**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM10-K**

x        ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2005**

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

**Forthe transition period from                   to                   **

**Commissionfile number 0-29486**

**MERGE TECHNOLOGIESINCORPORATED**

(Exact name of Registrantas 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** |
| Securities  registered 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 Exchange Act: **NONE**           |

 

Indicate by check mark ifthe Registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act

Yes   o    No  x

Indicate by check mark ifthe Registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.

Yes  o    No  x

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes  o    No  x

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 to this Form 10-K.  o

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of 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-2 of theAct).

Yes   o    No  x

The aggregate value for theRegistrant’s voting and non-voting common equity held by non-affiliates of theRegistrant as of June 30, 2005, based upon the closing sale price of the CommonStock on June 30, 2005, as reported on the NASDAQ Global Market, wasapproximately****$378,166,275.  Shares ofCommon Stock held by each officer and director and by each person who owns tenpercent or more of the outstanding Common Stock have been excluded in that suchpersons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusivedetermination for other purposes.

Thenumber of shares outstanding of the Registrant’s common stock, par value $0.01per share, as of August 22, 2006:  29,069,624

 

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**INDEX**
| Explanatory Note—Restatement  of Financial Information | 1                                                                                                                   |
|-------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|
| PART  I                                                     |                                                                                                                |
| Item 1.                                                     | Business                                                                                                            | 2 |
| Item 1A.                                                    | Risk Factors                                                                                                        | 16 |
| Item 1B.                                                    | Unresolved  Staff Comments                                                                                          | 27 |
| Item 2.                                                     | Properties                                                                                                          | 27 |
| Item 3.                                                     | Legal  Proceedings                                                                                                  | 28 |
| 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                         | 32 |
| Item 7A.                                                    | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 54 |
| Item 8.                                                     | Financial  Statements and Supplementary Data                                                                        | 55 |
| Item 9.                                                     | Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure                               | 108 |
| Item 9A.                                                    | Controls  and Procedures                                                                                            | 108 |
| Item 9B.                                                    | Other  Information                                                                                                  | 115 |
| PART III                                                    |                                                                                                                |
| Item 10.                                                    | Directors  and Executive Officers of the Registrant                                                                 | 116 |
| Item 11.                                                    | Executive  Compensation                                                                                             | 120 |
| Item 12.                                                    | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 126 |
| Item 13.                                                    | Certain  Relationships and Related Transactions                                                                     | 128 |
| Item 14.                                                    | Principal  Accountant Fees and Services                                                                             | 128 |
| PART IV                                                     |                                                                                                                |
| Item 15.                                                    | Exhibits,  Financial Statement Schedules                                                                            | 129 |

 

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**MERGE TECHNOLOGIESINCORPORATED**

**EXPLANATORY NOTE—RESTATEMENTOF FINANCIAL INFORMATION**

**This Annual Reporton Form 10-K for the year ended December 31, 2005, includes (1) a restatedbalance sheet as of December 31, 2004, (2) restated consolidated statements ofoperations, consolidated statements of shareholders’ equity, consolidatedstatements of cash flows and consolidated statements of comprehensive incomefor the years ended December 31, 2003 and 2004, (3) restated quarterlyfinancial information for the quarters ended March 31, 2005 and 2004, June 30,2005 and 2004 and September 30, 2005 and 2004, and (4) restated selectedfinancial data for the years ended December 31, 2002, 2003 and 2004. TheCompany will not file amended periodic reports for any of the affected periods.See Item 6, “Selected Financial Data,” Item 8, “Financial Statements andSupplementary Data,” and Item 9A, “Controls and Procedures,” in Part II of thisAnnual Report on Form 10-K, including Footnotes 12 and 13 to the notes toconsolidated financial statements, for more information concerning theserestatements. This Annual Report on Form 10-K should be read in conjunctionwith our Quarterly Report on Form 10-Q for the quarter ended March31, 2006, which is being filed contemporaneously with this Form 10-K.**

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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 21E of theSecurities 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” in Part I ofthis Annual Report 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 (“Merge Healthcare,” “we,” “us,” or “our”), develops medical imagingand information management software and delivers related services. There arethree principal sales and business development channels for Merge Healthcare:Direct, which generally sells to the United States of America (“U.S.”) end-userhealthcare market comprised of hospitals, imaging centers and specialtyclinics; OEM and International, which primarily sells to Original EquipmentManufacturers (“OEMs”) and Value Added Resellers (“VARs”), comprised ofcompanies that develop, manufacture or resell medical imaging software ordevices, and also to the international end-user healthcare market; andeCommerce which distributes certain products through the Internet via ourwebsite. Merge Healthcare is unique in the industry in its three-channeldistribution methodology. Products and services developed throughout MergeHealthcare are sold via Direct, OEM/VAR and International, and eCommercechannels worldwide. This multiple channel approach was developed to optimizethe sales of the products created throughout all of Merge Healthcare, resultingin a large portfolio of solutions that can be sold in the manner that bestbenefits our customers, and generates both upstream and downstream revenues forus.

On June 1, 2005, we completed our business combinationwith Cedara Software Corp., including its subsidiary eMed. Since the businesscombination with Cedara Software Corp., we have done business under the nameMerge Healthcare, and have referred to our OEM/VAR and International channel asCedara and our direct channel as Merge eMed.

We have over 20 years of leadership in the medicalimaging and healthcare information technology markets, throughout which we haveprovided innovative solutions for OEMs, VARs and healthcare end-users. Wedevelop clinical and medical imaging software applications and developmenttools that are on the forefront of medicine. We also develop medical imagingsoftware solutions that support end-to-end business and clinical workflow forradiology department and specialty practices, imaging centers and hospitals. Oursoftware technologies accelerate market delivery for our OEM customers, whileour end-user solutions improve our customers’ productivity and enhance thequality of the patient experience. Our diagnostic imaging workflow applicationsare commonly categorized as Picture Archiving and Communication Systems (“PACS”),Radiology Information Systems (“RIS”) and Clinical Applications, which include,but are not limited to, software that supports medical imaging in manyspecialized areas 

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such as orthopaedics,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 accuracy of the diagnosis ofgeneral 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 medical imaging andinformation OEM and International markets. Our software is deployed inhospitals and clinics worldwide through our partners and is licensed by many ofthe world’s largest medical device and healthcare information technology (IT)companies as well as our Direct and eCommerce channels. Our technologies helpour OEM customers increase revenues, create competitive advantages, and delivertechnologies to end-user markets throughout the world. We may serve as anextended research and development team for the OEM, helping them to befirst-to-market with innovative medical imaging technologies. We leverage ourglobal end-user distribution channels to sell our customers existingtechnologies and applications, and expand the value of medical imagingsolutions by licensing additional applications for our customers to sellthrough their own sales forces. Our technologies and expertise span all themajor digital imaging modalities, including computed tomography (CT), magneticresonance 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 clinicalimaging workflow, including: the capture of a patient’s digital image; thearchiving, communication and manipulation of digital images; sophisticatedClinical Applications 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, particularly in the past four years. We see ourRIS/PACS/Clinical Applications single-vendor approach as a unique advantage inour end-user target market. Additionally, we became a leading medical imagingOEM partner-company through our combination with Cedara Software Corp.

We believe the combinedinnovation model between our OEM medical imaging engineering and our RIS/PACS/ClinicalApplication offerings positions us uniquely among our competitors in themedical imaging and information markets, provides for a product innovationmodel that accelerates our development efforts by providing software-basedtechnologies that can be embedded in solutions for the end-user market, andcreates a product and distribution platform to allow us to explore new clinicaland geographic markets beyond radiology. We believe that leveraging this uniqueinnovation model and our ability to innovate new medical imaging solutions iskey to our long term strategy to expand our products and services beyond thetraditional boundaries of radiology.

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**Our Market**

Millennium ResearchGroup, an international market research firm, recently reported the following marketplaceinformation:

·  In 2005, 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.

·  By 2010, this market will grow to over $3.0billion, representing a compound annual growth rate of nearly 15%.

·  Growth for the RIS market is primarily drivenby imaging centers and small hospitals, particularly those that do not alreadyhave a PACS or RIS and elect for an integrated RIS/PACS solution.

·  Growth for the PACS market is primarily drivenby:

·   adoption of EPR;

·   growing customer receptiveness of PACS;

·   the conversion from radiology to enterprisePACS solutions;

·   customer demand for replacement PACS andintegrated RIS/PACS solutions;

·   affordable price points for small hospitalsand imaging centers;

·   growth in diagnostic capabilities for thecardiology market; and

·   growth of in-office modalities in theorthopedic 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 clinical applications throughdevelopment, partnership and acquisition activities. However, we do not believethat any other competitor that specifically serves our end-user target marketis able to offer the combined RIS, PACS and clinical applications that aredeveloped and integrated by a single vendor, providing customers with a singlesystem that yields strong productivity gains, attracts referrals from primarycare and specialty physicians, and yields enhanced support and technologymigration by having only a single vendor relationship to manage.

Our OEM market, which consists of organizations thatutilize medical imaging or information in any element of their business, isalso highly competitive. Thousands of imaging-related prospective customersexist throughout the world. In addition, we utilize a Technology PartnershipProgram, where we work with academic researchers and entrepreneurial companiesthat have developed new, innovative medical imaging applications that are notyet fully commercialized. These technology partnerships further accelerate theinnovation of our own technologies, allowing us to approach new clinicalimaging markets outside of radiology. In exchange, we can offer our partnerdistribution channels, commercialization of their products, and an approach toOEM’s globally that we have developed over the last 18 years. Working withthese partners, we use our depth of medical imaging technology, global OEMdistribution, and business expertise to commercialize and launch thoseproducts.

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 utilizeinternal resources to create a similar technology or eventually replace our 

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softwareutilized in the customer’s marketed solution. There are also a number ofcompanies that specialize in one particular technology, which may compete withus in a selected market. However, we believe that there are no directcompetitors in the OEM market that have the breadth of technologies,engineering resources and capabilities to compete with us in all aspects of ourtechnology portfolio.

**Recent Challenges**

We continue to facesignificant business challenges that stem from the uncertainty created bychanges in our senior management, announcements regarding our inability to meetrequirements of the NASDAQ National Market (now designated the NASDAQ GlobalMarket) for continued listing, an informal, non-public inquiry being conductedby the Securities and Exchange Commission and class action and other lawsuits. Webelieve that these matters have adversely affected the morale of our employees,our relationships with certain customers and potential customers and ourreputation in the marketplace, and have diverted the attention of our Board ofDirectors and management from our business operations. We also have experiencedchallenges integrating the businesses and personnel of Merge Healthcare andCedara Software Corp., which we acquired on June 1, 2005. In particular,we struggled to realize synergistic benefits as a consequence of organizationalchanges, primarily within our sales and service groups, following that businesscombination. In addition, since the business combination, we may not havedevoted adequate resources to the development and acquisition of additionalproducts. See Part I, Item 1A, “Risk Factors,” Part I, Item 3,“Legal Proceedings,” and Part II, Item 7, “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” to this AnnualReport on Form 10-K for more detailed discussion regarding thesematters.

**History**

Merge Technologies Incorporated, now doing business asMerge Healthcare, was founded in 1987 and built a reputation as a company thatenabled the transformation of legacy radiology (film-based) images into modern(filmless) digitized images for distribution and diagnostic interpretation. Weacquired eFilm Medical Inc. (“eFilm”) in June 2002 and began doing businessunder the name of Merge eFilm in order to leverage eFilm’s international namerecognition for diagnostic medical image workstation software with thousands ofusers worldwide. In July 2003, we acquired 100% of the outstanding shares ofRIS Logic, Inc. (“RIS Logic”), a RIS company that designed software to managebusiness and clinical workflow for imaging centers that streamlines operationsand accelerates productivity. We acquired AccuImage Diagnostics Corp.(“AccuImage”) in January 2005. AccuImage was founded from radiology academicresearch, and created products that utilized advanced visualizationtechnologies for clinical specialty medical imaging. In June 2005, we completedour business combination with Cedara Software Corp. Cedara Software Corp. wasestablished in 1982, bringing together some the world’s most experiencedmedical imaging technology experts to create medical imaging software for OEMand VAR customers.

We believe our combined end-user and OEM capabilitiesposition us uniquely as the only medical imaging/healthcare IT company thatcreates imaging software for new technologies being developed by our OEMcustomers, improving the likelihood that these new technologies, whenintroduced into the end-user marketplace, can effectively be incorporated inclinical and operational workflow of imaging centers, hospitals and specialtyclinics. We believe that our end-user solutions improve our customers’ profitabilityby accelerating productivity and optimizing investments in imaging equipmentand IT systems. We believe our OEM technologies improve our OEM customers’profitability and decrease their time to market. We believe the combinedinnovation model of our OEM medical imaging engineering with ourRIS/PACS/Clinical Application offerings positions us well among our competitorsfor future success.

We have consistentlymaintained a commitment to industry standards designed to benefit bothhealthcare providers and technology vendors. We have been a contributor to thedevelopment of the industry’s standard network communications protocol known asDigital Imaging Communications in 

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Medicine(“DICOM”), open medical standards such as Health Level Seven, Inc. (“HL7”), andthe Integrated Healthcare Enterprise (“IHE”) framework that has been createdthrough an initiative cosponsored by the Radiological Society of North America(“RSNA”) and the Healthcare Information and Management Systems Society (“HIMSS”).The IHE initiative represents a consortium of companies in the Radiology andHealthcare Information Technology (“HIT”) fields. This set of requirements haspaved the way for healthcare organizations to begin to integrate the complexworkflow systems of the radiology department with the entire healthcare systemby using equipment and software applications that connect the various imagecommunication and information management components. We have incorporated thesestandards in our radiology workflow technologies, software applications and OEMconnectivity components, establishing the basis for seamless integration ofimages and healthcare information across an organization’s computinginfrastructure.

**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:

·  Accelerated productivity gained by utilizing asingle integrated software solution for all business and clinical workflowtools designed to automate operations, including digital dictation, billing,registration and scheduling, productivity analysis, image and reportmanagement, and storage and distribution;

·  Increased accuracy through real time patientdemographic matching across all business and clinical workflow tools;

·  More accountability and convenience in workingwith one vendor that develops, installs and supports the entire spectrum ofradiology workflow tools and integration services;

·  The creation of permanent electronic archives ofdiagnostic quality images that enable the retrieval of prior and current imagesand reports;

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

·  Networking of multiple image producing andimage utilizing devices to eliminate redundancies and reduce the need forcapital equipment expenditures or disaster recovery; and

·  Optimizing image viewing and diagnosticcapabilities.

OurOEM/International customers benefit from our software technologies andprofessional services in a number of ways, including:

·  Using our technologies and services to enhancethe workflow capabilities of their solutions;

·  Accelerating the time to market in thedevelopment of new solutions;

·  Creating greater product differentiationcompared to their competitors; and

·  Leveragingour technical and deployment skills, which facilitates an increased ability tofocus on core competencies.

**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 $13,535, $5,446 and $4,737 for 

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2005, 2004 and 2003,respectively, which includes capitalized software development costs andresearch and development expense. Our strong market position is the result ofour expertise in clinical workflow and integration, technically innovativesoftware products, modular software solutions, and continued focus onaccelerating healthcare organizations’ productivity. Our OEM software technologiesaddress the global market in medical imaging software innovation. Leveragingthe clinical 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, we can expand the solution set offered toboth our OEM and end-user customers, accelerate the innovation of new products,and enter new markets such as orthopaedic, veterinary, pharmaceutical clinicaltrials, oncology and EPR. This strategy is the direct result of combiningCedara Software with Merge Healthcare, and forms the basis for our continuedgrowth, innovation and new product and market development in the coming years.

During 2005, we focused our operational efforts onimplementing an integration plan to yield revenue, product and operationalsynergies. We progressed with our next generation integrated RIS/PACS,utilizing its advanced features to enhance our value proposition to our customers.We focused on a web-based distribution solution to extend our RIS/PACS offeringto referring physicians, strengthening our financial foundation, enhancing oursales and distribution channels, and leveraging the strength of our productbrands. We also made steady progress in strengthening our reputation as aleading medical imaging workflow solution provider. We marketed and cross soldbundled products from across all of our combined product lines.

In line with thisfocused operational plan, we:

·  Capitalized on opportunities within ourexisting OEM customer base by offering an expanded portfolio of medical imagingtechnologies, development platforms and products. This is evidenced by signingagreements with two customers, Toshiba Medical Systems Corporation and HitachiMedical Corporation, that generated 16% and 10%, respectively, of our 2005 netsales;

·  Expanded our U.S. healthcare RIS, PACS,RIS/PACS and Clinical Applications customer base to nearly 1,000 organizations,including over 700 end-user customers and over 275 OEM/VAR customers;

·  Announced an expanded strategic agreement withEklin Medical Systems, Inc., a veterinary imaging company;

·  Received FDA 510(K) clearance for B-CAD, thefirst commercially available Computer Aided Detection (CAD) solution designedto assist radiologists in the analysis of breast ultrasound images;

·  Announced agreement to provide Cedara B-CAD toKodak as a part of its breast imaging suite;

·  Released Cedara PET/CT Workstation as asoftware plug-in application available to OEM medical imaging companies and tohealthcare professionals as a diagnostic software workstation that can beintegrated into existing PACS and RIS/PACS solutions;

·  Released a new version of our market leadingdiagnostic workstation, eFilm WorkstationTM, and introduced clinical plug-inapplications such as 3D/4D, virtual colonoscopy, calcium scoring, lung noduleanalysis and image stitching;

·  Released our next generation versions of RISand RIS/PACS solutions; and

·  Released Referring Practice Portal, anintegrated web-based solution that provides referring physicians with real timeaccess to patient information and status, medical images and reports.

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

·  Medical imaging innovation with our OEMpartners, creating software applications, technologies and tools that optimizethe growing and evolving capabilities of imaging acquisition devices such asmulti-slice CT, PET, ultrasound and MRI;

·  End-user sales initiatives, including targetedsales/marketing activities designed to achieve broader geographic coverage,expanded presence in other healthcare vertical markets and expanded productpurchases from current customers;

·  Clinical Application software and informationsystems development, both in partnership with OEM and technology partners andon a direct basis to end-users, providing growth opportunities globally andinto new markets outside of radiology;

·  Creating enhanced product offerings such asFUSION MATRIX PACSTM and FUSION RIS/PACSTM MX that expand the functionality ofRIS/PACS to clinical applications beyond radiology; and

·  Innovating technologies and solutions thatserve new markets such as orthopaedic, veterinary, pharmaceutical clinicaltrials, 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/International relationships allow us to work with leadingmedical equipment manufacturers as they develop future plans for new productintroductions. We sometimes partner with leading OEM companies in the designand development of new medical imaging software applications, and thenincorporate those innovative medical imaging software modules within ourintegrated RIS/PACS solutions for sale on a direct basis to our end-usercustomers. This unique model of both OEM and end-user solution developmentaccelerates our ability to innovate our products ahead of the needs of ourcurrent and future target markets.

**End-User Products and Services Description**

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 asto increase productivity and reduce costs for our end-user customers. Productsin place 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 ascomputer 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 enable usto 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.

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Our RIS and PACS offeringsstrengthened in 2005 as we began to make available clinical applicationtechnologies from our OEM group to our growing medical imaging software productsuite. We have multiple solution offerings tailored to meet the needs ofvarious market segments. For the international healthcare market, we havecontinued to offer two platforms under the FUSION PACSTM brand name based onFusion eFilm PACS and Cedara I-ReachTM andCedara I-SoftviewTM technologies.Our software modules are designed to allow continuous innovation of our fullyintegrated radiology workflow system product line and are sold as individualmodules or as a fully integrated solution, depending on the needs of thecustomer. It is our intent to integrate our clinical application portfolio intoour solution offerings thereby providing even more accelerated productivity asmedical imaging moves beyond radiology. Our product innovation team is workingclosely with our customers to develop next generation products****for our RIS, PACS, RIS/PACS and OEM product lines. Inaddition, our software development team is engineering various clinicalapplication and advanced visualization software modules 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 OEM/International, Direct and eCommerce channels.

**OEM Products andServices Descriptions**

Software development can be accelerated by buildingapplications on a software technology platform consisting of libraries andtools. We developed a software imaging platform, called Imaging ApplicationPlatform® (“IAP”), which has been used to developimaging technologies and products for sale to OEMs and VARs, as well aslicensed to these customers as a platform for their development of customapplications. Building on the success of IAP, we have created additionalsoftware engineering tools and platforms, including Cedara OpenEyesTM and CedaraBlue PrintTM, which provide support for rapid application development. IAP, themiddleware between applications, provides a complete software developmentenvironment with technology and capabilities for 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.

Our most advanced imaging software platform, CedaraOpenEyes, 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 OpenEyes 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. Bringingfurther capability to Cedara OpenEyes,Cedara BluePrint providesadvanced structure and application component support for software development.

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 are 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.

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**Merge HealthcareProduct Portfolio**

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 and International, Direct and eCommerce. Our comprehensiveproduct portfolio consists of the following:

**FUSION RISTM** 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.

**FUSION MATRIX PACSTM** is an image visualization, image management,archive and web distribution system. The workflow engine for radiologists,FUSION MATRIX PACSTM provides relevant clinical information at the radiologist’sfingertips, and provides efficient distributed workflow that allows them towork at any location without sacrificing performance, workflow or featurefunctionality. The first PACS solution built on Microsoft.NET, its SmartClientTM technology, combines the power of the personal computer with the reachof the web for easier deployment, maintenance and improved local clientperformance.

**FUSION PACSTM** is an integrated repository of healthcareinformation and a suite of software application modules that provide PACS andweb distribution of images and reports on a single, integrated PACS platform. FUSIONPACSTM is the foundation for the integrated software application modules thatprovides optimal functionality for our customers’ radiology workflow. FUSIONPACSTM and its modules are designed to allow the user to customize the wayimages and information are delivered and viewed, supporting user-centricworkflow.

**FUSION RIS/PACSTM**was createdthrough ourcomprehensive integration approach, fusing our RIS workflow with our imagevisualization, distribution and storage technologies into a unified,intelligent, distributed business and clinical workflow solution that helps ourcustomers accelerate their productivity while also providing a higher level ofvalue and convenience. Radiologists, technologists and administrators benefitfrom having a single solution for their mission critical business and clinicalworkflow tools, all integrated into a simpler, faster, unified desktop.

**Referring Practice PortalTM** allows real-time access to reports and theirassociated images from within FUSION RIS/PACSTM or just reports from FUSION RISTMvia the web. Additionally, the portal provides access to the Exam/AppointmentStatus, as well as offering an Emergency/Referral Access for hospital andclinic referrals in emergency situations. The portal has Health InsurancePortability and Accountability Act of 1996 (“HIPAA”) supportive security andauditing features, and can be customized with a facility’s brand identity andservice information. The referring practice portal is an optional module thatcan be purchased with FUSION RIS/PACSTM or FUSION RISTM.

*****Connectivity Tools support DICOM and HL7 interfacing whileproviding ready-made solutions for tackling various aspects of the hospitalwide information workflow. Our connectivity tools include, but are not limitedto, MergePortTM, MergeCOM3TM,ExamWorksTM, MergeMVPTM, Cedara I-Acquire/FDTM, Cedara I-BridgeTMandDataBridgeTM.

***eFilm WorkstationTM** is a desktop diagnostic, image and analysis toolfor viewing and interpreting medical images. eFilm WorkstationTM is sold asstand alone software that allows radiologists to view and manipulate anydigital diagnostic study, and is integrated into FUSION RIS/PACSTM and FUSIONPACSTM as its diagnostic workstation. eFilm WorkstationTM, sold via eCommercefrom our website and through VAR distributors, is the most widely useddiagnostic workstation in the world.

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***Cedara I-ReadMammoTM** is a universal breast imaging workstation designedfor reading mammography, ultrasound and MRI studies. Cedara I-ReadMammoTMeliminates the hassle of switching between different workstations throughvendor independence, multi-modality support and dedicated tools for breastimaging workflow.

***Cedara B-CADTM** isthe world’s first CAD solution designed to assist radiologists in analyzingbreast ultrasound. With integrated tools for ACR BI- RADS® characterization and automatic reportgeneration, Cedara B-CADTM is an ideal complement for diagnostic breastultrasound. Integrated with Cedara I-ReadMammoTM, Cedara B-CADTMdemonstrates functional multi-modality breast imaging workflow.

***Cedara PET/CTTM** provides fastand efficient workflow by combining images from CT and PET modalities, which isparticularly useful in allowing a radiologist to see cancerous activity at ametabolic level and pinpoint its exact location in the tissue so a biopsy canbe performed and proper treatment begun.

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

**Cedara OrthoWorks SpineAnalyzerTM** is an advancedapplication that helps spine surgeons, orthopedists, and chiropractors analyzecervical, thoracic and lumbar spine mobility, alignment and deformities. Spinesurgeons can use OrthoWorks Spine Analyzer to assist in planning therapy, such assurgical procedures, and help evaluate post therapy outcome.

**Cedara OrthoWorks CareManagerTM** is a clinical datamanagement system that uses unique patented technology to help easily capturerelevant clinical parameters during diagnosis, therapy and post therapy followup, and automatically populate an SQL database. Powerful and intuitive datamining tools allow users to quickly perform outcome analyses that can be lateranalyzed by a statistical package.

***CalScore ReviewTM** is an advanced calcium scoring module. It supportslesion-by-lesion and side-by-side comparison for follow up or repeat scanning,as well as detailed report generation. This clinical application also hasworkflow tools that allow customization of a patient database, tracking of thecurrent referral base, comparison of prior versus current calcium scores andcapture of follow-up appointments.

***Colon ReviewTM** is a complete workflow solution with powerful toolsfor reviewing colon or other luminal studies and reporting the findings. ColonReview is a practical, intuitive solution for expanding imaging capabilities toinclude virtual colonoscopy.

***Lung ReviewTM** is a comprehensive lung nodule visualization andanalysis package that incorporates advanced viewing tools, nodule segmentation,decision tree based on ELCAP recommendations and automatic report generation.

***3D/4D Review**TM provides comprehensive visualization for rapid andefficient everyday clinical workflow, along with a real time editing tool onecan use in combination with standard visualization tools such as MIP, MinIP,MPR, 3D, VRT and interactive 4D Image Review. This product is sold to the end-usermarket via eCommerce from our website, and through VAR distributors.

***AccuStitch**TM is an advanced image stitching and anglemeasurement application, which allows the user to stitch thoracic and lumbarfilms. This product is sold to the end-user market via eCommerce from ourwebsite, and through VAR distributors.

**Cedara OpenEyes**TM& Cedara BluePrintTM are advanced software platforms for the rapiddevelopment of medical imaging applications. Cedara OpenEyesTM provides astructured framework on which layered and protocol based applications can bequickly and efficiently created without reinventing 

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**basefunctionality. Packaged with sophisticated image viewing, DICOM, databasing andimage manipulation capabilities, Cedara OpenEyesTM allows healthcare companiesto focus on the development of workflow and specific clinical tools. OpenEyesprovides an excellent framework for both plug-in integration and completesoftware development. For additional development capabilities, CedaraBluePrintTM provides extended structure and features for the Cedara OpenEyesTMdevelopment environment.**

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

**Cedara I-ReportTM** is a radiologist’s diagnostic workstation utilizingautomated workflow, presentation protocols, and advanced post-processingtoolsets.

**Cedara I-Report CTTM** is specifically tailored for CT data sets; thissoftware features optimized navigation tools, easy-to-use 3D volume rendering,MPR, measurement tools, support for orthopedic templates, and Cedara Software’slatest plug-ins.

**Cedara I-ReadTM** is optimized for multi-modality viewing; the userpreferences and intuitive user interfaces enable reporting physicians andspecialists to have efficient, effective workflow.

**Cedara I-ViewTM** is a simple, cost-effective review station thatprovides DICOM connectivity with high performance display and facilitatesclinicians’ access to patient data.

**Cedara I-AcquireTM** is a universal software application in whichmultiple digital detectors, computed radiography (CR) scanners and x-raygenerators can be integrated into a powerful acquisition console, whichimproves ease of use and productivity for busy technologists, as well as givingOEMs and system integrators the freedom to choose and quickly packagedetectors, scanners, and generators from different vendors into an assortmentof tailored solutions, thereby addressing a broader range of clinicalapplications with less effort and faster time to market.

***Cedara Baby Explorer** software is an application that adds 3D fetalimaging to any existing ultrasound system, allowing expectant parents, duringscheduled ultrasound examinations, to view and record 3D images months before ababy’s arrival. This product is sold to the end-user market via eCommerce fromour website, and through VAR distributors.

***Cedara I-ReachTM**is a PACS web-based viewer that significantlyadvances the current capabilities of PACS viewers by providing fast access toimages through the use of the latest compression techniques, while maintaininghigh image quality and providing complete seamless integration with hospitalPACS, HIS and RIS.

***Cedara I-StoreTM** is a DICOM compliant, scalable, archivingsolution designed to meet the evolving performance and redundancy requirementsof a healthcare enterprise. Its scalable architecture allows users to startsmall and expand the archive as their imaging requirements grow.

***Cedara** I-ConferenceTMassistshealthcare 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 imagingdevices to connect to a DICOM clinical network. They provide efficient andtransparent network connectivity, allowing imaging devices to share resourcesthroughout the department.

**Cedara I-ResponseTM** is a software solution for early detection oftreatment response in brain cancer care that capitalizes on a molecular imagingtechnique to assess tumor response from cellular mechanisms. 

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**Usingfunctional diffusion mapping (ƒDM), it provides the potential to evaluate theimpact of anti-cancer drugs and radiation therapy on tumors at an unprecedentedrate.**

**Cedara DentalWorks Implant PlannerTM** is an innovative dental implant planning systemused by dentists and radiologists that makes the accurate planning andplacement of dental implants easy. Using CT data and a smart, automatedworkflow, users can determine the optimal location of dental implants.

***Cedara aXigateTM** is an electronic patient record application thatscales to provide enterprise-wide patient information-based workflow. Thisapplication has been implemented at a number of medical facilities as anElectronic Health Record (“EHR”), Healthcare Information Technology (“HIT”) andClinical Information System (“CIS”).

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**     *******Indicatesproducts sold to Direct and OEM customers.

**Employees**

We had approximately 550employees as of December 31, 2005. In 2005, we implemented initiatives toenhance the work experiences and benefits that employees identified as beingmost important to them. With recognition that our employees are our mostimportant assets, we will continue to invest in human capital development toensure that we maintain our reputation as a highly desirable employer withinour industry. See “—Recent Challenges” above.

**Sales, Marketingand Distribution**

We use a multi-channel approach to reach our targetcustomers. We struggled to realize synergistic benefits as a consequence oforganizational changes, primarily within our sales and service groups,following our June 1, 2005 business combination with Cedara Software Corp. Nevertheless,we began introducing OEM clinical applications to the end-user healthcaremarket and to our RIS, PACS and RIS/PACS customers. We also cross sold RIS andPACS solutions to existing customers. We have added sales professionals to oursales force, and refined our sales processes and tracking mechanisms to providereal time information to manage our sales efforts. Of our net sales in the 12months ended December 31, 2005, approximately 16% and 10% were attributable tosales to Toshiba Medical Systems Corporation and Hitachi Medical Corporation,respectively.

We have reached thousands of current and prospectivecustomers through proactive electronic marketing, utilizing the emails andaddresses captured in connection with eFilm WorkstationTM downloads thatnumbered approximately 70,000 from July 2000 through July 2006. In addition, weregularly participate in major radiology and healthcare information systemindustry trade shows. The largest trade show, the RSNA 2005, which was held inChicago, Illinois in November 2005, was a highly visible event for our productofferings and demonstrating our value propositions for our OEM and end-usercustomers. Finally, our ongoing participation in the IHE initiative andradiology industry panels regarding open communications and medical standards,including our Director of Quality and Medical Standards who served as the 2005co-chair of the International DICOM committee through December 31, 2005, is anadded opportunity to maintain a leadership position within the healthcareindustry and enables us to demonstrate our value on many levels.

As a result of ourbusiness combination with Cedara Software Corp., we are able to capitalize onopportunities within our existing OEM customer base by offering an expandedportfolio of medical imaging technologies, development platforms and products. Theseopportunities aligned with our goal of cross selling our expanding productportfolio through all three distribution channels and will continue to be acore value for us in future years.

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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 will often “compete” with an OEM’sinternal software engineering group to develop next generation technologies, orsingle product focused companies. Competition is present from new competitorsentering the market, as well as current OEM partners that can offer productssimilar to our solutions.

In the developing area of RIS and PACS workflowapplications, there are many newly emerging competitors that offer portions ofthe integrated radiology solution through their RIS and PACS to the markettargeted by us. Additionally, certain competitors are integrating RIS and PACStechnologies through 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 installation 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. In 2005,with the addition of Cedara and AccuImage, we became one of the few radiologysoftware vendors that can offer such comprehensive workflow solutions acrossmany clinical specialties that utilize medical imaging.

Many of the current and potentialcompetitors may have greater resources than we have, including greaterfinancial resources, research and development capabilities, intellectualproperty and marketing resources. Many of these competitors may also havebroader product lines and longer standing relationships with customers. Ourability to compete successfully depends on a number of factors both in andoutside of our control, including: product innovation; product quality andperformance; price; experienced sales, marketing and service professionals;rapid development of new products and features; and product and policydecisions announced by competitors. There can be no assurance that we will beable to compete successfully.

**IntellectualProperty Rights**

We currently own 21patents issued by the intellectual property offices of various jurisdictions,including the U.S. Patent and Trademark Office (“PTO”) and the CanadianIntellectual Property Office (“CIPO”). We continue to expand our intellectualproperty portfolio and have applied for 29 additional patents currently underreview by the PTO, CIPO or Korean Intellectual Property Office. There can be noassurance that these patents will afford any commercial benefits. We do not,however, rely principally on patent protection with respect to our products. Wealso rely on a combination of copyright and trade secret laws, employee andthird party confidentiality agreements and other measures to protectintellectual property rights pertaining to our systems and technology. Wecurrently hold 35 registered or unregistered trademarks in the United States orCanada, and have applied for at least two trademarks currently under review bythe PTO or CIPO. Our trademarks include FUSION RISTM, FUSION MATRIX PACSTM,FUSION PACSTM, FUSION RIS/PACSTM, Referring Practice PortalTM, eFilm WorkstationTM,Cedara I-ReadMammoTM, Cedara B-CADTM, Cedara PET/CTTM, Cedara PET/CTTM,Cedara OrthoWorks PlannerTM, Cedara OrthoWorks Spine AnalyzerTM, CedaraOrthoWorks Care ManagerTM, CalScore ReviewTM, Colon ReviewTM, Lung ReviewTM, 3D/4DReviewTM, AccuStitchTM, Cedara OpenEyesTM, Cedara BluePrintTM, Cedara I-SoftViewTM,Cedara I-ReportTM, Cedara I-Report CTTM, Cedara I-ReadTM, Cedara I-ViewTM,Cedara I-AcquireTM, I-RouteTM, Cedara I-ReachTM, Cedara I-StoreTM, CedaraI-ConferenceTM, ExamWorksTM, ExamWorks+TM, Cedara I-ResponseTM and CedaraDentalWorks Implant PlannerTM. We believe that, in the age of rapidly changingtechnology, our continued success is primarily dependent upon the technicalcompetence and creative skill of our personnel, 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, consideredby Congress. 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 PartI, Item 1A, “Risk Factors” to 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:

·  Changes in Medicare and private insurancereimbursement rates may affect the financial health of our customers’businesses. For example, on February 8, 2006, the President signed into law theDeficit Reduction Act of 2005 (“DRA”). Effective for services provided on orafter January 1, 2007, the DRA provides that reimbursement for the technicalcomponent for imaging services (excluding diagnostic and screening mammography)in non-hospital based freestanding facilities will be capped at the lesser ofreimbursement under the Medicare Part B physician fee schedule or the HospitalOutpatient Prospective Payment System (“HOPPS”) schedule. See Part I, Item 1A, “RiskFactors” for a discussion of the risks and effects of the DRA.

·  The Health Insurance Portability andAccountability Act of 1996 (“HIPAA”) has mandated the use of standard transactionsand identifiers, prescribed security measures and other provisions designed tosimplify and secure the exchange of medical information. The compliance datesfor initial phases of the requirements phase began on April 14, 2003, andcontinued through 2005. We took necessary measures to assist our customers tomeet HIPAA compliance.

·  The U.S. Food and Drug Administration (“FDA”),which is responsible for assuring the safety and effectiveness of medicaldevices under the Federal Food, Drug and Cosmetic Act, has regulatoryjurisdiction over computer software applications when they are labeled orintended to be used in the diagnosis of disease or other conditions. In Canada,medical devices are regulated under Health Canada’s Medical Devices Regulations(“Health Canada”). Our ability to market new products and improvements toexisting products depends upon the timing of appropriate licenses, pre-marketclearance or approval from the FDA, Health Canada, or other applicable foreignregulatory authorities. Failure to comply with applicable domestic or otherforeign regulatory requirements at any time during the production, marketing ordistribution of products regulated by the FDA, Health Canada or otherapplicable foreign regulatory authorities could result in, among other things,seizures of products, total or partial suspension of production, refusal togrant licenses, clearances or approvals, withdrawal of existing licenses,clearances or approvals, or criminal prosecution, any one of which could have amaterial adverse effect on our business, financial condition, results ofoperations and prospects.

·  International sales of products outside of theU. S. are subject to foreign regulatory requirements (in particular, therequirements of the European Union, where most of our international sales aremade), that can vary from country to country.

·  Laws and regulations may be adopted to addressInternet commerce such as online content, user privacy, pricing andcharacteristics and quality of applications and services.

·  The tax treatment of the Internet andeCommerce is currently unsettled.

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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. Participatingin IHE and a variety of DICOM working groups specializing in HIPAA, HL7 andother standards helps to ensure that our products and services align with theefforts of these committees and meet the evolving interoperability needs ofhealthcare technologies.

**Other Information**

Our website address iswww.merge.com. We make available within the “Investors Relations” portion ofour website under the caption “SEC Filings,” free of charge, our annual reportson Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K,including any amendments to those reports, as soon as reasonably practicableafter we electronically file them with, or furnish them to, the SEC. Materialswe file with or furnish to the SEC may also be read and copied at the SEC’sPublic Reference Room at 100 F Street, NE, Room 1580, Washington, D.C. 20549.Information on the operation of the Public Reference Room may be obtained bycalling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet site atwww.sec.gov that contains reports, proxy and information statements, and otherinformation that we file electronically with SEC.

**Item 1A.     RISK FACTORS**

*You shouldcarefully consider the risks, uncertainties and other factors described below,in addition to the other information set forth in this Annual Report on Form10-K, because they could materially and adversely affect our business,operating results, financial condition, cash flows and prospects, as well asadversely affect the value of an investment in our Common Stock. Also, youshould be aware that the risks and uncertainties described below are not theonly ones facing us. Additional risks and uncertainties that we do not yet knowof, or that 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, including ourconsolidated financial statements and the related notes.*

***We have identifiedmaterial weaknesses in our disclosure controls and procedures and our internalcontrol over financial reporting, which, if not remedied effectively, couldhave an adverse effect on the trading price of our Common Stock and otherwiseseriously harm our business***—As discussed in Item9A, “Controls and Procedures” in Part II of this Annual Report on Form 10-K,from January 10, 2006 to May 26, 2006, we received 11 anonymous lettersprimarily alleging improprieties relating to our financial reporting,fulfillment of customer contracts and disclosure practices. More specifically,the letters contained allegations of improper revenue recognition practices. TheAudit Committee retained the independent national law firm of Sidley Austin LLPand Alvarez & Marsal Dispute Analysis and Forensic Services, LLC(“Alvarez & Marsal”), a nationally-recognized forensic accountingfirm, to conduct an independent investigation of the allegations contained inthe anonymous letters. Based upon the normal year end closing process and thepreliminary findings of the investigation, we identified certain errors in ourfinancial statements for the second and third quarters of 2005. On June 29,2006, Sidley Austin LLP reported its findings to the Audit Committee, and theAudit Committee determined that, because of improper accounting and financialreporting practices with respect to reporting periods in the fiscal years 2002through 2005, the previously issued financial statements for each of thereporting periods in 2002 through 2005 should no longer be relied upon. SeeItem 9A, “Controls and Procedures” in Part II of this Annual Report on Form10-K and Footnotes 12 and 13 to the notes to our consolidated financialstatements in Part II, Item 8, “Financial Statements and Supplementary Data” tothis Annual Report on Form 10-K for more information concerning the independentinvestigation. The investigation and the remedial actions resulting from theinvestigation have caused and will likely continue to cause uncertainty anddisruption of our business and operations.

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As discussed in Item 9A, as a consequence of theAudit Committee’s determination that because of improper accounting andfinancial reporting practices with respect to reporting periods in the fiscalyears 2002 through 2005, the previously issued financial statements for each ofthe reporting periods in 2002 through 2005 should no longer be relied upon. Ourmanagement has concluded that our disclosure controls and procedures were noteffective and our internal control over financial reporting had materialweaknesses as of December 31, 2005. Among other things, our controlenvironment was not adequate because certain former members of seniormanagement did not set a proper ethical tone within our organization andinstill an attitude of compliance. Certain former members of our management weredirectly involved in circumventing our accounting controls, and other formermembers of our management were aware of, or should have been aware, that suchcontrols were being circumvented. Further, we do not currently have anenterprise resource planning (“ERP”) system, and, accordingly, are unable tomanage our operations or generate reports from a single integrated data set. Althoughwe have taken actions to begin to address the material weaknesses, ourinability to remedy such material weaknesses promptly and effectively couldhave a material adverse effect on the accuracy and completeness of ourfinancial statements, as well as impair our ability to meet our quarterly andannual reporting requirements in a timely manner and could also have a materialadverse effect on our business relationships and our reputation. Moreover, ourremediation efforts will likely require the commitment of significant financialand managerial resources. Prior to the remediation of these materialweaknesses, there remains the risk that the controls on which we currently relywill fail to be sufficiently effective, which could result in a materialmisstatement of our financial position or results of operations and requirefurther restatement of our financial statements. If we are unable, or areperceived as unable, to produce reliable financial reports due to disclosurecontrol or internal control deficiencies, investors could lose confidence inour reported financial information and our operating results and the marketprice of our Common Stock could be adversely affected. In addition, even if weare successful in strengthening our controls and procedures, such controls andprocedures may not be adequate to prevent or identify misstatements or toprovide reasonable assurance that our financial statements are prepared inconformity with United States of America generally accepted accountingprinciples (“GAAP”).

***Litigation orregulatory actions could adversely affect our financial condition***—We,Richard A. Linden, our former President and Chief Executive Officer, andScott T. Veech, our former Chief Financial Officer, are defendants inseveral lawsuits relating to our accounting and financial disclosure. Inaddition, Brian E. Pedlar, our former Senior Vice President and former Presidentof Cedara Software Corp., who served as our interim co-President and interim co-ChiefExecutive Officer from July 2, 2006 to August 18, 2006, has beennamed in one of the lawsuits. Mr. Linden, Mr. Veech, William C.Mortimore (our founder, former Chairman and former Chief Strategist, who servedas our interim Chief Executive Officer from May 15, 2006 to July 2,2006) and all of the members of our Board of Directors are also defendants in aderivative action, alleging breaches of fiduciary duties and failure to hold a2006 annual meeting of shareholders. These lawsuits and other legal matters inwhich we have become involved, are described in Item 3, “Legal Proceedings”in Part I of this Annual Report on Form 10-K. Those lawsuitspresent material and significant risk to us. We are unable at this time topredict the outcome of these actions or reasonably estimate a range of damagesin the event plaintiffs in these or other potential matters relating to thesame events prevail under one or more of their claims.

The Midwest Office of the Securities and ExchangeCommission (“SEC”) has notified us that we are the subject of an informal,non-public inquiry. We are cooperating with the SEC in response to its requestfor information. The inquiry generally concerns our financial statementrestatements and the anonymous letters we have received regarding ouraccounting and financial disclosure. We cannot predict whether the SEC willexpand the scope of its inquiry or obtain a formal order of investigation.

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These lawsuits and regulatory matters are having, andwill continue to have, a disruptive effect upon the operations of the business,including the diversion of significant time and attention of our seniormanagement, which have adversely affected our results of operations for thefirst and second quarters of fiscal 2006 and we expect will affect our resultsof operations for at least the remainder of 2006. In addition, we are likely toincur substantial expenses in connection with such matters, including substantialfees for attorneys and other professional advisors.

We have purchased Directors and Officers (“D&O”)liability insurance that may provide coverage for some or all of these matters.However, there is risk that the D&O insurers will attempt to rescind thepolicies; that some or all of the claims will not be covered by such policies;or that, even if covered, our ultimate liability will exceed the availableinsurance.

***We may be unable tomaintain our listing on the NASDAQ Global Market, which could impact ourability to secure financing, cause our stock price to fall and decrease theliquidity of our Common Stock***—Our Common Stock iscurrently listed on the NASDAQ National Market (now designated the NASDAQGlobal Market). The continued listing of our Common Stock requires us to meetcertain quantitative and qualitative standards, including the timely filing ofour periodic reports with the SEC. On March 20, 2006, May 16, 2006 and August14, 2006, we received written notifications from the staff of The NASDAQ StockMarket that we were not in compliance with National Association of SecuritiesDealers’ (“NASD”) rules because we did not timely file our Form 10-K for theyear ended December 31, 2005 and our Forms 10-Q for the first and secondquarter of 2006, and that our Common Stock was, therefore, subject to delistingfrom the NASDAQ Global Market. On July 11, 2006, we announced that we hadreceived written notification from the NASDAQ Listing Qualifications Panelstating that the Panel determined to continue the listing of our common stocksubject to our filing of our Form 10-K, our Form 10-Q for the quarter endedMarch 31, 2006 and all required restatements by no later thanAugust 29, 2006. On August 30, 2006, before the commencement of trading onthe NASDAQ Global Market, we filed this Form 10-K and our Form 10-Q for thequarter ended March 31, 2006 with the SEC. We have not yet filed our Form 10-Qfor the quarter ended June 30, 2006. We have requested that the Panel grant usan additional extension until September 8, 2006 to regain compliance with theNASDAQ listing requirements by filing our Form 10-Q for the quarter endedJune 30, 2006, but we cannot be certain that the Panel will grant thisrequest. In any event, we will not be certain that our Common Stock will remainlisted on the NASDAQ Global Market until we receive notification from theNASDAQ Listing Qualifications Panel that all conditions to our continuedlisting on the NASDAQ Global Market have been satisfied.

If delisting of our Common Stock occurs, the tradingof our Common Stock may be conducted on the Over The Counter Bulletin Board orthe Pink Sheets. If our Common Stock is delisted and we are not at that timecurrent in our SEC filings, our Common Stock will trade on the Pink Sheets. Thedelisting of our Common Stock from the NASDAQ Global Market would result indecreased liquidity of our outstanding shares of our Common Stock (and aresulting decrease in the ability of our shareholders to sell our Common Stockor obtain timely quotations as to their market value). For example, certaininstitutions may be unwilling or unable to hold our shares in the event thatour Common Stock were to be delisted. To the extent they currently hold ourCommon Stock, such institutions could be required to divest their holdings,which could impose additional downward pressure on the price of our CommonStock. The delisting of our Common Stock could also deter broker-dealers frommaking a market in or otherwise generating interest in our Common Stock andmight deter certain persons from investing in our Common Stock. Furthermore,our ability to raise additional capital through equity or debt financing couldbe severely impaired, which could materially adversely affect our liquidity andfinancial condition. As a result of these factors, the value of the CommonStock could decline significantly and our stockholders could lose some or allof their investment.

***The turnover in our management team could negativelyimpact our business and the trading price of our Common Stock******—***On May 15,2006, our Board of Directors accepted the resignation of Richard A. Linden, 

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our formerPresident and Chief Executive Officer, from all positions with us and oursubsidiaries, including as an officer, employee and director. At the same time,we appointed William C. Mortimore, who founded the Company and was then servingas our Chairman and Chief Strategist, as our interim Chief Executive Officer. Sixweeks later, on July 2, 2006, our Board of Directors accepted the resignationsof Mr. Mortimore, Scott T. Veech, our former Chief Financial Officer,Treasurer and Secretary, and David M. Noshay, our former Senior VicePresident, Strategic Business Development, from all positions with us and oursubsidiaries, including as officers, employees and directors. At the same time,our Board appointed Michael D. Dunham, the Chairman of our Board of Directors,as our principal executive officer on an interim basis, and Brian E. Pedlar,who had been serving as Senior Vice President of Merge Healthcare and Presidentof Cedara Software Corp., and Robert J. White, who had been serving as SeniorVice President of Merge Healthcare and President of Merge eMed, were eachappointed as our co-President and co-Chief Executive Officer on an interimbasis. On August 17, 2006, we received a written notification from Mr. Pedlar’scounsel of Mr. Pedlar’s departure from us and our subsidiaries, effective as ofthe close of business on August 18, 2006. Our Board is searching for a newChief Executive Officer.

On July 2, 2006, the Boardalso appointed Steven M. Oreskovich, who had been serving as our Vice Presidentand Corporate Controller, as our Chief Accounting Officer and interim Treasurerand Secretary. Mr. Oreskovich will serve as our principal accounting officerand interim principal financial officer. Our Board is searching for a ChiefFinancial Officer.

We may not be able tofind, attract and retain a suitable new Chief Executive Officer and ChiefFinancial Officer on acceptable terms. The new members of our management teammay need to devote a significant amount of time to learning about our businessand its markets, which could limit their effectiveness in managing our businessfor a period of time. Further, there will likely be significant uncertainty asto how we will perform under new leadership.

With the recent departuresof five of our senior executives, we lost persons with a significant amount ofexperience and knowledge about our business, our customers and our industry andstrong relationships with our customers, suppliers and employees. We believethat the turnover of our senior management has created uncertainty that hasadversely affected our relationships with our customers and employees and alsoour reputation in the marketplace. Mr. White, who is President of Merge eMedand has been serving as our interim President and Chief Executive Officer, hasonly been with us for a short time (since April 2006) and continues to learnabout our business. Similarly, Mr. Oreskovich was only recently given theresponsibilities of principal accounting officer and interim principalfinancial officer. We may not be successful if the members of our managementteam, including our new Chief Executive Officer and new Chief FinancialOfficer, once hired, cannot effectively manage and operate our business.

***Our performance and future success depends on ourability to attract, integrate and retain qualified technical, managerial andsales personnel******—***We aredependent, in part, upon the services of our senior executives, some of whomare new hires or have recently assumed new roles, and other key business andtechnical personnel. We do not 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 us. Our continuedcommercialization will depend upon, among other things, the successfulrecruiting and retention of highly skilled technical, managerial and salespersonnel with experience in business activities such as ours. Competition forthe type of highly skilled individuals sought by us is intense. We may not beable to retain existing key employees or be able to find, attract and retainskilled personnel on acceptable terms.

***Relationships with our customers, potential customersand suppliers may be adversely affected, and our competitors’ competitiveposition improved, by our restatement of our financial results, related andregulatory proceedings, potential NASDAQ delisting and management turnover******—***Due to ourrestatement of our financial statements, related litigation and regulatoryproceedings, potential NASDAQ delisting and uncertainty regarding changes in oursenior management team, our customers and potential customers, new or existingsuppliers or others may have concerns that we will become unreliable inoperating our business. As a 

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result, we mayexperience a decrease in the number of new customers or reluctance on the partof existing customers to renew their contracts with us. In addition, we mayexperience a loss of other important business relationships. If our customers,potential customers, suppliers or others lose confidence in our ability to operateour business, our business may be materially harmed and our competitors’competitive position relative to us may be improved.

***Our ability to obtain D&O liability insurance inthe future may be adversely affected by the lawsuits and regulatory actions againstus and certain of our executive officers******—***Thelawsuits and regulatory actions described above, and the facts underlying them,may make director and officer liability insurance extremely expensive orunavailable for us in the future. Increased premiums could materially harm ourfinancial results in future periods. The inability to obtain this coverage dueto its unavailability or prohibitively expensive premiums would make it moredifficult to retain and attract officers and directors and expose us to potentiallyself-funding any potential future liabilities ordinarily mitigated by directorand officer liability insurance.

***Our quarterly net sales may vary significantly******—***Ourquarterly operating results have varied in the past and may continue to vary infuture periods. 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. The salesmay be subject to delays due to customers’ internal budgets and procedures forapproving capital expenditures and by competing needs for other capitalexpenditures, the deployment of new technologies and personnel resources. Delaysin the expected sale or installation of these contracts may have a significantimpact on our anticipated quarterly revenues and consequently, our earnings,since a significant percentage of our expenses are relatively fixed.

Additionally, we generallydepend, in part, upon large contracts with a small number of OEMs to meet oursales goals in any particular quarter. For example, one customer accounted forapproximately 37% of our total net sales for the three months ended September30, 2005, and during the three months ended December 31, 2005, another customeraccounted for approximately 27% of our total net sales. Delays in the expectedsale or installation of solutions under these large contracts may have asignificant impact on our quarterly revenues and consequently our earnings,particularly because a significant percentage of our expenses are fixed.

***Recognition of certain of our revenues may be deferred******—***Recognitionof all or a portion of revenue under certain customer agreements, includinglicense fees and related professional and consulting fees, may be deferred inaccordance with applicable accounting standards. Software revenue is generallyrecognized at the time of shipment to our customers, provided that services arenot considered as essential to the functionality of the software, the contractterms are fixed and determinable, collection is probable, and we have vendorspecific objective evidence (“VSOE”) of fair value of the undelivered contractelements.

Software revenue fromsales of RIS and RIS/PACS solutions, where consulting and installation servicesare generally considered essential to the functionality of the software, arerecognized on the percentage-of-completion method as the services areperformed. We estimate the number of days that services will have to beprovided under each contract relating to such sales to estimate the percentageof completion. At times, we have had difficulty accurately estimating thenumber of days required to complete the consulting and installation servicesand, accordingly, accurately estimating the percentages of completion.

***The length of our sales and implementation cycles mayadversely affect our future operating results******—***We haveexperienced long sales and implementation cycles. How and when to implement,replace, expand or 

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substantiallymodify medical imaging management software, or modify or add businessprocesses, are major decisions for our end-user target market. Furthermore, oursoftware generally requires significant capital expenditures by our customers. Thesales cycle for our software ranges from 6 to 18 months or more from initialcontact to contract execution. Our implementation cycle has generally rangedfrom 3 to 9 months from contract execution to completion ofimplementation. During the sales and implementation cycles, we will expendsubstantial time, effort and resources preparing contract proposals,negotiating the contract and implementing the software. We may not realize anyrevenues to offset these expenditures. Additionally, any decision by ourcustomers to delay or cancel purchases or the implementation of our softwaremay adversely affect our revenues.

***Our dependence on a limited number of suppliers forsoftware and hardware could adversely impact our business and results ofoperations******—***Our accessto certain software and hardware components is dependent in some cases uponsingle and sole source suppliers. The inability of any supplier to fulfill oursupply requirements could adversely affect our business and results ofoperations.

***We face aggressive competition in many areas of ourbusiness, and our business will be harmed if we 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 and potentialcompetitors have greater financial, technical, product development, marketingand other resources than we have, and we may not be able to compete effectivelywith them. In addition, new competitors may emerge and our system and softwaresolution offerings may be threatened by new technologies or market trends thatreduce the value of our solutions.

The development andacquisition of additional products and technologies, and the improvement of ourexisting products requires significant investments in research and development.For example, our current product candidates are in various stages ofdevelopment, and may require significant further research, development,pre-clinical or clinical testing, regulatory approval and commercialization. Wealso may not have devoted adequate resources to the development and acquisitionof additional products since our June2005 business combination with Cedara Software Corp. If we fail tosuccessfully sell new products and update our existing products, our operatingresults may decline as our existing products reach the end of their commerciallife cycles.

***Our proprietary technology may be subjected toinfringement claims or may be infringed upon which could result in additionalcosts 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 patentapplications. We may not, however, be able to obtain additional licenses topatents of others or be able to develop additional patentable technology of ourown. Any patents issued to us may not provide us with competitive advantages,or the patents or proprietary rights of others may have an adverse effect onour ability to do business. Others may independently develop similar productsor design around or infringe such patents or proprietary rights owned by orlicensed to us. Any patent obtained or licensed by us may not be held to bevalid and enforceable if challenged by another party.

Although we endeavor toprotect our patent rights from infringement, we may not be aware, or becomeaware, of patents issued to our competitors or others that conflict with ourown. Such conflicts could result in a rejection of important patentapplications or the invalidation of important patents, which could have amaterially adverse effect on our competitive position. In the event of such conflicts,or in the event we believe that competitive products infringe patents to whichwe hold rights or others believe that our products infringe patents to whichthey hold rights, we may pursue patent infringement litigation or interferenceproceedings against, or may be required to defend against such litigation orproceedings involving holders of such conflicting patents or competingproducts. Such litigation or proceedings may have a materially adverse effecton our competitive position, and there can be no assurance that we will besuccessful in any such litigation or proceeding. Litigation and otherproceedings relating to patent matters, 

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whetherinitiated by us or a third party, can be expensive and time consuming,regardless of whether the outcome is favorable to us, and can result in thediversion of substantial financial, managerial and other resources. An adverseoutcome could subject us to significant liabilities to third parties or requireus to cease any related development or commercialization activities. Inaddition, if patents that contain dominating or conflicting claims have been orare subsequently issued to others and such claims are ultimately determined tobe valid, we may be required to obtain licenses under patents or other proprietaryrights of others. Any licenses required under any such patents or proprietaryrights may not be made available on terms acceptable to us, if at all. If we donot obtain such licenses, we could encounter delays or could find that thedevelopment, manufacture or sale of products requiring such licenses isforeclosed.

We also rely onproprietary know how and confidential information and employ various methods,such as entering into confidentiality and non-compete agreements with ourcurrent employees and with certain third parties to whom we have divulgedproprietary information, to protect the processes, concepts, ideas anddocumentation associated with our solutions. Such methods may not affordsufficient protection to us, and may not be able to adequately protect ourtrade secrets or ensure that other companies would not acquire information thatwe consider proprietary.

***We depend on licenses from third parties for rights tosome technology we use, and if we are unable to continue these relationshipsand maintain our rights to this technology, our business could suffer******—***We dependupon licenses for some of the technology used in our software 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. Inaddition, 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 Food and DrugAdministration (“FDA”), including periodic FDA inspections, in Canada underHealth Canada’s Medical Devices Regulations, and in other countries bycorresponding regulatory authorities. There can be no assurances that we willnot be required to undertake additional actions in the U.S. to comply with theFederal Food, Drug and Cosmetic Act (the “Act”), its implementing regulationsand 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 activelyregulated medical devices by the FDA, we could be subject to more extensiverequirements governing pre- and post-marketing activities. Complying with theseregulations could be time consuming and expensive, and may include:

·  requiring us to receive FDA clearance of apre-market notification submission demonstrating substantial equivalence to adevice already legally marketed, or to obtain FDA approval of a pre-marketapproval application establishing the safety and effectiveness of the software;

·  requiring us to comply with rigorousregulations governing the pre-clinical and clinical testing, manufacture,distribution, labeling and promotion of medical devices; and

·  requiring us to comply with the Act regardinggeneral controls, including establishment registration, device listing,compliance with good manufacturing practices, reporting of specifiedmalfunctions and adverse device events.

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Similar obligations mayexist in other countries in which we do business, including Canada. Any failureby us to comply with the Act and any other applicable regulatory requirements,both domestic and foreign, could subject us to a number of enforcement actions,including warning letters, fines, product seizures, recalls, injunctions, totalor partial suspension of production, operating restrictions or limitations onmarketing, refusal of the government to grant new clearances or approvals,withdrawal of marketing clearances or approvals and civil and criminalpenalties.

***Changes in the healthcare industry, including thechanges to reimbursement schedules under the Deficit Reduction Act of 2005,could negatively impact our business******—***Thehealthcare industry is highly regulated and is subject to changing political,economic and regulatory influences. These factors affect the purchasingpractices and operation of healthcare organizations. Federal and statelegislatures have periodically considered programs to reform the U. S.healthcare system and to change healthcare financing and reimbursement systems.In 2005, Congress legislated an increase (fee schedule update) of approximately1.5% in the overall reimbursement rates for physician and outpatient services,including diagnostic imaging services. On February 8, 2006, the Presidentsigned into law the Deficit Reduction Act of 2005 (“DRA”). Effective forservices 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. The DRA also codifies the reduction in reimbursementfor multiple images on contiguous body parts previously announced by theCenters for Medicare and Medicaid Services (“CMS”). In November 2005, CMSannounced that it would pay 100% of the technical component of the higherpriced imaging procedure and 50% for the technical component of each additionalimaging procedure for imaging procedures involving contiguous body parts withina family of codes when performed in the same session. Under currentmethodology, Medicare pays 100% of the technical component of each procedure. CMSwill phase in this rate reduction over two years, so that the reduction will be25% for each additional imaging procedure in 2006 and another 25% in 2007.

A significant portion ofour net sales are directly or indirectly derived from sales to end-users,including hospitals, diagnostic imaging centers and specialty clinics, many ofwhich generate some or all of their revenues from government sponsoredhealthcare programs (principally, Medicare and Medicaid). We believe that theimplementation of the reimbursement reductions contained in the DRA will adverselyimpact our end-user customers’ revenues, which may cause some of them torespond by reducing their investments or postponing investment decisions,including investments in our software solutions and services.

***Changes in federal and state regulations relating topatient data could depress the demand for our software and impose significantsoftware redesign costs on us******—***Federalregulations under HIPAA impose national health data standards on healthcareproviders that conduct electronic health transactions, healthcareclearinghouses that convert health data between HIPAA compliant andnon-compliant formats and health plans. Collectively, these groups are known ascovered entities. The HIPAA regulations prescribe transaction formats and codesets for electronic health transactions; protect individual privacy by limitingthe uses and disclosures of individually identifiable health information; andrequire covered entities to implement administrative, physical andtechnological safeguards to ensure the confidentiality, integrity, availabilityand security of individually identifiable health information in electronicform. Though we are not a covered entity, most of our customers are and requirethat our software and services adhere to HIPAA regulations. Any failure orperception of failure of our software or services to meet HIPAA regulationscould adversely affect demand for our software and services and force us topotentially expend significant capital, research and development and otherresources to modify our software or services to address the privacy andsecurity requirements of our clients.

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States and foreignjurisdictions in which our clients or we operate have adopted, or may adopt,privacy standards that are similar to or more stringent than the federal HIPAAprivacy regulations. This may lead to different restrictions for handlingindividually identifiable health information. As a result, our customers maydemand IT solutions and services that are adaptable to reflect different andchanging regulatory requirements, which could increase our development costs. Inthe future, federal, state or foreign governmental authorities may impose newdata security regulations or additional restrictions on the collection, use,transmission and other disclosures of health information. We cannot predict thepotential impact that these future rules may have on our business; however, thedemand for our software and services may decrease if we are not able to developand offer software and services that can address the regulatory challenges andcompliance obligations facing our clients.

***The complexity presented by international operationscould negatively affect our business******—***Revenuesfrom customers headquartered outside of the U. S., which we classify asinternational revenues, account for a material portion of our revenues. Netsales from our international locations accounted for approximately 41% of ourtotal net sales for the year ended December 31, 2005, 32% of our total netsales for the year ended December 31, 2004 and 43% of our total net sales forthe year ended December 31, 2003. While we plan to continue expanding ourpresence in international markets, our international operations present anumber of risks, including the following:

·  greater difficulty in collecting accountsreceivable and longer collection periods;

·  potentially unfavorable economic conditionsoutside of the U. S.;

·  changes in local currencies may impact theattractiveness of our product competitiveness as we invoice most of our netsales in U. S. Dollars;

·  certification requirements;

·  lack of, or limited protection of intellectualproperty rights in some countries;

·  potentially adverse tax consequences;

·  political instability;

·  trade protection measures and other regulatoryrequirements;

·  service provider and government spendingpatterns;

·  potential adverse impact on the demand forproducts and services of U. S.-based businesses due to global perceptionsregarding U. S. foreign policy;

·  natural disasters, war or terrorist acts;

·  ineffective strategic relationships withinternational partners; and

·  political conditions which may threaten thesafety of our employees or the employees of our customers or our continuedpresence in foreign countries.

***We provide our customers with certain warranties whichcould result in higher costs than we anticipate******—***Softwareproducts as complex as those offered by us and used in a wide range of clinicaland health information systems settings are likely to contain a number oferrors or “bugs,” especially early in their product life cycle. Our productsare clinical 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, which couldhave a material adverse effect upon results of operations or financialcondition, business and reputation.

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***We may be unable to successfully integrateacquisitions, which could negatively impact our results******—***We haveexperienced significant challenges integrating Merge Healthcare’s and CedaraSoftware Corp.’s businesses and personnel. In particular, we have struggled torealize synergistic benefits as a consequence of organizational changes,primarily within our sales and service groups, following our June 1, 2005business combination with Cedara Software Corp. We may continue to acquire ormake investments in complementary businesses, products or technologies. Theprocess of integrating any acquired business, product or technology into ourbusiness and operations may result in unforeseen operating difficulties andexpenditures. Any acquisition may involve a number of risks, including:

·  an increase in our expenses and workingcapital requirements in connection with the integration of the personnel,operations, technologies or products of the acquired companies;

·  other financial risks, such as potentialliabilities associated with the businesses that we acquire;

·  diversion of capital and management’sattention from our core business;

·  adverse effects on business relationships withour existing customers and suppliers and those of the acquired company;

·  an increased risk that we become the subjectof litigation regarding intellectual property or other matters;

·  difficulty in successfully implementingacquired operations, IT systems, customers, OEM supplier and partnerrelationships, products and business with our operations;

·  acquired assets becoming impaired as a resultof technical advancements or worse than expected performance by the acquiredcompany;

·  entering markets in which we have no, orlimited, prior experience; and

·  potential loss of our key employees and thoseof the acquired company.

Inaddition, in connection with any business combinations or acquisitions orinvestments we could:

·  issue stock that would dilute existingshareholders’ percentage of ownership;

·  incur debt and assume liabilities;

·  obtain financing on unfavorable terms;

·  incur amortization expenses related to acquiredintangible assets, or incur large write-offs (see Part II, Item 9B,“Other Information,” in this Annual Report on Form 10-K);

·  incur significant expenditures related tooffice closures of the acquired companies, including costs relating totermination of employees and leasehold improvement charges relating to vacatingthe acquired companies’ or our premises; and

·  reduce the cash that would otherwise beavailable to fund operations or to use for other purposes.

***Product liability suits against us could result inexpensive and time consuming litigation, payment of substantial damages and anincrease 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 

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damages. Althoughwe maintain product liability insurance coverage, our coverage may not cover aparticular claim that may be brought in the future, prove to be adequate orthat may not be available in the future on acceptable terms, if at all. Asuccessful claim brought against us, which is uninsured or underinsured, couldmaterially harm our business, results of operations or financial condition.

***Beginning in fiscal 2006, under SFAS No. 123(R) wewill begin recording compensation expense in connection with the stock optionsprovided to our employees and directors which may have a significant negativeimpact on future operating results******—***In December2004, the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (revised), *Share-BasedPayment* (“SFAS No. 123(R)”), which requires companies tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in the consolidated financial statements. The impact ofadoption of SFAS No. 123(R) depends on, among other things, levels ofshare-based payments granted in the future, the market value of our CommonStock as well as assumptions regarding a number of complex variables. Thesevariables include, but are not limited to, our stock price, volatility, andemployee stock option exercise behaviors and the related tax impact. Theexpense recorded in future periods may significantly reduce future earnings. Forexample, in 2006, we expect that the application of SFAS No. 123(R) will reduceour net income by at least $3.4 million. Additionally, as a result of ourcombination with Cedara Software Corp., a significant number of our optionholders are residents of Canada. Although we will incur expense under SFAS No. 123(R)for options held by Canadian residents like those held by U.S. residents, we donot receive a tax benefit with respect to options exercised by Canadianresidents such as we receive with respect to options exercised by U. S.residents.

***We may not be able to generate sufficient cash fromour operations to meet our future operating, financing and capital requirements******—***At June 30,2006, our cash and cash equivalents were approximately $60 million. Our uses ofcash in 2006 and future periods will depend on a variety of factors such as theamount of cash that we are required to devote to defend and address ouroutstanding legal and regulatory proceedings (see Part I, Item 3, “LegalProceedings,” in this Annual Report on Form 10-K) and our capital expenditureplans. In the event that we are unable to generate sufficient cash from ouroperations to meet our short term or long term liquidity needs, we may need toraise additional capital. If we need to raise additional capital, sellingadditional equity or raising debt from third party sources may raise suchcapital. The sale of additional equity or convertible debt securities couldresult in dilution to current stockholders. In addition, debt financing, ifavailable, could involve restrictive covenants, which could adversely affectoperations. Furthermore, these financing alternatives may not be available inamounts or on terms acceptable to us.

Our failure to timelyprovide Lincoln State Bank with annual financial statements for the year endedDecember 31, 2005 and interim financial statements for the quarters ended March31, 2006 and June 30, 2006 constituted an event of default under our creditagreement. Accordingly, the obligation of Lincoln State Bank to extend uscredit with respect to our $35 million line of credit terminated. We arecurrently negotiating a new credit agreement with Lincoln State Bank. There canbe no assurance that Lincoln State Bank or any other lender will provide uswith debt financing, or that any such financing will be provided in amounts oron terms acceptable to us.

***We maintain substantial deposits of cash and cashequivalents at a limited number of financial institutions in excess of amountscovered by insurance. If one or more of these financial institutions fail, ourfinancial condition may be adversely affected******—***Substantiallyall of our cash and cash equivalents are held at a few financial institutionslocated in the U. S., Canada and the Netherlands. Deposits held with thesebanks exceed the amount of insurance, if any, provided on such deposits and,with respect to one such banking institution, we are one of the largestdepositors. If one or more of these financial institutions were to fail and weare unable to timely recover the cash and cash equivalents deposited at suchinstitution, it could adversely affect our financial condition.

***Healthcare industryconsolidation could impose pressure on our software prices, reduce ourpotential client base and reduce demand for our software******—***Manyhospitals and imaging centers have consolidated to create 

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larger healthcareenterprises with greater market power. If this consolidation trend continues,it could reduce the size of our target market and give the resultingenterprises greater bargaining power, which may lead to erosion of the pricesfor our software. In addition, when hospitals and imaging centers combine, theyoften consolidate infrastructure, and acquisition of our customers could erodeour revenue base.

***The trading price of our Common Stock has beenvolatile and may fluctuate substantially in the future******—***The priceof our Common Stock has been, and is likely to continue to be, volatile. Forexample, the closing price of our Common Stock from January 1, 2006 through August 28, 2006****was as high as $27.36 and as low as$6.43. The trading price of our Common Stock may fluctuate widely as a resultof a number of factors, some of which are not in our control, including:

·  Our ability to meet or exceed the expectationsof analysts or investors;

·  Changes in our own forecasts or earningsestimates by analysts;

·  Perceptions regarding how our operatingresults presented in accordance with GAAP compare to forecasts of non-GAAPmeasures for our operating results;

·  Quarter-to-quarter variations in our operatingresults;

·  Announcements regarding clinical activities ornew products by our competitors or us;

·  General conditions in the healthcare ITindustry;

·  Governmental regulatory action and healthcarereform measures, including changes in reimbursement rates for imagingprocedures;

·  Rumors about our performance or softwaresolutions;

·  Price and volume fluctuations in the overallstock market, which have particularly affected the market prices of manysoftware, healthcare and technology companies; and

·  General economic conditions.

In addition, the marketfor our Common Stock may experience price and volume fluctuations unrelated ordisproportionate to our operating performance. As a result, you may not be ableto sell shares of our Common Stock at or above the price at which you purchasedthem.

**Item1B.     UNRESOLVED STAFF COMMENTS**

None.

**Item2.        PROPERTIES**

Our principal facilitiesare located in Milwaukee, Wisconsin in an approximately 22,000 square footoffice leased through April 2011 at a rate of approximately $300 per year, andin Toronto, Ontario in an approximately 75,000 square foot office leasedthrough December 31, 2009 at a rate of approximately CDN $1.1 million per year.We also have subsidiary or branch locations with leased facilities in Mississauga,Canada; Hudson, Ohio; Burlington, Massachusetts; San Francisco, California;Nuenen, the Netherlands; Paris, France; Tokyo, Japan and Shanghai, China. OnJune 1, 2006, we signed a letter exercising our right to lease an additional14,000 square feet at our Milwaukee facility, commencing September 1, 2006through April 2011.

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.

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**Item3.        LEGAL PROCEEDINGS**

Between March 22, 2006 andApril 26, 2006, seven putative securities class action lawsuits were filed inthe United States District Court for the Eastern District of Wisconsin, onbehalf of a class of persons who acquired shares of our Common Stock betweenAugust 2, 2005 and March 16, 2006, against us, Richard A. Linden, our formerPresident and Chief Executive Officer, and Scott T. Veech, our former ChiefFinancial 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 from July 2,2006 to August 18, 2006. One case has been voluntarily dismissed. The casesarise out of our March 17, 2006 announcement that that we would revise ourresults of operations for the fiscal quarters ended June 30, 2005 and September30, 2005, as well as our investigation of allegations made in anonymous lettersreceived by us. The lawsuits allege that we and individual defendants violatedSections 10(b) and 20(a) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”). The complaints seek damages in unspecifiedamounts. Competing motions for the appointment of lead plaintiff have beenfiled, but they have not yet been ruled upon by the Court. We intend tovigorously defend these lawsuits, including, but not limited to, possiblymoving to dismiss the consolidated amended complaint when filed.

On August 28, 2006, aderivative action was filed in the Circuit Court of Milwaukee County, CivilDivision, against Messrs. Linden, Mortimore and Veech, all of the currentmembers of our Board of Directors. The plaintiffs allege that each of theindividual defendants breached fiduciary duties to us by violating generally acceptedaccounting principles, willfully ignoring problems with accounting and internalcontrol practices and procedures and participating in the dissemination offalse financial 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.

On April 27, 2006, wereceived an informal, nonpublic inquiry from the SEC requesting voluntaryproduction of documents and other information. The inquiry principally relatesto our announcement on March 17, 2006 that we would revise our results ofoperations for the fiscal quarters ended June 30, 2005 and September 30, 2005,as well as our investigation of allegations made in anonymous letters receivedby us. The SEC has advised us that this inquiry should not be interpreted as anadverse reflection on any entity or individual involved, nor should it beinterpreted as an indication by the SEC that any violation of the federalsecurities laws has occurred. We are cooperating with the SEC.

In March 2006, the patentinfringement lawsuit filed by ScheduleQuest, Inc. was dismissed.

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, wemay be 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.

Item 4.        SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of securityholders during the fourth quarter of 2005.

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**PARTII**

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

Our Common Stock commencedtrading on the NASDAQ SmallCap Market on January 29, 1998, under the symbol MRGE.On June 3, 2003, our Common Stock commenced trading on the NASDAQ NationalMarket (now designated the NASDAQ Global Market) (“NASDAQ”). On March 20, 2006,we received a written notification from the staff of the NASDAQ stating that wewere not in compliance with NASD Marketplace Rule 4310(c)(14) because we didnot timely file our Annual Report on Form 10-K for the year ended December 31,2005, and that our Common Stock was, therefore, subject to delisting from theNASDAQ. On April 20, 2006, three of our independent directors and one of ourofficers appeared before a NASDAQ Listing Qualifications Panel to, among otherthings, request that the panel grant us an extension until June 30, 2006 toregain compliance with the filing requirement. We received a secondnotification from the staff on May 16, 2006, stating that our failure to timelyfile our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006,would serve as an additional basis for delisting our Common Stock. On May 31,2006, we received written notification from the NASDAQ Listing QualificationsPanel stating that it had determined to continue the listing of our CommonStock on the NASDAQ subject to our filing of this Annual Report on Form 10-Kfor the year ended December 31, 2005, our Quarterly Report on Form 10-Q for thequarter ended March 31, 2006 and all required restatements by no later thanJuly 7, 2006. When it became clear that we would be unable to file thesereports by July 7, 2006, we requested an additional extension until September30, 2006 to regain compliance with the NASDAQ listing requirements. On July 11,2006, we received written notification from the NASDAQ Listing QualificationsPanel stating that the Panel determined to continue the listing of our CommonStock subject to our filing of this Annual Report on Form 10-K, our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2006 and all requiredrestatements by no later than August 29, 2006. On August 14, 2006, we receiveda written notification from the Panel stating that our failure to timely fileour Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 wouldserve as an additional basis for delisting our Common Stock from the NASDAQGlobal Market. On August 30,2006, before the commencement of trading on the NASDAQ Global Market, we filedthis Form 10-K and our Form 10-Q for the quarter ended March 31,2006. We have not yet filed our Form 10-Q for the quarter endedJune 30, 2006. We have requested that the Panel grant us an additionalextension until September 8, 2006 to regain compliance with the NASDAQlisting requirements by filing our Form 10-Q for the quarter endedJune 30, 2006, and expect to file that Form 10-Q by this requestedadditional extension date. See Part I, Item 1A, “Risk Factors,” to thisAnnual Report on Form 10-K for a discussion of the risks and effects if we areunable to maintain our listing on the NASDAQ Global Market.

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

**Common Stock Market Prices**

| ** ** | ** ** | **4th Quarter** | ** ** | **3rd Quarter** | ** ** | **2nd Quarter** | ** ** | **1st Quarter** | ** ** |
|------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| 2005       |       |                 |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| High       |       |                 | $          | 30.05                |       |                 |       | $                    | 20.49      |   |   |   | $ | 20.00 |   |   |   | $ | 22.90 |   |   |
| Low        |       |                 | $          | 16.29                |       |                 |       | $                    | 16.50      |   |   |   | $ | 14.90 |   |   |   | $ | 17.05 |   |   |
| 2004       |       |                 |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| High       |       |                 | $          | 23.54                |       |                 |       | $                    | 17.94      |   |   |   | $ | 18.37 |   |   |   | $ | 20.10 |   |   |
| Low        |       |                 | $          | 16.39                |       |                 |       | $                    | 11.36      |   |   |   | $ | 13.16 |   |   |   | $ | 12.20 |   |   |

 

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According to the recordsof American Stock Transfer & Trust Company, our registrar and transferagent, we had 236 stockholders of record of Common Stock as of August 22, 2006.As of the same date, we estimate that there were in excess of 4,800 beneficialholders 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 of UnregisteredSecurities**

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 2005.

On March 1, 2006, weannounced that our Board had authorized us to expand our stock repurchaseprogram to a total of $20 million of our Common Stock, from the priorauthorization of $10 million. This repurchase program expired on August 24,2006, two years after its initial implementation, without any shares havingbeen repurchased. Our Board has not made any decision as to if or when asimilar program will be implemented.

**Item 6.        SELECTED FINANCIAL DATA**

Wehave not amended our Annual Reports on Form 10-K or Quarterly Reports on Form10-Q for the periods affected by the restatements and the financial statementsand related financial information contained in such reports should no longer berelied upon. See Item 8 “Financial Statements and Supplementary Data” and Item9A “Controls and Procedures” in Part II of this Annual Report on Form 10-K,and Notes 12 and 13 to the notes to consolidated financial statements, for moreinformation concerning the restatements. The information that has beenpreviously filed or otherwise reported for these periods is superseded by theinformation in this Annual Report on Form 10-K and in our Quarterly Reports onForm 10-Q for the quarter ended March 31, 2006, which is being filedcontemporaneously with this Form 10-K.

| ** **                            | ** ** | **Year Ended December 31,**                                                      | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2005(1)**                                                                                     | ** ** | **2004(2)** | ** ** | **2003(2)** | ** ** | **2002(2)** | ** ** | **2001** | ** ** |
| ** **                            | ** ** | ** **                                                                                      | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** | **(As restated** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | **(in thousands, except for share and per share data)** | ** ** |
| Statements of Operations  Data:       |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Net sales                             |       | $                                                                                               | 82,601     |   | $ | 26,347 |   | $ | 24,560 |   | $ | 19,147 |   | $ | 15,741 |   |
| Operating income(3)                   |       | 4,526                                                                                           |       | 499 |   | 3,310 |   | 2,782 |   | 1,296 |   |
| Income before income taxes            |       | 5,232                                                                                           |       | 968 |   | 3,208 |   | 2,846 |   | 1,358 |   |
| Income tax expense (benefit)          |       | 7,889                                                                                           |       | (1,222 | ) | (1,226 | ) | 79 |   | 87 |   |
| Net income (loss)                     |       | (2,657                                                                                          | )          | 2,190 |   | 4,434 |   | 2,767 |   | 1,271 |   |
| Earnings (loss) per  share:           |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                 |       | $                                                                                               | (0.11      | ) | $ | 0.17 |   | $ | 0.38 |   | $ | 0.29 |   | $ | 0.17 |   |
| Diluted                               |       | (0.11                                                                                           | )          | 0.16 |   | 0.35 |   | 0.25 |   | 0.15 |   |
| Weighted average shares  outstanding: |       |                                                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                 |       | 24,696,762                                                                                      |       | 13,013,927 |   | 11,566,054 |   | 8,840,059 |   | 6,178,821 |   |
| Diluted                               |       | 24,696,762                                                                                      |       | 13,827,522 |   | 12,586,900 |   | 10,383,651 |   | 7,310,731 |   |

 

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| ** **                    | ** ** | **As of December 31,** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **2005**                              | ** ** | **2004(2)** | ** ** | **2003(2)** | ** ** | **2002(2)** | ** ** | **2001** | ** ** |
| ** **                    | ** ** | ** **                            | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **(in thousands)**               | ** ** |
| Balance Sheet  Data:          |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Working capital               |       | $                                     | 57,336     |   |   | $ | 22,785 |   |   |   | $ | 18,187 |   |   |   | $ | 7,010 |   |   | $ | 2,628 |   |
| Total assets(4)               |       | 501,673                               |       |   | 85,491 |   |   |   | 66,085 |   |   |   | 27,481 |   |   | 10,056 |   |
| Long-term debt obligations    |       | —                                |       |   | — |   |   |   | — |   |   |   | — |   |   | 159 |   |
| Shareholders’  equity(4) |       | 443,841                               |       |   | 55,623 |   |   |   | 50,856 |   |   |   | 20,821 |   |   | 6,169 |   |
|                               |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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  (1) Includes the results of Cedara Software Corp.from June 1, 2005, the date of our business combination.

  (2) As disclosed under “ExplanatoryNote—Restatements of Financial Information” immediately preceding Part I, Item1 of this Annual Report on Form 10-K, we have restated certain financial datafor the years ended December 31, 2004, 2003 and 2002. The effects on net salesrelated to these restatements were a decrease of $10.7 million, $4.1 millionand $1.6 million, respectively, for the years ended December 31, 2004, 2003 and2002. The net effects on income before income taxes related to theserestatements were a decrease of $8.8 million, $3.7 million and $0.9 million,respectively, for the years ended December 31, 2004, 2003 and 2002. The effectson net income for the periods ended December 31, 2004, 2003 and 2002 werea decrease of $5.3 million, $1.8 million and $0.9 million,respectively. Refer to Note 13 of notes to consolidated financialstatements for additional information.

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

  (4) As disclosed under “ExplanatoryNote—Restatements of Financial Information” immediately preceding Part I, Item1 of this Annual Report on Form 10-K, we have restated certain financial data asof December 31, 2004, 2003 and 2002. The effects on total assets were anincrease of $6.5 million, $2.2 million and $0.2 million, as ofDecember 31, 2004, 2003 and 2002, respectively. The effects on shareholders’equity were a decrease of $7.9 million, $2.7 million and$0.9 million as of December 31, 2004, 2003 and 2002, respectively.

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**Item 7.        MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*The discussionbelow contains “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the Securities Act,and Section 21E of the Exchange Act. We have used words such as “believes,” “intends,”“anticipates,” “expects” and similar expressions which are intended to identifyforward-looking statements. 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 andopportunities and the timing of certain events to differ materially from thoseexpressed in, or implied by, these statements. These risks, uncertainties andother factors include, without limitation, those matters discussed in Item 1A “RiskFactors” in Part I of this Annual Report on Form 10-K. Except as expresslyrequired by the federal securities laws, we undertake no obligation to updatesuch factors or to publicly announce the results of any of the forward-lookingstatements contained herein to reflect future events, developments, or changedcircumstances, or for any other reason. The following discussion should be readin conjunction with the consolidated financial statements and notes theretoappearing elsewhere in this report, as well as consolidated financialstatements and notes thereto and related management discussion and analysis offinancial conditions and results of operations included in our Quarterly Reporton Form 10-Q for the quarter ended March 31, 2006, which is being filedcontemporaneously with this Form 10-K.*

*The financial data in this Annual Report on Form 10-Kfor the first three quarters of 2005 and for each of the quarters in 2004 hasbeen restated from amounts previously reported to correct accounting errors. Adiscussion of the restatement for these quarters is provided in Note 12 to the consolidatedfinancial statements contained in this report and under “Restatement ofPreviously Issued Consolidated Financial Statements” below. Dollars are inthousands unless otherwise noted.*

**Overview**

Operating under the name Merge Healthcare, we developmedical imaging and information management software and deliver relatedservices. We operate three principal sales and business development channels:Direct, which generally sells to the U.S. end-user healthcare market comprisedof hospitals, imaging centers and specialty clinics; OEM and International,which primarily sells to OEMs and VARs, comprised of companies that develop,manufacture or resell medical imaging software or devices, and also to theinternational end user healthcare market; and eCommerce which distributescertain products through the Internet via our website. Our three-channeldistribution methodology is unique in our industry. Products and servicesdeveloped throughout Merge Healthcare are sold via Direct, OEM/VAR andInternational, and eCommerce channels worldwide. This multiple channel approachwas developed to optimize the sales of the products created throughout all ofMerge Healthcare, resulting in a large portfolio of solutions that can be soldin the manner that best benefits our customers, and generates both upstream anddownstream revenues for us.

Healthcare providerscontinue to be challenged by declining reimbursements, competition and reducedoperating profits brought about by the increasing costs of deliveringhealthcare services. In the U. S., we are focusing our direct salesefforts on single and multi-site imaging centers that complete more than 10,000studies per year, small-to-medium sized hospitals (fewer than 400 beds), andcertain specialty clinics like orthopedic practices that offer imagingservices. Millennium Research Group, an international market research firm,recently reported that, in 2005, the U.S. market for RIS and PACS, consistingof RIS and enterprise, radiology, orthopedic and cardiology PACS, was valued atover $1.5 billion; that by 2010 this market will grow to over $3.0 billion,representing a compound annual growth rate of nearly 15%; and that growth forthe RIS market is primarily driven by imaging centers and small hospitals,particularly those that do not already have a PACS or RIS and elect for anintegrated RIS/PACS solution.

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*Acquisitions*

We have aggressively expanded our product offerings,especially in the past four years, through our acquisitions of eFilm in 2002,RIS Logic in 2003, and more recently through our acquisition of AccuImage inJanuary 2005, and our business combination with Cedara Software Corp. in June2005. We acquired AccuImage for an aggregate transaction consideration of$6,978 in cash. In the case of the business combination with Cedara SoftwareCorp., each Cedara Software Corp. share was exchanged for either 0.587 Mergecommon share or 0.587 exchangeable share of our wholly owned subsidiary, MergeCedara ExchangeCo Limited, and each Cedara Software Corp. option was exchanged foran option to purchase 0.587 Merge common share with the exercise price adjustedby the U. S. dollar/Canadian dollar exchange rate as of June 1, 2005. Theaggregate transaction consideration was valued at approximately $386,899. SeeNote 2 to our consolidated financial statements for more information about our AccuImageand RIS Logic acquisitions, as well as our business combination with CedaraSoftware Corp. See Part II, Item 9B, “Other Information” for adiscussion of the impairment of goodwill associated with our businesscombination with Cedara Software Corp.

At the time of its acquisition, AccuImage was in thedevelopment, marketing and support of software for the advanced visualization,analysis and management of medical imaging data from medical imagingmodalities. The capabilities of AccuImage have strengthened our valueproposition both to our end-user and OEM/VAR customers. Similarly, at the timeof our business combination with Cedara Software Corp., Cedara Software Corp.was unique among medical imaging technology companies in that it hadtechnologies and expertise that spanned all of the major digital imagingmodalities including CT, MRI, digital x-ray, mammography, ultrasound, echo-cardiology,angiography, nuclear medicine, PET and fluoroscopy. Our business combinationwith Cedara Software Corp. substantially increased our market penetration inthe OEM/VAR medical imaging market, adding more than 200 customers that utilizeCedara Software Corp. products or services and expanded our direct end-usercustomer base and technology suite. As a result of the business combination, wenow have an extensive imaging product suite to meet the current and emergingneeds of OEM and end-user customers in radiology and multiple clinicalspecialties. We believe that the international presence, strong product anddistribution market coverage and financial strength of the combined companywill allow us to capitalize on the continued digitization of the healthcareindustry.

Our expanded portfolio oftechnology solutions created by our strategic acquisitions allow us to crosssell existing solutions, and provide more comprehensive solutions to ourcustomers, allowing them to adopt digital imaging technology more easily andinexpensively. In 2005, we also focused our integration efforts on formingsales and service groups with an emphasis on revenue synergies. For example, weintroduced OEM clinical applications to the end-user healthcare market and toour RIS, PACS and RIS/PACS customers. In 2005, we also began to cross sell RISand PACS solutions to existing customers, added sales professionals to oursales force and refined our sales processes and tracking mechanisms to providereal time information to manage our sales efforts.

**Restatement ofPreviously Issued Consolidated Financial Statements**

From January 10, 2006 through May 26, 2006, wereceived 11 anonymous letters primarily alleging improprieties relating to ourfinancial reporting, fulfillment of customer contracts and related revenuerecognition, and disclosure practices. The Audit Committee of our Board ofDirectors took a leadership role in assessing these matters and determining theappropriate corrective action with the assistance of outside counsel. The AuditCommittee of our Board of Directors retained the independent national law firmof Sidley Austin LLP and Alvarez & Marsal, a nationally recognized forensicaccounting firm, to conduct an independent investigation of the allegationscontained in the anonymous letters. Sidley Austin LLP and Alvarez & Marsalconducted a comprehensive investigation of our accounting and financialreporting practices, which included, among other things, a review of relevantdocuments and interviews of 

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current and formeremployees of Merge Healthcare and Cedara Software Corp., which we acquired inJune 2005. On May 15, 2006, Richard A. Linden, our former President and ChiefExecutive Officer, submitted his resignation from all positions with us and oursubsidiaries, including as an officer, employee and director, and our Board ofDirectors accepted Mr. Linden’s resignation.

On June 29, 2006, soon after Sidley Austin LLPcompleted its investigation, Sidley Austin LLP reported its findings to theAudit Committee, and the Audit Committee determined that, because of improperaccounting and financial reporting practices with respect to reporting periodsin the fiscal years 2002 through 2005, the previously issued financialstatements for each of the reporting periods in 2002 through 2005 should nolonger be relied upon. Furthermore, the audit reports of KPMG LLP with respectto those financial statements (including the report of KPMG with respect to management’sassessment of and the effectiveness of our internal control over financialreporting) should no longer be relied upon. On June 30, 2006, the AuditCommittee presented its recommendations to all of our non-employee directors. OnJuly 2, 2006, our Board of Directors held a meeting at which it accepted theresignations of each of William C. Mortimore, our former interim ChiefExecutive Officer, Scott T. Veech, our former Chief Financial Officer,Treasurer and Secretary, and David M. Noshay, our former Senior Vice President,Strategic Business Development, from all positions with us and oursubsidiaries, including as officers, employees and directors.

The errors identified inpreviously issued financial statements are described below.

*Revenue Recognition*

We determined thatwe overstated net sales for 2002, 2003, 2004 and the first nine months of 2005due to the following:

·  Delivery of certain software products toend-user customers that did not fully meet the functionality that we believeour customers expected based on express representations we made to ourcustomers or implied representations, made to our customers that arose from ourdemonstrations of the software products during the sales process. We have deferredsuch revenue until the delivery of the expected product functionality, themajority of which occurred in the third and fourth quarters of 2005 and thesecond quarter of 2006.

·  Collectibility was not reasonably assured atthe time certain revenue was recognized. Some of our contracts failed toreflect contingencies expressly demanded by the customer. We have notrecognized revenue until collectibility became reasonably assured, generally ascash was collected from the respective customer.

·  Recording revenue prior to shipment of thecorrect products included in a customer’s contract. We have deferred revenueuntil shipment of the appropriate products occurred.

·  Recording revenue prior to shipment of allsoftware products included in a customer’s contract. Since we did not havevendor specific objective evidence of fair value for the software element ofcertain of our contracts, we were required to defer all revenue for certaincustomer orders with partial software product shipment until delivery of allsoftware products occurred.

·  For certain customers’ contracts, we wereunable to establish vendor specific objective evidence of fair value ofmaintenance. We have deferred the related contract value and are recognizingrevenue ratably over the related maintenance period.

·  Wedetermined that we failed to reduce net sales attributable to a contract,although we had agreed to provide the customer with $200****in additional software at no additionalcost to the customer.

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*Income Tax Expense*

We determined that weunderstated income tax expense, income tax payable and goodwill in the amountsof $1,308, $3,854 and $2,546, respectively, for the quarter ended, and as of,June 30, 2005, due to a failure to record additional tax liabilityand income tax expense in connection with our June 2005 businesscombination with Cedara Software Corp.

In addition, we adjustedthe provisions for income tax and related tax accounts at the applicablestatutory rates to account for the effects of the restatement adjustmentsdescribed herein.

*Other Adjustments*

As a result of the revenueadjustments, certain revenue-related accounts were impacted and also restated. Theseincluded cost of goods sold related to contracts impacted, deferred revenue(net of the costs of goods), bad debt expense, and the related accountsreceivable allowance, accounts receivable and commission expense.

Please refer to Note 13 ofour accompanying consolidated financial statements for a discussion of therestatement of certain of our previously reported financial information, andNote 12 for a summary of the impact of the restatement on our previouslyreported quarterly financial information in 2004 and 2005. Please also refer toPart I, Item 1A, “Risk Factors,” in this Annual Report on Form 10-K for adescription of the costs, risks and uncertainties related to the investigationand restatement.

We, by means of thisAnnual Report on Form 10-K, have restated our previously issued consolidatedfinancial statements and financial information for each of the fiscal yearsended December 31, 2004 and 2003, including unaudited interim quarterlyfinancial statements and financial information for each of the quarters of 2004and unaudited interim financial statements and financial information for eachof the first three quarters of 2005. This filing also includes revisedfinancial data for fiscal years ended December 31, 2002 and 2001 on anunaudited basis. We have not amended our Annual Reports on Form 10-K orQuarterly Reports on Form 10-Q for any of the affected periods. The informationthat has been previously filed or otherwise reported for these periods issuperseded by the information contained in this Annual Report on Form 10-K, andthe financial statements and related financial information contained in suchreports should no longer be relied upon.

**Other Recent Developments**

During 2005, we focused onthe following key initiatives: expanding our OEM and International channels;expanding our business development and sales distribution capabilities;expanding our RIS/PACS product features and market share; implementingstrategies to enhance and strengthen the relationship with our customers,employees and shareholders, and forming strategic relationships to expand ourproducts and services in line with emerging medical imaging market trends.

We also focused ouroperational efforts on implementing an integration plan to yield revenue,product and operational synergies. We progressed with our next generationintegrated RIS/PACS, utilizing its advanced features to enhance our valueproposition to our customers. We focused on a web-based distribution solutionto extend our RIS/PACS offering to referring physicians, strengthening ourfinancial foundation, enhancing our sales and distribution channels, andleveraging the strength of our product brands. We also made steady progress instrengthening our reputation as a leading medical imaging workflow solutionprovider. We marketed and cross sold bundled products from across all of ourcombined product lines.

We continued to expand ourOEM and International channel in 2005 by offering an expanded portfolio ofmedical imaging technologies, development platforms and products, accomplishedthrough our business combination with Cedara Software Corp., including newclinical applications such as: Cedara I-ConferenceTM andCedara PET/CT WorkstationTM; Cedara I-ResponseTM designed to 

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assistphysicians in cancer research and treatment; the MergeCOM-3TM AdvancedIntegrator’s Native Java Tool Kit Version 3.0 utilized by OEM customers in thedevelopment of medical imaging software that requires DICOM conformance; and,Cedara B-CAD, the first CAD solution for breast ultrasound. Cedara B-CADis currently being offered through Eastman Kodak Company to its customersworldwide as part of an integrated solution with their KODAK CARESTREAMMammography Workstation. Our portfolio of technologies is more fully describedin Part I, Item 1, “Business,” in this Annual Report on Form 10-K.

Through our OEM andInternational channel (“Cedara”), we entered into several strategic partnershipsand ventures in new markets. In 2005, we announced a strategic partnership withi-Dent Imaging Inc. (“I-Dent”), pursuant to which we acquired an equity stakein i-Dent, received exclusive global rights for distribution of i-Dent’s dentalimplant technology and agreed to work with i-Dent to develop products. We alsoentered into a strategic partnership with a veterinary radiology company, EklinMedical Systems Inc. (“Elkin”), pursuant to which we became a 10% equitystakeholder in Eklin, and Eklin became a strategic partner to distribute oureFilm WorkstationTM and FUSION PACSTM, and medical image and informationmanagement solutions. We and Eklin further agreed to exclusively co-market andco-brand our medical software solutions and to collaborate on new products formedical image and data management for the veterinary market. We also continuedto deploy resources and build strategic relationships in several new marketsincluding workflow and electronic medical records, cardiology, pathology andpharmaceutical and life sciences.

In 2005, we expanded ourend-user business development and sales distribution capabilities to broadenour coverage of the North American healthcare market and to develop long-termrelationships with national imaging center chains, including three of the TopTen Medical Imaging Chains as recently acknowledged by *Medical Imaging* magazine. Our ability tounderstand the intricacies of business and clinical workflow within our end-usertarget market, especially imaging centers, has enabled us to expand ourrelationship with regional and national imaging center chains such as InSightHealth, CDI and Regional Diagnostic, and helped us win an important newRIS/PACS software and service contract with Radiologix. In 2005, we alsocontinued to implement end-user sales initiatives, including targeted sales andmarketing activities designed to achieve broader geographic coverage, expandedpresence in other healthcare vertical markets and expanded product purchases bycurrent customers.

We expanded our U.Shealthcare RIS, PACS, RIS/PACS and Clinical Applications customer base tonearly 1,000 organizations, including over 700 end-user customers and over 275OEM/VAR customers. Use of our eFilm WorkstationTM desktop medical imagingsoftware increased substantially during the year, delivering strong softwarelicensing revenues and exposing eFilm WorkstationTM to over 60,000 cliniciansand healthcare professionals worldwide. This eCommerce marketing and softwaredistribution strategy continues to be a strong source of FUSION RIS/PACSTM salesleads and is intended to serve as a platform for distribution of our newadvanced visualization and clinical applications.

In 2006, we have continuedto develop products and services that enhance the value of our RIS/PACSfoundation beyond radiology, creating clinical applications for use by theincreasing number of specialists that utilize diagnostic imaging in theirpractices, and developing products to launch into new markets. We anticipateaccelerating product innovation in partnership with our OEM customers andleveraging those relationships to strategically innovate our end-user productsmore rapidly to meet future customer needs.

In 2005, Congresslegislated an increase (fee schedule update) of approximately 1.5% in theoverall reimbursement rates for physician and outpatient services, includingdiagnostic imaging services. On February 8, 2006, the President signed into lawthe DRA, which provides that reimbursement for the technical component forimaging services (excluding diagnostic and screening mammography) in non-hospitalbased freestanding facilities will be capped at the lesser of reimbursementunder the Medicare Part B physician fee schedule or the HOPPS schedule. The DRAalso codifies the reduction in reimbursement for multiple images on contiguousbody parts previously announced by the CMS. In 

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November2005, CMS announced that it would pay 100% of the technical component of thehigher priced imaging procedure and 50% for the technical component of eachadditional imaging procedure for imaging procedures involving contiguous bodyparts within a family of codes when performed in the same session. Undercurrent methodology, Medicare pays 100% of the technical component of eachprocedure. CMS will phase in this rate reduction over two years, so that thereduction will be 25% for each additional imaging procedure in 2006 and another25% in 2007. We believe that the implementation of the reimbursement reductionscontained in the DRA will adversely impact our end-user customers’ revenues,and may cause some of our existing or new customers to respond by reducingtheir investments or postponing investment decisions, including investments inour software solutions and services.

We continue to facesignificant business challenges that stem from the uncertainty created bychanges in our senior management, announcements regarding our inability to meetrequirements of the NASDAQ Global Market for continued listing, an informal,non-public inquiry being conducted by the Securities and Exchange Commissionand class action and other lawsuits. We believe that these matters haveadversely affected the morale of our employees, our relationships with certaincustomers and potential customers and our reputation in the marketplace, andhave diverted the attention of our Board of Directors and management from ourbusiness operations. We also have experienced challenges integrating thebusinesses and personnel of Merge Healthcare and Cedara Software Corp. Inparticular, we struggled to realize synergistic benefits as a consequence oforganizational changes, primarily within our sales and service groups,following that business combination. See Part II, Item 9B, “OtherInformation” for a discussion of the impairment of goodwill associated with ourbusiness combination with Cedara Software Corp. In addition, since our businesscombination with Cedara Software Corp., we may not have devoted adequateresources to the development and acquisition of additional products. See PartI, Item 1A, “Risk Factors,” and Part I, Item 3, “Legal Proceedings,” in thisAnnual Report on Form 10-K for more detailed discussion regarding thesematters.

**Revenues and Expenses**

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. Service and maintenance consists ofinstallation 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 discounted at our cost of capital) to the carrying value ofthe software. If the carrying value of the software exceeds its fair value, werecord an impairment charge in the period in which the impairment is incurredequal to the amount of the difference between the carrying value and discountedcash flows.

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*Selling and MarketingExpense*

Selling and marketingexpense includes the costs of sales and marketing departments, commissions andcosts associated with trade shows.

*Research and Development Expense*

Research and developmentexpense consists of expenses incurred for the development of our proprietarytechnologies, included in Part I, Item 1, “Business” in this Annual Report onForm 10-K. The costs reflected in this category are reduced by softwaredevelopment capitalized in accordance with Statement of Financial Accounting Standard(“SFAS”) No. 86, *Accounting for the Costs of**Computer Software to Be Sold, Leased, or Otherwise Marketed*.The amortization of capitalized software development costs is included in costof sales.

*General and Administrative Expense*

General and administrativeexpense includes costs for information systems, accounting, administrativesupport, management personnel, bad debt expenses and general corporate matters.

*Acquired In-Process Research and Development*

In connection with ouracquisition of Cedara Software Corp. in 2005 (see “Acquisitions” above), weincurred a charge for acquired in-process research 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) the fairvalue was estimable with reasonable reliability. At the date of the businesscombination, Cedara Software Corp. had in-process projects meeting thisdefinition associated with the Cedara next generation PACS workstation, OEMimaging platforms and image acquisition console projects.

The estimated fair valueof the Cedara Software Corp. projects was determined by using the excessearnings approach. Appraisal assumptions utilized under this method included aforecast of estimated future net cash flows, as well as discounting the futurenet cash flows to their present value. We used a 20% discount rate, which wascalculated using an industry beta and capital structure.

*Restructuring and Other Expenses*

In 2005, we incurredrestructuring and other expenses consisting of the impairment of a non-cancelablebuilding lease, which we ceased using during 2005 as we combined two of ouroffices located in the same geographic region, severance to involuntarilyterminated employees as we combined the historic Merge and Cedara SoftwareCorp. businesses, and option acceleration expense related to such employees. Wedid not incur restructuring and other expenses in 2004 or 2003.

*Depreciation and Amortization*

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 at Cedara Software Corp. and on foreign currencypayables and receivables at our Nuenen, The Netherlands branch.

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**Critical Accounting Policies**

Our consolidated financialstatements are impacted by the accounting policies used and the estimates,judgments, and assumptions made by management during their preparation. We baseour estimates and judgments on our experience, our current knowledge (includingterms of existing contracts), our beliefs of what could occur in the future,our observation of trends in the industry, information provided by ourcustomers and information available from other sources. Actual results maydiffer from these estimates under different assumptions 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 intangible assetvaluation, loss contingencies and income taxes.

*Revenue Recognition*

We derive revenuesprimarily from the licensing and sublicensing of software, sales of hardwareand related ancillary products, installation, 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 element arrangementshould be treated as separate units of accounting for revenue recognitionpurposes in accordance with Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition*, or EmergingIssues Task Force (“EITF”) Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*, and if so, the relativefair value that should be allocated to each of the elements as well as when torecognize revenue for each element.

For software arrangements,we recognize revenue in accordance with SOP No. 97-2*.* This generally requires revenue recognized on software arrangementsinvolving multiple elements to be allocated to each element based on the vendor-specificobjective evidence of fair values of those elements. Revenue from multiple-elementsoftware arrangements is recognized using the residual method, pursuant to SOPNo. 98-9, *Modification of SOP No. 97-2,Software Revenue Recognition, With Respect to Certain Transactions* (“SOPNo. 98-9)*.* Under the residualmethod, revenue is recognized in a multiple element arrangement when VSOE offair value exists for all of the undelivered elements in the arrangement, evenif vendor-specific objective evidence of fair value does not exist for one ormore of the delivered elements in the arrangement, assuming all otherconditions for revenue recognition have been satisfied. For sales transactionswhere the software is incidental, and hardware transactions where no softwareis involved, we recognize revenue in accordance with EITF Issue No. 00-21 andStaff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition*.

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 may be stated in the contract, or forcertain customer groups using the bell-shaped curve approach. The fair value ofinstallation, engineering services, training, and consulting is based upon theprice charged when these services are sold separately. If evidence of the fairvalue cannot be established for undelivered elements of a sale, the entireamount of revenue under the arrangement is deferred until elements without VSOEof fair value have been delivered or VSOE of fair value can be established. Ifevidence of fair value cannot be established for the maintenance element of a 

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sale,and it represents the only undelivered element, the software, hardware, orsoftware maintenance elements of the sale are deferred and recognized ratablyover the related maintenance period.

Revenue from sublicenses sold on an individual basisand software licenses are recognized upon shipment, provided that evidence ofan arrangement exists, delivery has occurred and risk of loss has passed to thecustomer, fees are fixed or determinable and collection of the relatedreceivable is probable. We assess collectibility based on a number of factors,including past transaction history with the customer and the credit worthinessof the customer. We must exercise our judgment when we assess the probabilityof collection and the current creditworthiness of each customer. If thefinancial condition of our customers were to deteriorate, it could affect thetiming and the amount of revenue we recognize on a contract. In addition, incertain transactions we may negotiate that the customer provides common stockownership in consideration as part of the sale. We generally do not requestcollateral from customers.

Revenue from software usage sublicenses sold throughannual contracts and 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.

Revenue from sales of RIS and from RIS/PACS solutions,where professional services are considered essential to the functionality ofthe solution sold, is recognized on the percentage-of-completion method, asprescribed by SOP No. 81-1, *Accounting forPerformance on Construction-Type and Certain Production-Type Contracts*.Percentage of completion is determined by the input method based upon theamount of labor hours expended compared to the total estimated amount of laborhours to complete the project. Total estimated labor hours is 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 expended and reflect changes in estimates in the periodthat such estimates are revised under the cumulative catch-up method. Attimes, we have had difficulty accurately estimating the number of days requiredto complete the consulting and installation services and, accordingly,accurately estimating 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. We provide engineering services to our OEMcustomers under time-and-material or fixed-price contracts that are generallylonger than one year in duration. Under engineering service contracts where theservices are performed and costs incurred in proportion with contracted billingschedules, revenue is recognized when the customer may be billed. This methodis expected to result in reasonably consistent profit margins over the contractterm. For certain fixed-price contracts, we use percentage-of-completionaccounting.

For contracts accounted for under SAB No. 104, wegenerally invoice the customer for the final 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 andacceptance criteria, we defer the related amount of product fair value andrecognize it upon completion of installation and acceptance.

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 revenuerepresents license fees, support and maintenance, and other services to beearned or provided beginning in periods on or after January 1, 2007. See Note13 of notes to consolidated financial statements for discussion of revenuerecognition matters that have lead to significant deferred revenue balances atDecember 31, 2005 and 2004.

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We record reimbursable out-of-pocketexpenses in both services and maintenance net sales and as a direct cost ofservices and maintenance in accordance with EITF Issue No. 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred*. In accordance withEITF Issue No. 00-10, *Accounting forShipping and Handling Fees*, the reimbursement by customers ofshipping and handling costs are recorded in software and other net sales andthe associated cost as a cost of sale.

*Allowance for Doubtful 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.

*Software Capitalization*

Software capitalizationcommences when management determines that projects have achieved technologicalfeasibility, unless the costs expected to be incurred after achievingtechnological feasibility until general release are immaterial. Management’sdetermination 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. Management also estimates therealizability of capitalized values based on projections of future netoperating cash flows through the sale of products related to each capitalizedproject. If we determine in the future that the value of capitalized softwarecannot be recovered, a write down of the value of the capitalized software toits recoverable value may be required. If the actual achieved revenues arelower than 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-Lived Assets*

Other long-lived assets,including property and equipment, and other intangibles, are amortized overtheir expected lives, which are estimated by management. Management also makesestimates of the impairment of long-lived assets whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable based primarily upon whether expected future undiscounted cashflows are sufficient to support the assets recovery. If the actual useful lifeof a long-lived asset is shorter than the useful life estimated by us, theassets may be deemed to be impaired and, accordingly, a write down of the valueof the assets or a shorter depreciation or amortization period may be required,generally determined by a discounted cash flow analysis.

*Goodwill and Other Intangible Assets*

Effective January 1,2002, we adopted SFAS No. 142, which requires that goodwill andindefinite lived intangible assets be reviewed for impairment annually, or morefrequently if impairment indicators arise. Our policy provides that goodwilland indefinite lived intangible assets will be reviewed for impairment as ofDecember 31 of each year. In calculating potential impairment losses, weevaluate the fair value of goodwill and intangible assets using either quotedmarket prices or, if not available, by estimating the expected present value oftheir future cash flows. Identification of, and assignment of assets andliabilities to, a reporting unit require management judgment and estimates. Inaddition, future cash flows are based upon management’s assumptions aboutfuture sales activity and market acceptance of our products. If 

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theseassumptions change, we may be required to write down the carrying value of theasset to a revised amount. See Part II, Item 9B, “Other Information”for a discussion of the impairment of goodwill associated with our businesscombination with Cedara Software Corp.

*Income Taxes*

As part of the process ofpreparing our consolidated financial statements, we are required to estimateincome taxes in each of the jurisdictions in which we operate. The provisionfor income taxes is determined using the asset and liability approach foraccounting for income taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*. A currentliability is recognized for the estimated taxes payable for the current year. Deferredtax assets and liabilities are recognized for the estimated future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabilities are measured using the enacted taxrates in effect for the year in which the timing differences are expected to berecovered or settled. The effect on deferred tax assets and liabilities ofchanges in tax rates or tax laws are recognized in the provision for incometaxes in the period that includes the enactment date.

Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount morelikely than not to be realized. To the extent we establish or change thevaluation allowance in a period, the tax effect will flow through the statementof operations. However, in the case of deferred tax assets of an acquired ormerged entity with a valuation allowance recorded for purchase accounting, anychange in that valuation allowance will be recorded 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 the all 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, when necessary, in accordancewith the requirements of SFAS No. 5, *Accountingfor Contingencies*. These tax contingencies accruals are reviewedquarterly and reverse 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. Due to the complexity involved, we are not able to estimatethe range of possible losses in excess of amounts recorded.

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 signficant unused or infrequently occurring items, discontinued operationsor extraordinary items are separately recognized in the income tax provision inthe quarter in which they occur.

*Guarantees*

Effective January 1, 2003,we adopted FASB Interpretation (“FIN”) No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*(“FIN No. 45”). FIN No.45 requires that we recognize the fair value for guarantee and indemnificationarrangements issued or modified by us after December 31, 2002, if thesearrangements are within the 

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scope ofthe interpretation. In addition, we must continue to monitor the 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 connection with claimsasserted under these provisions and, accordingly, we have not recorded aliability relating to such provisions.

Under our software license, services and maintenanceagreement, we also represent and warrant to licensees that our softwareproducts operate substantially in accordance with published specifications, andthat the services we perform will be undertaken by qualified personnel in aprofessional manner conforming to generally accepted industry standards andpractices. Historically, only minimal costs have been incurred relating to thesatisfaction 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,we, Richard A. Linden, our former President and Chief Executive Officer andScott T. Veech, our former Chief Financial Officer, are defendants in severallawsuits relating to our accounting and financial disclosure; one of thesesuits also names Brian E. Pedlar, former President of Cedara Software Corp. andformer Senior Vice President of Merge Healthcare, who served as interim co-Presidentand co-Chief Executive Officer from July 2, 2006 to August 18, 2006. Theselawsuits and other legal matters in which we have become involved, includingour receipt of a shareholder demand for derivative action, are described inNote 8 of notes to consolidated financial statements. We may be required toindemnify these individuals and advance them for their expenses in connectionwith such matters and therefore, may be required to accrue for such guaranteesin future periods.

*Loss Contingencies*

We may, in the future,accrue for costs associated with certain contingencies, including, but notlimited to settlement of legal proceedings and regulatory compliance matters,when such costs are probable and reasonably estimable. Liabilities establishedto provide for contingencies are adjusted as further information develops,circumstances change, or contingencies are resolved. See Part I, Item 3, “LegalProceedings,” in this Annual Report on Form 10-K for a discussion of mattersfor which we may be required, in the future, to accrue costs.

*Recent AccountingPronouncements*

In December 2004, the FASB issued SFAS No. 123(R),*Share-Based Payment*, to beeffective for interim or annual periods beginning after September 15,2005. On April 14, 2005, the SEC amended the compliance dates to requireSFAS No. 123(R) to be effective for fiscal years beginning after September15, 2005. SFAS No. 123(R) revises SFAS No. 123 and supersedes AccountingPrinciples Board Opinion No. 25 and requires all share-based payments toemployees, including grants of employee stock options, to be recognized as anexpense in the statement of operations. The cost will be recognized over therequisite service period based on fair values measured on the respective grantdates. We have adopted the new standard, as of January 1, 2006, using themodified prospective transition method, which permits recognition of expense onor after the effective date for the portion of outstanding awards for which therequisite service has not yet been rendered. The adoption of SFAS No. 123(R)will result in additional 

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expense being recordedbeginning in 2006 related to our share-based employee compensation programs. Weexpect the adoption of SFAS No. 123(R) will have a material impact on ourresults of operations (see Note 1(u) to notes to consolidated financialstatements).

In July 2006, FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes anInterpretation of FASB Statement No. 109*, (“FIN No. 48”). FIN No. 48is effective for the first interim or annual reporting period for the firstfiscal year beginning on or after December 15, 2006, although earlier adoptionis encouraged. FIN No. 48 applies to all tax positions for income taxesaccounted for in accordance with SFAS No. 109. We are currently evaluating theimpact of the adoption of FIN No. 48.

In June 2005, FASB issuedSFAS No. 154, *Accounting Changes and ErrorCorrections*. This statement replaces APB Opinion No. 20, *Accounting Changes*, and SFAS No. 3, *Reporting Accounting Changes in Interim FinancialStatements*. The statement applies to all voluntary changes inaccounting for and reporting of changes in accounting principles. SFAS No. 154requires retrospective application to prior periods’ financial statements of avoluntary change in accounting principles unless it is not practical to do so. APBNo. 20 previously required that most voluntary changes in accounting principlesbe recognized by including in net income of the period of the change thecumulative effect of changing to the new accounting principle. SFAS No. 154 iseffective for accounting changes made in fiscal years beginning after December15, 2005. Earlier application is permitted for accounting changes madeoccurring in fiscal years beginning after May 31, 2005.

**Results of Operations**

***(in thousands, except for share and per share data)***

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

The results of operationsfor the year ended December 31, 2005 include those of AccuImage and CedaraSoftware Corp. since the date of each respective acquisition. The followingtable sets forth selected, unauditedconsolidated financial data for the periods indicated, expressed as apercentage of net sales.

| ** **                                   | ** ** | **Twelve Months Ended** | ** ** |
|----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **December 31,**             | ** ** |
| ** **                                   | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | ** **                        | ** ** | **(As restated)** | ** ** |
| 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         |   |   |   | — |   |   |
| 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** | ** ** |
| ** **                          | ** ** | ** **            | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Software and other                  |       | $                     | 60,120     |                   |       | $ | 17,444 |   |   |   | 245 | % |   |
| As a percentage of total  net sales |       | 73                    | %          |                   | 66         | % |   |   |   |   |   |
| Service 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 was $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 since thedate of the business combination with Cedara Software Corp. As a result of thisbusiness combination, we have been able to offer an extensive imaging productsuite that has allowed us to meet the current and emerging needs of OEM and end-usercustomers in radiology and multiple clinical specialties.

Sales from service 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 OEM and end-user customers, whilethe rest of the increase was primarily attributable to the growth in sales madedirectly to healthcare facilities and imaging centers, where such sales areaccompanied by installation services and service contracts.

Of our net sales in the twelve months ended December31, 2005, approximately 16% and 10%, respectively, were attributable to twocustomers, Toshiba Medical Systems Corporation and Hitachi Medical Corporation.We anticipate that we may sign large customer contracts that may or may nothave an immediate impact to our net sales. The impact to net sales in anyperiod will depend on a number of factors, most notably whether or not we havemet all the criteria for software revenue recognition and have established VSOEof fair value for the undelivered contract elements.

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

·  We deferredapproximately $1,800 and $10,700 for 2005 and 2004, respectively, due tocurrent year and prior years’ contracts, for which the software product solddid not meet functionality we believe was expected by the customer and as towhich revenue was therefore deferred into future periods.

·  Net saleswere reduced by approximately $1,000 related to customer contracts wherecollectibility was not reasonably assured at time of delivery of the software.

·  Netsales for 2005 were reduced by approximately $900 for 2005 due to contracts inwhich we did not deliver all contract software products.

·  Netsales were reduced by approximately $300 for 2005 due to contracts for which wedid not have vendor specific objective evidence of fair value of maintenance.

Webelieve that the aggregate amount of total net sales that is recognized in thestatement of operations and the net change in the deferred revenue accounts(current and long-term) on the balancesheet, could be useful indicators of the approximate value of newcontracts during the period. Certaincontracts, and portions of other contracts, may not be recorded as revenue ordeferred revenue due to the timing in which we can invoice our customers aswell as revenue recognition guidelines, including, but not 

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limited to, our determination ofwhen contract collectibility is reasonably assured. The following tablesets forth such data for the twelve months ended December 31, 2005 and December31, 2004:

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

 

*Cost of Sales*

Thefollowing table sets forth cost of sales data:

|                          | ** ** | **December 31,** | ** ** | ** **             | ** ** |
|--------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **               | ** ** | **2005**              | ** ** | **2004**               | ** ** | **% Change** | ** ** |
| ** **               | ** ** | ** **            | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Software and  other      |       | $                     | 6,921      |                   |       | $ | 2,302 |   |   |   | 201 | % |   |
| Service 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 112%, of this increase was attributable tocosts incurred 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. This decrease was attributable torevenue recognized as a result of the inclusion of sales to Cedara OEMcustomers, which generally do not include any component costs.

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 and end-usercustomer custom engineering, installation, engineering, training and consultingservices, and maintenance and support departments. As a percentage of net serviceand maintenance sales, the cost of services and maintenance for 2005 was 49%,compared to 69% for 2004. The costs to provide all services to our customerswere recognized as a period cost. The unusually high percentage for 2004 wasattributed to our deferral of service revenue related to sales of certainsoftware products to end-user customers that did not meet the functionalitythat we believe was expected by the customer.

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% of net sales for 2005compared to 59% for 2004. The increase in gross margin as a percentage of saleswas primarily due to the greater percentage of software-only sales in thetwelve months ended December 31, 2005 as a result of the inclusion of OEM andinternational customer sales. Sales relating to our OEM customers are primarilysales of imaging software without services, which generally carry highermargins than our solutions that may also include a service or 

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hardwarecomponent. The relatively low percentage for 2004 was primarily attributed toour deferral of service net sales, in addition to the software and other netsales, related to sales of certain software products to end-user customers thatdid not meet the functionality that we believe was expected by the customer,sales in which we did not ship all software products, and sales wherecollectibility was not reasonably assured. The costs to provide all services toour customers were recognized as a period cost.

*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. Sales and marketing expense for 2005 as a percentage of salesdecreased to 17% compared to 27% for 2004. The relatively high percentage for2004 was attributed to our deferral of revenue related to sales of certainsoftware products to end-user customers that did not meet the functionalitythat we believe was expected by the customer.

*Product Research and 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 increased 4%from 8% for 2004 to 12% for 2005. The majority of these increases were theresult of the inclusion of expenses for Cedara’s OEM operations, which have asignificant engineering department due to the importance of innovating softwaretechnologies in our OEM business. Capitalization of software development costsincreased $142, or 4%, to $3,621 for 2005, from $3,479 for 2004.

*General and Administrative*

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. As described in the section above captioned“Restatement of Previously Issued Consolidated Financial Statements,” certainof our previously issued financial statements have been restated. We haveincurred, and continue to incur, substantial additional costs related to thecompletion of our 2005 audit and the reviews of restated periods that will beexpensed in the first, second and third quarters of 2006. In addition, we mayalso incur substantial expenses, including substantial fees for attorneys andother professional advisors, in connection with the lawsuits and regulatorymatters described in Part I, Item 3, “Legal Proceedings,” to this Annual Reporton Form 10-K.

*Acquired In-Process Research 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.

*Restructuring and Other Expenses*

We incurred $530 ofrestructuring and other expenses in the twelve months ended December 31, 2005,consisting of the lease exit costs associated with a non-cancelable buildinglease of approximately $175 which we ceased using during 2005 as we combinedtwo of our offices located in the same geographic region, severance toinvoluntarily terminated employees of $263 and option acceleration expense of$92 related to such employees, based on the intrinsic value of options at thetime of termination. We did not incur restructuring and other expenses in 2004.In August 2006, we settled our outstanding lease obligations with the landlordfor $175.

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*Depreciation and Amortization*

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 was 4%in 2005 and 2004. These increases were primarily due to the $610 impairment ofcertain customer relationships as the result of triggering events that occurredin 2005 and amortization of customer contracts associated with the Cedara SoftwareCorp. 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 balance, and increased interest rates on our cashbalances in 2005 compared to 2004. Other expense, net, was $317 in 2005compared to other income, net, of $146 in 2004. Net other expense for 2005 was primarily attributable to foreign exchangelosses on foreign currency payables at Cedara Software Corp., where thefunctional currency is the U. S. Dollar. Net other income for 2004was primarily attributable to the recovery from an insurance claim that wasfiled in 2003 for business interruption. As a percentage of net sales, totalnet other income decreased slightly to 1% for 2005 compared to 2% for 2004.

*Income Taxes*

We recorded income taxexpense of $7,889 for 2005, an increase of $9,111, or 746%, from the benefit of$1,222 recorded for 2004. As a percentage of net sales, income tax increased to10% expense, from a 5% benefit in 2004.

Our effective tax rate for2005 was approximately 151%. Our effective tax rate differed from the statutoryrate primarily due to the in-process research and development cost which is notdeductible for income tax purposes and a $1,308 accrual associated withtransaction-related legal restructuring during 2005. Excluding these two items,our 2005 effective tax rate 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.

***YearEnded December 31, 2004 Compared to Year Ended December 31, 2003***

OnJuly 17, 2003 we acquired RIS Logic. The results of operations for 2003 includethose of RIS Logic since the date of acquisition. The following table setsforth selected, unaudited consolidated financial data for the periodsindicated, expressed as a percentage of net sales.

| ** **                          | ** ** | **Twelve Months Ended  December 31,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **                          | ** ** | **2004**                                             | ** ** | **2003** | ** ** |
| ** **                          | ** ** | **(As restated)**                               | ** ** | **(As restated)** | ** ** |
| Net sales                           |       |                                                 | 100        | % |   |   | 100 | % |   |
| Cost of sales                       |       |                                                 | 41         |   |   |   | 33 |   |   |
| Gross margin                        |       |                                                 | 59         |   |   |   | 67 |   |   |
| Operating costs and  expenses:      |       |                                                 |       |   |   |   |   |   |   |
| Sales and marketing                 |       |                                                 | 27         |   |   |   | 27 |   |   |
| Product research and  development   |       |                                                 | 8          |   |   |   | 8 |   |   |
| General and  administrative         |       |                                                 | 18         |   |   |   | 15 |   |   |
| Depreciation and  amortization      |       |                                                 | 4          |   |   |   | 4 |   |   |
| Total operating costs and  expenses |       |                                                 | 57         |   |   |   | 54 |   |   |
| Operating income                    |       |                                                 | 2          |   |   |   | 13 |   |   |
| Total other income, net             |       |                                                 | 2          |   |   |   | — |   |   |
| Income before income  taxes         |       |                                                 | 4          |   |   |   | 13 |   |   |
| Income tax expense  (benefit)       |       |                                                 | (4         | ) |   |   | (5 | ) |   |
| Net income                          |       |                                                 | 8          | % |   |   | 18 | % |   |

 

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*Net Sales*

Thefollowing table sets forth net sales component data for the twelve months endedDecember 31, 2004 and December 31, 2003:

| ** **                         | ** ** | **December 31,**  | ** ** | ** **             | ** ** |
|------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **2004**               | ** ** | **2003**               | ** ** | **% Change** | ** ** |
| ** **                         | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Software and  other                |       |                   | $          | 17,444                 |       |   |   | $ | 17,532 |   |   |   | (1 | )% |   |
| As a percentage of total net sales |       |                   | 66         | %                      |       |   | 71 | % |   |   |   |   |   |
| Service and  maintenance           |       |                   | $          | 8,903                  |       |   |   | $ | 7,028 |   |   |   | 27 | % |   |
| As a percentage of total net sales |       |                   | 34         | %                      |       |   | 29 | % |   |   |   |   |   |
| Total net sales                    |       |                   | $          | 26,347                 |       |   |   | $ | 24,560 |   |   |   | 7 | % |   |

 

Software and other sales for 2004 was $17,444, adecrease of $88, or 1%, from software and other sales of $17,532 for 2003.Software and other sales remained relatively consistent due to the deferral ofcertain sales in which we did not deliver software products to end-usercustomers that did not meet the functionality that we believe was expected bythe customer.

Sales from service andmaintenance for 2004 was $8,903, an increase of $1,875, or 27%, from2003 net sales of $7,028. The growth of sales from the professional servicesgroup was attributed to a continued increase in the number of service contractsfor customer sales in the current year and prior years pursuant to which wedelivered the software product functionality contracted by the customer.

Net sales decreased byapproximately $10.1 million and $3.8 million, respectively, of netsales from current year and prior years’ contracts for 2004 and 2003, for whichthe software products sold did not meet functionality we believe was expectedof customer and was therefore deferred into future periods.

Webelieve that the aggregate amount of total net sales that is recognized in thestatement of operations and the net change in the deferred revenue accounts on the 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, 2004 and December 31, 2003:

| ** **                        | ** ** | **December 31,**  | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **2004**               | ** ** | **2003** | ** ** |
| ** **                        | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Revenue                           |       |                   | $          | 26,347 |   |   |   | $ | 24,560 |   |   |
| Net increase in deferred  revenue |       |                   | $          | 13,742 |   |   |   | $ | 7,836 |   |   |

 

*Cost of Sales*

Thefollowing table sets forth cost of sales data for the twelve months endedDecember 31, 2004 and December 31, 2003:

| ** **               | ** ** | **December 31,**  | ** ** | ** **             | ** ** |
|--------------------------|------------|------------------------|------------|------------------------|------------|
| ** **               | ** ** | **2004**               | ** ** | **2003**               | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Software and  other      |       |                   | $          | 2,302                  |       |   |   | $ | 2,867 |   |   |   | (20 | )% |   |
| Service and  maintenance |       |                   | 6,108      |                   |       |   | 3,530 |   |   |   | 73 | % |   |
| Amortization             |       |                   | 2,492      |                   |       |   | 1,771 |   |   |   | 41 | % |   |
| Total cost of sales      |       |                   | $          | 10,902                 |       |   |   | $ | 8,168 |   |   |   | 33 | % |   |

 

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The cost of software and other for 2004 was $2,302, adecrease of $565 or 20% from the cost of software and other for 2003 of $2,867.This decrease was attributable to deferral of recognition of the purchasedcomponents that were included in FUSION RIS/PACSTM sales, and to FUSION PACSTMonly sales during 2004 related to contracts with deferred revenue attributed tothe delay in delivery of software functionality. As a percentage of netsoftware and other sales, the cost of purchased components for 2004 was 13%,compared to 16% for 2003. We deferredsoftware and other costs in 2004 and 2003 related to sales of certainsoftware products to end-user customers that did not meet the functionalitythat we believe was expected by the customer. This cost will be recognized inthe period when the delivery of the expected product functionality occurs.

The cost of professional services and maintenance was$6,108 for 2004, an increase of $2,578, or 73%, from $3,530 for 2003. As apercentage of net service and maintenance sales, the cost of professionalservices and maintenance for 2004 was 69%, compared to 50% for 2003. The coststo provide all services to our customers were recognized as a period cost. The relatively high percentage for 2004 wasattributed to our deferral of service revenue related to sales of certainsoftware products to end-user customers that did not meet the functionalitythat we believe was expected by the customer. This service and maintenancerevenue will be recognized when the delivery of the expected productfunctionality occurs. Cost ofprofessional services for the twelve months ended December 31, 2003 includeonly associated costs of RIS Logic operations since the acquisition date.

Amortization of purchasedand developed software was $2,492, an increase of $721, or 41%, from $1,771 for2003. As a percentage of total net sales, amortization of purchased anddeveloped software for 2004 was 9%, compared to 7% for 2003. The increase in2004 was a result of the commencement of amortization on software available forgeneral release throughout 2004 as well as the amortization of RIS Logic-relatedacquired technology since the acquisition date.

*Gross Margin*

Gross margin was $15,445in 2004, a decrease of $947, or 6%, from $16,392 for 2003. As a percentage oftotal net sales, gross margin decreased to 59% of net sales in 2004 compared to67% for 2003. The relatively low percentagefor 2004 was attributed to our deferral of service revenue, in addition to thesoftware and other revenue, related to sales of certain softwareproducts to end-user customers that did not meet the functionality that webelieve was expected by the customer. The costs to provide all services to ourcustomers were recognized as a period cost.

*Sales and Marketing*

Sales and marketing expensefor 2004 was $7,006, an increase of $463, or 7%, from $6,543 for 2003. Theincrease was the result of our objective to increase our investment in salesand marketing activities, particularly for sales team efforts in connectionwith sales made directly to healthcare facilities and imaging centers and anincreased presence at our industry’s largest tradeshow, RSNA, in late November2004. As a percentage of net sales, sales and marketing expense for 2004 and2003 was 27%.

*Product Researchand Development*

Research and developmentexpense for 2004 was $1,967, a decrease of $96, or 5%, from $2,063 for 2003.Research and development expense as a percentage of net sales was 8% in 2004and 2003. Capitalization of software development costs increased $805, or 30%,to $3,479 in 2004, from $2,674 in 2003, as a result of our continueddevelopment of FUSIONTM application modules and further integration of ourFUSION RIS/PACSTM technologies during 2004. The decrease as a percentage ofsales was attributable to our quality assurance efforts, which allowed us tospend a greater percentage of time on capitalizable projects.

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*General andAdministrative*

General and administrativeexpense for 2004 was $4,820, an increase of $1,192, or 33%, from $3,628 for2003. As a percentage of net sales, general and administrative expense for 2004was 18%, compared to 15% for 2003. The increase was primarily attributable toincreased costs associated with our efforts to comply with the Sarbanes-OxleyAct of 2002, and to building infrastructure to support our growth.

*Depreciation andAmortization*

Depreciation andamortization expense for 2004 was $1,153, an increase of $305, or 36%, from$848 for 2003 as a result of fixed assets acquired from the RIS Logicacquisition being depreciated for an entire twelve months in 2004. Depreciationand amortization expense as a percentage of net sales was 4% in 2004 and 2003.

*Other Income,Expense*

Our interest expenseincreased slightly to $21 in 2004 compared to $18 in 2003, while interestincome was $344 in 2004 compared to $100 in 2003. The increase in interestincome was directly attributable to our increased cash and cash equivalentbalances throughout 2004 compared to 2003. Net other income was $146 in 2004compared to net other expense of $184 in 2003. The increase in net other incomefor 2004 was attributable to the recovery from an insurance claim filed in 2003for business interruption and to unrealized foreign exchange gains on Euro-denominatedcash held in our Netherlands branch, where the functional currency is theU. S. Dollar. Net other expense for 2003 was primarily attributable tounrealized foreign exchange losses on U. S. Dollar receivables and cashheld in our Canadian subsidiary, where the functional currency was the Canadiandollar until June 2005.

*Income Taxes*

We recorded income tax benefit of $1,222 for 2004, adecrease of $4 from the benefit of $1,226 recorded from 2003. As a percentageof sales, income tax benefit for 2004 was 4%, compared to 5% for 2003.

Our effective tax rate for 2004 was approximately126%. Our effective tax rate differed from the statutory rate primarily due to anextraterritorial income tax benefit and research and experimentation credit.

Our effective tax rate for2003 was approximately (38)%. Our effective tax rate differed from thestatutory rate primarily due to us benefiting from the reversal of the assetvaluation allowance established against our net deferred tax asset (netoperating loss carryforwards and research credits) recorded prior to 2003.Excluding this item, the 2003 effective tax rate would have been approximately42%.

**Liquidity and Capital Resources**

***(in thousands, except for share data)***

Our cash and cashequivalents were $64,278 at December 31, 2005, an increase of $36,211 from ourbalance of $28,067 at December 31, 2004. In addition, our working capital,defined as the amount of our current assets that exceed our currentliabilities, was $57,336 at December 31, 2005, an increase of $34,551 from ourworking capital of $22,785 million at December 31, 2004. At June 30, 2006, ourcash and cash equivalents were $60,689.

*Operating CashFlows*

Cash provided by operating activities was $23,602 in2005, an increase of $9,690, or 70%, from $13,912 in 2004. Our positiveoperating cash flow in 2005 was due primarily to charges reflected in ourstatement of 

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operations that do notrequire cash outlay, such as stock compensation expense, provision for doubtfulaccounts, depreciation, amortization, in-process research and development costsand deferred income taxes totaling $33,410 and an increase in deferred revenueof $6,973, offset in part by a net loss of $2,657, an increase in accountsreceivable of $5,421, a decrease of accounts payable of $3,474 and a netdecrease in other assets of $5,117. The increase in accounts receivable wasprimarily attributable to increased sales as a result of the businesscombination with Cedara Software Corp. The decrease in accounts payable wasprimarily attributable to payment of liabilities assumed as part of thebusiness combination with Cedara Software Corp.

Although we recorded income tax expense in 2005, thecash flow impact is expected to be less than the income tax expense in the nexttwo years, due to tax benefits associated with utilizing net operating losses,tax credits (including losses and credits acquired in the Cedara Software Corp.transaction) and tax deductions associated with certain stock option exercisesor disqualifying dispositions of Common Stock.

As described in thesection above captioned “Overview—Restatement of Previously Issued ConsolidatedFinancial Statements,” the previously issued financial statements for each ofthe reporting periods in 2002 through 2005 should no longer be relied upon andrequired restatement. We have incurred approximately $4.3 million in coststhrough June 30, 2006 related to the completion of our 2005 audit and thereviews of restated quarterly periods, and continue to incur, substantialadditional costs that will be expensed in the third quarter of 2006. Inaddition, we may also incur substantial expenses, including substantial feesfor attorneys and other professional advisors, in connection with the lawsuitsand regulatory matters described in Part I, Item 3, “Legal Proceedings,” tothis Annual Report on Form 10-K. These cash payments will adversely affect ouroperating cash flows in 2006 and beyond.

*Investing CashFlows*

Cash provided by investingactivities was $3,027 in 2005, due primarily to cash acquired in acquisitions,net of cash paid, of $9,644, offset by capitalized software development costsof $3,621 and purchases of capital equipment of $2,996. We expect to continueto invest in software development projects in our effort to continue toincrease sales. As part of the business combination with Cedara Software Corp.,we acquired $21,639 of cash. This amount was in part offset by net cash paid inthe AccuImage acquisition of $6,785 and transaction costs related to the CedaraSoftware Corp. transaction of $5,210 incurred by us and paid as of December 31,2005.

*Financing CashFlows*

Cash provided by financingactivities was $9,572 in 2005. We received net proceeds of $9,508 from employeeand director stock option exercises and $64 from purchases of Common Stockunder our employee stock purchase plan.

*Share RepurchaseProgram*

On March 1, 2006, weannounced that our Board had authorized us to expand our stock repurchaseprogram to a total of $20 million of our Common Stock, from the priorauthorization of $10 million. This repurchase program expired on August 24,2006, two years after its initial implementation, without any shares havingbeen repurchased. Our Board has not made any decision as to if or when asimilar program will be implemented.

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*ContractualObligations*

Totaloutstanding commitments at December 31, 2005, 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                 |       | $          | 8,017      |                                     |       | $ | 2,201 |   |   |   | $ | 3,885 |   |   |   | $ | 1,781 |   |   |   | $ | 150 |   |   |
|                                  |            |            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In April 2005, we moved to our new headquarters inMilwaukee, Wisconsin, which has approximately 22,000 square feet and is leasedthrough April 2011. In connection with the business combination with CedaraSoftware Corp., we assumed lease obligations associated with a leased facilityin Mississauga, Ontario, Canada, which has approximately 60,000 square feet andis leased through December 2009, and a leased facility in Burlington,Massachusetts, which has approximately 24,000 square feet and is leased throughOctober 2008. The contractual obligations table above reflects amounts dueunder all leases, including the new lease in Milwaukee and leases acquired fromthe business combination with Cedara Software Corp. On June 1, 2006, we signeda letter exercising our right to lease an additional 14,000 square feet at ourMilwaukee facility, commencing September 1, 2006 through April 2011.****In August 2006, we settled our outstandinglease obligations with the landlord of a facility that we ceased using during2005 for $175. The effects of these two events are not included in the tableabove.

In September 2005, we amended our unsecured revolvingline of credit agreement with Lincoln State Bank, increasing our line to$35,000 from $15,000 effective September 27, 2005, and maturing September 26,2006. The interest rate on the line of credit was at a variable rate that isequal to the prime rate as published in *TheWall Street Journal*, less 75 basis points. At December 31, 2005, theloan’s interest rate was 6.5%. No amounts were outstanding on the line ofcredit as of December 31, 2005. As of December 31, 2005, we were in compliancewith all covenants under this line of credit.

Our failure to provide Lincoln State Bank with timelyannual financial statements for the year ended December 31, 2005 and interimfinancial statements for the quarters ended March 31, 2006 and June 30, 2006,constituted an event of default under our credit agreement. Accordingly, theobligation of Lincoln State Bank to extend us credit with respect to our$35,000 line of credit terminated. We are currently negotiating a new creditagreement with Lincoln State Bank. There can be no assurance that Lincoln StateBank or any other lender will provide us with debt financing, or that any suchfinancing will be provided in amounts or on terms acceptable to us.

We have incurred certain costs associated withinvoluntarily terminated employees, which have been accrued for and included inthe estimated value of liabilities assumed in conjunction with our businesscombination with Cedara Software Corp. At December 31, 2005, there wereapproximately $1,621, based on a present value using a 6% discount rate, ofremaining severance payments, which will be made over a period of approximately18 months.

We do not have any othersignificant long-term obligations, contractual obligations, lines of credit,standby letters of credit, guarantees, standby repurchase obligations or othercommercial commitments.

*General*

We believe that ourexisting cash and cash equivalents and future cash flows from operations willbe sufficient to otherwise meet our liquidity needs in 2006. However, anyprojections of future cash inflows and outflows are subject to uncertainty. Inparticular, our uses of cash in 2006 will depend on a variety of factors suchas, potential losses from operations, the amount of cash that we are requiredto devote to defend and address our outstanding legal and regulatoryproceedings (see Part I, Item 3, “Legal Proceedings,” in this Annual Report onForm 10-K), and potential merger and acquisition activities. We believe ourcurrent cash and investment balances, in addition to cash generated fromoperations, will be 

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sufficientto meet our operating, financing and capital requirements through at least thenext 12 months. We also believe our cash and investment balances will besufficient on a longer term basis; however, that will depend on numerousfactors, including market acceptance of our existing and future solutions; thesuccessful commercialization of solutions in development and costs associatedwith that commercialization; progress in our software development efforts; themagnitude and scope of such efforts; clinical trials and product clearance bythe FDA; the successful integration of businesses that we acquire; the cost andtiming of our efforts to expand our sales and marketing capabilities; andcompeting technological and market developments. In the event that it isnecessary to raise additional capital for activities necessary to meet ourshort term or long term liquidity needs, such capital may be raised by sellingadditional equity or raising debt from third party sources. The sale ofadditional equity or convertible debt securities could result in dilution tocurrent stockholders. In addition, debt financing, if available, could involverestrictive covenants, which could adversely affect operations. However, thesefinancing alternatives, including raising additional capital, may not beavailable in amounts or on terms acceptable to us.

**Material OffBalance Sheet Arrangements**

We have no material offbalance sheet arrangements.

**Item 7A.     QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT 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, 2005,our cash and cash equivalents included money market funds and short-term depositstotaling approximately $64.3 million, and earned interest at a weighted averagerate of 2.8%. The value of the principal amounts is equal to the fair value forthese instruments. Due to the relative short-term nature of our investmentportfolio, our interest income is vulnerable to changes in short-term interestrates. At current investment levels, our pre-tax results of operations wouldvary by approximately $643 for every 100 basis point change in our weightedaverage short-term interest rate. We do not use our portfolio for trading orother speculative purposes.

*Foreign CurrencyExchange Risk*

We have sales and expensesin Canada, China, Japan and Europe that are denominated in currencies otherthan the U.S. Dollar and, as a result, have exposure to foreign currencyexchange risk. We have periodically entered into forward exchange contracts tohedge exposures denominated in foreign currencies. We did not have any forwardcontracts outstanding at December 31, 2005. We do not enter into derivativefinancial instruments for trading or speculative purposes. In the event ourexposure to foreign currency risk increases to levels that we do not deemacceptable, we may choose to hedge those exposures.

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**Item 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA**

**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 ofDecember 31, 2005 and 2004, and the related consolidated statements ofoperations, shareholders’ equity, comprehensive income (loss), and cash flowsfor each of the years in the three-year period ended December 31, 2005.These consolidated 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 ofDecember 31, 2005 and 2004, and the results of their operations and theircash flows for each of the years in the three-year period endedDecember 31, 2005, in conformity with U.S. generally accepted accountingprinciples.

As discussed in Note 13 to the consolidatedfinancial statements, the Company has restated its consolidated financialstatements as of and for the year ended December 31, 2004 and for the yearended December 31, 2003.

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, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), andour report dated August 29, 2006 expressed an unqualified opinion on management’sassessment of, and an adverse opinion on the effective operation of, internalcontrol over financial reporting.

| /s/ KPMG LLP |   |
|-------------------|--------|
| Chicago, Illinois |
| August 29, 2006   |

 

55

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except for share data)**

| ** **                                                                                                                                                                                        | ** ** | **December 31,** | ** ** | **December 31,**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2005**              | ** ** | **2004**               | ** ** |
| ** **                                                                                                                                                                                        | ** ** | ** **            | ** ** | **(As restated)** | ** ** |
| ASSETS                                                                                                                                                                                            |       |                  |       |                   |       |   |   |   |   |
| Current assets:                                                                                                                                                                                   |       |                  |       |                   |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                         |       |                  | $          | 64,278                 |       |   |   | $ | 28,067 |   |   |
| Accounts receivable, net  of allowance for doubtful accounts of $1,892 and $450 at December 31,  2005 and December 31, 2004, respectively                                                    |       |                  | 23,624     |                   |       |   | 10,306 |   |   |
| Inventory                                                                                                                                                                                         |       |                  | 2,440      |                   |       |   | 1,082 |   |   |
| Prepaid expenses                                                                                                                                                                                  |       |                  | 2,646      |                   |       |   | 701 |   |   |
| Deferred income taxes                                                                                                                                                                             |       |                  | 11,213     |                   |       |   | 7,310 |   |   |
| Other current assets                                                                                                                                                                              |       |                  | 3,208      |                   |       |   | 4,319 |   |   |
| Total current  assets                                                                                                                                                                             |       |                  | 107,409    |                   |       |   | 51,785 |   |   |
| Property and equipment:                                                                                                                                                                           |       |                  |       |                   |       |   |   |   |   |
| Computer equipment                                                                                                                                                                                |       |                  | 4,025      |                   |       |   | 5,275 |   |   |
| Office equipment                                                                                                                                                                                  |       |                  | 1,759      |                   |       |   | 755 |   |   |
| Leasehold improvements                                                                                                                                                                            |       |                  | 1,372      |                   |       |   | 351 |   |   |
|                                                                                                                                                                                              |       |                  | 7,156      |                   |       |   | 6,381 |   |   |
| Less accumulated  depreciation                                                                                                                                                                    |       |                  | 2,716      |                   |       |   | 4,884 |   |   |
| Net property and  equipment                                                                                                                                                                       |       |                  | 4,440      |                   |       |   | 1,497 |   |   |
| Purchased and  developed software, net of accumulated amortization of $6,759 and $9,804 at  December 31, 2005 and December 31, 2004, respectively                                                 |       |                  | 19,539     |                   |       |   | 9,751 |   |   |
| Acquired  intangibles, net of accumulated amortization of $1,687 and $760 at December  31, 2005 and December 31, 2004, respectively                                                               |       |                  | 11,789     |                   |       |   | 1,183 |   |   |
| Goodwill                                                                                                                                                                                          |       |                  | 350,634    |                   |       |   | 21,167 |   |   |
| Other assets                                                                                                                                                                                      |       |                  | 7,862      |                   |       |   | 108 |   |   |
| Total assets                                                                                                                                                                                      |       |                  | $          | 501,673                |       |   |   | $ | 85,491 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                        |       |                  |       |                   |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                              |       |                  |       |                   |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                  |       |                  | $          | 5,938                  |       |   |   | $ | 2,011 |   |   |
| Accrued wages                                                                                                                                                                                     |       |                  | 5,870      |                   |       |   | 1,414 |   |   |
| Income taxes payable                                                                                                                                                                              |       |                  | 3,894      |                   |       |   | 0 |   |   |
| Other accrued liabilities                                                                                                                                                                         |       |                  | 3,453      |                   |       |   | 1,007 |   |   |
| Deferred revenue                                                                                                                                                                                  |       |                  | 30,918     |                   |       |   | 24,568 |   |   |
| Total current  liabilities                                                                                                                                                                        |       |                  | 50,073     |                   |       |   | 29,000 |   |   |
| Deferred income taxes                                                                                                                                                                             |       |                  | 3,491      |                   |       |   | 868 |   |   |
| Deferred revenue                                                                                                                                                                                  |       |                  | 3,784      |                   |       |   | — |   |   |
| Other                                                                                                                                                                                             |       |                  | 484        |                   |       |   | — |   |   |
| Total liabilities                                                                                                                                                                                 |       |                  | 57,832     |                   |       |   | 29,868 |   |   |
| Shareholders’ equity:                                                                                                                                                                        |       |                  |       |                   |       |   |   |   |   |
| Preferred stock, $0.01  par value: 3,999,997 shares authorized; zero shares issued and outstanding at  December 31, 2005 and December 31, 2004                                                    |       |                  | —     |                   |       |   | — |   |   |
| Series A Preferred Stock,  $0.01 par value: 1,000,000 shares authorized; zero shares issued and  outstanding at December 31, 2005 and December 31, 2004                                           |       |                  | —     |                   |       |   | — |   |   |
| Special Voting Preferred  stock, no par value: one share authorized; zero shares issued and outstanding  at December 31, 2005 and December 31, 2004                                               |       |                  | —     |                   |       |   | — |   |   |
| Series 2 Special Voting  Preferred stock, no par value: one share authorized; zero shares issued and  outstanding at December 31, 2005 and December 31, 2004                                      |       |                  | —     |                   |       |   | — |   |   |
| Series 3 Special Voting  Preferred stock, no par value: one share authorized; one share issued and  outstanding at December 31, 2005 and zero shares issued and outstanding at  December 31, 2004 |       |                  | —     |                   |       |   | — |   |   |
| Common Stock, $0.01 par  value: 100,000,000 shares authorized; 26,500,140 shares and 13,186,185 shares  issued and outstanding at December 31, 2005 and December 31, 2004,  respectively     |       |                  | 265        |                   |       |   | 132 |   |   |
| Common Stock subscribed:  706 and 817 shares at December 31, 2005 and December 31, 2004, respectively                                                                                             |       |                  | 17         |                   |       |   | 14 |   |   |
| Additional paid-in  capital                                                                                                                                                                       |       |                  | 445,954    |                   |       |   | 55,418 |   |   |
| Deferred stock  compensation                                                                                                                                                                      |       |                  | (1,245     | )                      |       |   | — |   |   |
| Accumulated deficit                                                                                                                                                                               |       |                  | (3,190     | )                      |       |   | (533 | ) |   |
| Accumulated other  comprehensive income                                                                                                                                                           |       |                  | 2,040      |                   |       |   | 592 |   |   |
| Total  shareholders’ equity                                                                                                                                                                  |       |                  | 443,841    |                   |       |   | 55,623 |   |   |
| Total liabilities  and shareholders’ equity                                                                                                                                                  |       |                  | $          | 501,673                |       |   |   | $ | 85,491 |   |   |

 

See accompanying notes to consolidated financial statements

56

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

| ** **                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                  | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Net sales:                                                                  |       |                                        |       |   |   |   |   |
| Software and other                                                          |       | $                                           | 60,120     |   | $ | 17,444 |   | $ | 17,532 |   |
| Services and maintenance                                                    |       | 22,481                                      |       | 8,903 |   | 7,028 |   |
| Total net sales                                                             |       | 82,601                                      |       | 26,347 |   | 24,560 |   |
| Cost of sales:                                                              |       |                                        |       |   |   |   |   |
| Software and other                                                          |       | 6,921                                       |       | 2,302 |   | 2,867 |   |
| Services and maintenance                                                    |       | 11,106                                      |       | 6,108 |   | 3,530 |   |
| Amortization                                                                |       | 7,740                                       |       | 2,492 |   | 1,771 |   |
| Total cost of  sales                                                        |       | 25,767                                      |       | 10,902 |   | 8,168 |   |
| Gross margin                                                                |       | 56,834                                      |       | 15,445 |   | 16,392 |   |
| Operating costs and  expenses:                                              |       |                                        |       |   |   |   |   |
| Sales and marketing                                                         |       | 13,647                                      |       | 7,006 |   | 6,543 |   |
| Product research and development                                            |       | 9,914                                       |       | 1,967 |   | 2,063 |   |
| General and administrative                                                  |       | 11,622                                      |       | 4,820 |   | 3,628 |   |
| Acquired in-process research and development                                |       | 13,046                                      |       | — |   | — |   |
| Restructuring and other expenses                                            |       | 530                                         |       | — |   | — |   |
| Depreciation and amortization                                               |       | 3,549                                       |       | 1,153 |   | 848 |   |
| Total operating  costs and expenses                                         |       | 52,308                                      |       | 14,946 |   | 13,082 |   |
| Operating income                                                            |       | 4,526                                       |       | 499 |   | 3,310 |   |
| Other income (expense):                                                     |       |                                        |       |   |   |   |   |
| Interest expense                                                            |       | (38                                         | )          | (21 | ) | (18 | ) |
| Interest income                                                             |       | 1,061                                       |       | 344 |   | 100 |   |
| Other, net                                                                  |       | (317                                        | )          | 146 |   | (184 | ) |
| Total other  income (expense)                                               |       | 706                                         |       | 469 |   | (102 | ) |
| Income before  income taxes                                                 |       | 5,232                                       |       | 968 |   | 3,208 |   |
| Income tax  expense (benefit)                                               |       | 7,889                                       |       | (1,222 | ) | (1,226 | ) |
| Net income (loss)                                                           |       | $                                           | (2,657     | ) | $ | 2,190 |   | $ | 4,434 |   |
| Net income (loss) per share—basic                                      |       | $                                           | (0.11      | ) | $ | 0.17 |   | $ | 0.38 |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       | 24,696,762                                  |       | 13,013,927 |   | 11,566,054 |   |
| Net income (loss) per share—diluted                                    |       | $                                           | (0.11      | ) | $ | 0.16 |   | $ | 0.35 |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       | 24,696,762                                  |       | 13,827,522 |   | 12,586,900 |   |

 

See accompanying notes to consolidated financial statements

57

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**MERGE TECHNOLOGIESINCORPORATEDCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITYYears Ended December 31, 2003, 2004 and 2005(in thousands, except for share data)**

| ** **                                                                            | ** ** | **Preferred Stock** | ** ** | **Common Stock**                                   | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** **                                          | **Accumulated** | ** ** | ** **     | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------|------------|----------------|------------|----------------|------------|------------|-----------------------------------------------------|-----------------|------------|----------------|------------|
| ** **                                                                            | ** ** | ** **               | ** ** | ** **                                              | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** **                                          | ** **      | ** ** | **Additional** | ** ** | **Deferred** | ** ** | ** ** | ** ** | **Stock** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                                                                            | ** ** | **Shares**               | ** ** | **Issued**                                              | ** ** | **Shares**     | ** ** | **Subscribed** | ** ** | **Shares** | ** **                                          | **Issued**      | ** ** | **Paid-in**    | ** ** | **Stock** | ** ** | **Accumulated** | ** ** | **Subscription** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                            | ** ** | **Issued**               | ** ** | **Amount**                                              | ** ** | **Subscribed** | ** ** | **Amount**     | ** ** | **Issued** | ** **                                          | **Amount**      | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Deficit** | ** ** | **Receivable** | ** ** | **Income** | ** ** | **Equity** | ** ** |
| ** **                                                                            | ** ** | ** **               | ** ** | ** **                                              | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** **                                          | ** **      | ** ** | ** **     | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Balance at  December 31,  2002                                              |       | 2                        |       | $        — |       |           | 3,542      |           |       |       | $        15 |            |       | 9,481,683      |       |   | $    95 |   |   |   | $ 28,035 |   |   |   | $      — |   |   |   | $(6,295 | ) |   |   | $(25 | ) |   |   | $ (142 | ) |   |   | $ 21,683 |   |   |
| Adjustments (see  Note 13)                                                       |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (862 | ) |   |   | — |   |   |   | — |   |   |   | (862 | ) |   |
| Balance at  December 31, 2002 (as restated)                                      |       | 2                        |       | $        — |       |           | 3,542      |           |       |       | $        15 |            |       | 9,481,683      |       |   | $    95 |   |   |   | $ 28,035 |   |   |   | $      — |   |   |   | $(7,157 | ) |   |   | $(25 | ) |   |   | $ (142 | ) |   |   | $ 20,821 |   |   |
| Accretion of put  value                                                               |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | 970 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 970 |   |   |
| Issuance of Common  Stock                                                             |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 701,664        |       |   | 7 |   |   |   | 7,738 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 7,745 |   |   |
| Stock issued and  options granted for acquisitions                                    |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 771,804        |       |   | 8 |   |   |   | 12,485 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 12,493 |   |   |
| Exchange of share  rights into Common Stock                                           |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 852,901        |       |   | 9 |   |   |   | (9 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock issued for  services rendered                                                   |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 28             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock issued under  ESPP                                                              |       | —                   |       | —                                                  |       |           | 4,516      |           |       |       | 32                                                  |            |       | 21,875         |       |   | — |   |   |   | 121 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 153 |   |   |
| Exercise of stock  options                                                            |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 551,690        |       |   | 6 |   |   |   | 2,110 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,116 |   |   |
| Exercise of stock  warrants                                                           |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | 104,001        |       |   | — |   |   |   | 68 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 68 |   |   |
| Tax benefit on  exercise of stock options                                             |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | 1,657 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,657 |   |   |
| Reduction of stock  subscription receivable from related  party                       |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   | 25 |   |   |   | — |   |   |   | 25 |   |   |
| Net income (as  restated)                                                             |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 4,434 |   |   |   | — |   |   |   | — |   |   |   | 4,434 |   |   |
| Other  comprehensive income                                                           |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 374 |   |   |   | 374 |   |   |
| Balance at  December 31, 2003 (as restated)                                      |       | 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 (as  restated)                                                             |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,190 |   |   |   | — |   |   |   | — |   |   |   | 2,190 |   |   |
| Other  comprehensive income                                                           |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 360 |   |   |   | 360 |   |   |
| Balance at  December 31, 2004 (as restated)                                      |       | —                   |       | $        — |       |           | 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 |   |   |
| Deferred stock  compensation                                                          |       | —                   |       | —                                                  |       |           | —     |           |       |       | —                                              |            |       | —         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock 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 |   |   |

 

See accompanying notes to consolidated financial statements.

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands, except for share data)**

| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| **Cash flows from operating  activities:**                                                | ** ** | ** **                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income (loss)                                                                         |       | $                                           | (2,657     | ) |   | $ | 2,190 |   |   |   | $ | 4,434 |   |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |                                        |       |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                             |       | 11,288                                      |       |   | 3,645 |   |   |   | 2,633 |   |   |
| Amortization of discount on note assumed in merger                                        |       | —                                      |       |   | 12 |   |   |   | 16 |   |   |
| Provision for doubtful accounts receivable, net of  recoveries                            |       | 723                                         |       |   | 147 |   |   |   | 140 |   |   |
| Deferred income taxes                                                                     |       | 7,374                                       |       |   | (1,631 | ) |   |   | (1,783 | ) |   |
| In-process research and development                                                       |       | 13,046                                      |       |   | — |   |   |   | — |   |   |
| Stock compensation expense                                                                |       | 979                                         |       |   | — |   |   |   | — |   |   |
| Change in assets and  liabilities, excluding effects from acquisitions:                   |       |                                        |       |   |   |   |   |   |   |   |   |
| Accounts receivable                                                                       |       | (5,421                                      | )          |   | (2,030 | ) |   |   | 433 |   |   |
| Inventory                                                                                 |       | (439                                        | )          |   | (189 | ) |   |   | (440 | ) |   |
| Prepaid expenses                                                                          |       | (76                                         | )          |   | (404 | ) |   |   | (51 | ) |   |
| Accounts payable                                                                          |       | (3,474                                      | )          |   | 711 |   |   |   | (483 | ) |   |
| Accrued wages                                                                             |       | 765                                         |       |   | 500 |   |   |   | (369 | ) |   |
| Other accrued liabilities                                                                 |       | (69                                         | )          |   | 221 |   |   |   | 78 |   |   |
| Deferred revenue                                                                          |       | 6,973                                       |       |   | 13,717 |   |   |   | 6,191 |   |   |
| Other assets                                                                              |       | (5,117                                      | )          |   | (2,645 | ) |   |   | (703 | ) |   |
| Other                                                                                     |       | (293                                        | )          |   | (332 | ) |   |   | 302 |   |   |
| Net cash provided by operating activities                                                 |       | 23,602                                      |       |   | 13,912 |   |   |   | 10,398 |   |   |
| **Cash flows from investing  activities:**                                                | ** ** | ** **                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Cash acquired in acquisitions, net of cash paid                                           |       | 9,644                                       |       |   | — |   |   |   | (4,417 | ) |   |
| Purchases of property, equipment, and leasehold  improvements                             |       | (2,996                                      | )          |   | (565 | ) |   |   | (1,117 | ) |   |
| Capitalized software development                                                          |       | (3,621                                      | )          |   | (3,479 | ) |   |   | (2,674 | ) |   |
| Net cash provided by (used in) investing activities                                       |       | 3,027                                       |       |   | (4,044 | ) |   |   | (8,208 | ) |   |
| **Cash flows from financing  activities:**                                                | ** ** | ** **                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Proceeds from exercise of stock options                                                   |       | 9,508                                       |       |   | 1,486 |   |   |   | 2,116 |   |   |
| Proceeds from employee stock purchase plan                                                |       | 64                                          |       |   | 68 |   |   |   | 153 |   |   |
| Proceeds from note receivable                                                             |       | —                                      |       |   | — |   |   |   | 25 |   |   |
| Proceeds from exercise of warrants                                                        |       | —                                      |       |   | — |   |   |   | 68 |   |   |
| Proceeds from sale of Common Stock                                                        |       | —                                      |       |   | — |   |   |   | 7,745 |   |   |
| Principal payment of notes                                                                |       | —                                      |       |   | (231 | ) |   |   | — |   |   |
| Principal payments under capital leases                                                   |       | —                                      |       |   | — |   |   |   | (6 | ) |   |
| Net cash provided by financing activities                                                 |       | 9,572                                       |       |   | 1,323 |   |   |   | 10,101 |   |   |
| Effect of exchange rate changes on cash                                                   |       | 10                                          |       |   | 5 |   |   |   | 169 |   |   |
| Net increase in cash                                                                      |       | 36,211                                      |       |   | 11,196 |   |   |   | 12,460 |   |   |
| Cash and cash equivalents, beginning of period                                            |       | 28,067                                      |       |   | 16,871 |   |   |   | 4,411 |   |   |
| Cash and cash equivalents, end of period                                                  |       | $                                           | 64,278     |   |   | $ | 28,067 |   |   |   | $ | 16,871 |   |   |
| **Supplemental  Disclosures of Cash Flow Information:**                                   |       |                                        |       |   |   |   |   |   |   |   |   |
| Cash paid for income taxes                                                                |       | $                                           | 286        |   |   | $ | 1,119 |   |   |   | $ | 237 |   |   |
| Cash paid for interest                                                                    |       | $                                           | —     |   |   | $ | — |   |   |   | $ | 3 |   |   |
| Equity securities received in sales transactions                                          |       | $                                           | 4,606      |   |   | $ | — |   |   |   | $ | — |   |   |
| **Non Cash Investing and  Financing Activities:**                                         | ** ** | ** **                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Redemption value related to exchangeable Common Stock                                     |       | $                                           | —     |   |   | $ | 1 |   |   |   | $ | 41 |   |   |
| Value of Common  Stock and options issued for acquisitions                                |       | $                                           | 381,689    |   |   | $ | — |   |   |   | $ | 12,493 |   |   |

 

See accompanying notes to consolidated financial statements.

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

| ** **                                  | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                  | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Net income (loss)                           |       | $                                           | (2,657     | ) |   | $ | 2,190 |   |   |   | $ | 4,434 |   |   |
| Accumulated other  comprehensive income:    |       |                                        |       |   |   |   |   |   |   |   |   |
| Cumulative translation adjustment(1)        |       | 800                                         |       |   | 215 |   |   |   | 225 |   |   |
| Unrealized gain on marketable securities(2) |       | 66                                          |       |   | — |   |   |   | — |   |   |
| Comprehensive income  (loss)                |       | $                                           | (1,791     | ) |   | $ | 2,405 |   |   |   | $ | 4,659 |   |   |

----

  (1)   Net of income taxexpense of $537, $145, and $150 for the twelve months ended December 31, 2005,2004, and 2003, respectively.

  (2)   Net of income tax expense of$45, $0, and $0 for the twelve months ended December 31, 2005, 2004, and 2003,respectively.

See accompanying notes to consolidated financial statements.

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

**(1)**          Basisof Presentation and Significant Accounting Policies

*(a) Nature ofOperations*

Merge Technologies Incorporated, a Wisconsincorporation, and its subsidiaries (which we sometimes refer to collectively as “MergeHealthcare,” “we,” “us,” or “our”) are in the business of development anddelivery of medical imaging and information management software and services. Weprovide innovative solutions for Original Equipment Manufacturers (“OEMs”),Value Added Resellers (“VARs”) and the end-user healthcare markets. We customengineer clinical and imaging applications and development tools that are onthe forefront of medicine and its use of medical imaging for OEM andinternational customers. We develop innovative medical imaging softwaresolutions that support end-to-end business and clinical workflow for radiologydepartment and specialty practices, imaging centers and hospitals. Our innovativesoftware solutions use our leading-edge imaging software technologies thataccelerate market delivery for our OEM customers, while our end-user solutionsimprove our customers’ productivity and enhance the quality of patient carethey provide.

On June 1, 2005, we completed our business combinationwith Cedara Software Corp. (“Cedara Software”), an Ontario corporation (seeNote 2). Subsequent to the transaction, the name under which we do business waschanged from Merge eFilm to Merge Healthcare.

The consolidated financialstatements as of and for the year ended December 31, 2004, statements ofoperations and cash flow for the year ended December 31, 2003 and unauditedstatements of operations for the first three quarters of 2005 and for each ofthe quarters in 2004 have been restated from amounts previously reported tocorrect accounting errors. See Notes 12 and 13 for further discussion andreconciliation of restated items from amounts previously reported. Openingretained earnings at December 31, 2002 has been restated to reflectdeferral of net sales, net of deferred costs and income tax adjustments.

*(b) Principles ofConsolidation*

The consolidated financial statements include thefinancial statements of our wholly owned subsidiaries. Our principal operatingsubsidiaries are Cedara Software and Merge eMed, Inc. All intercompany balancesand transactions have been eliminated in consolidation.

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

*(c) ReportingPeriods Presented*

The accompanyingconsolidated financial statements include the results of Cedara Softwaresubsequent 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 

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assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period. Estimatesare used when accounting for items and matters such as revenue recognition andallowances for uncollectible accounts receivable, inventory obsolescence,amortization, asset valuations, impairment assessments, taxes and relatedvaluation allowance, income tax provisions, stock-based compensation, andcontingencies. We believe that the estimates, judgments and assumptions are reasonable,based on information available at the time they are made. Actual results coulddiffer from those estimates.

*(e)Reclassifications*

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

*(f) SegmentReporting*

In June 1997, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standard (“SFAS”) No. 131, *Disclosures about Segments of an Enterprise andRelated Information* (“SFAS No. 131”). SFAS No. 131establishes annual and interim reporting standards for operating segments of acompany. It also requires entity-wide disclosures about the products andservices an entity provides, the material countries in which it holds assetsand reports revenues, and its major customers.

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. Theoperating 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 of our foreign subsidiaries,with the exception of our subsidiaries in Japan and China, is the United Statesof America dollar (“U. S. Dollar”).

On June 1, 2005, we changed the functional currency ofour subsidiary, eFilm, from the Canadian dollar to the U. S. Dollar. Thischange was due to significant changes in the economic facts and circumstancessurrounding the operational environment of this subsidiary. As a result of thischange, certain long-lived assets, which were previously translated fromCanadian dollars to U. S. Dollars at the historical exchange rate on thedate the asset was acquired, were revalued based upon the exchange rate as ofJune 1, 2005, leading to a currency translation adjustment, reflected inaccumulated other comprehensive income, and increase in the value of applicableassets 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. Foreignexchange gains and losses on transactions during the year are reflected in theconsolidated statements of operations, as a component of other income(expense), net.

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*(h) Fair Value ofFinancial Instruments*

Our financial instrumentsinclude cash and cash equivalents, accounts receivable, marketable and non-marketablesecurities, accounts payable and certain accrued liabilities. The carryingamounts approximate fair value due to the short maturity of these instrumentsexcept the non-marketable equity securities. The carrying value of long-termreceivables or long-term deferred revenues is not materially different from thefair value. Other than securities available-for-sale, the estimated fair valueshave been determined from information obtained from independent valuations andmanagement estimates.

*(i) DerivativeFinancial Instruments*

Fluctuating foreignexchange rates may negatively impact the accompanying consolidated financialstatements. Substantially all of our billings are in U. S. Dollars,however, due to our Canadian operations, substantial salary and other expensesare payable in Canadian dollars. To effectively manage these market risks, wemay enter into foreign currency forward contracts. We do not hold or issuederivative instruments for trading purposes. We have elected not to apply hedgeaccounting under the provision of SFAS No. 133 *Accountingfor Derivative Instruments and Hedging Activities* and accordingly, recognize any change infair value through current earnings. As of December 31, 2005, we had noderivatives instruments outstanding.

*(j) Cash and CashEquivalents*

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 purchased third-partyhardware), is stated at the lower of cost or market. Cost is determined usingthe first-in, first-out method.

*(l) Property andEquipment*

Property and equipment are stated 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-LivedAssets*

We account for long-livedassets in accordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*. Long-term assets,including property and equipment and other intangibles, are amortized overtheir expected lives, which are estimated by management. Management also makesestimates of the impairment of long-term assets whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable, based primarily upon whether expected future undiscounted cashflows are sufficient to support the assets recovery. If the actual useful lifeof a long-term asset is shorter than the useful life estimated by us, theassets may be deemed to be impaired and, accordingly, a write-down of the valueof the assets or a shorter amortization period may be required, determined by adiscounted cash flow analysis. We have recorded in our consolidated statementof operations, impairment charges as discussed in Note 1(p). We have reviewedlong-lived assets and certain intangible assets with estimable useful lives anddetermined that their carrying values as of December 31, 2005 are recoverablein future periods.

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*(n) Purchased andDeveloped 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 a product-by-productbasis over the expected economic life of the related software, generally fiveyears, using the straight-line method. This method generally results in greateramortization than the method based on the ratio that current gross revenues fora product bear to the total of current and anticipated future gross revenuesfor that product. During 2005, 2004 and 2003, we capitalized softwaredevelopment costs of $3,621, $3,479, and $2,674, respectively. Amortizationexpense related to purchased and developed software for 2005, 2004 and 2003,was $7,740, $2,492, and $1,771, respectively. The2005 expense includes the impairment of certain of our capitalized softwareprojects of approximately $3,547 attributed to overlapping technologies as aresult of the Cedara Software transaction.

We assess therecoverability of these costs periodically by determining whether theunamortized capitalized costs can be recovered through future net operatingcash flows through the sale of that product.

*(o) Investments*

At December 31, 2005, weheld certain securities in both publicly traded entities of $329 and privatecompanies of $6,150, which are included in other assets. The investments inpublicly traded equity securities over which we do not exert significantinfluence are classified as “available-for-sale” and are reported at fairvalue. Unrealized gains and losses are reported within the accumulated othercomprehensive income component of shareholders’ equity. The investments inequity securities of private companies over which we do not exert significantinfluence are reported at cost. The estimated fair values have been determinedfrom information obtained from market sources, independent valuations, andmanagement estimates. Any loss due to impairment in value is recorded when suchloss occurs. We did not record any such losses in the accompanying consolidatedfinancial statements.

*(p) Goodwill andOther Intangibles*

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

| ** **              | ** ** | **Weighted  Average**                            | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Remaining  Amortization  Period (Years)** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization**   | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Purchased  technology   |       |                                             | 4.8        |                            |       | $                               | 16,633     |   |   | $ | (3,118 | ) |   |   | $ | 2,901 |   |   |   | $ | (1,230 | ) |   |
| Customer  relationships |       |                                             | 5.2        |                            |       | 13,476                          |       |   | (1,687 | ) |   |   | 1,943 |   |   |   | (760 | ) |   |
| Total                   |       |                                             | 5.0        |                            |       | $                               | 30,109     |   |   | $ | (4,805 | ) |   |   | $ | 4,844 |   |   |   | $ | (1,990 | ) |   |

 

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Amortization expense was$4,288, $974, and $693 for the years ended 2005, 2004 and 2003, respectively. Includedin the amortization expense above for 2005 is an impairment charge forpurchased technology of $67, which is recorded in cost of goods sold, and acharge for $610 related to customer relationships, which is recorded indepreciation and amortization operating costs and expenses. Estimated aggregateamortization expense for each of the next five years is as follows:

| For the year ended: |   | 2006 |   | $ | 5,171 |   |
|---------------------|--------|------|--------|---|-------|--------|
|                |   | 2007 |   | $ | 5,027 |   |
|                |   | 2008 |   | $ | 4,678 |   |
|                |   | 2009 |   | $ | 4,391 |   |
|                |   | 2010 |   | $ | 4,265 |   |

 

The provisions of SFAS No. 142 require that goodwilland other intangible assets with indefinite useful lives be tested at leastannually for impairment or when indicators of potential impairment exist, usinga fair value based approach. We continue tomonitor the carrying value of goodwill through annual impairment tests. AtDecember 31, 2005, we performed our annual impairment tests and found none ofour goodwill to be impaired.

During2005, we increased goodwill due to the business combination with CedaraSoftware and acquisition of AccuImage, as well as the change in functionalcurrency of eFilm. The changes in the carrying amount of goodwill for the yearended December 31, 2005, were as follows:

| Balance as of  January 1, 2005                   |   | $       | 21,167  |   |
|--------------------------------------------------|--------|---------|---------|--------|
| Goodwill related  to Cedara Software acquisition |   | 323,886 |    |
| Goodwill related  to AccuImage acquisition       |   | 4,248   |    |
| Goodwill  adjustments                            |   | 1,333   |    |
| Balance as of December  31, 2005                 |   | $       | 350,634 |   |

 

We review goodwill and indefinite lived intangibleassets for impairment annually, as of December 31 of each year. In addition,we test an intangible asset or group for impairment between annual testswhenever events or changes in circumstances indicate that we may not be able torecover the asset’s carrying amount. Goodwill of a reporting unit is tested forimpairment between annual tests if an event occurs or circumstances change thatwould more likely than not reduce the fair value of a reporting unit below itscarrying amount.

During the three months ended June 30, 2006,several material events occurred that resulted in an environment of uncertaintycreating significant business challenges, and diverted the attention of ourBoard of Directors and management from our business operations. These eventsincluded the resignation of certain members of our senior management, thecompletion of an independent investigation conducted by the Audit Committee ofour Board of Directors during which the Audit Committee concluded that severalof our previously issued financial statements would require restatement, thepossible delisting of our common stock from the NASDAQ Global Market and noticeof an informal non-public inquiry with the Securities Exchange Commission.These events, which did not exist as of December 31, 2005, resulted incircumstances which indicated that we may not be able to recover the intangibleassets’ carrying amounts or that the fair value of our single reporting unitdoes not support the carrying value of goodwill.

We have tested our indefinite lived intangible assetsand goodwill for impairment as of June 30, 2006 and concluded that ourindefinite lived intangible assets were not impaired.

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 

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Step I of the impairmenttest by estimating the Company’s fair value using what we considered to be themost reliable and readily available indicator of fair value, that being thequoted market prices of our shares of common stock. The results of Step Iof the impairment test indicated that we have a potential impairment of ourgoodwill since the carrying value of our single reporting unit exceeded thereporting unit’s estimated fair value. On August 29, 2006, the AuditCommittee of our Board of Directors determined that there was such animpairment.

*We arein the process of completing Step II to measure the amount of impairmentloss relating to goodwill, by comparing the implied fair value of our reportingunit goodwill with the carrying amount of that goodwill. The estimate of fairvalue of our reporting unit was reduced by the fair value of all other assetsto determine the implied fair value of reporting unit goodwill. We are in theprocess of finalizing our assessment of the fair value utilizing the assistanceof independent valuation specialists. We preliminarily estimate that as aresult of our Step II analysis, we will record a goodwill impairmentcharge during the three months ended June 30, 2006 of approximately$220 million, none of which will result in future cash expenditures.*

*(q) Warranties*

We generally provide up totwelve months of warranty on our hardware, software and system sales. We haveprovided for expected hardware warranty costs based on our historical experience.Accrued warranty was $267, $17 and $67 at December 31, 2005, 2004 and 2003,respectively. The increase in the accrual during 2005 of $250 was primarilyattributed to the business combination with Cedara Software as a result of therecording of the fair value of the assumed warranty liability.

*(r) Guarantees*

Effective January 1, 2003, we adopted FASBInterpretation (“FIN”) No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*(“FIN No. 45”). FIN No.45 requires that we recognize the fair value for guarantee and indemnificationarrangements issued or modified by us after December 31, 2002, if thesearrangements are within the scope of the interpretation. In addition, we mustcontinue to monitor the conditions that are subject to the guarantees andindemnifications, as required under the previously existing GAAP, in order toidentify if a loss has occurred. If we determine it is probable that a loss hasoccurred, then any such estimable loss would be recognized under thoseguarantees and indemnifications. Under our standard Software License, Servicesand Maintenance Agreement, we agree to indemnify, defend and hold harmless ourlicensees from and against certain losses, damages and costs arising fromclaims alleging the licensees’ use of our software infringes the intellectualproperty rights of a third party. Historically, we have not been required topay material amounts in connection with claims asserted under these provisionsand, accordingly, have not recorded a liability relating to such provisions.

Under our software license, services and maintenanceagreement, we also represent and warrant to licensees that our softwareproducts operate substantially in accordance with published specifications, andthat the services we perform will be undertaken by qualified personnel in aprofessional manner conforming to generally accepted industry standards andpractices. Historically, only minimal costs have been incurred relating to thesatisfaction 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 

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Presidentand Chief Executive Officer, Scott T. Veech, our former Chief FinancialOfficer, and Brian E. Pedlar, our former President of Cedara Software andSenior Vice President of Merge Healthcare, who served as co-President andco-Chief Executive Officer from July 2, 2006 to August 18, 2006, are defendantsin several lawsuits relating to our accounting and financial disclosure. Theselawsuits and other legal matters in which we have become involved, includingour receipt of a shareholder demand for derivative action, are described inNote 8. We may be required to indemnify these individuals and advance them fortheir expenses in connection with such matters and therefore, may be requiredto accrue for such guarantees 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, *Accounting forIncome Taxes*. A current liability is recognized for the estimatedtaxes payable for the current year. Deferred tax assets and liabilities arerecognized for the estimated future tax consequences attributable todifferences 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 are established when necessary toreduce deferred tax assets to the amount more likely than not to be realized. Tothe extent we establish or change the valuation allowance in a period, the taxeffect will flow through the statement of operations. However, in the case ofdeferred tax assets of an acquired or merged entity with a valuation allowancerecorded for purchase accounting, any change in that asset valuation allowancewill be recorded 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 with therequirements 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. Due to thecomplexity involved, we are not able to estimate the range of possible lossesin excess of amounts recorded.

*(t) Earnings PerShare*

Basicearnings per share is computed by dividing income available to commonshareholders by the weighted average number of shares outstanding. We have madean accounting policy election to use the if-converted method for convertiblesecurities that participate in Common Stock dividends; however, the 

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two-class method must be used if the effect is moredilutive. Diluted earnings per share reflects the potential dilution that couldoccur based on the effect of the conversion of outstanding convertiblepreferred shares and the exercise of stock options and warrants with anexercise price of less than the average market price of our Common Stock. Thefollowing table sets forth the computation of basic and diluted earnings pershare for the years ended December 31, 2005, 2004 and 2003.

| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                             | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Numerator:                                                             |       |                                        |       |   |   |   |   |
| Net income (loss)                                                      |       | $                                           | (2,657     | ) | $ | 2,190 |   | $ | 4,434 |   |
| Accretion of  redemption value related to exchangeable shares          |       | —                                      |       | (1 | ) | (41 | ) |
| Allocation of  income to exchangeable shares                           |       | —                                      |       | (1 | ) | (56 | ) |
| Numerator for net  income (loss) per share—basic and diluted |       | $                                           | (2,657     | ) | $ | 2,188 |   | $ | 4,337 |   |
| Denominator:                                                           |       |                                        |       |   |   |   |   |
| Weighted average  number shares of Common Stock outstanding            |       | 24,696,762                                  |       | 13,013,927 |   | 11,566,054 |   |
| Effect of stock  options                                               |       | —                                      |       | 813,595 |   | 972,380 |   |
| Effect of  warrants                                                    |       | —                                      |       | — |   | 48,466 |   |
| Denominator for  net income per share—diluted                     |       | 24,696,762                                  |       | 13,827,522 |   | 12,586,900 |   |
| Net income (loss)  per share—basic                                |       | $                                           | (0.11      | ) | $ | 0.17 |   | $ | 0.38 |   |
| Net income (loss) per  share—diluted                              |       | $                                           | (0.11      | ) | $ | 0.16 |   | $ | 0.35 |   |

 

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, 2005, 2004, and2003 of 6,653,815, 167,589, and 653,148, respectively.

As a result of the loss during the twelve months endedDecember 31, 2005, incremental shares from the assumed conversion of employeestock options totaling 1,237,210 shares, respectively, have been excluded fromthe calculation of diluted loss per share as their inclusion would have beenanti-dilutive.

For the years ended December 31, 2004 and 2003,options and warrants to purchase 39,500 and 464,000 shares of our Common Stock,respectively, had exercise prices greater than the average market price of theshares of our Common Stock and were excluded from the diluted net income pershare calculation as their inclusion would have been anti-dilutive.

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Thefollowing potentially dilutive Common Stock equivalent securities, includingsecurities considered in the calculation of diluted earnings per share, wereoutstanding at December 31, 2005, 2004 and 2003.

| ** **           | ** ** | **2005**   | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|----------------------|------------|------------|------------|-----------|------------|-----------|------------|
| Stock options        |       | 2,979,139  |       | 1,590,085 |       | 1,664,557 |       |
| Exchangeable  shares |       | 7,129,246  |       | —    |       | 352,261   |       |
|                 |       | 10,108,385 |       | 1,590,085 |       | 2,016,818 |       |

 

*(u) Stock OptionPlans*

As of December 31, 2005, we maintained four stock-basedemployee compensation plans and one director option plan, which are describedmore fully in Note 10. We applied the provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*, as amended (“SAFSNo. 123”), which required entities to recognize as expense over the vestingperiod the fair value of all stock-based awards on the date of grant.Alternatively, through December 31, 2005, SFAS No. 123 allowed us to continueto apply the provisions of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APBopinion No. 25”) and provide pro forma disclosures as if the fair-value-basedmethod defined in SFAS No. 123 had been applied.

Weelected to continue to apply the provisions of APB Opinion No. 25 in accountingfor our plans. Substantially all stock options under the plans have been grantedat exercise prices of not less than the market value at the date of grant, andas a result, compensation expense to be recorded under APB Opinion No. 25has not been significant. Stock compensation expense recognized in theaccompanying consolidated financial statements is the result of recording theintrinsic value of unvested Cedara Software stock options that were replacedwith our stock options on the date of transaction closing. Had we determinedcompensation cost based on the fair value at the grant date under SFAS No. 123,our net income (loss) would have been the pro forma amounts indicated below:

| ** **                                                                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                         | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Net income  (loss), as reported                                                                                                                    |       | $                                           | (2,657     | ) |   | $ | 2,190 |   |   |   | $ | 4,434 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income (loss), net of  related tax                                        |       | 587                                         |       |   | — |   |   |   | — |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair-value based  method for all awards, net of related tax benefit |       | (4,101                                      | )          |   | (1,507 | ) |   |   | (1,300 | ) |   |
| Pro forma net income (loss)                                                                                                                        |       | $                                           | (6,171     | ) |   | $ | 683 |   |   |   | $ | 3,134 |   |   |
| Net income (loss) per  share:                                                                                                                      |       |                                        |       |   |   |   |   |   |   |   |   |
| Basic—as reported                                                                                                                             |       | $                                           | (0.11      | ) |   | $ | 0.17 |   |   |   | $ | 0.38 |   |   |
| Basic—pro forma                                                                                                                               |       | $                                           | (0.25      | ) |   | $ | 0.05 |   |   |   | $ | 0.27 |   |   |
| Diluted—as reported                                                                                                                           |       | $                                           | (0.11      | ) |   | $ | 0.16 |   |   |   | $ | 0.35 |   |   |
| Diluted—pro forma                                                                                                                             |       | $                                           | (0.25      | ) |   | $ | 0.05 |   |   |   | $ | 0.25 |   |   |

 

*(v) RevenueRecognition*

Revenues are derived primarily from the licensing andsublicensing of software, sales of hardware and related ancillary products,installation and engineering services, training, consulting, and softwaremaintenance and support. Inherent to software revenue recognition aresignificant management estimates and judgments in the interpretation andpractical application of the complex rules to individual contracts. 

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These interpretationsgenerally would not influence the amount of revenue recognized, but couldinfluence the timing of such revenues. Typically our contracts contain multipleelements, and while the majority of our contracts contain standard terms andconditions, there are instances where our contracts contain non-standard termsand conditions. As a result, contract interpretation is sometimes required todetermine the appropriate accounting, including whether the deliverablesspecified in a multiple element arrangement should be treated as separate unitsof accounting for revenue recognition purposes in accordance with Statement ofPosition (“SOP”) No. 97-2, *Software RevenueRecognition*, or Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with MultipleDeliverables*, and if so, the relative fair value that should beallocated to each of the elements and when to recognize revenue for eachelement.

For software arrangements, we recognize revenue inaccordance with SOP No. 97-2*.* Thisgenerally requires revenue earned on software arrangements involving multipleelements to be allocated to each element based on the vendor-specific objectiveevidence of fair values of those elements. Revenue from multiple-elementsoftware arrangements is recognized using the residual method, pursuant to SOP No. 98-9 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 vendor-specific objectiveevidence of fair value exists for all of the undelivered elements in thearrangement, but does not exist for one or more of the delivered elements in thearrangement, assuming all other conditions for revenue recognition have beensatisfied. For sales transactions where the software is incidental, andhardware transactions where no software is involved, we recognize revenue inaccordance with EITF Issue No. 00-21 and Staff Accounting Bulletin (“SAB”) No. 104,*Revenue Recognition*.

We allocate revenue to each undelivered element in amultiple element arrangement based on its respective fair value determined bythe price charged when that element is sold separately. Specifically, wedetermine the fair value of the maintenance portion of the arrangement based onthe substantive renewal price of the maintenance offered to customers, whichmay be stated in the contract, or for certain customer groups using the bell-shapedcurve approach. The fair value of the installation and training is based uponthe price charged when these services are sold separately. If evidence of thefair value cannot be established for undelivered elements of a sale, the entireamount of revenue under the arrangement is deferred until these elements havebeen delivered or vendor-specific objective evidence of fair value can beestablished. 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 sublicenses sold on an individual basisand software licenses are recognized upon shipment, provided that evidence ofan arrangement exists, delivery has occurred and risk of loss has passed to thecustomer, fees are fixed or determinable and collection of the relatedreceivable is probable. We assess collectibility based on a number of factors,including past transaction history with the customer and the credit worthinessof the customer. We must exercise our judgment when we assess the probabilityof collection and the current creditworthiness of each customer. For example,if the financial condition of our customers were to deteriorate, it couldaffect the timing and the amount of revenue we recognize on a contract to theextent of cash collected. In addition, in certain transactions we may negotiatethat the customer provides Common Stock ownership in consideration as part ofthe software sale. We generally do not request collateral from customers.

Revenue from software usage sublicenses sold throughannual contracts and software maintenance and support is deferred and recognizedratably over the contract period. Revenue from installation and engineeringservices, training, and consulting services is recognized as services areperformed.

Revenue from sales of Radiology Information Systems (“RIS”)and from RIS/Picture Archiving and Communication Systems (“PACS”) solutions,where professional services are considered essential to the 

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functionality of thesolution sold, is recognized on the percentage-of-completion method, asprescribed by AICPA Statement of Position 81-1. Percentage of completion isdetermined by the input method based upon the amount of labor hours expendedcompared to the total estimated amount of labor hours to complete the project.Total estimated labor hours is based on management’s best estimate of the totalamount of time it will take to complete a project. These estimates require the use of judgment. A significant change in oneor more of these estimates could affect the profitability of one or more of ourcontracts. We review our contract estimates periodically to assess revisions incontract values and estimated labor hours expended and reflect changes inestimates in the period that such estimates are revised under the cumulativecatch-up method.

Our Original Equipment Manufacturer (“OEM”) softwareproducts are typically fully functional upon delivery and do not requiresignificant modification or alteration. Fees for services to OEM customers arebilled separately from licenses of our software products. We provideengineering services to our OEM customers under time-and-material or fixed-pricecontracts that are generally longer than one year in duration. Underengineering service contracts where the services are performed and costsincurred in proportion with contracted billing schedules, revenue is recognizedwhen the customer may be billed. This method is expected to result inreasonably consistent profit margins over the contract term. For certain fixed-pricecontracts, we use percentage of completion accounting.

For contracts accounted for under SAB No. 104, wegenerally invoice the customer for the final 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 andacceptance criteria, we defer the related amount of product fair value andrecognize it upon completion of installation and acceptance.

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 revenuerepresents license fees, support and maintenance, and other services to beearned or provided beginning in periods on or after January 1, 2007. See Note13 for discussion of revenue recognition matters that have led to significantdeferred revenue balances at December 31, 2005 and 2004.

We record reimbursable out-of-pocketexpenses in both services and maintenance net sales and as a direct cost ofservices and maintenance in accordance with EITF Issue No. 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred*. In accordance withEITF Issue No. 00-10, *Accounting forShipping and Handling Fees*, the reimbursement by customers ofshipping and handling costs are recorded in software and other net sales andthe associated cost as a cost of sale.

*(w) RecentAccounting Pronouncements*

In December of 2004, theFASB issued SFAS No. 123(R), to be effective for interim or annual periodsbeginning after September 15, 2005. On April 14, 2005, the SEC amended thecompliance dates to require SFAS No. 123(R) to be effective for fiscal yearsbeginning after September 15, 2005. SFAS No. 123(R) revises SFAS No.123 and supersedes APB Opinion No. 25 and requires all share-based payments toemployees, including grants of employee stock options, to be recognized as anexpense in the statement of operations. The cost will be recognized over therequisite service period based on fair values measured on the respective grantdates. We have adopted the new standard, as of January 1, 2006, using themodified prospective transition method, which permits recognition of expense onor after the effective date for the portion of outstanding awards for which therequisite service has not yet been rendered. The adoption of SFAS No. 123(R)will result in additional expense being recorded beginning in 2006 related to 

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ourshare-based employee compensation programs. We expect the adoption of SFAS No. 123(R)will have a material impact on our results of operations in 2006 of at least$3,400.

In July 2006, FASB issuedFASB Interpretation No. 48, *Accounting forUncertainty in Income Taxes an Interpretation of FASB Statement No. 109*,(“FIN No. 48”). FIN No. 48 is effective for the first interim or annualreporting period for the first fiscal year beginning on or after December 15,2006, although earlier adoption is encouraged. FIN No. 48 applies to all taxpositions for income taxes accounted in accordance with SFAS No. 109. We arecurrently evaluating the impact of the adoption of FIN No. 48.

In June of 2005, FASBissued SFAS No. 154,*Accounting Changes andError Corrections*. This statement replaces APB Opinion No. 20, *Accounting Changes,* and SFAS No. 3, *Reporting Accounting Changes in Interim FinancialStatements*. The statement applies to all voluntary changes inaccounting for and reporting of changes in accounting principles. SFAS No. 154requires retrospective application to prior periods’ financial statements of avoluntary change in accounting principles unless it is not practical to do so. APBNo. 20 previously required that most voluntary changes in accounting principlesbe recognized by including the cumulative effect of changing to the newaccounting principle in net income during the period of the change. SFAS No.154 is effective for accounting changes made in fiscal years beginning afterDecember 15, 2005. Earlier application is permitted for accounting changesoccurring in fiscal years beginning after May 31, 2005.

**(2)   Acquisitions**

*(a) Cedara Software*

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 agreement andclosed on June 1, 2005, following approval by both Merge Healthcare and CedaraSoftware shareholders and receipt of necessary regulatory approvals. Thebusiness combination was effected through an exchange of stock, in which CedaraSoftware shareholders received 0.587 shares of our Common Stock for each CedaraSoftware common share. Also, Cedara Software shareholders who are Canadianresidents were permitted to receive either our Common Stock or newly createdexchangeable shares of our wholly owned subsidiary, Merge Cedara ExchangeCoLimited (“ExchangeCo Exchangeable Shares”). Canadian residents who receivedExchangeCo Exchangeable Shares in the transaction defer paying income taxes onthe transaction until such time as they exchange the shares for Common Stock orotherwise dispose of them. The ExchangeCo Exchangeable Shares are freelytradable on the Toronto Stock Exchange (TSX) under the ticker symbol “MRG.” TheExchangeCo Exchangeable Shares are exchangeable into shares of Merge HealthcareCommon Stock on a one-for-one basis at any time at the option of the holder(see Note 10(g) for updated status). Holders of Cedara Software stock optionsexchanged each option to purchase one common share of Cedara Software for anoption to purchase 0.587 shares of Merge Healthcare Common Stock , and weadjusted strike prices for the stock and currency conversion rates, with nochanges to the vesting terms of the option. We issued replacement options topurchase approximately 1.9 million shares of Common Stock as a result of thisexchange.

*Reasons for the Transaction*

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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*Purchase Accounting*

Thetransaction consideration was valued at approximately $386,899, including theexchange of approximately 18.8 million equivalent shares at a market price of$18.97 per share, estimated fair value for outstanding options at the date ofclosing and direct transaction costs incurred by us. The fair value of stockissued was based upon the 0.587 exchange ratio and a four-day weighted averageof our stock price two days prior, the day of and one day after theannouncement, based on NASDAQ closing prices. The fair value of the outstandingoptions are estimated at approximately $25,211, based on a 1.247 U. S.Dollar to Canadian dollar currency exchange ratio, the 0.587 exchange ratio andon the four-day weighted average indicated above. The total purchase price wasas 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. We haveallocated 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 June1, 2005, was as follows:

| ** **                            | ** ** | **Fair Value** | ** ** |
|---------------------------------------|------------|---------------------|------------|
| Assets acquired                       |       | $                   | 44,823     |   |
| 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      |       | 323,886             |       |
| 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 and developedsoftware and customer relationships, which was calculated using an industrybeta and capital structure. These amounts are being amortized over a six-yearperiod. The estimated asset lives were determined based on projected futureeconomic benefits and expected life cycles of the technologies and customerrelationships.

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.

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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) there was noalternative future use, and (3) the fair value was estimable with reasonablereliability. The nature of the efforts to develop the in-process technologyinto the commercially viable products are expected to principally relate to thecompletion of all planning, designing, prototyping, verification and testingactivities that are necessary to establish that the technology can be producedto meet its design specification, including function, features and technicalperformance requirements. At the date of the business combination, CedaraSoftware had in-process projects meeting the above definition associated withthe Cedara Software next generation PACS workstation, OEM imaging platforms andimage acquisition console projects.

We estimated the fair value of the Cedara Software projectsto 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 compensation was valued based on theintrinsic value of each outstanding and unvested stock option assumed on theclosing date. The charge for stock compensation for the twelve months endedDecember 31, 2005 was $887 and was classified in the statement of operationsbased on each applicable employee’s position. Estimated aggregate expense foreach of the next five years is as follows:

| For the year  ended December 31: |   | 2006 |   | $      | 873    |   |
|----------------------------------|--------|------|--------|--------|--------|--------|
|                             |   | 2007 |   | 310    |   |
|                             |   | 2008 |   | 62     |   |
|                             |   | 2009 |   | — |   |
|                             |   | 2010 |   | — |   |

 

The $323,886 assigned togoodwill and $13,046 estimated fair value of in-process research anddevelopment will not 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.

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Thefollowing unaudited pro forma condensed combined results of operations for thetwelve months ended December 31, 2005 and 2004 are based on the historicalfinancial statements of Merge Healthcare and Cedara Software giving effect tothe business combination as if it had occurred at the beginning of the periodspresented. Therefore, this pro forma data has been adjusted to exclude CedaraSoftware pre-acquisition intangible amortization and the in-processresearch and development expense, while including amortization of intangibleassets and expense of deferred stock compensation during the entire applicableperiods. This data also reflects only the historical Merge Healthcare andCedara Software tax expense. This data is not indicative of the results ofoperations that would have arisen if the transaction had occurred at thebeginning of the respective periods. Moreover, this data is not intended to beindicative of future results of operations.

| ** **                             | ** ** | **Twelve Months Ended  December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                             | ** ** | **2004** | ** ** |
| ** **                             | ** ** | ** **                                           | ** ** | **(pro forma,  as restated)** | ** ** |
| Revenue                                |       | $                                                    | 107,529    |   |   | $ | 75,642 |   |   |
| Net income from  continuing operations |       | $                                                    | 7,227      |   |   | $ | 10,873 |   |   |
| Earnings per  share:                   |       |                                                 |       |   |   |   |   |
| Basic                                  |       | $                                                    | 0.17       |   |   | $ | 0.34 |   |   |
| Diluted                                |       | $                                                    | 0.16       |   |   | $ | 0.32 |   |   |

 

*(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 our end-usercustomers.

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 on January 3, 2006.

The acquisition was accounted for using the purchasemethod of accounting. The accompanying consolidated statements of operationsinclude the results of operations for AccuImage since the acquisition date,January 28, 2005. The amount allocated to purchased and developed software andcustomer relationships are being amortized over a five-year period. Theestimated asset lives were determined based on projected future economicbenefits and expected life cycles of the technologies and 

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customerrelationships. The amount assigned to goodwill is not being amortized, but willbe tested for impairment annually or under certain circumstances that mayindicate a potential impairment. The following is a summary of purchaseconsideration for the acquisition of AccuImage:

Thefollowing table represents the allocation of the total purchase considerationfor the purchase of AccuImage. The allocation of the purchase consideration isbased in part upon 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 a result of the CedaraSoftware transaction, there were overlapping technologies, which led to thewrite-off of approximately $73 of purchased and developed technologies. Inaddition, a trigger event, outside of our control, occurred during 2005 thatresulted in the write-off of the $80 customer relationship.

*(c) RIS Logic*

On July 17, 2003 we acquired all of the outstandingstock of RIS Logic pursuant to a merger agreement dated July 9, 2003 for atotal purchase price of $16,984, consisting primarily of cash, vested optionsand 771,804 shares of Common Stock. An escrow of 173,093 shares of Common Stockwas established as a reserve against any claims regarding breaches ofrepresentations and warranties. See Note 10(a) for discussion ofescrow settlement. RIS Logic had been in the business of the development andsales of RIS products to end-user imaging centers.

Wepaid a significant premium above the fair value of RIS Logic’s tangible netassets, principally because we determined that RIS Logic’s software developmentability and trade name were particularly important to us. We foresaw the needto expand our software product offerings to healthcare institutions and imagingcenters as many of our competitors are developing more integrated solutions. Inaddition, we expected to be able to sell our software products to RIS Logic’scustomers. The fair value of each share issued to RIS Logic was determined tobe $14.305 using a four-day average of the closing price of our Common Stockbefore and after the signing of the definitive agreement. The following is asummary of the purchase consideration for the acquisition of RIS Logic:

| **Form of Consideration** | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
|-------------------------------------|------------|------------|------------|---------------------|------------|
| Cash                                |       |       | $          | 4,311               |       |   |
| Stock issued                        |       |       | 11,041     |                |       |
| Vested stock  options               |       |       | 1,452      |                |       |
| Direct  transaction costs           |       |       | 180        |                |       |
| Total consideration                 |       |       | $          | 16,984              |       |   |

 

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Theacquisition was accounted for using the purchase method of accounting. Theaccompanying consolidated statements of operations include the results ofoperations for RIS Logic since the acquisition date of July 17, 2003. Theamounts allocated to purchased and developed technologies are being amortizedover periods ranging from three to five years. The estimated asset lives aredetermined based on projected future economic benefits and expected life cyclesof the technologies. The amount assigned to goodwill is not being amortized,but is tested for impairment annually or under certain circumstances that mayindicate a potential impairment. The total purchase consideration was allocatedto the fair value of the net assets acquired as follows:

| ** **                            | ** ** | **Fair Value** | ** ** |
|---------------------------------------|------------|---------------------|------------|
| Assets acquired                       |       |                | $          | 2,431 |   |   |
| Liabilities  assumed                  |       |                | (2,376     | ) |   |
| Purchased and  developed technologies |       |                | 1,483      |   |   |
| Customer  relationships               |       |                | 977        |   |   |
| Deferred income  tax                  |       |                | 496        |   |   |
| Goodwill,  including trade names      |       |                | 13,973     |   |   |
| Total consideration                   |       |                | $          | 16,984 |   |   |

 

**(3)   Accounts Receivable**

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 indicatedin Note 11.

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 2005 and 2004, the allowance for estimated uncollectibleaccounts was $1,892 and $450, 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, 2005                       |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| **Allowance  for doubtful accounts**                    |       |       | $          | 450                                                  |       |                                     |       | $                                                        | 719        |           |       |                                     | $          | 1,012 |   |   |   | $ | (289 | ) |   |   | $ | 1,892 |   |   |
| For year ended  December 31, 2004                       |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| **Allowance  for doubtful accounts (As restated)** |       |       | $          | 303                                                  |       |                                     |       | $                                                        | —     |           |       |                                     | $          | 158 |   |   |   | $ | (11 | ) |   |   | $ | 450 |   |   |
| For year ended  December 31, 2003                       |       |       |       |                                                 |       |                                     |       |                                                     |       |           |       |                                     |       |   |   |   |   |   |   |   |   |
| **Allowance for doubtful accounts  (As restated)** |       |       | $          | 163                                                  |       |                                     |       | $                                                        | —     |           |       |                                     | $          | 140 |   |   |   | $ | — |   |   |   | $ | 303 |   |   |

 

**(4)   Indebtedness**

In September 2005, we amended our unsecured revolvingline of credit agreement with our bank, increasing our line to $35,000 from$15,000 effective September 27, 2005, and maturing September 26, 2006. The linewas subject to covenants including financial covenants, as defined, withrespect to minimum net income, tangible net worth, current ratio, totalliabilities to tangible net worth ratio, interest coverage ratio, and othercustomary covenants. The interest rate on the line of credit is at a variablerate that is equal to the prime rate as published in *The WallStreet Journal*, less 75 basis points. At December 31, 2005, the loan’sinterest rate was 6.5%. No amounts were outstanding on the line of credit as ofDecember 31, 2005. As of December 31, 2005, we were in compliance with allcovenants under this line of credit.

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Our failure to timelyprovide our bank with annual financial statements for the year ended December 31,2005 and interim financial statements for the quarters ended March 31, 2006 andJune 30, 2006, constituted an event of default under our credit agreement.Accordingly, the obligation of the bank to extend us credit with respect to our$35,000 line of credit terminated. We are currently negotiating a new creditagreement with the bank.

**(5)   Employee Benefit Plan**

We maintain defined contribution retirement plans(401(k) profit sharing plan for the U. S. employees and RRSP for theCanadian employees), covering employees who meet the minimum servicerequirements and have elected to participate. We made matching contributions(under the 401(k) profit sharing plan for the U. S. employees and DPSP forthe Canadian employees) equal to a maximum of 3.0% in 2005, and 2.5% in 2004and 2003. Our matching contributions totaled $415, $203 and $112 for the yearsended December 31, 2005, 2004 and 2003, respectively.

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

**(6)   Income Taxes**

Theprovision for income taxes consists of the following for the years endedDecember 31, 2005, 2004 and 2003.

| ** **      | ** ** | **2005**   | ** ** | **2004**               | ** ** | **2003**               | ** ** |
|-----------------|------------|------------|------------|------------------------|------------|------------------------|------------|
| ** **      | ** ** | ** ** | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Current:        |       |       |       |                   |       |                   |       |   |   |   |   |
| Federal Federal |       | $          | 2,816      |                   |       | $                      | 699        |   |   |   | $ | 1,282 |   |   |
| State           |       | 767        |       |                   | 436        |                   |       |   | 357 |   |   |
| Foreign         |       | 669        |       |                   | 119        |                   |       |   | 149 |   |   |
| Total current   |       | 4,252      |       |                   | 1,254      |                   |       |   | 1,788 |   |   |
| Deferred:       |       |       |       |                   |       |                   |       |   |   |   |   |
| Federal         |       | 692        |       |                   | (2,241     | )                      |       |   | (2,145 | ) |   |
| State           |       | (469       | )          |                   | (464       | )                      |       |   | (932 | ) |   |
| Foreign         |       | 3,414      |       |                   | 229        |                   |       |   | 63 |   |   |
| Total deferred  |       | 3,637      |       |                   | (2,476     | )                      |       |   | (3,014 | ) |   |
| Total provision |       | $          | 7,889      |                   |       | $                      | (1,222     | ) |   |   | $ | (1,226 | ) |   |

 

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Actualincome taxes varied from the expected income taxes (computed by applying thestatutory income tax rate of 35% to income before income taxes) as a result ofthe following:

| ** **                                                       | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                       | ** ** | ** **                                  | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Expected tax  expense                                            |       | $                                           | 1,831      |   |   | $ | 339 |   |   |   | $ | 1,123 |   |   |
| Total increase  (decrease) in income taxes resulting from:       |       |                                        |       |   |   |   |   |   |   |   |   |
| Nondeductible amortization and acquired in-process  technology   |       | 4,566                                       |       |   | — |   |   |   | — |   |   |
| Change in valuation allowance allocated to income  tax expense   |       | —                                      |       |   | — |   |   |   | (2,575 | ) |   |
| Extraterritorial income tax benefit                              |       | (323                                        | )          |   | (1,457 | ) |   |   | — |   |   |
| Research and experimentation credit                              |       | —                                      |       |   | (228 | ) |   |   | (198 | ) |   |
| Nondeductible expenses                                           |       | 173                                         |       |   | (39 | ) |   |   | 112 |   |   |
| Foreign income taxes, net of federal income tax  benefit         |       | (407                                        | )          |   | 74 |   |   |   | 256 |   |   |
| State and local income taxes, net of federal income  tax benefit |       | 194                                         |       |   | (18 | ) |   |   | (431 | ) |   |
| Foreign income tax rate differential                             |       | 183                                         |       |   | 15 |   |   |   | 20 |   |   |
| Business combination tax restructuring                           |       | 1,308                                       |       |   | — |   |   |   | — |   |   |
| Other                                                            |       | 364                                         |       |   | 92 |   |   |   | 467 |   |   |
| Actual income tax  expense (benefit)                             |       | $                                           | 7,889      |   |   | $ | (1,222 | ) |   |   | $ | (1,226 | ) |   |

 

Thetax effects of temporary differences that give rise to significant portions ofthe deferred tax assets and deferred tax liabilities at December 31, 2005 and2004 are presented below:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | ** **            | ** ** | **(As restated)** | ** ** |
| Deferred tax  assets:                              |       |                  |       |   |   |   |   |
| Accrued wages                                      |       | $                     | 1,110      |   |   | $ | 124 |   |   |
| Deferred revenue                                   |       | 5,561                 |       |   | 5,258 |   |   |
| Depreciation                                       |       | 662                   |       |   | 152 |   |   |
| Research and experimentation credit carry forwards |       | 3,956                 |       |   | 2,331 |   |   |
| Other credit carry forwards                        |       | 1,470                 |       |   | 150 |   |   |
| Net operating loss carry forwards                  |       | 8,588                 |       |   | 1,395 |   |   |
| Foreign net operating loss carry forwards          |       | 11,950                |       |   | 283 |   |   |
| Other                                              |       | 1,743                 |       |   | 105 |   |   |
| Total gross  deferred tax assets                   |       | 35,040                |       |   | 9,798 |   |   |
| Less: asset  valuation allowance                   |       | (15,410               | )          |   | — |   |   |
| Net deferred tax  asset                            |       | 19,630                |       |   | 9,798 |   |   |
| Deferred tax liabilities:                          |       |                  |       |   |   |   |   |
| Software development costs and intangible assets   |       | (6,394                | )          |   | (2,783 | ) |   |
| Intangibles—customer contracts                |       | (4,929                | )          |   | (479 | ) |   |
| Other                                              |       | (585                  | )          |   | (94 | ) |   |
| Total gross deferred  liabilities                  |       | (11,908               | )          |   | (3,356 | ) |   |
| Net deferred tax  asset                            |       | $                     | 7,722      |   |   | $ | 6,442 |   |   |
| ** **                                         | ** ** | ** **            | ** ** | **(As restated)** | ** ** |
| Included on  balance sheet:                        |       |                  |       |   |   |   |   |
| Current assets: Deferred income taxes              |       | $                     | 11,213     |   |   | $ | 7,310 |   |   |
| Non-current liabilities: Deferred income taxes     |       | (3,491                | )          |   | (868 | ) |   |
| Net deferred  income taxes                         |       | $                     | 7,722      |   |   | $ | 6,442 |   |   |

 

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The increase (decrease) in the valuation allowance forthe years ending December 31, 2005, 2004 and 2003 were, $15,410, $0 and($2,575), respectively. Management has an obligation under SFAS 109*, Accountingfor Income Taxes,* to review, at least annually, the components ofour deferred tax assets. This review is to ascertain that, based upon theinformation available at the time of the preparation of financial statements,it is more likely than not, that we expect to utilize these future deductionsand credits. In the event that management determines that it is more likelythan not these future deductions, or credits, will not be utilized, a valuationallowance is recorded, reducing the deferred tax asset to the amount expectedto be realized.

In management’s judgment, a valuation allowance of$15,410 is necessary for Cedara Software’s net operating losses and researchcredits generated prior to June 1, 2005. This decision is based upon many factors,both quantitative and qualitative, such as (1) the short expiration periods ofnet operating losses and tax credits, (2) a history of net operating lossesexpiring unused, and (3) a lack of long term historical operatingprofitability. Reductions in the valuation allowance, if any, will not have anyimpact on the income tax expense provision recorded in the statement ofoperations, rather changes will be recorded as a decrease in goodwill. Duringthe seven-month period ended December 31, 2005, Cedara Software benefited fromits federal and provincial net operating losses in the amount of $4,857, whichreduced the valuation allowance and goodwill recorded through purchaseaccounting.

Management’s analysis for 2005 determined that avaluation allowance was not necessary at December 31, 2005, for its historicoperations, nor the U. S. subsidiaries acquired during 2005. This decisionwas based upon many factors, both quantitative and qualitative, such as (1)five–years of positive taxable income, before net operating loss deductions,(2) expected future operating profitability, and (3) the relatively longexpiration periods of net operating losses and tax credits. However,fluctuation in the actual outcome of these expectations could materially impactour income tax expense provision, and deferred tax assets in the future. Priorto 2003, management determined that the ultimate realization of the deferredtax assets was, based upon the relatively low levels of historical taxableincome at that time, not more likely than not, therefore, a valuation allowancewas recorded against the net deferred tax asset at that time.

The income tax benefit of disqualifying dispositionsof employee incentive stock options exercised during 2005, 2004 and 2003 in theamount of $1,811, $595 and $1,657, respectively, was recorded as additionalpaid-in-capital, and did not result in a benefit on the statements ofoperations.

In 2005, we benefited from the utilization of federaland state net operating losses in the amount of $1,891 and $51, respectively,and federal and state research and development credits in the amount of $67 and$439, respectively.

At December 31, 2005, we had federal net operatingloss carryforwards and research credit carryforwards of $21,968 and $2,326,respectively, state net operating loss carryforwards and research creditcarryforwards of $10,385 and $0, respectively, foreign tax credits of $1,075,foreign federal and provincial net operating loss carryforwards of $37,240 and$25,606, 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 and2011, respectively, and continuing through 2022 and 2025, respectively. Thestate net operating loss carryforwards expire in varying amounts beginning in2006, and continuing through 2025. The foreign tax credits expire in varyingamounts beginning in 2006, and continuing through 2015. The foreign federal andprovincial net operating loss carryforwards expire in varying amounts beginningin 2006 and 2007, respectively, and continuing through 2015. Of the foreignfederal net operating loss carryforwards noted above, approximately $27,254expire on December 31, 2007.

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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 netoperating loss and research and development credit carryforwards will besubject to these rules. In addition, we experienced an ownership change, asdefined under Treasury regulations, on June 1, 2005. We believe that thisownership change will not have an impact on our ability to fully utilize ourhistorical tax attributes. However, if certain additional changes in ourownership should occur, net operating loss and credit carryforwards may belimited.

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 indefinitely reinvestedprofits is not feasible.

**(7)   Leases**

We have non-cancelable operating leases at variouslocations. In April 2005, we moved to our new headquarters in Milwaukee,Wisconsin, which has approximately 22,000 square feet and is leased through April2011. In connection with the business combination with Cedara Software, weassumed lease obligations associated with a leased facility in Mississauga,Ontario, Canada, which has approximately 60,000 square feet and is leasedthrough December 2009, and a leased facility in Burlington, Massachusetts,which has approximately 24,000 square feet and is leased through October 2008. OnJune 1, 2006, we signed a letter exercising our right to lease an additional14,000 square feet at our Milwaukee facility, commencing September 1, 2006through April 2011. The effects of this event was not included in the tablebelow.

Totalrent expense for the years ended December 31, 2005, 2004 and 2003 were $1,473,$324 and $307, respectively. Future minimum lease payments under all non-cancelableoperating leases (with initial or remaining lease terms in excess of one year),as of December 31, 2005, are:

| 2006                          |   | $     | 2,201  |   |
|-------------------------------|--------|-------|--------|--------|
| 2007                          |   | 1,988 |   |
| 2008                          |   | 1,897 |   |
| 2009                          |   | 1,355 |   |
| 2010                          |   | 426   |   |
| Thereafter                    |   | 150   |   |
| Total minimum lease  payments |   | $     | 8,017  |   |

 

**(8)   Commitments and Contingencies**

Between March 22, 2006 and April 26, 2006, sevenputative 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, against us, Richard A. Linden, our former President and ChiefExecutive Officer, and Scott T. Veech, our former Chief Financial Officer; oneof the suits also names Brian E. Pedlar, former President of Cedara Software andour former Senior Vice President, who served as our interim co-President and co-ChiefExecutive Officer from July 2, 2006 to August 18, 2006. One case has beenvoluntarily dismissed. The cases arise out of our March 17, 2006announcement that that we would revise our results of operations for the fiscalquarters ended June 30, 2005 and September 30, 2005, as well as ourinvestigation of allegations made in anonymous letters received by us. Thelawsuits allege that we and individual defendants violated Sections 10(b)and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). Thecomplaints seek damages in unspecified amounts. Competing motions for the appointmentof lead plaintiff have been 

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filed, but they have notyet been ruled upon by the Court. We intend to vigorously defend theselawsuits, including, but not limited to, possibly moving to dismiss theconsolidated amended complaint when filed.

On August 28, 2006, a derivative action was filed inthe Circuit Court of Milwaukee County, Civil Division, against Messrs. Linden,Mortimore and Veech and all of the current members of our Board of Directors.The plaintiffs allege that each of the individual defendants breached fiduciaryduties to us by violating generally accepted accounting principles, willfullyignoring problems with accounting and internal control practices and proceduresand participating in the dissemination of false financial statements and alsoallege that we and the current director defendants failed to hold an annualmeeting of shareholders for 2006 in violation of Wisconsin law. The plaintiffsask for unspecified amounts in damages and costs, as well as equitable relief.

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 lawsuit filedagainst us by ScheduleQuest, Inc. was dismissed.

We, and our subsidiaries, are from time to timeparties to legal proceedings, lawsuits and other claims incident to ourbusiness activities. Such matters may include, among other things, assertionsof contract breach or intellectual property infringement, claims for indemnityarising in the course of our business and claims by persons whose employmenthas been terminated. Such matters are subject to many uncertainties andoutcomes are not predictable with assurance. Consequently, we are unable toascertain the ultimate aggregate amount of monetary liability, amounts whichmay be covered by insurance or recoverable from third parties, or the financialimpact with respect to these matters as of the date of this report.

Wehave incurred certain costs associated with the Cedara Software business combinationfor certain terminated employees that have been accrued for and included in theestimated value of liabilities assumed. At December 31, 2005, there wereapproximately $1,621, based on a present value using a 6% discount rate, ofremaining severance payments, which will be made over a period of approximately18 months.

**(9)   Restructuring**

Weincurred $530 of restructuring charges in the twelve months ended December 31,2005. Restructuring charges are comprised of lease exit costs associated with thesettlement of our lease of approximately $175, which we ceased using during2005 as we combined two of our offices located in the same geographic region,severance to involuntarily terminated employees of $263 and option accelerationexpense of $92 related to such employees, based on the intrinsic value ofoptions at the time of termination. At December 31, 2005, we had $17 inremaining severance payments and $175 of lease settlement payments.

**(10) Shareholders’ Equity**

*(a) Common Stock*

On August 24, 2004, we announced a stockrepurchase plan providing for the purchase of up to $10,000 of our CommonStock. Purchases may be made over a period of two years and the timing, priceand volume of repurchases will be based on market conditions, applicablesecurities laws and other factors. As of December 31, 2005, we have notmade any repurchases under this plan. In March 2006, we 

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announced an expansion ofthe stock repurchase program from $10,000 to $20,000. This repurchase programexpired on August 24, 2006, two years after its initial implementation, withoutany shares having been repurchased. Our Board has not made any decision as toif or when a similar program will be implemented.

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 our CommonStock to the shareholders of Cedara Software and 13,210,168 Merge CedaraExchangeCo Exchangeable Shares to Canadian shareholders of Cedara Software. ThroughDecember 31, 2005, 6,080,922 Merge Cedara ExchangeCo Exchangeable Shareswere exchanged for an equal number of shares of our Common Stock.

InOctober 2005, 90,000 shares of our Common Stock previously held in escrow inconnection with our acquisition of RIS Logic in 2003 were returned to us asconsideration for the release of RIS Logic’s warranty and indemnificationrequirements under the merger agreement and such shares were retired as of December31, 2005.

*(b) Special VotingPreferred Stock*

During2004, the one share issued to our former transfer agent, which served as atrustee in voting matters on behalf of the Interpra Medical Network SystemsLtd. exchangeable shareholders, was retired.

*(c) Series 2Special Voting Preferred Stock*

During2004, the one share issued to our former transfer agent, which served as atrustee in voting matters on behalf of the eFilm exchangeable shareholders, wasretired.

*(d) Series 3Special Voting Preferred Stock*

InJune 2005, we issued 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 exchangeable shares.As of December 31, 2005, this share was issued and outstanding.

*(e) Stock OptionPlans*

On May 24, 2005, our shareholders approved our 2005Equity Incentive Plan (“EIP”). The EIP provides for awards of Common Stock, non-statutorystock options, incentive stock options, stock unit and performance unit grantsand stock appreciation rights to eligible participants to equate to a maximumof 7.5 million shares of our Common Stock, of which incentive stock optiongrants are limited to 5.0 million shares. Under the EIP, new stock optiongrants have an exercise price equal to the fair market value of our CommonStock at the date of grant. The EIP includes options granted to replaceexisting Cedara Software Corp. options (“Replacement Options”) and new optiongrants. Replacement Options were granted pursuant to the merger agreement withthe same economic terms, as adjusted for conversion ratio and currency. The majority of these options vest over a three orfour-year period. As of December 31, 2005, incentive stock options topurchase 79,500 shares of our Common Stock and non-statutory stock options to purchase 1,940,815 shares of ourCommon Stock were outstanding under this plan.

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, 2005,there were 379,655 shares of our Common Stock available for option grants underthis plan, however, we do not plan on issuing any more options under this plan.

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Our 1998 Director Stock Option Plan, for our non-employeedirectors, provided for the granting of options to purchase a maximum of300,000 shares of our Common Stock. Under this plan, options have anexercise price equal to the fair market value of our Common Stock at the dateof grant. The majority of options granted under this plan fully vested at thedate of grant. Any expired or forfeited options granted under this plan are noteligible for re-issuance. The options granted under this plan expire ten yearsand one day from the date of grant. At December 31, 2005, there were 9,592 sharesof Common Stock available for option grants; however, we do not plan on issuingany more options under this plan.

Our Board of Directors adopted an equity compensationplan in connection with our acquisition on July 17, 2003 of RIS Logic. AtDecember 31, 2005, options to purchase 43,270 shares of our CommonStock were outstanding under this plan.

On March 17, 2006, use of our registration statementon Form S-8 relating to the issuance of our Common Stock was suspended. Consequently,we have not accepted exercises by any option holder. We also suspended theissuance of new options.

Thefair value of each option grant is estimated on the date of grant using the Black-Scholesoption-pricing model with the following assumptions:

| Year of grant | ** ** | ** ** | ** **             | **Expected  Option  Life** | ** ** | **Expected  Volatility**     | ** ** | **Dividend  Yield** | ** ** | **Risk-free  Interest Rate** | ** ** |
|--------------------|------------|------------|------------------------|----------------------------|------------|------------------------------|------------|---------------------|------------|-----------------------------------|------------|
| ** **         | ** ** | ** ** | ** **             | **(in years)**        | ** ** | ** **                   | ** ** | ** **          | ** ** | ** **                        | ** ** |
| 2003               |       |       | 0 – 6   |                       |       | 50%                          |       |                | 0%         |                              |       | 0.90% **–** 3.27% |   |
| 2004               |       |       | 0 – 4   |                       |       | 50%                          |       |                | 0%         |                              |       | 2.06% **–** 3.12% |   |
| 2005               |       |       | 0 – 3.5 |                       |       | 30% **–** 50% |       |                | 0%         |                              |       | 2.79% **–** 4.28% |   |

 

Asummary of stock option activity is as follows:

| ** **                              | ** ** | **Number** | ** ** | **Weighted-average  exercise price** | ** ** | **Weighted-  average  fair value of  options granted** | ** ** |
|-----------------------------------------|------------|------------|------------|-------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Options outstanding,  December 31, 2002 |       | 1,435,298  |       |                                      | $          | 3.62                                                                  |       |   |   |   |   |   |
| Options granted                         |       | 824,324    |       |                                      | $          | 11.42                                                                 |       |   |   | $ | 6.37 |   |   |
| Options exercised                       |       | (551,690   | )          |                                      | 3.88       |                                                                  |       |   |   |   |   |
| Options forfeited  and expired          |       | (43,375    | )          |                                      | 6.58       |                                                                  |       |   |   |   |   |
| Options outstanding, December 31, 2003  |       | 1,664,557  |       |                                      | 7.34       |                                                                  |       |   |   |   |   |
| Options granted                         |       | 390,500    |       |                                      | $          | 15.08                                                                 |       |   |   | $ | 5.90 |   |   |
| Options exercised                       |       | (336,472   | )          |                                      | 4.48       |                                                                  |       |   |   |   |   |
| Options forfeited  and expired          |       | (128,500   | )          |                                      | 13.35      |                                                                  |       |   |   |   |   |
| Options  outstanding, December 31, 2004 |       | 1,590,085  |       |                                      | 7.34       |                                                                  |       |   |   |   |   |
| Options granted                         |       | 3,346,827  |       |                                      | $          | 11.21                                                                 |       |   |   | $ | 5.34 |   |   |
| Options exercised                       |       | (1,737,943 | )          |                                      | 5.47       |                                                                  |       |   |   |   |   |
| Options forfeited  and expired          |       | (219,830   | )          |                                      | 15.69      |                                                                  |       |   |   |   |   |
| Options  outstanding, December 31, 2005 |       | 2,979,139  |       |                                      | 13.24      |                                                                  |       |   |   |   |   |
| Options exercisable,  December 31, 2005 |       | 1,040,883  |       |                                      | $          | 11.84                                                                 |       |   |   |   |   |   |

 

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Thefollowing table summarizes information about stock options outstanding atDecember 31, 2005:

| **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 – $  4.00 |            |                         | 369,255    |   |   | 2.60 |   |   |   | $ | 2.11 |   |   | 166,640 |   |   | $ | 2.28 |   |   |
| $  4.16 – $  9.90 |            |                         | 455,152    |   |   | 3.96 |   |   |   | 6.20 |   |   | 246,146 |   |   | 6.55 |   |   |
| $12.49 – $16.86                       |            |                         | 758,360    |   |   | 4.16 |   |   |   | 14.78 |   |   | 290,539 |   |   | 15.17 |   |   |
| $17.00 – $17.50                       |            |                         | 1,097,750  |   |   | 5.81 |   |   |   | 17.48 |   |   | 320,000 |   |   | 17.50 |   |   |
| $17.56 – $22.10                       |            |                         | 298,622    |   |   | 5.56 |   |   |   | 18.18 |   |   | 17,558 |   |   | 18.73 |   |   |
|                                                 |       |                         | 2,979,139  |   |   | 4.69 |   |   |   | $ | 13.24 |   |   | 1,040,883 |   |   | $ | 11.84 |   |   |
|                                                      |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*(f) Stock PurchasePlan*

We maintain an employee stock purchase plan thatallowed employees during the last three quarters of 2005 to purchase stock at a5% discount from the market price at the end of each calendar quarter. During2004 and the first quarter of 2005, employees purchased stock at the lesser ofthe stock price at the start of each calendar quarter or the end of eachcalendar quarter. During 2003, employees purchased stock at 85% of the lesserof the stock price at the start of the plan year or the end of each calendarquarter. Contributions to the employee stock purchase plan are made throughpayroll deductions. Employees contributed $65, $68 and $153 during 2005, 2004and 2003, respectively, to purchase shares of our Common Stock under theemployee stock purchase plan.

As ofMarch 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.

*(g) Exchange Rights*

As part of our business combination with Cedara Software,we granted rights for the issuance of 13,210,168 shares of Common Stock toholders of Cedara Software exchangeable shares on a one-for-one basis. As ofDecember 31, 2005, there were 7,129,246 Cedara Software exchangeableshares outstanding. We have the right to redeem all of the exchangeable sharesat anytime after April 29, 2010 or if less than 10% of the number ofexchangeable shares issued on the effective date of the business combinationremain outstanding, provided that we give sixty days advance written notice.

As ofMarch 17, 2006, our registration statement on Form S-3 relating to issuance ofour Common Stock upon exchange of exchangeable shares was suspended.

**(11) Concentrations of Risk**

*(a) Cash in Excessof Federally Insured Amount*

Substantially all of our cash and cash equivalents areheld at a few financial institutions located in the U. S., Canada and theNetherlands. Deposits held with these banks exceed the amount of insuranceprovided on such deposits. Generally these deposits may be redeemed upon demandand, therefore, bear minimal risk.

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*(b) Net Sales andAccounts Receivable*

The majority of our clients are OEM’s, imagingcenters, hospitals and integrated delivery networks. If significant adversemacro–economic factors were to impact these organizations, it could materiallyadversely affect us. Our access to certain software and hardware components isdependent upon single and sole source suppliers. The inability of any supplierto fulfill our supply requirements could affect future results.

Foreign sales, denominated in U. S. Dollars,accounted for approximately 40%, 32% and 43% of our net sales for the yearsended December 31, 2005, 2004 and 2003, respectively. For the years endedDecember 31, 2005, 2004 and 2003, sales in foreign currency represented 4%, 13%and 16%, respectively, of our net sales.

For the years ended December 31, 2005, 2004 and 2003,we had two, one and one individual customer that represented more than 10% ofnet sales. For the year ended December 31, 2005, Toshiba Medical SystemsCorporation and Hitachi Medical Corporation accounted for 16% and 10%,respectively, of net sales. For the years ended December 31, 2004 and 2003,Philips Medical Systems accounted for 10% and 17%, respectively, of net sales. Wehad one customer, Hitachi Medical Corporation, which comprised 27% of the totalaccounts receivable as of December 31, 2005. No individual customeraccounted for more than 10% of our total accounts receivable as of December 31,2004.

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

| ** **                | ** ** | **Net Sales** | ** ** |
|---------------------------|------------|--------------------|------------|
| ** **                | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                | ** ** | ** **         | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| United States of  America |       | $                  | 49,244     |   |   | $ | 17,965 |   |   |   | $ | 14,062 |   |   |
| Japan                     |       | 24,377             |       |   | 1,122 |   |   |   | 1,007 |   |   |
| Europe                    |       | 6,626              |       |   | 4,704 |   |   |   | 6,717 |   |   |
| Canada                    |       | 1,877              |       |   | 2,458 |   |   |   | 2,760 |   |   |
| Other                     |       | 477                |       |   | 98 |   |   |   | 14 |   |   |
| Total net sales           |       | $                  | 82,601     |   |   | $ | 26,347 |   |   |   | $ | 24,560 |   |   |

 

| ** ** | ** ** | **Long-Lived Assets** | ** ** |
|------------|------------|----------------------------|------------|
| ** ** | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Canada     |       | $                          | 1,504      |   | $ | 338 |   | $ | 404 |   |
| Europe     |       | 45                         |       | 28 |   | 40 |   |
|            |            |                            |            |  |  |  |  |  |  |  |

 

Long-lived assetsrepresent property, plant and equipment, net of related depreciation.****Long-lived assets in service at the Japan and Chinaoffices were not material as of December 31, 2005 and 2004.

**(12) Quarterly Results (unaudited)**

The following selected quarterly data has been derivedfrom our unaudited consolidated financial statements that, in our opinion,reflect all recurring adjustments necessary to fairly present our financialinformation when read in conjunction with our Consolidated Financial Statementsand Notes. This selected quarterly information has been restated for, and as ofthe end of, the first three quarters of 2005 and all quarters of 2004 frompreviously reported information filed on Forms 10-Q and Form 10-K,as a result of the restatement of our financial results as discussed inNote 13. These restatement adjustments are described in Note 13 forthe respective annual periods. The results of operations for any quarter arenot necessarily indicative of the results to be expected for any future period.

We have not amended ourAnnual Reports on Form 10-K or Quarterly Reports on Form 10-Q forthe quarterly periods affected by the restatement. The information that hasbeen previously filed or otherwise 

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reportedfor these periods is superseded by the information in this Annual Report onForm 10-K, and the financial statements and related financialinformation contained in such reports should no longer be relied upon.Footnotes (a) through (e) in the following tables may be found on page 101of this Annual Report on Form 10-K.

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

| ** **                                                                  | ** ** | **March 31, 2004**                                                                    | ** ** | **Adjustments** | ** ** | **March 31, 2004** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                                                  | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**       | ** ** |
| ** **                                                                  | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                  |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Software and other(a)                                                       |       |                                                                                            | $          | 6,156           |       |                         |       | $ | (2,113 | ) |   |   | $ | 4,043 |   |   |
| Services and maintenance(a)                                                 |       |                                                                                            | 2,481      |            |       |                         | (522       | ) |   |   | 1,959 |   |   |
| Total net sales                                                             |       |                                                                                            | 8,637      |            |       |                         | (2,635     | ) |   |   | 6,002 |   |   |
| Cost of sales:                                                              |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Software and other(d)                                                       |       |                                                                                            | 1,115      |            |       |                         | (534       | ) |   |   | 581 |   |   |
| Services and maintenance                                                    |       |                                                                                            | 1,466      |            |       |                         |       |   |   |   | 1,466 |   |   |
| Amortization(e)                                                             |       |                                                                                            | 638        |            |       |                         | (97        | ) |   |   | 541 |   |   |
| Total cost of  sales                                                        |       |                                                                                            | 3,219      |            |       |                         | (631       | ) |   |   | 2,588 |   |   |
| Gross margin                                                                |       |                                                                                            | 5,418      |            |       |                         | (2,004     | ) |   |   | 3,414 |   |   |
| Operating costs  and expenses:                                              |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                      |       |                                                                                            | 1,694      |            |       |                         | (84        | ) |   |   | 1,610 |   |   |
| Product research and development                                            |       |                                                                                            | 482        |            |       |                         |       |   |   |   | 482 |   |   |
| General and administrative                                                  |       |                                                                                            | 912        |            |       |                         |       |   |   |   | 912 |   |   |
| Depreciation and amortization(e)                                            |       |                                                                                            | 189        |            |       |                         | 97         |   |   |   | 286 |   |   |
| Total operating  costs and expenses                                         |       |                                                                                            | 3,277      |            |       |                         | 13         | ) |   |   | 3,290 |   |   |
| Operating income                                                            |       |                                                                                            | 2,141      |            |       |                         | (2,017     | ) |   |   | 124 |   |   |
| Other income                                                                |       |                                                                                            | 52         |            |       |                         |       |   |   |   | 52 |   |   |
| Income before  income taxes                                                 |       |                                                                                            | 2,193      |            |       |                         | (2,017     | ) |   |   | 176 |   |   |
| Income tax  expense(c)                                                      |       |                                                                                            | 839        |            |       |                         | (772       | ) |   |   | 67 |   |   |
| Net income                                                                  |       |                                                                                            | $          | 1,354           |       |                         |       | $ | (1,245 | ) |   |   | $ | 109 |   |   |
| Net income per share—basic                                             |       |                                                                                            | $          | 0.10            |       |                         |       | (0.09 | ) |   |   | $ | 0.01 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 12,886,780 |            |       |                         |       |   |   |   | 12,886,780 |   |   |
| Net income per share—diluted                                           |       |                                                                                            | $          | 0.10            |       |                         |       | (0.09 | ) |   |   | $ | 0.01 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 13,752,543 |            |       |                         |       |   |   |   | 13,752,543 |   |   |

 

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**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **March 31, 2004** | ** ** | **Adjustments** | ** ** | **March 31, 2004** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**       | ** ** | ** **      | ** ** | **(As restated)**       | ** ** |
| ASSETS                                           |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Current assets:                                  |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                         | $          | 18,113          |       |                         |       |   |   |   |   | $ | 18,113 |   |   |
| Accounts receivable, net                         |       |                         | 8,230      |            |       |                         |       |   |   |   | 8,230 |   |   |
| Inventory                                        |       |                         | 910        |            |       |                         |       |   |   |   | 910 |   |   |
| Prepaid expenses(b)                              |       |                         | 447        |            |       |                         | 84         |   |   |   | 531 |   |   |
| Deferred income taxes(c)                         |       |                         | 2,953      |            |       |                         | 1,669      |   |   |   | 4,622 |   |   |
| Other current assets(d)                          |       |                         | 276        |            |       |                         | 1,707      |   |   |   | 1,983 |   |   |
| Total current  assets                            |       |                         | 30,929     |            |       |                         | 3,460      |   |   |   | 34,389 |   |   |
| Net property and  equipment                      |       |                         | 1,671      |            |       |                         |       |   |   |   | 1,671 |   |   |
| Purchased and  developed software, net           |       |                         | 8,828      |            |       |                         |       |   |   |   | 8,828 |   |   |
| Acquired  intangibles, net                       |       |                         | 1,475      |            |       |                         |       |   |   |   | 1,475 |   |   |
| Goodwill                                         |       |                         | 21,736     |            |       |                         |       |   |   |   | 21,736 |   |   |
| Other assets                                     |       |                         | 141        |            |       |                         |       |   |   |   | 141 |   |   |
| Total assets                                     |       |                         | $          | 64,780          |       |                         |       | 3,460 |   |   |   | $ | 68,240 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Current liabilities:                             |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Accounts payable                                 |       |                         | $          | 998             |       |                         |       |   |   |   |   | $ | 998 |   |   |
| Accrued wages                                    |       |                         | 803        |            |       |                         |       |   |   |   | 803 |   |   |
| Other accrued liabilities                        |       |                         | 878        |            |       |                         |       |   |   |   | 878 |   |   |
| Deferred revenue(a)                              |       |                         | 4,704      |            |       |                         | 8,360      |   |   |   | 13,064 |   |   |
| Total current  liabilities                       |       |                         | 7,383      |            |       |                         | 8,360      |   |   |   | 15,743 |   |   |
| Deferred income taxes(c)                         |       |                         | 2,106      |            |       |                         | (988       | ) |   |   | 1,118 |   |   |
| Total liabilities                                |       |                         | 9,489      |            |       |                         | 7,372      |   |   |   | 16,861 |   |   |
| Total  shareholders’ equity                 |       |                         | 55,291     |            |       |                         | (3,912     | ) |   |   | 51,379 |   |   |
| Total liabilities and  shareholders’ equity |       |                         | $          | 64,780          |       |                         |       | 3,460 |   |   |   | $ | 68,240 |   |   |

 

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

| ** **                                                                  | ** ** | **June 30, 2004**                                                                     | ** ** | **Adjustments** | ** ** | **June 30, 2004** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------------------|------------|
| ** **                                                                  | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**      | ** ** |
| ** **                                                                  | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                  |       |                                                                                            |       |            |       |                        |       |   |   |
| Software and other(a)                                                       |       | $                                                                                               | 6,113      |            |       | $                           | (1,805     | ) |   | $ | 4,308 |   |
| Services and maintenance(a)                                                 |       | 2,794                                                                                           |       |            | (770       | )                           |       | 2,024 |   |
| Total net sales                                                             |       | 8,907                                                                                           |       |            | (2,575     | )                           |       | 6,332 |   |
| Cost of sales:                                                              |       |                                                                                            |       |            |       |                        |       |   |   |
| Software and other(d)                                                       |       | 962                                                                                             |       |            | (494       | )                           |       | 468 |   |
| Services and maintenance                                                    |       | 1,568                                                                                           |       |            |       |                        |       | 1,568 |   |
| Amortization(e)                                                             |       | 642                                                                                             |       |            | (97        | )                           |       | 545 |   |
| Total cost of  sales                                                        |       | 3,172                                                                                           |       |            | (591       | )                           |       | 2,581 |   |
| Gross margin                                                                |       | 5,735                                                                                           |       |            | (1,984     | )                           |       | 3,751 |   |
| Operating costs and  expenses:                                              |       |                                                                                            |       |            |       |                        |       |   |   |
| Sales and marketing(b)                                                      |       | 1,711                                                                                           |       |            | (44        | )                           |       | 1,667 |   |
| Product research and development                                            |       | 423                                                                                             |       |            |       |                        |       | 423 |   |
| General and administrative                                                  |       | 1,024                                                                                           |       |            |       |                        |       | 1,024 |   |
| Depreciation and amortization(e)                                            |       | 196                                                                                             |       |            | 97         |                        |       | 293 |   |
| Total operating  costs and expenses                                         |       | 3,354                                                                                           |       |            | 53         |                        |       | 3,407 |   |
| Operating income                                                            |       | 2,381                                                                                           |       |            | (2,037     | )                           |       | 344 |   |
| Other income                                                                |       | 108                                                                                             |       |            |       |                        |       | 108 |   |
| Income before  income taxes                                                 |       | 2,489                                                                                           |       |            | (2,037     | )                           |       | 452 |   |
| Income tax  expense(c)                                                      |       | 992                                                                                             |       |            | (814       | )                           |       | 178 |   |
| Net income                                                                  |       | $                                                                                               | 1,497      |            |       | $                           | (1,223     | ) |   | $ | 274 |   |
| Net income per share—basic                                             |       | $                                                                                               | 0.12       |            |       | (0.10                       | )          |   | $ | 0.02 |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       | 12,968,889                                                                                      |       |            |       |                        |       | 12,968,889 |   |
| Net income per share—diluted                                           |       | $                                                                                               | 0.11       |            |       | (0.09                       | )          |   | $ | 0.02 |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       | 13,782,440                                                                                      |       |            |       |                        |       | 13,782,440 |   |

 

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**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **June 30, 2004** | ** ** | **Adjustments** | ** ** | **June 30, 2004** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **(As reported)**      | ** ** | ** **      | ** ** | **(As restated)**      | ** ** |
| ASSETS                                           |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Current assets:                                  |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                        | $          | 20,683          |       |                        |       |   |   |   |   | $ | 20,683 |   |   |
| Accounts receivable, net                         |       |                        | 8,751      |            |       |                        |       |   |   |   | 8,751 |   |   |
| Inventory                                        |       |                        | 958        |            |       |                        |       |   |   |   | 958 |   |   |
| Prepaid expenses(b)                              |       |                        | 469        |            |       |                        | 130        |   |   |   | 599 |   |   |
| Deferred income taxes(c)                         |       |                        | 2,850      |            |       |                        | 1,773      |   |   |   | 4,623 |   |   |
| Other current assets(d)                          |       |                        | 491        |            |       |                        | 2,073      |   |   |   | 2,564 |   |   |
| Total current  assets                            |       |                        | 34,202     |            |       |                        | 3,976      |   |   |   | 38,178 |   |   |
| Net property and  equipment                      |       |                        | 1,530      |            |       |                        |       |   |   |   | 1,530 |   |   |
| Purchased and  developed software, net           |       |                        | 9,170      |            |       |                        |       |   |   |   | 9,170 |   |   |
| Acquired  intangibles, net                       |       |                        | 1,378      |            |       |                        |       |   |   |   | 1,378 |   |   |
| Goodwill                                         |       |                        | 21,714     |            |       |                        |       |   |   |   | 21,714 |   |   |
| Other assets                                     |       |                        | 134        |            |       |                        |       |   |   |   | 134 |   |   |
| Total assets                                     |       |                        | $          | 68,128          |       |                        |       | 3,976 |   |   |   | $ | 72,104 |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY        |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Current  liabilities:                            |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Accounts payable                                 |       |                        | $          | 1,042           |       |                        |       |   |   |   |   | $ | 1,042 |   |   |
| Accrued wages                                    |       |                        | 817        |            |       |                        |       |   |   |   | 817 |   |   |
| Other accrued liabilities(b)                     |       |                        | 1,229      |            |       |                        | (711       | ) |   |   | 518 |   |   |
| Deferred revenue(a)                              |       |                        | 5,797      |            |       |                        | 10,810     |   |   |   | 16,607 |   |   |
| Total current  liabilities                       |       |                        | 8,885      |            |       |                        | 10,100     |   |   |   | 18,984 |   |   |
| Deferred income taxes(c)                         |       |                        | 2,106      |            |       |                        | (987       | ) |   |   | 1,119 |   |   |
| Total liabilities                                |       |                        | 10,991     |            |       |                        | 9,112      |   |   |   | 20,103 |   |   |
| Total  shareholders’ equity                 |       |                        | 57,137     |            |       |                        | (5,136     | ) |   |   | 52,001 |   |   |
| Total liabilities and  shareholders’ equity |       |                        | $          | 68,128          |       |                        |       | 3,976 |   |   |   | $ | 72,104 |   |   |

 

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

| ** **                                                                            | ** ** | **September 30, 2004**                                                                | ** ** | **Adjustments** | ** ** | **September 30, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**           | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                            |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Software and other(a)                                                                 |       |                                                                                            | $          | 6,280           |       |                             |       | $ | (1,517 | ) |   |   | $ | 4,763 |   |   |
| Services and maintenance(a)                                                           |       |                                                                                            | 3,027      |            |       |                             | (646       | ) |   |   | 2,381 |   |   |
| Total net sales                                                                       |       |                                                                                            | 9,307      |            |       |                             | (2,163     | ) |   |   | 7,144 |   |   |
| Cost of sales:                                                                        |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Software and other(d)                                                                 |       |                                                                                            | 964        |            |       |                             | (234       | ) |   |   | 730 |   |   |
| Services and maintenance                                                              |       |                                                                                            | 1,490      |            |       |                             |       |   |   |   | 1,490 |   |   |
| Amortization(e)                                                                       |       |                                                                                            | 754        |            |       |                             | (97        | ) |   |   | 657 |   |   |
| Total cost of  sales                                                                  |       |                                                                                            | 3,208      |            |       |                             | (331       | ) |   |   | 2,877 |   |   |
| Gross margin                                                                          |       |                                                                                            | 6,099      |            |       |                             | (1,832     | ) |   |   | 4,267 |   |   |
| Operating costs  and expenses:                                                        |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                                |       |                                                                                            | 1,683      |            |       |                             | (31        | ) |   |   | 1,652 |   |   |
| Product research and development                                                      |       |                                                                                            | 559        |            |       |                             |       |   |   |   | 559 |   |   |
| General and administrative                                                            |       |                                                                                            | 1,258      |            |       |                             |       |   |   |   | 1,258 |   |   |
| Depreciation and amortization(e)                                                      |       |                                                                                            | 202        |            |       |                             | 97         |   |   |   | 299 |   |   |
| Total operating  costs and expenses                                                   |       |                                                                                            | 3,702      |            |       |                             | 66         |   |   |   | 3,768 |   |   |
| Operating income                                                                      |       |                                                                                            | 2,397      |            |       |                             | (1,898     | ) |   |   | 499 |   |   |
| Other income                                                                          |       |                                                                                            | 92         |            |       |                             |       |   |   |   | 92 |   |   |
| Income before  income taxes                                                           |       |                                                                                            | 2,489      |            |       |                             | (1,898     | ) |   |   | 591 |   |   |
| Income tax  expense (benefit)(c)                                                      |       |                                                                                            | 252        |            |       |                             | (589       | ) |   |   | (337 | ) |   |
| Net income                                                                            |       |                                                                                            | $          | 2,237           |       |                             |       | $ | (1,309 | ) |   |   | $ | 928 |   |   |
| Net income per share—basic                                                       |       |                                                                                            | $          | 0.17            |       |                             |       | (0.10 | ) |   |   | $ | 0.07 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 13,039,123 |            |       |                             |       |   |   |   | 13,039,123 |   |   |
| Net income per share—diluted                                                     |       |                                                                                            | $          | 0.16            |       |                             |       | (0.09 | ) |   |   | $ | 0.07 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 13,748,894 |            |       |                             |       |   |   |   | 13,748,894 |   |   |

 

91

----

**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **September 30, 2004** | ** ** | **Adjustments** | ** ** | **September 30, 2004** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|-----------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**           | ** ** | ** **      | ** ** | **(As restated)**           | ** ** |
| ASSETS                                           |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Current assets:                                  |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                             | $          | 23,977          |       |                             |       |   |   |   |   | $ | 23,977 |   |   |
| Accounts receivable, net(a)                      |       |                             | 10,254     |            |       |                             | (794       | ) |   |   | 9,460 |   |   |
| Inventory                                        |       |                             | 1,094      |            |       |                             |       |   |   |   | 1,094 |   |   |
| Prepaid expenses(b)                              |       |                             | 606        |            |       |                             | 161        |   |   |   | 767 |   |   |
| Deferred income taxes(c)                         |       |                             | 2,620      |            |       |                             | 2,516      |   |   |   | 5,136 |   |   |
| Other current assets(d)                          |       |                             | 1,124      |            |       |                             | 2,082      |   |   |   | 3,206 |   |   |
| Total current  assets                            |       |                             | 39,675     |            |       |                             | 3,965      |   |   |   | 43,640 |   |   |
| Net property and  equipment                      |       |                             | 1,424      |            |       |                             |       |   |   |   | 1,424 |   |   |
| Purchased and  developed software, net           |       |                             | 9,502      |            |       |                             |       |   |   |   | 9,502 |   |   |
| Acquired  intangibles, net                       |       |                             | 1,280      |            |       |                             |       |   |   |   | 1,280 |   |   |
| Goodwill                                         |       |                             | 21,714     |            |       |                             |       |   |   |   | 21,714 |   |   |
| Other assets                                     |       |                             | 129        |            |       |                             |       |   |   |   | 129 |   |   |
| Total assets                                     |       |                             | $          | 73,724          |       |                             |       | 3,965 |   |   |   | $ | 77,689 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Current liabilities:                             |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Accounts payable(b)                              |       |                             | $          | 1,346           |       |                             |       | (9 | ) |   |   | $ | 1,337 |   |   |
| Accrued wages                                    |       |                             | 1,338      |            |       |                             |       |   |   |   | 1,338 |   |   |
| Other accrued liabilities(b)                     |       |                             | 786        |            |       |                             | (735       | ) |   |   | 51 |   |   |
| Deferred revenue(a)                              |       |                             | 7,759      |            |       |                             | 12,139     |   |   |   | 19,898 |   |   |
| Total current  liabilities                       |       |                             | 11,229     |            |       |                             | 11,395     |   |   |   | 22,624 |   |   |
| Deferred income taxes(c)                         |       |                             | 2,170      |            |       |                             | (987       | ) |   |   | 1,183 |   |   |
| Total liabilities                                |       |                             | 13,399     |            |       |                             | 10,408     |   |   |   | 23,807 |   |   |
| Total  shareholders’ equity                 |       |                             | 60,325     |            |       |                             | (6,443     | ) |   |   | 53,882 |   |   |
| Total liabilities and  shareholders’ equity |       |                             | 73,724     |            |       |                             | 3,965      |   |   |   | $ | 77,689 |   |   |

 

92

----

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

| ** **                                                                            | ** ** | **December 31, 2004**                                                                 | ** ** | **Adjustments** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**          | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                            |       |                                                                                            |       |            |       |                            |       |   |   |   |   |   |   |
| Software and other(a)                                                                 |       |                                                                                            | $          | 6,721           |       |                            |       | $ | (2,393 | ) |   |   | $ | 4,328 |   |   |
| Services and maintenance(a)                                                           |       |                                                                                            | 3,433      |            |       |                            | (893       | ) |   |   | 2,540 |   |   |
| Total net sales                                                                       |       |                                                                                            | 10,154     |            |       |                            | (3,286     | ) |   |   | 6,868 |   |   |
| Cost of sales:                                                                        |       |                                                                                            |       |            |       |                            |       |   |   |   |   |   |   |
| Software and other(d)                                                                 |       |                                                                                            | 858        |            |       |                            | (336       | ) |   |   | 522 |   |   |
| Services and maintenance                                                              |       |                                                                                            | 1,583      |            |       |                            |       |   |   |   | 1,583 |   |   |
| Amortization(e)                                                                       |       |                                                                                            | 847        |            |       |                            | (97        | ) |   |   | 750 |   |   |
| Total cost of  sales                                                                  |       |                                                                                            | 3,288      |            |       |                            | (433       | ) |   |   | 2,855 |   |   |
| Gross margin                                                                          |       |                                                                                            | 6,866      |            |       |                            | (2,853     | ) |   |   | 4,013 |   |   |
| Operating costs and  expenses:                                                        |       |                                                                                            |       |            |       |                            |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                                |       |                                                                                            | 2,124      |            |       |                            | (45        | ) |   |   | 2,079 |   |   |
| Product research and development                                                      |       |                                                                                            | 503        |            |       |                            |       |   |   |   | 503 |   |   |
| General and administrative(a)                                                         |       |                                                                                            | 1,645      |            |       |                            | (19        | ) |   |   | 1,626 |   |   |
| Depreciation and amortization(e)                                                      |       |                                                                                            | 177        |            |       |                            | 97         |   |   |   | 274 |   |   |
| Total operating costs  and expenses                                                   |       |                                                                                            | 4,449      |            |       |                            | 33         |   |   |   | 4,482 |   |   |
| Operating income                                                                      |       |                                                                                            | 2,417      |            |       |                            | (2,886     | ) |   |   | (469 | ) |   |
| Other income                                                                          |       |                                                                                            | 217        |            |       |                            |       |   |   |   | 217 |   |   |
| Income before  income taxes                                                           |       |                                                                                            | 2,634      |            |       |                            | (2,886     | ) |   |   | (252 | ) |   |
| Income tax  expense (benefit)(c)                                                      |       |                                                                                            | 255        |            |       |                            | (1,385     | ) |   |   | (1,130 | ) |   |
| Net income                                                                            |       |                                                                                            | $          | 2,379           |       |                            |       | $ | (1,501 | ) |   |   | $ | 878 |   |   |
| Net income per share—basic                                                       |       |                                                                                            | $          | 0.18            |       |                            |       | (0.11 | ) |   |   | $ | 0.07 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 13,159,781 |            |       |                            |       |   |   |   | 13,159,781 |   |   |
| Net income per share—diluted                                                     |       |                                                                                            | $          | 0.17            |       |                            |       | (0.11 | ) |   |   | $ | 0.06 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 14,007,183 |            |       |                            |       |   |   |   | 14,007,183 |   |   |

 

93

----

**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **December 31, 2004** | ** ** | **Adjustments** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|-----------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**          | ** ** | ** **      | ** ** | **(As restated)**          | ** ** |
| ASSETS                                           |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Current assets:                                  |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                            | $          | 28,067          |       |                            |       |   |   |   |   | $ | 28,067 |   |   |
| Accounts receivable, net(a)                      |       |                            | 11,100     |            |       |                            | (794       | ) |   |   | 10,306 |   |   |
| Inventory                                        |       |                            | 1,082      |            |       |                            |       |   |   |   | 1,082 |   |   |
| Prepaid expenses(b)                              |       |                            | 495        |            |       |                            | 206        |   |   |   | 701 |   |   |
| Deferred income taxes(c)                         |       |                            | 3,076      |            |       |                            | 4,234      |   |   |   | 7,310 |   |   |
| Other current assets(d)                          |       |                            | 1,417      |            |       |                            | 2,902      |   |   |   | 4,319 |   |   |
| Total current  assets                            |       |                            | 45,237     |            |       |                            | 6,548      |   |   |   | 51,785 |   |   |
| Net property and  equipment                      |       |                            | 1,497      |            |       |                            |       |   |   |   | 1,497 |   |   |
| Purchased and  developed software, net           |       |                            | 9,751      |            |       |                            |       |   |   |   | 9,751 |   |   |
| Acquired  intangibles, net                       |       |                            | 1,183      |            |       |                            |       |   |   |   | 1,183 |   |   |
| Goodwill                                         |       |                            | 21,167     |            |       |                            |       |   |   |   | 21,167 |   |   |
| Other assets                                     |       |                            | 108        |            |       |                            |       |   |   |   | 108 |   |   |
| Total assets                                     |       |                            | $          | 78,943          |       |                            |       | 6,548 |   |   |   | $ | 85,491 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Current  liabilities:                            |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Accounts payable(b)                              |       |                            | $          | 2,020           |       |                            |       | (9 | ) |   |   | $ | 2,011 |   |   |
| Accrued wages                                    |       |                            | 1,414      |            |       |                            |       |   |   |   | 1,414 |   |   |
| Other accrued liabilities(b)                     |       |                            | 1,202      |            |       |                            | (195       | ) |   |   | 1,007 |   |   |
| Deferred revenue(a)                              |       |                            | 8,678      |            |       |                            | 15,890     |   |   |   | 24,568 |   |   |
| Total current  liabilities                       |       |                            | 13,314     |            |       |                            | 15,686     |   |   |   | 29,000 |   |   |
| Deferred income taxes(c)                         |       |                            | 2,062      |            |       |                            | (1,194     | ) |   |   | 868 |   |   |
| Total liabilities                                |       |                            | 15,376     |            |       |                            | 14,492     |   |   |   | 29,868 |   |   |
| Total  shareholders’ equity                 |       |                            | 63,567     |            |       |                            | (7,944     | ) |   |   | 55,623 |   |   |
| Total liabilities and  shareholders’ equity |       |                            | $          | 78,943          |       |                            |       | 6,548 |   |   |   | $85,491 |   |   |

 

94

----

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

| ** **                                                                            | ** ** | **March 31, 2005**                                                                    | ** ** | **Adjustments** | ** ** | **March 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                                                            | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**       | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                            |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Software and other(a)                                                                 |       |                                                                                            | $          | 7,109           |       |                         |       | $ | (2,461 | ) |   |   | $ | 4,648 |   |   |
| Services and maintenance(a)                                                           |       |                                                                                            | 3,392      |            |       |                         | (1,103     | ) |   |   | 2,289 |   |   |
| Total net sales                                                                       |       |                                                                                            | 10,501     |            |       |                         | (3,564     | ) |   |   | 6,937 |   |   |
| Cost of sales:                                                                        |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Software and other(d)                                                                 |       |                                                                                            | 989        |            |       |                         | (419       | ) |   |   | 570 |   |   |
| Services and maintenance                                                              |       |                                                                                            | 1,634      |            |       |                         |       |   |   |   | 1,634 |   |   |
| Amortization(e)                                                                       |       |                                                                                            | 806        |            |       |                         | (104       | ) |   |   | 702 |   |   |
| Total cost of  sales                                                                  |       |                                                                                            | 3,429      |            |       |                         | (523       | ) |   |   | 2,906 |   |   |
| Gross margin                                                                          |       |                                                                                            | 7,072      |            |       |                         | (3,041     | ) |   |   | 4,031 |   |   |
| Operating costs  and expenses:                                                        |       |                                                                                            |       |            |       |                         |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                                |       |                                                                                            | 1,655      |            |       |                         | (75        | ) |   |   | 1,580 |   |   |
| Product research and development                                                      |       |                                                                                            | 753        |            |       |                         |       |   |   |   | 753 |   |   |
| General and administrative(a)                                                         |       |                                                                                            | 1,318      |            |       |                         | (100       | ) |   |   | 1,218 |   |   |
| Acquired in-process research and development                                          |       |                                                                                            | —     |            |       |                         |       |   |   |   | — |   |   |
| Restructuring and other expenses                                                      |       |                                                                                            | —     |            |       |                         |       |   |   |   | — |   |   |
| Depreciation and amortization(e)                                                      |       |                                                                                            | 199        |            |       |                         | 104        |   |   |   | 303 |   |   |
| Total operating  costs and expenses                                                   |       |                                                                                            | 3,925      |            |       |                         | (71        | ) |   |   | 3,854 |   |   |
| Operating income                                                                      |       |                                                                                            | 3,147      |            |       |                         | (2,970     | ) |   |   | 177 |   |   |
| Other income                                                                          |       |                                                                                            | 77         |            |       |                         |       |   |   |   | 77 |   |   |
| Income before  income taxes                                                           |       |                                                                                            | 3,224      |            |       |                         | (2,970     | ) |   |   | 254 |   |   |
| Income tax  expense(c)                                                                |       |                                                                                            | 1,128      |            |       |                         | (1,039     | ) |   |   | 89 |   |   |
| Net income                                                                            |       |                                                                                            | $          | 2,096           |       |                         |       | $ | (1,931 | ) |   |   | $ | 165 |   |   |
| Net income per share—basic                                                       |       |                                                                                            | $          | 0.16            |       |                         |       | (0.15 | ) |   |   | $ | 0.01 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 13,208,370 |            |       |                         |       |   |   |   | 13,208,370 |   |   |
| Net income per share—diluted                                                     |       |                                                                                            | $          | 0.15            |       |                         |       | (0.14 | ) |   |   | $ | 0.01 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 13,992,241 |            |       |                         |       |   |   |   | 13,992,241 |   |   |

 

95

----

**MERGE TECHNOLOGIESINCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **March 31, 2005** | ** ** | **Adjustments** | ** ** | **March 31, 2005** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**       | ** ** | ** **      | ** ** | **(As restated)**       | ** ** |
| ASSETS                                           |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Current assets:                                  |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                         | $          | 22,569          |       |                         |       |   |   |   |   | $ | 22,569 |   |   |
| Accounts receivable, net(a)                      |       |                         | 12,552     |            |       |                         | (995       | ) |   |   | 11,557 |   |   |
| Inventory                                        |       |                         | 1,094      |            |       |                         |       |   |   |   | 1,094 |   |   |
| Prepaid expenses(b)                              |       |                         | 1,069      |            |       |                         | 281        |   |   |   | 1,350 |   |   |
| Deferred income taxes(c)                         |       |                         | 2,841      |            |       |                         | 5,273      |   |   |   | 8,114 |   |   |
| Other current assets(d)                          |       |                         | 1,951      |            |       |                         | 3,231      |   |   |   | 5,182 |   |   |
| Total current  assets                            |       |                         | 42,076     |            |       |                         | 7,790      |   |   |   | 49,866 |   |   |
| Net property and  equipment                      |       |                         | 1,758      |            |       |                         |       |   |   |   | 1,758 |   |   |
| Purchased and  developed software, net           |       |                         | 10,685     |            |       |                         |       |   |   |   | 10,685 |   |   |
| Acquired  intangibles, net                       |       |                         | 1,163      |            |       |                         |       |   |   |   | 1,163 |   |   |
| Goodwill                                         |       |                         | 25,995     |            |       |                         |       |   |   |   | 25,995 |   |   |
| Other assets                                     |       |                         | 775        |            |       |                         | (2         | ) |   |   | 773 |   |   |
| Total assets                                     |       |                         | $          | 82,452          |       |                         |       | 7,788 |   |   |   | $ | 90,240 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Current liabilities:                             |       |                         |       |            |       |                         |       |   |   |   |   |   |   |
| Accounts payable(b)                              |       |                         | $          | 2,888           |       |                         |       | (11 | ) |   |   | $ | 2,877 |   |   |
| Accrued wages                                    |       |                         | 896        |            |       |                         |       |   |   |   | 896 |   |   |
| Other accrued liabilities(b)                     |       |                         | 1,727      |            |       |                         | (204       | ) |   |   | 1,523 |   |   |
| Deferred revenue(a)                              |       |                         | 9,025      |            |       |                         | 19,073     |   |   |   | 28,098 |   |   |
| Total current  liabilities                       |       |                         | 14,536     |            |       |                         | 18,858     |   |   |   | 33,394 |   |   |
| Deferred income taxes(c)                         |       |                         | 2,060      |            |       |                         | (1,195     | ) |   |   | 865 |   |   |
| Total liabilities                                |       |                         | 16,596     |            |       |                         | 17,663     |   |   |   | 34,259 |   |   |
| Total  shareholders’ equity                 |       |                         | 65,856     |            |       |                         | (9,875     | ) |   |   | 55,981 |   |   |
| Total liabilities and  shareholders’ equity |       |                         | $          | 82,452          |       |                         |       | 7,788 |   |   |   | $ | 90,240 |   |   |

 

96

----

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

| ** **                                                                  | ** ** | **June 30, 2005**                                                                     | ** ** | **Adjustments** | ** ** | **June 30, 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------------------|------------|
| ** **                                                                  | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**      | ** ** |
| ** **                                                                  | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                  |       |                                                                                            |       |            |       |                        |       |   |   |   |   |
| Software and other(a)                                                       |       |                                                                                            | $          | 13,755          |       |                        |       | $ | (2,718 | ) |   | $ | 11,037 |   |
| Services and maintenance(a)                                                 |       |                                                                                            | 5,018      |            |       |                        | (894       | ) |   | 4,124 |   |
| Total net sales                                                             |       |                                                                                            | 18,773     |            |       |                        | (3,612     | ) |   | 15,161 |   |
| Cost of sales:                                                              |       |                                                                                            |       |            |       |                        |       |   |   |   |   |
| Software and other(d)                                                       |       |                                                                                            | 2,066      |            |       |                        | (261       | ) |   | 1,805 |   |
| Services and maintenance                                                    |       |                                                                                            | 2,478      |            |       |                        |       |   |   | 2,478 |   |
| Amortization(e)                                                             |       |                                                                                            | 1,881      |            |       |                        | 6          |   |   | 1,887 |   |
| Total cost of  sales                                                        |       |                                                                                            | 6,425      |            |       |                        | (255       | ) |   | 6,170 |   |
| Gross margin                                                                |       |                                                                                            | 12,348     |            |       |                        | (3,357     | ) |   | 8,991 |   |
| Operating costs and  expenses:                                              |       |                                                                                            |       |            |       |                        |       |   |   |   |   |
| Sales and marketing(b)                                                      |       |                                                                                            | 2,880      |            |       |                        | (70        | ) |   | 2,810 |   |
| Product research and development                                            |       |                                                                                            | 1,648      |            |       |                        |       |   |   | 1,648 |   |
| General and administrative(a)                                               |       |                                                                                            | 4,122      |            |       |                        | (156       | ) |   | 3,966 |   |
| Acquired in-process research and development                                |       |                                                                                            | 12,989     |            |       |                        |       |   |   | 12,989 |   |
| Restructuring and other expenses                                            |       |                                                                                            | 589        |            |       |                        |       |   |   | 589 |   |
| Depreciation and amortization(e)                                            |       |                                                                                            | 1,093      |            |       |                        | (6         | ) |   | 1,087 |   |
| Total operating  costs and expenses                                         |       |                                                                                            | 23,321     |            |       |                        | (232       | ) |   | 23,089 |   |
| Operating income  (loss)                                                    |       |                                                                                            | (10,973    | )               |       |                        | (3,125     | ) |   | (14,098 | ) |
| Other income                                                                |       |                                                                                            | 87         |            |       |                        |       |   |   | 87 |   |
| Income (loss)  before income taxes                                          |       |                                                                                            | (10,886    | )               |       |                        | (3,125     | ) |   | (14,011 | ) |
| Income tax  expense(c)                                                      |       |                                                                                            | 991        |            |       |                        | 199        |   |   | 1,190 |   |
| Net income (loss)                                                           |       |                                                                                            | $          | (11,877         | )          |                        |       | $ | (3,324 | ) |   | $ | (15,201 | ) |
| Net income (loss) per share—basic                                      |       |                                                                                            | $          | (0.62           | )          |                        |       | (0.17 | ) |   | $ | (0.79 | ) |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 19,254,640 |            |       |                        |       |   |   | 19,254,640 |   |
| Net income (loss) per share—diluted                                    |       |                                                                                            | $          | (0.62           | )          |                        |       | (0.17 | ) |   | $ | (0.79 | ) |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 19,254,640 |            |       |                        |       |   |   | 19,254,640 |   |

 

97

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**MERGETECHNOLOGIES INCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **June 30, 2005** | ** ** | **Adjustments** | ** ** | **June 30, 2005** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **(As reported)**      | ** ** | ** **      | ** ** | **(As restated)**      | ** ** |
| ASSETS                                           |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Current assets:                                  |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                        | $          | 39,830          |       |                        |       |   |   |   |   | $ | 39,830 |   |   |
| Accounts receivable, net(a)                      |       |                        | 24,944     |            |       |                        | (1,190     | ) |   |   | 23,754 |   |   |
| Inventory                                        |       |                        | 1,814      |            |       |                        |       |   |   |   | 1,814 |   |   |
| Prepaid expenses(b)                              |       |                        | 2,507      |            |       |                        | 350        |   |   |   | 2,857 |   |   |
| Deferred income taxes(c)                         |       |                        | 2,936      |            |       |                        | 5,887      |   |   |   | 8,823 |   |   |
| Other current assets(d)                          |       |                        | 1,733      |            |       |                        | 3,091      |   |   |   | 4,824 |   |   |
| Total current  assets                            |       |                        | 73,764     |            |       |                        | 8,138      |   |   |   | 81,902 |   |   |
| Net property and  equipment                      |       |                        | 3,882      |            |       |                        |       |   |   |   | 3,882 |   |   |
| Purchased and  developed software, net           |       |                        | 22,905     |            |       |                        |       |   |   |   | 22,905 |   |   |
| Acquired  intangibles, net                       |       |                        | 12,934     |            |       |                        |       |   |   |   | 12,934 |   |   |
| Goodwill(b)                                      |       |                        | 353,832    |            |       |                        | 1,121      |   |   |   | 354,953 |   |   |
| Other assets(b)                                  |       |                        | 1,947      |            |       |                        | 1,400      |   |   |   | 3,347 |   |   |
| Total assets                                     |       |                        | $          | 469,264         |       |                        |       | 10,659 |   |   |   | $ | 479,923 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Current  liabilities:                            |       |                        |       |            |       |                        |       |   |   |   |   |   |   |
| Accounts payable(b)                              |       |                        | $          | 7,300           |       |                        |       |   |   |   |   | $ | 7,300 |   |   |
| Accrued wages                                    |       |                        | 5,988      |            |       |                        |       |   |   |   | 5,988 |   |   |
| Other accrued liabilities(b)                     |       |                        | 5,635      |            |       |                        | (522       | ) |   |   | 5,113 |   |   |
| Deferred revenue(a)                              |       |                        | 12,853     |            |       |                        | 22,111     |   |   |   | 34,964 |   |   |
| Income taxes payable(c)                          |       |                        | —     |            |       |                        | 3,464      |   |   |   | 3,464 |   |   |
| Total current  liabilities                       |       |                        | 31,776     |            |       |                        | 25,053     |   |   |   | 56,829 |   |   |
| Deferred income taxes and other(c)               |       |                        | 2,251      |            |       |                        | (1,195     | ) |   |   | 1,056 |   |   |
| Total  shareholders’ equity                 |       |                        | 435,237    |            |       |                        | (13,199    | ) |   |   | 422,038 |   |   |
| Total liabilities and  shareholders’ equity |       |                        | $          | 469,264         |       |                        |       | 10,659 |   |   |   | $ | 479,923 |   |   |

 

98

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

| ** **                                                                       | ** ** | **September 30, 2005**                                                                | ** ** | **Adjustments** | ** ** | **September 30, 2005** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------------------|------------|
| ** **                                                                       | ** ** | **(As reported)**                                                                          | ** ** | ** **      | ** ** | **(As restated)**           | ** ** |
| ** **                                                                       | ** ** | **(In thousands, except for share and per share data)** | ** ** |
| Net sales:                                                                       |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Software and other(a)                                                            |       |                                                                                            | $          | 24,744          |       |                             |       | $ | 1,989 |   |   |   | $ | 26,733 |   |   |
| Services and maintenance(a)                                                      |       |                                                                                            | 7,979      |            |       |                             | 331        |   |   |   | 8,310 |   |   |
| Total net sales                                                                  |       |                                                                                            | 32,723     |            |       |                             | 2,320      |   |   |   | 35,043 |   |   |
| Cost of sales:                                                                   |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Software and other(d)                                                            |       |                                                                                            | 2,144      |            |       |                             | 443        |   |   |   | 2,587 |   |   |
| Services and maintenance                                                         |       |                                                                                            | 3,451      |            |       |                             |       |   |   |   | 3,451 |   |   |
| Amortization(e)                                                                  |       |                                                                                            | 1,211      |            |       |                             | (49        | ) |   |   | 1,162 |   |   |
| Total cost of  sales                                                             |       |                                                                                            | 6,806      |            |       |                             | 394        |   |   |   | 7,200 |   |   |
| Gross margin                                                                     |       |                                                                                            | 25,917     |            |       |                             | 1,926      |   |   |   | 27,843 |   |   |
| Operating costs  and expenses:                                                   |       |                                                                                            |       |            |       |                             |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                           |       |                                                                                            | 4,252      |            |       |                             | 4          |   |   |   | 4,256 |   |   |
| Product research and development                                                 |       |                                                                                            | 3,513      |            |       |                             |       |   |   |   | 3,513 |   |   |
| General and administrative(a)                                                    |       |                                                                                            | 4,392      |            |       |                             | (387       | ) |   |   | 4,005 |   |   |
| Acquired in-process research and development                                     |       |                                                                                            | 57         |            |       |                             |       |   |   |   | 57 |   |   |
| Restructuring and other expenses                                                 |       |                                                                                            | 160        |            |       |                             |       |   |   |   | 160 |   |   |
| Depreciation and amortization(e)                                                 |       |                                                                                            | 990        |            |       |                             | 49         |   |   |   | 1,039 |   |   |
| Total operating  costs and expenses                                              |       |                                                                                            | 13,364     |            |       |                             | (334       | ) |   |   | 13,030 |   |   |
| Operating income                                                                 |       |                                                                                            | 12,553     |            |       |                             | 2,260      |   |   |   | 14,813 |   |   |
| Other income                                                                     |       |                                                                                            | 160        |            |       |                             |       |   |   |   | 160 |   |   |
| Income before  income taxes                                                      |       |                                                                                            | 12,713     |            |       |                             | 2,260      |   |   |   | 14,973 |   |   |
| Income tax  expense(c)                                                           |       |                                                                                            | 4,596      |            |       |                             | 777        |   |   |   | 5,373 |   |   |
| Net income                                                                       |       |                                                                                            | $          | 8,117           |       |                             |       | $ | 1,483 |   |   |   | $ | 9,600 |   |   |
| Net income per share—basic                                                  |       |                                                                                            | $          | 0.25            |       |                             |       | 0.05 |   |   |   | $ | 0.30 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                            | 32,491,717 |            |       |                             |       |   |   |   | 32,491,717 |   |   |
| Net income per share—diluted                                                |       |                                                                                            | $          | 0.24            |       |                             |       | 0.04 |   |   |   | $ | 0.28 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                            | 34,271,312 |            |       |                             |       |   |   |   | 34,271,312 |   |   |

 

99

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**MERGETECHNOLOGIES INCORPORATED AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                       | ** ** | **September 30, 2005** | ** ** | **Adjustments** | ** ** | **September 30, 2005** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|-----------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**           | ** ** | ** **      | ** ** | **(As restated)**           | ** ** |
| ASSETS                                           |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Current assets:                                  |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                             | $          | 46,465          |       |                             |       |   |   |   |   | $ | 46,465 |   |   |
| Accounts receivable, net(a)                      |       |                             | 34,251     |            |       |                             | (1,154     | ) |   |   | 33,097 |   |   |
| Inventory                                        |       |                             | 1,838      |            |       |                             |       |   |   |   | 1,838 |   |   |
| Prepaid expenses(b)                              |       |                             | 2,502      |            |       |                             | 347        |   |   |   | 2,849 |   |   |
| Deferred income taxes(c)                         |       |                             | 3,023      |            |       |                             | 4,976      |   |   |   | 7,999 |   |   |
| Other current assets(d)                          |       |                             | 2,443      |            |       |                             | 2,403      |   |   |   | 4,846 |   |   |
| Total current  assets                            |       |                             | 90,522     |            |       |                             | 6,572      |   |   |   | 97,094 |   |   |
| Net property and  equipment                      |       |                             | 3,758      |            |       |                             |       |   |   |   | 3,758 |   |   |
| Purchased and  developed software, net           |       |                             | 22,633     |            |       |                             |       |   |   |   | 22,633 |   |   |
| Acquired  intangibles, net                       |       |                             | 12,359     |            |       |                             |       |   |   |   | 12,359 |   |   |
| Goodwill                                         |       |                             | 348,575    |            |       |                             | 1,121      |   |   |   | 349,696 |   |   |
| Other assets(d)                                  |       |                             | 2,350      |            |       |                             | 1,324      |   |   |   | 3,674 |   |   |
| Total assets                                     |       |                             | $          | 480,197         |       |                             |       | 9,017 |   |   |   | $ | 489,214 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Current liabilities:                             |       |                             |       |            |       |                             |       |   |   |   |   |   |   |
| Accounts payable                                 |       |                             | $          | 6,071           |       |                             |       |   |   |   |   | $ | 6,071 |   |   |
| Accrued wages                                    |       |                             | 6,657      |            |       |                             |       |   |   |   | 6,657 |   |   |
| Other accrued liabilities(b)                     |       |                             | 3,672      |            |       |                             | (656       | ) |   |   | 3,016 |   |   |
| Deferred revenue(a)                              |       |                             | 12,129     |            |       |                             | 19,033     |   |   |   | 31,162 |   |   |
| Income taxes payable(c)                          |       |                             | —     |            |       |                             | 3,550      |   |   |   | 3,550 |   |   |
| Total current  liabilities                       |       |                             | 28,529     |            |       |                             | 21,927     |   |   |   | 50,456 |   |   |
| Deferred income taxes(c)                         |       |                             | 2,268      |            |       |                             | (1,194     | ) |   |   | 1,074 |   |   |
| Total liabilities                                |       |                             | 30,797     |            |       |                             | 20,733     |   |   |   | 51,530 |   |   |
| Total  shareholders’ equity                 |       |                             | 449,400    |            |       |                             | (11,716    | ) |   |   | 437,684 |   |   |
| Total liabilities and  shareholders’ equity |       |                             | $          | 480,197         |       |                             |       | 9,017 |   |   |   | $ | 489,214 |   |   |

 

100

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

| ** **                                                                  | ** ** | **December 31, 2005**                                                         | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **(In thousands,  except for share and  per share data)** | ** ** |
| Net sales:                                                                  |       |                                                                                    |       |   |   |
| Software and other                                                          |       |                                                                                    | $          | 17,702 |   |   |
| Services and maintenance                                                    |       |                                                                                    | 7,758      |   |   |
| Total net sales                                                             |       |                                                                                    | 25,460     |   |   |
| Cost of sales:                                                              |       |                                                                                    |       |   |   |
| Software and other                                                          |       |                                                                                    | 1,959      |   |   |
| Services and maintenance                                                    |       |                                                                                    | 3,542      |   |   |
| Amortization                                                                |       |                                                                                    | 3,989      |   |   |
| Total cost of  sales                                                        |       |                                                                                    | 9,490      |   |   |
| Gross margin                                                                |       |                                                                                    | 15,970     |   |   |
| Operating costs  and expenses:                                              |       |                                                                                    |       |   |   |
| Sales and marketing                                                         |       |                                                                                    | 5,000      |   |   |
| Product research and development                                            |       |                                                                                    | 4,000      |   |   |
| General and administrative                                                  |       |                                                                                    | 2,435      |   |   |
| Restructuring and other expenses                                            |       |                                                                                    | (219       | ) |   |
| Depreciation and amortization                                               |       |                                                                                    | 1,119      |   |   |
| Total operating  costs and expenses                                         |       |                                                                                    | 12,335     |   |   |
| Operating income                                                            |       |                                                                                    | 3,635      |   |   |
| Other income                                                                |       |                                                                                    | 382        |   |   |
| Income before  income taxes                                                 |       |                                                                                    | 4,017      |   |   |
| Income tax  expense                                                         |       |                                                                                    | 1,238      |   |   |
| Net income                                                                  |       |                                                                                    | $          | 2,779 |   |   |
| Net income per share—basic                                             |       |                                                                                    | $          | 0.08 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                                                                    | 33,523,440 |   |   |
| Net income per share—diluted                                           |       |                                                                                    | $          | 0.08 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                                                                    | 34,930,278 |   |   |

----

(a)    Impact of deferral of net sales attributed to factors discussedin the *Revenue Recognition* section ofNote 13 for the period, including cumulative effect of all periods onaccounts receivable and related reserves and deferred revenue.

(b)   Impact of other adjustments discussed in Note 13 for currentperiod, primarily consisting of an allocation adjustment between goodwill andother assets and commissions. Balance sheet impact is cumulative for allperiods impacted.

(c)    Impact on income tax expense, net of all adjustments during theperiod at the statutory tax rate, including cumulative effect of all periods oncurrent deferred income taxes and long-term deferred income tax liabilities.Impact of factors discussed in the *Income Taxes*sectionof Note 13.

(d)   Impact of deferral of costs associated with net sales deferredattributed to factors discussed in the *Revenue Recognition*section of Note 13 for the period, including cumulative effect of allperiods on other current assets, where such deferred costs are classified.

(e)    Reclassificationof amortization associated with customer intangibles to be consistent withprior year classification.

101

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**(13) Restatement of Consolidated FinancialStatements**

From January 10, 2006through May 26, 2006, we received eleven anonymous letters primarily allegingimproprieties relating to our financial reporting, fulfillment of customercontracts and related revenue recognition, and disclosure practices. The AuditCommittee of our Board of Directors retained the law firm of Sidley Austin LLP(“Sidley”) and the forensic accounting firm of Alvarez & Marsal to conductan independent investigation of the allegations contained in the anonymousletters. Sidley and Alvarez & Marsal conducted a comprehensiveinvestigation of our accounting and financial reporting practices related tothe matters described in the anonymous letters, which included, among other things,a review of relevant documents and interviews of current and former employeesof Merge Healthcare and Cedara Software, which we acquired in June 2005. Basedupon the results of the investigation, the Audit Committee determined that,because of improper accounting and financial reporting practices with respectto reporting periods in the fiscal years 2002 through 2005, the previouslyissued financial statements for each of the reporting periods in 2002 through2005 should no longer be relied upon. The errors identified in previouslyissued financial statements are described below.

*Revenue Recognition*

We determined thatwe overstated net sales during 2002, 2003, 2004 and the first three quarters of2005 due to the following:

·  Delivery of certain software products toend-user customers that did not fully meet the functionality that we believeour customers expected based on express representations we made to ourcustomers or implied representations, made to our customers that arose from ourdemonstrations of the software products during the sales process. We havedeferred such revenue until the delivery of the expected product functionality,the majority of which occurred in the third and fourth quarters of 2005 and thesecond quarter of 2006.

·  Collectibility was not reasonably assured atthe time certain revenue was recognized. Some of our contracts failed toreflect contingencies expressly demanded by the customer. We have notrecognized revenue until collectibility became reasonably assured, generally ascash was collected from the respective customer.

·  Recording revenue prior to shipment of thecorrect products included in a customer’s contract. We have deferred revenueuntil shipment of the appropriate products occurred.

·  Recording of revenue prior to shipment of allsoftware products included in a customer’s contract. Since we did not havevendor specific objective evidence of fair value for the software element ofcertain of our contracts, we were required to defer all revenue for certaincustomer orders with partial software product shipment until delivery of allsoftware products occurred.

·  For certain customers’ contracts, we wereunable to establish vendor specific objective evidence of fair value ofmaintenance. We have deferred the related contract value and are recognizingrevenue ratably over the related maintenance period.

·  Wedetermined that we failed to reduce net sales attributable to a contractalthough we had agreed to provide the customer with $200****in additional software at no additionalcost to the customer.

*Income Tax Expense*

We determined that we understated income tax expense,income tax payable and goodwill in the amounts of $1,308, $3,854 and $2,546,respectively, for the quarter ended, and as of, June 30, 2005, due to a failureto record additional tax liability and income tax expense in connection withour June 2005 business combination with Cedara Software.

102

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In addition, we adjustedthe provisions for income tax and related tax accounts at the applicablestatutory rates to account for the effects of the restatement adjustmentsdescribed herein.

*Other Adjustments*

As a result of the revenue adjustments, certainrevenue-related accounts were impacted and also restated. These included cost ofgoods sold related to contracts impacted, deferred revenue (net of the costs ofgoods), bad debt expense, and the related accounts receivable allowance,accounts receivable and commission expense.

The effect of thesechanges on the Consolidated Balance Sheet, Consolidated Statements ofOperations and Consolidated Statements of Cash Flows are set forth below. Openingretained earnings at December 31, 2002 has been restated to reflectdeferral of net sales, net of deferred costs and income tax adjustments.Footnotes (a) through (e) in the following tables may be found onpage 107 of this Annual Report on Form 10-K.

**MERGETECHNOLOGIES INCORPORATED AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(inthousands)**

| ** **                                       | ** ** | **December 31, 2004** | ** ** | **Adjustments** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|-----------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **(As reported)**          | ** ** | ** **      | ** ** | **(As restated)**          | ** ** |
| ASSETS                                           |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Current assets:                                  |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Cash and cash equivalents                        |       |                            | $          | 28,067          |       |                            |       |   |   |   |   | $ | 28,067 |   |   |
| Accounts receivable, net(a)                      |       |                            | 11,100     |            |       |                            | (794       | ) |   |   | 10,306 |   |   |
| Inventory                                        |       |                            | 1,082      |            |       |                            |       |   |   |   | 1,082 |   |   |
| Prepaid expenses(b)                              |       |                            | 495        |            |       |                            | 206        |   |   |   | 701 |   |   |
| Deferred income taxes(c)                         |       |                            | 3,076      |            |       |                            | 4,234      |   |   |   | 7,310 |   |   |
| Other current assets(d)                          |       |                            | 1,417      |            |       |                            | 2,902      |   |   |   | 4,319 |   |   |
| Total current  assets                            |       |                            | 45,237     |            |       |                            | 6,548      |   |   |   | 51,785 |   |   |
| Net property and  equipment                      |       |                            | 1,497      |            |       |                            |       |   |   |   | 1,497 |   |   |
| Purchased and  developed software, net           |       |                            | 9,751      |            |       |                            |       |   |   |   | 9,751 |   |   |
| Acquired  intangibles, net                       |       |                            | 1,183      |            |       |                            |       |   |   |   | 1,183 |   |   |
| Goodwill                                         |       |                            | 21,167     |            |       |                            |       |   |   |   | 21,167 |   |   |
| Other assets                                     |       |                            | 108        |            |       |                            |       |   |   |   | 108 |   |   |
| Total assets                                     |       |                            | $          | 78,943          |       |                            |       | 6,548 |   |   |   | $ | 85,491 |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY       |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Current  liabilities:                            |       |                            |       |            |       |                            |       |   |   |   |   |   |   |
| Accounts payable(b)                              |       |                            | $          | 2,020           |       |                            |       | (9 | ) |   |   | $ | 2,011 |   |   |
| Accrued wages                                    |       |                            | 1,414      |            |       |                            |       |   |   |   | 1,414 |   |   |
| Other accrued liabilities(b)                     |       |                            | 1,202      |            |       |                            | (195       | ) |   |   | 1,007 |   |   |
| Deferred revenue(a)                              |       |                            | 8,678      |            |       |                            | 15,890     |   |   |   | 24,568 |   |   |
| Total current  liabilities                       |       |                            | 13,314     |            |       |                            | 15,686     |   |   |   | 29,000 |   |   |
| Income taxes payable                             |       |                            | —     |            |       |                            | —     |   |   |   | — |   |   |
| Deferred income taxes(c)                         |       |                            | 2,062      |            |       |                            | (1,194     | ) |   |   | 868 |   |   |
| Total liabilities                                |       |                            | 15,376     |            |       |                            | 14,492     |   |   |   | 29,868 |   |   |
| Total  shareholders’ equity                 |       |                            | 63,567     |            |       |                            | (7,944     | ) |   |   | 55,623 |   |   |
| Total liabilities and  shareholders’ equity |       |                            | $          | 78,943          |       |                            |       | 6,548 |   |   |   | $ | 85,491 |   |   |

 

103

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except for share and per share data)**

| ** **                                                                  | ** ** | **Year Ended  December 31, 2003** | ** ** | **Adjustments** | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-----------------|------------|--------------------------------------------------|------------|
| ** **                                                                  | ** ** | **(As reported)**                           | ** ** | ** **      | ** ** | **(As restated)**                           | ** ** |
| Net sales:                                                                  |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Software and other(a)                                                       |       |                                             | $          | 21,153          |       |                                             |       | $ | (3,621 | ) |   |   | $ | 17,532 |   |   |
| Services and maintenance(a)                                                 |       |                                             | 7,524      |            |       |                                             | (496       | ) |   |   | 7,028 |   |   |
| Total net sales                                                             |       |                                             | 28,677     |            |       |                                             | (4,117     | ) |   |   | 24,560 |   |   |
| Cost of sales:                                                              |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Software and other(d)                                                       |       |                                             | 3,394      |            |       |                                             | (527       | ) |   |   | 2,867 |   |   |
| Services and maintenance                                                    |       |                                             | 3,530      |            |       |                                             |       |   |   |   | 3,530 |   |   |
| Amortization(e)                                                             |       |                                             | 2,046      |            |       |                                             | (275       | ) |   |   | 1,771 |   |   |
| Total cost of  sales                                                        |       |                                             | 8,970      |            |       |                                             | (802       | ) |   |   | 8,168 |   |   |
| Gross margin                                                                |       |                                             | 19,707     |            |       |                                             | (3,315     | ) |   |   | 16,392 |   |   |
| Operating costs and  expenses:                                              |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Sales and marketing                                                         |       |                                             | 6,543      |            |       |                                             |       |   |   |   | 6,543 |   |   |
| Product research and development                                            |       |                                             | 2,063      |            |       |                                             |       |   |   |   | 2,063 |   |   |
| General and administrative(a)                                               |       |                                             | 3,527      |            |       |                                             | 101        |   |   |   | 3,628 |   |   |
| Depreciation and amortization(e)                                            |       |                                             | 573        |            |       |                                             | 275        |   |   |   | 848 |   |   |
| Total operating  costs and expenses                                         |       |                                             | 12,706     |            |       |                                             | 376        |   |   |   | 13,082 |   |   |
| Operating income                                                            |       |                                             | 7,001      |            |       |                                             | (3,691     | ) |   |   | 3,310 |   |   |
| Other income  (expense)                                                     |       |                                             | (102       | )               |       |                                             |       |   |   |   | (102 | ) |   |
| Income before  income taxes                                                 |       |                                             | 6,899      |            |       |                                             | (3,691     | ) |   |   | 3,208 |   |   |
| Income tax  expense (benefit)(c)                                            |       |                                             | 660        |            |       |                                             | 1,886      |   |   |   | (1,226 | ) |   |
| Net income                                                                  |       |                                             | $          | 6,239           |       |                                             |       | $ | (1,805 | ) |   |   | $ | 4,434 |   |   |
| Net income per share—basic                                             |       |                                             | $          | 0.53            |       |                                             |       | (0.15 | ) |   |   | $ | 0.38 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                             | 11,566,054 |            |       |                                             |       |   |   |   | 11,566,054 |   |   |
| Net income per share—diluted                                           |       |                                             | $          | 0.49            |       |                                             |       | (0.14 | ) |   |   | $ | 0.35 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                             | 12,586,900 |            |       |                                             |       |   |   |   | 12,586,900 |   |   |

 

104

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Continued) (in thousands, except for share and per share data)**

 

| ** **                                                                       | ** ** | **Year Ended  December 31, 2004** | ** ** | **Adjustments** | ** ** | **Year Ended  December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-----------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **(As reported)**                           | ** ** | ** **      | ** ** | **(As restated)**                           | ** ** |
| Net sales:                                                                       |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Software and other(a)                                                            |       |                                             | $          | 25,270          |       |                                             |       | $ | (7,826 | ) |   |   | $ | 17,444 |   |   |
| Services and maintenance(a)                                                      |       |                                             | 11,735     |            |       |                                             | (2,832     | ) |   |   | 8,903 |   |   |
| Total net sales                                                                  |       |                                             | 37,005     |            |       |                                             | (10,658    | ) |   |   | 26,347 |   |   |
| Cost of sales:                                                                   |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Software and other(d)                                                            |       |                                             | 3,898      |            |       |                                             | (1,596     | ) |   |   | 2,302 |   |   |
| Services and maintenance                                                         |       |                                             | 6,108      |            |       |                                             |       |   |   |   | 6,108 |   |   |
| Amortization(e)                                                                  |       |                                             | 2,881      |            |       |                                             | (390       | ) |   |   | 2,491 |   |   |
| Total cost of  sales                                                             |       |                                             | 12,887     |            |       |                                             | (1,986     | ) |   |   | 10,901 |   |   |
| Gross margin                                                                     |       |                                             | 24,118     |            |       |                                             | (8,672     | ) |   |   | 15,446 |   |   |
| Operating costs and  expenses:                                                   |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Sales and marketing(b)                                                           |       |                                             | 7,212      |            |       |                                             | (206       | ) |   |   | 7,006 |   |   |
| Product research and development                                                 |       |                                             | 1,967      |            |       |                                             |       |   |   |   | 1,967 |   |   |
| General and administrative(a)                                                    |       |                                             | 4,839      |            |       |                                             | (19        | ) |   |   | 4,820 |   |   |
| Acquired in-process research and development                                     |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Restructuring and other expenses                                                 |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Depreciation and amortization(e)                                                 |       |                                             | 764        |            |       |                                             | 390        |   |   |   | 1,154 |   |   |
| Total operating  costs and expenses                                              |       |                                             | 14,782     |            |       |                                             | 165        |   |   |   | 14,947 |   |   |
| Operating income                                                                 |       |                                             | 9,336      |            |       |                                             | (8,837     | ) |   |   | 499 |   |   |
| Other income                                                                     |       |                                             | 469        |            |       |                                             |       |   |   |   | 469 |   |   |
| Income before  income taxes                                                      |       |                                             | 9,805      |            |       |                                             | (8,837     | ) |   |   | 968 |   |   |
| Income tax  expense (benefit)(c)                                                 |       |                                             | 2,338      |            |       |                                             | 3,560      |   |   |   | (1,222 | ) |   |
| Net income                                                                       |       |                                             | $          | 7,467           |       |                                             |       | $ | (5,277 | ) |   |   | $ | 2,190 |   |   |
| Net income per share—basic                                                  |       |                                             | $          | 0.57            |       |                                             |       | (0.40 | ) |   |   | $ | 0.17 |   |   |
| Weighted average  number of shares of Common Stock outstanding—basic   |       |                                             | 13,013,927 |            |       |                                             |       |   |   |   | 13,013,927 |   |   |
| Net income per share—diluted                                                |       |                                             | $          | 0.54            |       |                                             |       | (0.38 | ) |   |   | $ | 0.16 |   |   |
| Weighted average number  of shares of Common Stock outstanding—diluted |       |                                             | 13,827,522 |            |       |                                             |       |   |   |   | 13,827,522 |   |   |

 

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)**

| ** **                                                                         | ** ** | **Year Ended  December 31, 2003** | ** ** | **Adjustments** | ** ** | **Year Ended  December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-----------------|------------|--------------------------------------------------|------------|
| ** **                                                                         | ** ** | **(As reported)**                           | ** ** | ** **      | ** ** | **(As restated)**                           | ** ** |
| Cash flows from  operating activities:                                             |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Net income(e)                                                                      |       |                                             | $          | 6,239           |       |                                             |       | (1,805 | ) |   |   | $ | 4,434 |   |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                     |       |                                             | 2,633      |            |       |                                             |       |   |   |   | 2,633 |   |   |
| Amortization of  discount on note assumed in merger                                |       |                                             | 16         |            |       |                                             |       |   |   |   | 16 |   |   |
| Provision for  doubtful accounts receivable, net of recoveries(a)                  |       |                                             | 81         |            |       |                                             | 59         |   |   |   | 140 |   |   |
| Deferred income  taxes(c)                                                          |       |                                             | 101        |            |       |                                             | (1,884     | ) |   |   | (1,783 | ) |   |
| In-process  research and development                                               |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Stock  compensation expense                                                        |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Change in assets and  liabilities, excluding effects from acquisitions:            |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Accounts  receivable(a)                                                            |       |                                             | 904        |            |       |                                             | (471       | ) |   |   | 433 |   |   |
| Inventory                                                                          |       |                                             | (440       | )               |       |                                             |       |   |   |   | (440 | ) |   |
| Prepaid expenses                                                                   |       |                                             | (51        | )               |       |                                             |       |   |   |   | (51 | ) |   |
| Accounts payable                                                                   |       |                                             | (483       | )               |       |                                             |       |   |   |   | (483 | ) |   |
| Accrued wages                                                                      |       |                                             | (369       | )               |       |                                             |       |   |   |   | (369 | ) |   |
| Other accrued  liabilities                                                         |       |                                             | 78         |            |       |                                             |       |   |   |   | 78 |   |   |
| Deferred revenue(a)                                                                |       |                                             | 1,561      |            |       |                                             | 4,630      |   |   |   | 6,191 |   |   |
| Other assets(d)                                                                    |       |                                             | (176       | )               |       |                                             | (527       | ) |   |   | (703 | ) |   |
| Other(b)                                                                           |       |                                             | 304        |            |       |                                             | (2         | ) |   |   | 302 |   |   |
| Net cash provided  by operating activities                                         |       |                                             | 10,398     |            |       |                                             | —     |   |   |   | 10,398 |   |   |
| Net cash provided  by (used in) investing activities                               |       |                                             | (8,208     | )               |       |                                             |       |   |   |   | (8,208 | ) |   |
| Net cash provided  by financing activities                                         |       |                                             | 10,101     |            |       |                                             |       |   |   |   | 10,101 |   |   |
| Effect of  exchange rate changes on cash                                           |       |                                             | 169        |            |       |                                             |       |   |   |   | 169 |   |   |
| Net increase in  cash                                                              |       |                                             | 12,460     |            |       |                                             |       |   |   |   | 12,460 |   |   |
| Cash and cash  equivalents, beginning of period                                    |       |                                             | 4,411      |            |       |                                             |       |   |   |   | 4,411 |   |   |
| Cash and cash  equivalents, end of period                                          |       |                                             | $          | 16,871          |       |                                             |       |   |   |   |   | $ | 16,871 |   |   |

 

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**MERGE TECHNOLOGIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (in thousands)**

 

| ** **                                                                         | ** ** | **Year Ended  December 31, 2004** | ** ** | **Adjustments** | ** ** | **Year Ended  December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-----------------|------------|--------------------------------------------------|------------|
| ** **                                                                         | ** ** | **(As reported)**                           | ** ** | ** **      | ** ** | **(As restated)**                           | ** ** |
| Cash flows from  operating activities:                                             |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Net income(e)                                                                      |       |                                             | $          | 7,467           |       |                                             |       | (5,277 | ) |   |   | $ | 2,190 |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                     |       |                                             | 3,645      |            |       |                                             |       |   |   |   | 3,645 |   |   |
| Amortization of  discount on note assumed in merger                                |       |                                             | 12         |            |       |                                             |       |   |   |   | 12 |   |   |
| Provision for  doubtful accounts receivable, net of recoveries(a)                  |       |                                             | 123        |            |       |                                             | 24         |   |   |   | 147 |   |   |
| Deferred income  taxes(c)                                                          |       |                                             | 1,913      |            |       |                                             | (3,544     | ) |   |   | (1,631 | ) |   |
| In-process  research and development                                               |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Stock  compensation expense                                                        |       |                                             | —     |            |       |                                             |       |   |   |   | — |   |   |
| Change in assets  and liabilities, excluding effects from acquisitions:            |       |                                             |       |            |       |                                             |       |   |   |   |   |   |   |
| Accounts  receivable(a)                                                            |       |                                             | (2,800     | )               |       |                                             | 770        |   |   |   | (2,030 | ) |   |
| Inventory                                                                          |       |                                             | (189       | )               |       |                                             |       |   |   |   | (189 | ) |   |
| Prepaid expenses(b)                                                                |       |                                             | (198       | )               |       |                                             | (206       | ) |   |   | (404 | ) |   |
| Accounts payable(b)                                                                |       |                                             | 720        |            |       |                                             | (9         | ) |   |   | 711 |   |   |
| Accrued wages                                                                      |       |                                             | 500        |            |       |                                             |       |   |   |   | 500 |   |   |
| Other accrued  liabilities(d)                                                      |       |                                             | 399        |            |       |                                             | (178       | ) |   |   | 221 |   |   |
| Deferred revenue(a)                                                                |       |                                             | 3,554      |            |       |                                             | 10,163     |   |   |   | 13,717 |   |   |
| Other assets(d)                                                                    |       |                                             | (917       | )               |       |                                             | (1,728     | ) |   |   | (2,645 | ) |   |
| Other(b)                                                                           |       |                                             | (317       | )               |       |                                             | (15        | ) |   |   | (332 | ) |   |
| Net cash provided  by operating activities                                         |       |                                             | 13,912     |            |       |                                             | —     |   |   |   | 13,912 |   |   |
| Net cash provided  by (used in) investing activities                               |       |                                             | (4,044     | )               |       |                                             |       |   |   |   | (4,044 | ) |   |
| Net cash provided  by financing activities                                         |       |                                             | 1,323      |            |       |                                             |       |   |   |   | 1,323 |   |   |
| Effect of  exchange rate changes on cash                                           |       |                                             | 5          |            |       |                                             |       |   |   |   | 5 |   |   |
| Net increase in  cash                                                              |       |                                             | 11,196     |            |       |                                             |       |   |   |   | 11,196 |   |   |
| Cash and cash  equivalents, beginning of period                                    |       |                                             | 16,871     |            |       |                                             |       |   |   |   | 16,871 |   |   |
| Cash and cash  equivalents, end of period                                          |       |                                             | $          | 28,067          |       |                                             |       |   |   |   |   | $ | 28,067 |   |   |

----

(a)    Impact of deferral of net sales attributed to factors describedabove in the *Revenue Recognition* section ofNote 13 for the period, including cumulative effect of all periods on accountsreceivable and related reserves and deferred revenue.

(b)   Impact of other adjustments discussed in Note 13 for currentperiod, primarily consisting of commissions. Balance sheet impact is cumulativefor all periods impacted.

(c)    Impact on income tax expense, net of all adjustments during theperiod at the statutory tax rate, including cumulative effect of all periods oncurrent deferred income taxes and long-term deferred income tax liabilities.Impact of factors discussed in the *Income Taxes*section of Note 13.

(d)   Impact of deferral of costs associated with net sales deferredattributed to factors described in the *Revenue Recognition*section of Note 13 for the period, including cumulative effect of all periodson other current assets, where such deferred costs are classified.

(e)    Reclassificationof amortization associated with customer intangibles to be consistent withprior year classification.

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Item 9.        CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE

None.

Item 9A.     CONTROLSAND PROCEDURES

(a)   Background on the Restatement

From January 10, 2006 through May 26, 2006, wereceived 11 anonymous letters primarily alleging improprieties relating to ourfinancial reporting, fulfillment of customer contracts and disclosurepractices. More specifically, the letters contained allegations of improperrevenue recognition practices. The Audit Committee of our Board of Directorstook a leadership role in assessing these matters and determining appropriatecorrective action with the assistance of outside counsel. The Audit Committeeretained the independent national law firm of Sidley Austin LLP and Alvarez& Marsal, a nationally-recognized forensic accounting firm, to conduct anindependent investigation of the allegations contained in the anonymousletters. Sidley Austin LLP and Alvarez & Marsal conducted a comprehensiveinvestigation of our accounting and financial reporting practices, whichincluded, among other things, a review of relevant documents and interviews ofcurrent and former employees of Merge Healthcare and former employees of CedaraSoftware Corp., which we acquired in June 2005. Throughout the investigation,the Audit Committee’s independent advisors provided the Audit Committee and theremainder of our Board of Directors with periodic updates with respect to theirfindings. In the course of the investigation, Sidley Austin LLP and Alvarez& Marsal regularly consulted with KPMG LLP, our independent registeredpublic accountants.

Based upon the normal year end closing process and thepreliminary findings of the investigation, we identified certain errors in ourfinancial statements for the second and third quarters of 2005. On May 15,2006, Richard A. Linden, our former President and Chief Executive Officer,submitted his resignation from all positions with us and our subsidiaries,including as an officer, employee and director, and our Board of Directorsaccepted Mr. Linden’s resignation.

On June 29, 2006, soon after Sidley Austin LLPcompleted its investigation, Sidley Austin LLP reported its findings to theAudit Committee, and the Audit Committee determined that, because of improperaccounting and financial reporting practices with respect to reporting periodsin the fiscal years 2002 through 2005, the previously issued financialstatements for each of the reporting periods in 2002 through 2005 should nolonger be relied upon. Furthermore, the audit reports of KPMG LLP with respectto those financial statements should no longer be relied upon. On June 30,2006, the Audit Committee presented its recommendations to all of ournon-employee directors. On July 2, 2006, our Board of Directors held a meetingat which it accepted the resignations of each of William C. Mortimore, ourformer interim Chief Executive Officer, Scott T. Veech, our former Chief FinancialOfficer, Treasurer and Secretary, and David M. Noshay, our former Senior VicePresident, Strategic Business Development, from all positions with us and oursubsidiaries, including as officers, employees and directors.

The errors identified inpreviously issued financial statements are described below.

*Revenue Recognition*

We determined thatwe overstated net sales for 2002, 2003, 2004 and the first nine months of 2005due to the following:

·   Delivery of certain software products toend-user customers that did not fully meet the functionality that we believeour customers expected based on express representations we made to ourcustomers or implied representations that arose from our demonstrations of thesoftware products during the sales process. We have deferred such revenue untilthe delivery of 

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the expected productfunctionality, the majority of which occurred in the third and fourth quartersof 2005 and the second quarter of 2006.

·   Collectibility was not reasonably assured atthe time certain revenue was recognized. Some of our contracts failed toreflect contingencies expressly demanded by the customer. We have notrecognized revenue until collectibility became reasonably assured, generally ascash was collected from the respective customer.

·   Recording revenue prior to shipment of thecorrect products included in a customer’s contract. We have deferred revenueuntil shipment of the appropriate products occurred.

·   Recording of revenue prior to shipment of allsoftware products included in a customer’s contract. Since we did not havevendor specific objective evidence of fair value for the undelivered softwareelement of certain of our contracts, we were required to defer all revenue forcertain customer orders with partial software product shipment until deliveryof all software products occurred.

·   For certain customers’ contracts, we wereunable to establish vendor specific objective evidence of fair value ofmaintenance. We have deferred the related contract value and are recognizingrevenue ratably over the related maintenance period.

·   Wedetermined that we failed to reduce net sales attributable to a contractalthough we had agreed to provide the customer with additional software at noadditional cost to the customer.

*Income Tax Expense*

We determined that we understated income tax expense,income tax payable and goodwill for the quarter ended, and as of, June 30,2005, due to a failure to record additional tax liability and income taxexpense in connection with our June 2005 business combination with CedaraSoftware Corp.

In addition, we adjustedthe provisions for income tax and related tax accounts at the applicablestatutory rates to account for the effects of the restatement adjustmentsdescribed herein.

*Other Adjustments*

As a result of the revenue adjustments, certainrevenue-related accounts were impacted and also restated. These included costof goods sold related to contracts impacted, deferred revenue (net of the costsof goods), bad debt expense, and the related accounts receivable allowance,accounts receivable and commission expense.

(b)   Disclosure Controls 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 Securities Exchange Act of 1934 (the “Exchange Act”) is properly recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s (“SEC”) rules and forms. Disclosurecontrols and procedures include processes to accumulate and evaluate relevantinformation and communicate such information to a registrant’s management,including its principal executive and financial officers, as appropriate, toallow for timely decisions regarding required disclosures.

We evaluated the effectiveness of the design andoperation of our disclosure controls and procedures as of December 31, 2005, asrequired by Rule 13a-15 of the Exchange Act. This evaluation was carried outunder the supervision and with the participation of our management, includingour principal executive officer and principal financial officer. As describedbelow, under “Management’s Report on Internal 

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Control Over FinancialReporting,” material weaknesses were identified in our internal control overfinancial reporting as of December 31, 2005 relating to our controlenvironment, revenue recognition, accounting for income taxes and accountingfor business combinations. Based on the evaluation described above, ourprincipal executive officer and principal financial officer have concludedthat, as of December 31, 2005, our disclosure controls and procedures were noteffective to ensure (1) that information required to be disclosed by us in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the SEC’s rulesand forms, and (2) information required to be disclosed by us in our reportsthat we file or submit under the Exchange Act is accumulated and communicatedto our management, including our principal executive officer and principalfinancial officer, or persons performing similar functions, as appropriate toallow timely decisions regarding required disclosure.

(c)   Management’s Report 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 improper managementoverride. 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 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 assessed the effectiveness of our internalcontrol over financial reporting as of December 31, 2005, using the criteriaset forth by the Committee of Sponsoring Organizations of the TreadwayCommission (“COSO”) in Internal Control-Integrated Framework. In assessing theeffectiveness of our internal control over financial reporting, managementidentified the following material weaknesses in internal control over financialreporting as of December 31, 2005:

1.     Ourcontrol environment was not adequate because certain former members of seniormanagement did not set a proper ethical tone within our organization andinstill an attitude of control compliance. Certain former members of ourmanagement were directly involved in circumventing our accounting controls, andother former members of our management were aware, or should have been aware,that such controls were being circumvented. This deficiency contributed tomaterial misstatements in our interim consolidated financial statements as of,and for the interim periods ended, September 30, 2005, June 30, 2005and March 31, 2005 and our annual consolidated financial statements as of,and for the years ended, December 31, 2004, 2003 and 2002, as well as ourconsolidated financial statements for interim periods within those years.

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2.     We did notmaintain effective policies and procedures relating to revenue recognitionassociated with our sales contracts. This lack of effective policies andprocedures contributed to our premature recognition of revenue related tocomponents of our software contracts that were undelivered as of a reportingdate, for which we were unable to establish fair value, or to contracts forwhich collectibility was not reasonably assured. These deficiencies resulted inmaterial misstatements in our interim consolidated financial statements as of,and for the interim periods ended, September 30, 2005, June 30, 2005and March 31, 2005 and our annual consolidated financial statements as of,and for the years ended, December 31, 2004, 2003 and 2002, as well as ourconsolidated financial statements for interim periods within those years.

3.     We did notmaintain effective policies and procedures over the accounting for incometaxes. Specifically, our policies and procedures did not provide for obtainingthird party technical assistance in connection with our accounting for theincome tax consequences of complex transactions. This deficiency resulted inmaterial misstatements in our interim consolidated financial statements as ofand for the interim periods ended September 30, 2005 and June 30,2005.

4.     We did notmaintain effective controls over the accounting for business combinations. Specifically,we did not have formal policies and procedures to provide for a sufficientanalysis to identify all assets acquired in business combinations toappropriately allocate the purchase price. This deficiency resulted in materialmisstatements in our interim consolidated financial statements as of, and forthe interim periods ended, September 30, 2005 and June 30, 2005.

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, 2005, based on the criteriaestablished by COSO.

We acquired Cedara Software Corp. during 2005. Theacquired assets represented $57,422,000 of our total consolidated assets as ofDecember 31, 2005 and $43,770,000 of our 2005 consolidated net sales. We didnot conduct an assessment of the effectiveness of internal control overfinancial reporting associated with Cedara Software Corp., as permitted by theimplementation guidance set forth by the SEC in June 2004 (and revised onOctober 6, 2004) to issuers relating to the SEC’s final rules on internalcontrol over financial reporting.

KPMG LLP, our independent registered public accountingfirm that audited our consolidated financial statements included in this AnnualReport on Form 10-K, has issued an audit report on management’s assessment ofour internal control over financial reporting. This report can be found insection (d) below.

(d)   Report of Independent Registered PublicAccounting Firm

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersMerge Technologies Incorporated:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over Financial Reporting(Item 9A((c)), that Merge Technologies Incorporated (the Company) did notmaintain effective internal control over financial reporting as ofDecember 31, 2005, because of the effect of material weaknesses identifiedin management’s assessment, 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 

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assessment and an opinionon the effectiveness of the Company’s internal control over financial reportingbased 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. Acompany’s internal 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.

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.      TheCompany’s control environment was not adequate because certain former membersof senior management did not set a proper ethical tone within the Company’sorganization and instill an attitude of control compliance. Certain formermembers of the Company’s management were directly involved in circumventing theCompany’s accounting controls, and other former members of the Company’smanagement were aware, or should have been aware, that such controls were beingcircumvented. This deficiency contributed to material misstatements in theCompany’s interim consolidated financial statements as of, and for the interimperiods ended, September 30, 2005, June 30, 2005 and March 31, 2005and the Company’s annual consolidated financial statements as of, and for theyears ended, December 31, 2004, 2003 and 2002, as well as the Company’sconsolidated financial statements for interim periods within those years.

2.      The Companydid not maintain effective policies and procedures relating to revenuerecognition associated with the Company’s sales contracts. This lack ofeffective policies and procedures contributed to the Company’s prematurerecognition of revenue related to components of its software contracts thatwere undelivered as of a reporting date, for which the Company was unable toestablish fair value, or to contracts for which collectibility was notreasonably assured. These deficiencies resulted in material misstatements inthe Company’s interim consolidated financial statements as of, and for the interimperiods ended, September 30, 2005, June 30, 2005 and March 31,2005 and the Company’s annual consolidated financial statements as of, and forthe years ended, December 31, 

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2004, 2003 and 2002, aswell as the Company’s consolidated financial statements for interim periodswithin those years.

3.      TheCompany did not maintain effective policies and procedures over the accountingfor income taxes. Specifically, the Company’s policies and procedures did notprovide for obtaining third party technical assistance in connection with theCompany’s accounting for the income tax consequences of complex transactions. Thisdeficiency resulted in material misstatements in the Company’s interimconsolidated financial statements as of and for interim periods ended September 30,2005 and June 30, 2005.

4.      TheCompany did not maintain effective controls over the accounting for businesscombinations. Specifically, the Company did not have formal policies andprocedures to provide for a sufficient analysis to identify all assets acquiredin business combinations to appropriately allocate the purchase price. Thisdeficiency resulted in material misstatements in the Company’s interimconsolidated financial statements as of, and for the interim periods ended, September 30,2005 and June 30, 2005.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO). Also, in ouropinion, because of the effect of the material weakness described above on theachievement of the objectives of the control criteria, the Company has notmaintained effective internal control over financial reporting as of December31, 2005, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).

The Company acquired Cedara Software Corp. (the“acquired entity”) during 2005, and management excluded from its assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2005, the acquired entity’s internal control overfinancial reporting associated with total assets of $57,422,000 and net salesof $43,770,000 included in the consolidated financial statements of the Companyas of, and for the year ended, December 31, 2005. Our audit of internal controlover financial reporting of the Company also excluded an evaluation of theinternal control over financial reporting of the acquired entity.

We also haveaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the accompanying consolidated balance sheetsof Merge Technologies Incorporated and subsidiaries as of December 31,2005 and 2004, 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, 2005. The aforementionedmaterial weaknesses were considered in determining the nature, timing, andextent of audit tests applied in our audit of the 2005 consolidated financialstatements, and this report does not affect our report dated August 29,2006, which expressed an unqualified opinion on the consolidated financialstatements.

/s/ KPMG LLP

Chicago, IllinoisAugust 29, 2006

(e)   Changes in Internal Control Over Financial Reporting

There were no changes in our internal control overfinancial reporting that occurred during the quarter ended December 31, 2005that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

Based on therecommendations of Sidley Austin LLP, Alvarez & Marsal and our ChiefAccounting Officer, the Audit Committee of our Board has approved and adoptedthe following remediation plan to 

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addressthe issues raised in the independent investigation conducted by Sidley Austin LLP,the deficiencies in our disclosure controls and procedures and the materialweaknesses in our internal control over financial reporting described aboveunder “Management’s Report on Internal Control Over Financial Reporting”:

1.     On May 15,2006, our Board accepted Mr. Linden’s resignation from all positions with usand our subsidiaries, including as an officer, employee and director, effectiveimmediately.

2.     Westrengthened the oversight role of our independent directors by determiningthat one of our non-employee directors will serve as Chairman of our Board ofDirectors. Accordingly, on May 15, 2006, Michael D. Dunham, who had beenserving as our lead independent director, was named Chairman of our Board ofDirectors.

3.     On July 2,2006, our Board of Directors accepted the resignations of Messrs. Mortimore,Noshay and Veech from all positions with the Company, effective immediately. Atthe same time, our Board appointed Michael D. Dunham, the Chairman of our Boardof Directors, as our principal executive officer on an interim basis. Our Boardis searching for a new Chief Executive Officer.

4.     On July 2,2006, our Board of Directors also appointed Steven M. Oreskovich, who had beenserving as our Vice President and Corporate Controller, as our Chief AccountingOfficer and interim Treasurer and Secretary. Mr. Oreskovich will serve as our principalaccounting officer and interim principal financial officer. Our Board issearching for a Chief Financial Officer.

5.     We willcreate an internal audit function and appoint a Director of Internal Audit, whowill report directly to the Audit Committee of our Board of Directors, tooversee the internal audit function for us. This internal audit function willinclude the review of each of our sales contracts under which we expect toreceive revenue in excess of $100,000. We have retained Alvarez & Marsal, theforensic accounting firm retained by Sidley Austin in connection with itsinvestigation, to consult on a variety of accounting and financial reportingmatters, at least until such time as we appoint a Director of Internal Audit.

6.     On August28, 2006, our Board of Directors approved a revised Audit Committee Charter.See Part III, Item 10, “Directors and Executive Officers of the Registrant—AuditCommittee; Audit Committee Financial Expert” in this Annual Report on Form 10-Kfor more information.

7.     At leastuntil a new Chief Executive Officer is retained, our principal financialofficer will report directly to the Audit Committee of our Board.

8.     We willfurther standardize our OEM contracts to provide additional clarity on issuesrelated to revenue recognition.

9.     Ourproduct documentation and marketing materials will clearly present productfunctionality available for sale.

10.   We willenhance our contract review process to include a cross functional group that isresponsible for reviewing contracts and providing information required toassist us in our determination of revenue recognition.

11.   We willformalize our procedures for project status determination and customeracceptance sign-off.

12.   We will establishformal policies and procedures for the customer audit confirmation process.

13.   We willenhance our continuing education program for our sales and service organizationto educate them regarding our revenue recognition policies and we will requiresales personnel to verify their compliance with these policies.

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14.   We willwork with KPMG LLP, our independent registered public accounting firm, toinstitute a formal disclosure review procedure between the Audit Committee ofour Board and our management.

15.   We willestablish an ongoing contract review process, related to contracts with non-standardor complex terms, with a goal of determining appropriate accounting treatmentprior to quarter-end.

16.   Inconnection with complex transactions, we will seek expert outside advice on taxissues.

17.   We willestablish formal policies and procedures to identify all assets we acquire inbusiness combination transactions.

18.   We haveestablished a disclosure committee to, among other things, assist our principalexecutive officer and principal financial officer in fulfilling theirresponsibilities with respect to Sections 302, 404 and 906 of theSarbanes-Oxley Act of 2002 and the rules of the SEC.

19.   We intendto hire a General Counsel to, among other things, work with our principalexecutive officer, principal financial officer, principal accounting officerand Director of Internal Audit to further improve our control environment.

We have already beguninstituting this remediation plan. The Audit Committee is committed to furtherrefinement and improvement of this plan.

**Item 9B.     OTHER INFORMATION**

During the fourth quarter of 2005, we did not fail tofile a Form 8-K to disclose any information required to be disclosedin a report on such form.

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 the three months ended June 30, 2006,several material events occurred that resulted in an environment of uncertaintycreating significant business challenges, and diverted the attention of ourBoard of Directors and management from our business operations. These eventsincluded the resignation of certain members of our senior management, thecompletion of an independent investigation conducted by the Audit Committee ofour Board of Directors during which the Audit Committee concluded that severalof our previously issued financial statements would require restatement, thepossible delisting of our common stock from the NASDAQ Global Market and noticeof an informal non-public inquiry with the Securities Exchange Commission.These events, which did not exist as of December 31, 2005, resulted incircumstances which indicated that we may not be able to recover the intangibleassets’ carrying amounts or that the fair value of our single reporting unitdoes not support the carrying value of goodwill.

We have tested our indefinite lived intangible assetsand goodwill for impairment as of June 30, 2006 and concluded that ourindefinite lived intangible assets were not impaired.

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 have apotential 

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impairment of our goodwillsince the carrying value of our single reporting unit exceeded the reportingunit’s estimated fair value. On August 29, 2006, the Audit Committee ofour Board of Directors determined that there was such an impairment.

We are in the process ofcompleting Step II to measure the amount of impairment loss relating togoodwill, by comparing the implied fair value of our reporting unit goodwillwith the carrying amount of that goodwill. The estimate of fair value of ourreporting unit was reduced by the fair value of all other assets to determinethe implied fair value of reporting unit goodwill. We are in the process offinalizing our assessment of the fair value utilizing the assistance ofindependent valuation specialists. We preliminarily estimate that as a resultof our Step II analysis, we will record a goodwill impairment chargeduring the three months ended June 30, 2006 of approximately$220 million, none of which will result in future cash expenditures.

**PART III**

**Item 10.      DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

**Directors andExecutive Officers**

Thefollowing table sets for the names of our Directors and executive officers, andtheir respective ages and positions with us, followed by a brief biography ofeach individual, including their business experience during the past fiveyears.

| Robert A. Barish, M. D. |   | 52 |   | Director                                                                                                   |
|-------------------------|--------|----|--------|------------------------------------------------------------------------------------------------------------|
| Dennis Brown            |   | 58 |   | Director                                                                                                   |
| Michael D. Dunham       |   | 61 |   | Chairman of Board  (interim principal executive officer)                                                   |
| Robert T. Geras         |   | 68 |   | Director                                                                                                   |
| Anna Marie Hajek        |   | 57 |   | Director                                                                                                   |
| R. Ian Lennox           |   | 53 |   | Director                                                                                                   |
| Steven M. Oreskovich    |   | 34 |   | Chief Accounting Officer, Interim Treasurer and  Interim           Secretary |
| Ramamritham Ramkumar    |   | 54 |   | Director                                                                                                   |
| Richard A. Reck         |   | 56 |   | Director                                                                                                   |
| Robert J. White         |   | 43 |   | Interim President  and Chief Executive Officer, and President, Merge eMed                                  |

 

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**Business Experienceof Directors and Executive Officers**

***Robert A. Barish,M. D.,***a Director, is Vice Dean for ClinicalAffairs and Professor of Surgery and Medicine at the University of MarylandSchool of Medicine. From 1996 to 1998, he served as the chief executive officerof University Care, for University of Maryland Medical. He is a Trustee of theEndowment Fund of the University of Maryland. Dr. Barish holds a B. A.from the University of New Hampshire, an M. D. from the New York MedicalCollege and an M.B.A. from Loyola College. Dr. Barish has served on ourBoard of Directors since our initial public offering in February 1998.

***Dennis Brown,***aDirector, served as vice president of finance, chief financial officer andtreasurer of Apogent Technologies Inc. (“Apogent”), a New York Stock Exchangecompany from January 2003 to December 2004. Fisher Scientific InternationalInc. acquired Apogent in August 2004, and after completion of a transitionperiod Mr. Brown retired from Apogent in December 2004. From December 2000through January 2003, Mr. Brown served as a financial consultant toApogent. Mr. Brown has also served as vice president, chief financialofficer and treasurer of Sybron International Corporation (“Sybron”), apublicly traded company formerly headquartered in Milwaukee, Wisconsin, fromJanuary 1993 through December 2000, at which time Sybron’s life sciences groupwas relocated to Portsmouth, New Hampshire, and Sybron was renamed Apogent.Mr. Brown is a Fellow of the Chartered Institute of Management Accountants(England). Mr. Brown has served on our Board of Directors since May 2003and previously served on our Board of Directors from the date of our initialpublic offering in February 1998 until May 2000.

***Michael D. Dunham,***Chairmanof the Board, has served on our Board of Directors since our initial publicoffering in February 1998 and Chairman of the Board of Directors since May 2006(including designation as our principal executive officer in July 2006).Mr. Dunham is the owner and, since 2002, has served as president of DunhamGlobal Associates, Ltd., which owns private companies in the softwaretechnology industry. Mr. Dunham previously served as senior vice presidentof business development of industrial and financial systems, IFS-AB, apublicly traded Sweden-based corporation that markets and supportsmanufacturing software systems, from 1999 to May 2006. Mr. Dunham co-foundedand served as chief executive officer of publicly traded Effective ManagementSystems, Inc. between 1978 and 1999. Mr. Dunham is a director of HeartlandGroup, Inc., a mutual funds holding company. Mr. Dunham also served as adirector of the Milwaukee Metropolitan Association of Commerce from 1991 to2004. Mr. Dunham holds a B. S. in Electrical Engineering from theUniversity of Denver and a M.M.S. from the Stevens Institute of Technology.

***Robert T. Geras,***aDirector, has been a shareholder since May 1989 and our Director sinceprior to our initial public offering in 1998. Since January 2004,Mr. Geras has been a director of Capital Growth Systems, Inc., apublic reporting holding company for Nexvu Technologies LLC, anapplication performance management software company. Mr. Geras has been aprivate venture investor for more than 25 years and has participated as adirector of, investor in, and/or advisor to numerous small businesses in fieldsranging from medical equipment, computer software, banking, telecommunications,industrial distribution and the internet. He has also assisted in corporateplanning, capital formation and management for his various investments.Mr. Geras holds a B.S.B.A. from Northwestern University.

***Anna Marie Hajek,***aDirector, has been president and chief executive officer of ClarityGroup, Inc., a healthcare risk and quality management company specializingin patient safety solutions and professional liability insurance operationssince she co-founded the firm in 2000. From 1995 to 2000, Ms. Hajekserved as executive vice president and president of the Healthcare RiskServices Group operating division of MMI Companies, Inc. (“MMI”), a New YorkStock Exchange company specializing in risk management and liability insuranceto the healthcare industry. From 1985 to 1994, she served in various othercapacities at MMI. Prior to that time, Ms. Hajek worked in hospital andacademic medical center settings in her capacity as a medical technologist andeducator. Ms. Hajek received her B. A. with honors from the 

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College ofSt. Teresa, Winona, Minnesota, and her Masters Degree in HealthProfessions Education from the University of Illinois at Chicago. She holds anactive Medical Technologist Certification from the American Society of ClinicalPathologists. Ms. Hajek joined our Board of Directors in May 2001.

***R. Ian Lennox,***a Director isan investor in the life sciences industry. He is a director of several lifesciences companies in North America. From 2000 to 2004, Mr. Lennox heldleadership positions at MDS Inc. (“MDS”), first as president and chiefexecutive officer, drug discovery and development, and later as president andchief executive officer, pharmaceutical and biotechnology markets. Prior tojoining MDS, he was president and chief executive officer of PhoenixInternational Life Sciences, a NASDAQ listed company, and chairman and chiefexecutive officer of Drug Royalty Corporation, a Toronto Stock Exchange listedcompany. From 1978 to 1997, Mr. Lennox held progressively seniormanagerial positions at Monsanto Company, in the U. S., Europe and LatinAmerica, including six years as president and chief executive officer, Monsanto(Canada), based in Toronto. Mr. Lennox has also served as director of anumber of life sciences companies and charitable foundations in North America.Mr. Lennox holds an Honours B. S. degree in physiology and pharmacologyand an M.B.A. from the University of Western Ontario. He has also completed theexecutive management program in finance at the Columbia School of Business. Mr. Lennoxjoined our Board of Directors in August 2005.

***Steven M.Oreskovich,***has served as our Chief AccountingOfficer and interim Treasurer and interim Secretary since July 2006, and servedas our Vice President and Corporate Controller from April 2004 to July 2006.Prior to joining us, Mr. Oreskovich served as vice president of financeand operations at Truis, Inc., a company that provided customerintelligence solutions for business-to-business enterprises, fromApril 2000 to January 2003, and had previously also worked as an auditor atPriceWaterhouseCoopers LLP from September 1994 to April 2000.Mr. Oreskovich holds a B. S. in Accounting from Marquette University.

***RamamrithamRamkumar,***a Director, and formerly a director ofCedara Software prior to our business combination with Cedara Software.Mr. Ramkumar has been a principal shareholder and chairman of the board ofProcess Research ORTECH, Inc., a metallurgical research and developmentorganization, since 1988, and has held various positions at Reff Incorporated,now a division of Knoll Incorporated until 1986. From 1988 to 2004,Mr. Ramkumar held the positions of president and chief executive officerat Inscape Corporation, formerly Office Specialty, and has held variouspositions at Clarkson Gordon, now Ernst and Young. Mr. Ramkumar has aBachelor of Technology from Metallurgical Engineering and an M.BA from theUniversity of Toronto. Mr. Ramkumar has been a member of President’s ofEntrepreneurial Organizations for over ten years, and is a charter member ofthe Toronto chapter of TIE and is on the board of Toronto RehabilitationHospital. He is also a member of the entrepreneurial advancement board of theRotman School of Business in Toronto. Mr. Ramkumar has served on our Boardof Directors since August 2005.

***Richard A. Reck,***a Director,is the president of Business Strategy Advisors LLC, a strategy consulting firm,and has served in such capacity since August 2002. During 2005,Mr. Reck joined the boards of Interactive Intelligence, Inc., a publiclyheld software company, and Advanced Life Sciences Holdings Inc., a publiclyheld biopharmaceutical company. Mr. Reck joined the certified publicaccounting firm of KPMG LLP in June 1973 and remained in their employ until hisretirement as a partner in July 2002. Since March 2004, Mr. Reck hasserved as a director of SIVOX Technologies, Inc., a privately held softwarecompany. Since 2002, Mr. Reck has served as a director of LiquidGeneration, Inc., a privately held company. Mr. Reck also serves on theboards of not for profit entities: the Illinois Information TechnologyAssociation, which is a trade association serving software and IT companies inthe Midwestern U. S.; the Illinois Technology Development Alliance, whichis a public / private partnership between businesses and the State of Illinois,with its objective being to foster economic growth in Illinois; the advisoryboard of the Illinois Fatherhood Initiative, to provide focus on the importanceof fathers in the growth and development of children; and the advisory board ofJourneys in Film, which utilizes film to bring 

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cross-culturalknowledge to middle school aged children. Mr. Reck is a certified publicaccountant and holds a B. A. in Mathematics from DePauw University and anM.B.A. in Accounting from the University of Michigan. Mr. Reck has been aDirector of Merge Healthcare since April 2003.

***Robert J. White***hasserved as our interim President and Chief Executive Officer since July 2006,and has served as President of Merge eMed since April 2006. Mr. White hasmore than 20 years of healthcare industry experience. From April 2003 toDecember 2005, Mr. White served in several key leadership roles, includingchief operating officer at SourceOne Healthcare Technologies (“SourceOne”), aleading provider of radiology and digital imaging solutions and services tovarious healthcare markets. While at SourceOne, Mr. White led overallproduct and services strategy, business development efforts, and operationalexecution. For 15 years prior to joining SourceOne, Mr. White served invarious senior executive and sales/marketing roles at IBM, including globalmarketing executive for IBM’s multi-billion dollar healthcare businesswith responsibility for global marketing, business development and strategy.Mr. White also held senior executive sales and marketing positions withAcclerys, Inc. and Chemdex, Inc. Mr. White holds a B.B.A. from ClevelandState University and an M.B.A. from Case Western Reserve University.

**Audit Committee;Audit Committee Financial Expert**

The Audit Committee recommends engagement of MergeHealthcare’s independent accountants, approves services performed by theseaccountants, and reviews and evaluates Merge Healthcare’s accounting andfinancial reporting system and its system of internal accounting controls.

The Audit Committee, which met nine times in 2005, iscomprised of Dennis Brown, as chair, Robert T. Geras and Ramamritham Ramkumar.Mr. Brown has been designated by our Board of Directors as our “auditcommittee financial expert,” as that term is defined in Item 401(h) ofRegulation S-K. All of the members of the Audit Committee are independent,as that term is defined in Section 4200(a)(15) of the National Association ofSecurities Dealers, Inc’s (the “NASD”) Marketplace Rules.

In August 2006, our Boardof Directors adopted a restated Audit Committee Charter. A copy of the restatedAudit Committee Charter is attached to this Annual Report on Form 10-Kat Exhibit 99 and is available on our website at *www.merge.com*.

**Code of Ethics**

We have adopted a Code ofEthics that applies to all of our Directors, employees and officers, includingour principal executive officer, our principal financial officer, ourcontroller and persons performing similar functions. Our Code of Ethics,together with the corresponding Whistleblower Policy, are available on ourwebsite at *www.merge.com*. Future material amendmentsor waivers relating to the Code of Ethics and/or the correspondingWhistleblower Policy will be disclosed on our website referenced in thisparagraph within four business days following the date of such amendment orwaiver.

**Section 16(a)Beneficial Ownership Reporting Compliance**

Section 16(a) of the Securities Exchange Act of 1934,as amended, requires our executive officers and members of our Board ofDirectors, and persons who own more than ten percent (10%) of a registeredclass of our equity securities, to file initial statements of beneficialownership (Form 3), and statements of changes in beneficial ownership(Forms 4 or 5) of our equity securities with the SEC and the NASD. The SECrequires executive officers, Directors and greater than ten percent (10%)shareholders to furnish us with copies of all these forms filed with the SEC orthe NASD.

To our knowledge, basedsolely upon our review of the copies of these forms received by us, or writtenrepresentations from certain reporting persons that no additional forms wererequired for those persons, 

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webelieve, with the exception of the filings that were not made on a timely basisas noted below, that all filing requirements applicable to its executiveofficers, Directors, and greater than ten percent (10%) beneficial owners havebeen complied with during 2005. A Form 4 was filed on October 26, 2005 onbehalf of Brian E. Pedlar with respect to the reporting of an option grant madeon October 20, 2005, and a Form 5 filed on May 8, 2006 on behalf of DennisBrown with respect to a “small share acquisition” made by one of Mr. Brown’smoney managers in December 2005, which acquisition Mr. Brown was unawareof at the time it occurred.

**Item 11.      EXECUTIVE COMPENSATION**

**Compensation ofDirectors and Executive Officers**

**Directors’Compensation**

Annualcompensation for non-employee Directors for 2005 was comprised of thefollowing components:   cash compensation, consisting of participationawards, meeting and committee meeting fees; and equity compensation, consistingof stock options. Each of these components is described in more detail below.The total compensation of our non-employee Directors for the year endedDecember 31, 2005 is shown in the following table.

| **Name**                   | ** ** | ** ** | ** ** | **Total ($)** | ** ** | **Fees earned  or paid in  cash ($)** | ** ** | **Option  Awards ($)(1)** | ** ** |
|----------------------------|------------|------------|------------|--------------------|------------|-----------------------------------------------------------|------------|--------------------------------|------------|
| Robert A. Barish,  M. D.   |       | $          | 60,750     |               |       | $                                                         | 33,750     |                           |       |   | $ | 27,000 |   |   |
| Dennis Brown*              |       | $          | 63,500     |               |       | $                                                         | 36,500     |                           |       |   | $ | 27,000 |   |   |
| Peter J. Cooper            |       | $          | 48,000     |               |       | $                                                         | 21,000     |                           |       |   | $ | 27,000 |   |   |
| Michael D.  Dunham*        |       | $          | 66,000     |               |       | $                                                         | 39,000     |                           |       |   | $ | 27,000 |   |   |
| Robert T. Geras            |       | $          | 63,500     |               |       | $                                                         | 36,500     |                           |       |   | $ | 27,000 |   |   |
| Anna Marie Hajek*          |       | $          | 64,750     |               |       | $                                                         | 37,750     |                           |       |   | $ | 27,000 |   |   |
| R. Ian Lennox              |       | $          | 45,000     |               |       | $                                                         | 18,000     |                           |       |   | $ | 27,000 |   |   |
| Ramamritham  Ramkumar      |       | $          | 38,672     |               |       | $                                                         | 16,428     |                           |       |   | $ | 22,244 |   |   |
| Richard A. Reck            |       | $          | 51,500     |               |       | $                                                         | 24,500     |                           |       |   | $ | 27,000 |   |   |
| Frank E. Seidelmann, D. O. |       | $          | 5,750      |               |       | $                                                         | 5,750      |                           |       |   | $ | 0 |   |   |

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      * Chair of Committee

  (1) The amounts shown represent 15,000 stockoptions granted on June 1, 2005 under our 2005 Equity Incentive Plan, each ofwhich had an exercise price of $17.50, the closing price of our Common Stock onthe date of grant. The amount shown for Mr. Ramkumar, however, represents11,178 stock options granted under our 2005 Equity Incentive Plan with anexercise price of $19.38 on the grant date of August 25, 2005, which date was thedate of Mr. Ramkumar’s election to our Board of Directors.Dr. Seidelmann, who was no longer on our Board of Directors at the time ofthe annual stock option grants to our non-employee Directors, was notgranted any stock options during 2005. The fair value of each option award wasestimated on the date of grant using the Black-Scholes-Mertonoption pricing model. Our determination of the fair value of share-basedawards on the date of grant is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to, our expected stock pricevolatility over the expected life of the awards and actual and projected employeestock option exercise behavior. See Note 10 of the notes to consolidatedfinancial statements included in this Annual Report on Form 10-K forinformation regarding the assumptions used to value these stock options.

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The following is adescription of the compensation plan for our Board of Directors for 2006:

**AnnualBoard / Committee Retainer Fees.****  **Non-employee Directors receivean annual participation award of $15,000 per year. The non-employeeDirectors who serve as the Chair of the Audit Committee and the Chair of theCompensation Committee receive an additional $5,000 annual participation award and$4,000 annual participation award, respectively.

**MeetingFees.****  **Non-employeeDirectors also received a fee of $1,500 for each Board of Directors meeting orBoard Committee meeting attended in person, and a fee of $750 for each Board ofDirectors or Board Committee meeting attended via teleconference. Directors arealso reimbursed for certain expenses incurred in connection with attendance atBoard of Directors and Board Committee meetings.

**StockOption Grants.****  **Onthe date of our Annual Meeting of Shareholders,****Directors****whoare not employees of Merge Healthcare receive immediately exercisablenonqualified stock options to purchase 15,000 shares of Common Stock of MergeHealthcare under Merge Healthcare’s 2005 Equity Incentive Plan (“EquityIncentive Plan”), with an exercise price equal to the closing price of MergeHealthcare’s shares of Common Stock on such date. Stock options granted to thenon-employee Directors under the Equity Incentive Plan expire at theearliest to occur of: (i) the expiration of the option term (no more thanten (10) years), or (ii) the expiration of six (6) months from thedate the Director ceases to serve on our Board.Options granted to non-employeeDirectors under the Equity Incentive Plan may be exercised in whole or in partuntil termination of the exercise period. If a Director is elected or appointedafter the date of the Annual Meeting, the amount of options issued will beprorated to coincide with the time Directors are elected or appointed for thefollowing annual term, and that Director’s stock option exercise price will beequal to the closing price of Merge Healthcare’s shares of Common Stock as ofthe date of such new Director’s election or appointment to the Board ofDirectors. Each option granted to Directors under the Equity Incentive Plan isevidenced by a written agreement between Merge Healthcare and the Director.

The Compensation Committeeof the Board of Directors has not yet determined whether any changes to thiscompensation structure will be recommended with respect to the term beginningafter the Merge Healthcare Annual Meeting.

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**ExecutiveCompensation**

Setforth below is information concerning the compensation for 2005, 2004 and 2003for our President and Chief Executive Officer and four other executive officersas of December 31, 2005 (collectively, the “Named Executive Officers”):

**SummaryCompensation Table**

|                                                                                                                                                      | ** ** | ** ** | ** ** | ** **                   | ** ** | **Long Term  Compensation  Awards** | ** ** | ** **   | ** ** | ** **                               | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------------------|------------|--------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                           | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Number of**                       | ** ** | ** **   | ** ** | ** **                               | ** ** |
| **Name and Principal  Position**                                                                                                           | ** ** | ** ** | ** ** | **Year**                     | ** ** | **Salary**                               | ** ** | **Bonus**(1) | ** ** | **Other Annual  Compensation  ($)** | ** ** | **Securities  Underlying  Options** | ** ** | **All Other  Compensation  ($)(2)** | ** ** | **Total  ($)**(3) | ** ** |
| Richard A. Linden                                                                                                                                    |       | 2005       |       | $                            | 322,917    |                                     |       | —       |       |                                     |       | — |   |   |             200,000 |   |   | $ | 6,300 |   |   | $ | 1,469,217 |   |
| Former President and                                                                                                                                 |       | 2004       |       | $                            | 219,792    |                                     |       | $            | 109,863    |                                     |       |   | — |   |   | 100,000 |   |   | $ | 8,047 |   |   |   |   |
| Chief Executive                                                                                                                                      |       | 2003       |       | $                            | 220,833    |                                     |       | $            | 68,200     |                                     |       |   | — |   |   | 100,000 |   |   | $ | 5,000 |   |   |   |   |
| Officer(4)                                                                                                                                           |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| William C. Mortimore                                                                                                                                 |       | 2005       |       | $                            | 129,167    |                                     |       | $            | 35,000     |                                     |       |   | — |   |   | 35,000 |   |   | $ | 2,583 |   |   | $ | 366,250 |   |
| Former interim                                                                                                                                       |       | 2004       |       | $                            | 100,000    |                                     |       | $            | 8,930      |                                     |       |   | — |   |   | — |   |   | $ | 3,189 |   |   |   |   |
| President and                                                                                                                                        |       | 2003       |       | $                            | 162,500    |                                     |       | $            | 12,390     |                                     |       |   | — |   |   | — |   |   | $ | 3,250 |   |   |   |   |
| Chief Executive Officer and                                                                                                                     |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| former Chief Strategist(5)                                                                                                                           |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| David M. Noshay                                                                                                                                      |       | 2005       |       | $                            | 185,000    |                                     |       | $            | 25,000     |                                     |       |   | — |   |   | 75,000 |   |   | $ | 5,550 |   |   | $ | 643,050 |   |
| Former Senior Vice                                                                                                                                   |       | 2004       |       | $                            | 145,000    |                                     |       | $            | 32,524     |                                     |       |   | — |   |   | 10,000 |   |   | $ | 5,720 |   |   |   |   |
| President, Strategic                                                                                                                                 |       | 2003       |       | $                            | 126,250    |                                     |       | $            | 24,480     |                                     |       |   | — |   |   | 35,000 |   |   | $ | 3,106 |   |   |   |   |
| Business                                                                                                                                             |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Development(6)                                                                                                                                       |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Brian E. Pedlar                                                                                                                                      |       | 2005       |       | $                            | 161,460    |                                     |       | $            | 90,257     |                                     |       |   | — |   |   | 115,000 |   |   | — |   |   | $ | 844,817 |   |
| Former Interim co-President and co-Chief  Executive Officer, Former Senior Vice President and Former President  of Cedara Software(7) |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Scott T. Veech                                                                                                                                       |       | 2005       |       | $                            | 216,667    |                                     |       | —       |       |                                     |       | $ | 75,000 | (8) |   | 150,000 |   |   | $ | 6,300 |   |   | $ | 1,152,967 |   |
| Former Chief                                                                                                                                         |       | 2004       |       | $                            | 168,333    |                                     |       | $            | 38,152     |                                     |       |   | — |   |   | 25,000 |   |   | $ | 6,896 |   |   |   |   |
| Financial Officer,                                                                                                                              |       | 2003       |       | $                            | 158,333    |                                     |       | $            | 30,400     |                                     |       |   | — |   |   | 35,000 |   |   | $ | 3,958 |   |   |   |   |
| Secretary & Treasurer(6)                                                                                                                         |       |       |       |                         |       |                                     |       |         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                                                      |            |            |            |                              |            |                                          |            |              |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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   (1) Includes amounts earned and accrued duringcalendar year, but not paid until following calendar year.

   (2) Represents paid contributions to401(k) profit sharing plan and deferred profit sharing plan (DPSP), asapplicable, for the benefit of employees.

   (3) Provided for 2005 only and represents theaggregate total dollar value of each form of compensation quantified in thecolumns captioned “Salary,” “Bonus,” “Other Annual Compensation” and “All OtherCompensation,” and the grant date fair value of the option awards specified inthe column captioned “Securities Underlying Options” in this table as disclosedin the Option Grants in Fiscal Year 2005 table (see below) under the columncaptioned “Grant Date Present Value.”

   (4) Mr. Linden resigned all positions with usand our subsidiaries, including as an officer, employee and Director, in May2006.

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   (5) Mr. Mortimore resigned all positions withus and our subsidiaries, including as an officer, employee and Director, inJuly 2006.

   (6) Messrs. Noshay and Veech resigned all positionswith us and our subsidiaries, including as officers and employees, in July2006.

   (7) Mr. Pedlar became our employee in June2005 upon consummation of our business combination with Cedara Software Corp.,and became an executive officer of Merge Healthcare on August 25, 2005.Mr. Pedlar departed Merge Healthcare, effective as of the close ofbusiness on August 18, 2006.

   (8) Mr. Veech received abonus for his efforts performed in connection with the business combinationwith Cedara Software Corp.

**OptionGrants in Fiscal Year 2005**

| ** **            | ** ** | **Number of  Securities  Underlying  Options  Granted** | ** ** | **Percent of  Total  Options  Granted to  Employees  in Fiscal  Year(2)** | ** ** | **Exercise  Price** | ** ** | **Expiration  Date** | ** ** | **Grant Date  Present Value  ($)**(4) | ** ** |
|-----------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|---------------------|------------|----------------------|------------|-------------------------------------------------|------------|
| Richard A. Linden     |       |                                                         | 200,000    | (1)                                                                                      |       |                | 15         | %                    |       |                                            | $          | 17.50 |   |   | 05/31/2011 |   |   | $ | 1,140,000 |   |   |
| William C.  Mortimore |       |                                                         | 35,000     | (1)                                                                                      |       |                | 3          | %                    |       |                                            | $          | 17.50 |   |   | 05/31/2011 |   |   | $ | 199,500 |   |   |
| David M. Noshay       |       |                                                         | 75,000     | (1)                                                                                      |       |                | 6          | %                    |       |                                            | $          | 17.50 |   |   | 05/31/2011 |   |   | $ | 427,500 |   |   |
| Brian E. Pedlar(3)    |       |                                                         | 75,000     |                                                                                     |       |                | 6          | %                    |       |                                            | $          | 17.50 |   |   | 05/31/2011 |   |   | $ | 427,500 |   |   |
|                  |       |                                                         | 40,000     |                                                                                     |       |                | 3          | %                    |       |                                            | $          | 17.82 |   |   | 10/19/2011 |   |   | $ | 165,600 |   |   |
| Scott T. Veech        |       |                                                         | 150,000    | (1)                                                                                      |       |                | 11         | %                    |       |                                            | $          | 17.50 |   |   | 05/31/2011 |   |   | $ | 855,000 |   |   |

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  (1) Options granted to purchase vest to the extentof 25% on the date of grant and the first, second, and third anniversaries ofthe grant date. These stock options are exercisable for a period of six monthsfollowing the termination of the grantee’s service, but only to the extent thatsuch stock options were exercisable upon such termination date.

  (2) Excludes 1,885,649 replacement stock optionsgranted from our 2005****EquityIncentive Plan to the former option holders of Cedara SoftwareCorp. at thebusiness combination of Merge Healthcare and Cedara Software Corp. on June 1,2005.

  (3) Excludes 61,723 replacement stock optionsgranted from our 2005 Equity Incentive Plan to Mr. Pedlar as a formeroption holder of Cedara Software Corp. at the business combination of MergeHealthcare and Cedara Software Corp. on June 1, 2005.

  (4) In accordance with SFAS123, the fair value of stock option grants is estimated on the date of grant usingthe Black-Scholes-Merton option pricing model. Our determination of the fairvalue of share-based awards on the date of grant is affected by our stockprice, as well as assumptions regarding a number of highly complex andsubjective variables. These variables include, but are not limited to, ourexpected stock price volatility over the expected life of the awards and actualprojected employee stock option exercise behavior. See Note 10 of notes toconsolidated financial statements included in this Annual Report on the Form 10-Kfor information regarding the assumptions used to value these stock options.

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**Aggregated2005 Fiscal Year End Option Values**

| ** **            | ** ** | **Shares**           | ** ** | ** **   | ** ** | **Number of Securities  Underlying Unexercised  Options at** | ** ** | **Value of Unexercised  In-the-Money  Options at** | ** ** |
|-----------------------|------------|----------------------|------------|--------------|------------|----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **            | ** ** | **Acquired**         | ** ** | **Value**    | ** ** | **Fiscal Year End(2)**                                                 | ** ** | **Fiscal Year End 2005**                           | ** ** |
| ** **            | ** ** | **on Exercise** | ** ** | **Realized** | ** ** | **Exercisable**                                                                  | ** ** | **Unexercisable**                                                 | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Richard A. Linden     |       |                 | 100,000    |         |       | $                                                                                | 1,500,000  |                                                              |       | 200,000 |   |   |   | 275,000 |   |   | $ | 3,194,525 |   |   | $ | 2,792,595 |   |   |
| William C.  Mortimore |       |                 | 142,278    |         |       | $                                                                                | 2,172,298  |                                                              |       | 8,750 |   |   |   | 26,250 |   |   | $ | 65,975 |   |   | $ | 197,925 |   |   |
| David M. Noshay       |       |                 | 30,000     |         |       | $                                                                                | 564,248    |                                                              |       | 45,000 |   |   |   | 76,000 |   |   | $ | 426,963 |   |   | $ | 673,568 |   |   |
| Brian E. Pedlar       |       |                 | 26,000     |         |       | $                                                                                | 435,257    |                                                              |       | 30,015 |   |   |   | 120,708 |   |   | $ | 385,340 |   |   | $ | 1,258,294 |   |   |
| Scott T. Veech        |       |                 | 29,000     |         |       | $                                                                                | 385,244    |                                                              |       | 56,000 |   |   |   | 142,500 |   |   | $ | 449,065 |   |   | $ | 1,185,806 |   |   |

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  (1)   The value realized is thedifference between the fair market value of the underlying stock at the time ofthe exercise and the exercise price.

  (2)   Basedon the closing price of our Common Stock on the NASDAQ Global Market onDecember 30, 2005 of $25.04 per share.

**Employment andChange of Control Agreements**

As of March 1, 2004, Merge Healthcare enteredinto amended and restated employment agreements with Richard A. Linden,William C. Mortimore and Scott T. Veech. As of April 1, 2006, weentered into an amended and restated employment agreement with David M. Noshay,and a new employment agreement with Robert J. White. On May 12, 2006, MergeHealthcare entered into a letter agreement pursuant to which we reaffirmed ourobligations under Mr. Veech’s employment agreement. As a result ofMr. Linden’s resignation on May 15, 2006, Mr. Linden will not beentitled to any benefits under his employment agreement following such date. Asa result of resignations by each of Messrs. Mortimore, Noshay and Veecheffective July 2, 2006, none of them will be entitled to any compensation orbenefits under his employment agreement (including, in the case ofMr. Veech, his May 12, 2006 letter agreement) following such date.

On July 2, 2006, our Board of Directors approveda cash retention award opportunity for each of Mr. Pedlar andMr. White, as interim co-Presidents and co-Chief Executive Officers, equalto sixty percent (60%) of such officer’s current base salary, or $162,602 inthe case of Mr. Pedlar, and $150,000 in the case of Mr. White, to bepaid on October 1, 2007 only if such officer were still employed by us onthat date. Mr. Pedlar will not be entitled to this award due to hisdeparture from us and our subsidiaries, effective as of the close of businesson August 18, 2006. These awards are in lieu of 2006 annual performancebonuses. Our Board of Directors also approved a one-time cash incentive awardin the amount of $50,000 payable to each of Messrs. Pedlar and White forhis agreement to serve as interim co-President and co-Chief Executive Officer.

Prior to his departure, Mr. Pedlar was paid abase salary of $271,003 per year and participated in our regular benefitprograms. Mr. Pedlar was not a party to a written employment agreementwith us. However, pursuant to a letter dated August 25, 2005 from us toMr. Pedlar, he was entitled to receive a bonus based upon Cedara SoftwareCorp.’s quarterly revenue for each of Cedara Software Corp.’s four quarterscommencing July 1, 2005 if (1) Cedara Software Corp.’s revenue met or exceededa quarterly target for such quarter, and (2) Mr. Pedlar was employed byCedara Software Corp. through June 30, 2006, with the accumulated quarterlyamounts to be paid within 30 days after June 30, 2006. Mr. Pedlar wasalso entitled to receive a discretionary cash bonus award in the amount of$50,000 for his performance in 2005, to be paid after this Annual Report onForm 10-K is filed with the Commission. Due to Mr. Pedlar’s departure fromus and our subsidiaries, effective as of the close of business on August 18,2006, we do not plan to pay this award to him. 

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Under the Employment Agreement dated as of April 1,2006 by and between us and Mr. White, Merge Healthcare agreed to payMr. White a base salary of no less than $250,000 per year. In addition,Mr. White is eligible for annual performance bonuses of up to 40% ofsalary, dependent on achievement of company and individual performance targets.In the event of a “change in control,” all stock options then held byMr. White will immediately vest and become exercisable. In addition, ifthe employment of Mr. White is terminated following a “change in control,”in certain circumstances, he will be entitled to (A) 18 months ofthen-current salary to be paid in a single payment; (B) an amount equal to one-twelfth(1¤12th)of the maximum amount of then-current bonus (without regard to achievement oftargets) for each month of the then-current plan year, plus 18 further months,to be paid in a single payment; and (C) continuation of benefits for 18months. In addition, we have agreed that upon a “change in control,” we willdeposit into an escrow account $100,000 for Mr. White to provide a “staybonus” to help assure a smooth transition, but only if the acquirer requestsMr. White’s continued employment. The amount in the escrow will be paid toMr. White 12 months after the change in control if he has substantiallyperformed the services requested by the acquirer. In the event thatMr. White’s employment is terminated by us without “cause” or byMr. White with “good reason,” we will pay to Mr. White an amountequal to (A) 18 months of then-current salary, to be paid in equalinstallments over the 18-month period; (B) an amount equal to one-twelfth (1¤12th)of the maximum amount of then-current bonus (without regard to achievement oftargets) for each month of the then-current plan year, plus 18 further months,to be paid in equal installments over the 18-month period; and (C) continuationof certain supplemental benefits for 18 months. In addition, in such acase, all stock options held by Mr. White would immediately vest andbecome exercisable. Mr. White’s employment agreement contains a provisionconcerning the circumstances where an excise tax equalization gross-up paymentfor any severance or other payments may apply. Mr. White’s employmentagreement also includes customary provisions with regard to non-competition(including during the 18-month period following termination of employment forany reason), ownership of inventions and confidentiality.

On July 2, 2006, we entered into a letter agreement(the “Oreskovich Agreement”) with Steven M. Oreskovich, our ChiefAccounting Officer and interim Treasurer and interim Secretary. Under theOreskovich Agreement, we agreed to (1) award Mr. Oreskovich a cashbonus of $35,000 within 30 days of our filing this Annual Report on Form 10-Kand Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2006,(2) increase Mr. Oreskovich’s base salary to $175,000 per year,effective July 1, 2006, and (3) pay Mr. Oreskovich a cashretention bonus in an amount equal to 60% of his base salary at the time ofpayout within thirty (30) days of June 30, 2007. We further agreed thatMr. Oreskovich will be entitled to the retention bonus if he(a) remains employed by us through June 30, 2007, (b) is employed byus at the time of a “change in control,” as defined in the Key OfficerAgreement dated October 12, 2005 by and between us and Mr. Oreskovich (the“Key Officer Agreement”), that occurs before June 30, 2007, (c) is“constructively terminated,” defined as any reduction in his responsibilities,authority or compensation package, before June 30, 2007, or (d) is terminatedby us, other than for “Cause,” as defined in the Oreskovich Agreement, beforeJune 30, 2007. Mr. Oreskovich will not receive the retention bonus if hevoluntarily terminates his employment with us prior to June 30, 2007, or if heis terminated for “Cause.”

Under the Key OfficerAgreement, in the event of a “change in control,” if Mr. Oreskovich is(i) involuntarily terminated within one year following the change incontrol, or (ii) voluntarily terminates his employment with us within 365days following such change in control, following any of: (a) a reductionin his responsibilities or authority with respect to the business; (b) anyreduction in his compensation package, including then current salary, in effectimmediately prior to the change in control; or (c) the relocation of MergeHealthcare’s principal place of business by more than 30 miles, thenMr. Oreskovich will be entitled to (X) 12 months of his then currentsalary, to be paid in a single payment within 30 days of termination of hisemployment, plus (Y) an amount equal to one-twelfth (1¤12th)of the maximum amount of his then current annual bonus determined withoutregard to achievement of performance targets for each month of the current planyear during which he was employed, plus an additional 12 months, to be 

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paid ina single payment within 30 days of the termination of his employment, and(Z) continuation of the welfare benefits of health care, life andaccidental death and dismemberment, and disability insurance coverage for 12months after the termination (collectively, the “Supplemental Benefits”). Inaddition, upon a “change in control,” we will deposit $50,000 into an interestbearing escrow account, the purpose of the escrow to be to provideMr. Oreskovich with a “stay bonus” to help assure a smooth transition ifthe acquirer requests that he continue his employment with us. The amount heldin escrow will be paid to Mr. Oreskovich 12 months after the change incontrol if he has substantially performed the services requested by theacquirer. In the event that Mr. Oreskovich’s employment is terminated (1)without “Cause,” (2) by Mr. Oreskovich for “Good Reason,” defined asconstructive termination or a material reduction in base salary orresponsibility, or (3) due to Mr. Oreskovich’s disability, then we willpay Mr. Oreskovich the Supplemental Benefits. The Key Officer Agreementalso includes certain non-competition and confidentiality provisions thatcontinue after a termination of his employment.

**Item 12.**                 SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

Thefollowing table sets forth information as of December 31, 2005, with respect toshares of our Common Stock that may be issued under our existing equitycompensation plans. The table does not include employee benefit plans intendedto meet the qualification requirements of Section 401(a) of the InternalRevenue Code. Our equity compensation plans are described more fully in Note 10to our consolidated financial statements. 

| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of Securities to  be Issued upon Exercise  of Outstanding Options  (a)** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options  (b)** | ** ** | **Number of Securities  Remaining Available for  Future Issuance under  Equity Compensation  Plans Excluding Securities  Reflected in Column (a)  (c)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       |       | 2,935,869  |                                                                                                                      |       |                                                                             | $          | 13.22                                                                                                                                                                                                               |       |   |   | 4,418,253 |   |   |
| Equity  compensation plans not approved by security holders |       |       | 43,270     | (1)                                                                                                                       |       |                                                                             | 14.33      |                                                                                                                                                                                                                |       |   | — |   |   |
| Total                                                       |       |       | 2,979,139  |                                                                                                                      |       |                                                                             | $          | 13.24                                                                                                                                                                                                               |       |   |   | 4,418,253 |   |   |

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(1)   Shares ofour Common Stock issuable upon exercise of options under an equity compensationplan adopted by our Board of Directors in connection with our acquisition ofRIS Logic on July 17, 2003.

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**Security Ownershipof Certain Beneficial Owners and Management**

Thefollowing table shows, as of August 22, 2006, the beneficial ownership ofshares of the Common Stock, by: (i) each person that is known to us tobeneficially own or exercise the voting or dispositive control of five percent(5%) or more of the outstanding Common Stock; (ii) each of our Directorsand Named Executive Officers, including Messrs. Linden, Mortimore, Noshay,Pedlar and Veech, who are no longer associated with us, and (iii) all ofour Directors and executive officers as a group. Except as otherwise indicated in the footnotes to the table, the personsnamed below have sole voting and investment power with respect to the sharesbeneficially owned by such persons. In general, a person is deemed to be a“beneficial owner” of a security if that person has or shares the power to voteor direct the voting of such security, or the power to dispose of or to directthe disposition of such security. A person is also deemed to be a beneficialowner of any securities of which the person has the right to acquire thebeneficial ownership within sixty (60) days. 

| **Name and Address of Beneficial Owner**(1) | ** ** | ** ** | ** ** | **Shares  Beneficially  Owned**(2)(3) | ** ** | **Percentage of  Total  Outstanding** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| FMR Corp.(4)                                                         |       |       | 2,982,703  |                                  |       |                                       | 10.26      | % |   |
| Glenhill  Advisors, LLC(5)                                           |       |       | 2,200,000  |                                  |       |                                       | 7.57       | % |   |
| Longwood  Investment Advisors, Inc.(6)                               |       |       | 1,792,200  |                                  |       |                                       | 6.17       | % |   |
| Larry N.  Feinberg(7)                                                |       |       | 1,489,693  |                                  |       |                                       | 5.12       | % |   |
| Robert A. Barish,  M. D.                                             |       |       | 62,781     |                                  |       |                                       | (*)        |   |   |
| Dennis Brown                                                         |       |       | 30,284     |                                  |       |                                       | (*)        |   |   |
| Michael D. Dunham                                                    |       |       | 64,912     |                                  |       |                                       | (*)        |   |   |
| Robert T. Geras                                                      |       |       | 305,591    |                                  |       |                                       | 1.05       | % |   |
| Anna Marie Hajek                                                     |       |       | 42,983     |                                  |       |                                       | (*)        |   |   |
| R. Ian Lennox(8)                                                     |       |       | 20,870     |                                  |       |                                       | (*)        |   |   |
| Richard A. Linden                                                    |       |       | 261,850    |                                  |       |                                       | (*)        |   |   |
| William C.  Mortimore                                                |       |       | 328,447    |                                  |       |                                       | 1.13       | % |   |
| David M. Noshay                                                      |       |       | 95,500     |                                  |       |                                       | (*)        |   |   |
| Brian E. Pedlar                                                      |       |       | 73,223     |                                  |       |                                       | (*)        |   |   |
| Ramamritham  Ramkumar                                                |       |       | 21,178     |                                  |       |                                       | (*)        |   |   |
| Richard A. Reck                                                      |       |       | 33,439     |                                  |       |                                       | (*)        |   |   |
| Scott T. Veech                                                       |       |       | 122,250    |                                  |       |                                       | (*)        |   |   |
| All Directors and  Executive Officers as a Group (10 persons)   |       |       | 612,285    |                                  |       |                                       | 2.11       | % |   |

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  (*) Less than 1% of outstanding Common Stock.

  (1) The business address of each beneficial ownerwho is also a Director or Named Executive Officer of Merge Healthcare is c/oMerge Technologies Incorporated, 6737 West Washington Street, Suite 2250,Milwaukee, Wisconsin 53214-5650. The business address for FMR Corp. is 82Devonshire Street, Boston, Massachusetts 02109. The business address ofGlenhill Advisors, LLC is 598 Madison Avenue, 12th Floor, New York, NY 10022.The business address of Longwood Investment Advisors, Inc. is 1275 DrummersLane, Suite 207, Wayne, Pennsylvania 19087. The business address of Larry N.Feinberg is c/o Oracle Partners, L.P., 200 Greenwich Avenue, 3rd Floor,Greenwhich, CT 06830.

  (2) Except pursuant to applicable marital propertylaws or as indicated in the footnotes to this table, to our knowledge, eachshareholder identified in the table possesses sole voting and investment powerwith respect to all Common Stock shown as beneficially owned by such beneficialowner.

  (3) Includes the following number of shares ofCommon Stock which may be acquired upon the exercise of stock options which arecurrently exercisable or exercisable within 60 days of August 22, 2006: 30,000for Mr. Brown; 57,500 for Mr. Dunham; 52,500 for Mr. Geras;36,000 for Ms. Hajek, 17,935 for 

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Mr. Lennox;50,000 for Mr. Linden; 17,500 for Mr. Mortimore; 69,750 forMr. Noshay; 73,223 for Mr. Pedlar; 11,178 for Mr. Ramkumar;30,411 for Mr. Reck; and 102,250 for Mr. Veech.

  (4) As reported on a Schedule 13G/A filed with theCommission on February 14, 2006 jointly by FMR Corp., a registered investmentadvisor, Fidelity Management & Research Company (“Fidelity”), a whollyowned subsidiary of FMR Corp. and a registered investment advisor, Edward C.Johnson 3d, Chairman of FMR Corp., and members of the family of Edward C.Johnson 3d (collectively, “FMR Corp.”) with respect to the number of sharesbeneficially owned by FMR Corp. Edward C. Johnson 3d and FMR Corp., through itscontrol of Fidelity and its subsidiaries, each has sole dispositive power withrespect to the number of shares beneficially owned.

  (5) As reported on a Schedule 13G filed with theCommission on July 7, 2006 jointly by Glenhill Advisors, LLC and Glenn J.Krevlin. Mr. Krevlin is the managing member and control person of GlenhillAdvisors, LLC. According to the Schedule 13G, each of Glenhill Advisors, LLCand Mr. Krevlin have sole voting and dispositive power with respect to2,200,000 shares of our Common Stock.

  (6) As reported on a Schedule 13G filed with theCommission on February 10, 2006 by Longwood Investment Advisors, Inc., aninvestment advisor, as having sole voting and dispositive power with respect tothe number of shares beneficially owned.

  (7) As reported on a Schedule 13D/A filed with theCommission on August 24, 2006 by Larry N. Feinberg, the senior managing memberof Oracle Associates, LLC, and the sole shareholder and president of OracleInvestment Management Inc. According to the Schedule 13D/A, the sharesbeneficially owned includes 12,000 shares of our Common Stock that may be acquiredpursuant to call options acquired in open market purchases. According to theSchedule 13D/A, Mr. Feinberg has shared voting and dispositive power withrespect to 1,476,593 shares of our Common Stock and sole voting and dispositivepower with respect to 13,100 shares of our Common Stock.

  (8) Reflects2,935 non-voting exchangeable shares of Merge Cedara Exchange Co Limited, whichexchangeable shares may be exchanged on a one-to-one basis for shares of ourCommon Stock.

**Item 13.      CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

Through June 30, 2006,Michael D. Dunham served as a member of the audit committee of the board ofdirectors of Merchants & Manufacturers Bancorporation Inc. (“MMB”), and asa director of the board of directors of Lincoln State Bank, the bank subsidiaryof MMB, with which we have depository accounts and had a $35 million line ofcredit. Our failure to timely provide Lincoln State Bank with annual financialstatements for the year ended December 31, 2005 and interim financial statementsfor the quarters ended March 31, 2006 and June 30, 2006 constituted an event ofdefault under our credit agreement. Accordingly, the obligation of LincolnState Bank to extend us credit with respect to our $35 million line of creditterminated. We are currently negotiating a new credit agreement with LincolnState Bank. There can be no assurance that Lincoln State Bank will provide uswith debt financing, or that any such financing will be provided in amounts oron terms acceptable to us.

**Item 14.      PRINCIPAL ACCOUNTANT FEES AND SERVICES**

**Audit and AuditRelated Fees**

KPMG LLP is Merge Healthcare’s independent publicaccountants and have audited our consolidated balance sheets as of December 31,2005 and December 31, 2004, and the consolidated statements of operations,shareholders’ equity, comprehensive income (loss) and cash flows for the yearsended December 31, 2005, December 31, 2004 and December 31, 2003, as stated intheir reports appearing herein.

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Representatives of KPMG LLP will be present at ourAnnual Meeting. They will have the opportunity to make a statement if they sodesire and to respond to appropriate questions.

Thefollowing table presents fees billed for professional services rendered for theaudit of our annual financial statements for 2005 and 2004 and fees billed forother services rendered during 2005 and 2004 by KPMG LLP: 

|                | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| Audit fees(1)  |       | $        | 2,690,000  |     | $          | 560,000 |   |
| Tax fees(2)    |       | —   |       | 53,000   |       |
| All other fees |       | 1,500    |       | 1,500    |       |
| Total fees     |       | $        | 2,691,500  |     | $          | 614,500 |   |

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  (1)   Audit fees include fees for theannual financial statement audit, quarterly reviews, audit of internal controlover financial reporting, consents, review of registration statements andreview of, and assistance with, Form 8-K filings.

  (2)   Tax fees consist of fees fortax compliance and tax consulting in the U. S. and Canada.

The Audit Committee of theBoard of Directors has considered whether the provisions of these services notrelated to the audit of the financial statements acknowledged above, other thanaudit fees, is compatible with maintaining the independence of KPMG LLP and isof the opinion that the provisions of these services does not compromise KPMGLLP’s independence.

**Pre-ApprovalPolicies and Procedures**

The Audit Committee, inaccordance with the Audit Committee’s Charter, must pre-approve all non-auditservices provided by our independent registered public accountants. The AuditCommittee generally pre-approves specified services in the defined categoriesof audit services, audit related services and tax services up to specifiedamounts. Pre-approval may also be given as part of our Audit Committee’sapproval of the scope of the engagement of the independent registered publicaccountants or on an individual, explicit case-by-case basis before theindependent auditor is engaged to provide each service.

**PART IV**

**Item 15.      EXHIBITS AND FINANCIAL STATEMENTSSCHEDULES**

(a)   Thefollowing documents are filed as part of this annual report:

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

·   Consolidated Balance Sheets at December 31,2005 and December 31, 2004 (as restated);

·   Consolidated Statements of Operations foreach of the three years ended December 31, 2005, December 31, 2004 (asrestated) and December 31, 2003 (as restated);

·   Consolidated Statements of Cash Flows foreach of the three years ended December 31, 2005, December 31, 2004 (asrestated) and December 31, 2003 (as restated);

·   Consolidated Statements of Shareholders’Equity for each of the three years ended December 31, 2005, December 31, 2004(as restated) and December 31, 2003 (as restated); and

·   Notes toConsolidated Financial Statements.

(b)   See Exhibit Index that follows.

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**ExhibitIndex**
| 2.1   |   | Merger Agreement by and among Merge Technologies  Incorporated, RL Acquisition Corp., RIS Logic Incorporated and  the Principal Shareholders of RIS Logic Incorporated dated July 9,  2003.(6)                                                                                                                                 |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.2   |   | Merger Agreement by and between Merge  Technologies Incorporated, AccuImage Diagnostics Corp.,  ADI Acquisition Corp. and the Principal Shareholder of AccuImage  Diagnostics Corp. dated November 24, 2004.(8)                                                                                                           |
| 2.3   |   | Merger Agreement by and between Merge Technologies Incorporated,  Cedara Software Corp. and Corrida, Ltd. dated January 17,  2005.(9)                                                                                                                                                                                               |
| 3.1   |   | Articles of Incorporation of Registrant,(2) Articles  of Amendment as filed on December 28, 1998,(3) Articles of Amendment as  filed on September 2, 1999,(4) Articles of Amendment as filed on  February 23, 2001,(4) Articles of Amendment as filed on August 9,  2002(7) and Articles of Amendment as filed on May 27, 2005.(11) |
| 3.2   |   | Amended and Restated Bylaws of Registrant.(1)                                                                                                                                                                                                                                                                                                           |
| 10.1  |   | Employment Agreement entered into as of  March 1, 2004, between Registrant and Richard A. Linden.(7)*                                                                                                                                                                                                                                         |
| 10.2  |   | Employment Agreement entered into as of  March 1, 2004, between Registrant and William C. Mortimore.(7)*                                                                                                                                                                                                                                      |
| 10.3  |   | Employment Agreement entered into as of  March 1, 2004, between Registrant and Scott T. Veech.(7) *                                                                                                                                                                                                                                           |
| 10.4  |   | Letter Agreement dated May 12, 2006, between  Registrant and Scott T. Veech.(15)*                                                                                                                                                                                                                                                                       |
| 10.5  |   | Employment Agreement entered into as of April 1,  2006, between Registrant and David M. Noshay.(14)*                                                                                                                                                                                                                                               |
| 10.6  |   | Employment Agreement entered into as of April 1,  2006, between Registrant and Robert J. White.(14)*                                                                                                                                                                                                                                                    |
| 10.7  |   | Key Officer Agreement entered into as of October 12,  2005, by and between Registrant and Steven M. Oreskovich.*                                                                                                                                                                                                                                        |
| 10.8  |   | Letter Agreement dated July 2, 2006 by and between  Registrant and Steven M. Oreskovich.(16)*                                                                                                                                                                                                                                                           |
| 10.9  |   | 1996 Stock Option Plan for Employees of Registrant  dated May 13, 1996,(2) as amended and restated in its entirety as of  September 1, 2003.(5)*                                                                                                                                                                                              |
| 10.10 |   | 1998 Stock Option Plan For Directors.(1)*                                                                                                                                                                                                                                                                                                               |
| 10.11 |   | 2003 Stock Option Plan of Registrant dated  June 24, 2003, and effective July 17, 2003.(5)*                                                                                                                                                                                                                                                   |
| 10.12 |   | Loan Agreement dated as of November 21, 2003,  by and between Registrant and Lincoln State Bank,(7) First Amendment to  Credit Agreement dated as of September 27, 2005, by and between Registrant  and Lincoln State Bank.(12)                                                                                                                    |
| 10.13 |   | 2005 Equity Incentive Plan adopted March 4, 2005,  and effective May 24, 2005.(10)*                                                                                                                                                                                                                                                                     |
| 10.14 |   | Termination Agreement between Cedara Software Corp.,  Abe Schwartz and Merge Technologies Incorporated dated June 1, 2005.(13)*                                                                                                                                                                                                                         |
| 10.15 |   | Form of Non-Qualified Stock Option Agreement under  Registrant’s 2005 Equity Incentive Plan.*                                                                                                                                                                                                                                                      |
| 10.16 |   | Form of Employee Incentive Stock Option Agreement  under Registrant’s 2005 Equity Incentive Plan.*                                                                                                                                                                                                                                                 |
| 10.17 |   | Form of Director Non-Qualified Stock Option  Agreement under Registrant’s 2005 Equity Incentive Plan.*                                                                                                                                                                                                                                             |
| 14.1  |   | Code of Ethics.(7)                                                                                                                                                                                                                                                                                                                                      |
| 14.2  |   | Whistleblower Policy.(7)                                                                                                                                                                                                                                                                                                                                |
| 21    |   | Subsidiaries of Registrant.                                                                                                                                                                                                                                                                                                                             |
| 23.1  |   | Consent of KPMG LLP.                                                                                                                                                                                                                                                                                                                                    |
| 31.1  |   | Certification of Chairman of the Board (principal  executive officer) Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934.                                                                                                                                                                                                       |

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| 31.2 |   | Certification of Chief Accounting Officer (principal  accounting officer) Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934.                                                                                                                      |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 32   |   | Certification of Chairman of the Board (principal  executive officer) and Chief Accounting 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.                                                                                                                                                                                                                              |

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  (1) Incorporated by reference from Annual Report on Form 10-KSB forthe fiscal year ended December 31, 1997.

  (2) Incorporatedby reference from Registration Statement on Form SB-2 (No. 333-39111)effective January 29, 1998.

  (3) Incorporatedby reference from Quarterly Report on Form 10-QSB for the three monthsended March 31, 1999.

  (4) Incorporatedby reference from Annual Report on Form 10-KSB for the fiscal year ended December 31,2000.

  (5) Incorporatedby reference from Quarterly Report on Form 10-Q for the three months endedSeptember 30, 2003.

  (6) Incorporatedby reference from Current Report on Form 8-K dated July 17, 2003.

  (7) Incorporatedby reference from Annual Report on Form 10-K for the fiscal year endedDecember 31, 2003.

  (8) Incorporatedby reference from Current Report on Form 8-K dated November 24, 2004.

  (9) Incorporatedby reference from Current Report on Form 8-K dated January 18, 2005.

 (10) Incorporatedby reference from Registration Statement on Form S-8 (No. 333-125386) effectiveJune 1, 2005.

 (11) Incorporatedby reference from Current Report on Form 8-K dated June 7, 2005.

 (12) Incorporatedby reference from Current Report on Form 8-K dated September 28, 2005.

 (13) Incorporatedby reference from Quarterly Report on Form 10-Q for the six months endedJune 30, 2005

 (14) Incorporatedby reference from Current Report on Form 8-K dated April 1, 2006.

 (15) Incorporatedby reference from Current Report on Form 8-K dated May 12, 2006.

 (16) Incorporatedby reference from Current Report on Form 8-K dated June 29, 2006.

      * Management contract, or compensatory plan, orarrangement, required to be filed as an exhibit to this Annual Report on Form10-K.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|                       | **MERGE TECHNOLOGIES INCORPORATED** |
|-----------------------|-------------------------------------|
| Date: August 29, 2006 | By:                                 | /s/ MICHAEL D. DUNHAM |   |
|                  |                                | Michael D. Dunham |
|                  |                                | *Chairman of the Board  (principal executive officer)* |

 

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**SIGNATURES**

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.
| By:      | /s/ MICHAEL D. DUNHAM                                   |     | By:      | /s/ STEVEN M.  ORESKOVICH                                            |
|----------|---------------------------------------------------------|----------|----------|----------------------------------------------------------------------|
|     | Michael D. Dunham                                       |     |     | Steven M. Oreskovich                                                 |
| * * | *Chairman  of the Board  (principal executive officer)* | * * |     | *Chief Accounting Officer, interim Secretary  and interim Treasurer* |
| * * | * *                                                | * * | * * | *(principal financial officer and principal  accounting officer)*    |
|     |                                                    |     |     |                                                                 |
| Date:    | August 29, 2006                                         |     | Date:    | August 29, 2006                                                      |
|     |                                                    |     |     |                                                                 |
| By:      | /s/ DENNIS BROWN                                        |     | By:      | /s/ ROBERT A.  BARISH, M. D                                     |
|     | Dennis Brown                                            |     |     | Robert A. Barish, M. D.                                         |
| * * | *Director*                                              | * * | * * | *Director*                                                           |
| * * | * *                                                | * * | * * | * *                                                             |
| Date:    | August 29, 2006                                         |     | Date:    | August 29, 2006                                                      |
|     |                                                    |     |     |                                                                 |
| By:      | /s/ ANNA MARIE HAJEK                                    |     | By:      | /s/ ROBERT T.  GERAS                                                 |
|     | Anna Marie Hajek                                        |     |     | Robert T. Geras                                                      |
| * * | *Director*                                              | * * | * * | *Director*                                                           |
|     |                                                    |     |     |                                                                 |
| Date:    | August 29, 2006                                         |     | Date:    | August 29, 2006                                                      |
|     |                                                    |     |     |                                                                 |
| By:      | /s/ RAMAMRITHAM RAMKUMAR                                |     | By:      | /s/ R. IAN  LENNOX                                                   |
|     | Ramamritham  Ramkumar                                   |     |     | R. Ian Lennox                                                        |
| * * | *Director*                                              | * * | * * | *Director*                                                           |
|     |                                                    |     |     |                                                                 |
| Date:    | August 29, 2006                                         |     | Date:    | August 29, 2006                                                      |
| * * | * *                                                | * * | * * | * *                                                             |
|     |                                                    |     | By:      | /s/ RICHARD A.  RECK                                                 |
|     |                                                    |     |     | Richard A. Reck                                                      |
| * * | * *                                                | * * | * * | *Director*                                                           |
|     |                                                    |     |     |                                                                 |
|     |                                                    |     | Date:    | August 29, 2006                                                      |

 

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