**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the fiscal year ended December 31,2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition periodfrom                  to                  **

**Commission file number 0-29486**

 

**MERGETECHNOLOGIES INCORPORATED**

(Exact name of Registrant as specified in its charter)

| **Wisconsin**                                                    |   | **39-1600938**                          |
|------------------------------------------------------------------|--------|-----------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |   | (I. R. S. Employer  Identification No.) |

 

**6737 West Washington Street, Suite 2250,Milwaukee, Wisconsin 53214-5650**

(Address of principal executive offices, including zip code)

(Registrant’s telephone number, including area code) **(414) 977-4000**

Securitiesregistered under Section 12(b) of the Exchange Act:

**Common Stock, $0.01 par value per share**

(Title of class)

Securities registered under Section 12(g) of the ExchangeAct: **NONE**

Indicate by check mark if theRegistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act

Yes o   No x

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

Yes o   No x

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.   o

Indicate by check mark whether the Registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

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

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2of the Act).

Yes   o    No  x

The aggregate market valuefor the Registrant’s voting and non-voting common equity held by non-affiliatesof the Registrant as of June 30, 2006, based upon the closing sale priceof the Common Stock on June 30, 2006, as reported on the NASDAQ GlobalMarket, was approximately****$346,618,800. Shares of Common Stockheld by each officer and director and by each person who owns ten percent ormore of the outstanding Common Stock have been excluded in that such personsmay be deemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for other purposes.

Thenumber of shares outstanding of the Registrant’s common stock, par value $0.01per share, as of March 2, 2007:  30,068,907

DOCUMENTSINCORPORATED BY REFERENCE

Certainof the information required by Part III is incorporated by reference from theRegistrant’s Proxy Statement for its 2007 Annual Meeting of Shareholders.

 

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**INDEX**

| PART I   |   |                                                                                                                |   |   |   |
|---------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Item  1.      |   | Business                                                                                                            |   | 2      |   |
| Item 1A.      |   | Risk Factors                                                                                                        |   | 15     |   |
| Item 1B.      |   | Unresolved Staff Comments                                                                                           |   | 26     |   |
| Item 2.       |   | Properties                                                                                                          |   | 26     |   |
| Item 3.       |   | Legal Proceedings                                                                                                   |   | 26     |   |
| Item 4.       |   | Submission of Matters  to a Vote of Security Holders                                                                |   | 28     |   |
| PART II  |   |                                                                                                                |   |   |   |
| Item 5.       |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   | 29     |   |
| Item 6.       |   | Selected Financial  Data                                                                                            |   | 30     |   |
| Item 7.       |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   | 31     |   |
| Item 7A.      |   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   | 52     |   |
| Item 8.       |   | Financial  Statements and Supplementary Data                                                                        |   | 53     |   |
| Item 9.       |   | Changes in and  Disagreements With Accountants on Accounting and Financial Disclosure                               |   | 90     |   |
| Item 9A.      |   | Controls and  Procedures                                                                                            |   | 90     |   |
| Item 9B.      |   | Other Information                                                                                                   |   | 95     |   |
| PART III |   |                                                                                                                |   |   |   |
| Item 10.      |   | Directors and  Executive Officers of the Registrant                                                                 |   | 96     |   |
| Item 11.      |   | Executive  Compensation                                                                                             |   | 97     |   |
| Item 12.      |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   | 97     |   |
| Item 13.      |   | Certain  Relationships and Related Transactions                                                                     |   | 97     |   |
| Item 14.      |   | Principal  Accountant Fees and Services                                                                             |   | 97     |   |
| PART IV  |   |                                                                                                                |   |   |   |
| Item 15.      |   | Exhibits,  Financial Statement Schedules                                                                            |   | 97     |   |

 

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**PART I**

**Item 1.**                        BUSINESS

**Cautionary NoteRegarding Forward-Looking Statements**

*Certain statements in this report that are nothistorical facts, including, without limitation, statements that reflect ourcurrent expectations regarding our future growth, results of operations,performance, business prospects and opportunities, constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, and Section 21Eof the Securities Exchange Act of 1934. When used in this report, the words “believes,”“intends,” “anticipates,” “expects,” “will” and similar expressions areintended to identify forward-looking statements, but are not the exclusivemeans of identifying them. These statements are based on information currentlyavailable to us and are subject to a number of risks and uncertainties that maycause our actual growth, results of operations, financial condition, cashflows, performance, business prospects and opportunities and the timing ofcertain events to differ materially from those expressed in, or implied by,these statements. These risks, uncertainties and other factors include, withoutlimitation, those matters discussed in Item 1A, “Risk Factors” of this AnnualReport on Form 10-K. Except as expressly required by the federalsecurities laws, we undertake no obligation to publicly update these factors orany of the forward-looking statements to reflect future events, developments orchanged circumstances, or for any other reason.*

**Overview**

Merge Technologies Incorporated, a Wisconsincorporation doing business as Merge Healthcare, and its subsidiaries oraffiliates (collectively, “Merge Healthcare,” “we,” “us,” or “our”), developsmedical imaging and information management software and delivers relatedservices. Late in 2006 we reorganized our business to better reflect emergingmarket needs. We established three distinct business units: Merge HealthcareNorth America, which primarily sells directly to the end-user healthcare marketcomprised of hospitals, imaging centers and specialty clinics located in theU.S. and Canada and also distributes certain products through the Internet viaour website; Cedara Software, which primarily sells to Original EquipmentManufacturers (“OEMs”) and Value Added Resellers (“VARs”), comprised ofcompanies that develop, manufacture or resell medical imaging software ordevices; and Merge Healthcare EMEA, which sells to the end-user healthcaremarket in Europe, the Middle East and Africa. Our principal executive officesare located at 6737 West Washington Street, Suite 2250, Milwaukee,Wisconsin 53214-5650, and our telephone number there is (414) 977-4000.

We develop clinical and medical imaging software applicationsand development tools that are on the forefront of medicine. We also developmedical imaging software solutions that support end-to-end business andclinical workflow for radiology department and specialty practices, imagingcenters and hospitals. Our software technologies accelerate market delivery forour global OEM customers, while our end-user solutions improve our customers’productivity and enhance the quality of the patient experience. Our diagnosticimaging workflow applications are commonly categorized as Picture Archiving andCommunication Systems (“PACS”), Radiology Information Systems (“RIS”) andclinical applications, which include, but are not limited to, software productsthat support medical imaging in many specialized areas such as orthopedics,cardiology, mammography and oncology. We believe the combination ofRIS/PACS/clinical applications and Healthcare Information Management improvesdiagnostic imaging workflow. It also provides value by making images and otherinformation available throughout the enterprise.

We directly provide PACS, RIS and clinical medicalimaging software applications and also sell select products through our website’seCommerce engine. Our products and solutions link business and clinicalworkflow by managing and distributing diagnostic images and informationthroughout the healthcare enterprise, and providing visualization tools thattarget improved productivity and enhanced clinical 

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accuracy of the diagnosisof general and specialty medical imaging exams. Our customers can enhance thequality of healthcare provided to patients because our solutions improveradiology workflow efficiencies and improve the clinical decision-makingprocesses. In addition, our solutions reduce the film, paper and labor costsinvolved in managing and distributing medical images and information, whichhelps drive increased profitability for our customers. We deliver value to manytypes of healthcare facilities of all sizes, but we specifically target imagingcenters and specialty clinics.

We also focus on the development of custom-engineeredsoftware applications and development tools for the global medical imaging andinformation OEM  markets. Our software isdeployed in hospitals and clinics worldwide through our partners and our directend-user and eCommerce channels and is licensed by many of the world’s largestmedical device and healthcare information technology (“IT”) companies. Ourtechnologies help our OEM customers increase revenues, create competitiveadvantages, and deliver technologies to end-user markets throughout the world.We often serve as an extended research and development team for the OEM,helping them to be first-to-market with innovative medical imagingtechnologies. We leverage our global end-user distribution channels to sell ourcustomers existing technologies and applications, and expand the value ofmedical imaging solutions by licensing additional applications for ourcustomers to sell through their own sales forces. Our technologies and expertisespan all the major digital imaging modalities, including computed tomography (“CT”),magnetic resonance imaging (“MRI”), digital x-ray, mammography, ultrasound,echo-cardiology, angiography, nuclear medicine, positron emission tomography (“PET”)and fluoroscopy. Our offerings are used in all aspects of clinical imagingworkflow, including: the capture of a patient’s digital image; the archiving,communication and manipulation of digital images; sophisticated clinicalapplications to analyze digital images; the use of imaging inminimally-invasive surgery; and the management of patient information stored asElectronic Patient Records (“EPR”). We target OEM/VARs that serve all marketsutilizing medical imaging in their businesses, regardless of the size or scopeof the market they serve, including non-radiology markets such as oncology,pharmaceutical and EPR.

We have consistently expanded our suite of product andservice offerings. We see our RIS/PACS/clinical applications single-vendorapproach as a unique advantage in our end-user target market. Additionally, webecame a leading medical imaging OEM partner-company through our combinationwith Cedara Software Corp. (“Cedara”).

We believe the combinedinnovation model between our OEM medical imaging engineering and ourRIS/PACS/clinical application offerings positions us uniquely among ourcompetitors in the medical imaging and information markets, provides for aproduct innovation model that accelerates our development efforts by providingsoftware-based technologies that can be embedded in solutions for the end-usermarket, and creates a product and distribution platform to allow us to explorenew clinical and geographic markets beyond radiology. We believe thatleveraging this unique innovation model and our ability to innovate new medicalimaging solutions is key to our long term strategy to expand our products andservices beyond the traditional boundaries of radiology.

**Our Market**

Millennium ResearchGroup, an international market research firm, reported the followingmarketplace information:

·       In2005, the U.S. market for RIS and PACS, consisting of RIS and enterprise,radiology, orthopedic and cardiology PACS, was valued at over $1.5 billion.

·       By2010, this market will grow to over $3.0 billion, representing a compoundannual growth rate of nearly 15%.

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·       Growthfor the RIS market is primarily driven by imaging centers and small hospitals,particularly those that do not already have a PACS or RIS and elect anintegrated RIS/PACS solution.

·       Growthfor the PACS market is primarily driven by:

·        adoptionof EPR;

·        growingcustomer receptiveness to PACS;

·        theconversion from radiology to enterprise PACS solutions;

·        customerdemand for replacement PACS and integrated RIS/PACS solutions;

·        affordableprice points for small hospitals and imaging centers;

·        growthin diagnostic capabilities for the cardiology market; and

·        growthof in-office modalities in the orthopedic market.

The market for our end-user solutions is highlycompetitive. Healthcare providers continue to be challenged by decliningreimbursements, intense competition and the increased cost of providinghealthcare services. Some customers purchase products from us and from ourcompetitors. In the developing area of RIS/PACS/clinical applications workflow,there are many newly emerging competitors that offer portions of an integratedradiology solution through their RIS, PACS and clinical applications.Additionally, certain competitors are integrating RIS, PACS and clinicalapplications through development, partnership and acquisition activities. Weoffer a combined RIS, PACS and clinical applications solution, providingcustomers with a single system that yields strong productivity gains, attractsreferrals from primary care and specialty physicians, and yields enhancedsupport and technology migration by having only a single vendor relationship tomanage.

Our OEM market, which consists of organizations that usemedical imaging or information in any element of their business, is also highlycompetitive. Thousands of imaging-related prospective customers existthroughout the world. In addition, we use a Technology Partnership Program, throughwhich we work with academic researchers and entrepreneurial companies that havedeveloped new, innovative medical imaging applications that are not yet fullycommercialized. These technology partnerships further accelerate the innovationof our own technologies, allowing us to approach new clinical imaging marketsinside and outside of radiology. In exchange, we can offer our partners accessto our distribution channels, commercialization of their products, and anapproach to our global OEM partners that we have developed over the last 18years. Working with these partners, we use our depth of medical imagingtechnology, global OEM distribution, and business expertise to commercializeand launch those products.

We believe that ourinnovation-driven model will enable us to proactively drive new demand formedical imaging solutions at both the OEM and end-user level. One of the mainsources of competition for our OEM products is the OEM’s own internal softwaredevelopment programs, where the customer may have the ability to use internalresources to create a similar technology or eventually replace our software employeedin the customer’s marketed solution. There are also a number of companies thatspecialize in one particular technology, which may compete with us in aselected market. However, we believe that there are no direct competitors inthe OEM market that have the breadth of technologies, engineering resources andcapabilities to compete with us in all aspects of our technology portfolio.

**Recent Challenges**

We continue to facesignificant business challenges from the informal, non-public inquiry beingconducted by the Securities and Exchange Commission and class action and otherlawsuits. We believe that these matters have adversely affected the morale ofour employees, our relationships with certain customers and potential customersand our reputation in the marketplace, and have diverted the attention 

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of ourBoard of Directors and management from our business operations. We also haveexperienced significant challenges integrating the businesses and personnel ofMerge Healthcare and Cedara, with which we combined on June 1, 2005. Inparticular, we struggled to realize synergistic benefits as a consequence oforganizational changes, primarily within our sales and service groups,following that business combination. However, during the fourth quarter of 2006we commenced a rightsizing and reorganization initiative to better align ourcosts with our revenue-generating strategies while at the same time eliminatingredundancies within our consolidated organization.  This initiative emphasizes the offshoring of asignificant portion of our software engineering and customer support. Significantknowledge transfer efforts have occurred since the commencement of theinitiative. However, it is possible that we have not devoted adequate resourcesto the development and acquisition of additional products or support of thoseproducts to our customers. Also,  we haveno integrated financial systems, and we are currently in the process ofimplementing a new enterprise resource planning (“ERP”) system which coulddivert the attention of employees and create temporary operating inefficiencies.See Item 1A, “Risk Factors,” Item 3, “Legal Proceedings,”Item 7, “Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” and Item 9A, “Controls and Procedures” of thisAnnual Report on Form 10-K for more detailed discussion regardingthese matters.

**History**

We were founded in 1987 and built a reputation as acompany that enabled the transformation of legacy radiology (film-based) imagesinto modern (filmless) digitized images for distribution and diagnosticinterpretation. We acquired eFilm Medical Inc. (“eFilm”) in June 2002 andbegan doing business under the name of Merge eFilm in order to leverage eFilm’sinternational name recognition for diagnostic medical image workstationsoftware. In July 2003, we acquired RIS Logic, Inc. (“RIS Logic”), aRIS company that designed software to manage business and clinical workflow forimaging centers to streamline operations and accelerate productivity. Weacquired AccuImage Diagnostics Corp. (“AccuImage”) in January 2005.AccuImage was founded from radiology academic research, and created productsthat used advanced visualization technologies for clinical specialty medicalimaging. In June 2005, we completed our business combination with CedaraSoftware Corp., which was established in 1982 and creates medical imagingsoftware for OEM and VAR customers worldwide.

We have consistentlymaintained a commitment to industry standards designed to benefit bothhealthcare providers and technology vendors including the industry’s standardnetwork communications protocol known as Digital Imaging Communications inMedicine (“DICOM”), open medical standards such as Health Level Seven, Inc.(“HL7”), and the Integrated Healthcare Enterprise (“IHE”) framework. Thesestandards have paved the way for healthcare organizations to begin tointegrate the complex workflow systems of the radiology department with theentire healthcare system by using equipment and software applications thatconnect the various image communication and information management components.We have incorporated these standards in our radiology workflow technologies,software applications and OEM connectivity components, establishing the basisfor seamless integration of images and healthcare information across anorganization’s computing infrastructure.

**How We Benefit OurCustomers**

Our end-usersolutions benefit hospital radiology departments, diagnostic imaging centers,specialty clinics and their patients in a variety of ways, including:

·       Acceleratedproductivity gained by using a single integrated software solution for mostbusiness and clinical workflow tools designed to automate operations, includingdigital dictation, billing, registration and scheduling, productivity analysis,image and report management, and storage and distribution;

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·       Increasedaccuracy through real-time patient demographic matching across allbusiness and clinical workflow tools;

·       Moreaccountability and convenience in working with one vendor that develops,installs and supports the entire spectrum of radiology workflow tools andintegration services;

·       Thecreation of permanent electronic archives of diagnostic quality images thatenable the retrieval of prior and current images and reports;

·       Improvedproductivity and lower cost by providing the capability to centralize manyfunctions such as scheduling, coding, transcription, billing and radiologistreading;

·       Modular,flexible and cost-effective systems that can expand as the imaging center,hospital or clinic’s business grows;

·       Networkingof multiple image producing and image utilizing devices to eliminateredundancies and reduce the need for capital equipment expenditures or disasterrecovery; and

·       Optimizingimage-viewing and diagnostic capabilities.

Our global OEMcustomers benefit from our software technologies and professional services in anumber of ways, including:

·       Usingour technologies and services to enhance the workflow capabilities of theirsolutions;

·       Acceleratingthe time to market in the development of new solutions;

·       Creatinggreater product differentiation compared to their competitors; and

·       Leveraging our technicaland deployment skills, which facilitates an increased ability to focus on corecompetencies.

**Business Strategy**

We continue to build upon our position as aninnovative medical imaging software and technology provider, and full solutionRIS/PACS/clinical applications developer for the global healthcare end-user andOEM markets. We maintain this position by employing more than half of ouremployees in research and development activities, with total engineering costs,in thousands, of $22,697, $13,535, and $5,446 for 2006, 2005 and 2004,respectively, which amounts include capitalized software development costs andresearch and development expense. Our market position is the result of ourexpertise in clinical workflow and integration, technically innovative softwareproducts, modular software solutions, and continued focus on acceleratinghealthcare organizations’ productivity. Our OEM software technologies addressthe global market in medical imaging software innovation. Leveraging theclinical application innovation of our OEM products, we believe that ourend-user products enable medical imaging and information to integrate moreefficiently throughout the healthcare enterprise. By effectively utilizing ourresearch and development activities and our global onshore-offshore engineeringservices, we can expand the solution set offered to both our OEM and end-usercustomers, accelerate the innovation of new products, and enter new marketssuch as orthopedic, veterinary, pharmaceutical clinical trials, oncology andEPR. This strategy is the direct result of combining Cedara Software with MergeHealthcare, and is expected to form the basis for our growth, innovation andnew product and market development in the coming years.

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During 2006, we focused our operational efforts onestablishing an onshore-offshore product development and service andsupport initiative; realigning our product development model, systems andprocesses to ensure timely product delivery to our customers; developing newpartnerships with OEM customers and leveraging our product brands. We marketedand cross-sold bundled products from across all of our combined productlines.

In line with thisoperational plan, we:

·       Reorganizedour business into three distinct business units;

·       Announcednew solutions for deformable registration and image fusion;

·       Partneredwith Advanced Imaging Technologies, a Washington corporation, in thedevelopment of an innovative breast ultrasound system;

·       Releaseda new .NET DICOM toolkit;

·       ReleasedFusion RISTM version 3.1;

·       Releaseda Spanish version of eFilm WorkstationTM;

·       Announceda distribution agreement with Medavis GmbH, a German corporation, to provideRIS software to selected European markets;

·       Signedan agreement to deliver comprehensive digital orthopedic solutions tohealthcare providers; and

·       Enteredinto a partnership with CPAGE, a French public information technology group, todeliver EPR functionality to the French hospital market based on our aXigateTMtechnology.

We anticipate thatany future growth will be driven primarily by continued concentration on thefollowing aspects of our business:

·       Medicalimaging innovation with our OEM partners, creating software applications,technologies and tools that optimize the growing and evolving capabilities ofimaging acquisition devices such as multi-slice CT, PET, ultrasound and MRI;

·       End-usersales initiatives, including targeted sales/marketing activities designed toachieve broader geographic coverage, expanded presence in other healthcarevertical markets and expanded product purchases from current customers, ongoingsolution selling training and investment in solution selling tools like return-on-investmentand cost-benefit analyses;

·       Clinicalapplication software and information systems development, both in partnershipwith OEM and technology partners and on a direct basis to end-users, providinggrowth opportunities globally and into new markets outside of radiology;

·       Creatingenhanced product offerings such as FUSION MATRIX PACSTM and FUSION RIS/PACSTM MXthat expand the functionality of RIS/PACS to clinical applications beyondradiology; and

·       Innovatingtechnologies and solutions that serve new markets such as orthopedic,veterinary, pharmaceutical clinical trials, oncology and EPR.

We believe our globalpresence and involvement in the creation of medical imaging softwaretechnologies and open medical standards places us in a strong position tomonitor medical imaging industry and technological forces that impact bothmedical equipment and software application innovations. In addition, ourestablished OEM relationships allow us to work with leading medical equipmentmanufacturers as they develop future plans for new product introductions. Wesometimes 

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partnerwith leading OEM companies in the design and development of new medical imagingsoftware applications, and then incorporate those innovative medical imagingsoftware modules within our integrated RIS/PACS solutions for sale on a directbasis to our end-user customers. This unique model of both OEM and end-usersolution development accelerates our ability to innovate our products ahead ofthe needs of our current and future target markets.

**End-User Products and ServicesDescription**

Focusing product innovation around the functionsrelated to image and information management is a hallmark of our end-userproduct development strategy. We view our expertise as developing software thatmanages the people, process, images and information workflow in such a way as toincrease productivity and reduce costs for our end-user customers. Products inplace and those in development are applied to the complex continuum of business (billing, scheduling, modalitymanagement, practice analysis), image and information management (integratingresults of CT, MRI, x-ray, etc., and the associated patient information relatedto them), interpretation and reporting (medical image visualization, analysisand management of medical imaging data, enhancing physicians’interpretation and reporting of data from medical imaging modalities, such ascomputed tomography and magnetic resonance imaging), and the distribution ofthose reports and images to referring physicians. We believe that our solutionsare differentiated by the integration of all of these elements, which enablesus to create a broad data set around a single patient experience, combined withthe capability for image interpretation using advanced tools for eachspecialty. The results are increased efficiency and productivity, more timedevoted to accurate analysis and diagnosis, and ultimately improved patientcare because the waiting time from diagnosis to treatment is reduced and allpertinent information is quickly and accurately provided to the primary caregiver via the web, wherever the physician is located. This integrated solutionwith enterprise-wide accessibility to images and information reinforces ourstrategy of delivering end-to-end clinical and business workflow solutions thataccelerate our customers’ productivity.

We have multiple solution offerings tailored to meetthe needs of various market segments. For the international healthcare market,we continue to offer two platforms under the FUSION PACSTM brand name. We alsooffer our aXigate technology to address the EPR needs of the French market.aXigate is a secure, web-based solution for patient, medical and clinicalprocess management. With components for patient registration, consultation,reporting, prescription, follow-up and codification, aXigate provides afolder-based approach to medical information management, displaying relevantinformation at the click of a button to different health care professionals.

Our software modules aredesigned to allow continuous innovation of our fully integrated radiologyworkflow system product line and are sold as individual modules or as a fullyintegrated solution, depending on the needs of the customer. We intend tointegrate our clinical application portfolio into our solution offerings,thereby providing even more accelerated productivity as medical imaging movesbeyond radiology. Our product innovation team is working closely with ourcustomers to develop next-generation products****forour RIS, PACS, RIS/PACS and EPR product lines. In addition, our softwaredevelopment team is integrating various clinical application and advancedvisualization software modules (like mammography and PET/CT) into our RIS/PACSworkflow solutions, further changing and enhancing the traditional definitionof RIS/PACS. These products can be sold throughout the world, and distributedthrough our global direct end-user and eCommerce channels.

**OEM Products andServices Descriptions**

Software development can be significantly acceleratedwith the use of powerful development environments incorporating reusablesoftware libraries and toolkits. We created such a development environment,called Imaging Application Platform® (“IAP”)to accelerate our internal development as well as that of our OEM partners. IAPprovides a complete suite of technologies and capabilities for 

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creating advanced,high-performance medical imaging applications. IAP is one of the most widelyused medical imaging platforms available with a proven track record in all themajor imaging modalities and clinical applications. All of our major OEMpartners and virtually all of their engineering service clients, directly orindirectly, use IAP in business critical applications.

Building on the success of IAP, we have created aneven more comprehensive development platform called Cedara OpenEyesTM, whichprovides, in addition to the benefits of IAP, support for rapid and flexibleapplication development using state of the art technologies and tools. CedaraOpenEyesTM is a powerful and flexible best practices development platform thatenables the rapid creation of medical applications. Its programming modelrepresents a paradigm shift from previous technologies, completely insulatingclients from the complexities of deep code development by providing a singleuniform set of controls and development interfaces. Cedara OpenEyesTM packagesconnectivity, visualization and printing services in a flexible and transparentarchitecture that can be deployed across a wide spectrum of applicationenvironments, from small “one-off” projects to complex web solution services.

Our OEM group also offers a full spectrum of PACSsolutions, workstations and plug-in modules that can easily be tailored to theneeds of different OEM customers. In addition, we develop image acquisitionconsole software for companies that need a workstation to drive the capture ofimages from imaging devices such as x-ray or CT scanners.

Clinical applicationssoftware can have a major impact on the delivery of patient care. In the pastseveral decades, a rapid expansion of clinical software systems has been notedwithin institutions that deliver healthcare. Today, more physicians rely onclinical applications to help them make even routine diagnostic and therapeuticdecisions. Our broad range of clinical applications is used in generalradiology and other specialty areas. Many of our clinical applications andworkflow solutions can be added by OEMs as plug-ins to existing PACSworkstations or used as dedicated, standalone workstations.

**Merge Healthcare ProductPortfolio**

The breadth and depth of our products across MergeHealthcare reflects our core strategy of blending technologies, features andfunctions, modules and product lines to form medical imaging and informationworkflow solutions that are distributed globally and across three distributionchannels: OEM, Direct and eCommerce. Our comprehensive product portfolioconsists of the following:

**FUSIONRISTM** allows users to realize improvements inproductivity by integrating information and automating traditional manual orpaper methods related to scheduling, patient registration and tracking,document management, dictation, report turnaround, billing, claims processingand other mission critical operational functions in a medical imaging practice.This automation reduces administrative workload while increasing patient,referring physician and employee satisfaction. Additionally, the user can uncoverways to reduce bottlenecks, maximize profits and increase revenue throughpractice analysis tools.

**FUSIONMATRIX PACSTM** is an image visualization, imagemanagement, archive and web distribution system. The workflow engine forradiologists, FUSION MATRIX PACS provides relevant clinical information at theradiologist’s fingertips, and provides efficient distributed workflow thatallows them to work at any location without sacrificing performance, workflowor feature functionality. The first PACS solution built on Microsoft.NET, itsSmart ClientTM technology, combines the power of the personal computer with thereach of the web for easier deployment, maintenance and improved local clientperformance.

**FUSION PACSTM**is an integrated repository of healthcare information and a suite of softwareapplication modules that provide PACS and web distribution of images andreports on a single, integrated PACS platform. FUSION PACS is the foundationfor the integrated software application modules that provides optimalfunctionality for our customers’ radiology workflow. FUSION PACS and itsmodules are 

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designed to allow theuser to customize the way images and information are delivered and viewed,supporting user-centric workflow.

**FUSION RIS/PACSTM** was created through our comprehensive integration approach, fusing our RISworkflow with our image visualization, distribution and storage technologiesinto a unified, intelligent, distributed business and clinical workflowsolution that helps our customers accelerate their productivity while alsoproviding a higher level of value and convenience. Radiologists, technologistsand administrators benefit from having a single solution for their missioncritical business and clinical workflow tools, all integrated into a simpler,faster, unified desktop.

**Referring Practice PortalTM**allows real-time access to reports and their associated images from withinFUSION RIS/PACS or just reports from FUSION RIS via the web. Additionally, theportal provides access to the Exam/Appointment Status, as well as offering anEmergency/Referral Access for hospital and clinic referrals in emergencysituations. The portal has Health Insurance Portability and Accountability Actof 1996 (“HIPAA”) supportive security and auditing features, and can becustomized with a facility’s brand identity and service information. TheReferring Practice Portal is an optional module that can be purchased withFUSION RIS/PACS or FUSION RIS.

**Connectivity Tools**support DICOM and HL7 interfacing while providing ready-madesolutions for tackling various aspects of the hospital wide informationworkflow. Our connectivity tools include, but are not limited to, **MergePortTM, MergeCOM3TM, ExamWorksTM, MergeMVPTM, CedaraI-Acquire/FDTM** and  **DataBridgeTM**.

**eFilm Workstation**is a desktop diagnostic, image and analysis tool for viewing and interpretingmedical images. eFilm Workstation is sold as standalone software that allowsradiologists to view and manipulate any digital diagnostic study, and isintegrated into FUSION RIS/PACS and FUSION PACS as its diagnostic workstation.We believe that eFilm Workstation, sold via eCommerce from our website andthrough VAR distributors, is the most widely used diagnostic workstation in theworld.

**Cedara I-ReadMammoTM**is a universal breast imaging workstation designed for reading mammography,ultrasound and MRI studies. Cedara I-ReadMammo eliminates the hassle ofswitching between different workstations through vendor independence,multi-modality support and dedicated tools for breast imaging workflow.

**Cedara B-CADTM**is the world’s first CAD solution designed to assist radiologists in analyzingbreast ultrasound. With integrated tools for ACR BI- RADS® characterizationand automatic report generation, Cedara B-CAD is an ideal complement fordiagnostic breast ultrasound. Integrated with Cedara I-ReadMammo, CedaraB-CAD demonstrates functional multi-modality breast imaging workflow.

**Cedara PET/CTTM**provides fast and efficient workflow by combining images from CT and PETmodalities, which is particularly useful in allowing a radiologist to seecancerous activity at a metabolic level and pinpoint its exact location in thetissue so a biopsy can be performed and proper treatment begun.

**Cedara OrthoWorksProPlannerTM** is a diagnostic workstation for orthopedicsurgical planning, templating, archiving and web distribution. OrthoWorksincludes libraries of digital orthopedic templates from all major prosthesisvendors, delivering advanced diagnostic and planning functionality for jointarthroplasty, trauma, deformity corrections and more.

**Cedara OrthoWorks SpineAnalyzerTM** is an advanced application that helps spinesurgeons, orthopedists, and chiropractors analyze cervical, thoracic and lumbarspine mobility, alignment and deformities. Spine surgeons can use OrthoWorksSpine Analyzer to assist in planning therapy, such as surgical procedures, andhelp evaluate post therapy outcome.

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**CedaraOrthoWorks Care ManagerTM** is a clinical data managementsystem that uses unique, patented technology to help easily capture relevantclinical parameters during diagnosis, therapy and post-therapy follow up,and automatically populate an SQL database. Powerful and intuitive data-miningtools allow users to quickly perform outcome analyses that can be analyzed laterby a statistical package.

**CalScoreReviewTM** is an advanced calcium-scoring module.It supports lesion-by-lesion and side-by-side comparison for follow up orrepeat scanning, as well as detailed report generation. This clinicalapplication also has workflow tools that allow customization of a patientdatabase, tracking of the current referral base, comparison of prior versuscurrent calcium scores and capture of follow-up appointments.

**ColonReviewTM** is a complete workflow solution with powerfultools for reviewing colon or other luminal studies and reporting the findings.Colon Review is a practical, intuitive solution for expanding imagingcapabilities to include virtual colonoscopy.

**LungReviewTM** is a comprehensive lung nodule visualizationand analysis package that incorporates advanced viewing tools, nodulesegmentation, decision tree based on ELCAP recommendations and automatic reportgeneration.

**3D/4D ReviewTM** providescomprehensive visualization for rapid and efficient everyday clinical workflow,along with a real-time editing tool one can use in combination withstandard visualization tools such as MIP, MinIP, MPR, 3D, VRT and interactive4D Image Review. This product is sold to the end user market via eCommerce fromour website, and through VAR distributors.

**AccuStitchTM** is an advanced imagestitching and angle measurement application, which allows the user to stitchthoracic and lumbar films. This product is sold to the end-user market viaeCommerce from our website, and through VAR distributors.

**Cedara OpenEyesTM** is an advancedsoftware platform for the rapid development of medical imaging applications.Cedara OpenEyes provides a structured framework on which layered and protocol-basedapplications can be quickly and efficiently created without reinventing basefunctionality. Packaged with sophisticated image viewing, DICOM, databasing andimage manipulation capabilities, Cedara OpenEyes allows healthcare companies tofocus on the development of workflow and specific clinical tools. OpenEyesprovides an excellent framework for both plug-in integration and completesoftware development.

**Cedara I-SoftViewTM** is a familyof clinically reliable, workflow-oriented PACS workstations.

**Cedara I-ReportTM** is aradiologist’s diagnostic workstation utilizing automated workflow, presentationprotocol and advanced post-processing toolsets.

**Cedara I-Report CTTM** isspecifically tailored for CT data sets. This software features optimizednavigation tools, easy-to-use 3D volume rendering, MPR, measurement tools,support for orthopedic templates, and Cedara Software’s latest plug-ins.

**Cedara I-ReadTM** is optimized formulti-modality viewing. The user preferences and intuitive user interfacesenable reporting physicians and specialists to have efficient, effectiveworkflow.

**Cedara I-ViewTM** is a simple,cost-effective review station that provides DICOM connectivity with highperformance display and facilitates clinicians’ access to patient data.

**Cedara I-AcquireTM** is a universalsoftware application in which multiple digital detectors, computed radiography(CR) scanners and x-ray generators can be integrated into a powerfulacquisition console, which improves ease of use and productivity for busytechnologists, as well as giving OEMs and system integrators the freedom tochoose and quickly package detectors, scanners, and generators from differentvendors into an assortment of tailored solutions, thereby addressing a broaderrange of clinical applications with less effort and faster time to market.

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**Cedara Baby Explorer** software isan application that adds 3D fetal imaging to any existing ultrasound system,allowing expectant parents, during scheduled ultrasound examinations, to viewand record 3D images months before a baby’s arrival. This product is sold tothe end-user market via eCommerce from our website, and through VARdistributors.

**Cedara I-ReachTM** is a PACSweb-based viewer that significantly advances the current capabilities of PACSviewers by providing fast access to images through the use of the latestcompression techniques, while maintaining high image quality and providing completeseamless integration with hospital PACS, HIS and RIS.

**Cedara I-StoreTM** is aDICOM-compliant, scalable, archiving solution designed to meet the evolvingperformance and redundancy requirements of a healthcare enterprise. Itsscalable architecture allows users to start small and expand the archive astheir imaging requirements grow.

**Cedara I-ConferenceTM** assistshealthcare professionals as a means to quickly and easily consolidate imagesand data for medical presentations, activities that normally represent atedious and time consuming process. This allows presenters to focus on contentdevelopment rather than formatting and technical issues. This product is soldto the end-user market via eCommerce from our website, and through VARdistributors.

**ExamWorksTM** and **ExamWorks+TM** are connectivity technologies that expand amodality’s DICOM capabilities by providing efficient and transparentintegration with departmental workflow and allow non DICOM imaging devices toconnect to a DICOM clinical network. They provide efficient and transparentnetwork connectivity, allowing imaging devices to share resources throughoutthe department.

**Cedara I-ResponseTM** is a softwaresolution for early detection of treatment response in brain cancer care thatcapitalizes on a molecular imaging technique to assess tumor response fromcellular mechanisms. Using functional diffusion mapping (ƒDM), it provides thepotential to evaluate the impact of anti-cancer drugs and radiation therapy ontumors at an unprecedented rate.

**aXigate**is an electronic patient record application that scales to provideenterprise-wide patient information-based workflow. This application isinitially targeted to address the EPR needs of the French market.

**Employees**

We had approximately 450employees as of December 31, 2006 and approximately 100 full-time contractedpersonnel in Pune, India. With recognition that our employees are our mostimportant assets, we will continue to invest in human capital development. See“Recent Challenges” above for information regarding recent events that have impacted,and may continue to impact, our employees.

**Sales, Marketingand Distribution**

We use a multi-channelapproach to reach our target customers. We also cross-sell RIS and PACSsolutions to existing customers. We have added sales professionals to our salesforce, and continue to refine our sales processes and tracking mechanisms toprovide real-time information to manage our sales efforts. We have reachedthousands of current and prospective customers through proactive electronicmarketing, utilizing the emails and addresses captured in connection with eFilmWorkstation downloads (including 30-day free trials) from our eCommercewebsite that numbered over 70,000 from January 2000 through December 2006. Inaddition, we regularly participate in major radiology and healthcareinformation system industry trade shows.

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**Competition**

The markets for our products in the end-user marketare highly competitive. Although the market for our OEM products may not appearto have as many third party competitors, we often “compete” with an OEM’sinternal software engineering group (to develop next generation technologies),or single-product focused companies. Competition is present from newcompetitors entering the market, as well as current OEM partners that can offerproducts similar to our solutions.

In the area of RIS and PACS workflow applications,there are many newly emerging competitors that offer portions of the integratedradiology solution through their RIS and PACS to the market targeted by us.Additionally, certain competitors are integrating RIS and PACS technologiesthrough development, partnership and acquisition activities.

We rely on our extensive experience in working in allaspects of the diagnostic imaging industry, our growing customer base, and ourstrong customer relations to maintain and grow our market share. We also relyon our global brand and historical installed base as a market leader inintegration expertise. Our growing base of customers is increasingly demandinga single vendor that can provide RIS, PACS and clinical applications. We areone of the few radiology software vendors that can offer such comprehensiveworkflow solutions across many clinical specialties that utilize medicalimaging.

Many of our current andpotential competitors may have greater resources than we have, includinggreater financial resources, research and development capabilities,intellectual property and marketing resources. Many of these competitors mayalso have broader product lines and longer standing relationships withcustomers. Our ability to compete successfully depends on a number of factorsboth within and outside of our control, including: product innovation; productquality and performance; price; experienced sales, marketing and serviceprofessionals; rapid development of new products and features; and product andpolicy decisions announced by competitors. There can be no assurance that wewill be able to compete successfully.

**IntellectualProperty Rights**

We currently own 30patents issued by the intellectual property offices of various jurisdictions,including the U.S. Patent and Trademark Office (“PTO”) and the CanadianIntellectual Property Office (“CIPO”), Israel & Japan. We continue toexpand our intellectual property portfolio and have applied for 20 additionalpatents currently under review by the PTO, CIPO or Korean Intellectual PropertyOffice. There can be no assurance that these patents will afford any commercialbenefits. We do not, however, rely principally on patent protection withrespect to our products. We also rely on a combination of copyright and tradesecret laws, employee and third party confidentiality agreements, productlicense agreements and other measures to protect intellectual property rightspertaining to our systems and technology. We currently hold 20 registeredtrademarks in the United States or Canada, and have applied for at least twotrademarks currently under review by the PTO or CIPO. Our trademarks includeFUSION RISTM, FUSION MATRIX PACSTM, FUSION PACSTM, FUSION RIS/PACSTM, ReferringPractice PortalTM, eFilm WorkstationTM, Cedara I-ReadMammoTM, Cedara B-CADTM,Cedara PET/CTTM, Cedara OrthoWorks ProPlannerTM, Cedara OrthoWorks SpineAnalyzerTM, Cedara OrthoWorks Care ManagerTM, CalScore ReviewTM, Colon ReviewTM,Lung ReviewTM, 3D/4D ReviewTM, AccuStitchTM, Cedara OpenEyesTM, Cedara I-SoftViewTM,Cedara I-ReportTM, Cedara I-Report CTTM, Cedara I-ReadTM, Cedara I-ViewTM, CedaraI-AcquireTM, Cedara I-RouteTM, Cedara I-ReachTM, Cedara I-StoreTM, CedaraI-ConferenceTM, ExamWorksTM, ExamWorks+TM, Cedara I-ResponseTM and aXigateTM. Webelieve that, in the age of rapidly changing technology, our continued successprimarily depends upon the technical competence and creative skill of ourpersonnel, in addition to our patents, copyrights and other proprietary rights.

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**Medical, Regulatoryand Government Standards and Reforms**

The healthcare industry is subject to changingpolitical, economic and regulatory influences that may affect the procurementpractices and operation of the entire healthcare industry. Proposals to reformthe U. S. healthcare system have been, and will continue to be, considered byCongress. We believe we have positioned ourselves to assist our customers inthe utilization, implementation, and adherence to most major radiologystandards and regulations. We cannot, however, predict with any certainty whatimpact, if any, new proposals, healthcare reforms or standards might have onthe business, our financial condition and our results of operations. See Item1A, “Risk Factors” of this Annual Report on Form 10-K for a descriptionof various industry and regulatory risks.

The following areexamples of some of the issues, standards and regulations that we monitor andprepare ourselves to address to protect our enterprise and that of ourcustomers:

·       Changesin Medicare and private insurance reimbursement rates may affect the financialhealth of our customers’ businesses. For example, on February 8, 2006, thePresident signed into law the Deficit Reduction Act of 2005 (“DRA”). Effectivefor services provided on or after January 1, 2007, the DRA provides thatreimbursement for the technical component for imaging services (excludingdiagnostic and screening mammography) in non-hospital based freestandingfacilities will be capped at the lesser of reimbursement under the MedicarePart B physician fee schedule or the Hospital Outpatient Prospective PaymentSystem (“HOPPS”) schedule. See Item 1A, “Risk Factors” of this Annual Report onForm 10-K for a discussion of the risks and effects of the DRA.

·       TheHealth Insurance Portability and Accountability Act of 1996 (“HIPAA”) hasmandated the use of standard transactions and identifiers, proscribed securitymeasures and other provisions designed to simplify and secure the exchange ofmedical information. The compliance dates for initial stages of therequirements phase began on April 14, 2003. We have taken necessary measures toassist our customers to meet HIPAA compliance.

·       TheU.S. Food and Drug Administration (“FDA”), which is responsible for assuringthe safety and effectiveness of medical devices under the Federal Food, Drugand Cosmetic Act, has regulatory jurisdiction over computer softwareapplications when they are labeled or intended to be used in the diagnosis ofdisease or other conditions. In Canada, medical devices are regulated underHealth Canada’s Medical Devices Regulations (“Health Canada”). Our ability tomarket new products and improvements to existing products depends upon thetiming of appropriate licenses, pre-market clearance or approval from the FDA,Health Canada, or other applicable foreign regulatory authorities.

·       Internationalsales of products outside of the U.S. are subject to foreign regulatoryrequirements (in particular, the requirements of the European Union, where mostof our international sales are made), that can vary from country to country.

·       Lawsand regulations may be adopted to address Internet commerce such as onlinecontent, user privacy, pricing and characteristics and quality of applicationsand services.

We continue to allocateinternal resources to industry standards committees and working groups who aretasked with setting and promoting both technology and functionality standardswithin the diagnostic imaging and healthcare information systems markets.Participating in IHE and a variety of DICOM working groups specializing inHIPAA, HL7 and other standards helps to ensure that our products and servicesalign with the efforts of these committees and meet the evolvinginteroperability needs of healthcare technologies.

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**Other Information**

Our website address iswww.mergehealthcare.com. We make available within the “Investor Relations”portion of our website under the caption “SEC Filings,” free of charge, ourannual reports on Form 10-K, quarterly reports on Form 10-Q andcurrent reports on Form 8-K, including any amendments to those reports,as soon as reasonably practicable after we electronically file them with, orfurnish them to, the SEC. Materials we file with or furnish to the SEC may alsobe read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Room1580, Washington, D.C. 20549. Information on the operation of the PublicReference Room may be obtained by calling the SEC at 1 800 SEC 0330. Also, theSEC maintains an Internet site at www.sec.gov that contains reports, proxy andinformation statements, and other information that we file electronically withSEC.

**Item 1A.**                RISKFACTORS

*You shouldcarefully consider the risks, uncertainties and other factors described below,in addition to the other information set forth in this Annual Report on Form 10-K,because they could materially and adversely affect our business, operatingresults, financial condition, cash flows and prospects, as well as adverselyaffect the value of an investment in our Common Stock. Also, you should beaware that the risks and uncertainties described below are not the only onesfacing us. Additional risks and uncertainties that we do not yet know of, orthat we currently think are immaterial, may also impair our businessoperations. You should also refer to the other information contained in andincorporated by reference into this Annual Report on Form 10-K, includingour consolidated financial statements and the related notes.*

***We have identified materialweaknesses in our disclosure controls and procedures and our internal controlover financial reporting, which, if not remedied effectively, could have anadverse effect on the trading price of our Common Stock and otherwise seriouslyharm our business—***As discussed in Item 9A, “Controls andProcedures” of this Annual Report on Form 10-K, our management hasconcluded that our disclosure controls and procedures were not effective andour internal control over financial reporting had material weaknesses as ofDecember 31, 2006. Although we have taken actions to remediate the materialweaknesses, our inability to remedy all such material weaknesses promptly andeffectively could have a material adverse effect on the accuracy andcompleteness of our financial statements, as well as impair our ability to meetour quarterly and annual reporting requirements in a timely manner and couldalso have a material adverse effect on our business relationships and ourreputation. Moreover, our remediation efforts have required, and may continueto require, the commitment of significant financial and managerial resources.Prior to the remediation of these material weaknesses, there remains the riskthat the controls on which we currently rely will fail to be sufficientlyeffective, which could result in a material misstatement of our financialposition or results of operations, delays in timely filing of our financialstatements and require restatement of our financial statements. If we areunable, or are perceived as unable, to produce reliable financial reports dueto disclosure control or internal control deficiencies, investors could loseconfidence in our reported financial information and our operating results andthe market price of our Common Stock could be adversely affected. In addition,even if we are successful in strengthening our controls and procedures, suchcontrols and procedures may not be adequate to prevent or identifymisstatements or to provide reasonable assurance that our financial statementsare prepared in conformity with U.S. generally accepted accounting principles (“GAAP”)and fairly present our operating results and financial condition.

***Theactual costs and savings associated with our reorganization and rightsizinginitiatives may differ materially from amounts we estimate—***InNovember 2006, we commenced various reorganization and rightsizing initiativesintended to streamline our operations, reduce costs and bring our staffing andstructure in line with our revenue base. These initiatives includedconsolidating many aspects of our operations, including centralizing theleadership of our worldwide software development activities under one person,hiring a Senior Vice President of worldwide product management, closing officesin San 

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Francisco,California and Tokyo, Japan, downsizing our operations in Burlington,Massachusetts, Cleveland, Ohio and Mississauga, Ontario and shifting to ablended onshore-offshore delivery model by establishing a global softwareengineering and customer support center in Pune, India.

We cannot provideassurance that we will be able to successfully implement these restructuring andrightsizing initiatives or the transition to a blended onshore-offshore globaldelivery model, or that such actions will produce the anticipated cost savings.Even if we are successful in our cost reduction initiatives, we may face otherrisks associated with these plans, including delayed product releases ordecreased customer satisfaction, which in turn could lead to decreased revenuesand profitability.

***We intend to rapidly grow our India operations, whichare subject to regulatory, economic and political uncertainties—******We*********intend to continue to develop and expand our offshore operationsin India through outsoucing partnerships and increasing numbers of our ownpersonnel. While wage costs are lower in India than in the United States andother developed countries for comparably skilled professionals, wages in Indiaare increasing at a faster rate than in the United States, which could resultin our incurring increased costs for technical professionals and reduced operatingmargins. In addition, there is intense competition in India for skilledtechnical professionals and we expect that competition to increase. With theexception of a few employees, we have limited experience in building andoperating offshore development and support operations. We may therefore havedifficulty managing our employees and our service vendor’s employees in ourIndian operations and maintaining uniform standards for our product engineeringand customer service as well as other policies and procedures across ourlocations. Our inability to properly manage and integrate our Indian operationinto the rest of the company could materially affect our financial results.

India has also experiencedcivil unrest and terrorism and has been involved in conflicts with neighboringcountries. In recent years, there have been military confrontations betweenIndia and Pakistan that have occurred in the region of Kashmir and along theIndia-Pakistan border. The potential for hostilities between the two countrieshas been high in light of tensions related to recent terrorist incidents inIndia and the unsettled nature of the regional geopolitical environment,including events in and related to Afghanistan and Iraq. If India were tobecome engaged in armed hostilities, particularly if these hostilities wereprotracted or involved the threat or use of weapons of mass destruction, ouroperations could be materially adversely affected. In addition, U.S. companiesmay decline to contract with us for services in light of internationalterrorist incidents or armed hostilities, even where India is not involved,because of more generalized concerns about relying on a service providerutilizing international resources.

In the past, the Indianeconomy has experienced many of the problems confronting the economies ofdeveloping countries, including high inflation, erratic gross domestic productgrowth and shortages of foreign exchange. The Indian government has exercisedand continues to exercise significant influence over many aspects of the Indianeconomy, and Indian government actions concerning the economy could have amaterial adverse effect on private sector entities, including us.

***Anti-outsourcing legislation, if adopted, couldadversely affect our business, financial condition and results of operationsand impair our ability to service our customers and develop products—******The*** issue ofoutsourcing of services abroad by U.S. companies is a topic of politicaldiscussion in the United States. Measures aimed at limiting or restrictingoutsourcing by U.S. companies are under discussion in Congress and in numerousstate legislatures. While no substantive anti-outsourcing legislation has beenintroduced to date, given the ongoing debate over this issue, the introductionof such legislation is possible. If new measures are introduced that impact theprivate sector, such as tax disincentives or intellectual property transferrestrictions, our financial condition and results of operations could beadversely affected and our ability to service our customers could be impaired.

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***Our recentheadcount reductions have placed additional strain on our resources, may impairour operations and may adversely impact our ability to attract and retainqualified technical, managerial and sales personnel—******In*********connection with our efforts tostreamline our operations, reduce costs and bring our staffing and coststructure in line with our revenue base, we restructured our organization andreduced our workforce by approximately 150 employees (including consultants andtemporary workforce), or approximately 28% of our workforce, in the fourthquarter of 2006. Offsetting this reduction, we have moved approximately 100 ofthese positions to our offshore software engineering and customer supportcenter in Pune, India and intend to increase this number to 200 or morepositions during 2007. Further reductions and possible offshore increases couldoccur if we are unable to grow our revenues. There have been and may continueto be substantial severance and other employee-related costs associated with theworkforce reduction and our restructuring plan may yield unanticipatedconsequences, such as attrition beyond the planned reduction. In addition, manyof the employees who were terminated possessed specific knowledge or expertise,and we may be unable to transfer that knowledge or expertise to others in ourIndian or domestic operations. In that case, the absence of such employeescreates significant operational difficulties. Further, the reduction inworkforce may reduce employee morale, may create concern among potential andexisting employees about job security, which may lead to difficulty in hiringand increased turnover in our current workforce and place undue strain upon ouroperational resources. As a result, our ability to respond to unexpected challengesmay be impaired, and we may be unable to take advantage of new opportunities.

***Changes in thehealthcare industry, including the changes to reimbursement schedules under theDeficit Reduction Act of 2005, could negatively impact our business—******The***healthcareindustry is highly regulated and is subject to changing political, economic andregulatory influences. These factors affect the purchasing practices andoperation of healthcare organizations. Federal and state legislatures haveperiodically considered programs to reform the U.S. healthcare system and tochange healthcare financing and reimbursement systems. In 2005, Congresslegislated an increase (fee schedule update) of approximately 1.5% in theoverall federal reimbursement rates for physician and outpatient services,including diagnostic imaging services. On February 8, 2006, the Presidentsigned the DRA into law. Effective for services provided on or after January 1,2007, the DRA provides that reimbursement for the technical component forimaging services (excluding diagnostic and screening mammography) innon-hospital-based freestanding facilities will be capped at the lesser ofreimbursement under the Medicare Part B physician fee schedule or the HOPPSschedule. The DRA also codifies the reduction in reimbursement for multipleimages on contiguous body parts previously announced by the Centers forMedicare and Medicaid Services (“CMS”). Effective January 1, 2007, CMS ispaying 100% of the technical component of the higher-priced imaging procedureand 75% for the technical component of each additional procedure for imagingprocedures within a family of codes involving contiguous body parts when the multipleprocedures are performed in the same session.

A significant portion of our net sales are deriveddirectly or indirectly from sales to end-users, including hospitals, diagnosticimaging centers and specialty clinics, many of which generate some or all oftheir revenues from government sponsored healthcare programs (principally,Medicare and Medicaid). We believe that the implementation of the reimbursementreductions contained in the DRA will adversely impact our end-user customers’revenues per examination, which may cause some of them to respond by reducingtheir investments or postponing investment decisions, including investments inour software solutions and services.

***Our operatingresults may be impacted by actions related to the implementation of a newinformation technology (or accounting) system—******We*********are in the process of implementingcertain financial modules of an enterprise resource planning system. Ourimplementation process will include the migration of data and users from multiplelegacy systems to a common platform. If we were to suffer any significantproblems related to this system implementation, our ability to fulfill and shipend-user customer orders might be 

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hindered or stopped andour ability to access and report financial information in a timely manner mightbe impaired. Because of the complexity of this initiative, we are subject tothe risks that (1) we may be unable to complete the implementation inaccordance with our timeline and incur additional costs, (2) the implementationcould result in operating inefficiencies which could impact operating results,and (3) the implementation could impact our ability to perform necessarybusiness transactions. All of these risks could adversely impact our results ofoperations, financial condition and cash flows.

***Litigation orregulatory actions could adversely affect our financial condition—******We***andcertain of our former officers are defendants in several lawsuits relating toour accounting and financial disclosure. These lawsuits and other legal mattersin which we have become involved are described in Item 3, “Legal Proceedings”of this Annual Report on Form 10-K. These lawsuits present materialand significant risks to us. We are unable at this time to predict the outcomeof these actions or reasonably estimate a range of damages in the eventplaintiffs in these or other potential matters relating to the same eventsprevail under one or more of their claims.

The Midwest Office of the SEC has notified us that weare the subject of an informal, non-public inquiry. We are cooperating with theSEC in response to its request for information. The inquiry generally concernsour financial statement restatements and the anonymous letters we have receivedregarding our accounting and financial disclosure. We cannot predict whetherthe SEC will expand the scope of its inquiry or obtain a formal order ofinvestigation. These lawsuits and regulatory matters are having, and willcontinue to have, a disruptive effect upon the operations of the business, includingthe diversion of significant time and attention of our senior management, whichadversely affected our results of operations for 2006 and may continue toadversely affect our results of operations in 2007. In addition, we have incurredand are likely to continue to incur substantial expenses in connection withsuch matters, including substantial fees for attorneys and other professionaladvisors, as well as amounts paid to settle certain actions, including the$0.5 million we recently paid to Brian Pedlar, the former President ofCedara, in settlement of the action he brought against us.

***Our ability toobtain directors’ and officers’ liability insurance in the future and tomaintain coverage under existing policies may be adversely affected by thelawsuits and regulatory actions against us and certain of our executiveofficers—***The Company has purchased directors’ andofficers’ liability insurance that may provide coverage for some or all of thematters described immediately above. However, the facts alleged in the lawsuitsand the regulatory actions described above may make directors’ and officers’liability insurance extremely expensive or unavailable for us now or in thefuture and may also jeopardize existing coverage. Certain of the D&Oinsurers have indicated they may seek to rescind the existing policies. If suchinsurance policies were rescinded, our results of operations and liquidity maybe significantly impaired. Further, the insurers may take the position thatsome or all of the claims will not be covered by such policies. Moreover, evenif there is full coverage, there is a chance that our ultimate liability willexceed the available insurance limits. Future D&O insurance coverage mayentail increased premiums which could materially harm our financial results infuture periods. The inability to obtain this coverage due to its unavailabilityor prohibitively expensive premiums would make it more difficult to retain andattract officers and directors and expose us to potentially self-funding anypotential future liabilities ordinarily mitigated by directors’ and officers’liability insurance.

***The turnover in ourmanagement team could negatively impact our business and the trading price ofour Common Stock—******As***previouslydisclosed, in 2006 we lost the services of most of our senior executiveofficers, including our Chief Executive Officer, our founder and interim ChiefExecutive Officer, our Chief Financial Officer, our Senior Vice President,Strategic Business Development and two of our business unit presidents. Inaddition, several other members of our senior management team have assumed newroles in our organization. With the departures, we lost persons with asignificant amount of experience and knowledge about our business, andindustry, and who maintained strong relationships with our customers, suppliersand employees. Further, we believe that our management turnover and theuncertainty it has 

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generated has adverselyaffected our relationships with customers and employees and impaired ourreputation in the marketplace. Kenneth D. Rardin, our President and ChiefExecutive Officer, andSteven R. Norton, our Executive Vice President and Chief Financial Officer,have only been with us for a short time (since September 2006 and January 2007,respectively) and each of them continues to learn our business. The new membersof our management team, and the persons now serving in new positions, may needto devote a significant amount of time to learning about aspects of ourbusiness and our markets, which could limit their effectiveness in managing ourbusiness for a period of time. If our management team cannot effectively manageand operate our business, our net sales and profitability and the trading priceof our Common Stock may be adversely affected.

***Our performance andfuture success depends on our ability to attract, integrate and retainqualified technical, managerial and sales personnel—******We***are dependent,in part, upon the services of our senior executives, some of whom are new hiresor have recently assumed new roles, and other key business and technicalpersonnel. We do not currently maintain key-man life insurance on our seniorexecutives. The loss of the services of any of our senior executives or keyemployees could have a material adverse effect on our business. Our commercialsuccess will depend upon, among other things, the successful recruiting andretention of highly skilled technical, managerial and sales personnel withexperience in business activities such as ours. Competition for the type ofhighly skilled individuals sought by us is intense. We may not be able toretain existing key employees or be able to find, attract and retain skilledpersonnel on acceptable terms.

***Relationships withour customers, potential customers and suppliers have been adversely affected,and our competitors’ competitive position improved, by our restatement of ourfinancial results, related litigation and regulatory proceedings and managementturnover—******Due*********to our restatement of our financialstatements, related litigation and regulatory proceedings, uncertaintyregarding changes in our senior management team, and the former threat of apotential NASDAQ delisting, our customers and potential customers, new orexisting suppliers or others have had concerns that we have become unreliablein operating our business. As a result, we have experienced, and may continueto experience, a decrease in the number of new customers or reluctance on thepart of existing customers to renew their contracts with us. In addition, wehave experienced and may continue to experience, a loss of other importantbusiness relationships. As a result, our business has been materially harmed andour competitors’ competitive positions relative to us have been improved.

***Our quarterly netsales may vary significantly—******Our***quarterlyoperating results have varied in the past and may continue to vary in futureperiods. Quarterly operating results may vary for a number of reasons,including, but not limited to, demand for our software solutions and services,our sales cycle, economic cycles, the level of reimbursements to our end-usercustomers from government sponsored healthcare programs (principally, Medicareand Medicaid), accounting policy changes mandated by regulating entities, andother factors described in this section and elsewhere in this report. As aresult of healthcare industry trends and the market for our RIS, PACS orRIS/PACS solutions, a large percentage of our revenues are generated by saleand installation of systems sold directly to healthcare institutions. Thesesales may be subject to delays due to customers’ internal budgets andprocedures for approving capital expenditures and by competing needs for othercapital expenditures, the deployment of new technologies and personnelresources. Delays in the expected sale or installation of these contracts mayhave a significant impact on our anticipated quarterly revenues and consequently,our earnings, since a significant percentage of our expenses are relativelyfixed. Additionally, we sometimes depend, in part, upon large contracts with asmall number of OEMs to meet our sales goals in any particular quarter. Forexample, one customer accounted for approximately 37% of our total net salesfor the three months ended September 30, 2005, and during the three monthsended December 31, 2005, another single customer accounted forapproximately 27% of our total net sales. Delays in the expected sale orinstallation of 

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solutions under theselarge contracts may have a significant impact on our quarterly net sales andconsequently our earnings, particularly because a significant percentage of ourexpenses are fixed.

***The length of oursales and implementation cycles may adversely affect our future operatingresults—******We***haveexperienced long sales and implementation cycles. How and when to implement,replace, expand or substantially modify medical imaging management software, ormodify or add business processes, are major decisions for our end-user targetmarket. Furthermore, our software generally requires significant capitalexpenditures by our customers, especially OEMs. The sales cycle for oursoftware ranges from six to 18 months or more from initial contact to contractexecution. Our end-user implementation cycle has generally ranged from three tonine months from contract execution to completion of implementation. During thesales and implementation cycles, we will expend substantial time, effort andresources preparing contract proposals, negotiating the contract andimplementing the software. We may not realize any revenues to offset theseexpenditures. Additionally, any decision by our customers to delay or cancelpurchases or the implementation of our software may adversely affect our netsales.

***We face aggressivecompetition in many areas of our business, and our business will be harmed ifwe fail to compete effectively—******The***marketfor medical imaging solutions is highly competitive and subject to rapidtechnological change. We may be unable to maintain our competitive positionagainst our current and potential competitors. Many of our current andpotential competitors have greater financial, technical, product development,marketing and other resources than we have, and we may not be able to competeeffectively with them. In addition, new competitors may emerge and our systemand software solution offerings may be threatened by new technologies or markettrends that reduce the value of our solutions. Further, our recent challengesmay have weakened our competitive position.

The development and acquisition of additional productsand technologies, and the improvement of our existing products requiressignificant investments in research and development. For example, our currentproduct candidates are in various stages of development, and may requiresignificant further research, development, pre-clinical or clinical testing,regulatory approval and commercialization. If we fail to successfully sell newproducts and update our existing products, our operating results may decline asour existing products reach the end of their commercial life cycles.

***Our proprietarytechnology may be subjected to infringement claims or may be infringed uponwhich could result in additional costs or lost sales—******Our***successdepends, in part, on our ability, and the ability of our licensors, to obtain,assert and defend patent rights, protect trade secrets and operate withoutinfringing the proprietary rights of others. We currently own or have rights toa number of U.S. patents and have a number of outstanding patent applications.We may not, however, be able to obtain additional licenses to patents of othersor be able to develop additional patentable technology of our own. Any patentsissued to us may not provide us with competitive advantages, or the patents orproprietary rights of others may have an adverse effect on our ability to dobusiness. Others may independently develop similar products or design aroundsuch patents or proprietary rights owned by or licensed to us. Any patentobtained or licensed by us may not be held to be valid and enforceable ifchallenged by another party. We also have operations in China and India, whoselaws do not protect intellectual property rights to the same extent as those inthe United States. Accordingly, our efforts to protect our intellectualproperty in such countries may be inadequate.

Although we endeavor to protect our patent rights frominfringement, we may not be aware, or become aware, of patents issued to ourcompetitors or others that conflict with our own. Such conflicts could resultin a rejection of important patent applications or the invalidation ofimportant patents, which could have a materially adverse effect on our competitiveposition. In the event of such conflicts, or in the event we believe thatcompetitive products infringe patents to which we hold rights or others believethat our products infringe patents to which they hold rights, we may pursuepatent infringement litigation or interference proceedings against, or may berequired to defend against such litigation or proceedings 

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involving holders of suchconflicting patents or competing products. Such litigation or proceedings mayhave a materially adverse effect on our competitive position, and there can beno assurance that we will be successful in any such litigation or proceeding.Litigation and other proceedings relating to patent matters, whether initiatedby us or a third party, can be expensive and time consuming, regardless ofwhether the outcome is favorable to us, and can result in the diversion ofsubstantial financial, managerial and other resources. An adverse outcome couldsubject us to significant liabilities to third parties or require us to cease anyrelated development or commercialization activities. In addition, if patentsthat contain dominating or conflicting claims have been or are subsequentlyissued to others and such claims are ultimately determined to be valid, we maybe required to obtain licenses under patents or other proprietary rights ofothers. Any licenses required under any such patents or proprietary rights maynot be made available on terms acceptable to us, if at all. If we do not obtainsuch licenses, we could encounter delays or could find that the development,manufacture or sale of products requiring such licenses is foreclosed.

We also rely on proprietary know how and confidentialinformation and employ various methods, such as entering into confidentialityand non-compete agreements with our current employees and with certain thirdparties to whom we have divulged proprietary information, to protect theprocesses, concepts, ideas and documentation associated with our solutions.Such methods may not afford sufficient protection to us, and we may not be ableto adequately protect our trade secrets or ensure that other companies wouldnot acquire information that we consider proprietary.

***We depend onlicenses from third parties for rights to some technology we use, and if we areunable to continue these relationships and maintain our rights to thistechnology, our business could suffer—******For***some ofthe technology used in our software, we depend upon licenses from a number ofthird party vendors. These licenses are provided to us under contracts thattypically expire within one to five years, can be renewed only by mutualconsent and may be terminated if we breach the terms of the contract and failto cure the breach within a specified period of time. We may not be able tocontinue using the technology made available to us under these contracts oncommercially reasonable terms or at all. As a result, we may have todiscontinue, delay or reduce software shipments until we obtain equivalenttechnology, which could hurt our business. Most of our third party licenses arenonexclusive. Our competitors may obtain the right to use any of the technologycovered by these licenses and use the technology to compete directly with us.In addition, if our vendors choose to discontinue support of the licensedtechnology in the future or are unsuccessful in their continued research anddevelopment efforts, particularly with regard to the Microsoft Windows/Intelplatform on which most of our products operate, we may not be able to modify oradapt our own software.

***We are subject to government regulation, changes towhich could negatively impact our business—******We***aresubject to regulation in the U.S. by the United States FDA, including periodicFDA inspections, in Canada under Health Canada’s Medical Devices Regulations,and in other countries by corresponding regulatory authorities. We may berequired to undertake additional actions in the U.S. to comply with the FederalFood, Drug and Cosmetic Act (the “Act”), regulations promulgated under suchact, and any other applicable regulatory requirements. For example, the FDA hasincreased its focus on regulating computer software intended for the use in ahealthcare setting. If our software solutions are deemed to be actively regulatedmedical devices by the FDA, we could be subject to more extensive requirementsgoverning pre- and post-marketing activities. Complying with these regulationscould be time consuming and expensive, and may include:

·       requiringus to receive FDA clearance of a pre-market notification submissiondemonstrating substantial equivalence to a device already legally marketed, orto obtain FDA approval of a pre-market approval application establishing thesafety and effectiveness of the software;

·       requiringus to comply with rigorous regulations governing the pre-clinical and clinicaltesting, manufacture, distribution, labeling and promotion of medical devices;and

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·       requiringus to comply with the Act regarding general controls, including establishmentregistration, device listing, compliance with good manufacturing practices,reporting of specified malfunctions and adverse device events.

Similar obligations may exist in other countries inwhich we do business, including Canada. Any failure by us to comply with theAct and any other applicable regulatory requirements, both domestic andforeign, could subject us to a number of enforcement actions, including warningletters, fines, product seizures, recalls, injunctions, total or partialsuspension of production, operating restrictions or limitations on marketing,refusal of the government to grant new clearances or approvals, withdrawal ofmarketing clearances or approvals and civil and criminal penalties.

***Changes in federaland state regulations relating to patient data could depress the demand for oursoftware and impose significant software redesign costs on us—******Federal***regulationsunder HIPAA impose national health data standards on healthcare providers thatconduct electronic health transactions, healthcare clearinghouses that converthealth data between HIPAA compliant and non-compliant formats and health plans.Collectively, these groups are known as covered entities. The HIPAA regulationsproscribe transaction formats and code sets for electronic health transactions;protect individual privacy by limiting the uses and disclosures of individuallyidentifiable health information; and require covered entities to implementadministrative, physical and technological safeguards to ensure theconfidentiality, integrity, availability and security of individuallyidentifiable health information in electronic form. Though we are not a coveredentity, most of our customers are and require that our software and servicesadhere to HIPAA regulations. Any failure or perception of failure of oursoftware or services to meet HIPAA regulations could adversely affect demandfor our software and services and force us to potentially expend significantcapital, research and development and other resources to modify our software orservices to address the privacy and security requirements of our clients. Statesand foreign jurisdictions in which our clients or we operate have adopted, ormay adopt, privacy standards that are similar to or more stringent than thefederal HIPAA privacy regulations. This may lead to different restrictions forhandling individually identifiable health information. As a result, ourcustomers may demand IT solutions and services that are adaptable to reflectdifferent and changing regulatory requirements, which could increase ourdevelopment costs. In the future, federal, state or foreign governmentalauthorities may impose new data security regulations or additional restrictionson the collection, use, transmission and other disclosures of healthinformation. We cannot predict the potential impact that these future rules mayhave on our business; however, the demand for our software and services maydecrease if we are not able to develop and offer software and services that canaddress the regulatory challenges and compliance obligations facing ourclients.

***The complexity presented by international operationscould negatively affect our business—******Net*********sales from customers outside of theU.S., which we classify as international net sales, account for a materialportion of our revenues. Net sales from our international customers accountedfor approximately 18% of our total net sales for the year ended December 31,2006, 40% of our total net sales for the year ended December 31, 2005, and32% of total net sales for the year ended December 31, 2004. While we planto continue expanding our presence in international markets, our internationaloperations may not produce sufficient international sales and our overseasdevelopment efforts may not generate saleable products. Our internationaloperations also present a number of other risks, including the following:

·       theneed to conform with local business and market norms;

·       difficultiesmanaging and integrating new international facilities;

·       greaterdifficulty in collecting accounts receivable and longer collection periods;

·       potentiallyunfavorable economic conditions outside of the U.S.;

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·       changesin local currencies may impact the attractiveness of our productcompetitiveness as we invoice most of our net sales in U.S. Dollars;

·       certification requirements;

·       lackof, or limited protection of intellectual property rights in some countries;

·       potentiallyadverse tax consequences;

·       wagepressures, particularly in India, where wages are generally rising at a fasterrate than in the United States;

·       politicalinstability;

·       tradeprotection measures and other regulatory requirements;

·       serviceprovider and government spending patterns;

·       potentialadverse impact on the demand for products and services of U.S.-based businessesdue to perceptions regarding U.S. foreign policy;

·       naturaldisasters, war or terrorist acts;

·       ineffectivestrategic relationships with international partners; and

·       politicalconditions which may threaten the safety of our employees or the employees ofour customers or our continued presence in foreign countries, particularlycivil unrest and hostilities among neighboring countries in South Asia,including India and Pakistan.

Furthermore, our entry into additional internationalmarkets requires significant management attention and financial resources,which could lessen our ability to manage our existing business effectively.

***We provide ourcustomers with certain warranties which could result in higher costs than weanticipate—******Software***productsas complex as those offered by us and used in a wide range of clinical andhealth information systems settings are likely to contain a number of errors or“bugs,” especially early in their product life cycle. Our products includeclinical information systems used in patient care settings where a lowtolerance for bugs exists. Testing of products is difficult due to the widerange of environments in which systems are installed. The discovery of defectsor errors in our software products may cause delays in product delivery, poorclient references, payment disputes, contract cancellations, or additionalexpenses and payments to rectify problems. Any of those factors may result indelayed acceptance of, or the return of, our software products.

***We may be unable to successfully integrateacquisitions, which could negatively impact our results—******We*********have experienced significantchallenges integrating our recent acquisitions. In particular, we havestruggled to realize synergistic benefits, primarily within our product salesand service groups, following our June 1, 2005, business combination withCedara Software Corp. We may continue to acquire or make investments incomplementary businesses, products or technologies. The process of integratingany acquired business, product or technology into our business and operationsmay result in unforeseen operating difficulties and expenditures. Anyacquisition may involve a number of risks, including:

·       anincrease in our expenses and working capital requirements in connection withthe integration of the personnel, operations, technologies or products of theacquired companies;

·       otherfinancial risks, such as potential liabilities associated with the businessesthat we acquire;

·       diversionof capital and management’s attention from our core business;

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·       adverseeffects on business relationships with our existing customers and suppliers andthose of the acquired company;

·       anincreased risk that we become the subject of litigation regarding intellectualproperty or other matters;

·       difficultyin successfully implementing acquired operations, IT systems, customers,supplier and partner relationships, products and business with our operations;

·       acquiredassets becoming impaired as a result of technical advancements or worse thanexpected performance by the acquired company;

·       enteringmarkets in which we have no, or limited, prior experience; and

·       potentialloss of our key employees and those of the acquired company.

In addition, inconnection with any business combinations, acquisitions or investments wecould:

·       issuestock that would dilute existing shareholders’ percentage of ownership;

·       incurdebt and assume liabilities, perhaps on terms that prove unfavorable to us orour security holders;

·       incursignificant expenditures related to office closures of the acquired companies,including costs relating to termination of employees and leasehold improvementcharges relating to vacating the acquired companies’ or our premises; or

·       usecash that would otherwise be available to fund operations or to use for otherpurposes.

***Product liabilitysuits against us could result in expensive and time consuming litigation,payment of substantial damages and an increase in our insurance rates—******Many***of oursoftware solutions provide data for use by healthcare providers in clinicaldecision making and creating patient treatment plans. If our software fails toprovide accurate and timely information, or if our content or any other elementof our software is associated with faulty clinical decisions or treatment, wecould be exposed to claims of liability by customers, clinicians or patientsagainst us relating to the use of our software solutions. The assertion of suchclaims, whether or not valid, and ensuing litigation, regardless of itsoutcome, could result in substantial cost to us, divert management’s attentionfrom our operations and decrease market acceptance of our software. Theallocations of responsibility and limitations of liability set forth in ourcontracts may not be enforceable, may not be binding upon patients, or may nototherwise protect us from liability for damages. Although we maintain productliability insurance coverage, our coverage may not cover a particular claimthat may be brought in the future, may prove to be inadequate or may not beavailable in the future on acceptable terms, if at all. A successful claimbrought against us, which is uninsured or underinsured, could materially harmour business, results of operations or financial condition.

***We may not be ableto generate sufficient cash from our operations to meet our future operating,financing and capital requirements—******At*********December 31, 2006, our cashand cash equivalents were approximately $45.9 million. Our uses of cash in thefuture will depend on a variety of factors, such as our results of operations,the amounts we are required to devote to defend and address our outstandinglegal and regulatory proceedings (see Item 3, “Legal Proceedings” of thisAnnual Report on Form 10-K) and our capital expenditure plans. If weare unable to generate sufficient cash from our operations to meet ourshort-term or long-term liquidity needs, we may need to raise additionalcapital. To raise such additional capital, we may sell equity or raise debtfrom third-party sources. The sale of additional equity or convertible debtsecurities could result in dilution to current shareholders. In addition, debtfinancing, if available, could involve restrictive covenants, which couldadversely affect operations. Furthermore, these financing alternatives may notbe available in amounts or on terms acceptable to us or our security holders.

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***We maintainsubstantial deposits of cash and cash equivalents at a limited number offinancial institutions in excess of amounts covered by insurance. If one ormore of these financial institutions fail, our financial condition may beadversely affected—******Substantially***allof our cash and cash equivalents are held at a few financial institutionslocated in the U.S., Canada and the Netherlands. Deposits held with these banksexceed the amount of insurance, if any, provided on such deposits and, withrespect to one such banking institution, we are the largest depositor. If oneor more of these financial institutions were to fail and we were unable totimely recover the cash and cash equivalents deposited at such institution, itcould adversely affect our financial condition.

***Healthcare industryconsolidation could impose pressure on our software prices, reduce ourpotential client base and reduce demand for our software—******Many*********hospitals and imaging centers haveconsolidated to create larger healthcare enterprises with greater market power.If this consolidation trend continues, it could reduce the size of our targetmarket and give the resulting enterprises greater bargaining power, which maylead to erosion of the prices for our software. In addition, when hospitals andimaging centers combine, they often consolidate infrastructure, and acquisitionof our customers could erode our revenue base.

***The trading price of our Common Stock has beenvolatile and may fluctuate substantially in the future—******The***price ofour Common Stock has been, and is likely to continue to be, volatile. Forexample, the closing price of our Common Stock from January 1, 2006through March 2, 2007 was as high as $27.36 and as low as $4.75. Thetrading price of our Common Stock may continue to fluctuate widely as a resultof a number of factors, some of which are not in our control, including:

·       our ability to meet orexceed the expectations of analysts or investors;

·       changesin our own forecasts or earnings estimates by analysts;

·       quarter-to-quartervariations in our operating results;

·       announcements regardingclinical activities or new products by our competitors or us;

·       generalconditions in the healthcare IT industry;

·       governmentalregulatory action and healthcare reform measures, including changes inreimbursement rates for imaging procedures;

·       rumorsabout our performance or software solutions;

·       priceand volume fluctuations in the overall stock market, which have particularlyaffected the market prices of many software, healthcare and technologycompanies; and

·       generaleconomic conditions.

In addition, the market for our Common Stock mayexperience price and volume fluctuations unrelated or disproportionate to ouroperating performance.

***Anti-takeover provisions in our governing documentsand under Wisconsin law and our shareholders’ rights plan could make anacquisition of us, which may be beneficial to our shareholders, more difficult—******Our***Articlesof Incorporation and our Amended and Restated Bylaws contain provisions thatmay delay, defer, or inhibit a future acquisition of us not approved by ourBoard of Directors. These provisions would likely encourage any personinterested in acquiring us to negotiate with, and obtain the approval of, ourBoard of Directors in connection with the transaction. Our Articles ofIncorporation authorize our Board of Directors to issue shares of preferredstock in one or more series with such dividend rights, dividend rate,conversion, voting, and other rights, preferences, privileges, and restrictionsas the Board determines, without any further vote or action by ourshareholders. Pursuant to these provisions, in September 2006, weimplemented a shareholders’ rights plan, also commonly called a “poison pill,”that would substantially reduce or eliminate the expected economic benefit toan acquirer from acquiring us in a manner or on 

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terms not approvedby our Board of Directors. A description of the terms of our shareholder rightsplan is set forth in our Current Report on Form 8-K, filed with theSEC on September 6, 2006. The rights of the holders of our Common Stockwill be subject to, and may be harmed by, the rights of the holders of thepreferred share purchase rights and any preferred stock that may be issued inthe future. We are also subject to the provisions of Wisconsin law that couldhave the effect of delaying, deferring, or preventing a change of control ofour company. One of these provisions prevents us from engaging in a businesscombination with any interested stockholder for a period of three years fromthe date the person becomes an interested stockholder, unless specifiedconditions are satisfied. These and other impediments to a third-partyacquisition or change of control could limit the price investors are willing topay in the future for shares of our Common Stock.

**Item 1B.**               UNRESOLVEDSTAFF COMMENTS

None.

**Item 2.**                        PROPERTIES

Our principal facilities are located in Milwaukee,Wisconsin in an approximately 36,000 square foot office leased throughApril 2011 at a rate of approximately $0.4 million per year, and inMississauga, Ontario in an approximately 75,000 square foot office leasedthrough December 31, 2009, at a rate of approximately $0.9 million peryear. We also have subsidiary or branch locations with leased facilities inHudson, Ohio; Burlington, Massachusetts; Nuenen, the Netherlands; Paris, Franceand Shanghai, China.

We actively monitor ourreal estate needs in light of our current utilization and projected growth. Webelieve that we can acquire any necessary additional facility capacity onreasonably acceptable terms within a relatively short timeframe. We devotecapital resources to facility improvements and expansions as we deem necessaryto promote growth and most effectively serve our customers.

**Item 3.**                        LEGALPROCEEDINGS

Between March 22, 2006 and April 26, 2006,seven putative securities class action lawsuits were filed in the United StatesDistrict Court for the Eastern District of Wisconsin, on behalf of a class ofpersons who acquired shares of our Common Stock between August 2, 2005 andMarch 16, 2006. Defendants in the suit include us, Richard A. Linden, ourformer President and Chief Executive Officer, and Scott T. Veech, our formerChief Financial Officer; one of the suits also names Brian E. Pedlar, formerPresident of Cedara Software Corp. and our former Senior Vice President, whoserved as our interim co-President and co-Chief Executive Officer fromJuly 2, 2006 to August 18, 2006. One case has been voluntarilydismissed. The cases arise out of our March 17, 2006 announcement that wewould revise our results of operations for the fiscal quarters endedJune 30, 2005 and September 30, 2005, as well as our investigation ofallegations made in anonymous letters received by us. The lawsuits allege thatwe and individual defendants violated Sections 10(b) and20(a) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”). The complaints seek damages in unspecified amounts. On November 22,2006, the Court consolidated the seven cases, appointed the SouthwestCarpenters Pension Trust to be the lead plaintiff and approved the Trust’schoice of its lead counsel. Pursuant to court order, the lead plaintiff is currentlyrequired to file its Amended Complaint on or before March 19, 2007. Weintend to vigorously defend these lawsuits, including, but not limited to,possibly moving to dismiss the consolidated amended complaint when filed.

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On August 28, 2006, a derivative action was filedin the Circuit Court of Milwaukee County, Civil Division, against Messrs. Linden,Mortimore and Veech, and all of the then-current members of our Board ofDirectors. The plaintiffs allege that each of the individual defendantsbreached fiduciary duties to us by violating generally accepted accountingprinciples, willfully ignoring problems with accounting and internal controlpractices and procedures and participating in the dissemination of falsefinancial statements and also allege that we and the director defendants failedto hold an annual meeting of shareholders for 2006 in violation of Wisconsinlaw. The plaintiffs ask for unspecified amounts in damages and costs, as wellas equitable relief. In response to the filing of this action, our Board ofDirectors formed a Special Litigation Committee, which Committee has fullauthority to investigate the allegations of the derivative complaint anddetermine whether pursuit of the claims against any or all of the individualdefendants would be in our best interest. The Special Litigation Committee’sinvestigation is substantially complete. Pursuant to stipulations among theparties and order of the court, the plaintiff has dismissed the claim seekingto require us to hold an annual meeting of shareholders, and the defendants’deadline to move, answer or otherwise respond to the remainder of operativecomplaint has been extended to April 16, 2007.

On April 27, 2006, we received an informal,nonpublic inquiry from the SEC requesting voluntary production of documents andother information. The inquiry principally relates to our announcement on March 17,2006 that we would revise our results of operations for the fiscal quartersended June 30, 2005 and September 30, 2005, as well as ourinvestigation of allegations made in anonymous letters received by us. The SEChas advised us that this inquiry should not be interpreted as an adversereflection on any entity or individual involved, nor should it be interpreted asan indication by the SEC that any violation of the federal securities laws hasoccurred. We are cooperating with the SEC.

We and our Cedara subsidiary were formerly defendantsin an action commenced by Brian Pedlar. Mr. Pedlar was formerly thePresident of Cedara (since the closing of our merger with Cedara) and served,from July 2, 2006, until his departure on August 18, 2006, as co-CEOand co-President of Merge Healthcare. In September 2006, Mr. Pedlarfiled suit in Ontario, Canada, against us and Cedara, claiming that he had beenconstructively discharged from his positions, and that we had defamed him indescribing his departure in public releases and filings with the SEC. Withoutadmitting any of the allegations of his complaint, on February 22, 2007,we agreed with Mr. Pedlar to settle this suit. Pursuant to the settlement,we agreed to pay Mr. Pedlar approximately $500,000 (less required taxwithholding) and also agreed to pay approximately $80,000 to Mr. Pedlar’scounsel in payment of his attorneys fees and expenses in his employmentproceedings. The settlement also included customary provisions addressingnon-disparagement, confidentiality, mutual releases and dismissal of the legalaction.

We, and our subsidiaries,are from time to time parties to legal proceedings, lawsuits and other claimsincident to our business activities. Such matters may include, among otherthings, assertions of contract breach or intellectual property infringement,claims for indemnity arising in the course of our business and claims bypersons whose employment has been terminated. Such matters are subject to manyuncertainties and outcomes are not predictable with assurance. Consequently, weare unable to ascertain the ultimate aggregate amount of monetary liability,amounts which may be covered by insurance or recoverable from third parties, orthe financial impact with respect to these matters as of the date of thisreport.

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**Item 4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

Weheld our Annual Meeting of Shareholders on December 18 and 28, 2006 (the “AnnualMeeting”). Our shareholders voted as follows to elect the following eleven (11)individuals to serve as Directors until the next annual meeting of theshareholders or otherwise as provided in our Bylaws:

| ** **                                               | ** ** | **Votes For** | ** ** | **Votes  Against or  Withheld** | ** ** | **Result** | ** ** |
|----------------------------------------------------------|------------|--------------------|------------|--------------------------------------|------------|------------|------------|
| Elect Robert A.  Barish, M. D. to serve as Director |       | 12,518,269         |       | 4,475,737                            |       | Elected    |       |
| Elect Dennis  Brown to serve as Director                 |       | 12,706,305         |       | 4,287,701                            |       | Elected    |       |
| Elect Michael D.  Dunham to serve as Director            |       | 13,369,802         |       | 3,624,204                            |       | Elected    |       |
| Elect Robert T.  Geras to serve as Director              |       | 13,333,430         |       | 3,660,576                            |       | Elected    |       |
| Elect Anna Marie  Hajek to serve as Director             |       | 12,514,552         |       | 4,479,454                            |       | Elected    |       |
| Elect R. Ian  Lennox to serve as Director                |       | 12,909,124         |       | 4,084,882                            |       | Elected    |       |
| Elect Kevin E.  Moley to serve as Director               |       | 14,033,653         |       | 2,960,353                            |       | Elected    |       |
| Elect Ramamritham  Ramkumar to serve as Director         |       | 13,209,695         |       | 3,784,311                            |       | Elected    |       |
| Elect Kenneth D.  Rardin to serve as Director            |       | 14,034,747         |       | 2,959,259                            |       | Elected    |       |
| Elect Kevin G.  Quinn to serve as Director               |       | 14,035,293         |       | 2,958,713                            |       | Elected    |       |
| Elect Richard A. Reck to  serve as Director              |       | 12,870,993         |       | 4,123,013                            |       | Elected    |       |

 

No other business wasbrought before the Annual Meeting.

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**PART II**

**Item 5.**                        MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Our Common Stock trades on the NASDAQ National Market(now designated the NASDAQ Global Market) (in both cases, the “NASDAQ”).

The following table setsforth for the periods indicated, the high and low sale prices of our CommonStock as reported by the NASDAQ:

**Common Stock Market Prices**

| ** ** | ** ** | **4th Quarter** | ** ** | **3rd Quarter** | ** ** | **2nd Quarter** | ** ** | **1st Quarter** | ** ** |
|------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ***2006*** |       |                 |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| High       |       |                 | $          | 8.14                 |       |                 |       | $                    | 8.17       |   |   |   | $ | 16.06 |   |   |   | $ | 27.36 |   |   |
| Low        |       |                 | $          | 5.72                 |       |                 |       | $                    | 6.43       |   |   |   | $ | 11.31 |   |   |   | $ | 15.01 |   |   |
| ***2005*** |       |                 |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| High       |       |                 | $          | 30.05                |       |                 |       | $                    | 20.49      |   |   |   | $ | 20.00 |   |   |   | $ | 22.90 |   |   |
| Low        |       |                 | $          | 16.29                |       |                 |       | $                    | 16.50      |   |   |   | $ | 14.90 |   |   |   | $ | 17.05 |   |   |

 

According to the recordsof American Stock Transfer & Trust Company, our registrar and transferagent, we had 254 shareholders of record of Common Stock as of March 2,2007. As of the same date, we estimate that there were in excess of 11,600beneficial holders of our Common Stock.

**Dividend Policy**

We have not paid any cashdividends on our Common Stock since formation. We currently do not intend todeclare or pay any cash dividends on our Common Stock in the foreseeablefuture.

**Recent Sales ofUnregistered Securities**

We did not sell any shares of our Common Stock intransactions not registered under the Securities Act of 1933, as amended (the “SecuritiesAct”) during the fourth quarter of 2006.

On September 6, 2006, we announced a stockrepurchase plan providing for the purchase of up to $20 million of ourCommon Stock over a two-year period. As of December 31, 2006, we had notmade any repurchases under this plan. This repurchase program replaces aprevious plan that expired on August 24, 2006, two years after its initialimplementation, without any shares having been repurchased.

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**Item 6.**                        SELECTEDFINANCIAL DATA

Thefollowing selected historical financial data are qualified in their entirety byreference to, and should be read in conjunction with, our consolidatedfinancial statements and the related notes thereto appearing elsewhere hereinand Item 7, “Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” in this Annual Report on Form 10-K.

| ** **                            | ** ** | **Year Ended December 31,**                                                      | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                                        | ** ** | **2005(1)** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                            | ** ** | **(in thousands, except for share and per share data)** | ** ** |
| Statements of Operations  Data:       |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Net sales                             |       | $                                                                                               | 75,042     |   | $ | 82,601 |   | $ | 26,347 |   | $ | 24,560 |   | $ | 19,147 |   |
| Operating income (loss)(2)(3)         |       | (258,612                                                                                        | )          | 4,526 |   | 499 |   | 3,310 |   | 2,782 |   |
| Income (loss) before income taxes     |       | (255,998                                                                                        | )          | 5,232 |   | 968 |   | 3,208 |   | 2,846 |   |
| Income tax expense (benefit)          |       | 2,460                                                                                           |       | 7,889 |   | (1,222 | ) | (1,226 | ) | 79 |   |
| Net income (loss)                     |       | (258,458                                                                                        | )          | (2,657 | ) | 2,190 |   | 4,434 |   | 2,767 |   |
| Earnings (loss) per  share:           |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                 |       | $                                                                                               | (7.67      | ) | $ | (0.11 | ) | $ | 0.17 |   | $ | 0.38 |   | $ | 0.29 |   |
| Diluted                               |       | (7.67                                                                                           | )          | (0.11 | ) | 0.16 |   | 0.35 |   | 0.25 |   |
| Weighted average shares  outstanding: |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                 |       | 33,701,735                                                                                      |       | 24,696,762 |   | 13,013,927 |   | 11,566,054 |   | 8,840,059 |   |
| Diluted                               |       | 33,701,735                                                                                      |       | 24,696,762 |   | 13,827,522 |   | 12,586,900 |   | 10,383,651 |   |

 

| ** **                 | ** ** | **As of December 31,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                 | ** ** | **(in thousands)**               | ** ** |
| Balance Sheet Data:        |       |                                  |       |   |   |   |   |   |   |   |   |
| Working capital            |       | $                                     | 28,870     |   | $ | 57,336 |   | $ | 22,785 |   | $ | 18,187 |   | $ | 7,010 |   |
| Total assets               |       | 234,663                               |       | 501,673 |   | 85,491 |   | 66,085 |   | 27,481 |   |
| Long-term debt obligations |       | —                                |       | — |   | — |   | — |   | — |   |
| Shareholders’  equity |       | 191,695                               |       | 443,841 |   | 55,623 |   | 50,856 |   | 20,821 |   |
|                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Includes the results ofCedara Software Corp. from June 1, 2005, the date of our businesscombination.

(2)          For the years ended December 31,2005 and 2002, we incurred a charge for acquired in-process research anddevelopment of $13.0 million and $0.1 million, respectively.

(3)          Forthe year ended December 31, 2006, we incurred charges of $221.4 millionrelated to the impairment of goodwill and $6.7 million related to theimpairment of tradenames. In addition, for the years ended December 31,2006 and 2005, we incurred restructuring charges of $2.7 million and $0.5 million,respectively.

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**Item7.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The discussion below contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act, and Section 21E of theExchange Act. We have used words such as “believes,” “intends,” “anticipates,” “expects”and similar expressions to identify forward-looking statements. Thesestatements are based on information currently available to us and are subjectto a number of risks and uncertainties that may cause our actual growth,results of operations, financial condition, cash flows, performance, businessprospects and opportunities and the timing of certain events to differmaterially from those expressed in, or implied by, these statements. Theserisks, uncertainties and other factors include, without limitation, thosematters discussed in Item 1A, “Risk Factors” in this Annual Report on Form 10-K.Except as expressly required by the federal securities laws, we undertake noobligation to update such factors or to publicly announce the results of any ofthe forward-looking statements contained herein to reflect future events,developments, or changed circumstances, or for any other reason. The followingdiscussion should be read in conjunction with the consolidated financialstatements and notes thereto appearing elsewhere in this report.*

**Overview**

Operating under the name Merge Healthcare, we developmedical imaging and information management software and deliver relatedservices. Late in 2006, we reorganized our business to better reflect emergingmarket needs.  We established threedistinct business units: Merge Healthcare North America, which primarily sellsdirectly to the end-user healthcare market comprised of hospitals, imagingcenters and specialty clinics located in the U.S. and Canada and alsodistributes certain products through the Internet via our website; CedaraSoftware, our OEM business unit, which primarily sells to OEMs and VARs,comprised of companies that develop, manufacture or resell medical imagingsoftware or devices; and Merge Healthcare EMEA, which sells to the end-userhealthcare market in Europe, the Middle East and Africa.

Healthcare providers continue to be challenged bydeclining reimbursements, competition and reduced operating profits broughtabout by the increasing costs of delivering healthcare services. In the U.S.,we are focusing our direct sales efforts on single and multi-site imagingcenters that complete more than 10,000 studies per year, small-to-medium sizedhospitals (fewer than 400 beds), and certain specialty clinics like orthopedicpractices that offer imaging services. Millennium Research Group, aninternational market research firm, reported that, in 2005, the U.S. market forRIS and PACS, consisting of RIS and enterprise, radiology, orthopedic andcardiology PACS, was valued at over $1.5 billion; that by 2010 this market willgrow to over $3.0 billion, representing a compound annual growth rate of nearly15%; and that growth for the RIS market is primarily driven by imaging centersand small hospitals, particularly those that do not already have a PACS or RISand elect for an integrated RIS/PACS solution.

We have aggressivelyexpanded our product offerings through our acquisitions of eFilm in 2002, RISLogic in 2003 and AccuImage in January 2005 and our business combinationwith Cedara Software Corp. in June 2005.

**Recent Developments**

Late in 2006, we commenced a rightsizing andreorganization initiative designed to reduce costs in our global development,delivery and support model through expanding our investment in onshore-offshoreinitiatives; to expand our direct sales presence in North America and Europe;to eliminate redundancies within our consolidated organization from not havingbenefited from the economies of scale and synergies that should have resultedfrom our business combination with Cedara Software; to better align our coststructure with our revenue-generating strategies; and to reduce time-to-marketfor new products and ultimately lower costs for our clients. In addition, weannounced several changes to our senior management team.

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The following aresome of the key details of the initiative:

·       Reductionof approximately 150 jobs (including consultants and temporary workforce), or28% of the then-current workforce, with plans to add more than 200 technical personneloffshore in our Pune, India software engineering and customer support center bythe end of 2007.

·       Strategictransition to a blended onshore-offshore global delivery model to improvequality and customer satisfaction, to decrease costs, to increase capacity, andto improve delivery and customer support. At December 31, 2006, we hadapproximately 100 persons employed by our partner in India, dedicated to thiseffort.

·       Operationalconsolidation of the Merge Healthcare and Cedara Software organizations,encompassing most administrative functions, as well as software engineering andproduct management.

·       Formationof Cedara Software Services (India) Pvt. Ltd. for the purpose of expanding ourcapacity for performing custom engineering services on behalf of our OEMcustomers, led by Managing Director Avinash Agrawal.

·       Closingof offices in San Francisco, CA, and Tokyo, Japan, and downsizing operations inBurlington, MA, Cleveland, OH and Mississauga, Ontario.

·       Formationof three business units:

·        MergeHealthcare North America (formerly Merge eMed, U.S. and Canada direct market),led by recently hired President Gary Bowers, former Senior Vice President,Strategic Business Initiatives at Merge Healthcare.

·        CedaraSoftware (Global OEM market), led by President Loris Sartor, former Vice Presidentof Sales at Cedara.

·        MergeHealthcare EMEA (Europe, Middle East, and Africa direct market), led byPresident Jacques Cornet, former Vice President of Marketing and BusinessDevelopment at Cedara Software.

·       Consolidationof two existing engineering groups into a single consolidated organization.Peter Bascom, former Vice President of Engineering for Cedara Software, waspromoted to Senior Vice President of Engineering for Merge Healthcare.

·       Promotionof Tim Kulbago, former Chief Technical Officer of Merge eMed, to ChiefTechnical Officer and Chief Strategy Officer for Merge Healthcare withresponsibility for strategic business initiatives, including merger andacquisition activities.

·       Consolidationof two existing product management groups into one consolidated organization.Recently-hired Senior Clinical Consultant, Cory Hall, was promoted to SeniorVice President of Product Management for Merge Healthcare.

We also enteredinto several strategic partnerships and ventures in new markets during 2006. Inaddition, we:

·       Announcedan agreement with Medavis GmbH to distribute their Radiology Information Systemin conjunction with our FUSION PACS offering to selected European markets.

·       Enteredinto a strategic relationship with Foresight Imaging to deliver the nextgeneration “Merge Box” to the market.

·       Enteredinto a partnership with CPAGE, a French public information technology group, todeliver EPR functionality to the French hospital market based on our aXigatetechnology.

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In 2006, we continued to enhance our productportfolios with the release of Matrix 2.1, RIS 3.1, Efilm 2.1,PET/CT 1.3, a beta version of ProPlanner (orthopedic workstation), thenext generation ExamWorks, MergeMammo and Softview 6.2. In addition, a Spanishversion of eFilm was developed for eCommerce and a veterinary-specific versionof eFilm was released. This year also saw the introduction of a .NET version ofthe industry standard MergeCOM3 DICOM toolkit and a 64 bit version of OpenEyes.

Innovation alsocontinued in 2006 with a focus on developing technology to enable theautomation of clinical workflow wherever possible. Our goal is ultimately toreduce user interaction, and enhance their experience by having our softwaremake intelligent choices based on the image content, thereby allowing the userto focus on solving the clinical issue at hand. The need for these tools hasbecome even more acute in light of the trend towards increased dataset sizes inmedical imaging. Specifically we:

·       Developedthe Cedara Clinical Control Center (“C4”) to enable us and our partners toeasily integrate clinical applications into existing products. A prototype ofC4 was shown at RSNA and was initially released as part of I-Softview 6.2.

·       Developeda number of novel oncology prototypes to handle prostate and tumor segmentation.The tumor segmentation algorithms were added to Cedara’s oncology workstationI-Response that will be released in 2007.

·       Createdan automatic mammography skin line detection algorithm that will be used in theI-ReadMammo product to be released in 2007. This algorithm enables theautomation of the comparison of prior images and automatically maximizing thedisplayable area.

·       Developedan automatic module to stitch overlapping X-Ray images for orthopedics. Inaddition, we worked to enhance the autotemplating functionality to improveaccuracy and performance while adding support for the coverage of full-hipimages.

·       Developeda complete X-Ray Pipeline solution that implements shutter detection, imageenhancement (“CIE”) and the setting of the optimal window width and level.

·       Developeda novel graphical processing unit (“GPU”)-based image enhancement filter foruse on ultrasound and angiography datasets.

Our North American business held its third annual users’group meeting in Boston on May 7-9, 2006. More than 150 customersspent time sharing their business challenges, discussing product features andsharing best-practices. Our customers continued to re-iterate how vital theMerge Healthcare solutions are in improving their business.

We continue to facechallenges including the informal, non-public inquiry being conducted by the SECand class action and other lawsuits. In addition, we have had significantchanges in our senior management team during 2006, including the resignationsof our former CEO, Rich Linden, our former CFO, Scott Veech, our founder and formerChief Strategist, William C. Mortimore, our former President of Cedara, BrianPedlar, our former President of Merge Healthcare North America, Robert White, ourformer Senior Vice President of Strategic Business Development, David Noshay,and several others as well. We believe that these matters have caused confusioninternally and adversely affected the morale of our employees, ourrelationships with certain customers and potential customers and our reputationin the marketplace, and have diverted the attention of our Board of Directorsand management from our business operations. We also have experiencedchallenges integrating the businesses and personnel of Merge Healthcare andCedara. In particular, we struggled to realize synergistic benefits as aconsequence of organizational changes, primarily within our sales and servicegroups, following that business combination. These challenges led tosignificant attrition at both Merge Healthcare and Cedara during the latterhalf of 2005 and also in 2006. In late 2006, we hired Ken Rardin as our new ChiefExecutive Officer and in January of 2007, we hired Steve Norton as ourExecutive Vice President and Chief Financial Officer. We anticipate that theseand other significant changes made during the latter half of 2006, as 

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discussedunder our rightsizing and reorganization initiative above, will havesignificant positive effects for us going forward. However, we believe that itwill take time for these initiatives and hirings to have an impact on our netsales and operating income. See Item 1A, “Risk Factors,” and Item 3, “LegalProceedings,” in this Annual Report on Form 10-K for more detaileddiscussion regarding these matters.

**Revenues andExpenses**

The following is a briefdiscussion of our revenues and expenses:

*Net Sales*

Net sales consist ofsoftware and other sales, net of estimated product returns, and professionalservices and maintenance. Software and other sales consist of software andpurchased component revenue recognized in sales to OEM customers, healthcarefacilities and imaging centers. Professional services and maintenance consistsof installation and engineering services, training, consulting, and softwaremaintenance and support.

*Cost of Sales*

Cost of sales consists ofpurchased components, third-party royalties, costs to service and support ourcustomers, and amortization of purchased and developed software. The cost ofsoftware and other includes purchased components and third-party royaltiesincluded in software and hardware sales to our customers. The cost of servicesand maintenance includes headcount and related costs incurred in ourperformance of installation and engineering services, training, consulting, andsoftware maintenance and support. Purchased and developed software is amortizedover its estimated useful life. Each quarter we test our purchased anddeveloped software for impairment by comparing its fair value (estimated usingfuture cash flows) to the carrying value of the software. If the carrying valueof the software exceeds its fair value, we record an impairment charge in theperiod in which the impairment is incurred equal to the amount of thedifference between the carrying value and estimated future cash flows.

*Sales and MarketingExpense*

Sales and marketing expense includes the costs of our salesand marketing departments, commissions and costs associated with trade shows.

*Research andDevelopment Expense*

Research and developmentexpense consists of expenses incurred for the development of our proprietarytechnologies, included in Item 1, “Business” in this Annual Report onForm 10-K. The costs reflected in this category are reduced bysoftware development costs capitalized in accordance with Statement ofFinancial Accounting Standard (“SFAS”) No. 86, *Accountingfor the Costs of**Computer Software to BeSold, Leased, or Otherwise Marketed*. The amortization of capitalizedsoftware development costs is included in cost of sales.

*General andAdministrative Expense*

General and administrativeexpense includes costs for information systems, accounting, administrativesupport, management personnel, bad debt expense, legal fees and generalcorporate matters.

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*Acquired In-ProcessResearch and Development*

In connection with our business combination withCedara Software Corp. in 2005, we incurred a charge for acquired in-processresearch and development.

The value we assigned toacquired in-process technology was determined by identifying the acquiredspecific in-process research and development projects that would be continued,and for which (1) technological feasibility had not been established atthe transaction date, (2) there was no alternative future use, and (3) thefair value was estimable with reasonable reliability. At the date of thebusiness combination, Cedara Software Corp. had in-process projects meetingthis definition associated with the Cedara next-generation PACSworkstation, OEM imaging platforms and image acquisition console projects.

*GoodwillImpairment, Restructuring and Other Expenses*

Goodwill impairment,restructuring and other expenses consist of impairment of goodwill andtradenames (see Note 3 of the notes to consolidated financial statementsincluded herein), severance to involuntarily terminated employees andimpairment of non-cancelable building leases associated with restructuringactivities.

*Depreciation andAmortization*

Depreciation andamortization is assessed on capital equipment, leasehold improvements andintangible assets with estimable useful lives. The amortization of capitalizedsoftware and acquired technology, which is a component of cost of sales, isexcluded.

*Other Income,Expense*

Other income, expense iscomprised of interest income earned on cash and cash equivalent balances,interest expense incurred from borrowings and foreign exchange gains or losseson foreign currency payables for Cedara Software and on foreign currencypayables and receivables at our Nuenen, Netherlands branch.

**Critical AccountingPolicies**

Our consolidated financial statements are impacted bythe accounting policies used and the estimates, judgments, and assumptions madeby management during their preparation. We base our estimates and judgments onour experience, our current knowledge (including terms of existing contracts),our beliefs of what could occur in the future, our observation of trends in theindustry, information provided by our customers and information available fromother sources. Actual results may differ from these estimates under differentassumptions or conditions.

We have identified thefollowing accounting policies and estimates as those that we believe are mostcritical to our financial condition and results of operations and that requiremanagement’s most subjective and complex judgments in estimating the effect ofinherent uncertainties: revenue recognition, allowance for doubtful accounts,software capitalization, other long-lived assets, goodwill and other intangibleasset valuation, share-based compensation expense, income taxes, guarantees andloss contingencies.

*Revenue Recognition*

We derive revenues primarily from the licensing ofsoftware, sales of hardware and related ancillary products, installation, engineeringservices, training, consulting, and software maintenance and support. Inherentto software revenue recognition are significant management estimates andjudgments in the interpretation and practical application of the complex rules toindividual contracts. These interpretations 

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generally would notinfluence the amount of revenue recognized, but could influence the timing ofsuch revenues. Typically our contracts contain multiple elements, and while themajority of our contracts contain standard terms and conditions, there areinstances where our contracts contain non-standard terms and conditions. As aresult, contract interpretation is sometimes required to determine theappropriate accounting, including whether the deliverables specified in a multipleelement arrangement should be treated as separate units of accounting forrevenue recognition purposes in accordance with Statement of Position (“SOP”) No. 97-2,*Software Revenue Recognition*, orEmerging Issues Task Force (“EITF”) Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*,and if so, the relative fair value that should be allocated to each of theelements as well as when to recognize revenue for each element.

For software arrangements, we recognize revenue inaccordance with SOP No. 97-2*.*This generally requires revenue recognized on software arrangements involvingmultiple elements, including separate arrangements with the same customerexecuted within a short time frame of each other, to be allocated to eachelement based on the vendor-specific objective evidence (“VSOE”) of fair valuesof those elements. Revenue from multiple-element software arrangements isrecognized using the residual method, pursuant to SOP No. 98-9, *Modification of SOP No. 97-2, SoftwareRevenue Recognition, With Respect to Certain Transactions* (“SOP No. 98-9”)*.* Under the residual method, revenue isrecognized in a multiple-element arrangement when VSOE of fair valueexists for all of the undelivered elements in the arrangement, even ifvendor-specific objective evidence of fair value does not exist for one or moreof the delivered elements in the arrangement, assuming all other conditions forrevenue recognition have been satisfied. For sales transactions where thesoftware is incidental, the only contract deliverable is custom engineering orinstallation services, and hardware transactions where no software is involved,we recognize revenue in accordance with EITF Issue No. 00-21 andStaff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition*.

We allocate revenue to each undelivered element in amultiple-element arrangement based on its respective fair valuedetermined by the price charged when that element is sold separately.Specifically, we determine the fair value of the maintenance portion of the arrangementbased on the substantive renewal price of the maintenance offered to customers,which generally is stated in the contract. The fair value of installation,engineering services, training, and consulting is based upon the price chargedwhen these services are sold separately. If evidence of the fair value cannotbe established for undelivered elements of a sale, the entire amount of revenueunder the arrangement is deferred until elements without VSOE of fair valuehave been delivered or VSOE of fair value can be established. If evidence offair value cannot be established for the maintenance element of a sale, and itrepresents the only undelivered element, the software, hardware, or softwaremaintenance elements of the sale are deferred and recognized ratably over therelated maintenance period.

Revenue from software licenses is recognized uponshipment, provided that evidence of an arrangement exists, delivery hasoccurred and risk of loss has passed to the customer, fees are fixed or determinableand collection of the related receivable is probable. We assess collectibilitybased on a number of factors, including past transaction history with thecustomer and the credit worthiness of the customer. We must exercise ourjudgment when we assess the probability of collection and the current creditworthiness of each customer. If the financial condition of our customers wereto deteriorate, it could affect the timing and the amount of revenue werecognize on a contract. In addition, in certain transactions we may negotiatethat the customer provides common stock ownership in consideration as part ofthe sale. We generally do not request collateral from customers.

Revenue from software licenses sold through annualcontracts that include software maintenance and support is deferred andrecognized ratably over the contract period. Revenue from installation,engineering services, training, and consulting services is recognized asservices are performed.

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Revenue from sales of RIS and from RIS/PACS solutions,and other specific arrangements where professional services are consideredessential to the functionality of the solution sold, is recognized on thepercentage-of-completion method, as prescribed by SOP No. 81-1, *Accounting for Performance on Construction-Type andCertain Production-Type Contracts*. Percentage of completion isdetermined by the input method based upon the amount of labor hours expendedcompared to the total labor hours expended plus the estimated amount of laborhours to complete the project. Total estimated labor hours are based onmanagement’s best estimate of the total amount of time it will take to completea project. These estimates require the useof judgment. A significant change in one or more of these estimates couldaffect the profitability of one or more of our contracts. We review ourcontract estimates periodically to assess revisions in contract values andestimated labor hours and reflect changes in estimates in the period that suchestimates are revised under the cumulative catch-up method. At times, wehave had difficulty accurately estimating the number of days required tocomplete the consulting and installation services and, accordingly, accuratelyestimating the percentages of completion.

Our OEM software products are typically fullyfunctional upon delivery and do not require significant modification oralteration. Fees for services to OEM customers are billed separately fromlicenses of our software products. For sales transactions involving only thedelivery of custom engineering services, we recognize revenue underproportional performance guidelines of SAB No. 104.

For certain contracts accounted for under SAB No. 104and EITF No. 00-21, the arrangement dictates that we invoice the customer for 10%of the contract value of the products delivered upon completion of hardwareinstallation and acceptance by the customer. As a result of this specificperformance obligation and acceptance criteria, we defer the related amount ofproduct fair value and recognize it upon completion of installation andacceptance.

Our policy is to allow returns when we havepreauthorized the return. Based on our historical experience of a limitednumber of returns and our expectation that returns, if any, will beinsignificant, we have provided for an allowance for specific potential returnsonly.

Deferred revenue is comprised of deferrals for licensefees, support and maintenance, and other services. Long-term deferred revenue asof December 31, 2006, represents license fees, support and maintenance,and other services to be earned or provided after January 1, 2008.

We record reimbursableout-of-pocket expenses in both services and maintenance net sales and as adirect cost of services and maintenance in accordance with EITF Issue No. 01-14,*Income Statement Characterization ofReimbursements Received for “Out-of-Pocket” Expenses Incurred*. Inaccordance with EITF Issue No. 00-10, *Accounting for Shipping and Handling Fees*, the reimbursementby customers of shipping and handling costs are recorded in software and othernet sales and the associated cost as a cost of sale.

*Allowance forDoubtful Accounts*

Based upon past experienceand judgment, we establish an allowance for doubtful accounts with respect toour accounts receivable. We determine collection risk and record allowances forbad debts based on the aging of accounts and past transaction history withcustomers. We monitor our collections and write-off experience to assesswhether adjustments to our allowance estimates are necessary. Changes in trendsin any of the factors that we believe impact the realizability of ourreceivables, or modifications to our credit standards, collection practices, orother related policies may impact our estimate of our allowance for doubtfulaccounts and our financial results.

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*SoftwareCapitalization*

Software capitalizationcommences when we determine that projects have achieved technologicalfeasibility, unless the costs expected to be incurred after achievingtechnological feasibility until general release are immaterial. Ourdetermination that a project has achieved technological feasibility does notensure that the project can be commercially salable. Amounts capitalizedinclude direct labor and estimates of overhead attributable to the projects. Theuseful lives of capitalized software projects are assigned by management, basedupon the expected life of the software. We also estimate the realizability ofcapitalized values based on projections of future net operating cash flowsthrough the sale of products related to each capitalized project. If wedetermine in the future that the value of capitalized software cannot berecovered, a write down of the value of the capitalized software to itsrecoverable value may be required. If the actual achieved revenues are lowerthan our estimates or the useful life of a project is shorter than theestimated useful life, the asset may be deemed to be impaired and, accordingly,a write down of the value of the asset or a shorter amortization period may berequired.

*Other Long-LivedAssets*

Other long-lived assets,including property and equipment, and other intangibles, are amortized overtheir expected lives, which are estimated by us. We also make estimates of theimpairment of long-lived assets whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable basedprimarily upon whether expected future undiscounted cash flows are sufficientto support the assets recovery. If the actual useful life of a long-lived assetis shorter than the useful life estimated by us, the assets may be deemed to beimpaired and, accordingly, a write down of the value of the assets or a shorterdepreciation or amortization period may be required, generally determined by adiscounted cash flow analysis.

*Goodwill and OtherIntangible Assets*

SFAS No. 142,*Goodwill and Other IntangibleAssets,* requires that goodwill and indefinite lived intangibleassets be reviewed for impairment annually, or more frequently if impairmentindicators arise. Our policy provides that goodwill and indefinite livedintangible assets will be reviewed for impairment as of December 31 ofeach year. In calculating potential impairment losses, we evaluate the fairvalue of goodwill and intangible assets using either quoted market prices or,if not available, by estimating the expected present value of their future cashflows. Identification of, and assignment of assets and liabilities to, areporting unit require our judgment and estimates. In addition, future cashflows are based upon our assumptions about future sales activity and marketacceptance of our products. If these assumptions change, we may be required towrite down the carrying value of the asset to a revised amount. See Note 3 innotes to consolidated financial statements for a discussion of the impairmentof goodwill and tradenames in 2006 which were previously recorded at the timeof our business combination with Cedara Software Corp.

*Share-basedCompensation Expense*

Effective January 1,2006, we adopted SFAS No. 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123, *Accounting for Stock-BasedCompensation*, as amended, to replace our previous method ofaccounting for share-based awards under APB Opinion No. 25, *Accounting for Stock Issued to Employees*, for periodsbeginning in 2006. We are using the modified prospective transition method.Under that transition method, compensation cost recognized in 2006 includes: (1) compensationcost for all share-based awards granted prior to, but not yet vested as of January 1,2006, based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS No. 123; and (2) compensation cost forall share-based awards granted subsequent to January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).We use the Black-Scholes option pricing model to 

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estimatethe fair value of stock-based awards on the date of grant utilizing certainassumptions including expected volatility, which we base on the historicalvolatility of our stock and other factors, and estimated option life, whichrepresents the period of time the options granted are expected to beoutstanding and is based, in part, on historical data. We also estimateemployee terminations (option forfeiture rate) which is based, in part, onhistorical data. Although we believe our assumptions used to calculateshare-based compensation expense are reasonable, these assumptions can involvecomplex judgments about future events, which are open to interpretation andinherent uncertainty. In addition, significant changes to our assumptions couldsignificantly impact the amount of expense recorded in a given period.

*Income Taxes*

As part of the process of preparing our consolidatedfinancial statements, we are required to estimate income taxes in each of thejurisdictions in which we operate. The provision for income taxes is determinedusing the asset and liability approach for accounting for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*. A current liability is recognized for theestimated taxes payable for the current year. Deferred tax assets andliabilities are recognized for the estimated future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using the enacted tax rates in effect forthe year in which the timing differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of changes in taxrates or tax laws are recognized in the provision for income taxes in theperiod that includes the enactment date.

Valuation allowances are established when necessary toreduce deferred tax assets to the amount more-likely-than-not to be realized.To the extent we establish or change the valuation allowance in a period, thetax effect will flow through the statement of operations. However, in the caseof deferred tax assets of an acquired or merged entity with a valuationallowance recorded for purchase accounting, any change in that valuationallowance will be recorded as an adjustment to goodwill to the extent goodwillexists. Otherwise, such valuation allowance will be reflected in the Statementof Operations.

The determination of our provision for income taxesrequires significant judgment, the use of estimates and the interpretation andapplication of complex tax laws. We are subject to income taxes in the U.S. andnumerous foreign jurisdictions. Significant judgment is required in determiningour worldwide provision for income taxes and recording the related tax assetsand liabilities. In the ordinary course of our business, there are transactionsand calculations for which the ultimate tax determination is uncertain. Inspite of our belief that we have appropriate support for all the positionstaken on our tax returns, we acknowledge that certain positions may besuccessfully challenged by the taxing authorities. Therefore, an accrual fortax contingencies is provided for, when necessary, in accordance with therequirements of SFAS No. 5, *Accountingfor Contingencies*. These tax contingency accruals are reviewedquarterly and reversed upon being sustained under audit, the expiration of thestatute of limitations, new information, or other determination by the taxingauthorities. The provision for income taxes includes the impact of changes inthe tax contingency accrual. Although we believe our recorded tax assets andliabilities are reasonable, tax laws and regulations are subject tointerpretation and inherent uncertainty; therefore our assessments can involveboth a series of complex judgments about future events and rely on estimatesand assumptions. Although we believe these estimates and assumptions arereasonable, the final determination could be materially different than thatwhich is reflected in our provision for income taxes and recorded tax assetsand liabilities.

In the calculation of ourquarterly provision for income taxes, we use an annual effective rate based onexpected annual income and statutory tax rates. The tax (or benefit) applicableto significant unused or infrequently occurring items, discontinued operationsor extraordinary items are separately recognized in the income tax provision inthe quarter in which they occur.

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*Guarantees*

In accordance with FASBInterpretation (“FIN”) No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*(“FIN No. 45”), werecognize the fair value of guarantee and indemnification arrangements issuedor modified by us, if these arrangements are within the scope of theinterpretation. In addition, we must continue to monitor the conditions thatare subject to the guarantees and indemnifications, as required under the previouslyexisting GAAP, in order to identify if a loss has occurred. If we determine itis probable that a loss has occurred, then any such estimable loss would berecognized under those guarantees and indemnifications. Under our standardSoftware License, Services and Maintenance Agreement, we agree to indemnify,defend and hold harmless our licensees from and against certain losses, damagesand costs arising from claims alleging the licensees’ use of our softwareinfringes the intellectual property rights of a third party. Historically, wehave not been required to pay material amounts in connection with claimsasserted under these provisions and, accordingly, we have not recorded aliability relating to such provisions.

Under our SoftwareLicense, Services and Maintenance Agreement, we also represent and warrant tolicensees that our software products will operate substantially in accordancewith published specifications, and that the services we perform will beundertaken by qualified personnel in a professional manner conforming togenerally accepted industry standards and practices. Historically, only minimalcosts have been incurred relating to the satisfaction of product warrantyclaims.

Other guarantees includepromises to indemnify, defend and hold harmless each of our executive officers,non-employee directors and certain key employees from and against losses,damages and costs incurred by each such individual in administrative, legal orinvestigative proceedings arising from alleged wrongdoing by the individualwhile acting in good faith within the scope of his or her job duties on ourbehalf. Historically, minimal costs have been incurred relating to suchindemnifications and, as such, no accrual for these guarantees have been made.However, we, Richard A. Linden, our former President and Chief ExecutiveOfficer and Scott T. Veech, our former Chief Financial Officer, are defendantsin several lawsuits relating to our accounting and financial disclosure; one ofthese suits also names Brian E. Pedlar, former President of Cedara SoftwareCorp. and former Senior Vice President of Merge Healthcare, who served asinterim co-President and co-Chief Executive Officer from July 2,2006 to August 18, 2006. These lawsuits and other legal matters in whichwe have become involved, including our receipt of a shareholder demand forderivative action, are described in Note 9 of notes to consolidated financialstatements. We have accrued for indemnification costs as of December 31,2006 for certain of these individuals for their expenses in connection withsuch matters and may be required to accrue for additional guarantee relatedcosts in future periods.

*Loss Contingencies*

We have accrued for costsas of December 31, 2006 and may, in the future, accrue for costs associatedwith certain contingencies, including, but not limited to settlement of legalproceedings and regulatory compliance matters, when such costs are probable andreasonably estimable. Liabilities established to provide for contingencies areadjusted as further information develops, circumstances change, orcontingencies are resolved. See Item 3, “Legal Proceedings,” in this AnnualReport on Form 10-K for a discussion of matters for which we may berequired, in the future, to accrue costs.

*Recent Accounting Pronouncements*

*In June2006, the FASB issued EITF No. 06-3,*How Sales TaxesCollected from Customers and Remitted to Governmental Authorities Should bePresented in the Income Statement (That Is, Gross Versus Net Presentation) (“EITF No.  06-3”), which discusses taxesimposed on, and imposed concurrent with, a specific revenue-producingtransaction between a seller and its customer. It requires entities todisclose, if significant, on an interim and annual basis for all periodspresented: (a) the accounting policy elected for these taxes; and (b) theamounts of the taxes reflected gross (as revenue) in the income statement. EITF

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*No.06-3 will become effective during the first quarter of 2007. We do not expect EITF No.06-3 to have a material impact on our financial condition or results ofoperations.*

In June 2006, FASBissued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes— an Interpretation of FASB Statement No. 109*(“FIN No. 48”). FIN No. 48 is effective for the first interim orannual reporting period for the first fiscal year beginning on or after December 15,2006, although earlier adoption is encouraged. FIN No. 48 applies to alltax positions for income taxes accounted for in accordance with SFAS No. 109.We are currently evaluating the impact of the adoption of FIN No. 48.

In September 2006,the SEC issued SAB No. 108, *Considering the Effects ofPrior Year Misstatements When Quantifying Misstatements in Current YearFinancial Statement*(“SAB No. 108”), which providesinterpretive guidance on how registrants should quantify financial statementmisstatements. SAB No. 108 requires companies to evaluate the materialityof identified unadjusted errors on each financial statement and relateddisclosures using both the rollover and the iron curtain approach. SAB No.108 applies to annual financial statements for fiscal years ending after November 15,2006. The adoption of SAB No. 108 did not have a material impact onour financial condition or results of operations.

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS No. 157”). SFAS No. 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements. SFAS No. 157applies to previous accounting pronouncements that require or permit fair valuemeasurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. We are currently evaluating the impact of theadoption of SFAS No. 157.

**Results ofOperations**

***(inthousands)***

***YearEnded December 31, 2006 Compared to Year Ended December 31, 2005***

The results of operations for the year ended December 31,2005 include those of AccuImage for the period subsequent the acquisition dateof January 28, 2005 and Cedara Software Corp. after the businesscombination on June 1, 2005. The following table sets forth selected, unaudited consolidatedfinancial data for the periods indicated, expressed as a percentage of netsales.

| ** **                                             | ** ** | **Twelve Months Ended** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                             | ** ** | **December 31,**             | ** ** |
| ** **                                             | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Net sales                                              |       |                              | 100        | % |   |   | 100 | % |   |
| Cost of sales                                          |       |                              | 39         |   |   |   | 31 |   |   |
| Gross margin                                           |       |                              | 61         |   |   |   | 69 |   |   |
| Operating costs and expenses:                          |       |                              |       |   |   |   |   |   |   |
| Sales and marketing                                    |       |                              | 27         |   |   |   | 17 |   |   |
| Product research  and development                      |       |                              | 27         |   |   |   | 12 |   |   |
| General and  administrative                            |       |                              | 38         |   |   |   | 14 |   |   |
| Acquired  in-process research and development          |       |                              | —     |   |   |   | 16 |   |   |
| Goodwill  impairment, restructuring and other expenses |       |                              | 308        |   |   |   | 1 |   |   |
| Depreciation and  amortization                         |       |                              | 5          |   |   |   | 4 |   |   |
| Total operating costs  and expenses                    |       |                              | 405        |   |   |   | 64 |   |   |
| Operating income (loss)                                |       |                              | (344       | ) |   |   | 5 |   |   |
| Total other income, net                                |       |                              | 3          |   |   |   | 1 |   |   |
| Income (loss) before  income taxes                     |       |                              | (341       | ) |   |   | 6 |   |   |
| Income tax expense                                     |       |                              | 3          |   |   |   | 9 |   |   |
| Net loss                                               |       |                              | (344       | )% |   |   | (3 | )% |   |

 

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*Net Sales*

Thefollowing table sets forth net sales component data for the twelve months endedDecember 31, 2006 and December 31, 2005:

| ** **                         | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                         | ** ** | **2006**              | ** ** | **2005**   | ** ** | **% Change** | ** ** |
| Software and  other                |       | $                     | 40,635     |       | $          | 60,120 |   |   | (32 | )% |   |
| As a percentage of total net sales |       | 54                    | %          | 73         | %          |   |   |   |   |
| Services and  maintenance          |       | $                     | 34,407     |       | $          | 22,481 |   |   | 53 | % |   |
| As a percentage of total net sales |       | 46                    | %          | 27         | %          |   |   |   |   |
| Total net sales                    |       | $                     | 75,042     |       | $          | 82,601 |   |   | (9 | )% |   |

 

Webelieve that the total net sales reflected in our statement of operations andthe net change in the deferred revenue accounts (current and long-term) on our balance sheet could be usefulindicators of the approximate value of new contracts during the period. Certain contracts, and portions of othercontracts, may not be recorded as revenue or deferred revenue due to the timingin which we can invoice our customers, as well as revenue recognitionguidelines, including, but not limited to, our determination of when contractcollectibility is probable. The following table sets forth such data forthe twelve months ended December 31, 2006 and December 31, 2005:

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Net sales                                    |       | $                     | 75,042     |   | $ | 82,601 |   |
| Net increase (decrease)  in deferred revenue |       | $                     | (13,309    | ) | $ | 10,134 |   |

 

The above data indicate that we have experienced asignificant decrease in the value of contracts for 2006 compared to 2005 due tothe challenges facing our business as described below, especially whenconsidering the fact that net sales for 2005 reflect net sales for CedaraSoftware Corp. for only a seven-month period following the businesscombination on June 1, 2005 compared to twelve months of net sales in 2006.

Software and other sales for 2006 were $40,635, adecrease of $19,485, or 32%, from net software and other sales of $60,120 for2005. This decrease was primarily attributable to approximately $18,800 of net salesrecognized from contracts with two international customers in 2005, compared tono such significant customer sales in 2006 and a significant decrease in newcustomer contracts signed during 2006, offset by $18,500 of revenue recognizedin 2006 as a result of the factors below and the inclusion of sales to Cedara’sOEM and end-user customers for the entire twelve-month period in 2006. We believe the reduction insales also resulted in part from a lack of clarity in the marketplace and inour sales channel regarding our integrated product strategy for direct salesfollowing the business combination with Cedara Software Corp. In addition, as aresult of the adverse business circumstances during 2006 following our delayedfilings and delisting notification from NASDAQ (we regained compliance with theSEC rules and were notified of our continued listing by NASDAQ in September 2006),we believe that many prospective customers reacted by either deferring theirbuying decision to a later date or by excluding us as a potential vendor from theirbuying decisions during 2006. These circumstances contributed to the overalldecrease in our net sales.

Net sales from services and maintenance for 2006 were$34,407, an increase of $11,926, or 53%, from 2005 net sales of $22,481. Thisincrease in net sales from services and maintenance was primarily attributableto the factors discussed below, as well as toservices performed in connection with Cedara OEM’s and end-usercustomers, which were included in sales for the entire twelve month period in2006, offset by the factors resulting in decreased net sales indicated above.

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Net sales in any period may be impacted by whether ornot we have satisfied the applicable criteria for software revenue recognitionand have established VSOE of fair value for any undelivered contract elements.

The followingfactors also affected our net sales results for 2006 and 2005:

·       Werecognized net sales of approximately $16,300 for 2006, due to the ultimatedelivery of certain software product functionality on certain customercontracts entered into in previous years. Net sales were reduced byapproximately $1,800 for 2005 due to our delivery of certain software productsto end-user customers that did not fully meet the functionality that we believeour customers expected. We deferred such revenue until the delivery of the expectedproduct functionality.

·       Werecognized approximately $900 in net sales in 2006 related to customercontracts where collectibility was not reasonably assured at time of deliveryof the software, but which became reasonably assured in 2006. Net sales for2005 were reduced by approximately $1,000 related to customer contracts wherecollectibility was not reasonably assured at time of delivery of the software.

·       We recognized approximately$300 in net sales in 2006 related to contracts under which we delivered certainsoftware products remaining on prior orders for which partial shipment hadpreviously occurred. Net sales in 2005 were reduced by approximately $300 dueto contracts under which we did not deliver all of the contracted software products.

·       Werecognized approximately $900 in net sales in 2006 due to ratable recognitionof sales from prior periods related to customer contracts for which we did nothave VSOE of fair value of maintenance. Net sales decreased in 2005 byapproximately $900 related to contracts for sales that we did not have VSOE offair value of maintenance.

·       We recognized approximately$100 in net sales in 2006 of previously deferred net sales upon delivery ofpromised additional software.

*Cost of Sales*

Thefollowing table sets forth cost of sales data for the periods indicated:

| ** **                | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|------------|------------|
| ** **                | ** ** | **2006**              | ** ** | **2005**   | ** ** | **% Change** | ** ** |
| Software and  other       |       | $                     | 9,611      |       | $          | 6,921 |   |   | 39 | % |   |
| Services and  maintenance |       | 14,464                |       | 11,106     |       |   | 30 | % |   |
| Amortization              |       | 5,532                 |       | 7,740      |       |   | (29 | )% |   |
| Total cost of sales       |       | $                     | 29,607     |       | $          | 25,767 |   |   | 15 | % |   |

 

The cost of software and other for 2006 was $9,611, anincrease of $2,690, or 39%, from the cost of software and other for 2005 of$6,921. Approximately $2,589, or 96%, of this increase was attributable tocosts that were associated with net sales recognized during 2006 which werepreviously deferred based on the factors described above. As a percentage ofnet software and other sales, the cost of software and other for 2006 was 24%,compared to 12% for 2005, as a result of the significant decrease in mix ofsoftware-only sales, such as the two significant customer sales in the twelvemonths ended December 31, 2005.

The cost of services and maintenance for 2006 was$14,464, an increase of $3,358, or 30%, from the cost of services andmaintenance for 2005 of $11,106. This increase was primarily the result of theinclusion of costs associated with Cedara’s OEM and end-user customer professionalservices, custom engineering and maintenance and support departments for twelvemonths in 2006 compared to seven months in 2005. 

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As a percentage of netservices and maintenance sales, the cost of services and maintenance for 2006was 41%, compared to 49% for 2005. The costs to provide all services to ourcustomers are recognized as a period cost. The relatively low cost of servicesand maintenance as a percentage of net services and maintenance sales for thetwelve months ended December 31, 2006 was primarily attributable to ourrecognition of services revenue related to sales of certain software productsupon ultimate delivery of specified software product functionality under certaincustomer contracts entered into in previous years (as described above in the *Net Sales*section), while the related costs, treated as a period expense, wererecognized in prior years.

Amortization of purchasedand developed software was $5,532 for 2006, a decrease of $2,208, or 29%, fromamortization of $7,740 for 2005. This decrease was attributable to theimpairment charge of $3,547 for 2005 related to prior purchased technology andcapitalized software development projects (due to overlapping technologies) ascompared with the impairment charge of $982 for 2006 (as we no longeranticipate future sales of such products), offset by amortization of purchasedsoftware associated with the business combination with Cedara Software Corp.for the entire period in 2006. As a percentage of total net sales, amortizationof purchased and developed software decreased to 7% in 2006 from 9% in 2005.

*Gross Margin*

Gross margin was $45,435for 2006, a decrease of $11,399, or 20%, from $56,834 for 2005. As a percentageof net sales, gross margin decreased to 61% of net sales for 2006 compared to69% for 2005, due primarily to the decrease in software-only sales, which aretypically contracted with our OEM customers. Sales relating to our OEMcustomers are primarily sales of imaging software without services, whichgenerally carry higher margins than our solutions that may also include aservice or hardware component. The decrease in gross margin as a percentage ofnet sales for 2006 was also offset by revenue recognized due to the factorsdescribed under *Net Sales* above.

*Sales and Marketing*

Sales and marketingexpense for 2006 was $20,132, an increase of $6,485, or 48%, from $13,647 for2005. The increase is to due to expenses incurred by Cedara’s OEM and end-usersales and marketing groups for twelve months in 2006 compared to seven monthsin 2005, our new business initiatives in Europe (which generated 2006 expensesof $1,248) and SFAS No. 123(R) stock-based compensation expense for2006 of $1,047. Sales and marketing expense for 2006 as a percentage of salesincreased to 27%, compared to 17% for 2005 primarily for the same reasons andas a result of the decrease in *Net Sales*.

*Product Researchand Development*

Product research anddevelopment expense for 2006 was $20,440, an increase of $10,526, or 106%, from$9,914 for 2005. As a percentage of net sales, research and development expenseincreased from 12% for 2005 to 27% for 2006. The majority of this increase wasthe result of the inclusion of expenses for Cedara’s OEM operations, which havea significant engineering department engaged in development of innovativesoftware technologies in our OEM business, for twelve months in 2006 comparedto seven months in 2005, a decrease in capitalized software development costs,and SFAS No. 123(R) stock-based compensation expense for 2006 of$1,186. Capitalization of software development costs decreased $1,364, or 38%,to $2,257 for 2006, from $3,621 for 2005, as we spent a greater percentage oftime on development of software product updates for our end-user products,which are generally not capitalizable.

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*General andAdministrative*

General and administrative expense for 2006 was$28,629, an increase of $17,007, or 146%, from $11,622 for 2005. The increasewas primarily attributable to the inclusion of expenses associated withCedara’s OEM and end-user operations for twelve months in 2006 compared toseven months in 2005, legal and accounting costs related to the completion ofour 2005 annual audit (including the restatement of previously issued financialstatements) and the review of our quarterly reports for the first two quartersof 2006 as well as other litigation related matters (including certainsettlements) of $8,909 and SFAS No. 123(R) stock-based compensationexpense for 2006 of $3,136. General and administrative expense as a percentageof net sales increased to 38% for 2006, compared to 14% for 2005 primarily forthe same reasons and as a result of the decrease in *Net Sales*. We expect to incur additional expenses, includingsubstantial fees for attorneys and other professional advisors, in connectionwith the class action, derivative and other lawsuits and regulatory matters,the completion of our audit and this Annual Report on Form 10-K (inthe first quarter of 2007) and implementation of our remediation plan forinternal control weaknesses identified.

*Acquired In-ProcessResearch and Development*

We incurred no acquiredin-process research and development cost for 2006, compared to $13,046 for2005. The in-process research and development costs incurred for 2005 relatedto the fair value of the projects acquired in June 2005 associated withthe business combination with Cedara Software Corp.

*GoodwillImpairment, Restructuring and Other Expenses*

Goodwill impairment,restructuring and other expenses for 2006 were $230,813, an increase of $230,283,from $530 for 2005. During 2006, we determined that the fair value of goodwillhad been impaired by $221,403 and the fair value of our tradenames had beenimpaired (in the fourth quarter of 2006) by $6,685. In addition, we recordedrestructuring charges of $2,725 in 2006 as a result of our right sizing andrestructuring initiative in the fourth quarter, primarily related to severancecosts. In 2005, we recorded restructuring and other related charges of $530related to our business combination with Cedara Software Corp. Weanticipate that we will incur additional restructuring costs of approximately$580 in the first two quarters of 2007 due to the manner in which certain costsassociated with our right-sizing and reorganization in the fourth quarter of2006 are recognized under GAAP. See Note 3 of the notes to our consolidatedfinancial statements for more information regarding our goodwill and tradenameimpairments.

*Depreciation andAmortization*

Depreciation andamortization expense for 2006 was $4,033, an increase of $484, or 14%, from$3,549 for 2005. This increase was primarily due to the amortization ofcustomer contracts associated with the Cedara transaction for twelve months in2006 compared to seven months in 2005, offset by a $610 impairment of certaincustomer relationships as the result of triggering events that occurred in 2005.Depreciation and amortization expense as a percentage of net sales was 5% in2006 and 4% in 2005.

*Other Income,Expense*

Our interest income was$2,548 in 2006, compared to $1,061 in 2005, while interest expense increased to$67 in 2006, compared to $38 in 2005. The increase in interest income wasdirectly attributable to our average cash and cash equivalent balance during2006 compared to 2005, attributed to the fact that our cash balance increasedsignificantly in June 2005 from cash acquired from Cedara, as well asincreased interest yield (from increased interest rates) on our cash balanceduring 2006 compared to 2005. Other income, net was $133 in 2006, compared toother expense, net of $317 in 2005. The change in other 

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income,net was primarily attributed to unrealized foreign exchange gains on foreigncurrency payables in 2006 compared to lossesin 2005 at Cedara, where the functional currency is the U.S. Dollar.

*Income Taxes*

We recorded income tax expense of $2,460 for 2006, adecrease of $5,429, or 69%, from the expense of $7,889 recorded for 2005.

Our effective tax rate for 2006 was approximately 1%. Oureffective rate differed significantly from the statutory rate primarily due tothe impairment of non-tax deductible goodwill, and the recording of a valuationallowance for deferred tax assets, which we have concluded are notmore-likely-than-not to be realized.

Our effective tax rate for 2005 was approximately 151%.Our effective tax rate differed significantly from the statutory rate primarilydue to the in-process research and development cost which is not deductible forincome tax purposes and a $1,308 accrual associated with transaction-relatedlegal restructuring during 2005.

Our expected effectiveincome tax rate is volatile and may move up or down with changes in, amongother items, operating income, the results of our purchase accounting, andchanges in tax law and regulation of the United States and foreignjurisdictions in which we operate.

***Year Ended December 31, 2005 Compared to YearEnded December 31, 2004***

Theresults of operations for the year ended December 31, 2005 include thoseof AccuImage for the period after the acquisition date of January 28, 2005and Cedara Software Corp. after the business combination on June 1, 2005. Thefollowing table sets forth selected,unaudited consolidated financial data for the periods indicated, expressed as apercentage of net sales.

| ** **                                             | ** ** | **Twelve Months Ended** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                             | ** ** | **December 31,**             | ** ** |
| ** **                                             | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net sales                                              |       |                              | 100        | % |   |   | 100 | % |   |
| Cost of sales                                          |       |                              | 31         |   |   |   | 41 |   |   |
| Gross margin                                           |       |                              | 69         |   |   |   | 59 |   |   |
| Operating costs  and expenses:                         |       |                              |       |   |   |   |   |   |   |
| Sales and marketing                                    |       |                              | 17         |   |   |   | 27 |   |   |
| Product research and development                       |       |                              | 12         |   |   |   | 8 |   |   |
| General and administrative                             |       |                              | 14         |   |   |   | 18 |   |   |
| Acquired in-process research and development           |       |                              | 16         |   |   |   | — |   |   |
| Goodwill impairment, restructuring and other  expenses |       |                              | 1          |   |   |   | — |   |   |
| Depreciation and amortization                          |       |                              | 4          |   |   |   | 4 |   |   |
| Total operating  costs and expenses                    |       |                              | 64         |   |   |   | 57 |   |   |
| Operating income                                       |       |                              | 5          |   |   |   | 2 |   |   |
| Total other  income, net                               |       |                              | 1          |   |   |   | 2 |   |   |
| Income before  income taxes                            |       |                              | 6          |   |   |   | 4 |   |   |
| Income tax  expense (benefit)                          |       |                              | 9          |   |   |   | (4 | ) |   |
| Net income (loss)                                      |       |                              | (3         | )% |   |   | 8 | % |   |

 

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*Net Sales*

Thefollowing table sets forth net sales component data for the twelve months endedDecember 31, 2005 and December 31, 2004:

| ** **                         | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2004**   | ** ** | **% Change** | ** ** |
| Software and  other                |       | $                     | 60,120     |       | $          | 17,444 |   |   | 245 | % |   |
| As a percentage of total net sales |       | 73                    | %          | 66         | %          |   |   |   |   |
| Services and  maintenance          |       | $                     | 22,481     |       | $          | 8,903 |   |   | 153 | % |   |
| As a percentage of total net sales |       | 27                    | %          | 34         | %          |   |   |   |   |
| Total net sales                    |       | $                     | 82,601     |       | $          | 26,347 |   |   | 214 | % |   |

 

Software and other sales for 2005 were $60,120, anincrease of $42,676, or 245%, from net software and other sales of $17,444 for2004. This increase was primarily attributable to revenue recognized as aresult of the inclusion of sales to Cedara OEM and end-user customers after thedate of the business combination with Cedara Software Corp. and by the factorsbelow, which primarily resulted in a greater amount of net sales deferred in2004 compared to 2005.

Sales from services and maintenance for 2005 were$22,481, an increase of $13,578, or 153%, from 2004 net sales of $8,903. Thisincrease in sales from services and maintenance was primarily attributable toservices performed in connection with Cedara’s OEM and end-user customers, whilethe rest of the increase was primarily attributable to the increase in salesmade directly to healthcare facilities and imaging centers, where such salesare accompanied by installation services and service contracts.

Of our net sales in 2005, approximately 16% and 10%,respectively, were attributable to two customers, Toshiba Medical SystemsCorporation and Hitachi Medical Corporation.

The followingfactors also affected our net sales for 2005 and 2004:

·       We deferred approximately $1,800 and $10,700 for 2005 and 2004,respectively, due to current year and prior years’ contracts, for which thesoftware product sold did not meet functionality we believe was expected by thecustomer and as to which revenue was therefore deferred into future periods.

·       Net sales for 2005 were reduced by approximately $1,000 relatedto customer contracts where collectibility was not reasonably assured at timeof delivery of the software.

·       Net sales for 2005 werereduced by approximately $300 due to contracts in which we did not deliver allcontracted software products.

·       Net sales were reduced byapproximately $900 for 2005 due to contracts for which we did not have vendorspecific objective evidence of fair value of maintenance.

Thefollowing table sets forth net sales and net change in deferred revenue for thetwelve months ended December 31, 2005 and December 31, 2004:

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Net sales                         |       | $                     | 82,601     |   | $ | 26,347 |   |
| Net increase in deferred  revenue |       | $                     | 10,134     |   | $ | 13,742 |   |

 

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*Cost of Sales*

Thefollowing table sets forth cost of sales data:

| ** **                | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|------------|------------|
| ** **                | ** ** | **2005**              | ** ** | **2004**   | ** ** | **% Change** | ** ** |
| Software and  other       |       | $                     | 6,921      |       | $          | 2,302 |   |   | 201 | % |   |
| Services and  maintenance |       | 11,106                |       | 6,108      |       |   | 82 | % |   |
| Amortization              |       | 7,740                 |       | 2,492      |       |   | 211 | % |   |
| Total cost of sales       |       | $                     | 25,767     |       | $          | 10,902 |   |   | 136 | % |   |

 

The cost of software and other for 2005 was $6,921, anincrease of $4,619, or 201%, from the cost of software and other for 2004 of$2,302. Approximately $3,100 or 67%, of this increase was attributable to costsincurred as a result of the inclusion of sales to Cedara OEM and end-usercustomers since the date of the business combination with Cedara Software Corp.As a percentage of net software and other sales, the cost of software and otherfor 2005 was 12%, compared to 13% for 2004.

The cost of services and maintenance for 2005 was$11,106, an increase of $4,998, or 82%, from the cost of services andmaintenance for 2004 of $6,108. Approximately $4,228, or 85% of this increasewas the result of the inclusion of costs associated with Cedara’s OEM andend-user professional services, custom engineering and maintenance and supportdepartments. As a percentage of net services and maintenance sales, the cost ofservices and maintenance for 2005 was 49%, compared to 69% for 2004. The coststo provide all services to our customers are recognized as a period cost. Theunusually high percentage of net sales for 2004 was attributed to our deferralof service revenue related to sales of certain software products until ultimatedelivery of certain software products functionality under certain customercontracts entered into in the current and previous years (as described above, under*Net Sales*), while the related costs, treated as a period expense, wererecognized in the year incurred.

Amortization of purchasedand developed software was $7,740 for 2005, an increase of $5,248, or 211%,from amortization of $2,492 for 2004. This increase was attributable to theimpairment of certain of our capitalized software projects of approximately$3,547, attributed to overlapping technologies due to the Cedara Software Corp.transaction, as well as the amortization of seven months of acquired technologyassociated with the Cedara Software Corp. transaction. As a percentage of totalnet sales, amortization of purchased and developed software was 9% of total netsales in 2005 and 2004.

*Gross Margin*

Gross margin was $56,834for 2005, an increase of $41,389, or 268%, from $15,445 for 2004. As apercentage of net sales, gross margin increased to 69% for 2005 compared to 59%for 2004. The increase in gross margin as a percentage of net sales wasprimarily due to the greater percentage of software-only sales in 2005 as aresult of the inclusion of Cedara Software Corp.’s OEM and end-user customersales. Sales relating to our OEM customers are primarily sales of imagingsoftware without services, which generally carry higher margins than oursolutions that may also include a service or hardware component. The relativelylow percentage for 2004 was primarily attributed to our deferral of service netsales, in addition to the software and other net sales, to sales of certainsoftware products until ultimate delivery of certain software productfunctionality on certain customer contracts entered into in the current andprevious years (as described under *Net Sales*), sales in which we did not ship allsoftware products, and sales where collectibility was not reasonably assured, while the related costs, treated as a periodexpense were recognized in the year incurred.

48

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*Sales and Marketing*

Sales and marketingexpense for 2005 was $13,647, an increase of $6,641, or 95%, from $7,006 for2004, as a result of expenses incurred by the historic Cedara Software Corp.business for seven months in 2005. Sales and marketing expense for 2005 as apercentage of sales decreased to 17% compared to 27% for 2004. The relativelyhigh percentage for 2004 was primarily a result of the deferral of net sales based on the factors discussed in *Net Sales*.

*Product Researchand Development*

Research and developmentexpense for 2005 was $9,914, an increase of $7,947, or 404%, from $1,967 for2004. As a percentage of net sales, research and development expense increasedfrom 8% for 2004 to 12% for 2005. The majority of these increases were theresult of the inclusion of expenses for Cedara’s OEM operations. Capitalizationof software development costs increased $142, or 4%, to $3,621 for 2005, from$3,479 for 2004.

*General andAdministrative*

General and administrativeexpense for 2005 was $11,622, an increase of $6,802, or 141%, from $4,820 for2004. The $6,802 increase was primarily attributable to the inclusion ofexpenses associated with Cedara’s OEM and direct sales operations since theacquisition of $3,825, increased net bad debt charges during 2005 of $723compared to $147 in 2004, and legal and accounting fees incurred subsequent tothe business combination with Cedara Software Corp. General and administrativeexpense as a percentage of net sales decreased slightly to 14% for 2005,compared to 18% for 2004.

*Acquired In-ProcessResearch and Development*

We estimated the fairvalue of the Cedara Software Corp. projects acquired in June 2005 to be$13,046, based on the work performed by independent valuation specialists, andrecorded an expense in the consolidated statements of operations for the yearended December 31, 2005.

*Goodwillimpairment, Restructuring and Other Expenses*

We incurred $530 ofrestructuring and other expenses in 2005, consisting of the lease exit costs ofapproximately $175 associated with a non-cancelable building lease which weceased using during 2005 as we combined two of our offices located in the samegeographic region, severance to involuntarily terminated employees of $263 andoption acceleration expense of $92 related to such employees, based on theintrinsic value of options at the time of termination. We did not incurrestructuring and other expenses in 2004.

*Depreciation andAmortization*

Depreciation andamortization expense for 2005 was $3,549, an increase of $2,396, or 208%, from$1,153 for 2004. Depreciation and amortization expense as a percentage of totalnet sales was 4% in 2005 and 2004. These increases were primarily due to the$610 impairment of certain customer relationships as the result of triggeringevents that occurred in 2005 and amortization of customer contracts associatedwith the Cedara Software Corp. transaction.

*Other Income,Expense*

Our interest income was$1,061 in 2005, compared to $344 in 2004, while interest expense increased to$38 in 2005, compared to $21 in 2004. The interest income was directlyattributable to our increased cash and cash equivalent balances, and increased interest rates on our cashbalances in 2005 compared to 2004. 

49

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Otherexpense, net, was $317 in 2005 compared to other income, net, of $146 in 2004.Net other expense for 2005 was primarilyattributable to foreign exchange losses on foreign currency payables at CedaraSoftware Corp., where the functional currency is the U.S. Dollar. Netother income for 2004 was primarily attributable to the recovery from aninsurance claim that was filed in 2003 for business interruption. As apercentage of net sales, total net other income decreased slightly to 1% for2005 compared to 2% for 2004.

*Income Taxes*

We recorded income tax expense of $7,889 for 2005, anincrease of $9,111, or 746%, from the benefit of $1,222 recorded for 2004.

Our effective tax rate for 2005 was approximately151%. Our effective tax rate differed from the statutory rate primarily due tothe in-process research and development cost which is not deductible for incometax purposes and a $1,308 accrual associated with transaction-related legalrestructuring during 2005. Excluding these two items, our 2005 effective taxrate would have been approximately 36%.

Our effective tax rate for2004 was approximately 126%. Our effective tax rate differed from the statutoryrate primarily due to an extraterritorial income tax benefit and research andexperimentation credit.

**Liquidity andCapital Resources**

***(in thousands)***

Our cash and cashequivalents were $45,945 at December 31, 2006, a decrease of $18,333, or29%, from our balance of $64,278 at December 31, 2005. In addition, ourworking capital, defined as the amount by which our current assets exceed ourcurrent liabilities, was $28,870 at December 31, 2006, a decrease of $28,466,or 50%, from our working capital of $57,336 at December 31, 2005.

*Operating CashFlows*

Cash used in operating activities was $14,960 in 2006,an increase of $38,562, or 163%, from cash provided by operations of $23,602 in2005. Our negative operating cash flow in 2006 was due to the loss fromoperations, primarily attributed to our decreased net sales during the year,while our operating expenses were not rightsized to meet such decreased netsales until the fourth quarter of 2006. In addition, we incurred substantiallegal, accounting and advisor costs (as discussed below) which we would notanticipate incurring in a normal operating environment.

In 2006, we incurred legaland accounting costs related to the completion of our 2005 annual audit(including the restatement of previously issued financial statements) and thereview of our quarterly reports for the first two quarters of 2006 as well asother litigation matters (including certain settlements) of $8,909. We alsoanticipate that we will pay approximately $1,960 of severance relatedrestructuring costs in the future as well as incur and pay additionalrestructuring costs of $580 in the first two quarters of 2007 due to the mannerin which certain costs associated with our rightsizing and restructuringinitiative announced in the fourth quarter of 2006 are recognized under GAAP.We expect to incur additional expenses, including substantial fees forattorneys and other professional advisors, in connection with the class action,derivative and other lawsuits and regulatory matters, the completion of ouraudit and this Annual Report on Form 10-K (in the first quarter of2007) and implementation of our remediation plan for internal controlweaknesses.

*Investing CashFlows*

Cash used in investingactivities was $3,876 in 2006, attributable to capitalized software developmentcosts of $2,257, purchases of capital equipment of $1,252 and $367 related tothe purchase of technology.

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*Financing CashFlows*

Cash provided by financingactivities was $504 in 2006. We received net proceeds of $471 from employee anddirector stock option exercises and $33 from purchases of Common Stock underour employee stock purchase plan.

*Contractual Obligations*

Totaloutstanding commitments at December 31, 2006, were as follows:

| ** **                       | ** ** | ** ** | ** ** | **Payment due by period** | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** ** | ** ** | **Total**                                | ** ** | **Less than  1 Year** | ** ** | **1 - 3 Years** | ** ** | **3 - 5 Years** | ** ** | **More than  5 Years** | ** ** |
| Operating leases                 |       | $          | 6,816      |                                     |       | $ | 2,110 |   |   |   | $ | 3,564 |   |   |   | $ | 890 |   |   |   | $ | 252 |   |   |
|                                  |            |            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The contractualobligations table above reflects amounts due under all our leases, net ofsub-lease income that is contractually owed to us of $180 in each of 2007, 2008and 2009. We do not have any other significant long-term obligations, contractualobligations, lines of credit, standby letters of credit, guarantees, standbyrepurchase obligations or other commercial commitments.

*Share RepurchaseProgram*

On September 6, 2006,we announced a stock repurchase plan providing for the purchase of up to$20,000 of our Common Stock over a two-year period. As of December 31,2006, we had not make any repurchases under this plan. This repurchase programreplaces a previous plan that expired on August 24, 2006, two years afterits initial implementation, without any shares having been repurchased.

*General*

We believe that ourexisting cash and cash equivalents will be sufficient to otherwise meet ourliquidity needs in 2007. However, any projections of future cash inflows andoutflows are subject to uncertainty. In particular, our uses of cash in 2007will depend on a variety of factors such as, the extent of losses fromoperations, the amount of cash that we are required to devote to defend andaddress our outstanding legal and regulatory proceedings, and potential mergerand acquisition activities. We believe our current cash and investmentbalances, will be sufficient to meet our operating, financing and capitalrequirements through at least the next 12 months. We also believe our cash andinvestment balances will be sufficient on a longer term basis; however, thatwill depend on numerous factors, including the uncertainty created by, theadverse impact on relationships with customers, potential customers, suppliersand investors potentially resulting from, and other risks associated with, thechanges in our senior management; costs, risks and effects of legal proceedingand investigations, including the informal, non-public inquiry being conductedby the SEC and class action, derivative, and other lawsuits; costs and risksassociated with our restructuring efforts; risks in product and technologydevelopment; market acceptance of new products and continuing product demand;the impact of competitive products and pricing; our ability to integrateacquistions; changing economic conditions; our credit and payment risksassociated with our end-users sales; our dependence on major customers;dependence on key personnel, and other risk factors detailed in Item 1A, “RiskFactors.”   If we need to raiseadditional capital to meet our short term or long term liquidity needs, suchcapital may be raised by selling additional equity or raising debt from thirdparty sources. The sale of additional equity or convertible debt securitiescould result in dilution to current shareholders. In addition, debt financing,if available, could involve restrictive covenants, which could adversely affectoperations. However, these financing alternatives, including raising additionalcapital, may not be available in amounts or on terms acceptable to us.

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**Material OffBalance Sheet Arrangements**

We have no material offbalance sheet arrangements.

**Item 7A.**   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

*Interest Rate Risk*

Our cash and cashequivalents are exposed to financial market risk due to fluctuations ininterest rates, which may affect our interest income. As of December 31,2006, our cash and cash equivalents included money market funds and short-termdeposits totaling approximately $45.9 million, and earned interest at aweighted average rate of 4.4%. The value of the principal amounts is equal tothe fair value for these instruments. Due to the short-term nature of ourinvestment portfolio, our interest income is vulnerable to changes inshort-term interest rates. At current investment levels, our pre-tax results ofoperations would vary by approximately $459 for every 100 basis point change inour weighted average short-term interest rate. We do not use our portfolio fortrading or other speculative purposes.

*Foreign CurrencyExchange Risk*

We have sales and expensesin Canada, China and Europe that are denominated in currencies other than theU.S. Dollar and, as a result, we have exposure to foreign currency exchangerisk. We have periodically entered into forward exchange contracts to hedgeexposures denominated in foreign currencies. We did not have any forwardcontracts outstanding at December 31, 2006. We do not enter intoderivative financial instruments for trading or speculative purposes. In theevent our exposure to foreign currency risk increases to levels that we do notdeem acceptable, we may choose to hedge those exposures.

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**Item 8.**   FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and ShareholdersMerge Technologies Incorporated:

We have audited the accompanying consolidated balancesheets of Merge Technologies Incorporated and subsidiaries (the Company) as of December 31,2006 and 2005, and the related consolidated statements of operations,shareholders’ equity, comprehensive income (loss), and cash flows for each ofthe years in the three-year period ended December 31, 2006. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 statementsreferred to above present fairly, in all material respects, the financialposition of Merge Technologies Incorporated and subsidiaries as of December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2006,in conformity with U.S. generally accepted accounting principles.

As discussed in Notes 1 and 6 to the consolidatedfinancial statements, effective January 1, 2006, the Company adopted theprovisions of Statement of Financial Accounting Standards No. 123 (revised2004), *Share-Based Payment*. 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), and our report dated March 8, 2007 expressedan unqualified opinion on management’s assessment of, and an adverse opinion onthe effective operation of, internal control over financial reporting.
| /s/ KPMG LLP   |   |
|---------------------|--------|
| Chicago, Illinois   |   |
| March 8,  2007 |   |

 

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**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands, except for share data)**

|                                                                                                                                                                                                                                                                              | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|--------|
| ** **                                                                                                                                                                                                                                                                   | ** ** | **2006**              | ** ** | **2005**              | ** ** |   |
| ASSETS                                                                                                                                                                                                                                                                       |       |                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                                                                                              |       |                  |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                   |       | $                     | 45,945     |                  |       | $      | 64,278 |   |   |
| Accounts receivable, net of allowance  for doubtful accounts of $1,683 and $1,892 at December 31, 2006 and  December 31, 2005, respectively                                                                                                                        |       | 17,210                |       |                  | 23,624     |   |   |
| Inventory                                                                                                                                                                                                                                                                    |       | 2,164                 |       |                  | 2,440      |   |   |
| Prepaid expenses                                                                                                                                                                                                                                                             |       | 1,660                 |       |                  | 2,646      |   |   |
| Deferred income  taxes                                                                                                                                                                                                                                                       |       | 196                   |       |                  | 11,213     |   |   |
| Other current assets                                                                                                                                                                                                                                                         |       | 812                   |       |                  | 3,208      |   |   |
| Total current  assets                                                                                                                                                                                                                                                        |       | 67,987                |       |                  | 107,409    |   |   |
| Property and equipment:                                                                                                                                                                                                                                                      |       |                  |       |                  |       |   |   |
| Computer equipment                                                                                                                                                                                                                                                           |       | 5,017                 |       |                  | 4,025      |   |   |
| Office equipment                                                                                                                                                                                                                                                             |       | 1,919                 |       |                  | 1,759      |   |   |
| Leasehold  improvements                                                                                                                                                                                                                                                      |       | 1,460                 |       |                  | 1,372      |   |   |
|                                                                                                                                                                                                                                                                              |       | 8,396                 |       |                  | 7,156      |   |   |
| Less accumulated  depreciation                                                                                                                                                                                                                                               |       | 4,456                 |       |                  | 2,716      |   |   |
| Net property and equipment                                                                                                                                                                                                                                                   |       | 3,940                 |       |                  | 4,440      |   |   |
| Purchased and  developed software, net of accumulated amortization of $11,235 and $6,759 at  December 31, 2006 and December 31, 2005, respectively                                                                                                                 |       | 16,628                |       |                  | 19,539     |   |   |
| Other intangibles, net of accumulated  amortization of $3,966 and $1,687 at December 31, 2006 and  December 31, 2005, respectively                                                                                                                                 |       | 9,511                 |       |                  | 11,789     |   |   |
| Goodwill                                                                                                                                                                                                                                                                     |       | 124,407               |       |                  | 350,634    |   |   |
| Deferred income taxes                                                                                                                                                                                                                                                        |       | 3,303                 |       |                  | —     |   |   |
| Other assets                                                                                                                                                                                                                                                                 |       | 8,887                 |       |                  | 7,862      |   |   |
| Total assets                                                                                                                                                                                                                                                                 |       | $                     | 234,663    |                  |       | $      | 501,673 |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                                                                                    |       |                  |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                                                                                         |       |                  |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                                                             |       | $                     | 8,284      |                  |       | $      | 5,938 |   |   |
| Accrued wages                                                                                                                                                                                                                                                                |       | 6,244                 |       |                  | 5,870      |   |   |
| Income taxes payable                                                                                                                                                                                                                                                         |       | 4,033                 |       |                  | 3,894      |   |   |
| Other accrued liabilities                                                                                                                                                                                                                                                    |       | 2,381                 |       |                  | 3,453      |   |   |
| Deferred revenue                                                                                                                                                                                                                                                             |       | 18,175                |       |                  | 30,918     |   |   |
| Total current liabilities                                                                                                                                                                                                                                                    |       | 39,117                |       |                  | 50,073     |   |   |
| Deferred income taxes                                                                                                                                                                                                                                                        |       | —                |       |                  | 3,491      |   |   |
| Deferred revenue                                                                                                                                                                                                                                                             |       | 3,218                 |       |                  | 3,784      |   |   |
| Other                                                                                                                                                                                                                                                                        |       | 633                   |       |                  | 484        |   |   |
| Total liabilities                                                                                                                                                                                                                                                            |       | 42,968                |       |                  | 57,832     |   |   |
| Shareholders’  equity:                                                                                                                                                                                                                                                  |       |                  |       |                  |       |   |   |
| Preferred stock, $0.01 par value:  2,999,997 and 3,999,997 shares authorized at December 31, 2006 and  December 31, 2005; zero shares issued and outstanding at  December 31, 2006 and December 31, 2005                                                 |       | —                |       |                  | —     |   |   |
| Series A Preferred  Stock, $0.01 par value: 1,000,000 shares authorized; zero shares issued and  outstanding at December 31, 2006 and December 31, 2005                                                                                                       |       | —                |       |                  | —     |   |   |
| Series B Junior Participating  Preferred Stock, $0.01 par value: 1,000,000 shares authorized and zero shares  authorized at December 31, 2006 and December 31, 2005; zero shares  issued and outstanding at December 31, 2006 and December 31, 2005 |       | —                |       |                  | —     |   |   |
| Series 3 Special  Voting Preferred stock, no par value: one share authorized; one share issued;  one share and zero shares issued and outstanding at December 31, 2006  and December 31, 2005                                                                 |       | —                |       |                  | —     |   |   |
| Common Stock, $0.01 par value:  100,000,000 shares authorized; 29,291,030 shares and 26,500,140 shares issued  and outstanding at December 31, 2006 and December 31, 2005,  respectively                                                                      |       | 293                   |       |                  | 265        |   |   |
| Common Stock subscribed:  5,242 and 706 shares at December 31, 2006 and December 31, 2005,  respectively                                                                                                                                                           |       | 33                    |       |                  | 17         |   |   |
| Additional paid-in capital                                                                                                                                                                                                                                                   |       | 451,130               |       |                  | 445,954    |   |   |
| Deferred stock  compensation                                                                                                                                                                                                                                                 |       | —                |       |                  | (1,245     | )      |   |
| Accumulated deficit                                                                                                                                                                                                                                                          |       | (261,648              | )          |                  | (3,190     | )      |   |
| Accumulated other  comprehensive income                                                                                                                                                                                                                                      |       | 1,887                 |       |                  | 2,040      |   |   |
| Total shareholders’ equity                                                                                                                                                                                                                                              |       | 191,695               |       |                  | 443,841    |   |   |
| Total liabilities and shareholders’ equity                                                                                                                                                                                                                              |       | $                     | 234,663    |                  |       | $      | 501,673 |   |   |

 

See accompanying notes to consolidated financial statements

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**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except for share and per share data)**

| ** **                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales:                                                                  |       |                                        |       |   |   |   |   |
| Software and other                                                          |       | $                                           | 40,635     |   | $ | 60,120 |   | $ | 17,444 |   |
| Services and maintenance                                                    |       | 34,407                                      |       | 22,481 |   | 8,903 |   |
| Total net sales                                                             |       | 75,042                                      |       | 82,601 |   | 26,347 |   |
| Cost of sales:                                                              |       |                                        |       |   |   |   |   |
| Software and other                                                          |       | 9,611                                       |       | 6,921 |   | 2,302 |   |
| Services and maintenance                                                    |       | 14,464                                      |       | 11,106 |   | 6,108 |   |
| Amortization                                                                |       | 5,532                                       |       | 7,740 |   | 2,492 |   |
| Total cost of  sales                                                        |       | 29,607                                      |       | 25,767 |   | 10,902 |   |
| Gross margin                                                                |       | 45,435                                      |       | 56,834 |   | 15,445 |   |
| Operating costs and  expenses:                                              |       |                                        |       |   |   |   |   |
| Sales and marketing                                                         |       | 20,132                                      |       | 13,647 |   | 7,006 |   |
| Product research and development                                            |       | 20,440                                      |       | 9,914 |   | 1,967 |   |
| General and administrative                                                  |       | 28,629                                      |       | 11,622 |   | 4,820 |   |
| Acquired in-process research and development                                |       | —                                      |       | 13,046 |   | — |   |
| Goodwill impairment, restructuring and other  expenses                      |       | 230,813                                     |       | 530 |   | — |   |
| Depreciation and amortization                                               |       | 4,033                                       |       | 3,549 |   | 1,153 |   |
| Total operating  costs and expenses                                         |       | 304,047                                     |       | 52,308 |   | 14,946 |   |
| Operating income  (loss)                                                    |       | (258,612                                    | )          | 4,526 |   | 499 |   |
| Other income (expense):                                                     |       |                                        |       |   |   |   |   |
| Interest expense                                                            |       | (67                                         | )          | (38 | ) | (21 | ) |
| Interest income                                                             |       | 2,548                                       |       | 1,061 |   | 344 |   |
| Other, net                                                                  |       | 133                                         |       | (317 | ) | 146 |   |
| Total other  income                                                         |       | 2,614                                       |       | 706 |   | 469 |   |
| Income (loss)  before income taxes                                          |       | (255,998                                    | )          | 5,232 |   | 968 |   |
| Income tax  expense (benefit)                                               |       | 2,460                                       |       | 7,889 |   | (1,222 | ) |
| Net income (loss)                                                           |       | $                                           | (258,458   | ) | $ | (2,657 | ) | $ | 2,190 |   |
| Net income (loss)  per share—basic                                     |       | $                                           | (7.67      | ) | $ | (0.11 | ) | $ | 0.17 |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       | 33,701,735                                  |       | 24,696,762 |   | 13,013,927 |   |
| Net income (loss)  per share—diluted                                   |       | $                                           | (7.67      | ) | $ | (0.11 | ) | $ | 0.16 |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       | 33,701,735                                  |       | 24,696,762 |   | 13,827,522 |   |

 

See accompanying notes to consolidated financial statements

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**MERGETECHNOLOGIES INCORPORATEDCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITYYears Ended December 31, 2004, 2005 and 2006(in thousands, except for share data)**

| ** ** | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** **     | ** ** | ** **     | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|------------|------------|--------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** ** | ** ** | ** **               | ** ** | ** **            | ** ** | ** **     | ** ** | ** **     | ** ** | ** **      | ** ** | ** ** | ** ** | **Additional** | ** ** | **Deferred** | ** ** | ** ** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** ** | ** ** | **Shares**               | ** ** | **Issued**            | ** ** | **Shares**     | ** ** | **Subscribed** | ** ** | **Shares**      | ** ** | **Issued** | ** ** | **Paid-in** | ** ** | **Stock** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** ** | ** ** | **Issued**               | ** ** | **Amount**            | ** ** | **Subscribed** | ** ** | **Amount**     | ** ** | **Issued**      | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Compensation** | ** ** | **Deficit** | ** ** | **Income** | ** ** | **Equity** | ** ** |

| Balance at December 31, 2003                                                     |   |   | 2      |   |   |   | $      | — |   |   |   | 8,058  |   |   |   | $      | 47     |      |   | 12,485,646 |   |   | $      | 125    |    |   |   | $      | 53,175  |   |   |   | $        | — |   |   |   | $      | (2,723   | )      |     |   | $      | 232   |   |   |   | $ | 50,856  |   |   |
|---------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-----------|--------|------------|--------|--------|--------|--------|---------|--------|--------|--------|---------|--------|--------|--------|----------|--------|--------|--------|--------|--------|----------|--------|----------|--------|--------|-------|--------|--------|--------|---|---------|--------|--------|
| Accretion of put value                                                                |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | 68      |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 68       |   |   |
| Exchange of share rights into Common Stock                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 352,261   |   |       | 4      |   |   |   | (4      | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | —   |   |   |
| Stock issued under ESPP                                                               |   |   | — |   |   |   | — |   |   |   | (7,241 | )      |   |   | (33    | )      |   | 11,806    |   |       | — |   |   |   | 101     |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 68       |   |   |
| Exercise of stock options                                                             |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 336,472   |   |       | 3      |   |   |   | 1,483   |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 1,486    |   |   |
| Retirement of preferred shares                                                        |   |   | (2     | )      |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | —   |   |   |
| Tax benefit on exercise of stock options                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | 595     |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 595      |   |   |
| Net income                                                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | 2,190    |   |   |   | — |   |     |   | 2,190    |   |   |
| Other comprehensive income                                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | —   |   |   |   | 360    |   |     |   | 360      |   |   |
| Balance at December 31, 2004                                                     |   |   | — |   |   |   | $      | — |   |   |   | 817    |   |   |   | $      | 14     |      |   | 13,186,185 |   |   | $      | 132    |    |   |   | $      | 55,418  |   |   |   | $        | — |   |   |   | $      | (533     | )      |     |   | $      | 592   |   |   |   | $ | 55,623  |   |   |
| Cedara Exchange of share rights into Common Stock                                     |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 6,080,922 |   |       | 61     |   |   |   | (61     | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | —   |   |   |
| Stock issued and options granted for acquisitions,  net of costs to issue shares |   |   | 1      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 5,581,517 |   |       | 56     |   |   |   | 380,794 |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 380,850  |   |   |
| Shares retired                                                                        |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | (90,000   | )      |       | (1     | )      |   |   | (1,603  | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | (1,604   | )      |   |
| Stock issued under ESPP                                                               |   |   | — |   |   |   | — |   |   |   | (111   | )      |   |   | 3      |   |   | 3,573     |   |       | — |   |   |   | 62      |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 65       |   |   |
| Exercise of stock options                                                             |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 1,737,943 |   |       | 17     |   |   |   | 9,491   |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 9,508    |   |   |
| Share-based compensation expense                                                      |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | 92      |   |   |   | (1,245  | )      |   |   | —   |   |   |   | — |   |     |   | (1,153   | )      |   |
| Legal fees S3/S8 filings                                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | (45     | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | (45      | )      |   |
| Nasdaq fees for increased trading shares                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | (5      | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | (5       | )      |   |
| Tax benefit on exercise of stock options                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | 1,811   |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 1,811    |   |   |
| Net loss                                                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | (2,657   | )      |   |   | — |   |     |   | (2,657   | )      |   |
| Other comprehensive income                                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | —   |   |   |   | 1,448  |   |     |   | 1,448    |   |   |
| Balance at December 31, 2005                                                     |   |   | 1      |   |   |   | $      | — |   |   |   | 706    |   |   |   | $      | 17     |      |   | 26,500,140 |   |   | $      | 265    |    |   |   | $      | 445,954 |   |   |   | $        | (1,245 | )      |   |   | $      | (3,190   | )      |     |   | $      | 2,040 |   |   |   | $ | 443,841 |   |   |
| Cedara Exchange of share rights into Common Stock                                     |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 2,561,085 |   |       | 26     |   |   |   | (26     | )      |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | —   |   |   |
| Stock issued under ESPP                                                               |   |   | — |   |   |   | — |   |   |   | 4,536  |   |   |   | 16     |   |   | 706       |   |       | — |   |   |   | 17      |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 33       |   |   |
| Exercise of stock options                                                             |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 229,099   |   |       | 2      |   |   |   | 469     |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 471      |   |   |
| Share-based compensation expense                                                      |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | 5,961   |   |   |   | —  |   |   |   | —   |   |   |   | — |   |     |   | 5,961    |   |   |
| Reduction of deferred stock compensation for  application of FAS 123R                 |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | (1,245  | )      |   |   | 1,245   |   |   |   | —   |   |   |   | — |   |     |   | —   |   |   |
| Net loss                                                                              |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | (258,458 | )      |   |   | — |   |     |   | (258,458 | )      |   |
| Other comprehensive income                                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | —    |   |       | — |   |   |   | —  |   |   |   | —  |   |   |   | —   |   |   |   | (153   | )      |     |   | (153     | )      |   |
| Balance at December 31, 2006                                                     |   |   | 1      |   |   |   | $      | — |   |   |   | 5,242  |   |   |   | $      | 33     |      |   | 29,291,030 |   |   | $      | 293    |    |   |   | $      | 451,130 |   |   |   | $        | — |   |   |   | $      | (261,648 | )      |     |   | $      | 1,887 |   |   |   | $ | 191,695 |   |   |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |      |   |       |   |   |   |   |    |   |   |   |    |   |   |   |     |   |   |   |   |   |     |   |     |   |   |

 

See accompanying notes to consolidated financialstatements.

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**MERGETECHNOLOGIES INCORPORATED AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating  activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $                                           | (258,458   | ) | $ | (2,657 | ) | $ | 2,190 |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                             |       | 9,565                                       |       | 11,288 |   | 3,645 |   |
| Amortization of discount on note assumed in merger                                        |       | —                                      |       | — |   | 12 |   |
| Provision for doubtful accounts receivable, net of  recoveries                            |       | 289                                         |       | 723 |   | 147 |   |
| Deferred income taxes                                                                     |       | 4,223                                       |       | 7,374 |   | (1,631 | ) |
| In-process research and development                                                       |       | —                                      |       | 13,046 |   | — |   |
| Stock-based compensation                                                                  |       | 5,961                                       |       | 979 |   | — |   |
| Goodwill and trade name impairment charge                                                 |       | 226,118                                     |       | — |   | — |   |
| Change in assets and  liabilities, excluding effects from acquisitions:                   |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                       |       | 6,125                                       |       | (5,421 | ) | (2,030 | ) |
| Inventory                                                                                 |       | 276                                         |       | (439 | ) | (189 | ) |
| Prepaid expenses                                                                          |       | 986                                         |       | (76 | ) | (404 | ) |
| Accounts payable                                                                          |       | 2,370                                       |       | (3,474 | ) | 711 |   |
| Accrued wages                                                                             |       | 350                                         |       | 765 |   | 500 |   |
| Other accrued liabilities                                                                 |       | (923                                        | )          | (69 | ) | 221 |   |
| Deferred revenue                                                                          |       | (13,309                                     | )          | 6,973 |   | 13,717 |   |
| Other assets                                                                              |       | 1,328                                       |       | (5,117 | ) | (2,645 | ) |
| Other                                                                                     |       | 139                                         |       | (293 | ) | (332 | ) |
| Net cash provided  by (used in) operating activities                                      |       | (14,960                                     | )          | 23,602 |   | 13,912 |   |
| **Cash flows from investing  activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash acquired in  acquisitions, net of cash paid                                          |       | —                                      |       | 9,644 |   | — |   |
| Purchases of  property, equipment, and leasehold improvements                             |       | (1,252                                      | )          | (2,996 | ) | (565 | ) |
| Purchased  technology                                                                     |       | (367                                        | )          | — |   | — |   |
| Capitalized  software development                                                         |       | (2,257                                      | )          | (3,621 | ) | (3,479 | ) |
| Net cash provided  by (used in) investing activities                                      |       | (3,876                                      | )          | 3,027 |   | (4,044 | ) |
| **Cash flows from financing  activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                                                  |       | 471                                         |       | 9,508 |   | 1,486 |   |
| Proceeds from  employee stock purchase plan                                               |       | 33                                          |       | 65 |   | 68 |   |
| Principal payment  of notes                                                               |       | —                                      |       | — |   | (231 | ) |
| Net cash provided  by financing activities                                                |       | 504                                         |       | 9,573 |   | 1,323 |   |
| Effect of  exchange rate changes on cash                                                  |       | (1                                          | )          | 9 |   | 5 |   |
| Net increase  (decrease) in cash                                                          |       | (18,333                                     | )          | 36,211 |   | 11,196 |   |
| Cash and cash  equivalents, beginning of period                                           |       | 64,278                                      |       | 28,067 |   | 16,871 |   |
| Cash and cash  equivalents, end of period                                                 |       | $                                           | 45,945     |   | $ | 64,278 |   | $ | 28,067 |   |
| **Supplemental  Disclosures of Cash Flow Information**                                    |       |                                        |       |   |   |   |   |
| Cash paid for  income taxes                                                               |       | $                                           | 69         |   | $ | 286 |   | $ | 1,119 |   |
| Equity securities  received in sales transactions                                         |       | $                                           | 2,010      |   | $ | 4,606 |   | $ | — |   |
| **Non  Cash Investing and Financing Activities:**                                         |       |                                        |       |   |   |   |   |
| Redemption value  related to exchangeable Common Stock                                    |       | $                                           | —     |   | $ | — |   | $ | 1 |   |
| Value of Common  Stock and options issued for acquisitions                                |       | $                                           | —     |   | $ | 381,689 |   | $ | — |   |

 

See accompanying notes to consolidated financial statements.

57

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)(in thousands)**

| ** **                                          | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                   |       | $                                           | (258,458   | ) | $ | (2,657 | ) | $ | 2,190 |   |
| Accumulated other  comprehensive income:            |       |                                        |       |   |   |   |   |
| Cumulative  translation adjustment(1)               |       | (89                                         | )          | 815 |   | 215 |   |
| Unrealized gain  (loss) on marketable securities(2) |       | (2                                          | )          | 51 |   | — |   |
| Comprehensive income  (loss)                        |       | $                                           | (258,549   | ) | $ | (1,791 | ) | $ | 2,405 |   |

----

(1)          Net of income tax expense (benefit) of $(60),$547, and $145 for the twelve months ended December 31, 2006, 2005, and2004, respectively.

(2)          Net of income tax expense (benefit) of $(2),$35, and $0 for the twelve months ended December 31, 2006, 2005, and 2004,respectively.

See accompanying notes to consolidated financial statements.

58

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (in thousands, except for share and per share data)**

**(1)   Basis ofPresentation and Significant Accounting Policies**

*(a) Nature ofOperations*

Merge TechnologiesIncorporated, a Wisconsin corporation, and its subsidiaries (which we sometimesrefer to collectively as “Merge Healthcare,” “we,” “us,” or “our”) are in thebusiness of development and delivery of medical imaging and informationmanagement software and services. We provide innovative solutions for OriginalEquipment Manufacturers (“OEMs”), Value Added Resellers (“VARs”) and theend-user healthcare markets. We custom engineer clinical and imagingapplications and development tools that are on the forefront of medicine andits use of medical imaging for OEM customers. We develop innovative medicalimaging software solutions that support end-to-end business and clinicalworkflow for radiology department and specialty practices, imaging centers andhospitals in North America and internationally. Our innovative softwaresolutions use our leading-edge imaging software technologies that acceleratemarket delivery for our OEM customers, while our end-user solutions improve ourcustomers’ productivity and enhance the quality of patient care they provide.

*(b) Principles ofConsolidation*

The consolidated financialstatements include the financial statements of our wholly owned subsidiaries.Our principal operating subsidiaries are Cedara Software and Merge eMed, Inc.All intercompany balances and transactions have been eliminated inconsolidation.

We have certain minorityequity stakes in various companies accounted for as cost method investments.The operating results of these companies are not included in our results ofoperations.

*(c) ReportingPeriods Presented*

The accompanyingconsolidated financial statements include the results of Cedara Software Corp.subsequent to the date of the transaction between Merge Healthcare and CedaraSoftware on June 1, 2005, and the results of AccuImage Diagnostics Corp. (“AccuImage”)subsequent to our acquisition of AccuImage on January 28, 2005.

*(d) Use ofEstimates*

Our consolidated financialstatements are prepared in accordance with U.S generally accepted accountingprinciples. These accounting principles require us to make certain estimates,judgments and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Estimates are used when accounting for items andmatters such as revenue recognition and allowances for uncollectible accountsreceivable, inventory obsolescence, amortization, asset valuations, impairmentassessments, taxes and related valuation allowance, income tax provisions,stock-based compensation, and contingencies. We believe that the estimates,judgments and assumptions are reasonable, based on information available at thetime they are made. Actual results could differ from those estimates.

*(e) Reclassifications*

Where appropriate, certainreclassifications have been made to the prior years financial statements toconform to the current year presentation.

59

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

*(f) Segment Reporting*

Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 131,*Disclosures about Segments of an Enterpriseand Related Information* (“SFAS No. 131”)  establishes annual and interim reportingstandards for operating segments of a company. It also requires entity-widedisclosures about the products and services an entity provides, the materialcountries in which it holds assets and reports revenues, and its majorcustomers.

In order to apply SFAS No. 131,the enterprise must first identify the chief operational decision maker (“CODM”).The CODM is usually the highest level of management responsible for theenterprise’s overall resource allocation. Our principal executive officer hasbeen identified as the CODM in assessing the performance of the segments andthe allocation of resources to segments. The next step in the application ofSFAS No. 131 is to identify the operating segments reported to the CODM.The operating segments are identified based on the way financial information isorganized and reported to the CODM. The principal executive officer relies onthe information derived directly from our reporting system. The primaryfinancial measure used by the principal executive officer in assessingperformance and allocating resources was revenue based on consolidatedfinancial statements.

*(g) FunctionalCurrency*

The functional currency ofour foreign subsidiaries, with the exception of our subsidiaries in Japan,France and China, is the United States of America dollar (“U.S. Dollar”).

On June 1, 2005, wechanged the functional currency of our subsidiary, eFilm Medical, Inc. (“eFilm”),from the Canadian dollar to the U.S. Dollar. This change was due to significantchanges in the economic facts and circumstances surrounding the operationalenvironment of this subsidiary. As a result of this change, certain long-livedassets, which were previously translated from Canadian dollars to U.S. Dollarsat the historical exchange rate on the date the asset was acquired, wererevalued based upon the exchange rate as of June 1, 2005, leading to acurrency translation adjustment, reflected in accumulated other comprehensiveincome, and an increase in the value of applicable assets of approximately$1,507.

Foreign currencydenominated revenues and expenses are translated at weighted average exchangerates throughout the year. Foreign currency denominated monetary assets andliabilities are translated at rates prevailing at the balance sheet dates.Foreign exchange gains and losses on transactions during the year are reflectedin the consolidated statements of operations, as a component of other income(expense), net.

*(h) Fair Value of Financial Instruments*

Our financial instrumentsinclude cash and cash equivalents, accounts receivable, marketable andnon-marketable securities, accounts payable and certain accrued liabilities.The carrying amounts  approximate fairvalue due to the short maturity of these instruments except the non-marketableequity securities. The carrying value of long-term receivables or long-termdeferred revenues is not materially different from the fair value. Theestimated fair values of the non-marketable equity securities have beendetermined from information obtained from independent valuations and managementestimates.

*(i) Derivative Financial Instruments*

Fluctuating foreignexchange rates may negatively impact the accompanying consolidated financialstatements. Substantially all of our billings are in U.S. Dollars, however, dueto our Canadian operations, 

60

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

substantialsalary and other expenses are payable in Canadian dollars. To effectivelymanage these market risks, we may enter into foreign currency forwardcontracts. We do not hold or issue derivative instruments for trading purposes.We have elected not to apply hedge accounting under the provision of SFAS No. 133*Accounting for Derivative Instruments and HedgingActivities* and accordingly,recognize any change in fair value through current earnings. As of December 31,2006 and 2005, we had no derivative financial instruments outstanding.

*(j) Cash and Cash Equivalents*

Cash and cash equivalentsconsist of balances with banks and liquid short-term investments with originalmaturities of ninety days or less and are carried on the balance sheet at costplus accrued interest.

*(k) Inventory*

Inventory, consistingprincipally of raw materials and finished goods (primarily purchasedthird-party hardware), is stated at the lower of cost or market. Cost isdetermined using the first-in, first-out method.

*(l) Property and Equipment*

Property and equipment arestated at cost.

Depreciation on propertyand equipment is calculated on the straight-line method over the estimateduseful lives of the assets. Useful lives of our major classes of property andequipment are: two to three years for computer and equipment and five to sevenyears for office equipment. Leasehold improvements are amortized using thestraight-line method over the shorter of the estimated life of the asset or theterm of the lease.

*(m) Long-Lived Assets*

We account for long-livedassets in accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*. Long-termassets, including property and equipment and other intangibles, are amortizedover their expected lives, which are estimated by us. We also make estimates ofthe impairment of long-term assets whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable, basedprimarily upon whether expected future undiscounted cash flows are sufficientto support the asset’s recovery. If the actual useful life of a long-term assetis shorter than the useful life estimated by us, the asset may be deemed to beimpaired and, accordingly, a write-down of the value of the asset or a shorteramortization period may be required, determined by a discounted cash flowanalysis. We have reviewed long-lived assets and certain intangible assets withestimable useful lives and determined that their carrying values as of December 31,2006 are recoverable in future periods.

*(n) Developed Software*

All research and development costs incurred prior tothe point at which management believes a project has reached technologicalfeasibility are expensed as incurred. Software development costs incurredsubsequent to reaching technological feasibility are capitalized and reportedat the lower of unamortized cost or net realizable value in accordance withSFAS No. 86, *Accounting for the Costs of**Computer Software to Be Sold, Leased, or Otherwise Marketed*.Amortization of purchased and developed software is provided on aproduct-by-product basis over the expected economic life of the related software,generally five years, using the straight-line method. This method generallyresults in greater amortization 

61

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

than the method based onthe ratio that current gross revenues for a product bear to the total ofcurrent and anticipated future gross revenues for that product. During 2006,2005 and 2004, we capitalized software development costs of $2,257, $3,621 and$3,479, respectively. Amortization expense related to developed software for2006, 2005 and 2004, was $2,520, $5,632 and $1,838, respectively. The 2006 amortization expense includes theimpairment of certain of our capitalized software projects of approximately$982 as we no longer anticipate future sales of such products. The 2005 amortization expense includes the impairmentof certain of our capitalized software projects of approximately $3,547attributed to overlapping technologies as a result of the Cedara Softwaretransaction.

We assess therecoverability of these costs periodically by determining whether the unamortizedcapitalized costs can be recovered through future net operating cash flowsthrough the sale of that product.

*(o) Investments*

At December 31, 2006,we held certain securities in both publicly traded entities of $239 and privatecompanies of $7,974, which are included in other non-current assets. Theinvestments in publicly traded equity securities over which we do not exertsignificant influence are classified as “available-for-sale” and are reportedat fair value. Unrealized gains and losses are reported within the accumulatedother comprehensive income component of shareholders’ equity. The investmentsin equity securities of private companies over which we do not exertsignificant influence are reported at cost. The estimated fair values have beendetermined from information obtained from market sources, independentvaluations, and estimates by us. Any loss due to impairment in value isrecorded when such loss occurs. We have recorded a loss of $186 in other expenses,net, in our 2006 consolidated statement of operations due to the impairment ofone of our investments.

*(p) Goodwill and Other Intangible Assets*

SFAS No. 142, *Goodwill and Other Intangible Assets*, requires that goodwilland indefinite lived intangible assets be reviewed for impairment annually, ormore frequently if impairment indicators arise. Our policy provides thatgoodwill and indefinite lived intangible assets will be reviewed for impairmentas of December 31 of each year. In calculating potential impairmentlosses, we evaluate the fair value of goodwill and intangible assets usingeither quoted market prices or, if not available, by estimating the expectedpresent value of their future cash flows. Identification of, and assignment ofassets and liabilities to, a reporting unit require our judgment and estimates.In addition, future cash flows are based upon our assumptions about futuresales activity and market acceptance of our products. If these assumptionschange, we may be required to write down the carrying value of the asset to arevised amount.

*(q) Warranties*

We generally provide up to twelve months of warrantyon our hardware, software and system sales. We have provided for expectedhardware warranty costs based on our historical experience. Accrued warrantywas $194, $267 and $17 at December 31, 2006, 2005 and 2004, respectively.

*(r) Guarantees*

In accordance with FASBInterpretation (“FIN”) No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*(“FIN No. 45”), werecognize the fair value for guarantee and indemnification arrangements issuedor modified by us, if these arrangements are within the scope of theinterpretation. In addition, we must continue to monitor the 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

conditionsthat are subject to the guarantees and indemnifications, as required under thepreviously existing GAAP, in order to identify if a loss has occurred. If wedetermine it is probable that a loss has occurred, then any such estimable losswould be recognized under those guarantees and indemnifications. Under ourstandard Software License, Services and Maintenance Agreement, we agree toindemnify, defend and hold harmless our licensees from and against certainlosses, damages and costs arising from claims alleging the licensees’ use ofour software infringes the intellectual property rights of a third party.Historically, we have not been required to pay material amounts in connectionwith claims asserted under these provisions and, accordingly, have not recordeda liability relating to such provisions.

Under our SoftwareLicense, Services and Maintenance Agreement, we also represent and warrant tolicensees that our software products operate substantially in accordance withpublished specifications, and that the services we perform will be undertakenby qualified personnel in a professional manner conforming to generallyaccepted industry standards and practices. Historically, only minimal costshave been incurred relating to the satisfaction of product warranty claims.

Other guarantees includepromises to indemnify, defend and hold harmless each of our executive officers,non-employee directors and certain key employees from and against losses,damages and costs incurred by each such individual in administrative, legal orinvestigative proceedings arising from alleged wrongdoing by the individualwhile acting in good faith within the scope of his or her job duties on ourbehalf. Historically, minimal costs have been incurred relating to suchindemnifications and, as such, no accrual for these guarantees have been made.However, Merge Healthcare, Richard A. Linden, our former President and ChiefExecutive Officer, Scott T. Veech, our former Chief Financial Officer, andBrian E. Pedlar, our former President of Cedara Software and Senior VicePresident of Merge Healthcare, who served as co-President and co-ChiefExecutive Officer from July 2, 2006 to August 18, 2006, aredefendants in several lawsuits relating to our accounting and financialdisclosure. These lawsuits and other legal matters in which we have becomeinvolved, including our receipt of a shareholder demand for derivative action,are described in Note 9. We have accrued for indemnification costs as of December 31,2006 for certain of these individuals for their expenses in connection withsuch matters and may be required to accrue for additional guarantee relatedcosts in future periods.

*(s) Income Taxes*

As part of the process of preparing our consolidatedfinancial statements, we are required to estimate income taxes in each of thejurisdictions in which we operate. The provision for income taxes is determinedusing the asset and liability approach for accounting for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*. A current liability is recognized for theestimated taxes payable for the current year. Deferred tax assets andliabilities are recognized for the estimated future tax consequences attributableto differences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets andliabilities are measured using the enacted tax rates in effect for the year inwhich the timing differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of changes in tax rates or taxlaws are recognized in the provision for income taxes in the period thatincludes the enactment date.

Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount more-likely-than-notto be realized. To the extent we establish or change the valuation allowance ina period, the tax effect will flow through the statement of operations.However, in the case of deferred tax 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

assetsof an acquired or merged entity with a valuation allowance recorded forpurchase accounting, any change in that asset valuation allowance will berecorded as an adjustment to goodwill.

The determination of ourprovision for income taxes requires significant judgment, the use of estimates,and the interpretation and application of complex tax laws. We are subject toincome taxes in the U.S. and numerous foreign jurisdictions. Significantjudgment is required in determining our worldwide provision for income taxesand recording the related tax assets and liabilities. In the ordinary course ofour business, there are transactions and calculations for which the ultimatetax determination is uncertain. In spite of our belief that we have appropriatesupport for all the positions taken on our tax returns, we acknowledge thatcertain positions may be successfully challenged by the taxing authorities.Therefore, an accrual for tax contingencies is provided for in accordance withthe requirements of SFAS No. 5, *Accountingfor Contingencies*. These tax accruals are reviewed quarterly andreverse upon being sustained under audit, the expiration of the statute oflimitations, new information, or other determination by the taxing authorities.The provision for income taxes includes the impact of changes in the tax contingencyaccrual. Although we believe our recorded tax assets and liabilities arereasonable, tax laws and regulations are subject to interpretation and inherentuncertainty; therefore, our assessments can involve both a series of complexjudgments about future events and rely on estimates and assumptions. Althoughwe believe these estimates and assumptions are reasonable, the finaldetermination could be materially different than that which is reflected in ourprovision for income taxes and recorded tax assets and liabilities.

*(t) Share-Based Compensation*

Effective January 1,2006, we adopted SFAS No. 123(R), *Share-Based Payment*(“SFAS No. 123(R)”), which is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*, as amended, toreplace our previous method of accounting for share-based awards under APBOpinion No. 25, *Accounting for StockIssued to Employees*, for periods beginning in 2006. In accordancewith APB Opinion No. 25, we had previously recognized no compensationexpense for options that were granted at or above fair market value on the dateof grant.

We adopted SFAS No. 123(R) using themodified-prospective-transition method. Under that transition method,compensation cost recognized in 2006 includes: (1) compensation cost forall share-based awards granted prior to, but not yet vested as of January 1,2006, based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (2) compensation cost forall share-based awards granted subsequent to January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).Under the modified-prospective-transition method, the provisions of SFAS No. 123(R) werenot applied to periods prior to adoption, and thus, prior period financialstatements were not restated to reflect our adoption of SFAS No. 123(R).SFAS No. 123(R) requires that we report the tax benefit from the taxdeduction related to share-based compensation that is in excess of recognizedcompensation costs, as a financing cash flow rather than as an operating cashflow in our consolidated statements of cash flows. Prior to January 1,2006, APB Opinion No. 25 required that we report the entire tax benefitrelated to the exercise of stock options as an operating cash flow.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

*(u) Revenue Recognition*

Revenues are derivedprimarily from the licensing of software, sales of hardware and relatedancillary products, installation and engineering services, training,consulting, and software maintenance and support. Inherent to software revenuerecognition are significant management estimates and judgments in theinterpretation and practical application of the complex rules to individualcontracts. These interpretations generally would not influence the amount ofrevenue recognized, but could influence the timing of such revenues. Typicallyour contracts contain multiple elements, and while the majority of ourcontracts contain standard terms and conditions, there are instances where ourcontracts contain non-standard terms and conditions. As a result, contractinterpretation is sometimes required to determine the appropriate accounting,including whether the deliverables specified in a multiple-elementarrangement should be treated as separate units of accounting for revenuerecognition purposes in accordance with Statement of Position (“SOP”)No. 97-2, *Software RevenueRecognition*, or Emerging Issues Task Force (“EITF”) IssueNo. 00-21, *Revenue Arrangementswith Multiple Deliverables*, and if so, the relative fair value thatshould be allocated to each of the elements and when to recognize revenue foreach element.

For software arrangements,we recognize revenue in accordance with SOP No. 97-2*.* This generally requires revenuerecognized on software arrangements involving multiple elements, includingseparate arrangements with the same customer executed within a short time frameof each other, to be allocated to each element based on the vendor-specificobjective evidence (“VSOE”) of fair values of those elements. Revenue frommultiple-element software arrangements is recognized using the residualmethod, pursuant to SOP No. 98-9, *Modificationof SOP No. 97-2, Software Revenue Recognition, With Respect toCertain Transactions* (“SOP No. 98-9”)*.* Under the residual method, revenue isrecognized in a multiple element arrangement when VSOE of fair value exists forall of the undelivered elements in the arrangement, even if vendor-specificobjective evidence of fair value does not exist for one or more of thedelivered elements in the arrangement, assuming all other conditions forrevenue recognition have been satisfied. For sales transactions where thesoftware is incidental, the only contract deliverable is custom engineering orinstallation services, and hardware transactions where no software is involved,we recognize revenue in accordance with EITF Issue No. 00-21 andStaff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition*.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

We allocate revenue toeach undelivered element in a multiple-element arrangement based on itsrespective fair value determined by the price charged when that element is soldseparately. Specifically, we determine the fair value of the maintenanceportion of the arrangement based on the substantive renewal price of themaintenance offered to customers, which generally is stated in the contract.The fair value of installation, engineering services, training, and consultingis based upon the price charged when these services are sold separately. Ifevidence of the fair value cannot be established for undelivered elements of asale, the entire amount of revenue under the arrangement is deferred untilelements without VSOE of fair value have been delivered or VSOE of fair valuecan be established. If evidence of fair value cannot be established for themaintenance element of a sale, and it represents the only undelivered element,the software, hardware, or software maintenance elements of the sale aredeferred and recognized ratably over the related maintenance period.

Revenue from softwarelicenses is recognized upon shipment, provided that evidence of an arrangementexists, delivery has occurred and risk of loss has passed to the customer, feesare fixed or determinable and collection of the related receivable is probable.We assess collectibility based on a number of factors, including pasttransaction history with the customer and the credit worthiness of thecustomer. We must exercise our judgment when we assess the probability ofcollection and the current credit worthiness of each customer. If the financialcondition of our customers were to deteriorate, it could affect the timing andthe amount of revenue we recognize on a contract. In addition, in certaintransactions we may negotiate that the customer provides common stock ownershipin consideration as part of the sale. We generally do not request collateralfrom customers.

Revenue from softwarelicenses sold through annual contracts that include software maintenance andsupport is deferred and recognized ratably over the contract period. Revenuefrom installation, engineering services, training, and consulting services isrecognized as services are performed.

Revenue from sales ofRadiology Information Systems (“RIS”) and from RIS/Picture Archiving andCommunication Systems (“PACS”) solutions, and other specific arrangements whereprofessional services are considered essential to the functionality of thesolution sold, is recognized on the percentage-of-completion method, asprescribed by AICPA Statement of Position 81-1,*Accounting for Performance on Construction-Type and CertainProduction-Type Contracts*. Percentage of completion is determined bythe input method based upon the amount of labor hours expended compared to thetotal labor hours expended plus the estimated amount of labor hours to completethe project. Total estimated labor hours are based on management’s best estimateof the total amount of time it will take to complete a project. These estimates require the use of judgment. Asignificant change in one or more of these estimates could affect theprofitability of one or more of our contracts. We review our contract estimatesperiodically to assess revisions in contract values and estimated labor hoursand reflect changes in estimates in the period that such estimates are revisedunder the cumulative catch-up method.

Our Original EquipmentManufacturer (“OEM”) software products are typically fully functional upondelivery and do not require significant modification or alteration. Fees forservices to OEM customers are billed separately from licenses of our softwareproducts. For sales transactions involving only the delivery of customengineering services, we recognize revenue under proportional performanceguidelines of SAB No. 104.

For certain contractsaccounted for under SAB No. 104 and EITF No. 00-21, the arrangementdictates that we invoice the customer for 10% of the contract value of theproducts delivered upon completion of hardware installation and acceptance bythe customer. As a result of this specific performance obligation 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

andacceptance criteria, we defer the related amount of product fair value andrecognize it upon completion of installation and acceptance.

Our policy is to allowreturns when we have preauthorized the return. Based on our historicalexperience of a limited number of returns and our expectation that returns, ifany, will be insignificant, we have provided for an allowance for specificpotential returns only.

Deferred revenue iscomprised of deferrals for license fees, support and maintenance, and otherservices. Long-term deferred revenue as of December 31, 2006 representslicense fees, support and maintenance, and other services to be earned orprovided beginning January 1, 2008.

We record reimbursableout-of-pocket expenses in both services and maintenance net sales and as adirect cost of services and maintenance in accordance with EITF Issue No. 01-14,*Income Statement Characterization ofReimbursements Received for “Out-of-Pocket” Expenses Incurred*. Inaccordance with EITF Issue No. 00-10, *Accounting for Shipping and Handling Fees*, the reimbursementby customers of shipping and handling costs are recorded in software and othernet sales and the associated cost as a cost of sale.

*(v) Recent Accounting Pronouncements*

*In June2006, the FASB issued EITF No. 06-3,*How Sales TaxesCollected from Customers and Remitted to Governmental Authorities Should bePresented in the Income Statement (That Is, Gross Versus Net Presentation) (“EITF No. 06-3”), which discusses taxes imposed on,and imposed concurrent with, a specific revenue-producing transaction between aseller and its customer. It requires entities to disclose, if significant, onan interim and annual basis for all periods presented: (a) the accountingpolicy elected for these taxes; and (b) the amounts of the taxes reflectedgross (as revenue) in the income statement. EITF No. 06-3 will become effectiveduring the first quarter of 2007. We do not expect EITF No. 06-3 to have amaterial impact on our financial condition or results of operations.

In June 2006, FASBissued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109*(“FIN No. 48”). FIN No. 48 is effective for the first interim orannual reporting period for the first fiscal year beginning on or after December 15,2006, although earlier adoption is encouraged. FIN No. 48 applies to alltax positions for income taxes accounted for in accordance with SFAS No. 109.We are currently evaluating the impact of the adoption of FIN No. 48.

In September 2006,the SEC issued SAB No. 108, *Considering the Effects ofPrior Year Misstatements When Quantifying Misstatements in Current YearFinancial Statement*(“SAB No. 108”), which provides interpretiveguidance on how registrants should quantify financial statement misstatements.SAB No. 108 requires companies to evaluate the materiality of identifiedunadjusted errors on each financial statement and related disclosures usingboth the rollover and the iron curtain approach. SAB No. 108 applies toannual  financial statements for fiscalyears ending after November 15, 2006. The adoption of SAB No. 108 did nothave a material impact on our financial condition or results of operations.

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value measurements. SFAS No. 157 applies to previousaccounting pronouncements that require or permit fair value measurements. SFAS No.157 is effective for fiscal years beginning after November 15, 2007. Weare currently evaluating the impact of the adoption of SFAS No. 157.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

**(2)**   EarningsPer Share

Basicearnings per share is computed by dividing income (loss) available to commonshareholders by the weighted average number of shares outstanding. Dilutedearnings per share reflects the potential dilution that could occur based on theexercise of stock options, except for options with an exercise price of morethan the average market price of our Common Stock, because such exercise wouldbe anti-dilutive. The following table sets forth the computation of basic anddiluted earnings per share for the years ended December 31, 2006, 2005 and2004.

| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                             |       |                                        |       |   |   |   |   |
| Net income (loss)                                                      |       | $                                           | (258,458   | ) | $ | (2,657 | ) | $ | 2,190 |   |
| Accretion of  redemption value related to exchangeable shares          |       | —                                      |       | — |   | (1 | ) |
| Allocation of  income to exchangeable shares                           |       | —                                      |       | — |   | (1 | ) |
| Numerator for net  income (loss) per share—basic and diluted |       | $                                           | (258,458   | ) | $ | (2,657 | ) | $ | 2,188 |   |
| Denominator:                                                           |       |                                        |       |   |   |   |   |
| Weighted average  number shares of Common Stock outstanding            |       | 33,701,735                                  |       | 24,696,762 |   | 13,013,927 |   |
| Effect of stock  options                                               |       | —                                      |       | — |   | 813,595 |   |
| Denominator for  net income (loss) per share—diluted              |       | 33,701,735                                  |       | 24,696,762 |   | 13,827,522 |   |
| Net income (loss)  per share—basic                                |       | $                                           | (7.67      | ) | $ | (0.11 | ) | $ | 0.17 |   |
| Net income (loss) per  share—diluted                              |       | $                                           | (7.67      | ) | $ | (0.11 | ) | $ | 0.16 |   |

 

The weighted average number of shares of Common Stockoutstanding used to calculate basic net income (loss) includes exchangeableshare equivalent securities for the years ended December 31, 2006, 2005,and 2004 of 4,749,969, 6,653,815, and 167,589, respectively.

As a result of the losses during the twelve monthsended December 31, 2006 and 2005, incremental shares from the assumedconversion of employee stock options totaling 602,696 and 1,237,210,respectively, have been excluded from the calculation of diluted loss per shareas their inclusion would have been anti-dilutive.

For the years ended December 31, 2006, 2005 and2004, options to purchase 1,218,053, 19,000 and 39,500 shares of our CommonStock, respectively, had exercise prices greater than the average market priceof the shares of Common Stock, and, therefore, are not included in the abovecalculations of net income (loss) per share.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

The following potentiallydilutive Common Stock equivalent securities, including securities that may beconsidered in the calculation of diluted earnings per share, were outstandingat December 31, 2006, 2005 and 2004.

| ** **           | ** ** | **2006**  | ** ** | **2005**   | ** ** | **2004**  | ** ** |
|----------------------|------------|-----------|------------|------------|------------|-----------|------------|
| Stock options        |       | 3,571,799 |       | 2,979,139  |       | 1,590,085 |       |
| Exchangeable  shares |       | 4,568,155 |       | 7,129,246  |       | —    |       |
|                 |       | 8,139,954 |       | 10,108,385 |       | 1,590,085 |       |

 

**(3)**   Goodwilland Other Intangibles

Ourintangible assets, other than developed software, subject to amortization aresummarized as follows:

| ** **              | ** ** | **Weighted  Average**                            | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Remaining  Amortization  Period (Years)** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization**   | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Purchased  technology   |       |                                             | 3.7        |                            |       | $                               | 16,990     |   |   | $ | (6,130 | ) |   | $ | 16,633 |   |   | $ | (3,118 | ) |   |
| Patents                 |       |                                             | 9.0        |                            |       | 117                             |       |   | (10 | ) |   | 101 |   |   | (1 | ) |   |
| Customer  relationships |       |                                             | 4.2        |                            |       | 13,477                          |       |   | (3,966 | ) |   | 13,477 |   |   | (1,688 | ) |   |
| Total                   |       |                                             | 3.9        |                            |       | $                               | 30,584     |   |   | $ | (10,106 | ) |   | $ | 30,211 |   |   | $ | (4,807 | ) |   |

 

Purchasedtechnology amortization expense, which is being recorded ratably over the lifeof the related intangible asset, was $3,012, $2,107, and $654 for the yearsended 2006, 2005 and 2004, respectively. Included in the amortization expenseabove for 2005 is an impairment charge for purchased technology of $67, whichis recorded in cost of goods sold. Customer relationships and patentamortization expense, which is being recorded ratably over the life of therelated intangible asset, was $2,287, $1,411 and $195 for 2006, 2005 and 2004,respectively, including a charge for 2005 of $610 related to customerrelationships, which is recorded in depreciation and amortization operatingcosts and expenses. Estimated aggregate amortization expense for the remainingperiods is as follows:

| For the year  ended: |   | 2007 |   | $      | 5,156 |   |
|----------------------|--------|------|--------|--------|-------|--------|
|                 |   | 2008 |   | $      | 4,807 |   |
|                 |   | 2009 |   | $      | 4,401 |   |
|                 |   | 2010 |   | $      | 4,277 |   |
|                 |   | 2011 |   | $      | 1,782 |   |
| Thereafter           |   | $    | 55     |   |

 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

The changes in thecarrying amount of goodwill for the year ended December 31, 2006, were asfollows:

| Balance as of  January 1, 2006   |   | $        | 350,634 |   |
|---------------------------------------|--------|----------|---------|--------|
| Adjustments to goodwill(1)            |   | 1,861    |    |
| Goodwill  impairment charge           |   | (221,403 | )       |
| Trade name  impairment charge         |   | (6,685   | )       |
| Balance as of  December 31, 2006 |   | $        | 124,407 |   |

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(1)          Comprised of $1,970 adjustment(See note 14) and $(109) purchase price allocation adjustment.

We review goodwill and indefinite lived intangibleassets for impairment annually, as of December 31 of each year. Inaddition, we test an intangible asset or group for impairment between annualtests whenever events or changes in circumstances indicate that we may not beable to recover the asset’s carrying amount. Goodwill of a reporting unit istested for impairment between annual tests if an event occurs or circumstanceschange that would more likely than not reduce the fair value of a reportingunit below its carrying amount.

During 2006, several material events occurred thatresulted in an environment of uncertainty creating significant businesschallenges, and diverted the attention of our Board of Directors and managementfrom our business operations. These events included the resignation of certainmembers of our senior management, the completion of an independentinvestigation conducted by the Audit Committee of our Board of Directors duringwhich the Audit Committee concluded that several of our previously issuedfinancial statements would require restatement, the possible delisting of our CommonStock from the NASDAQ Global Market and notice of an informal non-publicinquiry with the Securities Exchange Commission. These events, which did notexist as of December 31, 2005, resulted in circumstances which indicatedthat we may not be able to recover the intangible assets’ carrying amounts orthat the fair value of our single reporting unit does not support the carryingvalue of goodwill.

In accordance with SFAS No. 142, *Goodwill and Other IntangibleAssets*, an impairment of goodwill is deemed to exist if the carryingvalue of a reporting unit exceeds its estimated fair value. We performed Step Iof the impairment test by estimating the Company’s fair value using what weconsidered to be the most reliable and readily available indicator of fairvalue, that being the quoted market prices of our shares of Common Stock. Theresults of Step I of the impairment test indicated that we had a potentialimpairment of our goodwill since the carrying value of our single reportingunit exceeded the reporting unit’s estimated fair value. On August 29,2006, the Audit Committee of our Board of Directors determined that there wassuch an impairment.

We completed Step II to measure the amount ofimpairment loss relating to goodwill, by comparing the implied fair value ofour reporting unit goodwill with the carrying amount of that goodwill. Theestimate of fair value of our reporting unit was reduced by the fair value ofall other assets to determine the implied fair value of reporting unitgoodwill. We completed our assessment of the fair value utilizing theassistance of independent valuation specialists. As a result of ourStep II analysis, we recorded a non-cash goodwill impairment charge for thesecond quarter of 2006, of $219,433. In addition, in the fourth quarter of2006, we recorded an adjustment to goodwill and additional impairment charge of$1,970 (see Note 14).

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

On December 31, 2006,we tested our indefinite lived intangible assets and concluded that while therewas no further impairment of our goodwill, the tradenames associated with ourCedara Software Corp. business transaction had been impaired. We recorded acharge within goodwill impairment, restructuring and other expenses of ourconsolidated statement of operations of $6,685 due, in part, to ourrestructuring in the fourth quarter of 2006 in which we decided to rename thebusiness unit responsible for end-user sales in North America to MergeHealthcare North America (thus discontinuing the eMed tradename). We measuredthis impairment charge based on the relief from royalty approach utilizing theassistance of independent valuation specialists.

**(4)**   Acquisitions

*(a) CedaraSoftware*

On June 1, 2005, wecompleted our business combination with Cedara Software, a leader in thedevelopment of custom engineered software applications and development toolsfor the medical imaging OEM and international markets. The transaction wasannounced on January 17, 2005 upon the execution of a definitive agreementand closed on June 1, 2005, following approval by both Merge Healthcareand Cedara Software shareholders and receipt of necessary regulatory approvals.The business combination was effected through an exchange of stock, in whichCedara Software shareholders received 0.587 shares of our Common Stock for eachCedara Software common share. Also, Cedara Software shareholders who areCanadian residents were permitted to receive either our Common Stock or newlycreated exchangeable shares of our wholly owned subsidiary, Merge CedaraExchangeCo Limited (“ExchangeCo Exchangeable Shares”). Canadian residents whoreceived ExchangeCo Exchangeable Shares in the transaction defer paying incometaxes on the transaction until such time as they exchange the shares for CommonStock or otherwise dispose of them. The ExchangeCo Exchangeable Shares arefreely tradable on the Toronto Stock Exchange (TSX) under the ticker symbol “MRG.”The ExchangeCo Exchangeable Shares are exchangeable into shares of MergeHealthcare Common Stock on a one-for-one basis at any time at the option of theholder (see Note 11(h) for updated status). Holders of Cedara Softwarestock options exchanged each option to purchase one common share of CedaraSoftware for an option to purchase 0.587 shares of Merge Healthcare CommonStock , and we adjusted strike prices for the stock and currency conversionrates, with no changes to the vesting terms of the option. We issuedreplacement options to purchase approximately 1.9 million shares of CommonStock as a result of this exchange.

*Reasons for theTransaction*

The business combinationwith Cedara Software placed us as a market leader in the development anddelivery of medical imaging and information management software and servicesfor the OEM market and end-user imaging centers, and small-to medium-sizedhospitals. Cedara Software had a substantial customer base and had experiencedcontinued sales growth over the few years prior to the acquisition. As aresult, we acquired the Cedara Software common shares at a premium, based onthe price of the Cedara Software common share price prior to the date ofannouncement.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

*Purchase Accounting*

The transaction consideration was valued atapproximately $386,899, including the exchange of approximately 18.8 millionequivalent shares at a market price of $18.97 per share, estimated fair valuefor outstanding options at the date of closing and direct transaction costsincurred by us. The fair value of stock issued was based upon the 0.587exchange ratio and a four-day weighted average of our stock price two daysprior, the day of and one day after the announcement, based on NASDAQ closingprices. The fair value of the outstanding options are estimated atapproximately $25,211, based on a 1.247 U.S. Dollar to Canadian dollar currencyexchange ratio, the 0.587 exchange ratio and the four-day weighted averageindicated above. The total purchase price was as follows:

| **Form of Consideration**      | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|------------|------------|---------------------|------------|
| Stock issued                             |       | $          | 356,478    |                |
| Estimated fair  value of options assumed |       | 25,211     |       |
| Direct  transaction costs                |       | 5,210      |       |
| Total consideration                      |       | $          | 386,899    |                |

 

Theacquisition was accounted for using the purchase method of accounting. MergeHealthcare was considered the accounting acquirer in the business combination,requiring the purchase consideration to be allocated to Cedara Software’s nettangible and intangible assets based on their respective fair values as of thedate of transaction close, with the residual reflected as goodwill. Weallocated the purchase price to Cedara Software’s assets and liabilities. Theallocation of the purchase consideration was based in part upon a valuation ofthe intangible assets performed by independent valuation specialists, primarilythrough the use of discounted cash flow techniques. The estimated purchaseprice allocation, based on Cedara Software’s assets and liabilities as of June 1,2005, was as follows:

| ** **                            | ** ** | **Fair Value** | ** ** |
|---------------------------------------|------------|---------------------|------------|
| Assets acquired                       |       | $                   | 44,714     |   |
| Liabilities  assumed                  |       | (22,507             | )          |
| Purchased and  developed technologies |       | 13,019              |       |
| Customer  relationships               |       | 12,500              |       |
| In-process  research and development  |       | 13,046              |       |
| Deferred stock  compensation          |       | 2,132               |       |
| Goodwill,  including trade names      |       | 323,995             |       |
| Total consideration                   |       | $                   | 386,899    |   |

 

The amounts allocated to in-process research anddevelopment, purchased and developed software and customer relationships wereestimated based on the work performed by independent valuation specialists. Theestimated fair value of the purchased and developed software was determined bythe utilization of a combination of the excess earnings and relief from royaltyapproaches. The estimated fair value of the customer relationships wasdetermined by the utilization of the cost savings approach. Appraisalassumptions utilized under these methods included a forecast of estimatedfuture net cash flows, as well as discounting the future net cash flows totheir present value. We used a 17% discount rate for both purchased anddeveloped software and customer relationships, which was calculated using anindustry beta and capital structure. These amounts are being amortized over asix-year period. The estimated asset 

72

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

lives were determinedbased on projected future economic benefits and expected life cycles of thetechnologies and customer relationships.

The amount assigned to goodwill includes $8,545associated with trade names and is not being amortized, but will be tested forimpairment annually or under certain circumstances that may indicate apotential impairment. At December 31, 2006 we determined that animpairment existed and as such recorded an impairment charge of $6,685 in 2006.

The value assigned to acquired in-process technologywas determined by identifying the acquired specific in-process research anddevelopment projects that would be continued, and for which (1) technologicalfeasibility had not been established at the acquisition date, (2) therewas no alternative future use, and (3) the fair value was estimable withreasonable reliability. The nature of the efforts to develop the in-processtechnology into the commercially viable products are expected to principallyrelate to the completion of all planning, designing, prototyping, verificationand testing activities that are necessary to establish that the technology canbe produced to meet its design specification, including function, features andtechnical performance requirements. At the date of the business combination,Cedara Software had in-process projects meeting the above definition associatedwith the Cedara Software next generation PACS workstation, OEM imagingplatforms and image acquisition console projects.

We estimated the fair value of the Cedara Softwareprojects to be $13,046, based on the work performed by independent valuationspecialists. Accordingly, this amount was immediately expensed in theconsolidated statement of operations upon the acquisition date. The estimatedfair value of the Cedara Software projects was determined by the utilization ofthe excess earnings approach. Appraisal assumptions utilized under this methodincluded a forecast of estimated future net cash flows, as well as discountingthe future net cash flows to their present value. We used a 20% discount rate,which was calculated using an industry beta and capital structure.

The $2,132 allocated to deferred stock compensationwas valued based on the intrinsic value of each outstanding and unvested stockoption assumed on the closing date. The charge for stock compensation for thetwelve months ended December 31, 2005 was $887 and was classified in thestatement of operations based on each applicable employee’s position. Upon ouradoption of SFAS No. 123(R) on January 1, 2006, we reclassifiedthe December 31, 2005 balance to additional paid-in capital.

The $323,995 assigned to goodwilland $13,046 estimated fair value of in-process research and development willnot be deductible for federal income tax purposes.

*Pro forma Results*

As discussed in Note 1, the results of Cedara Softwarehave been included in the consolidated financial statements since June 1,2005.

73

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

The following unaudited pro forma condensed combinedresults of operations for the twelve months ended December 31, 2005 arebased on the historical financial statements of Merge Healthcare and CedaraSoftware giving effect to the business combination as if it had occurred at thebeginning of the periods presented. Therefore, this pro forma data hasbeen adjusted to exclude Cedara Software pre-acquisition intangibleamortization and the in-process research and development expense, whileincluding amortization of intangible assets and expense of deferred stockcompensation during the entire applicable periods. This data also reflects onlythe historical Merge Healthcare and Cedara Software tax expense. These data arenot indicative of the results of operations that would have arisen if thetransaction had occurred at the beginning of the respective periods. Moreover, thesedata are not intended to be indicative of future results of operations.

| ** **                             | ** ** | **Year  Ended  December 31, 2005** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------|------------|
| Revenue                                |       |                                                   | $          | 107,529 |   |   |
| Net income from  continuing operations |       |                                                   | $          | 7,227 |   |   |
| Earnings per  share:                   |       |                                                   |       |   |   |
| Basic                                  |       |                                                   | $          | 0.17 |   |   |
| Diluted                                |       |                                                   | $          | 0.16 |   |   |

 

*(b) AccuImage*

On January 28, 2005, we acquired all of theoutstanding capital stock of AccuImage in an all cash transaction. The totalpurchase price for the acquisition was $6,978. AccuImage was in the business ofthe development, marketing and support of software for advanced visualization,analysis and management of medical imaging data from medical imagingmodalities.

We paid a significant premiumabove the fair value of AccuImage’s tangible net assets, principally because wedetermined that AccuImage’s software development ability and advancedvisualization products would contribute to future products offered to ourend-user customers.

An escrow of $1,000 of the purchase price wasestablished as a reserve for 24 months against any claims regarding breaches ofrepresentations and warranties, as well as adjustments to the net asset valueof the AccuImage balance sheet at the date of closing. This escrow was fullysettled in the seller’s favor on January 3, 2006.

The acquisition wasaccounted for using the purchase method of accounting. The accompanyingconsolidated statements of operations include the results of operations forAccuImage since the acquisition date, January 28, 2005. The amountallocated to purchased and developed software and customer relationships arebeing amortized over a five-year period. The estimated asset lives were determinedbased on projected future economic benefits and expected life cycles of thetechnologies and customer relationships. The amount assigned to goodwill is notbeing amortized, but will be tested for impairment annually or under certaincircumstances that may indicate a potential impairment.

74

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

The following tablerepresents the allocation of the total purchase consideration for the purchaseof AccuImage. The allocation of the purchase consideration is based in partupon an independent valuation.

| ** **                            | ** ** | **Fair Value** | ** ** |
|---------------------------------------|------------|---------------------|------------|
| Assets acquired                       |       |                | $          | 584 |   |   |
| Purchased and  developed technologies |       |                | 763        |   |   |
| Customer  relationship                |       |                | 80         |   |   |
| Goodwill                              |       |                | 4,248      |   |   |
| Deferred tax  asset                   |       |                | 1,676      |   |   |
| Liabilities  assumed                  |       |                | (1,385     | ) |   |
| Debt assumed and  paid                |       |                | 1,012      |   |   |
| Total consideration                   |       |                | $          | 6,978 |   |   |

 

The $4,248 assigned to goodwill in the acquisitionwill not be deductible for federal income tax purposes. We have not includedpro forma results of operations for AccuImage, as the impact on our results for2005 and 2004 are not significant.

As aresult of the Cedara Software transaction, there were overlapping technologies,which led to the write-off of approximately $73 of purchased and developedtechnologies. In addition, a trigger event, outside of our control, occurredduring 2005 that resulted in the write-off of the $80 customer relationship.

**(5)   AccountsReceivable**

Substantially all receivables are derived from salesand related support and maintenance of our products to healthcare providerslocated throughout the U.S. and in certain foreign countries as indicated inNote 13.

Our accounts receivable balance is reported net of anallowance for doubtful accounts. We provide for an allowance for estimateduncollectible accounts based upon historical experience and management’sjudgment. At the end of 2006 and 2005, the allowance for estimated uncollectibleaccounts was $1,683 and $1,892, respectively.

Thefollowing table shows the changes in our allowance for doubtful accounts.

| **Description**                        | ** ** | ** ** | ** ** | **Balance at  beginning of   period** | ** ** | **Additions  due to  acquisitions** | ** ** | **Additions  charged to  costs and  expenses** | ** ** | **Deductions** | ** ** | **Balance at  end of  period** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| For year ended  December 31, 2006 |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts       |       |       | $          | 1,892                                                |       |                                     |       | $                                                        | —     |           |       |                                     | $          | 289 |   |   |   | $ | (498 | ) |   |   | $ | 1,683 |   |   |
| For year ended  December 31, 2005 |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts       |       |       | $          | 450                                                  |       |                                     |       | $                                                        | 719        |           |       |                                     | $          | 1,012 |   |   |   | $ | (289 | ) |   |   | $ | 1,892 |   |   |
| For year ended  December 31, 2004 |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts       |       |       | $          | 303                                                  |       |                                     |       | $                                                        | —     |           |       |                                     | $          | 158 |   |   |   | $ | (11 | ) |   |   | $ | 450 |   |   |

 

75

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

**(6)   Share-BasedCompensation**

We maintain four stock-based employee compensationplans (including our employee stock purchase plan) and one director option planunder which we grant options to acquire shares of our Common Stock to certainemployees, non-employees, non-employee directors and to existing stock optionholders in connection with the consolidation of option plans following anacquisition. Options generally have an exercise price equal to the fair marketvalue of our Common Stock at the date of grant, with the exception of theoptions granted in 2005 to replace existing Cedara Software Corp. options (“ReplacementOptions”). The Replacement Options which we granted pursuant to the mergeragreement had the same economic terms as the Cedara options which theyreplaced, as adjusted for the conversion ratio and currency. The majority of these options vest over a three orfour–year period and have a contractual life of ten years.

We maintain an employee stock purchase plan thatallows eligible employees to purchase shares of our Common Stock throughpayroll deductions of up to 10% of eligible compensation on an after-tax basis.The price eligible employees pay per share is at a 5% discount from the marketprice at the end of each calendar quarter.

Our adoption of SFAS No. 123(R) on January 1,2006, resulted in an increase of our loss before income taxes and net loss forthe year ended December 31, 2006, of $5,911 and $4,543, respectively. Ifwe had not adopted SFAS No. 123(R) but, rather, continued to accountfor share-based compensation under the provisions of APB Opinion No. 25,basic net loss per share for the year ended December 31, 2006, would havebeen $7.54, compared to reported basic net loss per share of $7.67.

Thefollowing table summarizes share-based compensation expense related toshare-based awards subject to SFAS No. 123(R) recognized during theyear ended December 31, 2006: 

| ** **                                                             | ** ** | **Year Ended  December 31,  2006** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| Share-based  compensation expense included in statement of operations: |       |                                         |       |   |   |
| Services and  maintenance (cost of sales)                              |       |                                         | $          | 542 |   |   |
| Sales and  marketing                                                   |       |                                         | 1,047      |   |   |
| Product research  and development                                      |       |                                         | 1,186      |   |   |
| General and  administrative                                            |       |                                         | 3,136      |   |   |
| Total                                                                  |       |                                         | 5,911      |   |   |
| Tax benefit                                                            |       |                                         | 1,368      |   |   |
| Share-based  compensation expense, net of tax                          |       |                                         | $          | 4,543 |   |   |
| Decrease in basic  loss per share                                      |       |                                         | $          | 0.13 |   |   |
| Decrease in diluted loss  per share                                    |       |                                         | $          | 0.13 |   |   |

 

We attributed the difference of $50 between the $5,911recorded as share-based compensation expense in the statement of operations forthe year ended December 31, 2006, and the $5,961 of share-

76

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

based compensation expenserecorded in additional paid-in capital in the statement of shareholders’ equityto expense incurred by product research and development personnel who worked oncapitalizable software development projects.

The table below reflectsnet loss and net loss per share for the year ended December 31, 2006,compared to pro forma net income (loss) and net income (loss) per share for theyears ended December 31, 2005, and 2004, presented as if we had appliedthe fair value recognition provisions of SFAS No. 123 to share-basedemployee compensation during the years ended December 31, 2005 and 2004:

| ** **                                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                          | ** ** | ** **                                  | ** ** | **(Pro Forma)** | ** ** | **(ProForma)** | ** ** |
| Net income (loss)(1)                                                                                                |       | $                                           | (258,458   | ) |   | $ | (2,657 | ) |   |   | $ | 2,190 |   |   |
| Share-based  employee compensation expense included in reported net income (loss), net of  tax effect(2)            |       | N/A                                         |       |   | 587 |   |   |   | — |   |   |
| Share-based  employee compensation expense determined under fair value method for all  awards, net of tax effect(2) |       | N/A                                         |       |   | (4,101 | ) |   |   | (1,507 | ) |   |
| Net income  (loss), including the effect of share-based employee compensation expense                               |       | $                                           | (258,458   | ) |   | $ | (6,171 | ) |   |   | $ | 683 |   |   |
| **Net income (loss) per share—Basic:**                                                                         | ** ** | ** **                                  | ** ** |   |   |   |   |   |   |   |   |
| Net income (loss)  as reported(1)                                                                                   |       | $                                           | (7.67      | ) |   | $ | (0.11 | ) |   |   | $ | 0.17 |   |   |
| Net income  (loss), including the effect of share-based employee compensation expense                               |       | N/A                                         |       |   | $ | (0.25 | ) |   |   | $ | 0.05 |   |   |
| **Net income (loss) per  share—Diluted:**                                                                      | ** ** | ** **                                  | ** ** |   |   |   |   |   |   |   |   |
| Net income (loss)  as reported(1)                                                                                   |       | $                                           | (7.67      | ) |   | $ | (0.11 | ) |   |   | $ | 0.16 |   |   |
| Net income (loss),  including the effect of share-based employee compensation expense                               |       | N/A                                         |       |   | $ | (0.25 | ) |   |   | $ | 0.05 |   |   |

 

----

(1)          Net income (loss) andnet income (loss) per share prior to 2006 do not include share-based employeecompensation expense under SFAS No. 123, as we had only adopted thedisclosure provisions of SFAS No. 123.

(2)          Share-based employeecompensation expense prior to 2006 was calculated in accordance with SFASNo.123.

77

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

We used the Black-Scholesoption pricing model to estimate the fair value of stock-based awards on thedate of grant utilizing the assumptions noted in the following table. Expectedvolatilities are based on the historical volatility of our stock and otherfactors. We use historical data to estimate option exercises and employeeterminations within the valuation model. The expected term of optionsrepresents the period of time that options granted are expected to be outstanding.The risk-free rate for periods during the contractual life of the option isbased on the U.S. Treasury rates in effect at the grant date. 

| ** **                              | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dividend yield                          |       | 0                                           | %          | 0 | % | 0 | % |
| Expected  volatility                    |       | 50% - 60                                    | %          | 30% - 50 | % | 50 | % |
| Risk-free  interest rate                |       | 4.3% - 4.8                                  | %          | 2.8% - 4.3 | % | 2.1% - 3.1 | % |
| Expected term (in  years)               |       | 3.5 - 4.0                                   |       | 0.2 - 3.5 |   | 0.0 - 4.0 |   |
| Weighted-average grant  date fair value |       | $                                           | 3.98       |   | $ | 5.34 |   | $ | 5.90 |   |
|                                         |            |                                             |            |  |  |  |  |  |  |  |

 

The assumptions above are based on multiple factors,including the historical exercise patterns of employees in relativelyhomogeneous groups with respect to exercise and post-vesting employmenttermination behaviors, expected future exercise patterns for these samehomogeneous groups, and the volatility of our stock price. Prior to January 1,2006, we used the actual forfeiture method allowed under SFAS No. 123,which assumed that all options would vest and pro forma expense was adjustedwhen options were forfeited prior to the vesting dates. SFAS No. 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.

At December 31, 2006, there was $9,597 ofunrecognized compensation cost related to share-based payments. We expect thiscompensation cost to be recognized over a weighted-average period of1.8 years.

Stockoption activity for the year ended December 31, 2006, was as follows:

| ** **                              | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted-Average  Remaining  Contractual  Term  (In Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------|------------|
| Options  outstanding, December 31, 2005 |       | 2,979,139               |       |                                       | $          | 13.24                                                               |       |                            |       | 4.7 |   |   |   | $ | 35,166 |   |   |
| Options granted                         |       | 2,193,772               |       |                                       | $          | 8.50                                                                |       |                            |       |   |   |   |   |   |   |   |
| Options exercised                       |       | (229,099                | )          |                                       | $          | 2.06                                                                |       |                            |       |   |   |   |   |   |   |   |
| Options forfeited  and expired          |       | (1,372,013              | )          |                                       | $          | 14.71                                                               |       |                            |       |   |   |   |   |   |   |   |
| Options  outstanding, December 31, 2006 |       | 3,571,799               |       |                                       | $          | 10.48                                                               |       |                            |       | 5.0 |   |   |   | $ | 1,035 |   |   |
| Options exercisable, December 31, 2006  |       | 1,382,857               |       |                                       | $          | 10.60                                                               |       |                            |       | 4.8 |   |   |   | $ | 697 |   |   |
| Options  exercisable, December 31, 2005 |       | 1,040,883               |       |                                       | $          | 11.84                                                               |       |                            |       | 4.6 |   |   |   | $ | 13,735 |   |   |
| Options exercisable,  December 31, 2004 |       | 831,416                 |       |                                       | $          | 6.64                                                                |       |                            |       | 3.7 |   |   |   | $ | 12,980 |   |   |

 

The weighted-average remaining contractual term andaggregate intrinsic value for options outstanding at December 31, 2004, was 4.2years and $20,502, respectively.

78

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Otherinformation pertaining to option activity was as follows:

| ** **                                                       | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------|-----------------------------|------------|
| ** **                                                       | ** **                  | **2006**   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted-average  grant-date fair value of stock options granted |                        | $          | 3.98 |   | $ | 5.34 |   | $ | 5.90 |   |
| Total fair value  of stock options vested                        |                        | $          | 7,289 |   | $ | 5,894 |   | $ | 2,562 |   |
| Total intrinsic value of  stock options exercised                |                        | $          | 1,446 |   | $ | 24,469 |   | $ | 3,940 |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2006:

| **Options Outstanding**                | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| **Range of exercise prices** | ** ** | ** **                   | ** ** | **Number of  shares** | ** ** | **Weighted-  average  remaining  contractual life  in years** | ** ** | **Weighted-  average  exercise price** | ** ** | **Number of  shares** | ** ** | **Weighted-  average  exercise price** | ** ** |
| $1.00 - $4.54                               |       | 279,063                      |       |   | 2.76 |   |   |   | $ | 3.57 |   |   | 194,124 |   |   | $ | 3.12 |   |   |
| $5.18 - $7.87                               |       | 1,024,546                    |       |   | 5.62 |   |   |   | 6.44 |   |   | 209,796 |   |   | 6.48 |   |   |
| $8.05 - $9.90                               |       | 1,052,137                    |       |   | 5.81 |   |   |   | 8.10 |   |   | 423,186 |   |   | 8.17 |   |   |
| $12.49 - $17.84                             |       | 1,015,635                    |       |   | 4.32 |   |   |   | 16.47 |   |   | 529,604 |   |   | 16.49 |   |   |
| $18.21 - $24.88                             |       | 200,418                      |       |   | 4.92 |   |   |   | 22.74 |   |   | 26,147 |   |   | 19.23 |   |   |
|                                        |       | 3,571,799                    |       |   | 5.04 |   |   |   | $ | 10.48 |   |   | 1,382,857 |   |   | $ | 10.60 |   |   |

 

**(7)   Income Taxes**

Componentsof income (loss) before income taxes for the years ended December 31, 2006, 2005and 2004 are as follows:

| ** **    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| United States |       | $        | (232,017   | )        | $          | (6,060   | )          | $ | 56 |   |
| Foreign       |       | (23,981  | )          | 11,292   |       | 912      |       |
|          |       | $        | (255,998   | )        | $          | 5,232    |       | $ | 968 |   |

 

The provision forincome taxes consists of the following for the years ended December 31,2006, 2005 and 2004.

| ** **      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|----------|------------|
| Current:        |       |     |       |     |       |     |       |
| Federal         |       | $        | 200        |     | $          | 2,816    |       | $ | 699 |   |
| State           |       | —   |       | 767      |       | 436      |       |
| Foreign         |       | 28       |       | 669      |       | 119      |       |
| Total current   |       | 228      |       | 4,252    |       | 1,254    |       |
| Deferred:       |       |     |       |     |       |     |       |
| Federal         |       | 410      |       | 692      |       | (2,241   | )          |
| State           |       | 532      |       | (469     | )          | (464     | )          |
| Foreign         |       | 1,290    |       | 3,414    |       | 229      |       |
| Total deferred  |       | 2,232    |       | 3,637    |       | (2,476   | )          |
| Total provision |       | $        | 2,460      |     | $          | 7,889    |       | $ | (1,222 | ) |

 

 

79

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Actualincome taxes varied from the expected income taxes (computed by applying thestatutory income tax rate of 34% for 2006 and 35% for 2005 and 2004 to incomebefore income taxes) as a result of the following:

| ** **                                                       | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected tax  expense (benefit)                                  |       | $                                           | (87,040    | ) | $ | 1,831 |   | $ | 339 |   |
| Total increase in income  taxes resulting from:                  |       |                                        |       |   |   |   |   |
| Nondeductible amortization and acquired in-process  technology   |       | —                                      |       | 4,566 |   | — |   |
| Nondeductible impairment of goodwill                             |       | 75,277                                      |       | — |   | — |   |
| Change in valuation allowance allocated to income  tax expense   |       | 14,353                                      |       | — |   | — |   |
| Extraterritorial income tax benefit                              |       | (219                                        | )          | (323 | ) | (1,457 | ) |
| Research and experimentation credit                              |       | (209                                        | )          | — |   | (228 | ) |
| Employee stock options                                           |       | 896                                         |       | — |   | — |   |
| Nondeductible expenses                                           |       | 175                                         |       | 173 |   | (39 | ) |
| Foreign income taxes, net of federal income tax  benefit         |       | 7                                           |       | (407 | ) | 74 |   |
| State and local income taxes, net of federal income  tax benefit |       | (491                                        | )          | 194 |   | (18 | ) |
| Foreign income tax rate differential                             |       | (565                                        | )          | 183 |   | 15 |   |
| Business combination tax restructuring                           |       | —                                      |       | 1,308 |   | — |   |
| Other                                                            |       | 276                                         |       | 364 |   | 92 |   |
| Actual income tax  expense (benefit)                             |       | $                                           | 2,460      |   | $ | 7,889 |   | $ | (1,222 | ) |

 

80

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

The tax effects oftemporary differences that give rise to significant portions of the deferredtax assets and deferred tax liabilities at December 31, 2006 and 2005 arepresented below:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets:                               |       |                  |       |   |   |
| Accrued wages                                      |       | $                     | 1,175      |   | $ | 1,110 |   |
| Deferred revenue                                   |       | —                |       | 5,561 |   |
| Depreciation                                       |       | 1,086                 |       | 662 |   |
| Research and experimentation credit carry forwards |       | 4,140                 |       | 3,956 |   |
| Other credit carry forwards                        |       | 1,515                 |       | 1,470 |   |
| Net operating loss carry forwards                  |       | 11,872                |       | 8,588 |   |
| Foreign net operating loss carry forwards          |       | 19,230                |       | 11,950 |   |
| Nonqualified stock options                         |       | 1,381                 |       | — |   |
| Other                                              |       | 2,727                 |       | 1,743 |   |
| Total gross  deferred tax assets                   |       | 43,126                |       | 35,040 |   |
| Less: asset  valuation allowance                   |       | (29,763               | )          | (15,410 | ) |
| Net deferred tax  asset                            |       | 13,363                |       | 19,630 |   |
| Deferred tax  liabilities:                         |       |                  |       |   |   |
| Software development costs and intangible assets   |       | (5,490                | )          | (6,394 | ) |
| Intangibles—customer contracts                |       | (3,884                | )          | (4,929 | ) |
| Other                                              |       | (490                  | )          | (585 | ) |
| Total gross  deferred liabilities                  |       | (9,864                | )          | (11,908 | ) |
| Net deferred tax  asset                            |       | $                     | 3,499      |   | $ | 7,722 |   |
| Included on  balance sheet:                        |       |                  |       |   |   |
| Current assets: Deferred income taxes              |       | $                     | 196        |   | $ | 11,213 |   |
| Non-current asset: Deferred income taxes           |       | 3,303                 |       | — |   |
| Non-current liabilities: Deferred income taxes     |       | —                |       | (3,491 | ) |
| Net deferred  income taxes                         |       | $                     | 3,499      |   | $ | 7,722 |   |

 

The increase in the valuation allowance for the yearsending December 31, 2006, 2005 and 2004 were, $14,353, $15,410 and $0, respectively.Management has an obligation under SFAS109*, Accounting for Income Taxes,* toreview, at least annually, the components of our deferred tax assets. Thisreview is to ascertain that, based upon the information available at the timeof the preparation of financial statements, it is more likely than not, that weexpect to utilize these future deductions and credits. In the event thatmanagement determines that it is more likely than not these future deductions,or credits, will not be utilized, a valuation allowance is recorded, reducingthe deferred tax asset to the amount expected to be realized.

Management’s analysis for 2006 determined that avaluation allowance of $29,763 is necessary at December 31, 2006 for amajority of our Canadian and U.S. deferred tax assets. This decision is based uponmany factors, both quantitative and qualitative, such as (1) substantialcurrent year losses, (2) significant unutilized operating loss and creditcarryforwards, (3) lack of any cash refund carryback 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

opportunities, (4) uncertainfuture operating profitability, (5) substantial organization and operatingrestructuring, and (6) unsettled resolution of ongoing regulatoryinquiries and litigation which may adversely affect operations in future years.

The income tax benefit of excess tax benefits relatedto nonqualified stock option exercises and disqualifying dispositions ofemployee incentive stock options during 2006, 2005, and 2004 were $988, $1,811and $595, respectively. Under SFAS No. 123(R) the income tax benefitrelated to excess tax benefits occurring in 2006 will be credited topaid-in-capital when recognized by reducing taxes payable.

At December 31, 2006, we had federal netoperating loss carryforwards and research credit carryforwards of $30,605 and$2,510, respectively, state net operating loss carryforwards and researchcredit carryforwards of $17,453 and $25, respectively, foreign tax credits of$1,034, foreign federal and provincial net operating loss carryforwards of $57,119and $45,485, respectively, and foreign federal and provincial research creditscarryforwards of $1,358 and $272, respectively.

These losses and credits are available to offsettaxable income and tax in the future. The federal net operating loss andresearch credit carryforwards expire at varying amounts beginning in 2007 and2012, respectively, and continuing through 2023 and 2026, respectively. Thestate net operating loss carryforwards expire in varying amounts beginning in2007, and continuing through 2026. The foreign tax credits expire in varyingamounts beginning in 2007, and continuing through 2016. The foreign federal andprovincial net operating loss carryforwards expire in varying amounts beginningin 2007 and 2008, respectively, and continuing through 2016. Of the foreignfederal net operating loss carryforwards noted above, approximately $27,254expires on December 31, 2007.

Under the Tax Reform Act of 1986 (“Code”), the amountsof, and the benefits from, net operating loss carryforwards may be limited orimpaired in certain circumstances, *i.e.*,Code section 382, tax benefit limitations after change in ownership. The timingand manner in which we will be able to utilize the acquired entities net operatingloss and research and development credit carryforwards will be subject to theserules. In addition, we experienced an ownership change, as defined underTreasury regulations, on June 1, 2005. If certain additional changes inour ownership should occur, net operating loss and credit carryforwards may be furtherlimited.

We have recorded incometax expense on all profits, except for undistributed profits of non-U.S.subsidiaries, which are considered indefinitely reinvested. Determination ofthe amount of unrecognized deferred tax liability related to indefinitelyreinvested profits is not feasible.

**(8)   Leases**

We have non-cancelable operating leases at variouslocations. Our headquarters in Milwaukee, Wisconsin, has approximately 36,000square feet and is leased through April 2011. We also have significantfacilities in Mississauga, Ontario, Canada, which has approximately 75,000square feet (of which approximately 15,000 is sub-leased) and is leased throughDecember 2009, and in Burlington, Massachusetts, which has approximately24,000 square feet and is leased through October 2008.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Total rent expense for theyears ended December 31, 2006, 2005 and 2004 were $1,389, $1,473 and $324,respectively, net of sub-lease income of $180. Future minimum lease paymentsunder all non-cancelable operating leases (with initial or remaining lease termsin excess of one year), net of sub-lease income that is contractually owed tous of $180 in each of 2007, 2008 and 2009, as of December 31, 2006, are:

| 2007                          |   | $     | 2,110  |   |
|-------------------------------|--------|-------|--------|--------|
| 2008                          |   | 2,052 |   |
| 2009                          |   | 1,512 |   |
| 2010                          |   | 585   |   |
| 2011                          |   | 305   |   |
| Thereafter                    |   | 252   |   |
| Total minimum lease  payments |   | $     | 6,816  |   |

 

**(9)   Commitments andContingencies**

Between March 22, 2006 and April 26, 2006,seven putative securities class action lawsuits were filed in the United StatesDistrict Court for the Eastern District of Wisconsin, on behalf of a class ofpersons who acquired shares of our Common Stock between August 2, 2005 andMarch 16, 2006. Defendants in the suit include us, Richard A. Linden, ourformer President and Chief Executive Officer, and Scott T. Veech, our formerChief Financial Officer; one of the suits also names Brian E. Pedlar, formerPresident of Cedara Software and our former Senior Vice President, who servedas our interim co-President and co-Chief Executive Officer from July 2,2006 to August 18, 2006. One case has been voluntarily dismissed. Thecases arise out of our March 17, 2006 announcement that that we wouldrevise our results of operations for the fiscal quarters ended June 30,2005 and September 30, 2005, as well as our investigation of allegationsmade in anonymous letters received by us. The lawsuits allege that we andindividual defendants violated Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934 (the “Exchange Act”). The complaints seekdamages in unspecified amounts. On November 22, 2006, the Courtconsolidated the seven cases and appointed the Southwest Carpenters PensionTrust to be the lead plaintiff and approved the Trust’s choice of its leadcounsel. Pursuant to court order, the lead plaintiff is currently required tofile its Amended Complaint on or before March 19, 2007. We intend tovigorously defend these lawsuits, including, but not limited to, possiblymoving to dismiss the consolidated amended complaint when filed.

On August 28, 2006, a derivative action was filedin the Circuit Court of Milwaukee County, Civil Division, against Messrs. Linden,Mortimore and Veech and all of the then-current members of our Board ofDirectors. The plaintiffs allege that each of the individual defendantsbreached fiduciary duties to us by violating generally accepted accountingprinciples, willfully ignoring problems with accounting and internal controlpractices and procedures and participating in the dissemination of falsefinancial statements and also allege that we and the current directordefendants failed to hold an annual meeting of shareholders for 2006 inviolation of Wisconsin law. The plaintiffs ask for unspecified amounts indamages and costs, as well as equitable relief. In response to the filing ofthis action, our Board of Directors formed a Special Litigation Committee,which Committee has full authority to review the allegations of the derivative complaintand determine whether pursuit of the claims against any or all of theindividual defendants would be in our best interest. The Special LitigationCommittee’s investigation is substantially complete. 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Pursuant to stipulationsamong the parties and order of the court, the plaintiff has dismissed the claimseeking to require us to hold an annual meeting of shareholders, and thedefendants’ deadline to move, answer or otherwise respond to the remainder ofoperative complaint has been extended to April 16, 2007.

On April 27, 2006, we received an informal,nonpublic inquiry from the SEC requesting voluntary production of documents andother information. The inquiry principally relates to our announcement on March 17,2006 that we would revise our results of operations for the fiscal quartersended June 30, 2005 and September 30, 2005, as well as ourinvestigation of allegations made in anonymous letters received by us. The SEChas advised us that this inquiry should not be interpreted as an adversereflection on any entity or individual involved, nor should it be interpretedas an indication by the SEC that any violation of the federal securities lawshas occurred. We are cooperating with the SEC.

In March 2006, a patent infringement lawsuitfiled against us by ScheduleQuest, Inc. was dismissed.

We and our Cedara subsidiary were formerly defendantsin an action commenced by Brian Pedlar. Mr. Pedlar was formerly thePresident of Cedara (since the closing of our merger with Cedara) and served,from July 2, 2006, until his departure on August 18, 2006, as co-CEOand co-President of Merge Healthcare. In September 2006, Mr. Pedlarfiled suit in Ontario, Canada, against us and Cedara claiming that he had beenconstructively discharged from his positions, and that we had defamed him indescribing his departure in our public releases and filing with SEC. Withoutadmitting any of the allegations of his complaint, on February 22, 2007,we agreed with Mr. Pedlar to settle this suit. Pursuant to the settlement,we agreed to pay Mr. Pedlar approximately $500 (less required taxwithholding) and also agreed to pay approximately $80 to Mr. Pedlar’scounsel in payment of his attorneys fees and expenses in his employmentproceedings. We have accrued for these amounts as of December 31, 2006 andrecorded the expense in General and Administrative Expenses. The settlementalso included customary provisions addressing non-disparagement, confidentiality,mutual release and of the dismissed legal action.

We, and our subsidiaries,are from time to time parties to legal proceedings, lawsuits and other claimsincident to our business activities. Such matters may include, among otherthings, assertions of contract breach or intellectual property infringement,claims for indemnity arising in the course of our business and claims bypersons whose employment has been terminated. Such matters are subject to manyuncertainties and outcomes are not predictable with assurance. Consequently, weare unable to ascertain the ultimate aggregate amount of monetary liability,amounts which may be covered by insurance or recoverable from third parties, orthe financial impact with respect to these matters as of the date of thisreport.

**(10)   Restructuring**

We incurred $2,725 and $530 of restructuring chargesin the twelve months ended December 31, 2006, and 2005, respectively ingoodwill impairment, restructuring charges and other expenses in the Statementof Operations. Restructuring charges in 2006 are comprised of termination costsof $2,666 and contract termination costs of $59 associated with our decision inthe fourth quarter of 2006, to reorganize and consolidate our operations. As aresult, approximately 150 individuals (including temporary persons andconsultants) were terminated, we ceased use of our San Francisco and Tokyofacilities and downsized operations in Burlington, MA, Cleveland, OH, andMississauga, Ontario. We expect to incur approximately $580 of additionalseverance costs in 2007 related to the Q4 2006 restructuring plan as suchseverance costs require the employees to render services through a retentionperiod.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Restructuring charges in 2005 are comprised of leaseexit costs associated with the settlement of our lease of approximately $175,which we ceased using during 2005 as we combined two of our offices located inthe same geographic region, severance to involuntarily terminated employees of$263 and option acceleration expense of $92 related to such employees, based onthe intrinsic value of options at the time of termination.

Thefollowing table shows the restructure activity for 2006 and 2005:  

| ** **                         | ** ** | **Accrued  Restructuring** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| Balance at  December 31, 2004 |       |                       | $          | — |   |   |
| Charges to  expense                |       |                       | 530        |   |   |
| Payments                           |       |                       | (338       | ) |   |
| Balance at  December 31, 2005 |       |                       | $          | 192 |   |   |
| Charges to  expense                |       |                       | 2,725      |   |   |
| Payments                           |       |                       | (920       | ) |   |
| Balance at  December 31, 2006 |       |                       | $          | 1,997 |   |   |

 

At December 31, 2006,the remaining costs consist of severance and as such are classified withinaccrued wages. At December 31, 2005, the charges consisted of our leasesettlement and, as such, was classified within other accrued liabilities.

**(11)   Shareholders’Equity**

*(a) CommonStock*

On May 24, 2005, our shareholders approved anamendment to our Articles of Incorporation to increase the number of authorizedshares of Common Stock from 30 million to 100 million.

In June 2005, we issued 5,581,517 shares of ourCommon Stock to the shareholders of Cedara Software and 13,210,168 Merge CedaraExchangeCo Exchangeable Shares to Canadian shareholders of Cedara Software.Through December 31, 2006, 8,642,013 Merge Cedara ExchangeCo ExchangeableShares were exchanged for an equal number of shares of our Common Stock.

In October 2005, 90,000 shares of our CommonStock previously held in escrow in connection with our acquisition of RIS Logicin 2003 were returned to us as consideration for the release of RIS Logic’swarranty and indemnification requirements under the merger agreement and suchshares were retired as of December 31, 2005.

On September 6, 2006,we announced a stock repurchase plan providing for the purchase of up to$20,000 of our Common Stock over a two-year period. As of December 31,2006, we have not made any repurchases under this plan.

*(b) SpecialVoting Preferred Stock*

During 2004, the one shareissued to our former transfer agent, which served as a trustee in votingmatters on behalf of the Interpra Medical Network Systems Ltd. exchangeableshareholders, was retired.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

*(c) Series 2Special Voting Preferred Stock*

During 2004, the one shareissued to our former transfer agent, which served as a trustee in votingmatters on behalf of the eFilm exchangeable shareholders, was retired.

*(d) Series 3Special Voting Preferred Stock*

In June 2005, weissued one share of Series 3 Special Voting Preferred Stock toComputershare Trust Company of Canada, which serves as a trustee in votingmatters on behalf of the holders of Merge Cedara ExchangeCo exchangeableshares. As of December 31, 2006, this share was issued and outstanding.

*(e) Series BJunior Participating Preferred Stock*

On September 6, 2006, we announced the implementationof a Shareholder Rights Plan. The Shareholder Rights Plan includes thedeclaration of a dividend of one preferred share purchase right on eachoutstanding share of our Common Stock and the distribution of one such rightwith respect to each outstanding exchangeable share of our subsidiary, MergeCedara ExchangeCo Limited. The issuance of the rights under the plan was madeon October 2, 2006, to shareholders of record at the close of business on September 25,2006. The adoption of the plan was intended to discourage discriminatory,coercive or unfair take-over bids and to provide the Board of Directors time topursue alternatives to maximize shareholder value in the event of anunsolicited take-over bid. The rights will become exercisable if a third party,person or group (subject to certain exceptions) acquires 15% or more of ourCommon Stock outstanding or announces a tender offer, consummation of whichwould result in ownership by a person or group of 15% or more of our CommonStock. Upon such a triggering event, each right will initially entitle theholder to purchase one one-hundredth of one share of our Series BPreferred Stock. If any person becomes a 15% or more holder of our CommonStock, each right will entitle the other holders to purchase our Common Stock,or the stock of the acquirer, at half of their respective then-applicablemarket price. We may also redeem the rights for $0.001 per right.

The rights were not issuedin response to any specific threat, and our Board is not aware of any suchthreat. The rights will expire on October 2, 2016, subject to extension. TheShareholder Rights Plan contains a so-called TIDE provision which requiresindependent directors to review the plan every three years to determine whetherit continues to be in shareholders’ best interest.

*(f) StockOption Plans*

On May 24, 2005, ourshareholders approved our 2005 Equity Incentive Plan (“EIP”). The EIP providesfor awards of Common Stock, non-statutory stock options, incentive stockoptions, stock unit and performance unit grants and stock appreciation rightsto eligible participants to equate to a maximum of 7.5 million shares ofour Common Stock, of which incentive stock option grants are limited to 5.0million shares. Under the EIP, new stock option grants have an exercise priceequal to the fair market value of our Common Stock at the date of grant. TheEIP includes options granted to replace existing Cedara Software Corp. options(“Replacement Options”) and new option grants. Replacement Options were grantedpursuant to the merger agreement with the same economic terms, as adjusted forconversion ratio and currency. The majorityof these options vest over a three or four-year period. As of December 31,2006, incentive stock options to purchase 464,500 shares of our Common Stockand non-statutory stock options topurchase 2,656,875 shares of our Common Stock were outstanding under this plan.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Our 1996 Employee Stock Option Plan provided for thegrant of options to purchase a maximum of 3,265,826 shares of our Common Stock.Under this plan, options have an exercise price equal to the fair market valueof our Common Stock at the date of grant. The majority of the options vest overa four-year period at 25% per year. The majority of the options granted underthis plan expire six years from the date of grant. At December 31, 2006,there were 801,556 shares of our Common Stock available for option grants underthis plan, however, we do not plan on issuing any more options under this plan.At December 31, 2006, options to purchase 285,243 shares of ourCommon Stock were outstanding under this plan.

Our 1998 Director Stock Option Plan, for ournon-employee directors, provided for the granting of options to purchase amaximum of 300,000 shares of our Common Stock. Under this plan, optionshave an exercise price equal to the fair market value of our Common Stock atthe date of grant. The majority of options granted under this plan fully vestedat the date of grant. Any expired or forfeited options granted under this planare not eligible for re-issuance. The options granted under this plan expireten years and one day from the date of grant. At December 31, 2006, therewere 9,592 shares of Common Stock available for option grants; however, wedo not plan on issuing any more options under this plan. At December 31,2006, options to purchase 130,411 shares of our Common Stock wereoutstanding under this plan.

Our Board of Directorsadopted an equity compensation plan in connection with our acquisition on July 17,2003 of RIS Logic. At December 31, 2006, options to purchase34,770 shares of our Common Stock were outstanding under this plan.

*(g) StockPurchase Plan*

We maintain an employee stock purchase plan thatallowed employees to purchase stock at a 5% discount from the market price atthe end of each calendar quarter during the last quarter of 2006 and the lastthree quarters of 2005. During 2004 and the first quarter of 2005, employeespurchased stock at the lesser of the stock price at the start of each calendarquarter or the end of each calendar quarter. Contributions to the employeestock purchase plan are made through payroll deductions. Employees contributed$33, $65 and $68 during 2006, 2005 and 2004, respectively, to purchase sharesof our Common Stock under the employee stock purchase plan.

As of March 17, 2006,use of our registration statement on Form S-8 relating to theissuance of Common Stock was suspended. Consequently, all 2006 contributionsunder this plan were returned and the plan was suspended. Contributions wereresumed during the fourth quarter of 2006.

*(h) ExchangeRights*

As part of our businesscombination with Cedara Software, we granted rights for the issuance of13,210,168 shares of Common Stock to holders of Cedara Software exchangeableshares on a one-for-one basis. As of December 31, 2006, there were 4,568,155Cedara Software exchangeable shares outstanding. We have the right to redeemall of the exchangeable shares at anytime after April 29, 2010 or if lessthan 10% of the number of exchangeable shares issued on the effective date ofthe business combination remain outstanding, provided that we give sixty daysadvance written notice.

As of March 17, 2006,our registration statement on Form S-3 relating to issuance of ourCommon Stock upon exchange of exchangeable shares was suspended. On February 13,2007, we filed the Final 

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Prospectusrelated to this registration of our Common Stock, following the SEC’s Notice ofEffectiveness on February 9, 2007. As a result, the exchangeable shares ofMerge Cedara ExchageCo Limited may once again be converted into the CommonStock of Merge on a one-to-one basis.

**(12)   EmployeeBenefit Plan**

We maintain defined contribution retirement plans (401(k) profitsharing plan for the U.S. employees and RRSP for the Canadian employees),covering employees who meet the minimum service requirements and have electedto participate. We made matching contributions (under the 401(k) profitsharing plan for the U.S. employees and DPSP for the Canadian employees) equalto a maximum of 3.0% in 2006 and 2005, and 2.5% in 2004. Our matchingcontributions totaled $806, $415 and $203 for the years ended December 31,2006, 2005 and 2004, respectively.

In 2005, we also paid adiscretionary profit sharing contribution of $120 that was accrued for at December 31,2004 under these plans.

**(13)   Concentrationsof Risk**

*(a) Cash inExcess of Federally Insured Amount*

Substantially all of ourcash and cash equivalents are held at a few financial institutions located inthe U.S., Canada and the Netherlands. Deposits held with these banks exceed theamount of insurance provided on such deposits. Generally these deposits may beredeemed upon demand and, therefore, bear minimal risk.

*(b) Net Sales and Accounts Receivable*

The majority of ourclients are OEM’s, imaging centers, hospitals and integrated delivery networks.If significant adverse macro—economic factors were to impact theseorganizations, it could materially adversely affect us. Our access to certainsoftware and hardware components is dependent upon single and sole sourcesuppliers. The inability of any supplier to fulfill our supply requirementscould affect future results.

Foreign sales, denominatedin U.S. Dollars, accounted for approximately 18%, 40% and 32% of our net salesfor the years ended December 31, 2006, 2005 and 2004, respectively. Forthe years ended December 31, 2006, 2005 and 2004, sales in foreigncurrency represented 4%, 4% and 13%, respectively, of our net sales.

For the years ended December 31, 2006, 2005 and2004, we had zero, two and one individual customer that represented more than10% of net sales. For the year ended December 31, 2005, Toshiba MedicalSystems Corporation and Hitachi Medical Corporation accounted for 16% and 10%,respectively, of net sales. For the years ended December 31, 2004, PhilipsMedical Systems accounted for 10% of net sales. We had one customer, HitachiMedical Corporation, which comprised 27% of the total accounts receivable as of December 31, 2005. Noindividual customer accounted for more than 10% of our total accountsreceivable as of December 31, 2006.

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**Merge Technologies Incorporated Notes to Consolidated Financial Statements (Continued) (in thousands, except for share and per share data)**

Thefollowing tables present certain geographic information, based on location ofcustomer:

| ** **                | ** ** | **Net Sales** | ** ** |
|---------------------------|------------|--------------------|------------|
| ** **                | ** ** | **2006**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States of  America |       | $                  | 61,467     |   | $ | 49,244 |   | $ | 17,965 |   |
| Japan                     |       | 3,394              |       | 24,377 |   | 1,122 |   |
| Europe                    |       | 7,024              |       | 6,626 |   | 4,704 |   |
| Canada                    |       | 2,052              |       | 1,877 |   | 2,458 |   |
| Other                     |       | 1,105              |       | 477 |   | 98 |   |
| Total net sales           |       | $                  | 75,042     |   | $ | 82,601 |   | $ | 26,347 |   |

 

| ** **                | ** ** | **Long-Lived Assets** | ** ** |
|---------------------------|------------|----------------------------|------------|
| ** **                | ** ** | **2006**                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States of  America |       | $                          | 2,576      |   | $ | 2,889 |   | $ | 1,128 |   |
| Canada                    |       | 1,096                      |       | 1,504 |   | 338 |   |
| Europe                    |       | 231                        |       | 45 |   | 28 |   |
| Other                     |       | 37                         |       | 2 |   | 4 |   |
|                           |            |                            |            |  |  |  |  |  |  |  |

 

Long-lived assetsrepresent property, plant and equipment, net of related depreciation.****Long-lived assets in service at the China office werenot material as of December 31, 2006 and 2005.

**(14)   QuarterlyResults (unaudited)**

| ** **                | ** ** | **2006 Quarterly Results** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **March 31**                    | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31(1)** | ** ** |
| Net sales                 |       |                                 | $          | 16,196 |   |   | $ | 31,722 |   |   | $ | 13,950 |   |   |   | $ | 13,174 |   |   |
| Loss before  income taxes |       |                                 | (6,718     | ) |   | (214,409 | ) |   | (9,963 | ) |   |   | (24,908 | ) |   |
| Net loss                  |       |                                 | (4,900     | ) |   | (215,769 | ) |   | (10,751 | ) |   |   | (27,038 | ) |   |
| Basic loss per  share     |       |                                 | $          | (0.15 | ) |   | $ | (6.41 | ) |   | $ | (0.32 | ) |   |   | $ | (0.80 | ) |   |
| Diluted loss per  share   |       |                                 | (0.15      | ) |   | (6.41 | ) |   | (0.32 | ) |   |   | (0.80 | ) |   |

 

| ** **                         | ** ** | **2005 Quarterly Results** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **March 31**                    | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Net sales                          |       |                                 | $          | 6,937 |   |   | $ | 15,161 |   |   | $ | 35,043 |   |   |   | $ | 25,460 |   |   |
| Income (loss)  before income taxes |       |                                 | 254        |   |   | (14,011 | ) |   | 14,973 |   |   |   | 4,016 |   |   |
| Net income (loss)                  |       |                                 | 165        |   |   | (15,201 | ) |   | 9,600 |   |   |   | 2,779 |   |   |
| Basic income  (loss) per share     |       |                                 | $          | 0.01 |   |   | $ | (0.79 | ) |   | $ | 0.30 |   |   |   | $ | 0.08 |   |   |
| Diluted earnings (loss)  per share |       |                                 | 0.01       |   |   | (0.79 | ) |   | 0.28 |   |   |   | 0.08 |   |   |

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(1)         Includesa $1,970 adjustment, recorded in the fourth quarter, related to the goodwillimpairment charge recorded in the second quarter. The correction resulted in anincrease to goodwill impairment, restructuring charges and other expenses inthe amount of $1,970.

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**Item 9.**                        CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**Item 9A.**                CONTROLSAND PROCEDURES

**(a)**          DisclosureControls and Procedures

Disclosure controls and procedures are controls andother procedures of a registrant designed to ensure that information requiredto be disclosed by the registrant in the reports that it files or submits underthe Exchange Act is properly recorded, processed, summarized and reported,within the time periods specified in the Securities and Exchange Commission’s (“SEC”)rules and forms. Disclosure controls and procedures include processes toaccumulate and evaluate relevant information and communicate such informationto a registrant’s management, including its principal executive and financialofficers, as appropriate, to allow for timely decisions regarding requireddisclosures.

We evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2006, as required by Rule 13a-15of the Exchange Act. This evaluation was carried out under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer. As described below, under “Management’sReport on Internal Control Over Financial Reporting,” material weaknesses wereidentified in our internal control over financial reporting as of December 31,2006 relating to our control environment, revenue recognition, accounting for incometaxes, accounting for business combinations and the implementation of a new accountingsystem. Based on the evaluation described above, our principal executiveofficer and principal financial officer have concluded that, as of December 31,2006, our disclosure controls and procedures were not effective to ensure (1) thatinformation required to be disclosed by us in the reports we file or submitunder the Exchange Act is recorded, processed, summarized and reported, withinthe time periods specified in the SEC’s rules and forms, and (2) informationrequired to be disclosed by us in our reports that we file or submit under theExchange Act is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer, or personsperforming similar functions, as appropriate to allow timely decisionsregarding required disclosure.

**(b)**          Management’sReport on Internal Control Over Financial Reporting

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting. Our internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof our financial statements for external reporting purposes in accordance withGAAP.

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internalcontrol over financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible todesign into the process safeguards to reduce, though not eliminate, this risk.

A material weakness in internal control over financialreporting (as defined in Auditing Standard No. 2 of the Public CompanyAccounting Oversight Board) is a significant deficiency, or combination ofsignificant deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected. A significant deficiency is a 

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control deficiency, orcombination of control deficiencies, that adversely affects a company’s abilityto initiate, authorize, record, process or report external financial datareliably in accordance with GAAP such that there is more than a remotelikelihood that a misstatement of the company’s annual or interim financialstatements that is more than inconsequential will not be prevented or detected.

Management assessedthe effectiveness of our internal control over financial reporting as of December 31,2006, using the criteria set forth by the Committee of Sponsoring Organizationsof the Treadway Commission (“COSO”) in *Internal Control—IntegratedFramework*. In assessing the effectiveness of our internal controlover financial reporting, management identified the following materialweaknesses in internal control over financial reporting as of December 31,2006:

1.                We did notmaintain an effective  controlenvironment. Specifically, we lacked an appropriate control consciousness andsufficient resources to address and remediate certain control deficiencies on atimely basis. These deficiencies resulted in more than a remote likelihood thata material misstatement of our annual or interim financial statements would notbe prevented or detected.

2.                We did notmaintain effective policies and procedures relating to revenue recognition.Specifically, the lack of effective policies and procedures surrounding thereview and determination of revenue recognition associated with our salescontracts and accurate recording of revenue contributed to incorrectrecognition of revenue in our preliminary 2006 consolidated financialstatements, which were corrected prior to issuance. These deficiencies resultedin more than a remote likelihood that a material misstatement of our annual orinterim financial statements would not be prevented or detected.

3.                We did notmaintain effective policies and procedures relating to the preparation ofcurrent and deferred income tax provisions and related balance sheet accounts.Specifically, we did not prepare account analyses and perform account reconciliationprocedures in a timely manner. In addition we lacked sufficient personnel with institutionalknowledge and technical expertise in the accounting for income taxes. Thesedeficiencies resulted in more than a remote likelihood that a materialmisstatement of our annual or interim financial statements would not beprevented or detected.

4.                We did notmaintain effective policies and procedures over the accounting for businesscombinations. Specifically, we did not have formal policies and procedures toprovide for sufficient analysis to identify all net assets acquired in a priorperiod business combination and allowable adjustments to goodwill, whichresulted in an adjustment to correct an error that we have recorded in thefourth quarter of 2006 in our consolidated financial statements. Thesedeficiencies resulted in more than a remote likelihood that a materialmisstatement of our annual or interim financial statements would not beprevented or detected.

5.                We did notmaintain effective policies and procedures over the implementation of our new accountingsystem for our U.S. operations, which we commenced in the fourth quarter.Specifically, we failed to apply  procedures with respect to program developmentto ensure that certain financial reports that impact our financial reportingwere developed and maintained appropriately. As a result, controls over theaccess to, and completeness, accuracy and validity of transactions processedthrough and reports generated from our accounting system were not designedappropriately or did not operate as designed. These deficiencies resulted inmore than a remote likelihood that a material misstatement of our annual orinterim financial statements would not be prevented or detected and contributedto the revenue recognition deficiency described above.

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As a result of the material weaknesses describedabove, our management concluded that we did not maintain effective internalcontrol over financial reporting as of December 31, 2006, based on thecriteria established by COSO.

KPMG LLP, our independentregistered public accounting firm that audited our consolidated financialstatements included in this Annual Report on Form 10-K, has issuedan audit report on management’s assessment of our internal control overfinancial reporting. This report can be found below.

**(c)**           Reportof Independent Registered Public Accounting Firm

The Board of Directors and ShareholdersMerge Technologies Incorporated:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting (Item 9A(b)), that Merge Technologies Incorporated (the Company) didnot maintain effective internal control over financial reporting as of December 31,2006, because of the effect of material weaknesses identified in management’sassessment, based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO)*.*The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

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

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A material weaknessis a control deficiency, or combination of control deficiencies, that resultsin more than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected. The followingmaterial weaknesses have been identified and included in management’sassessment:

1.                The Company didnot maintain an effective control environment. Specifically, the Company lackedan appropriate control consciousness and sufficient resources to address andremediate certain control deficiencies on a timely basis. These deficienciesresulted in more than a remote likelihood that a material misstatement of theCompany’s annual or interim financial statements would not be prevented ordetected.

2.                The Company didnot maintain effective policies and procedures relating to revenue recognition.Specifically, the lack of effective policies and procedures surrounding thereview and determination of revenue recognition associated with the Company’s  sales contracts and accurate recording ofrevenue contributed to incorrect recognition of revenue in the Company’spreliminary 2006 consolidated financial statements. These deficiencies resultedin more than a remote likelihood that a material misstatement of the Company’sannual or interim financial statements would not be prevented or detected.

3.                The Company didnot maintain effective policies and procedures relating to the preparation ofcurrent and deferred income tax provisions and related balance sheet accounts.Specifically,the Company did not prepare account analyses and perform accountreconciliation procedures in a timely manner. In addition, the Company lacked sufficientpersonnel with institutional knowledge and technical expertise in theaccounting for income taxes. These deficiencies resulted in more than a remotelikelihood that a material misstatement of the Company’s annual or interimfinancial statements would not be prevented or detected.

4.                The Company didnot maintain effective policies and procedures over the accounting for businesscombinations. Specifically, the Company did not have formal policies andprocedures to provide for sufficient analysis to identify all net assetsacquired in a prior period business combination and allowable adjustments togoodwill, which resulted in an error in the Company’s preliminary 2006financial statements. These deficiencies resulted in more than a remotelikelihood that a material misstatement of the Company’s annual or interimfinancial statements would not be prevented or detected.

5.                The Company didnot maintain effective policies and procedures over the implementation of theCompany’s new accounting system for the Company’s U.S. operations, which theCompany commenced in the fourth quarter. Specifically, the Company failed toapply procedures with respect to program development to ensure that certainfinancial reports that impact the Company’s financial reporting were developedand maintained appropriately. As a result, controls over the access to, andcompleteness, accuracy and validity of transactions processed through andreports generated from the Company’s accounting  system were not designed appropriately or didnot operate as designed. These deficiencies resulted in more than a remotelikelihood that a material misstatement of the Company’s annual or interimfinancial statements would not be prevented or detected and contributed to therevenue recognition deficiency described above.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof December 31, 2006, is fairly stated, in all material respects, based oncriteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Also, in our opinion, because of the effect of thematerial weakness described above on the achievement of the objectives of thecontrol criteria, the Company has not maintained effective internal controlover financial reporting as of December 31, 2006, 

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based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the accompanying consolidatedbalance sheets of Merge Technologies Incorporated and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations,shareholders’ equity, comprehensive income (loss), and cash flows for each ofthe years in the three-year period ended December 31, 2006. Theaforementioned material weaknesses were considered in determining the nature,timing, and extent of audit tests applied in our audit of the 2006 consolidatedfinancial statements, and this report does not affect our report dated March 8,2007, which expressed an unqualified opinion on the consolidated financialstatements.

| /s/ KPMG LLP   |
|---------------------|
| Chicago, Illinois   |
| March 8,  2007 |

 

**(d)**          Changesin Internal Control Over Financial Reporting

The followingsignificant changes in our internal control over financial reporting occurredduring the quarter ended December 31, 2006 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting:

1.                Wehave restructured our organization such that we have three business units, withpresidents, that report to our CEO and controllers that report to members ofthe finance department under the direct responsibility of the Chief AccountingOfficer.

2.                Wehave created an internal audit function that reports directly to the AuditCommittee of our Board of Directors and is responsible for, among other things,a quarterly review of each of our sales contracts under which we expect to receiverevenue in excess of $100,000.

3.                Wecommenced an accounting system replacement initiative for our U.S. operations. Theproject scope includes a replacement of certain aspects of our financialsystems (general ledger, accounts payable, accounts receivable, order entry andfulfillment) as a first phase of the overall project plan. The above namedaspects of our financial systems and related control processes and procedureswere operating, to a limited extent, as of December 31, 2006.

**(e)**        Remediation Efforts toAddress Material Weaknesses in Internal Control Over Financial Reporting

We havesubstantially completed the items outlined in the remediation plan that waspreviously approved by the Audit Committee of our Board (see the 2005 Annual Reporton Form 10-K for a full description of the remediation plan).  Based on a review conducted by our internalaudit function, we continue to address the following steps from the 2005remediation plan, as well as additional items that we will address as a resultof our 2006 assessment of internal control over financial reporing:

1.                We continue toenhance our contract review processes to include a cross functional group thatis responsible for reviewing contracts and providing information required toassist us in our determination of revenue recognition.

2.                We continue to formalizeour procedures for project status determination and customer acceptance sign-off.

3.                We continue to enhanceour education program for our sales and service organization to educate themregarding our revenue recognition policies. We continue to implement formalrepresentation and verification procedures with sales staff as of December 31,2006.

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4.                We continue to refineour contract review process, related to contracts with non-standard or complexterms, with a goal of determining the appropriate accounting treatment prior toquarter-end. We have refined our contract review processes and procedures as ofDecember 31, 2006. In addition, we have refined our goal with respect tothis remediation item to determining the appropriate accounting treatment priorto providing our quarterly results to our external auditors.

Based on ourassessment of our internal control over financial reporting as of December 31,2006, management has committed to the following additional remediation items:

1.                The formalizationof policies and procedures to provide for sufficient analysis to identify allnet assets acquired in a business combination. Specifically, the institution of a formal checklist that we will use toensure that we have considered applicable issues and considerations associatedwith purchase price allocation, including income tax related items.

2.                The expansion ofour policies and procedures surrounding the program development orimplementation of internal-use software applications.  Specifically, we will adjust our currentpolicies and procedures to ensure that more significant testing procedures,including the testing of multiple transactions and reports over an extendedperiod of time, are performed prior to implementing significant changes to ourinternal-use software applications (including our accounting systems) thatdirectly impact our financial reporting process.

In addition to ourcontinued institution, refinement and improvement of our remediation plan, theAudit Committee has committed to expanding the resources of our accounting andfinance organization. Most notably, we have hired, subsequent to December 31,2006, a Chief Financial Officer, Vice President of Finance, Director of SECFinancial Reporting, and a Corporate Controller and plan to expand the financedepartment further during 2007. In addition, it is anticipated that our currentChief Accounting Officer will transition his responsibilities to the VicePresident of Finance and he will become the leader of our Internal Auditfunction. We will also utilize external professional accounting resources toassist with the identification and proper application of generally acceptedaccounting principles in all of our ongoing tax activities (in addition tocomplex transactions).

**Item 9B.**               OTHERINFORMATION

None.

**PART III**

As permitted by SEC rules,we have omitted certain information required by Part III from this Reporton Form 10-K, because we will file (pursuant to Section 240.14a-101)our definitive proxy statement for our 2007 annual shareholder meeting (the ‘‘ProxyStatement’’) not later than April 30, 2007, and are thereforeincorporating by reference in this Annual Report on Form 10-K suchinformation from the Proxy Statement.

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**Item 10.**                 DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

**Executive Officers**

Thefollowing table sets forth the names of our Executive Officers, and theirrespective ages and positions with us, followed by a brief biography of eachindividual, including his business experience during the past five years. 

| **Name**          | ** ** | ** ** | ** ** | **Age**                                               | ** ** | **Position** |
|-------------------|------------|------------|------------|-------------------------------------------------------|------------|--------------|
| Kenneth D. Rardin |       | 56         |       | President and Chief  Executive Officer, Director      |
| Gary D. Bowers    |       | 54         |       | President, Merge  Healthcare North America            |
| Jacques F. Cornet |       | 51         |       | President, Merge  Healthcare EMEA                     |
| Steven R. Norton  |       | 45         |       | Executive Vice President  and Chief Financial Officer |
| Loris Sartor      |       | 49         |       | President, Cedara Software                            |

 

***Kenneth D. Rardin,*** was appointed as a Director andour President and Chief Executive Officer on September 6, 2006.Mr. Rardin has over 25 years of senior executive management experience inthe healthcare information technology, computer software and computer servicesindustries. From October 2004 to January 2006, Mr. Rardin servedas Chairman and Chief Executive Officer of Park City Solutions, a leadingeHealth company that specialized in electronic health records, systemsintegration and consulting. Prior to joining Park City Solutions,Mr. Rardin was the Managing Partner of Rardin Capital Management, a technologyand financial consulting company. From October 1992 to October 1998,Mr. Rardin served as Chairman and Chief Executive Officer of IMNETSystems, Inc., an electronic healthcare information management systemcompany.

***Gary D. Bowers***was appointed President, Merge Healthcare NorthAmerica on February 12,2007. He had earlier served as our Senior Vice President for Strategic BusinessInitiatives from November 2006, from which position he led the Company’s onshore-offshoredevelopment, service and support initiative in Pune, India. He joined the Company as VicePresident in September 2006. Previously, Mr. Bowers was Senior VicePresident, Product Technology, for Park City Solutions from October 2004to November 2005, and was a General Partner of Rardin Capital Managementfrom December 1999 to September 2004. From October 1992 to April 1999, Mr. Bowersheld various senior executive positions at IMNET Systems, Inc., includingExecutive Vice President of Product Technology and Chief Operating Officer. Mr. Bowersholds a B.A. inStatistics (magna cum laude) from the University of Rochester.

***Jacques F. Cornet*** was appointed President, MergeHealthcare EMEA (Europe, Middle East, Africa) in November 2006. He wasformerly Vice President Business Development and Strategic Marketing of Cedara.Before joining Cedara in mid-2000, Mr. Cornet held several strategicbusiness management positions at ADAC Laboratories (now part of Philips MedicalSystems) in the U.S., GE HealthCare in Europe and the U.S. and GE Calma inEurope. Mr. Cornet holds a M. Sc. Degree in ElectroMechanical and ComputerSciences and Executive Marketing from HEC France.

***Steven R. Norton*** joined the Company as Executive Vice President andChief Financial Officer effective January 8, 2007. Mr. Norton managesall financial areas of the Company, as well as human resources, legal,information technology, and investor relations. Previously, Mr. Norton wasSenior Vice President and Chief Financial Officer at Manhattan Associates, apublicly traded supplier of supply chain management software and systems, from January 2005to March 2006. From November 1999 to January 2005, he was anExecutive Vice President and Chief Financial Officer for Concurrent ComputerCorporation. Additionally, Mr. Norton has held senior management positionsat LHS Group, Ernst & Young, and KPMG. Mr. Norton earned his Bachelorof Arts degree from Michigan State University in 1983.

***Loris Sartor*** was appointed President, CedaraSoftware in November 2006. He formerly held various positions with Cedara,including Director of the Platforms Products Division, Product Vice President,Divisional Vice President of Engineering and Customer Solutions, and mostrecently Vice President of 

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***Sales. Prior to joining Cedara in December 1993, Mr. Sartorheld several technical and management positions in the Sietec Open SystemsDivision at Siemens Electric Ltd., as well as various other technical positionswithin the software industry. Mr. Sartor holds a Bachelor of AppliedScience and Engineering Degree (Computer Science Option) and an M.B.A. from theUniversity of Toronto.***

Theremaining information required by this item is incorporated herein by referenceto the information set forth under the caption ‘‘Directors and ExecutiveOfficers’’ in our Proxy Statement.

**Item 11.**                 EXECUTIVECOMPENSATION

The information requiredby this item is incorporated herein by reference to the information set forthunder the caption ‘‘Compensation of Executive Officers and Directors’’ in ourProxy Statement.

**Item 12.**              SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information requiredby this item is incorporated herein by reference to the information set forthunder the caption ‘‘Security Ownership and Certain Beneficial Owners andManagement’’ in our Proxy Statement.

**Item 13.**              CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information requiredby this item is incorporated herein by reference to the information set forthunder the caption ‘‘Related Party Transactions’’ in our Proxy Statement.

**Item 14.**                 PRINCIPALACCOUNTING FEES AND SERVICES

The information requiredby this item is incorporated herein by reference to the information set forthunder the caption ‘‘Accounting Fees and Services’’ in our Proxy Statement.

**PART IV**

**Item 15.**                 EXHIBITS ANDFINANCIAL STATEMENTS SCHEDULES

(a)   The followingdocuments are filed as part of this annual report:

FinancialStatements filed as part of this report pursuant to Part II, Item 8 ofthis Annual Report on Form 10-K:

·        ConsolidatedBalance Sheets at December 31, 2006 and December 31, 2005;

·        ConsolidatedStatements of Operations for each of the three years ended December 31,2006, December 31, 2005 and December 31, 2004;

·        ConsolidatedStatements of Shareholders’ Equity for each of the three years ended December 31,2006, December 31, 2005 and December 31, 2004;

·        ConsolidatedStatements of Cash Flows for each of the three years ended December 31,2006, December 31, 2005 and December 31, 2004;

·        ConsolidatedStatements of Comprehensive Income (Loss) for each of the three years ended December 31,2006, December 31, 2005 and December 31, 2004; and

·        Notesto Consolidated Financial Statements.

(b)   See Exhibit Indexthat follows.

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**Exhibit Index**

|   2.1 |   | Merger Agreement by and  among Merge Technologies Incorporated, AccuImage Diagnostics Corp.,  ADI Acquisition Corp. and the Principal Shareholder of AccuImage  Diagnostics Corp. dated November 24, 2004(B)                                                                                                                                                                                                |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   2.2 |   | Merger Agreement by and  among Merge Technologies Incorporated, Cedara Software Corp. and  Corrida, Ltd. dated January 17, 2005(C)                                                                                                                                                                                                                                                                                    |
|   3.1 |   | Articles of  Incorporation of Registrant(D), Articles of Amendment as filed on  December 28, 1998 (E) Articles of Amendment as filed on  September 2, 1999(F), Articles of Amendment as filed on  February 23, 2001(F), Articles of Amendment as filed on  August 9, 2002(G), Articles of Amendment as filed on May 27,  2005(H), and Articles of Amendment as filed on September 6, 2006(J) |
|   3.2 |   | Amended and Restated  Bylaws of Registrant(J)                                                                                                                                                                                                                                                                                                                                                                                             |
|   4.1 |   | Rights Agreement, dated  as of September 6, 2006, between the Registrant and American Stock  Transfer & Trust Co.(J)                                                                                                                                                                                                                                                                                                        |
| 10.1            |   | Employment Agreement  entered into as of March 1, 2004, between Registrant and Richard A.  Linden(G)*                                                                                                                                                                                                                                                                                                                           |
| 10.2            |   | Employment Agreement  entered into as of March 1, 2004, between Registrant and William C.  Mortimore(G)*                                                                                                                                                                                                                                                                                                                        |
| 10.3            |   | Employment Agreement  entered into as of March 1, 2004, between Registrant and Scott T.  Veech(G)*                                                                                                                                                                                                                                                                                                                              |
| 10.4            |   | Letter Agreement dated  May 12, 2006, between Registrant and Scott T. Veech(K)*                                                                                                                                                                                                                                                                                                                                                      |
| 10.5            |   | Employment Agreement  entered into as of April 1, 2006, between Registrant and David M.  Noshay(L)*                                                                                                                                                                                                                                                                                                                             |
| 10.6            |   | Employment Agreement  entered into as of April 1, 2006, between Registrant and Robert J. White(L)*                                                                                                                                                                                                                                                                                                                                   |
| 10.7            |   | Key Officer Agreement  entered into as of October 12, 2005, by and between Registrant and  Steven M. Oreskovich(M)*                                                                                                                                                                                                                                                                                                                  |
| 10.8            |   | Letter Agreement dated  July 2, 2006 by and between Registrant and Steven M. Oreskovich(N)*                                                                                                                                                                                                                                                                                                                                          |
| 10.9            |   | 1996 Stock Option Plan  for Employees of Registrant dated May 13, 1996(D), as amended and  restated in its entirety as of September 1, 2003(O)*                                                                                                                                                                                                                                                                                 |
| 10.10           |   | Employment Agreement  entered into as of September 6, 2006, between the Registrant and  Kenneth D. Rardin (J)*                                                                                                                                                                                                                                                                                                             |
| 10.11           |   | Employment Agreement  entered into as of January 8, 2007 between the Registrant and Steven R.  Norton(P)*                                                                                                                                                                                                                                                                                                                            |
| 10.12           |   | Employment Agreement  entered into as of February 5, 2007 between the Registrant and Gary  Bowers*                                                                                                                                                                                                                                                                                                                                   |
| 10.13           |   | 1998 Stock Option Plan  For Directors(Q)*                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.14           |   | 2003 Stock Option Plan  of Registrant dated June 24, 2003, and effective July 17, 2003(O)*                                                                                                                                                                                                                                                                                                                                      |
| 10.15           |   | 2005 Equity Incentive  Plan adopted March 4, 2005, and effective May 24, 2005(R)*                                                                                                                                                                                                                                                                                                                                               |
| 10.16           |   | Termination Agreement  between Cedara Software Corp., Abe Schwartz and Merge Technologies  Incorporated dated June 1, 2005(S)*                                                                                                                                                                                                                                                                                                       |
| 10.17           |   | Form of  Non-Qualified Stock Option Agreement under Registrant’s 2005 Equity Incentive  Plan(M)*                                                                                                                                                                                                                                                                                                                                |
| 10.18           |   | Form of Employee  Incentive Stock Option Agreement under Registrant’s 2005 Equity Incentive  Plan(M)*                                                                                                                                                                                                                                                                                                                           |
| 10.19           |   | Form of Director  Non-Qualified Stock Option Agreement under Registrant’s 2005 Equity Incentive  Plan(M)*                                                                                                                                                                                                                                                                                                                       |
| 14.1            |   | Code of Ethics(G)                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 14.2            |   | Whistleblower Policy(G)                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 21              |   | Subsidiaries of  Registrant.                                                                                                                                                                                                                                                                                                                                                                                                              |

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| 23.1 |   | Consent of KPMG LLP.                                                                                                                                                                                                                                                   |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 |   | Certification of Chief  Executive Officer (principal executive officer) Pursuant to Rule 13a-14(a)  under the Securities Exchange Act of 1934.                                                                                                                    |
| 31.2 |   | Certification of Chief  Financial Officer (principal accounting officer) Pursuant to Rule 13a-14(a)  under the Securities Exchange Act of 1934.                                                                                                                   |
| 32   |   | Certification of Chief  Executive Officer (principal executive officer) and Chief Financial Officer  (principal accounting officer) Pursuant to Section 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 99   |   | Amended and Restated  Audit Committee Charter(M)                                                                                                                                                                                                                       |

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(A)       Intentionally omitted.

(B)        Incorporated by referencefrom Current Report on Form 8-K dated November 24, 2004.

(C)        Incorporated by referencefrom Current Report on Form 8-K dated January 18, 2005.

(D)       Incorporated by referencefrom Registration Statement on Form SB-2 (No. 333-39111),effective January 29, 1998.

(E)        Incorporated by referencefrom Quarterly Report on Form 10-QSB for the three months ended March 31,1999.

(F)         Incorporated by referencefrom Annual Report on Form 10-KSB for the year ended December 31,2000.

(G)      Incorporated by referencefrom Annual Report on Form 10-K for the year ended December 31,2003.

(H)      Incorporated by referencefrom Current Report on Form 8-K dated June 7, 2005.

(J)           Incorporated byreference from Current Report on Form 8-K dated September 6, 2006.

(K)       Incorporated by referencefrom Current Report on Form 8-K dated May 12, 2006.

(L)         Incorporated by referencefrom Current Report on Form 8-K dated April 1, 2006.

(M)     Incorporated by referencefrom Annual Report on Form 10-K for the year ended December 31,2005.

(N)       Incorporated by referencefrom Current Report on Form 8-K dated June 29, 2006.

(O)      Incorporated by referencefrom Quarterly Report on Form 10-Q for the three months ended September 30,2003.

(P)         Incorporated by referencefrom the Registrant’s Current Report on Form 8-K dated January 16,2007.

(Q)      Incorporated by referencefrom Annual Report on Form 10-KSB for the fiscal year ended December 31,1997.

(R)       Incorporated by referencefrom Registration Statement on Form S-8 (No. 333-125386) effectiveJune 1, 2005.

(S)          Incorporated by referencefrom Quarterly Report on Form 10-Q for the six months ended June 30,2005.

*                    Management contract,or compensatory plan, or arrangement, required to be filed as an exhibit tothis Annual Report on Form 10-K.

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| **SIGNATURES** |
|----------------|

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchangeof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

|                           | ** ** | **MERGE TECHNOLOGIES  INCORPORATED** |
|--------------------------------|------------|--------------------------------------|
| Date: March 8,  2007 |       | By:                                  | /s/ KENNETH D. RARDIN |
|                           |       |                                 | Kenneth D. Rardin |
|                           |       |                                 | *President and Chief Executive Officer  (principal executive officer)* |
| Date: March 8,  2007 |       | By:                                  | /s/ STEVEN R. NORTON |
|                           |       |                                 | Steven R. Norton |
|                           |       |                                 | *Executive Vice President & Chief  Financial Officer  (principal financial officer and principal accounting officer)* |

 

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Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

| Date: March 8, 2007  |   | By:    | /s/ MICHAEL D. DUNHAM         |
|---------------------------|--------|--------|-------------------------------|
|                      |   |   | Michael D. Dunham             |
|                      |   |   | *Chairman of the Board*       |
| Date: March 8,  2007 |   | By:    | /s/ ROBERT A. BARISH          |
|                      |   |   | Robert A. Barish,  M. D. |
|                      |   |   | *Director*                    |
| Date: March 8,  2007 |   | By:    | /s/ DENNIS BROWN              |
|                      |   |   | Dennis Brown                  |
|                      |   |   | *Director*                    |
| Date: March 8,  2007 |   | By:    | /s/ ROBERT T. GERAS           |
|                      |   |   | Robert T. Geras               |
|                      |   |   | *Director*                    |
| Date: March 8,  2007 |   | By:    | /s/ ANNA MARIE HAJEK          |
|                      |   |   | Anna Marie Hajek              |
|                      |   |   | *Director*                    |
| Date: March 8,  2007 |   | By:    | /s/ R. IAN LENNOX             |
|                      |   |   | R. Ian Lennox                 |
|                      |   |   | *Director*                    |
| Date: March 8,  2007 |   | By:    | /s/ KEVIN E. MOLEY            |
|                      |   |   | Kevin E. Moley                |
|                      |   |   | *Director*                    |
| Date: March 8, 2007  |   | By:    | /s/ KEVIN G. QUINN            |
|                      |   |   | Kevin G. Quinn                |
|                      |   |   | *Director*                    |
| Date: March 8, 2007  |   | By:    | /s/ RAMAMRITHAM RAMKUMAR      |
|                      |   |   | Ramamritham Ramkumar          |
|                      |   |   | *Director*                    |
| Date: March 8, 2007  |   | By:    | /s/ KENNETH D. RARDIN         |
|                      |   |   | Kenneth D. Rardin             |
|                      |   |   | *Director*                    |
| Date: March 8, 2007  |   | By:    | /s/ RICHARD A. RECK           |
|                      |   |   | Richard A. Reck               |
|                      |   |   | *Director*                    |

 

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