If G4 is not
commercialized according to plan, our financial projections may not be
attained.

EIS
was named in a U.S. lawsuit in 2006 for infringement of a patent. On October
31, 2007, the courts entered judgment that EIS had not infringed on the patent.
The plaintiff appealed the decision early in 2008, and the case currently
resides in the appellate court. Under the EIS asset purchase agreement, EIS is
required to continue to defend this case. In addition, EIS must indemnify us
for all expenses, claims or judgments related to this lawsuit up to the amount
of the purchase price, including any earn-out payments. Management believes
that the ultimate outcome of this legal action will not have a material adverse
effect on our financial statements.

In
conjunction with the EIS asset purchase, $600,000 in cash and 35,328 shares of
stock, with a value of approximately $600,000, issued in connection with the
transaction were placed in escrow to secure potential indemnification
obligations. Any amounts remaining in escrow on December 6, 2012 will then be
released.

The
results of ISS/Canada and Canada Sales Corp. operations are included in the
accompanying financial statements since the date of the EIS asset purchase. The
following pro forma summary presents the results of operations as if the EIS
asset purchase had occurred on January 1, 2006. EIS fiscal year ended on
September 30. The table below includes our results for the years ended December
31, 2007 and 2006, respectively, and EIS for the years ended September 30, 2007
and 2006, respectively. During the years ended September 30, 2007 and 2006,
respectively, EIS incurred $409,000 and $2.6 million of legal fees to defend
the patent infringement lawsuit.

The
pro forma results are not necessarily indicative of the results that would have
been achieved had the EIS asset purchase taken place on that date (in
thousands, except per share amounts):

|                              |  |               |        |      |   |        |  
|----------------------------- |  | ------------- | ------ | ---- | - | ------ | -
|                              |  | December
 31, |       
|                              |  |               |       
|                              |  | 2007          |        | 2006 |  
|                              |  |               |        |      |  
|Total
 revenue                |  | $             | 23,825 |      | $ | 21,187 |  
|Net income
 (loss)            |  |               | 3,897  |      |   | (2,170 | )
|                              |  |               |        |      |   |        |  
|Net income
 (loss) per share: |  |               |        |      |   |        |  
|Basic                         |  | $             | 0.99   |      | $ | (0.56  | )
|Diluted                       |  |               | 0.97   |      |   | (0.56  | )

38

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|   |                               
|-- | ------------------------------
|5. | GOODWILL AND INTANGIBLE ASSETS

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic and $5.0
million related to the EIS asset purchase, consisting of $3.8 million recorded
at the time of the purchase and an additional $1.2 million recorded in 2008 in
conjunction with earn-out payments due.

Intangible
assets consisted of the following (dollars in thousands):

|                                           |  |                   |       |                   |   |       |  
|------------------------------------------ |  | ----------------- | ----- | ----------------- | - | ----- | -
|                                           |  | December 31, 2008 |       | December 31, 2007 |  
|                                           |  |                   |       |                   |  
|Developed technology (8 year life)         |  | $                 | 3,900 |                   | $ | 3,900 |  
|Trade names (5 year life)                  |  |                   | 1,200 |                   |   | 1,200 |  
|Other intangibles (5 year life)            |  |                   | 200   |                   |   | 200   |  
|Less: Accumulated amortization             |  |                   | (819  | )                 |   | (51   | )
|                                           |  |                   |       |                   |   |       |  
|Total identifiable
 intangible assets, net |  | $                 | 4,481 |                   | $ | 5,249 |  
|                                           |  |                   |       |                   |   |       |  

We expect
to recognize amortization expense for the intangible assets in the above table
of $768,000 in each of our years ending December 31, 2009, 2010 and 2011 and of
$749,000 in 2012. The weighted average amortization period remaining for
intangible assets is 6.2 years. Goodwill and intangible assets related to the
EIS asset purchase are deductible for tax purposes over 15 years.

|   |                  
|-- | -----------------
|6. | CREDIT FACILITIES

We
have a revolving line of credit and a term loan with our bank. These credit agreements were entered
into on May 1, 2008 and replaced all prior bank agreements, including the
repayment of loans under the previous agreements. Both agreements additionally
include the pledge of our ARS investment.

The
revolving line of credit agreement provides up to $5.0 million in short-term
borrowings at the banks prime rate (effective rate of 4.66% at December 31,
2008), expiring May 1, 2011. Any loans are secured by inventories, accounts
receivable and equipment, and the bank has the right of setoff against
checking, savings and other accounts. We had $2.0 million of outstanding
borrowings under this credit agreement at December 31, 2008, all of which are
due May 1, 2011.

The
term loan initially provides up to $3.0 million at a fixed rate of 6.75%, expiring
May 1, 2011. The loan is secured by inventories, accounts receivable and
equipment, and the bank has the right of setoff against checking, savings and
other accounts. At December 31, 2008, we had $1.75 million outstanding on this
loan. The loan is repayable in equal monthly installments, of which $1.0 million
is due in 2009 and $750,000 is due in 2010.

Subsequent
to year end, we fully repaid the term loan and the revolving line of credit and
were released from our pledge of investments.

|   |                  
|-- | -----------------
|7. | LEASE COMMITMENTS

We
rent office space and equipment under operating lease agreements expiring at
various dates through December 2010. The leases provide for monthly payments of
$44,000, and we are responsible for our proportionate share of increases in
operating expenses that exceed a base rent factor. Rent expense amounted to
$555,000 in 2008, $319,000 in 2007, and $261,000 in 2006.

Future
minimum annual lease payments under noncancelable operating leases for the
years ending December 31, 2009 and 2010 are $236,000 and $156,000,
respectively.

39

---



|   |             
|-- | ------------
|8. | INCOME TAXES

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

|                                                |  |              |       |      |   |       |  
|----------------------------------------------- |  | ------------ | ----- | ---- | - | ----- | -
|                                                |  | December
 31 |      
|                                                |  |              |      
|                                                |  | 2008         |       | 2007 |  
|                                                |  |              |       |      |  
|Current
 deferred tax assets (liabilities):     |  |              |       |      |   |       |  
|Accrued compensation                            |  | $            | 40    |      | $ | 25    |  
|Prepaid expenses                                |  |              | (43   | )    |   | (39   | )
|Inventory reserves                              |  |              | 165   |      |   | 118   |  
|Stock option expense (NQO)                      |  |              | 90    |      |   | 36    |  
|Other                                           |  |              | 124   |      |   | 2     |  
|Foreign net operating loss carryforwards        |  |              | 9     |      |   | 86    |  
|Less valuation allowance                        |  |              | (9    | )    |   | (86   | )
|                                                |  |              |       |      |   |       |  
|                                                |  |              | 376   |      |   | 142   |  
|Non-current
 deferred tax assets (liabilities): |  |              |       |      |   |       |  
|Intangible asset amortization                   |  |              | 1,611 |      |   | 1,684 |  
|Other                                           |  |              | (36   | )    |   | (8    | )
|                                                |  |              |       |      |   |       |  
|                                                |  |              | 1,575 |      |   | 1,676 |  
|                                                |  |              |       |      |   |       |  
|Net deferred tax assets                         |  | $            | 1,951 |      | $ | 1,818 |  
|                                                |  |              |       |      |   |       |  

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 $2.4 million, $913,000 and $449,000 in undistributed earnings of our
wholly-owned foreign subsidiaries at December 31, 2008, 2007 and 2006,
respectively. We have not provided any additional federal or state income taxes
or foreign withholding taxes on the undistributed earnings, as such earnings
have been indefinitely reinvested in the business as defined in SFAS
No. 109, Accounting for Income Taxesand Accounting Principles Board
Opinion 23.

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 (benefit) are as follows (in thousands):

|                                    |  |                          |       |      |   |        |   |   |       |  
|----------------------------------- |  | ------------------------ | ----- | ---- | - | ------ | - | - | ----- | -
|                                    |  | Years
 Ended December 31 |      
|                                    |  |                          |      
|                                    |  | 2008                     |       | 2007 |   | 2006   |  
|                                    |  |                          |       |      |   |        |  
|Current:                            |  |                          |       |      |   |        |   |   |       |  
|Federal                             |  | $                        | 1,738 |      | $ | 1,318  |   | $ | 1,039 |  
|State                               |  |                          | 38    |      |   | 20     |   |   | 49    |  
|Foreign                             |  |                          | 564   |      |   | 116    |   |   | 57    |  
|                                    |  |                          |       |      |   |        |   |   |       |  
|                                    |  |                          | 2,340 |      |   | 1,454  |   |   | 1,145 |  
|                                    |  |                          |       |      |   |        |   |   |       |  
|Deferred:                           |  |                          |       |      |   |        |   |   |       |  
|Federal                             |  |                          | (59   | )    |   | (1,638 | ) |   | (173  | )
|State                               |  |                          | (23   | )    |   | (15    | ) |   | (30   | )
|Foreign                             |  |                          | (51   | )    |   |       |   |   |      |  
|                                    |  |                          |       |      |   |        |   |   |       |  
|                                    |  |                          | (133  | )    |   | (1,653 | ) |   | (203  | )
|                                    |  |                          |       |      |   |        |   |   |       |  
|Total income
 tax expense (benefit) |  | $                        | 2,207 |      | $ | (199   | ) | $ | 942   |  
|                                    |  |                          |       |      |   |        |   |   |       |  

Income
before taxes for the foreign operations were $2.1 million, $509,000 and
$236,000 for the years ended December 31, 2008, 2007 and 2006.

40

---



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

|                                                  |  |              |       |      |   |      |   |   |       |  
|------------------------------------------------- |  | ------------ | ----- | ---- | - | ---- | - | - | ----- | -
|                                                  |  | December
 31 |      
|                                                  |  |              |      
|                                                  |  | 2008         |       | 2007 |   | 2006 |  
|                                                  |  |              |       |      |   |      |  
|Federal tax statutory rate                        |  | $            | 2,438 |      | $ | 225  |   | $ | 1,382 |  
|State taxes, net of federal benefit               |  |              | 10    |      |   | 2    |   |   | 13    |  
|Tax exempt interest                               |  |              |      |      |   | (146 | ) |   | (124  | )
|Research and development tax credits              |  |              | (120  | )    |   | (120 | ) |   | (135  | )
|Domestic production activity deduction            |  |              | (83   | )    |   | (61  | ) |   | (39   | )
|Effect of lower rates on foreign income           |  |              | (125  | )    |   | (57  | ) |   | (23   | )
|Use of foreign loss carryforwards                 |  |              | (77   | )    |   |     |   |   |      |  
|Stock option expense                              |  |              | 66    |      |   | 32   |   |   | 60    |  
|Adjustment of prior year tax credits and
 refunds |  |              | (50   | )    |   | (26  | ) |   | (202  | )
|FIN 48 adjustments                                |  |              | 96    |      |   | 50   |   |   |      |  
|Other                                             |  |              | 52    |      |   | (98  | ) |   | 10    |  
|                                                  |  |              |       |      |   |      |   |   |       |  
|Income taxes                                      |  | $            | 2,207 |      | $ | (199 | ) | $ | 942   |  
|                                                  |  |              |       |      |   |      |   |   |       |  

In
July 2006, the FASB issued Interpretation No. 48, Accounting
for Uncertainty in Income Taxesan Interpretation of FASB Statement
No. 109, (FIN 48) which clarifies what criteria must be met
prior to recognition of the financial statement benefit of a position taken in
a tax return. FIN 48 also provides guidance on derecognition of tax benefits,
classification on the balance sheet, interest and penalties, accounting in
interim periods, disclosure and transition. We adopted FIN 48 effective
January 1, 2007. As a result of the implementation of FIN 48, we did not
change our tax liability for uncertain tax benefits. A reconciliation of the
beginning and ending amount of the tax liability for uncertain tax benefits is
as follows (in thousands):

|                                          |  |   |     | 
|----------------------------------------- |  | - | --- | 
|Balance at January 1, 2007                |  | $ | 100 | 
|Additions for current year
 tax positions |  |   | 50  | 
|Reductions                                |  |   |    | 
|                                          |  |   |     | 
|Balance at December 31,
 2007             |  |   | 150 | 
|Additions for current year
 tax positions |  |   | 96  | 
|Reductions                                |  |   |    | 
|                                          |  |   |     | 
|Balance at December 31,
 2008             |  | $ | 246 | 
|                                          |  |   |     | 

We
are subject to income taxes in the U.S. federal jurisdiction and various state
and foreign jurisdictions. Tax regulations within each jurisdiction are subject
to the interpretation of the related tax laws and require significant judgment
to apply. Generally, we are subject to U.S. federal, state, local and foreign
tax examinations by taxing authorities for years after the fiscal year ended
December 31, 2004.

|   |          
|-- | ---------
|9. | LICENSING

The
United States patent for some aspects of the technology underlying our
Autoscope system was issued in 1989 to the University of Minnesota. We had an
exclusive worldwide license from the University of Minnesota for that
technology and paid royalties to the University of Minnesota in exchange for
such license. Our exclusive license, and all related royalty obligations,
expired July 2006. Royalty expense under the agreement was $220,000 in the year
ended December 31, 2006.

We
have sublicensed the right to manufacture and market the Autoscope technology
in North America, the Caribbean and Latin America to Econolite and receive
royalties from Econolite on sales of the Autoscope system in those territories.
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 agreements initial term as amended was 20 years, ending in
2011. In 2008, we extended the agreement an additional 20 years, unless
terminated by either party upon three years notice.

We
recognized royalty income from this agreement of $13.3 million, $10.7 million
and $10.1 million in 2008, 2007 and 2006, respectively.

|    |                               
|--- | ------------------------------
|10. | REVENUE FROM FOREIGN COUNTRIES

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

|               |  |      |     |      |  |      |  |  |     | 
|-------------- |  | ---- | --- | ---- |  | ---- |  |  | --- | 
|               |  | 2008 |     | 2007 |  | 2006 | 
|               |  |      |     |      |  |      | 
|Asia Pacific   |  |      | 12% |      |  | 11%  |  |  | 10% | 
|Europe         |  |      | 16% |      |  | 16%  |  |  | 13% | 
|North
 America |  |      | 72% |      |  | 73%  |  |  | 77% | 

41

---



Revenue
originating from Poland was 11% of our revenue in the year ended December 31,
2007. The aggregate net book value of long-lived assets held outside of
the United States was $258,000 and $356,000 at December 31, 2008 and 2007,
respectively.

|    |                                                        
|--- | -------------------------------------------------------
|11. | SIGNIFICANT
 CUSTOMERS AND CONCENTRATION OF CREDIT RISK

Royalty
income from Econolite comprised 50%, 71% and 77% of revenue in the years ended
December 31, 2008, 2007 and 2006, respectively. Accounts receivable from
Econolite were $2.9 million and $3.3 million at December 31, 2008 and 2007,
respectively. One international customer comprised 13% of accounts receivable
at December 31, 2008, and a separate international customer comprised 15% of
accounts receivable at December 31, 2007.

|    |                 
|--- | ----------------
|12. | RETIREMENT PLANS

Substantially
all of our employees in the United States are eligible to participate in a
qualified defined contribution 401(k) plan in which participants may elect to
have a specified portion of their salary contributed to the plan and we may
make discretionary contributions to the plan. Flow Traffic is obligated to
contribute to an employee pension plan. The Company made contributions totaling
$97,000, $89,000 and $87,000 to the plans for 2008, 2007 and 2006,
respectively.

|    |              
|--- | -------------
|13. | STOCK OPTIONS

In
February 1995 and April 2005, we adopted the 1995 Long-Term Incentive and Stock
Option Plan (the 1995 Plan) and the 2005 Stock Incentive Plan (the 2005 Plan),
respectively, which provide for the granting of incentive (ISO) and
non-qualified (NQO) stock options, stock appreciation rights, restricted stock
awards and performance awards to our officers, directors, employees, consultants
and independent contractors. The 1995 Plan terminated in February 2005. Options
granted under the Plans generally vest over three to five years based on
service and have a contractual term of six to ten years and are amortized to
expense on a straight-line basis. The following table summarizes stock option
activity for 2008 and 2007:

|                              |  |                                     |          |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|----------------------------- |  | ----------------------------------- | -------- | ------------------------- | --- | ------------------------------ | --- | -------------------------------------------- | ------- | - |  | ------- | - | - | ----- | 
|                              |  | Plan
 Options
 Available
 For Grant |          | Plan Options
 Outstanding |     | Non-Plan
 Options
 Outstanding |     | Weighted
 Average
 Exercise Price
 Per Share |        
|                              |  |                                     |          |                           |     |                                |     |                                              |        
|                              |  |                                     |          |                           | ISO |                                | NQO |                                              |         |   |  |         |   |  
|                              |  |                                     |          |                           |     |                                |     |                                              |         |   |  |         |   |  
|Balance at
 December 31, 2006 |  |                                     | 263,200  |                           |     | 70,700                         |     |                                              | 102,333 |   |  | 42,000  |   | $ | 3.38  | 
|Granted                       |  |                                     | (141,000 | )                         |     | 68,088                         |     |                                              | 72,912  |   |  |        |   |   | 15.34 | 
|Exercised                     |  |                                     |         |                           |     | (18,800                        | )   |                                              |        |   |  |        |   |   | 2.12  | 
|                              |  |                                     |          |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|Balance at
 December 31, 2007 |  |                                     | 122,200  |                           |     | 119,988                        |     |                                              | 175,245 |   |  | 42,000  |   | $ | 8.47  | 
|Granted                       |  |                                     | (95,500  | )                         |     | 48,130                         |     |                                              | 47,370  |   |  |        |   |   | 13.58 | 
|Exercised                     |  |                                     |         |                           |     | (13,000                        | )   |                                              | (10,000 | ) |  | (36,000 | ) |   | 3.31  | 
|Plan addition                 |  |                                     | 138,800  |                           |     |                               |     |                                              |        |   |  |        |   |   |       | 
|                              |  |                                     |          |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|Balance at
 December 31, 2008 |  |                                     | 165,500  |                           |     | 155,118                        |     |                                              | 212,615 |   |  | 6,000   |   | $ | 10.59 | 
|                              |  |                                     |          |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 

The
following table summarizes information about the stock options outstanding at
December 31, 2008.

|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |         | 
|------------------------ |  | ------------------- | ------- | ----------------------------------------------- |  | ---------------------------------- |  | --------------------------- | ----- | ------------------- | - | ---------------------------------- |  | --------------------------- | ------- |  | - | ----- |  | - | ------- | 
|                         |  | Options Outstanding |         | Options Exercisable                             | 
|                         |  |                     |         |                                                 | 
|Range of
 Exercise Price |  | Number
 Outstanding |         | Weighted
 Average
 Remaining
 Contractual
 Life |  | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |       | Number
 Exercisable |   | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |        
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |        
|$1.30-1.99               |  |                     | 59,100  |                                                 |  | 3.2 years                          |  | $                           | 1.34  |                     | $ | 408,736                            |  |                             | 59,100  |  | $ | 1.34  |  | $ | 408,736 | 
|2.00-2.99                |  |                     | 16,200  |                                                 |  | 3.2 years                          |  |                             | 2.35  |                     |   | 95,742                             |  |                             | 16,200  |  |   | 2.35  |  |   | 95,742  | 
|3.00-3.99                |  |                     | 38,933  |                                                 |  | 3.7 years                          |  |                             | 3.15  |                     |   | 199,083                            |  |                             | 38,933  |  |   | 3.15  |  |   | 199,083 | 
|7.00-7.93                |  |                     | 6,000   |                                                 |  | 1.3 years                          |  |                             | 7.50  |                     |   | 4,560                              |  |                             | 6,000   |  |   | 7.50  |  |   | 4,560   | 
|12.00-12.99              |  |                     | 62,000  |                                                 |  | 6.0 years                          |  |                             | 12.44 |                     |   |                                   |  |                             | 12,000  |  |   | 12.61 |  |   |        | 
|14.00-14.99              |  |                     | 105,500 |                                                 |  | 4.6 years                          |  |                             | 14.25 |                     |   |                                   |  |                             | 17,750  |  |   | 14.20 |  |   |        | 
|15.00-15.99              |  |                     | 39,000  |                                                 |  | 3.1 years                          |  |                             | 15.34 |                     |   |                                   |  |                             | 18,750  |  |   | 15.70 |  |   |        | 
|16.00-16.99              |  |                     | 15,000  |                                                 |  | 4.9 years                          |  |                             | 16.00 |                     |   |                                   |  |                             | 3,750   |  |   | 16.00 |  |   |        | 
|17.00-17.99              |  |                     | 32,000  |                                                 |  | 3.9 years                          |  |                             | 17.50 |                     |   |                                   |  |                             | 8,000   |  |   | 17.50 |  |   |        | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |         | 
|                         |  |                     | 373,733 |                                                 |  |                                    |  | $                           | 10.59 |                     | $ | 708,121                            |  |                             | 180,483 |  | $ | 6.55  |  | $ | 708,121 | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |         | 

42

---



The
weighted average fair value of the 95,500 and 141,000 options granted during
2008 and 2007, respectively, was $387,975 and $851,910.

The
total intrinsic value of options exercised during 2008, 2007 and 2006 was
$292,084, $255,000 and $607,000, respectively. The total fair value of shares vested during
2008, 2007 and 2006 was $807,000, $25,000 and $170,000, 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
during 2008, 2007 and 2006, respectively: zero dividend yield; expected
volatility of 41%, 127% and 127%; risk-free interest rate of 3.68%, 4.75% and
4.27%; and expected life of 3.5, 3.9 and 3 years. The expected life of the
options is based on evaluations of historical and expected future exercise
behavior. The risk-free interest rate is based on the US Treasury rates at the
date of grant, with maturity dates approximately equal to the expected life at
the grant date. Volatility is based on historical volatility of the Companys
stock over the past three years. The Company has not historically paid any
dividends and does not expect to in the foreseeable future. We recognized stock
option expense of $339,000, $194,000 and $177,000 in the years ended
December 31, 2008, 2007 and 2006, respectively, and the expense is
included within general and administrative expense on the consolidated
statements of income.

There
were 183,633 and 195,833 options exercisable at December 31, 2007 and 2006,
respectively. The weighted average exercise price of these options was $2.94
and $2.53 at December 31, 2007 and 2006, respectively.

|    |                    
|--- | -------------------
|13. | SEGMENT INFORMATION

We currently
operate in two reportable segments: Autoscope and RTMS. Autoscope is our
machine-vision product line, and revenue consists of royalties (all of which
are received from Econolite), as well as a portion of international sales. RTMS
is our radar product line acquired in the EIS asset purchase in December 2007,
and revenue consists of all North American sales and a portion of international
sales. All segment revenues are derived from external customers.

The following
table sets forth selected unaudited financial information for the year ended
December 31, 2008 for each of the Companys reportable segments
(in thousands):

|                                   |  |           |        |      |   |        |  |   |        | 
|---------------------------------- |  | --------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                   |  | Autoscope |        | RTMS |   | Total  | 
|                                   |  |           |        |      |   |        | 
|Revenue                            |  | $         | 18,705 |      | $ | 7,760  |  | $ | 26,465 | 
|Depreciation                       |  |           | 242    |      |   | 115    |  |   | 357    | 
|Amortization of intangible
 assets |  |           |       |      |   | 768    |  |   | 768    | 
|Income before income taxes         |  |           | 5,939  |      |   | 1,232  |  |   | 7,171  | 
|Capital expenditures               |  |           | 273    |      |   | 112    |  |   | 385    | 
|Total assets                       |  |           | 24,135 |      |   | 11,973 |  |   | 36,108 | 

43

---



Report of Independent Registered Public
Accounting Firm

Board of
Directors and Shareholders
Image Sensing Systems, Inc.

We have
audited the accompanying consolidated balance sheets of Image Sensing Systems,
Inc. (a Minnesota Corporation) and subsidiaries (the Company) as of
December 31, 2008 and 2007, and the related consoli­dated statements
income, shareholders equity, and cash flows for each of the three years in the
period ended December 31, 2008. These consolidated 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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Image
Sensing Systems, Inc. and subsidiaries as of December 31, 2008 and 2007, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2008 in conformity with
accounting principles generally accepted in the United States of America.

/s/ GRANT
THORNTON LLP

Minneapolis,
MinnesotaMarch 26, 2009

44

---



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

None.

|            |                        
|----------- | -----------------------
|Item 9A(T). | Controls and Procedures

Evaluation of disclosure controls and procedures

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

Managements report on internal control over financial
reporting

Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting. Our internal control over financial reporting
is a process designed to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles in the
United States of America. Our internal control over financial reporting
includes those policies and procedures that (i) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly reflect our
transactions and dispositions of our assets; (ii) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of
the financial statements in accordance with generally accepted accounting
principles in the United States of America, and that our receipts and
expenditures are being made only in accordance with authorizations of our
management and directors; and (iii) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use or disposition
of our assets that could have a material effect on the financial statements.

Internal
control over financial reporting cannot provide absolute assurance of achieving
financial reporting objectives because of its inherent limitations. Internal
control over financial reporting is a process that involves human diligence and
is subject to lapses in judgment or breakdowns resulting from human failures. Internal
control over financial reporting also can be circumvented by collusion or
improper management override. Because of such limitations, there is a risk that
material misstatements may not be prevented or detected on a timely basis by
internal control over financial reporting. However, these inherent limitations
are known features of the financial reporting process. Therefore, it is
possible to design into the process safeguards to reduce, though not eliminate,
this risk.

Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect all misstatements. Further, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.

Management
assessed the effectiveness of our internal control over financial reporting as
of December 31, 2008. In making this assessment, management used the criteria
set forth by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in Internal
ControlIntegrated Framework. Based on this assessment, management
has concluded that our internal control over financial reporting was effective
as of December 31, 2008.

45

---



This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting.
Managements report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only managements report in this annual
report.

Changes in internal control over financial reporting

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

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

None.

46

---



PART III

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

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

The
sections entitled Proposal I - Election of Directors, Audit Committee and
Section 16(a) Beneficial Ownership Reporting Compliance in our definitive
proxy statement for our 2009 annual meeting of shareholders are incorporated
into this Form 10-K by reference.

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

The
sections entitled Executive Compensation and Compensation of Directors in
our definitive proxy statement for the 2009 annual meeting of shareholders are
incorporated into this Form 10-K by reference.

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

Equity
Compensation Plan Information

The
following table provides information as of December 31, 2008 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)  |  |                                                                                                 |  | 367,733                                                                         |  |                                                                                                                                                            |  | $ | 10.64 |  |  |  |  | 165,500 |  | 
|Equity compensation plans not approved by
 shareholders |  |                                                                                                 |  | 6,000                                                                           |  |                                                                                                                                                            |  | $ | 7.50  |  |  |  |  |        |  | 
|                                                        |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                            |  |   |       |  |  |  |  |         |  | 
|Total                                                   |  |                                                                                                 |  | 373,733                                                                         |  |                                                                                                                                                            |  | $ | 10.59 |  |  |  |  | 165,500 |  | 
|                                                        |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                            |  |   |       |  |  |  |  |         |  | 

---

(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 165,500 shares available for grant under the 2005 Stock Incentive
Plan may become the subject of future awards in the form of stock options, stock
appreciation rights, restricted stock, performance awards or other stock-based
awards.

The
section entitled Security Ownership of Certain Beneficial Owners and
Management in our definitive proxy statement for the 2009 annual meeting of
shareholders is incorporated into this Form 10-K by reference.

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

The
section entitled Certain Relationships and Related Transactions in our
definitive proxy statement for the 2009 annual meeting of shareholders is
incorporated into this Form 10-K by reference.

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

The
sections entitled Audit Fees, Audit-Related Fees, Tax Fees, All Other
Fees and Policy on Audit Committee Pre-Approval of Audit and Permissible
Non-Audit Services Provided by Our Independent Registered Public Accounting
Firm in our definitive proxy statement for our 2009 annual meeting of
shareholders are incorporated into this Form 10-K by reference.

47

---



PART IV

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

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

|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|----------- | ----------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. | Description
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 2.1*        | Asset Purchase Agreement
 dated December 6, 2007 by and among Image Sensing Systems, Inc. (ISS), EIS
 Electronic Integrated Systems Inc., Dan Manor and the other parties named
 therein, incorporated by reference to Exhibit 2.1 to ISS Annual Report on
 Form 10-K for the year ended December 31, 2007 (2007 Form 10-K). (Schedules
 to this Agreement have not been filed in reliance on Item 601(b)(2) of
 Regulation S-K of the Securities and Exchange Commission (SEC). ISS will
 furnish supplementally copies of such schedules to the SEC upon its request.)
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.1         | Restated Articles of
 Incorporation of ISS, incorporated by reference to Exhibit 3.1 to ISS
 Registration Statement on Form SB-2 (Registration No. 33-90298C) filed on
 March 14, 1995, as amended (Registration Statement).                                                                                                                                                                                                                                                                                                                                            
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.2         | Articles of Amendment to
 Articles of Incorporation of ISS, incorporated by reference to Exhibit 3.2 to
 ISS Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001.                                                                                                                                                                                                                                                                                                                                                                                       
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.3         | Bylaws of ISS,
 incorporated by reference to Exhibit 3.3 to ISS Registration Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 4.1         | Specimen form of ISS
 common stock certificate, incorporated by reference to Exhibit 4.1 to ISS
 Registration Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                               
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.1        | Form of Distributor
 Agreement, incorporated by reference to Exhibit 10.1 to ISS Registration
 Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.2**      | 1995 Long-Term Incentive
 and Stock Option Plan, amended and restated through May 17, 2001,
 incorporated by reference to Exhibit 10.10 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 2001.                                                                                                                                                                                                                                                                                                                                                      
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.3**      | Employment Agreement
 between ISS and Kenneth R. Aubrey, dated December 12, 2006, effective on or
 about January 15, 2007 (in capacity as President) and effective on or about
 June 1, 2007 (in capacity of President and Chief Executive Officer),
 incorporated by reference to Exhibit 10.1 to ISS Current Report on Form 8-K
 dated December 14, 2006.                                                                                                                                                                                                             
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.4**      | Employment Agreement
 between ISS and Gregory R. L. Smith, dated December 8, 2006, incorporated by
 reference to Exhibit 10.1 to ISS Current Report on Form 8-K dated December
 8, 2006.                                                                                                                                                                                                                                                                                                                                                                                
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.5**      | Employment Agreement
 between ISS and James Murdakes, dated March 9, 2007, incorporated by
 reference to Exhibit 10.1 to ISS Current Report on Form 8-K dated March 13,
 2007.                                                                                                                                                                                                                                                                                                                                                                                          
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.6        | Business Loan Agreement
 dated December 4, 2007 by and between ISS and Wells Fargo Bank, National
 Association (Wells Fargo), incorporated by reference to Exhibit 10.6 to ISS
 2007 Form 10-K.                                                                                                                                                                                                                                                                                                                                                                         
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.7        | Promissory Note dated
 December 4, 2007 in the original principal amount of $3,000,000 issued by ISS
 to Wells Fargo, incorporated by reference to Exhibit 10.7 to ISS 2007 Form
 10-K.                                                                                                                                                                                                                                                                                                                                                                                 
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.8        | Business Loan Agreement
 dated December 4, 2007 by and between ISS and Wells Fargo, incorporated by
 reference to Exhibit 10.8 to ISS 2007 Form 10-K.                                                                                                                                                                                                                                                                                                                                                                                                                   
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.9        | Promissory Note dated
 December 4, 2007 in the original principal amount of $8,000,000 issued by ISS
 to Wells Fargo, incorporated by reference to Exhibit 10.9 to ISS 2007 Form
 10-K.                                                                                                                                                                                                                                                                                                                                                                                 
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.10       | Commercial Security
 Agreement dated January 8, 2002 by and between ISS and Wells Fargo, incorporated
 by reference to Exhibit 10.10 to ISS 2007 Form 10-K.                                                                                                                                                                                                                                                                                                                                                                                                             
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.11       | Amendment VII to Office
 Lease Agreement dated April 26, 2007 by and between ISS and Spruce Tree
 Centre L.L.P., incorporated by reference to Exhibit 10.11 to ISS 2007 Form
 10-K.                                                                                                                                                                                                                                                                                                                                                                                     

48

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| |         |                                                                                                                                                                                                                                                          
| | ------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.12   | Modification to
 Manufacturing, Distributing and Technology License Agreement dated
 September 1, 2000 by and between ISS and Econolite Control Products,
 Inc. (Econolite), incorporated by reference to Exhibit 10.12 to ISS 2007
 Form 10-K.         
| |         |                                                                                                                                                                                                                                                          
| | 10.13** | Image Sensing Systems,
 Inc. 2005 Stock Incentive Plan, incorporated by reference to Appendix A
 to ISS proxy statement filed with the SEC on April 19, 2005.                                                                                           
| |         |                                                                                                                                                                                                                                                          
| | 10.14   | Manufacturing,
 Distributing and Technology License Agreement dated June 11, 1991 by and
 between ISS and Econolite Control Products, Inc., incorporated by reference
 to Exhibit 10.1 to the Registration Statement.                                    
| |         |                                                                                                                                                                                                                                                          
| | 10.15   | Extension and Second
 Modification to License Agreement dated July 13, 2001 by and between ISS and
 Econolite, incorporated by reference to Exhibit 10.12 to ISS Annual Report
 on Form 10-KSB for the year ended December 31, 2001.                    
| |         |                                                                                                                                                                                                                                                          
| | 10.16   | Distribution Agreement
 dated January 1, 2001 by and between ISS and Wireless Technology, Inc.,
 incorporated by reference to Exhibit 10.1 to ISS Quarterly Report on Form
 10-QSB for the quarter ended June 30, 2001.                                 
| |         |                                                                                                                                                                                                                                                          
| | 10.17   | Office Lease Agreement
 dated November 24, 1998 by and between ISS and Spruce Tree Centre L.L.P.,
 incorporated by reference to Exhibit 10.18 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 1998.                                
| |         |                                                                                                                                                                                                                                                          
| | 10.18   | Production Agreement dated
 February 14, 2002 by and among ISS, Wireless Technology, Inc. and Econolite,
 incorporated by reference to Exhibit 10.20 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 2001.                         
| |         |                                                                                                                                                                                                                                                          
| | 10.19   | Extension and Third
 Modification to Manufacturing Distributing and Technology License Agreement
 dated July 3, 2008 by and between ISS and Econolite, incorporated by
 reference to Exhibit 10.1 to ISS Current Report on Form 8-K dated July 3,
 2008.
| |         |                                                                                                                                                                                                                                                          
| | 10.20** | Employment Agreement dated
 December 6, 2007 by and between ISS Image Sensing Systems Canada Ltd. and Dan
 Manor, incorporated by reference to Exhibit 99.1 to ISS 2007 Form 10-K.                                                                      
| |         |                                                                                                                                                                                                                                                          
| | 10.21   | Loan Agreement dated May 1, 2008 by and between ISS and Associated Bank,
National Association (Associated Bank), incorporated by reference to Exhibit
10.19 to ISS Registration Statement on Form S-1 filed on May 12, 2008
(Form S-1).                 
| |         |                                                                                                                                                                                                                                                          
| | 10.22   | Security Agreement dated May 1, 2008 by and between ISS and Associated Bank, incorporated by reference to Exhibit 10.20 to ISS Form S-1.                                                                                                                
| |         |                                                                                                                                                                                                                                                          
| | 10.23   | Promissory Note (Line of Credit) dated May 1, 2008 in the original principal amount of $5,000,000 issued by ISS to Associated Bank, incorporated by reference to Exhibit 10.21 to ISS Form S-1.                                                         
| |         |                                                                                                                                                                                                                                                          
| | 10.24   | Promissory Note (Loan) dated May 1, 2008 in the original principal amount of $3,000,000 issued by ISS to Associated Bank, incorporated by reference to Exhibit 10.22 to ISS Form S-1.                                                                   
| |         |                                                                                                                                                                                                                                                          
| | 21      | List of Subsidiaries of
 ISS (filed herewith).                                                                                                                                                                                                           
| |         |                                                                                                                                                                                                                                                          
| | 23.1    | Consent of Independent
 Registered Public Accounting Firm.                                                                                                                                                                                               
| |         |                                                                                                                                                                                                                                                          
| | 24      | Power of Attorney
 (included on signature page).                                                                                                                                                                                                         
| |         |                                                                                                                                                                                                                                                          
| | 31.1    | Certification of Chief
 Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                          
| | 31.2    | Certification of Chief
 Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                          
| | 32.1    | Certification of Chief
 Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                          
| | 32.2    | Certification of Chief
 Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                          
| | 99.1    | Extension of Modification
 to Manufacturing, Distributing and Technology License Agreement dated
 May 31, 2002 by and between ISS and Econolite, incorporated by reference
 to Exhibit 99.2 to ISS 2007 Form 10-K.                                      
| |         |                                                                                                                                                                                                                                                          
| | 99.2    | Letter agreement dated
 June 19, 1997 by and between ISS and Econolite, incorporated by reference to
 Exhibit 99.3 to ISS 2007 Form 10-K.                                                                                                               

---

|   |                                                                                                                                                                                         
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*  | Portions of this exhibit
 are treated as confidential pursuant to a request for confidential treatment
 filed by ISS with the SEC.                                                      
|   |                                                                                                                                                                                         
|** | Management contract or
 compensatory plan or arrangement.                                                                                                                               
|   |                                                                                                                                                                                         
|   | Copies of all exhibits not
 attached will be furnished without charge upon written request to the Company
 at the address set forth on the inside back cover page of this Annual Report.

49

---



SIGNATURES

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

Image Sensing Systems, Inc.

|                                       |  |                     
|-------------------------------------- |  | --------------------
|/s/ Kenneth R. Aubrey                  |  | Date: March 26, 2009
|                                       |  |                     
|Kenneth R. Aubrey                      |  |                     
|President and Chief
 Executive Officer |  |                     

Each
person whose signature to this report on Form 10-K appears below hereby
constitutes and appoints Kenneth R. Aubrey and Gregory R. L. Smith, and each of
them, as his or her true and lawful attorney-in-fact and agent, with full power
of substitution, to sign on his or her behalf individually and in the capacity
stated below and to perform any acts necessary to be done in order to file all
amendments to this report on Form 10-K, and any and all instruments or
documents filed as part of or in connection with this report on Form 10-K or
the amendments hereto, and each of the undersigned does hereby ratify and
confirm all that said attorney-in-fact and agent, or his substitutes, shall do
or cause to be done by virtue hereof.

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

|                                                        |  |                     
|------------------------------------------------------- |  | --------------------
|/s/ Kenneth R. Aubrey                                   |  | Date: March 26, 2009
|                                                        |  |                     
|Kenneth R. Aubrey                                       |  |                     
|President and Chief
 Executive Officer                  |  |                     
|(Principal Executive
 Officer)                          |  |                     
|                                                        |  |                     
|/s/ Gregory R. L. Smith                                 |  | Date: March 26, 2009
|                                                        |  |                     
|Gregory R. L. Smith                                     |  |                     
|Chief Financial Officer                                 |  |                     
|(Principal Financial and
 Principal Accounting Officer) |  |                     
|                                                        |  |                     
|/s/ James Murdakes                                      |  | Date: March 26, 2009
|                                                        |  |                     
|James Murdakes                                          |  |                     
|Chairman of the Board of
 Directors                     |  |                     
|                                                        |  |                     
|/s/ Panos G. Michalopoulos                              |  | Date: March 26, 2009
|                                                        |  |                     
|Panos G. Michalopoulos                                  |  |                     
|Director                                                |  |                     
|                                                        |  |                     
|/s/ Michael G. Eleftheriou                              |  | Date: March 26, 2009
|                                                        |  |                     
|Michael G. Eleftheriou                                  |  |                     
|Director                                                |  |                     
|                                                        |  |                     
|/s/ Sven A. Wehrwein                                    |  | Date: March 26, 2009
|                                                        |  |                     
|Sven A. Wehrwein                                        |  |                     
|Director                                                |  |                     

50

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