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


|          |  | 
|--------- |  | 
|          |  | 
|FORM 10-K
|          |  | 

|  |                                                                                           | 
|- | ----------------------------------------------------------------------------------------- | 
|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934     | 
|  |                                                                                           | 
|  | For
 the fiscal year ended December 31, 2009                                              | 
|  |                                                                                           | 
|  | OR                                                                                        | 
|  |                                                                                           | 
|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934 | 
|  |                                                                                           | 
|  | For
 the transition period from ____________ to ____________                              | 

Commission file number: 0-26056

|                                                        |  | 
|------------------------------------------------------- |  | 
|                                                        |  | 
|                                                        |  | 
|Image Sensing Systems, Inc.                            
|(Exact
 name of registrant as specified in its charter)

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

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

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

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

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

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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 whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the
preceding 12 months (or for such shorter period that the registrant was
required to submit and post such files).      Yes o 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.
      x

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, 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, 2009, the aggregate market value of the registrants common stock
held by non-affiliates of the registrant was $32,910,719 based on the closing
sale price as reported on The NASDAQ Capital Market. The number of shares
outstanding of the registrants $0.01 par value common stock as of March 12,
2010 was 3,993,919 shares.

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DOCUMENTS INCORPORATED BY REFERENCE

|                                                                                                  |  |                              
|------------------------------------------------------------------------------------------------- |  | -----------------------------
|Document                                                                                          |  | Parts Into Which Incorporated
|                                                                                                  |  |                              
|                                                                                                  |  |                              
|Proxy Statement for the
 Annual Meeting of Shareholders to be held May 26, 2010 (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, 13.6 million vehicles were introduced in 2009, up 45% from
the 9.4 million vehicles introduced in 2008. 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, 2009, we had sold over 100,000 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.

1

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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. Based on our determination, the
U.S. ITS video detection market sales in 2008 were approximately $110 million
and were growing on average approximately 15% per year until the recession of
2009. 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 2008.

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 China, 13.6 million
vehicles were introduced in 2009, up 45% from the 9.4 million vehicles
introduced in 2008. 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.

2

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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, the sharing of detection
information across service domains should 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. The lower
cost of deployment should 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, our CED technology can be adapted to
or is already capable of addressing these adjacent markets.

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. 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 our proprietary technologies, we
believe we command premium pricing. CED technologies similar to ours are also
difficult to develop and refine in a commercially viable manner. We therefore
should be well positioned to quickly introduce next-generation products to
market and continue our historically strong growth.

3

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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, the continuity of
our engineering staff should allow us to continuously develop improved
products.

Strong Financial Performance. Prior to the recession in 2009, we had grown
our revenue organically at an average double-digit compound annual growth rate
over the six year period from 2003 through 2008. During this time, we
maintained average net margins approaching 25%. As of December 31, 2009, we had
$32.7 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 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 plan to 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 to 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 should be able to effectively utilize our core software skills 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.

4

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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. 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 the 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 $3.3 million, $2.9 million, and $2.8 million on
research and development in 2009, 2008 and 2007, respectively, to develop and
enhance our Autoscope and RTMS technology. 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 our 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.

By
combining video and radar sensors and algorithmically comparing their outputs,
we believe 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.

6

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Distribution, Sales and Marketing

We
market and sell our products globally. As of December 31, 2009, we had supplied
systems for more than 100,000 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 our 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 five of these applications, and the remaining application is
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 33 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, 2010, we
had 97 employees. We have 72 employees in our main offices in St. Paul and
Toronto and 25 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. Sales of our Autoscope
System accounted for 66% of our revenue in 2009, 71% in 2008 and 99% in 2007.
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 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. In addition, the agreement
grants Econolite 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, a substantial portion of our revenue has
consisted of royalties resulting from sales made by Econolite, including 49% in
2009, 50% in 2008 and 71% in 2007. Econolites account receivable represented
39% of our accounts receivable at December 31, 2009 and 44% of our accounts
receivable at December 31, 2008. 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 current Autoscope and RTMS
systems and also 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 current Autoscope and RTMS systems or
hybrid or other systems we may develop in the future, 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 continuing to
grow. 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
or 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 any 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 five of these applications. The remaining application is
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, or 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.

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 products using less
sophisticated technologies. As the technological sophistication of our
competitors and the size of the market increase, 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 identify
and 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
2009, 2008 and 2007, 25%, 28% and 27% 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
U.S. 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 is denominated in non-U.S.
currency, this percentage may increase in the future, in which case
fluctuations in exchange rates could affect demand for our products. Engaging
in international business inherently involves a number of other difficulties
and risks, including:

| |   |                                                                                     
| | - | ------------------------------------------------------------------------------------
| |  | export restrictions and
 controls relating to technology;                           
| |   |                                                                                     
| |  | pricing pressure that we
 may experience internationally;                           
| |   |                                                                                     
| |  | required compliance with
 existing and new foreign regulatory requirements and laws;

12

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| |   |                                                                                                
| | - | -----------------------------------------------------------------------------------------------
| |  | 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 will be
financially responsible under the WEEE legislation. This may impose
requirements on us, 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 restricts the use of such substances as mercury, lead,
cadmium and hexavalent cadmium. If we are unable to have our products
manufactured in compliance with the RoHS directive, we would be unable to
market our products in European Union countries, and our 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, or our inability to hire and retain qualified
personnel, would harm our business.

13

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

Our
common stock is thinly traded, with 3,549,387 shares of our 3,993,919
outstanding shares held by non-affiliates as of March 12, 2010. 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
fluctuations 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, 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 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 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.

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

Our
recorded goodwill of approximately $7.6 million at December 31, 2009 relates to
our Hong Kong-based subsidiary, Flow Traffic Ltd., and the assets purchased in
the EIS asset purchase. Each year, we perform an impairment test of goodwill in
October for the EIS assets and in December for Flow Traffic or whenever an impairment
indicator arises, and we test our long-lived assets for impairment when
indicators of impairment are present. 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
charge. We estimate the fair value primarily by using a combination of income
and market approaches, where fair value under the income approach is dependent
on the present value of future economic benefits to be derived from ownership
of Flow Traffic and the EIS assets and fair value under the market approach
considers recently completed transactions within our industry sectors, comparable
trading values and other market conditions. 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
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. 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.

14

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Difficult and volatile conditions in the
capital, credit and commodities markets and in the overall economy could
continue to 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 continue to be
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
recession in the United States and other parts of the world. The continuing
impact 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,
 National Association, 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 continuing to experience financial
 difficulties or electing to limit spending because of the 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.                                   

We
do not know if market conditions or the state of the overall economy will
improve in the near future or when improvement will occur.

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
12, 2010, assuming the exercise by them of all of their options that were
currently exercisable or that vest within 60 days of March 12, 2010. 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.

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;

15

---



| |   |                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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 of the MBCA 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.

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

None.

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

We
currently lease and occupy 16,115 square feet in St. Paul, Minnesota for our
headquarters. This lease expires in May 2013, 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 2010.

16

---



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

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

|        |         
|------- | --------
|Item 4. | Reserved

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.

|        |  |      |       |      |   |       |  |     |       |  |   |       | 
|------- |  | ---- | ----- | ---- | - | ----- |  | --- | ----- |  | - | ----- | 
|        |  | 2009 |       | 2008 |  
|        |  |      |       |      |  
|Quarter |  | High |       | Low  |   | High  |  | Low |      
|        |  |      |       |      |   |       |  |     |      
|        |  |      |       |      |   |       |  |     |       |  |   |       | 
|First   |  | $    | 10.51 |      | $ | 6.69  |  | $   | 17.50 |  | $ | 12.08 | 
|Second  |  |      | 10.25 |      |   | 8.19  |  |     | 16.40 |  |   | 11.37 | 
|Third   |  |      | 13.11 |      |   | 8.61  |  |     | 15.12 |  |   | 10.71 | 
|Fourth  |  |      | 14.10 |      |   | 11.40 |  |     | 12.00 |  |   | 6.12  | 

Shareholders

As
of March 5, 2010, there were 24 holders of record of our common stock and
approximately 1,702 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 five-year 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, 2004, 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.

(LINE GRAPH)

|                                                   |  |       |        |       |  |        |  |       |        |       |  |        |  |  |       |  |  |        | 
|-------------------------------------------------- |  | ----- | ------ | ----- |  | ------ |  | ----- | ------ | ----- |  | ------ |  |  | ----- |  |  | ------ | 
|                                                   |  |       |        |       |  |        |  |       |        |       |  |        | 
|                                                   |  | 12/04 |        | 12/05 |  | 12/06  |  | 12/07 |        | 12/08 |  | 12/09  | 
|                                                   |  |       |        |       |  |        |  |       |        |       |  |        |  |  |       |  |  |        | 
|                                                   |  |       |        |       |  |        |  |       |        |       |  |        |  |  |       |  |  |        | 
|Image Sensing Systems, Inc.                        |  |       | 100.00 |       |  | 78.93  |  |       | 84.73  |       |  | 102.84 |  |  | 37.69 |  |  | 67.46  | 
|                                                  
|Wilshire 5000                                      |  |       | 100.00 |       |  | 106.38 |  |       | 123.16 |       |  | 130.07 |  |  | 81.64 |  |  | 102.00 | 
|                                                  
|Dow Jones US Electrical Components & Equipment TSM |  |       | 100.00 |       |  | 106.11 |  |       | 120.92 |       |  | 144.16 |  |  | 76.84 |  |  | 118.25 | 

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, 2009. The statement of income and balance
sheet data for the years ended and as of December 31, 2009, 2008, 2007, 2006
and 2005 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,       |       
|                                                      |  |                                       |       
|                                                      |  | 2009                                  |        | 2008 |   | 2007   |  | 2006 |        | 2005 |  
|                                                      |  |                                       |       
|                                                      |  | (in thousands, except per share data) |       
|Consolidated Statement of Income Data:                |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Revenue:                                              |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|International sales                                   |  | $                                     | 6,162  |      | $ | 7,455  |  | $    | 4,067  |      | $ | 2,980  |  | $ | 2,407  | 
|North American sales                                  |  |                                       | 6,321  |      |   | 5,689  |  |      | 269    |      |   |       |  |   |       | 
|Royalties                                             |  |                                       | 12,110 |      |   | 13,321 |  |      | 10,747 |      |   | 10,136 |  |   | 8,595  | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Total revenue                                         |  |                                       | 24,593 |      |   | 26,465 |  |      | 15,083 |      |   | 13,116 |  |   | 11,002 | 
|Cost of revenue:                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|International sales                                   |  |                                       | 2,063  |      |   | 2,805  |  |      | 1,927  |      |   | 1,501  |  |   | 1,042  | 
|North American sales                                  |  |                                       | 2,234  |      |   | 2,107  |  |      | 60     |      |   |       |  |   |       | 
|Royalties                                             |  |                                       |       |      |   |       |  |      |       |      |   | 220    |  |   | 383    | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Total cost of revenue                                 |  |                                       | 4,297  |      |   | 4,912  |  |      | 1,987  |      |   | 1,721  |  |   | 1,425  | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Gross profit                                          |  |                                       | 20,296 |      |   | 21,553 |  |      | 13,096 |      |   | 11,395 |  |   | 9,577  | 
|Operating expenses:                                   |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Selling, marketing and product support                |  |                                       | 7,201  |      |   | 6,680  |  |      | 3,463  |      |   | 2,850  |  |   | 2,567  | 
|General and administrative                            |  |                                       | 3,779  |      |   | 4,069  |  |      | 2,653  |      |   | 2,383  |  |   | 1,400  | 
|Research and development                              |  |                                       | 3,336  |      |   | 2,908  |  |      | 2,299  |      |   | 2,639  |  |   | 1,516  | 
|Amortization of intangible assets                     |  |                                       | 768    |      |   | 768    |  |      | 51     |      |   |       |  |   |       | 
|In-process research and development                   |  |                                       |       |      |   |       |  |      | 4,500  |      |   |       |  |   |       | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|                                                      |  |                                       | 15,084 |      |   | 14,425 |  |      | 12,966 |      |   | 7,871  |  |   | 5,483  | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Income from operations                                |  |                                       | 5,212  |      |   | 7,128  |  |      | 130    |      |   | 3,524  |  |   | 4,094  | 
|Other income, net                                     |  |                                       | 7      |      |   | 43     |  |      | 543    |      |   | 523    |  |   | 252    | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Income before income taxes                            |  |                                       | 5,219  |      |   | 7,171  |  |      | 673    |      |   | 4,047  |  |   | 4,346  | 
|Income tax expense (benefit)                          |  |                                       | 1,354  |      |   | 2,207  |  |      | (199   | )    |   | 942    |  |   | 1,505  | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Net income                                            |  | $                                     | 3,865  |      | $ | 4,964  |  | $    | 872    |      | $ | 3,105  |  | $ | 2,841  | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Net income per share:                                 |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Basic                                                 |  | $                                     | 0.97   |      | $ | 1.26   |  | $    | 0.23   |      | $ | 0.83   |  | $ | 0.79   | 
|Diluted                                               |  |                                       | 0.95   |      |   | 1.24   |  |      | 0.22   |      |   | 0.80   |  |   | 0.73   | 
|                                                      |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Weighted average number of common shares outstanding: |  |                                       |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Basic                                                 |  |                                       | 3,985  |      |   | 3,943  |  |      | 3,789  |      |   | 3,725  |  |   | 3,602  | 
|Diluted                                               |  |                                       | 4,081  |      |   | 4,001  |  |      | 3,881  |      |   | 3,891  |  |   | 3,868  | 

|                                  |  |                 |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|--------------------------------- |  | --------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ | 
|                                  |  | At December 31, |       
|                                  |  |                 |       
|                                  |  | 2009            |        | 2008 |   | 2007   |  | 2006 |        | 2005 |  
|                                  |  |                 |       
|                                  |  | (in thousands)  |       
|Consolidated
 Balance Sheet Data: |  |                 |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Total assets                      |  | $               | 41,150 |      | $ | 36,108 |  | $    | 30,388 |      | $ | 21,224 |  | $ | 16,791 | 
|Bank debt                         |  |                 | 4,000  |      |   | 3,750  |  |      | 5,000  |      |   |       |  |   |       | 
|Total shareholders equity        |  |                 | 32,713 |      |   | 28,530 |  |      | 23,225 |      |   | 19,333 |  |   | 15,722 | 

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, 2009.

| |                                                                                                    |                                                                                                                                                                                                   
| | -------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Trends and Challenges in Our Business                                                             
| |                                                                                                    |                                                                                                                                                                                                   
| | We believe the growth in
 our business can be attributed primarily to the following global trends:
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | worsening traffic caused
 by increased numbers of vehicles in metropolitan areas without corresponding
 expansions of road infrastructure, which has increased demand for our
 products;          
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | advances in information
 technology, which have made our products easier to market and implement;                                                                                                 
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | the continuing rise in
 funding allocations in large cities for centralized traffic management
 services, which has increased the ability of our primary end users to
 implement our products; and
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | general increases in the
 cost-effectiveness of electronics, which make our products more affordable
 for end users.                                                                              
| |                                                                                                    |                                                                                                                                                                                                   
| | We believe our continued
 growth primarily depends upon:                                          
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | continued adoption and
 governmental funding of intelligent transportation systems, or ITS, for
 traffic control in developed countries;                                                          
| |                                                                                                    |                                                                                                                                                                                                   
| |                                                                                                   | countries in the
 developing world adopting above-ground detection technology, such as video or
 radar, instead of in-pavement loop technology to manage traffic;                                 

21

---



| |   |                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | use of CED to provide
 solutions to security/surveillance and environmental issues associated with
 increasing automobile use in metropolitan areas; and                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                    
| |  | 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
continue to negatively affect our 2010 revenue. We believe we will continue to
be a beneficiary of the federal stimulus bill enacted early in 2009, but it is
difficult to determine the level of impact it has on 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 in December 2007 gives us an additional source of
revenue that increased our overall revenue and helped to 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

---



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 tables set forth selected unaudited financial information for each of
the Companys reportable segments (in thousands):

|                                   |  |                                      |        |      |   |        |  |   |        | 
|---------------------------------- |  | ------------------------------------ | ------ | ---- | - | ------ |  | - | ------ | 
|                                   |  | For the year ended December 31, 2009 |       
|                                   |  |                                      |       
|                                   |  | Autoscope                            |        | RTMS |   | Total  | 
|                                   |  |                                      |        |      |   |        | 
|Revenue                            |  | $                                    | 16,240 |      | $ | 8,353  |  | $ | 24,593 | 
|Depreciation                       |  |                                      | 292    |      |   | 132    |  |   | 424    | 
|Amortization
 of intangible assets |  |                                      |       |      |   | 768    |  |   | 768    | 
|Income
 before income taxes        |  |                                      | 3,807  |      |   | 1,412  |  |   | 5,219  | 
|Capital
 expenditures              |  |                                      | 555    |      |   | 139    |  |   | 694    | 
|Total assets                       |  |                                      | 29,752 |      |   | 11,398 |  |   | 41,150 | 
|                                   |  |                                      |        |      |   |        |  |   |        | 
|                                   |  | For the year ended December 31, 2008 |       
|                                   |  |                                      |       
|                                   |  | 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, |      
|                                        |  |                         |      
|                                        |  | 2009                    |       | 2008 |  | 2007  |  
|                                        |  |                         |       |      |  |       |  
|International
 sales                    |  |                         | 25.1  | %    |  | 28.2  | % |  | 27.0  | %
|North
 American sales                   |  |                         | 25.7  |      |  | 21.5  |   |  | 1.8   |  
|Royalties                               |  |                         | 49.2  |      |  | 50.3  |   |  | 71.2  |  
|                                        |  |                         |       |      |  |       |   |  |       |  
|Total revenue                           |  |                         | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|                                        |  |                         |       |      |  |       |   |  |       |  
|Gross
 margininternational sales       |  |                         | 66.5  |      |  | 62.4  |   |  | 52.4  |  
|Gross
 marginNorth American sales      |  |                         | 64.7  |      |  | 63.0  |   |  | 77.7  |  
|Gross
 marginroyalties                 |  |                         | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|Selling,
 marketing and product support |  |                         | 29.3  |      |  | 25.2  |   |  | 23.0  |  
|General and
 administrative             |  |                         | 15.4  |      |  | 15.4  |   |  | 17.6  |  
|Research and
 development               |  |                         | 13.6  |      |  | 11.0  |   |  | 15.2  |  
|Amortization
 of intangibles            |  |                         | 3.1   |      |  | 2.9   |   |  | 0.3   |  
|In process
 research and development    |  |                         | ―     |      |  | ―     |   |  | 29.8  |  
|Income from
 operations                 |  |                         | 21.2  |      |  | 26.9  |   |  | 0.9   |  
|Income tax
 expense (benefit)           |  |                         | 5.5   |      |  | 8.3   |   |  | (1.3  | )
|Net income                              |  |                         | 15.7  |      |  | 18.8  |   |  | 5.8   |  

23

---



Year
Ended December 31, 2009 Compared to Year Ended December 31, 2008.
Total revenue decreased to $24.6 million in 2009 from $26.5 million in
2008, a decrease of 7.1%. Royalty income decreased to $12.1 million in 2009
from $13.3 million in 2008, a decrease of 9.1%. We attribute the decrease in
royalties to the economic recession in North America and its negative impact on
state and federal spending. North American sales, which are sales of RTMS in
North America, increased to $6.3 million in 2009 from $5.7 million in 2008, an
increase of 11.1%. International sales, which include both Autoscope and RTMS sales
outside of North America, decreased to $6.2 million in 2009 from $7.5 million
in 2008, a decrease of 17.3%. The decrease in international sales was mainly
due to weakness in the Asian market in the first half of 2009. Revenue for the
Autoscope segment decreased to $16.2 million in 2009 from $18.7 million in
2008, a decrease of 13.2%. The decrease related to lower royalties and weakness
in Asia as discussed above. Revenue for the RTMS segment increased to $8.4
million in 2009 from $7.8 million in 2008, an increase of 7.6%. The increase
resulted mainly as a result of improved sales in North America.

Gross
margins for international sales increased to 66.5% in 2009 from 62.4% in 2008.
The increase resulted mainly from the increase in RTMS revenue, which typically
earns higher margins than Autoscope, and to a lesser extent by a revenue mix
shift to higher margin product within the Autoscope product family. Gross
margins for North American sales increased to 64.7% in 2009 from 63.0% in 2008.
The change was impacted by fewer lower of cost or market adjustments to
inventory in 2009 as compared to 2008. Gross margins on royalty income remained
consistent at 100% in 2009 and 2008. We anticipate that gross margins for our
international and North American sales will be in the ranges of 60% to 65% in
2010, while we expect royalty gross margins will be 100% in 2010.

Selling,
marketing and product support expense increased to $7.2 million or 29.3% of
total revenue in 2009 from $6.7 million or 25.2% of total revenue in 2008. The
selling, marketing and product support expense increased in 2009 as we invested
in market expansion activities in Europe and Asia and realized the impact of
headcount additions made late in 2008. We anticipate that selling, marketing
and product support expense will increase in terms of actual expense in 2010,
as compared to 2009, as we continue to invest in market expansion activities in
Europe and Asia.

General
and administrative expense decreased to $3.8 million or 15.4% of total revenue
in 2009, down from $4.1 million or 15.4% of total revenue in 2008. The general
and administrative expenses decrease in 2009 resulted mainly from lower
incentive pay expense and higher foreign currency transaction gains, which were
partially offset by increased professional services expense. We anticipate that
general and administrative expense will increase both in terms of actual costs
and as a percentage of revenue in 2010 as compared to 2009.

Research
and development expense increased to $3.3 million or 13.6% of total revenue in
2009, up from $2.9 million or 11.0% of total revenue in 2008. The increase was
directly related to our investment in video/radar hybrid solutions and tailored
international offerings, development projects to reduce manufacturing costs,
and the realization of the impact of headcount additions made late in 2008. We
anticipate that research and development expense will increase both in terms of
dollar amount and as a percentage of revenue in 2010 as compared to 2009 as we
continue to invest in hybrid and international offerings and manufacturing cost
reduction projects.

Amortization
of intangibles expense was $768,000 in 2009 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 2010.

Other
income decreased to $7,000 in 2009 from $43,000 in 2008 mainly due to lower
interest rates. 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.

Income
before income taxes for the Autoscope segment decreased to $3.8 million in 2009
from $5.9 million in 2008, a decrease of 35.9%. The decrease was mainly due to
lower revenues in the segment. Income before income taxes for the RTMS segment
increased to $1.4 million in 2009 from $1.2 million in 2008, an increase of
14.6%. The increase was due to higher revenues in the segment, which were
partially offset by increased expenses, a majority of which were caused by the
U.S. Dollar weakening over the course of 2009 against the Canadian Dollar.

Our
income tax effective rate was 25.9% in 2009 compared to 30.8% in 2008. The 2009
effective rate was positively impacted by the realization of $236,000 in
foreign tax credits whose status was uncertain prior to 2009. We expect the
effective rate in 2010 to be below 30%.

24

---



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 reflected 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
reflected market gains for Autoscope. We acquired the RTMS family of products
in December 2007.

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 from a revenue mix shift
to higher margin product in Autoscope. Gross margins on royalty income remained
consistent at 100.0% in 2008 and 2007.

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.

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.

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.

Amortization
of intangibles expense was $768,000 in 2008 and reflects the amortization of
intangible assets acquired in the EIS asset purchase.

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.

Liquidity
and Capital Resources

At
December 31, 2009, we had $14.1 million in cash and cash equivalents and $3.9
million in short-term investments, compared to $10.3 million in cash and cash
equivalents and $4.0 million in short-term investments at December 31, 2008.
Our investments held at December 31, 2008 were auction rate securities that
were redeemed at par in January 2009.

Net
cash provided by operating activities was $5.4 million in 2009, compared to
$5.2 million and $1.5 million in 2008 and 2007, respectively. In 2009 as
compared to 2008, our lower net income and increased inventory balances were
offset by decreased accounts receivable outstanding. The primary reasons for
the 2008 change compared to 2007 were the incremental net income increase in
2008, significant increases in depreciation and amortization, and stabilization
of working capital because of the EIS asset purchase. In 2009, investment
balances were similar to those of 2008. 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 anticipate that average receivable
collection days in 2010 will be similar to 2009 and 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 2010.

In
December 2009, we entered into a term loan agreement for $4.0 million with
Associated Bank, National Association,
or Associated Bank. The interest rate for the term loan is based on a formula
of LIBOR plus 3.75% (current rate is 4.0%). The term loan has $4.0 million
outstanding and contains a call provision that would require us to repay the
note in full in May 2010 if we do not meet certain covenants. We previously had
a separate $4.0 million term note with Associated Bank that originated in May
2008 and was fully repaid in February 2009.

25

---



We
also have a revolving line of credit agreement with Associated Bank. 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 the bank. Advances on the line of credit cannot exceed a borrowing base
determined under a formula, which is a percentage of the amounts of eligible
receivables. The line of credit currently has no borrowings outstanding and
matures on May 1, 2011. We believe, on an ongoing basis, we will have regular
availability to draw a minimum of $3.0 million on our line of credit based on
our qualifying assets.

In
conjunction with our EIS asset purchase, the sellers have an earn-out
arrangement over approximately three years from the December 2007 date of
purchase. The earn-out is based on earnings before taxes from RTMS sales less
related cost of revenue and operating expenses, excluding depreciation,
amortization and interest expenses, 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 results for RTMS for the first earn-out period, which ended
December 31, 2008, the sellers of the EIS assets were entitled to receive a
$1.2 million earn-out payment, which was paid in March and April 2009. Based on
2009 results for RTMS, the sellers are entitled to a $1.5 million earn-out for
the second earn-out period, which ran from January 1, 2009 to December 31,
2009. The earn-out is expected to be paid in March 2010, with the liability
recorded on our balance sheet as of December 31, 2009. 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.

EIS
was named in a U.S. lawsuit in 2006 for infringement of a patent. This lawsuit
was dismissed upon appeal in August 2009 and is no longer contested by the
plaintiff. We incurred no expense over the life of the lawsuit, as EIS was
responsible for costs of defense.

We
believe that cash and cash equivalents on hand at December 31, 2009, along with
the availability of funds under 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.

Critical
Accounting Policies

Goodwill
and Intangible Assets. 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 (RTMS) related
goodwill is tested on October 1 of each year.

On
an annual basis, we reconcile our market value to the estimated combined fair
value of our business segments and reporting units as a separate measure to
determine whether goodwill is impaired.

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 comparable
market transactions method. The future economic benefits are significantly dependent
on sustaining revenue levels for all product lines. For the RTMS reporting
units, 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, 2009, 2008 and 2007. If Flow Traffic and/or the RTMS reporting
units 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.

26

---



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.

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

Effective
September 15, 2009, we adopted Accounting Standards Codification (ASC)
105-10, making the ASC of the Financial Accounting Standards Board (FASB) the
single source of authoritative nongovernmental U.S. generally accepted
accounting principles (GAAP). Rules and interpretive releases of the
Securities and Exchange Commission (SEC) under authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. All
other accounting literature not included in the ASC is non-authoritative. The
Codification did not have a significant impact on our consolidated financial
statements or disclosures.

In
December 2007, the FASB issued ASC 805, Business
Combinations. ASC 805 significantly changed the accounting for
business combinations. Under ASC 805, 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. ASC 805 will change
the accounting treatment for certain specific items. ASC 805 also includes a
substantial number of new disclosure requirements. ASC 805 applies to us
prospectively for business combinations beginning in 2009, and this adoption
did not have a material impact on our consolidated financial statements.

In
December 2007, the FASB issued ASC 810, Consolidation.
ASC 810 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. ASC 810 also includes expanded disclosure requirements regarding
the interests of the parent and its noncontrolling interest. ASC 810 is
effective for fiscal years, and interim periods within those fiscal years, beginning
on or after December 15, 2008. The adoption of ASC 810 did not have a material
impact on our consolidated financial statements.

27

---



In
June 2009, the FASB amended ASC 810, Consolidation,
to improve how enterprises disclose their involvement with variable interest
entities (VIE), which are special-purpose entities, and other entities whose
equity at risk is insufficient or lacks certain characteristics. Among other
things, ASC 810 changes how an entity determines whether it is the primary
beneficiary of a VIE and whether that VIE should be consolidated. ASC 810
requires an entity to provide significantly more disclosures about its
involvement with a VIE. Companies must comprehensively review involvements with
potential VIEs, including those previously considered to be qualifying
special-purpose entities, to determine the effect on their consolidated
financial statements and related disclosures. ASC 810 is effective
prospectively for interim or annual reporting periods beginning after December
15, 2009. We do not believe that the adoption of this portion of ASC 810 will
have a significant effect on our consolidated financial statements.

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. From time to time, we enter into currency hedges to
attempt to lower our exposure to translation gains and losses as well as to
limit the impact of foreign currency translation upon the consolidation of our
foreign subsidiaries. A 10% adverse change in foreign currency rates, if we
have not hedged, could have a material effect on our results of operations or
financial position. Our current greatest exposure for a negative material
impact to our operations is a rising Canadian Dollar versus the U.S. Dollar.

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 |       
|                                                                                                                  |  |             |       
|                                                                                                                  |  | 2009        |        | 2008 |  
|                                                                                                                  |  |             |        |      |  
|                                                                                                                  |  |             |        |      |   |        |  
|ASSETS                                                                                                            |  |             |        |      |   |        |  
|Current assets:                                                                                                   |  |             |        |      |   |        |  
|Cash and cash equivalents                                                                                         |  | $           | 14,084 |      | $ | 10,289 |  
|Investments                                                                                                       |  |             | 3,935  |      |   | 4,000  |  
|Accounts receivable, net of allowance for returns
 and doubtful accounts of $90 ($96 in 2008)                     |  |             | 5,660  |      |   | 6,620  |  
|Inventories                                                                                                       |  |             | 2,734  |      |   | 1,608  |  
|Prepaid expenses                                                                                                  |  |             | 588    |      |   | 376    |  
|Deferred income taxes                                                                                             |  |             | 328    |      |   | 376    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total current assets                                                                                              |  |             | 27,329 |      |   | 23,269 |  
|                                                                                                                  |  |             |        |      |   |        |  
|Property and equipment:                                                                                           |  |             |        |      |   |        |  
|Furniture and fixtures                                                                                            |  |             | 274    |      |   | 265    |  
|Leasehold improvements                                                                                            |  |             | 92     |      |   | 64     |  
|Equipment                                                                                                         |  |             | 2,288  |      |   | 1,631  |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             | 2,654  |      |   | 1,960  |  
|Accumulated depreciation                                                                                          |  |             | 1,656  |      |   | 1,232  |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             | 998    |      |   | 728    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Deferred income taxes                                                                                             |  |             | 1,485  |      |   | 1,575  |  
|Intangible assets                                                                                                 |  |             | 3,714  |      |   | 4,481  |  
|Goodwill                                                                                                          |  |             | 7,624  |      |   | 6,055  |  
|                                                                                                                  |  |             |        |      |   |        |  
|TOTAL ASSETS                                                                                                      |  | $           | 41,150 |      | $ | 36,108 |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             |        |      |   |        |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                              |  |             |        |      |   |        |  
|Current liabilities:                                                                                              |  |             |        |      |   |        |  
|Accounts payable                                                                                                  |  | $           | 953    |      | $ | 251    |  
|Current portion of bank debt                                                                                      |  |             | 4,000  |      |   | 1,000  |  
|Accrued compensation                                                                                              |  |             | 858    |      |   | 1,091  |  
|Accrued warranty and other                                                                                        |  |             | 643    |      |   | 793    |  
|EIS earn-out payable                                                                                              |  |             | 1,541  |      |   | 1,164  |  
|Income taxes payable                                                                                              |  |             | 234    |      |   | 283    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total current liabilities                                                                                         |  |             | 8,229  |      |   | 4,582  |  
|                                                                                                                  |  |             |        |      |   |        |  
|Bank debt, less current portion                                                                                   |  |             |       |      |   | 2,750  |  
|Income taxes payable                                                                                              |  |             | 208    |      |   | 246    |  
|                                                                                                                  |  |             |        |      |   |        |  
|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, 3,985,819 issued and outstanding (3,985,219 in 2008) |  |             | 40     |      |   | 40     |  
|Additional paid-in capital                                                                                        |  |             | 11,994 |      |   | 11,652 |  
|Accumulated other comprehensive loss                                                                              |  |             | (171   | )    |   | (147   | )
|Retained earnings                                                                                                 |  |             | 20,850 |      |   | 16,985 |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total shareholders equity                                                                                        |  |             | 32,713 |      |   | 28,530 |  
|                                                                                                                  |  |             |        |      |   |        |  
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                        |  | $           | 41,150 |      | $ | 36,108 |  
|                                                                                                                  |  |             |        |      |   |        |  

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 |       
|                                                       |  |                         |       
|                                                       |  | 2009                    |        | 2008 |   | 2007   | 
|                                                       |  |                         |        |      |   |        | 
|Revenue:                                               |  |                         |        |      |   |        |  |   |        |  
|International sales                                    |  | $                       | 6,162  |      | $ | 7,455  |  | $ | 4,067  |  
|North American sales                                   |  |                         | 6,321  |      |   | 5,689  |  |   | 269    |  
|Royalties                                              |  |                         | 12,110 |      |   | 13,321 |  |   | 10,747 |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|                                                       |  |                         | 24,593 |      |   | 26,465 |  |   | 15,083 |  
|Cost of
 revenue:                                      |  |                         |        |      |   |        |  |   |        |  
|International sales                                    |  |                         | 2,063  |      |   | 2,805  |  |   | 1,927  |  
|North American sales                                   |  |                         | 2,234  |      |   | 2,107  |  |   | 60     |  
|Royalties                                              |  |                         |       |      |   |       |  |   |       |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|                                                       |  |                         | 4,297  |      |   | 4,912  |  |   | 1,987  |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Gross profit                                           |  |                         | 20,296 |      |   | 21,553 |  |   | 13,096 |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Operating
 expenses:                                   |  |                         |        |      |   |        |  |   |        |  
|Selling, marketing and product support                 |  |                         | 7,201  |      |   | 6,680  |  |   | 3,463  |  
|General and administrative                             |  |                         | 3,779  |      |   | 4,069  |  |   | 2,653  |  
|Research and development                               |  |                         | 3,336  |      |   | 2,908  |  |   | 2,299  |  
|Amortization of intangible assets                      |  |                         | 768    |      |   | 768    |  |   | 51     |  
|In-process research and development                    |  |                         |       |      |   |       |  |   | 4,500  |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|                                                       |  |                         | 15,084 |      |   | 14,425 |  |   | 12,966 |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Income from
 operations                                |  |                         | 5,212  |      |   | 7,128  |  |   | 130    |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Other
 income, net                                     |  |                         | 7      |      |   | 43     |  |   | 543    |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Income
 before income taxes                            |  |                         | 5,219  |      |   | 7,171  |  |   | 673    |  
|Income tax
 expense (benefit)                          |  |                         | 1,354  |      |   | 2,207  |  |   | (199   | )
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Net income                                             |  | $                       | 3,865  |      | $ | 4,964  |  | $ | 872    |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Net income
 per share:                                 |  |                         |        |      |   |        |  |   |        |  
|Basic                                                  |  | $                       | 0.97   |      | $ | 1.26   |  | $ | 0.23   |  
|Diluted                                                |  |                         | 0.95   |      |   | 1.24   |  |   | 0.22   |  
|                                                       |  |                         |        |      |   |        |  |   |        |  
|Weighted
 average number of common shares outstanding: |  |                         |        |      |   |        |  |   |        |  
|Basic                                                  |  |                         | 3,985  |      |   | 3,943  |  |   | 3,789  |  
|Diluted                                                |  |                         | 4,081  |      |   | 4,001  |  |   | 3,881  |  

See accompanying notes to the consolidated
financial statements.

30

---



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

|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|---------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------- | -
|                                                                                   |  | Years ended December 31 |       
|                                                                                   |  |                         |       
|                                                                                   |  | 2009                    |        | 2008 |   | 2007   |  
|                                                                                   |  |                         |        |      |   |        |  
|Operating activities:                                                              |  |                         |        |      |   |        |   |   |         |  
|Net income                                                                         |  | $                       | 3,865  |      | $ | 4,964  |   | $ | 872     |  
|Adjustments to reconcile net income to net
 cash provided by operating activities: |  |                         |        |      |   |        |   |   |         |  
|Depreciation                                                                       |  |                         | 424    |      |   | 357    |   |   | 226     |  
|Amortization                                                                       |  |                         | 768    |      |   | 768    |   |   | 51      |  
|In-process research and development                                                |  |                         |       |      |   |       |   |   | 4,500   |  
|Tax benefit from disqualifying disposition                                         |  |                         |       |      |   | 137    |   |   | 112     |  
|Stock option expense                                                               |  |                         | 341    |      |   | 339    |   |   | 194     |  
|Deferred income taxes                                                              |  |                         | 138    |      |   | (133   | ) |   | (1,653  | )
|Changes in operating assets and
 liabilities:                                      |  |                         |        |      |   |        |   |   |         |  
|Accounts receivable                                                                |  |                         | 960    |      |   | (1,623 | ) |   | (2,040  | )
|Inventories                                                                        |  |                         | (1,126 | )    |   | (29    | ) |   | (909    | )
|Prepaid expenses                                                                   |  |                         | (212   | )    |   | (148   | ) |   | (102    | )
|Accounts payable                                                                   |  |                         | 702    |      |   | (565   | ) |   | 200     |  
|Accrued liabilities                                                                |  |                         | (384   | )    |   | 671    |   |   | 177     |  
|Income taxes payable                                                               |  |                         | (87    | )    |   | 445    |   |   | (147    | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Net cash
 provided by operating activities                                         |  |                         | 5,389  |      |   | 5,183  |   |   | 1,481   |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Investing activities:                                                              |  |                         |        |      |   |        |   |   |         |  
|Purchase of EIS assets                                                             |  |                         |       |      |   |       |   |   | (11,406 | )
|EIS earn-out payment                                                               |  |                         | (1,192 | )    |   |       |   |   |        |  
|Purchase of short-term investments                                                 |  |                         | (6,640 | )    |   | (7,400 | ) |   |        |  
|Sale of short-term investments                                                     |  |                         | 6,705  |      |   | 3,400  |   |   | 1,800   |  
|Maturity of callable FHLB bonds                                                    |  |                         |       |      |   |       |   |   | 2,300   |  
|Purchases of property and equipment                                                |  |                         | (694   | )    |   | (385   | ) |   | (104    | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Net cash
 used in investing activities                                             |  |                         | (1,821 | )    |   | (4,385 | ) |   | (7,410  | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Financing activities:                                                              |  |                         |        |      |   |        |   |   |         |  
|Proceeds from exercise of stock options                                            |  |                         | 1      |      |   | 173    |   |   | 34      |  
|Proceeds from bank debt                                                            |  |                         | 4,000  |      |   |       |   |   | 5,000   |  
|Repayment of bank debt                                                             |  |                         | (3,750 | )    |   | (1,250 | ) |   |        |  
|Cash (restricted for) released from
 restriction on bank debt                      |  |                         |       |      |   | 5,263  |   |   | (5,263  | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Net cash
 provided by (used in) financing activities                               |  |                         | 251    |      |   | 4,186  |   |   | (229    | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Effect of
 exchange rate changes on cash                                           |  |                         | 24     |      |   | (308   | ) |   | 145     |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Increase
 (decrease) in cash and cash equivalents                                  |  |                         | 3,795  |      |   | 4,676  |   |   | (6,013  | )
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Cash and
 cash equivalents at beginning of year                                    |  |                         | 10,289 |      |   | 5,613  |   |   | 11,626  |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Cash and
 cash equivalents at end of year                                          |  | $                       | 14,084 |      | $ | 10,289 |   | $ | 5,613   |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Supplemental disclosure:                                                           |  |                         |        |      |   |        |   |   |         |  
|Income taxes paid                                                                  |  | $                       | 1,488  |      | $ | 1,680  |   | $ | 1,352   |  
|Interest expense paid                                                              |  | $                       | 33     |      | $ | 278    |   | $ | 35      |  
|                                                                                   |  |                         |        |      |   |        |   |   |         |  
|Supplemental non-cash disclosure:                                                  |  |                         |        |      |   |        |   |   |         |  
|Common stock issued in connection with EIS
 asset purchase                         |  | $                       |       |      | $ |       |   | $ | 2,534   |  
|EIS earn-out payable recorded as additional
 goodwill                              |  | $                       | 1,541  |      | $ | 1,164  |   | $ |        |  

See accompanying notes to the consolidated
financial statements.

31

---



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

|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  
|------------------------------------------ |  | -------------- | --------- | ------------- | - | ---------------------------- |  | ------------------------------------------------- | ------ | ----------------- | - | ----- | - | - | ------ |  | - | ------ | -
|                                           |  | Shares
 Issued |           | Common
 Stock |   | Additional
 Paid-In
 Capital |  | Accumulated
 Other
 Comprehensive
 Income
 (Loss) |        | Retained Earnings |   | Total |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |  
|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 |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  
|Common stock issued for options exercised  |  |                | 600       |               |   |                             |  |                                                   | 1      |                   |   |      |   |   |       |  |   | 1      |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  
|Stock option expense                       |  |                |          |               |   |                             |  |                                                   | 341    |                   |   |      |   |   |       |  |   | 341    |  
|Foreign currency translation adjustment    |  |                |          |               |   |                             |  |                                                   |       |                   |   | (24   | ) |   |       |  |   | (24    | )
|Net income                                 |  |                |          |               |   |                             |  |                                                   |       |                   |   |      |   |   | 3,865  |  |   | 3,865  |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  
|Comprehensive income                       |  |                |          |               |   |                             |  |                                                   |       |                   |   |      |   |   |       |  |   | 3,841  |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2009               |  |                | 3,985,819 |               | $ | 40                           |  | $                                                 | 11,994 |                   | $ | (171  | ) | $ | 20,850 |  | $ | 32,713 |  
|                                           |  |                |           |               |   |                              |  |                                                   |        |                   |   |       |   |   |        |  |   |        |  

See accompanying notes to the consolidated
financial statements.

32

---



Notes to Consolidated Financial Statements

December 31, 2009

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 $3.6 million and $1.0 million at
December 31, 2009 and 2008, respectively. We hold our cash and cash equivalents
with financial institutions and, at times, the amounts of our balances may be
in excess of insurance limits.

INVESTMENTS

Investments
and marketable securities held at December 31, 2009 that do not qualify as cash
equivalents have been designated as available for sale. The estimated fair
value of the investments held at December 31, 2009 was determined using level 1
measurements under the fair value hierarchy.

At
December 31, 2008, we held $4.0 million (par value) of investments comprised of
auction rate securities, or ARS, which were designated as trading. The
balance of investments at December 31, 2008, consisted of the combination of
the fair value of ARS 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.
In January 2009, our ARS were purchased by the broker/dealer at par.

33

---



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.

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 $6,000, $211,000 and $253,000 for
the years ended December 31, 2009, 2008 and 2007, 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

Fair
value is determined on the exchange price that 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. Each major asset and liability category is
measured at fair value on either a recurring or nonrecurring basis using 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 on October 1 of each year.

34

---



During
our annual impairment testing, we reconcile our market value, based on the
value of our common stock, to the estimated combined fair value of our
reporting units, to ensure that goodwill is not impaired. At December 31, 2008,
we performed a reconciliation, as our market capitalization was similar to our
consolidated shareholders equity. We determined that no goodwill impairment
existed.

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, 2009, 2008 or 2007.

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 $175,000, $153,000, and $44,000 for the
years ended December 31, 2009, 2008 and 2007, respectively, and our warranty
liability was $289,000 and $217,000 at December 31, 2009 and 2008,
respectively.

ADVERTISING

Advertising
costs are charged to operations in the period incurred and totaled $151,000,
$196,000 and $247,000 for the years ended December 31, 2009, 2008 and 2007,
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 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, 2009, 2008 and 2007, respectively, 95,000, 58,000
and 92,000 common share equivalents were included in the computation of diluted
net income per share.

At
December 31, 2009, 2008 and 2007, the exercise prices of 36,000, 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.

35

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STOCK OPTIONS

We
recognize compensation expense for share-based awards using the fair value of
the option at the time of the grant and amortizing the fair value over the
estimated service period on the straight-line attribute method. Unrecognized compensation costs were $792,655
at December 31, 2009, with a weighted average remaining life of 2.9 years.

NEW ACCOUNTING
PRONOUNCEMENTS

Effective
September 15, 2009, we adopted Accounting Standards Codification (ASC)
105-10, making the ASC of the Financial Accounting Standards Board (FASB) the
single source of authoritative nongovernmental U.S. generally accepted
accounting principles (GAAP). Rules and interpretive releases of the
Securities and Exchange Commission (SEC) under authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. All
other accounting literature not included in the ASC is non-authoritative. The
Codification did not have a significant impact on our consolidated financial
statements or disclosures.

In
December 2007, the FASB issued ASC 805, Business
Combinations. ASC 805 significantly changed the accounting for
business combinations. Under ASC 805, 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. ASC 805 will change
the accounting treatment for certain specific items. ASC 805 also includes a
substantial number of new disclosure requirements. ASC 805 applies to us
prospectively for business combinations beginning in 2009, and this adoption
did not have a material impact on our consolidated financial statements.

In
December 2007, the FASB issued ASC 810, Consolidation.
ASC 810 establishes new accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary. ASC 810
also includes expanded disclosure requirements regarding the interests of the
parent and its noncontrolling interest. ASC 810 is effective for fiscal years,
and interim periods within those fiscal years, beginning on or after December
15, 2008. The adoption of ASC 810 did not have a material impact on our
consolidated financial statements.

In
June 2009, the FASB amended ASC 810, Consolidation,
to improve how enterprises disclose their involvement with variable interest
entities (VIE), which are special-purpose entities, and other entities whose
equity at risk is insufficient or lacks certain characteristics. Among other
things, ASC 810 changes how an entity determines whether it is the primary
beneficiary of a VIE and whether that VIE should be consolidated. ASC 810
requires an entity to provide significantly more disclosures about its
involvement with a VIE. Companies must comprehensively review involvements with
potential VIEs, including those previously considered to be qualifying
special-purpose entities, to determine the effect on its consolidated financial
statements and related disclosures. It is effective prospectively for interim
or annual reporting periods beginning after December 15, 2009. We do not
believe that the adoption of this portion of ASC 810 will have a significant
effect on our consolidated financial statements.

RECLASSIFICATIONS

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

2.          INVESTMENTS

Investments
and marketable securities held at December 31, 2009 that do not qualify as cash
equivalents have been designated as available for sale. The estimated fair
value of the investments held at December 31, 2009 was determined using level 1
measurements.

At
December 31, 2008, we held $4.0 million (par value) of investments comprised of
auction rate securities, or ARS, which were designated as trading. The
balance of investments at December 31, 2008 consisted of the combination of the
fair value of ARS 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. In January 2009, our
ARS were purchased by the broker/dealer at par.

36

---



Our
current portfolio is composed of high-grade tax-exempt municipal bonds. The
maximum term to maturity or time to next reset is six months.

Proceeds
from maturities and sales of investments totaled $6.7 million, $3.4 million and
$4.1 million for the years ended December 31, 2009, 2008 and 2007,
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, 2009 and 2007.

3.          INVENTORIES

Inventories,
net of reserves, consisted of the following (in thousands):

|                      |  |              |       |      |   |       | 
|--------------------- |  | ------------ | ----- | ---- | - | ----- | 
|                      |  | December 31, |      
|                      |  |              |      
|                      |  | 2009         |       | 2008 |  
|                      |  |              |       |      |  
|Electronic components |  | $            | 1,733 |      | $ | 1,097 | 
|Finished goods        |  |              | 1,001 |      |   | 511   | 
|                      |  |              |       |      |   |       | 
|                     
|Total                 |  | $            | 2,734 |      | $ | 1,608 | 
|                      |  |              |       |      |   |       | 

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. 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.

Earn-out
payments related to the EIS asset purchase will be recorded as additional
goodwill when earned. In 2008, the sellers were entitled to receive an earn-out
of $1.2 million, which was paid in March and April 2009. Based on 2009 results
for RTMS, the sellers are entitled to a $1.5 million earn-out for the second
earn-out period, which is expected to be paid in March 2010.

Prior
to the asset purchase, EIS was engaged in research and development activity
with respect to 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.

The
results of ISS/Canada and Canada Sales Corp., which were formed to assume the
operations of EIS, are included in the consolidated financial statements since
the date of the EIS asset purchase.

EIS
was named in a U.S. lawsuit in 2006 for infringement of a patent. This lawsuit
was dismissed upon appeal in August 2009 and is no longer contested by the
plaintiff. We incurred no expense over the life of the lawsuit, as EIS was
responsible for costs of defense.

5.          GOODWILL
AND INTANGIBLE ASSETS

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic (Autoscope
segment) and $6.6 million related to the EIS asset purchase (RTMS segment),
consisting of $3.8 million recorded at the time of the purchase and an
additional $1.5 million and $1.2 million, recorded in 2009 and 2008,
respectively, in conjunction with earn-out payments due.

37

---



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

|                                          |  |              |        |      |   |       |  
|----------------------------------------- |  | ------------ | ------ | ---- | - | ----- | -
|                                          |  | December 31, |       
|                                          |  |              |       
|                                          |  | 2009         |        | 2008 |  
|                                          |  |              |        |      |  
|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           |  |              | (1,586 | )    |   | (819  | )
|                                          |  |              |        |      |   |       |  
|Total identifiable intangible assets, net |  | $            | 3,714  |      | $ | 4,481 |  
|                                          |  |              |        |      |   |       |  

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, 2010 and 2011 and of
$749,000 in 2012. The weighted average amortization period remaining for
intangible assets is 5.2 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.

The
revolving line of credit agreement provides up to $5.0 million in short-term
borrowings at the banks prime rate expiring May 1, 2011. Any loans are secured
by inventories, accounts receivable and equipment, and the bank has the right
of setoff against our checking, savings and other accounts. We had $2.0 million
of outstanding borrowings under the line of credit at December 31, 2008. There
was no outstanding balance at December 31, 2009.

In
December 2009, we entered into a term loan agreement for $4.0 million with
Associated Bank, National Association, or Associated Bank. The interest rate
for the term loan is based on a formula of LIBOR plus 3.75% (current rate is
4.0%). We had $4.0 million of outstanding borrowings under the term loan at
December 31, 2009. The term loan has a call provision that would require us to
repay the note in full in May 2010 if we do not meet certain covenants.

Principal
and accrued interest on the term loan are due and payable in installments
beginning on March 31, 2010 and continuing on the last day of each successive
June, September, December and March. Each of such installments is to be equal
to the sum of (a) all accrued and unpaid interest on the term loan as of the
due date of payment; (b) on each of March 31, 2010 and June 30, 2010, a
principal payment of $100,000; and (c) beginning with the installment due on
September 30, 2010, and continuing for each installment thereafter, a principal
payment of $380,000. The term note matures and becomes due and payable on
December 31, 2012, subject to earlier repayment as set forth in a related
Modification Agreement. It may be prepaid, without premium or fee, in whole or
in part, at any time, with partial prepayments in the minimum amount of
$10,000.

We
previously had a separate $4.0 million term note with Associated Bank that
originated in May 2008 and was fully repaid in February 2009.

7.          LEASE
COMMITMENTS

We
rent office space and equipment under operating lease agreements expiring at
various dates through May 2013. The leases provide for monthly payments of
$40,000, and we are responsible for our proportionate share of increases in
operating expenses that exceed a base rent factor. Rent expense amounted to
$585,000 in 2009, $555,000 in 2008, and $319,000 in 2007.

Future
minimum annual lease payments under noncancelable operating leases for the years
ending December 31, 2010, 2011, 2012 and 2013 are $354,000, $199,000, $128,000
and $53,000, respectively.

38

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8.          INCOME
TAXES

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

|                                                |  |              |       |      |   |       |  
|----------------------------------------------- |  | ------------ | ----- | ---- | - | ----- | -
|                                                |  | December 31, |      
|                                                |  |              |      
|                                                |  | 2009         |       | 2008 |  
|                                                |  |              |       |      |  
|                                               
|Current deferred tax
 assets (liabilities):     |  |              |       |      |   |       |  
|Accrued compensation                            |  | $            | 47    |      | $ | 40    |  
|Prepaid expenses                                |  |              | (48   | )    |   | (43   | )
|Inventory reserves                              |  |              | 66    |      |   | 165   |  
|Stock option expense (non-qualified)            |  |              | 131   |      |   | 90    |  
|Other                                           |  |              | 132   |      |   | 124   |  
|Foreign net operating loss carryforwards        |  |              | 55    |      |   | 9     |  
|Less valuation allowance                        |  |              | (55   | )    |   | (9    | )
|                                                |  |              |       |      |   |       |  
|                                                |  |              | 328   |      |   | 376   |  
|Non-current deferred tax
 assets (liabilities): |  |              |       |      |   |       |  
|Intangible asset amortization                   |  |              | 1,525 |      |   | 1,611 |  
|Other                                           |  |              | (40   | )    |   | (36   | )
|                                                |  |              |       |      |   |       |  
|                                                |  |              | 1,485 |      |   | 1,575 |  
|                                                |  |              |       |      |   |       |  
|Net deferred tax assets                         |  | $            | 1,813 |      | $ | 1,951 |  
|                                                |  |              |       |      |   |       |  

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
were $3.3 million, $2.0 million and $913,000 in undistributed earnings of our
wholly-owned foreign subsidiaries at December 31, 2009, 2008 and 2007,
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.

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, |      
|                                    |  |                          |      
|                                    |  | 2009                     |       | 2008 |   | 2007  |  
|                                    |  |                          |       |      |   |       |  
|Current:                            |  |                          |       |      |   |       |   |   |        |  
|Federal                             |  | $                        | 1,222 |      | $ | 1,738 |   | $ | 1,318  |  
|State                               |  |                          | 23    |      |   | 38    |   |   | 20     |  
|Foreign                             |  |                          | (29   | )    |   | 564   |   |   | 116    |  
|                                    |  |                          |       |      |   |       |   |   |        |  
|                                    |  |                          | 1,216 |      |   | 2,340 |   |   | 1,454  |  
|                                    |  |                          |       |      |   |       |   |   |        |  
|Deferred:                           |  |                          |       |      |   |       |   |   |        |  
|Federal                             |  |                          | 82    |      |   | (59   | ) |   | (1,638 | )
|State                               |  |                          | 5     |      |   | (23   | ) |   | (15    | )
|Foreign                             |  |                          | 51    |      |   | (51   | ) |   |       |  
|                                    |  |                          |       |      |   |       |   |   |        |  
|                                    |  |                          | 138   |      |   | (133  | ) |   | (1,653 | )
|                                    |  |                          |       |      |   |       |   |   |        |  
|Total income tax expense
 (benefit) |  | $                        | 1,354 |      | $ | 2,207 |   | $ | (199   | )
|                                    |  |                          |       |      |   |       |   |   |        |  

Income
before taxes for the foreign operations were $1.3 million, $1.7 million and
$509,000 for the years ended December 31, 2009, 2008 and 2007.

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

|                                                  |  |              |       |      |   |       |   |   |      |  
|------------------------------------------------- |  | ------------ | ----- | ---- | - | ----- | - | - | ---- | -
|                                                  |  | December 31, |      
|                                                  |  |              |      
|                                                  |  | 2009         |       | 2008 |   | 2007  |  
|                                                  |  |              |       |      |   |       |  
|Federal tax statutory rate                        |  | $            | 1,774 |      | $ | 2,438 |   | $ | 225  |  
|State taxes, net of
 federal benefit              |  |              | 18    |      |   | 10    |   |   | 2    |  
|Tax exempt interest                               |  |              | (4    | )    |   |      |   |   | (146 | )
|Research and development
 tax credits             |  |              | (301  | )    |   | (120  | ) |   | (120 | )
|Domestic production
 activity deduction           |  |              | (62   | )    |   | (83   | ) |   | (61  | )
|Effect of lower rates on
 foreign income          |  |              | (58   | )    |   | (125  | ) |   | (57  | )
|Use of foreign loss
 carryforwards                |  |              |      |      |   | (77   | ) |   |     |  
|Stock option expense                              |  |              | 74    |      |   | 66    |   |   | 32   |  
|Adjustment of prior year
 tax credits and refunds |  |              | (77   | )    |   | (50   | ) |   | (26  | )
|Uncertain tax positions                           |  |              | (38   | )    |   | 96    |   |   | 50   |  
|Other                                             |  |              | (42   | )    |   | 52    |   |   | (98  | )
|                                                  |  |              |       |      |   |       |   |   |      |  
|                                                  |  | $            | 1,354 |      | $ | 2,207 |   | $ | (199 | )
|                                                  |  |              |       |      |   |       |   |   |      |  

39

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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, 2008                                           |  | $ | 150 |  
|Additions for current year
 tax positions                            |  |   | 96  |  
|Reductions                                                           |  |   |    |  
|                                                                     |  |   |     |  
|Balance at December 31,
 2008                                        |  |   | 246 |  
|Additions for current year
 tax positions                            |  |   |    |  
|Reductions as a result of
 tax positions taken in the current period |  |   | (38 | )
|                                                                     |  |   |     |  
|Balance at December 31,
 2009                                        |  | $ | 208 |  
|                                                                     |  |   |     |  

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, 2005.

9.          LICENSING

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 to 2028, unless terminated by either
party upon three years notice.

We
recognized royalty income from this agreement of $12.1 million, $13.3 million
and $10.7 million in 2009, 2008 and 2007, respectively.

10.          REVENUE
FROM FOREIGN COUNTRIES

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

|              |  |      |   |      |    |      |  |    |   | 
|------------- |  | ---- | - | ---- | -- | ---- |  | -- | - | 
|              |  | 2009 |   | 2008 |    | 2007 | 
|              |  |      |   |      |    |      | 
|Asia Pacific  |  | 10   | % |      | 12 | %    |  | 11 | % | 
|Europe        |  | 15   | % |      | 16 | %    |  | 16 | % | 
|North America |  | 75   | % |      | 72 | %    |  | 73 | % | 

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 $288,000 and $258,000 at December 31, 2009 and 2008,
respectively.

11.          SIGNIFICANT
CUSTOMERS AND CONCENTRATION OF CREDIT RISK

Royalty
income from Econolite comprised 49%, 50% and 71% of revenue in the years ended
December 31, 2009, 2008 and 2007, respectively. Accounts receivable from
Econolite were $2.2 million and $2.9 million at December 31, 2009 and 2008,
respectively. Major disruptions in the manufacturing and distribution of our
products by Econolite or the inability of Econolite to make payments on their
accounts receivable with us could have a material adverse effect on our
business, financial condition and results of operations. One international
customer comprised 10% of accounts receivable at December 31, 2009 and 13% of
accounts receivable at December 31, 2008.

40

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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. We made contributions totaling $98,000,
$97,000 and $89,000 to the plans for 2009, 2008 and 2007, 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, although the options granted under the 1995 Plan remain outstanding
according to their terms. 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 2009 and 2008:

|                              |  |                                     |         |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|----------------------------- |  | ----------------------------------- | ------- | ------------------------- | --- | ------------------------------ | --- | -------------------------------------------- | ------- | - |  | ------- | - | - | ----- | 
|                              |  | Plan
 Options
 Available
 For Grant |         | Plan Options
 Outstanding |     | Non-Plan
 Options
 Outstanding |     | Weighted
 Average
 Exercise Price
 Per Share |        
|                              |  |                                     |         |                           |     |                                |     |                                              |         |   | 
|                              |  |                                     |         |                           | ISO |                                | NQO |                                              |         |   |  |         |   |  
|                              |  |                                     |         |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|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 | 
|                              |  |                                     |         |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|Granted                       |  |                                     | (68,000 | )                         |     | 19,000                         |     |                                              | 49,000  |   |  |        |   |   | 8.62  | 
|Exercised                     |  |                                     |        |                           |     | (600                           | )   |                                              |        |   |  |        |   |   | 1.30  | 
|Forfeited                     |  |                                     | 10,000  |                           |     | (10,000                        | )   |                                              |        |   |  |        |   |   | 9.22  | 
|                              |  |                                     |         |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 
|Balance at December 31,
 2009 |  |                                     | 107,500 |                           |     | 163,518                        |     |                                              | 261,615 |   |  | 6,000   |   | $ | 8.10  | 
|                              |  |                                     |         |                           |     |                                |     |                                              |         |   |  |         |   |   |       | 

In
June 2009, under a shareholder approved plan, we exchanged options to purchase
168,500 shares with exercise prices ranging from $12.37 to $17.50 on a
one-for-one basis for options with an exercise price of $9.22. This option
exchange did not have a material effect on the compensation expense for the
year ended December 31, 2009.

The
following table summarizes information about the stock options outstanding at
December 31, 2009:

|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 
|------------------------ |  | ------------------- | ------- | ----------------------------------------------- |  | ---------------------------------- |  | --------------------------- | ----- | ------------------- | - | ---------------------------------- |  | --------------------------- | ------- |  | - | ----- |  | - | --------- | 
|                         |  | 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               |  |                     | 58,500  |                                                 |  | 2.2
 years                         |  | $                           | 1.34  |                     | $ | 665,342                            |  |                             | 58,500  |  | $ | 1.34  |  | $ | 665,342   | 
|2.00-2.99                |  |                     | 16,200  |                                                 |  | 2.1
 years                         |  |                             | 2.35  |                     |   | 167,959                            |  |                             | 16,200  |  |   | 2.35  |  |   | 167,959   | 
|3.00-3.99                |  |                     | 38,933  |                                                 |  | 2.8
 years                         |  |                             | 3.15  |                     |   | 372,639                            |  |                             | 38,933  |  |   | 3.15  |  |   | 372,639   | 
|7.00-7.93                |  |                     | 10,000  |                                                 |  | 1.9
 years                         |  |                             | 7.30  |                     |   | 54,178                             |  |                             | 6,000   |  |   | 7.50  |  |   | 31,307    | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 
|8.00-8.99                |  |                     | 48,000  |                                                 |  | 6.9
 years                         |  |                             | 8.63  |                     |   | 196,335                            |  |                             |        |  |   |      |  |   |          | 
|9.00-9.99                |  |                     | 174,500 |                                                 |  | 5.3
 years                         |  |                             | 9.20  |                     |   | 613,888                            |  |                             |        |  |   |      |  |   |          | 
|12.00-12.99              |  |                     | 49,000  |                                                 |  | 5.2
 years                         |  |                             | 12.46 |                     |   | 12,723                             |  |                             | 25,750  |  |   | 12.54 |  |   | 4,636     | 
|15.00-15.99              |  |                     | 36,000  |                                                 |  | 2.0
 years                         |  |                             | 15.31 |                     |   |                                   |  |                             | 36,000  |  |   | 15.31 |  |   |          | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 
|                         |  |                     | 431,133 |                                                 |  |                                    |  | $                           | 8.10  |                     | $ | 2,083,064                          |  |                             | 181,383 |  | $ | 6.39  |  | $ | 1,241,883 | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 

41

---



The
weighted average fair value of the 68,000, 95,500 and 141,000 options granted
during 2009, 2008 and 2007, respectively, was $278,840, $387,975 and $851,910.

The
total intrinsic value of options exercised during 2009, 2008 and 2007 was
$7,000, $292,000 and $255,000, respectively. The total fair value of shares
vested during 2009, 2008 and 2007 was $578,000, $807,000 and $25,000,
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 2009, 2008 and 2007, respectively: zero dividend yield;
expected volatility of 45%, 41% and 127%; risk-free interest rate of 3.19%,
3.68% and 4.75%; and expected life of 3.0, 3.5 and 3.9 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 U.S. 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 our stock over the past three years. We have not historically paid any
dividends and do not expect to in the foreseeable future. We recognized stock
option expense of $341,000, $339,000 and $194,000 in the years ended December 31,
2009, 2008 and 2007, respectively, and the expense is included within general
and administrative expense on the consolidated statements of income.

There
were 181,383 and 183,633 options exercisable at December 31, 2009 and 2008,
respectively. The weighted average exercise price of these options was $6.39
and $2.94 at December 31, 2009 and 2008, respectively.

14.          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 tables set forth selected unaudited financial information for each of
the Companys reportable segments (in thousands):

|                                   |  |                                       |        |      |   |        |  |   |        | 
|---------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                   |  | For the
 year ended December 31, 2009 |       
|                                   |  |                                       |       
|                                   |  | Autoscope                             |        | RTMS |   | Total  | 
|                                   |  |                                       |        |      |   |        | 
|Revenue                            |  | $                                     | 16,240 |      | $ | 8,353  |  | $ | 24,593 | 
|Depreciation                       |  |                                       | 292    |      |   | 132    |  |   | 424    | 
|Amortization of intangible
 assets |  |                                       |       |      |   | 768    |  |   | 768    | 
|Income before income taxes         |  |                                       | 3,807  |      |   | 1,412  |  |   | 5,219  | 
|Capital expenditures               |  |                                       | 555    |      |   | 139    |  |   | 694    | 
|Total assets                       |  |                                       | 29,752 |      |   | 11,398 |  |   | 41,150 | 

|                                   |  |                                       |        |      |   |        |  |   |        | 
|---------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                   |  | For the
 year ended December 31, 2008 |       
|                                   |  |                                       |       
|                                   |  | 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 | 

15.          RELATED
PARTY TRANSACTIONS

Dan
Manor, who is a named executive officer, is a beneficiary of the earn-out for
the EIS asset purchase as further described in Note 4.

42

---



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 as of December 31,
2009 and 2008, and the related consolidated statements income, shareholders
equity and comprehensive income, and cash flows for each of the three years in
the period ended December 31, 2009. 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 financial position of Image Sensing
Systems, Inc. and subsidiaries as of December 31, 2009 and 2008, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2009 in conformity with accounting principles
generally accepted in the United States of America.

|                      
|----------------------
|/s/ GRANT THORNTON LLP
|                      
|Minneapolis, Minnesota
|March 23, 2010        

43

---



|        |                                                                                      
|------- | -------------------------------------------------------------------------------------
|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. 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, 2009. 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, 2009.

44

---



This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting. Internal
control over financial reporting 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.

45

---



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 2010 annual meeting of shareholders are incorporated
into this Annual Report on 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 2010 annual meeting of shareholders are
incorporated into this Annual Report on 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, 2009 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)  |  |                                                                                                | 425,133 |                                                                                | $ | 8.11                                                                                                                                                     |  |  | 107,500 | 
|Equity compensation plans not approved by shareholders |  |                                                                                                | 6,000   |                                                                                | $ | 7.50                                                                                                                                                     |  |  |        | 
|                                                       |  |                                                                                                |         |                                                                                |   |                                                                                                                                                          |  |  |         | 
|Total                                                  |  |                                                                                                | 431,133 |                                                                                | $ | 8.10                                                                                                                                                     |  |  | 107,500 | 
|                                                       |  |                                                                                                |         |                                                                                |   |                                                                                                                                                          |  |  |         | 

|                                                                                                                                                                                                                                                                                              
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                              
|(1)
 Includes shares underlying stock options under the Image Sensing Systems,
 Inc. 1995 Long-Term Incentive and Stock Option Plan (1995 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 107,500 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 Annual Report on 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 2010 annual meeting of shareholders is
incorporated into this Annual Report on Form 10-K by reference.

46

---



|         |                                        
|-------- | ---------------------------------------
|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 2010 annual meeting of
shareholders are incorporated into this Annual Report on Form 10-K by
reference.

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        | 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 Annual
 Report on Form 10-K for the year ended December 31, 2007 (2007 Form 10-K).                                                                                                                                                                                                                                                                                                                   
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.6        | 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.                                                                                                                                                                                                                                                                                                                          
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.7**      | 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.                                                                                                                                                                                                                                                                                                                                                                                                           
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

47

---



| |         |                                                                                                                                                                                                                                                         
| | ------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.8    | Manufacturing,
 Distributing and Technology License Agreement dated June 11, 1991 by and
 between ISS and Econolite Control Products, Inc. (Econolite), incorporated by
 reference to Exhibit 10.1 to the Registration Statement.                       
| |         |                                                                                                                                                                                                                                                         
| | 10.09   | 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.                   
| |         |                                                                                                                                                                                                                                                         
| | 10.10   | 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.                               
| |         |                                                                                                                                                                                                                                                         
| | 10.11   | 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.                        
| |         |                                                                                                                                                                                                                                                         
| | 10.12   | 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.
| |         |                                                                                                                                                                                                                                                         
| | 10.13** | 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.                                                                     
| |         |                                                                                                                                                                                                                                                         
| | 10.14   | 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).             
| |         |                                                                                                                                                                                                                                                         
| | 10.15   | 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.                                                                                                             
| |         |                                                                                                                                                                                                                                                         
| | 10.16   | 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.                                                     
| |         |                                                                                                                                                                                                                                                         
| | 10.17   | 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.                                                               
| |         |                                                                                                                                                                                                                                                         
| | 10.18   | Modification Agreement
 dated December 28, 2009 by and between ISS and Associated Bank under which
 ISS and Associated Bank amended the Loan Agreement dated as of May 1, 2008 by
 and between ISS and Associated Bank (filed herewith).                
| |         |                                                                                                                                                                                                                                                         
| | 10.19   | Promissory Note (Loan)
 dated December 28, 2009 in the original principal amount of $4,000,000 issued
 by ISS to Associated Bank (filed herewith).                                                                                                      
| |         |                                                                                                                                                                                                                                                         
| | 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.                                     

48

---



| |      |                                                                                                                                           
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------
| | 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 23, 2010
|                                       |  |                      
|Kenneth R. Aubrey                      |  |                      
|President and Chief
 Executive Officer |  |                      
|(Principal Executive
 Officer)         |  |                      

Each
person whose signature to this Annual 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 Annual Report on Form 10-K, and any and all instruments or
documents filed as part of or in connection with this Annual Report on Form
10-K or any 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 23, 2010
|                                                        |  |                      
|Kenneth R. Aubrey                                       |  |                      
|President and Chief
 Executive Officer                  |  |                      
|(Principal Executive
 Officer)                          |  |                      
|                                                        |  |                      
|/s/ Gregory R. L. Smith                                 |  | Date:
 March 23, 2010
|                                                        |  |                      
|Gregory R. L. Smith                                     |  |                      
|Chief Financial Officer                                 |  |                      
|(Principal Financial and
 Principal Accounting Officer) |  |                      
|                                                        |  |                      
|/s/ James Murdakes                                      |  | Date:
 March 23, 2010
|                                                        |  |                      
|James Murdakes                                          |  |                      
|Chairman of the Board of
 Directors                     |  |                      
|                                                        |  |                      
|/s/ Panos G. Michalopoulos                              |  | Date:
 March 23, 2010
|                                                        |  |                      
|Panos G. Michalopoulos                                  |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ Michael G. Eleftheriou                              |  | Date:
 March 23, 2010
|                                                        |  |                      
|Michael G. Eleftheriou                                  |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ Sven A. Wehrwein                                    |  | Date:
 March 23, 2010
|                                                        |  |                      
|Sven A. Wehrwein                                        |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ James W. Bracke                                     |  | Date:
 March 23, 2010
|                                                        |  |                      
|James W. Bracke                                         |  |                      
|Director                                                |  |                      

50

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