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


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

|                                                             |                                                                                          
|------------------------------------------------------------ | -----------------------------------------------------------------------------------------
|x                                                            | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934    
|                                                            
|For
 the fiscal year ended December 31, 2010                
|                                                            
|OR                                                          
|                                                            
|o                                                            | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934
|                                                            
|For
 the transition period from ____________ to ____________
|                                                            
|Commission
 file number: 0-26056                            

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

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

|                                                                                   
|-----------------------------------------------------------------------------------
|(651) 603-7700                                                                     
|(Registrants
 telephone number, including area code)                              
|                                                                                   
|Not applicable.                                                                    
|(Former
 name, former address and former fiscal year, if changed since last report)
|                                                                                   
|Securities
 registered pursuant to Section 12(b) of the Act:                       

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

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

Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.      Yes o No x

Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.      Yes o No x

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

Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the
preceding 12 months (or for such shorter period that the registrant was
required to submit and post such files).      Yes o No o

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

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

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

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

As
of June 30, 2010, the aggregate market value of the registrants common stock
held by non-affiliates of the registrant was $44,962,906 based on the closing
sale price as reported on The NASDAQ Capital Market. The number of shares
outstanding of the registrants $0.01 par value common stock as of February 28,
2011 was 4,880,619 shares.

DOCUMENTS INCORPORATED BY REFERENCE

|                                                                               |  |                              
|------------------------------------------------------------------------------ |  | -----------------------------
|Document                                                                       |  | Parts Into Which Incorporated
|                                                                               |  |                              
|                                                                              
|Proxy Statement for the
 2011 Annual Meeting of Shareholders (Proxy Statement) |  | Part III                     

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TABLE OF CONTENTS

|           |                                                                                                                |  |   
|---------- | -------------------------------------------------------------------------------------------------------------- |  | --
|PART I     |                                                                                                                |  |   
|           |                                                                                                                |  |   
|Item 1.    | Business                                                                                                       |  | 2 
|           |                                                                                                                |  |   
|Item 1A.   | Risk Factors                                                                                                   |  | 9 
|           |                                                                                                                |  |   
|Item 1B.   | Unresolved
 Staff Comments                                                                                     |  | 15
|           |                                                                                                                |  |   
|Item 2.    | Properties                                                                                                     |  | 15
|           |                                                                                                                |  |   
|Item 3.    | Legal
 Proceedings                                                                                             |  | 16
|           |                                                                                                                |  |   
|Item 4.    | [Removed and
 Reserved]                                                                                        |  | 16
|           |                                                                                                                |  |   
|PART II    |                                                                                                                |  |   
|           |                                                                                                                |  |   
|Item 5.    | Market for
 Registrants Common Equity, Related Stockholder Matters and Issuer Purchases
 of Equity Securities |  | 17
|           |                                                                                                                |  |   
|Item 6.    | Selected
 Financial Data                                                                                       |  | 19
|           |                                                                                                                |  |   
|Item 7.    | Managements
 Discussion and Analysis of Financial Condition and Results of Operations                         |  | 20
|           |                                                                                                                |  |   
|Item 7A.   | Quantitative
 and Qualitative Disclosures About Market Risks                                                   |  | 26
|           |                                                                                                                |  |   
|Item 8.    | Financial
 Statements and Supplementary Data                                                                   |  | 27
|           |                                                                                                                |  |   
|Item 9.    | Changes in and
 Disagreements with Accountants on Accounting and Financial Disclosure                          |  | 43
|           |                                                                                                                |  |   
|Item 9A.   | Controls and
 Procedures                                                                                       |  | 43
|           |                                                                                                                |  |   
|Item 9B.   | Other
 Information                                                                                             |  | 43
|           |                                                                                                                |  |   
|PART III   |                                                                                                                |  |   
|           |                                                                                                                |  |   
|Item 10.   | Directors,
 Executive Officers and Corporate Governance                                                        |  | 44
|           |                                                                                                                |  |   
|Item 11.   | Executive
 Compensation                                                                                        |  | 44
|           |                                                                                                                |  |   
|Item 12.   | Security
 Ownership of Certain Beneficial Owners and Management and Related Stockholder
 Matters               |  | 44
|           |                                                                                                                |  |   
|Item 13.   | Certain
 Relationships and Related Transactions, and Director Independence                                     |  | 44
|           |                                                                                                                |  |   
|Item 14.   | Principal
 Accounting Fees and Services                                                                        |  | 44
|           |                                                                                                                |  |   
|PART IV    |                                                                                                                |  |   
|           |                                                                                                                |  |   
|Item 15.   | Exhibits and
 Financial Statement Schedules                                                                    |  | 45
|           |                                                                                                                |  |   
|Signatures |                                                                                                                |  | 48

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Table of Contents

PART I

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|------- | --------
|Item 1. | Business

Business

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

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

CED
is a process in which software rather than humans examines outputs from various
types of sophisticated sensors to determine what is happening in a field of
view. In the ITS industry, CED is a critical component of managing congestion
and traffic flow. In many markets, it is not possible to build roads, bridges
and highways quickly enough to accommodate increasing automobile ownership. For
example, in 2007 there were approximately 3.0 million vehicles in Moscow, and
the number of vehicles is expected to increase by 50% to 4.5 million vehicles
by 2012. In China, 13.8 million vehicles were introduced in 2010, up from the
9.4 million vehicles introduced in 2008. This is expected to rise to 19.0
million in 2011. We believe this growing use of vehicles worldwide will make
CED-based ITS solutions increasingly necessary to complement existing and new
roadway infrastructure to manage traffic flow and optimize throughput.

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

We
believe the strength of our distribution channels positions us to increase the
penetration of our technology-driven solutions in the marketplace. We market
our Autoscope products in North America, the Caribbean and Latin America
through an exclusive agreement with Econolite Control Products, Inc., or Econolite,
which we believe is the leading distributor of ITS intersection control
products in North America and the Caribbean. We market our Autoscope products
outside of North America, the Caribbean and Latin America and our RTMS and
CitySync products through a combination of distribution and direct sales
channels, including our wholly-owned subsidiaries in Hong Kong, Poland and the
United Kingdom. Our end users primarily include governmental agencies and
municipalities, and, as of December 31, 2010, we had sold over 120,000 units in
more than 60 countries.

In
June 2010, we purchased all of the outstanding equity of CitySync Limited, or
CitySync. CitySync was a privately-held, European-based developer and marketer
of automatic number plate recognition, or ANPR, products and solutions. In
December 2007, we completed our purchase of certain assets of EIS Electronic
Integrated Systems, Inc., or EIS. EIS was a leading provider of radar-based
detection solutions. In addition to the increased scale we gain through these
transactions, the addition of EIS and CitySyncs products and operations
expands our addressable markets and selling presence, enables us to provide a
wider array of CED products to our end user, and supports the introduction of
hybrid product offerings to help drive market demand.

Industry
Overview

The Intelligent Transportation Systems Market.
The market for ITS is large and growing. According to a September 2010 report
by Global Industry Analysts, Inc., total ITS sales in the United States and
Europe for 2009 were approximately $4.2 billion and $3.4 billion, respectively,
and total global ITS sales were approximately $10.8 billion. Global Industry
Analysts expects total global ITS sales to reach $18.6 billion by the end of
2015, representing a compound annual growth rate of 10.0% for the period from
2007 to 2015.

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

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In
traffic management applications, CED products are used for automated vehicle
detection and are a primary data source upon which ITS solutions are built.
Traditionally, automated vehicle detection is performed using inductive wire
loops buried in the pavement. However, in-pavement loop detectors are costly to
install, difficult to maintain, expensive to repair and not capable of
wide-area vehicle detection without installations of multiple loops nor
recognizing license plate numbers.

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

We
believe our Autoscope and RTMS products are competitive with and can take
market share from in-pavement loop detectors. Based on our determination, the
U.S. ITS above ground detection market sales in 2010 were approximately $160
million and were growing on average approximately 15% per year until the
recession of 2009. We also have determined that the market in 2009 and 2010 was
flat or slightly down from 2008 levels as governments in North America and
Europe faced budgetary constraints. We believe that we are the leader in the
U.S. above ground detection market in terms of unit sales, and we estimate that
U.S. sales of the in-pavement loop detectors our Autoscope and RTMS products
can supplant were approximately $300 million in 2010.

Our
CitySync solutions add further to our offerings in ITS. In many ITS
applications, such as tolling or journey time measurement, it is critical to
ascertain the identity of the vehicle or to be able to uniquely identify a
vehicle at a different time or location. ANPR is among the most widely used
methods for these applications.

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

Proliferation
of Traffic.In many countries, there has been a surge in the
number of vehicles on roadways. Due to the growth of emerging economies and
elevated standards of living, more people desire and are able to afford
automobiles. For example, in China, 13.8 million vehicles were introduced in
2010, up from the 9.4 million vehicles introduced in 2008. This is expected to
rise to 19.0 million in 2011. The number of vehicles utilizing the worlds
roadway infrastructure is growing at a quicker pace than new roads, bridges and
highways are being constructed. The population of the United States has grown
by about 30%, or 70 million, from 1982 to 2007, while highway miles have
increased by approximately 5% in the same period. Between 1970 and 2005, the
number of registered highway vehicles in the U.S. increased from 111 million to
247 million. Overall, the growth in roadway infrastructure is failing to match
the surge in the number of vehicles using it. CED-based traffic management and
control systems attempt to solve the problem by monitoring high traffic areas
and analyzing data that can be used to mitigate traffic problems.

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

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

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

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

The non- ITS Automatic Number Plate Recognition Market.
In addition to ITS, ANPR is widely used for applications in security, police and
parking, among others. We believe the sum of these markets is significant and
currently is in excess of $200 million for their ANPR components. We also
believe the competitive landscape is fragmented, with no dominant market share
for any one competitor.

Security.
ANPR is used in security applications world-wide for border-crossings, airports
and venues such as convention centers or sports arenas. Additionally, private
industry uses ANPR to help control entrances at high value locations, such as
power plants. Homeland security and counter-terrorism activities benefit from
ANPR as part of the solution.

Police.Law enforcement has adopted ANPR for a variety of
applications. Police may use ANPR to gather information on a stopped vehicle in
a faster, automated fashion. ANPR can scan for vehicles of interest from a
fixed position or from a moving police vehicle, looking for stolen cars or for
automobiles of individuals with arrest warrants outstanding. Also, ANPR is
regularly used as a component of red light, speed and bus lane enforcement
systems.

Parking.
Both public and private parking facilities have recently undergone a
significant period of automation where human attendants have been replaced by
machines that control access. ANPR is employed in numerous parking functions
including automatic entrance/exit, open spot locator assistance, lost vehicle
location, theft-avoidance and related security aspects.

Solutions
for Adjacent Markets.
We believe that the adjacent markets of ITS, security/surveillance and
environmental management are converging, and that this convergence will
accelerate as CED systems become more cost-effective when a single CED unit can
be used for multiple purposes. Because the CED technologies involved are
closely related, our CED technology can be adapted to or is already capable of
addressing these adjacent markets.

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

Our
Competitive Strengths

We
are a leading provider of software-based CED products and solutions for the ITS
industry and related security and law enforcement markets. We have the
following competitive strengths that we expect will continue to enhance our
leadership position:

Leading Proprietary Technologies.
Over the last two decades, we have developed or acquired a proprietary
portfolio of complex software algorithms and applications that we have
continuously enhanced and refined. These algorithms, which include our advanced
signal processing technologies, allow our video and radar detection products to
capture and analyze objects in diverse weather and lighting conditions and to
balance the accuracy of positive detection and the avoidance of false detections.
Due to the strength of our proprietary technologies, we believe we command
premium pricing. CED technologies similar to ours are also difficult to develop
and refine in a commercially viable manner. We therefore should be well
positioned to quickly introduce next-generation products to market.

Proven Ability to Develop, Enhance and Market New
Products. We are continually developing and
enhancing our product offerings. Over the last two decades, we have
demonstrated our ability to lead the market with new products and product
enhancements. For example, the Autoscope Solo system was the first fully
integrated color camera, zoom lens and machine vision processor in the above
ground detection market. EIS was one of the first companies to introduce
radar-based technology solutions for ITS applications, and it has continued to
lead the market with technology enhancements and new products, such as RTMS.

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Additionally, the CitySync system was the first in the
ANPR market to capture multiple license plates in the same lane with a standard
configuration. We have successfully collaborated with our long-term channel
partners to market these new products. We believe that developing, enhancing
and marketing new products with our partners translates into strong organic
revenue growth and high levels of profitability.

Leading
Distribution Channel.
We have maintained a relationship with Econolite for the distribution of our
Autoscope products in North America and the Caribbean since 1991 and in Latin
America since 2002. We believe that Econolite is the leading distributor of ITS
control products in North America and the Caribbean. In our view, this
relationship enhances our ability to commercialize and market new products and
allows us to focus more resources on developing advanced signal processing
software algorithms.

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

Experienced
Management Team and Engineering Staff. Our management
team and engineering staff are highly experienced in the ITS and software
industries. Additionally, the continuity of our engineering staff should allow
us to continuously develop new or improved products.

Strong
Financial Performance. Prior to the recession in 2009, we
had profitably grown our revenue organically at an average double-digit
compound annual growth rate over the six year period from 2003 through 2008. As
of December 31, 2010, we had $46.0 million in shareholders equity. We believe
our financial performance and strength gives us the ability to take advantage
of favorable market trends without the restrictions that often handicap other
technology companies similar to us in size.

Our
Growth Strategy

As
part of our growth strategy, we seek to:

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

Expand
Success in ANPR Markets.Prior to our acquisition of CitySync in June 2010, it had an annual revenue run
rate in excess of $7.0 million and had 10 years of experience in ANPR. We
believe that the ANPR market is poised for growth at a higher rate than the ITS
market. Further, we believe that our financial strength, distribution channels
and customer base will add to our ability to grow CitySync related revenue. We
believe these synergies could lead to above average revenue growth.

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

Increase
the Scope of Our Distribution and Direct Sales. We have made substantial investments in
product adjustments to tailor our solutions to the differing needs of our
international end users and in new product acquisitions for both domestic and
international markets. We have also invested in sales and marketing expansion,
with a focus on our European and Asian subsidiaries. The addition of CitySync
brought further critical mass to our European organization. Markets in Eastern
Europe, the Asia/Pacific region, the Middle East, Africa and South America,
which have historically lagged North America and Western Europe in their use of
CED, have recently begun to increase the adoption of CED in their traffic,
security/surveillance and environmental management systems. We intend to
continue to refine our product offerings through engineering development and
technology licensing to take advantage of the accelerated pace of the adoption
of CED throughout the developing world.

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Our
Products and Solutions

Our
vehicle and traffic detection products are critical components of many ITS and
adjacent security and law enforcement applications. Our Autoscope video systems
and RTMS radar systems convert sensory input collected by video cameras and radar
units into vehicle detection and traffic data used to
operate, monitor and improve the efficiency of roadway infrastructure. Our
CitySync systems use video sensors in the visible and infrared spectrums to
read license or number plates for tolling, traffic data, security, police and
parking applications. At the core of each product line are proprietary digital
signal processing algorithms and sophisticated embedded software that analyze
sensory input and deliver actionable data to integrated applications. We
invested approximately $3.6 million, $3.3 million and $2.9 million on research
and development in 2010, 2009 and 2008, respectively, to develop and enhance
our product technology. Our digital signal processing software algorithms
represent a foundation on which support for additional sensory inputs such as
acoustic, chemical, smoke, weather and vibration sensors may be added in the
future. A diagram displaying our fundamental product architecture is shown
below.

The Image Sensing Product Architecture

(FLOW CHART)

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

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

The Terra platform comes in two varieties. Autoscope
Solo Terra is our integrated color zoom camera and machine vision processing
computer contained in one compact housing unit that is our leading Autoscope
offering in the North American market. Autoscope RackVision is our card only
machine vision processing computer that is located in an intersection signal
controller, control hub, incident management center or traffic management
center that receives video from a separate camera. The RackVision and its
variants are our top selling Autoscope products in international markets.

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

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

CitySync.
Our CitySync systems process video information gathered from the visible and
infrared spectrum to perform ANPR for ITS, security, police and parking
applications. Data is transmitted to other integrated systems or stored in
onboard vehicle systems for later processing. Data can be processed to assist
in traffic and parking management, tolling applications, real-time law
enforcement and traffic alerts and stored for later analysis for traffic,
security and commercial purposes.

At
the core of each CitySync system is the JetBase software suite which runs the
ANPR algorithms and related processes including communications. JetBase
operates with both non-proprietary and proprietary cameras. We offer a range of
proprietary analog, high definition and intelligent cameras for both fixed and
mobile systems.

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

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

Distribution,
Sales and Marketing

We
market and sell our products globally. As of December 31, 2010, we had supplied
systems for more than 120,000 units in more than 60 countries. Together with
our partners, we offer a combination of high-performance CED technology and
experienced local support. Our end users primarily consist of federal, state,
city and county departments of transportation, port, highway, tunnel, toll and
other transportation authorities, law enforcement agencies and parking facility
operators. The decision-makers within these entities typically are traffic
planners and engineers, who in turn often rely on consulting firms that perform
planning and feasibility studies. Our products sometimes are sold directly to
system integrators or other suppliers of systems and services who are operating
under subcontracts in connection with major road construction contracts.

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

RTMS and CitySync North American, Caribbean and Latin
American Sales.We market the RTMS and CitySync
systems to a network of distributors covering countries in North America, the
Caribbean and Latin America. On a limited basis, we sell directly to the
end-user. We provide technical support to these distributors from our various
North American locations.

European and Asian Sales.We
market Autoscope, RTMS and CitySync to a network of distributors covering
countries in Europe, the Middle East, Africa and Asia through our wholly-owned
subsidiaries that have offices in Hong Kong, Poland and the United Kingdom. On
a limited a basis, we sell directly to the end-user. Technical support to these
distributors is provided by our wholly-owned subsidiaries in Europe and Asia,
with second-tier support provided by our engineering groups.

Competition

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

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Among
the companies that provide direct competition to Autoscope worldwide are
Traficon N.V., Signal Group Inc. (Semex), Iteris, Inc. and Citilog S.A. Among
the companies that provide direct competition to RTMS worldwide are Wavetronix,
LLC, MS Sedco Inc. and Xtralis, LLC. Among the companies that provide direct
competition to CitySync worldwide are Federal Signal Corporation (PIPS),
Perceptics LLC, Genetec Inc., Elsag Datamat S.p.a. All of these companies have
working installations of their video or radar systems in the U.S. and other
parts of the world. To our knowledge, Autoscope and RTMS have the largest
number of installations as compared to their direct competitors. In addition,
there are smaller local companies providing direct competition in specific
markets throughout the world. We are aware that these and other companies will
continue to develop technologies for use in traffic management, security,
police and parking applications. One or more of these technologies could in the
future provide increased competition for our systems.

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

Manufacturing

Autoscope
products for sale under the Econolite license agreement are manufactured
through agreements with Econolite and Wireless Technology, Inc. In 1991, we
appointed Econolite as our exclusive licensee to manufacture and sell the Autoscope
system and related technology and to sell the products in North America and the
Caribbean. Econolite is responsible for setting warranty terms and must provide
all service required under this warranty. In Europe and Asia, we engage
contract manufacturers to manufacture the Autoscope family of products.

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

CitySync
products are manufactured through contract manufacturers in the United Kingdom
and the United States.

We
typically provide a two-year warranty on our products.

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

Intellectual
Property

To
protect our rights to our proprietary know-how, technology and other intellectual
property, it is our policy to require all employees and consultants to sign
confidentiality agreements that prohibit the disclosure of confidential
information to any third parties. These agreements also require disclosure and
assignment to us of any discoveries and inventions made by employees and
consultants while they are devoted to our business activities. We also rely on
trade secret, copyright and trademark laws to protect our intellectual
property.

We
intend to protect our intellectual property assets and will actively seek, when
appropriate, protection for owned or licensed products and proprietary
information by means of U.S. and international copyrights, trademarks, patents
and contractual arrangements. We have registered trademark rights to
Autoscope and RTMS in the U.S. and in the European Union (E.U.). We have
further registered Autoscope in Canada and 10 Asian-Pacific Rim countries,
including China, while RTMS is pending registration in several additional
countries. CitySync and Jet trademark designs are registered in the U.S.
and E.U. We have other product trademarks that we have chosen not to register,
but we aggressively monitor and protect their use in the market. Our patent
portfolio includes six patents on RTMS technology which are registered in the
U.S. and select E.U. countries, one CitySync ANPR patent registered in the U.K.
and two CitySync patent applications pending in the U.S. and the E.U.

Employees

As
of February 28, 2011, we had 123 employees, consisting of 73 employees in North
America, 36 employees in Europe and 14 employees in Asia. None of our employees
is represented by a union. We believe our employee relations are good.

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

Information Regarding Forward-Looking Statements

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

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

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

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

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

Historically,
a majority of our gross profit has been generated from sales of, or royalties
from the sales of, Autoscope products. Gross profit from Autoscope sales
accounted for approximately 63% of our gross profit in 2010, 73% in 2009 and
76% in 2008. We anticipate that gross profit from the sale of Autoscope systems
will continue to account for a substantial portion of our gross profit for the
foreseeable future. As such, any significant decline in sales of our Autoscope
system would have a material adverse impact on our business, financial
condition and results of operations.

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

We
have an agreement with Econolite under which Econolite is the exclusive
distributor of the Autoscope system in North America, the Caribbean and Latin
America. The agreement grants Econolite a first refusal right that arises when
we make a proposal to Econolite to extend the license to additional products in
North America, the Caribbean and Latin America. In addition, the agreement
grants Econolite a first negotiation right that arises when we make a proposal
to Econolite to include rights corresponding to Econolites rights under our
current agreement in countries not in these territories. In exchange for its
rights under the agreement, Econolite pays us royalties for sales of the
Autoscope system. Since 2002, a substantial portion of our revenue has
consisted of royalties resulting from sales made by Econolite, including 40% in
2010, 49% in 2009 and 50% in 2008. Econolites account receivable represented
25% of our accounts receivable at December 31, 2010 and 39% of our accounts
receivable at December 31, 2009. We expect that Econolite will continue to
account for a significant portion of our revenue for the foreseeable future.
Any decrease in Econolites sales volume could significantly reduce our royalty
revenue and adversely impact earnings. A failure by Econolite to make royalty
payments to us in a timely manner or at all will harm our financial condition.
In addition, we believe sales of our products are a material part of
Econolites business, and any significant decrease in Econolites sales of the
other products it sells could harm Econolite, which could have a material
adverse effect on our business and prospects.

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

Video
and radar technologies have not been utilized in the traffic management
industry as extensively as other more traditional technologies, mainly
in-pavement loop detectors. Our financial success and growth prospects depend
on the continued development of the market for advanced technology solutions
for traffic detection and management and the acceptance of our current
Autoscope, RTMS and CitySync systems and also future systems we may develop as
reliable, cost-effective alternatives to traditional vehicle detection systems.
We cannot assure you that we will be able to utilize our technology profitably
in other products or markets. If our end users do not continue to increase
their acceptance of the features and functions provided by our current systems
or hybrid or other systems we may develop in the future, our business and
growth prospects could be adversely affected.

Existing and future laws, regulations and constitutional
provisions protecting privacy rights could delay the acceptance and sale of our
video and ANPR products and systems and have a negative effect on our financial
condition and results of operations.

The
use of video and ANPR products and systems has been challenged and limited
under existing laws, regulations and constitutional provisions protecting
privacy rights. For example, both Maine and New Hampshire have laws limiting
the use of ANPR systems. In addition, laws, regulations and constitutional
provisions may be adopted in the future to limit the use of video and ANPR
products and systems. These existing and new laws, regulations and
constitutional provisions could negatively affect the acceptance and sale of
our video and ANPR products and systems and thus have a negative effect on our
financial condition and results of operations.

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

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

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

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

Additionally,
the market for vehicle detection and ANPR is continuously seeking more advanced
technological solutions to problems. Technologies such as embedded loop
detectors, pressure plates, pneumatic tubes, radars, lasers, magnetometers,
acoustics and microwaves that have been used as traffic sensing devices in the
past are being enhanced for use in the traffic management industry, and new
technologies may be developed. We are aware of several companies that are
developing traffic management devices using machine vision technology or other
advanced technology. Floating vehicle and/or radio frequency identification
(RFID) tagged license plate initiatives are under consideration and may be
implemented. We expect to face increasingly competitive product developments,
applications and enhancements. New technologies or applications in traffic
control systems from other companies may provide our end users with
alternatives to our products and could render our solutions noncompetitive or
obsolete. If we are unable to increase the number of our applications and
develop and commercialize product enhancements and applications in a timely
manner that respond to changing technology and satisfy the needs of our end
users, our business and financial results will suffer.

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

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

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

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

Some of our products are covered by our
warranties, and, if the cost of fulfilling these warranties exceeds our
warranty allowance, it could adversely affect our financial condition and results
of operations.

Unanticipated
warranty and other costs for defective products could adversely affect our
financial condition and results of operations and our reputation.We generally provide a two-year
warranty on our product sales. These warranties require us to repair or replace
faulty products, among other customary warranty provisions. Although we monitor
our warranty claims and provide an allowance for estimated warranty costs,
unanticipated claims in excess of the allowance could have a material adverse
impact on our financial condition and results of operations. In addition, the
need to repair or replace products with design or manufacturing defects could
adversely affect our reputation.

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

Our
success depends in large measure on the protection of our proprietary
technology rights. We rely on trade secret, copyright and trademark laws, and
confidentiality agreements with employees and third parties, all of which offer
only limited protection. We have six patents related to RTMS technology and one
patent related to CitySync technology. However, we cannot assure you that the
scope of these or any future patents relating to our products will exclude
competitors or provide competitive advantages to us. We also cannot assure you
that we will become aware of all instances in which others develop similar
products, duplicate any of our products, or reverse engineer or misappropriate
our proprietary technology. If our proprietary technology is misappropriated,
our business and financial results could be adversely affected. Litigation may
be necessary in the future to enforce our intellectual property rights, to
protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. In addition, we may be the subject of lawsuits by
others who claim we violate their intellectual property rights. Even if the
result is favorable, litigation could result in substantial costs and the
diversion of management resources, either of which could harm our business.

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

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

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

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

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

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

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

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

Within
our product families, we currently utilize only certain detection technologies
available in the ITS field. If we fail to predict convergence of technology
preferences in the market for ITS, or fail to identify and acquire
complementary businesses or products that broaden our current product
offerings, we may not capture certain segments of the market, which could harm
our business and reduce our sales.

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

During
2010, 2009 and 2008, 37%, 25% and 28% of our total revenue, respectively, was
attributable to international sales. By doing business in international
markets, we are exposed to risks separate and distinct from those we face in
our U.S. operations. Our international business may be adversely affected by
changing economic conditions in foreign countries. Additionally fluctuations in
currency exchange rates could affect demand for our products or otherwise
negatively affect profitability. Engaging in international business inherently
involves a number of other difficulties and risks, including:

| |   |                                                                                                
| | - | -----------------------------------------------------------------------------------------------
| |  | export restrictions and
 controls relating to technology;                                      
|
| |  | pricing pressure that we
 may experience internationally;                                      
|
| |  | required compliance with
 existing and new foreign regulatory requirements and laws;           
|
| |  | laws and business practices
 favoring local companies;                                         
|
| |  | longer payment cycles;                                                                         
|
| |  | difficulties in enforcing
 agreements and collecting receivables through foreign legal systems;
|
| |  | political and economic
 instability;                                                           
|
| |  | potentially adverse tax
 consequences, tariffs and other trade barriers;                       
|
| |  | international terrorism and
 anti-American sentiment;                                          
|
| |  | difficulties and costs of
 staffing and managing foreign operations; and                       
|
| |  | difficulties in enforcing
 intellectual property rights.                                       

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Our
exposure to each of these risks may increase our costs, lengthen our sales
cycle and require significant management attention. One or more of these
factors may harm our business.

Our inability to comply with European and
Asian regulatory restrictions over hazardous substances and electronic waste
could restrict product sales in those markets and reduce profitability in the
future.

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

Our inability to manage growth effectively
could seriously harm our business.

Growth
and expansion of our business could significantly strain our capital resources
as well as the time and abilities of our management personnel. Our ability to
manage growth effectively will require continued improvement of our
operational, financial and management systems and the successful training,
motivation and management of our employees. If we are unable to manage growth
successfully, our business and operating results will suffer.

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

Our
technology depends upon the knowledge, experience and skills of our key
management and scientific and technical personnel. Additionally, our ability to
continue technological developments and to market our products, and thereby
develop a competitive edge in the marketplace, depends in large part on our
ability to attract and retain qualified scientific and technical personnel.
Competition for qualified personnel is intense, and we cannot assure you that
we will be able to attract and retain the individuals we need, especially if
our business expands and requires us to employ additional personnel. In
addition, the loss of personnel or our failure to hire additional personnel
could materially and adversely affect our business, operating results and
ability to expand. The loss of key personnel, including Kenneth R. Aubrey, our
President and Chief Executive Officer, or our inability to hire and retain
qualified personnel, would harm our business.

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

Our
common stock is thinly traded, with 3,468,301 shares of our 4,880,619
outstanding shares held by non-affiliates as of February 28, 2011.
Based on the trading history of our common stock and the nature of the market
for publicly traded securities of companies in evolving high-tech industries,
we believe there are several factors that have caused and are likely to
continue to cause the market price of our common stock to fluctuate
substantially. The fluctuations may occur on a day-to-day basis or over a longer
period of time. Factors that may cause fluctuations in our stock price include
announcements of large orders obtained by us or our competitors, substantial
cutbacks in government funding of highway projects or of the potential
availability of alternative technologies for use in traffic control and safety,
quarterly fluctuations in our financial results or the financial results of our
competitors, consolidation among our competitors, fluctuations in stock market
prices and volumes, and the volatility of the stock market.

We may not be successful in integrating
acquired companies into our business which could materially and adversely
affect our financial condition and operating results.

Part
of our business strategy has been to acquire or invest in companies, products
or technologies that complement our current products, enhance our market
coverage or technical capabilities or offer growth opportunities. As part of
this strategy, in December 2007, we completed the EIS asset purchase and in
June 2010, we acquired CitySync Limited. For any acquisition, a significant
amount of managements time and financial resources may be required to complete
the acquisition and integrate the acquired business into our existing
operations. Even with this investment of management time and financial
resources, an acquisition may not produce the revenue, earnings or business
synergies anticipated. Acquisitions involve numerous other risks, including the
assumption of unanticipated operating problems or legal liabilities; problems
integrating the purchased operations, technologies or products; the diversion
of managements attention from our core businesses; restrictions on the manner
in which we may use purchased companies or assets imposed by acquisition
agreements; adverse effects on existing business relationships with
suppliers and customers; incorrect
estimates made in the accounting for acquisitions and amortization of acquired
intangible assets that would reduce future reported earnings (such as goodwill impairments);
ensuring acquired companies compliance with the requirements of the
Sarbanes-Oxley Act; and the potential loss of customers or key employees of
acquired businesses. We cannot assure you that any acquisitions, investments,
strategic alliances or joint ventures will be completed or integrated in a
timely manner or achieve anticipated synergies, will be structured or financed
in a way that will enhance our business or creditworthiness, or will meet our
strategic objectives or otherwise be successful.

13

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

Our
recorded goodwill of approximately $14.7 million at December 31, 2010 relates
to our Hong Kong-based subsidiary, Flow Traffic Ltd., the EIS asset purchase
and the CitySync acquisition. Each year, we perform an impairment test of
goodwill in October for the EIS assets and in December for Flow Traffic or
whenever an impairment indicator arises, and we test our long-lived assets for
impairment when indicators of impairment are present. We plan to test CitySync
annually beginning with April 2011. The impairment test requires us to estimate
the fair value of our reporting units and then compare it to the carrying value
of the reporting units. If the carrying value exceeds the fair value, further
analysis is performed to determine if there is an impairment charge. We
estimate the fair value primarily by using a combination of income and market
approaches, where fair value under the income approach is dependent on the
present value of future economic benefits to be derived from the reporting
units and fair value under the market approach considers recently completed
transactions within our industry sectors, comparable trading values and other
market conditions. The future economic benefits are significantly dependent on
future revenue growth. If the reporting units do not provide the future
economic benefits we project, the fair value of these assets may become
impaired, and we would need to record an impairment loss. Fair market valuation
requires assumptions and estimates of many critical factors, including revenue
and market growth, operating cash flows, market multiples and discount rates.
As general market conditions have deteriorated, our reporting units could
experience a decline in fair market value, which could adversely affect the
results of the impairment testing that we perform in the future and could
potentially lead to a future impairment charge of some or all of our goodwill
at one or all of our reporting units. In addition, ongoing financial market turmoil
could impact common stock trading prices for many companies, including ours. If
our market capitalization falls below our shareholders equity, it could
trigger an impairment of goodwill in the future.

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

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

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

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

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

Our
executive officers and directors and entities affiliated with them, in the
aggregate, beneficially owned 11% of our outstanding common stock as of March
24, 2011, assuming the exercise by them of all of their options that were
currently exercisable or that vest within 60 days of March 24, 2011. Our
executive officers and directors and their affiliated entities, if acting
together, thus are able to influence significantly all matters requiring
approval by our shareholders, including the election of directors and the
approval of mergers or other significant corporate transactions. These
shareholders may have interests that differ from other shareholders, and they may
vote in a way with which other shareholders disagree and that may be adverse to
other shareholders interests. The concentration of ownership of our common
stock may have the effect of delaying, preventing or deterring a change of
control of our company, could deprive our shareholders of an opportunity to
receive a premium for their common stock as part of a sale of our company, and
may affect the market price of our common stock. This concentration of
ownership of our common stock may also have the effect of influencing the
completion of a change in control that may not necessarily be in the best
interests of all of our shareholders.

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Table of Contents

Our articles of incorporation and bylaws
and Minnesota law may inhibit a takeover that shareholders consider favorable.

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

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

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

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

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

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

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

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

None.

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

We
currently lease and occupy approximately 20,000 square feet in St. Paul,
Minnesota for our headquarters. This lease expires in May 2014, and we have the
right to renew the lease for two additional three-year terms. Our office in
suburban north London, United Kingdom
consists of 17,000 square feet of space, and our lease for this space expires
at our option in January 2015. We also lease smaller facilities in Canada, Hong
Kong, China and Poland. We believe that our facilities are adequate to meet our
current and expected needs.

15

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Table of Contents

We
believe that our current space is generally adequate in the United States, Asia
and Europe, and we do not intend to lease significantly more space in 2011.

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

We
are involved in legal actions and claims relating to various matters. Although
we are unable to predict the ultimate outcome of these legal actions and
claims, it is the opinion of management that the disposition of these matters,
taken as a whole, will not have a material adverse effect on our consolidated
financial statements.

|        |                        
|------- | -----------------------
|Item 4. | [Removed
 and Reserved]

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Table of Contents

PART II

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

Market Information

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

|        |  |      |       |     |      |       |  |     |       |  |   |       | 
|------- |  | ---- | ----- | --- | ---- | ----- |  | --- | ----- |  | - | ----- | 
|        |  | 2010 |       |     | 2009 |      
|        |  |      |       |     |      |      
|Quarter |  | High |       | Low |      | High  |  | Low |      
|        |  |      |       |     |      |       |  |     |      
|       
|First   |  | $    | 15.53 |     | $    | 11.50 |  | $   | 10.51 |  | $ | 6.69  | 
|Second  |  |      | 14.47 |     |      | 12.20 |  |     | 10.25 |  |   | 8.19  | 
|Third   |  |      | 13.50 |     |      | 10.10 |  |     | 13.11 |  |   | 8.61  | 
|Fourth  |  |      | 13.50 |     |      | 11.10 |  |     | 14.10 |  |   | 11.40 | 

Shareholders

As
of February 28, 2011, there were 25 holders of record of our common
stock. The number of holders of record is based upon the actual number of
holders registered at such date and does not include holders of shares in
street names or persons, partnerships, associates, corporations, or other
entities identified in security position listings maintained by depositories.

Dividends

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

17

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Table of Contents

Comparative Stock Performance Graph

The
graph below compares the five-year cumulative total stockholder return on our
common stock with the cumulative total stockholder return of (i) the Dow Jones
Wilshire 5000 Index and (ii) the Dow Jones Wilshire Electronic Equipment Index,
assuming an investment of $100 on December 31, 2005, including reinvestment of
dividends.

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

COMPARISON OF 5 YEAR
CUMULATIVE TOTAL RETURN*Among Image Sensing Systems, Inc, the Wilshire 5000 Index
and the Dow Jones US Electrical Components & Equipment TSM Index

(LINE GRAPH)

|                                                    |  |       |        |       |  |        |  |       |        |       |  |       |  |  |        |  |  |        | 
|--------------------------------------------------- |  | ----- | ------ | ----- |  | ------ |  | ----- | ------ | ----- |  | ----- |  |  | ------ |  |  | ------ | 
|                                                    |  |       |        |       |  |        |  |       |        |       |  |       | 
|                                                    |  | 12/05 |        | 12/06 |  | 12/07  |  | 12/08 |        | 12/09 |  | 12/10 | 
|                                                    |  |       |        |       |  |        |  |       |        |       |  |       | 
|                                                   
|Image Sensing Systems, Inc                          |  |       | 100.00 |       |  | 107.35 |  |       | 130.28 |       |  | 47.75 |  |  | 85.46  |  |  | 97.53  | 
|Wilshire 5000                                       |  |       | 100.00 |       |  | 115.77 |  |       | 122.27 |       |  | 76.75 |  |  | 98.47  |  |  | 115.37 | 
|Dow Jones US Electrical Components & Equipment
 TSM |  |       | 100.00 |       |  | 113.96 |  |       | 135.86 |       |  | 72.41 |  |  | 111.44 |  |  | 139.51 | 

18

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Table of Contents

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

The
following table sets forth selected consolidated financial data for each of the
five fiscal years ended December 31, 2010. The statement of income and balance
sheet data for the years ended and as of December 31, 2010, 2009, 2008, 2007
and 2006 are derived from our audited consolidated financial statements. The
following information should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations and
with our consolidated financial statements and the related notes thereto
included elsewhere in this report.

|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|------------------------------------------------------ |  | -------------------------------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                       |  | Fiscal
 Years Ended December 31,       |       
|                                                       |  |                                        |       
|                                                       |  | 2010                                   |        | 2009 |   | 2008   |  | 2007 |        | 2006 |  
|                                                       |  |                                        |       
|                                                       |  | (in
 thousands, except per share data) |       
|Consolidated Statement of Income Data:                 |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Revenue:                                               |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Product sales                                          |  | $                                      | 19,162 |      | $ | 12,483 |  | $    | 13,144 |      | $ | 4,336  |   | $ | 2,980  | 
|Royalties                                              |  |                                        | 12,519 |      |   | 12,110 |  |      | 13,321 |      |   | 10,747 |   |   | 10,136 | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Total revenue                                          |  |                                        | 31,681 |      |   | 24,593 |  |      | 26,465 |      |   | 15,083 |   |   | 13,116 | 
|Cost of revenue:                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Product sales                                          |  |                                        | 7,799  |      |   | 4,297  |  |      | 4,912  |      |   | 1,987  |   |   | 1,501  | 
|Royalties                                              |  |                                        |       |      |   |       |  |      |       |      |   |       |   |   | 220    | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Total cost of revenue                                  |  |                                        | 7,799  |      |   | 4,297  |  |      | 4,912  |      |   | 1,987  |   |   | 1,721  | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Gross profit                                           |  |                                        | 23,882 |      |   | 20,296 |  |      | 21,553 |      |   | 13,096 |   |   | 11,395 | 
|Operating expenses:                                    |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Selling, marketing and product support                 |  |                                        | 9,807  |      |   | 7,201  |  |      | 6,680  |      |   | 3,463  |   |   | 2,850  | 
|General and administrative                             |  |                                        | 4,372  |      |   | 3,779  |  |      | 4,069  |      |   | 2,653  |   |   | 2,383  | 
|Research and development                               |  |                                        | 3,630  |      |   | 3,336  |  |      | 2,908  |      |   | 2,299  |   |   | 2,639  | 
|Amortization of intangible assets                      |  |                                        | 1,218  |      |   | 768    |  |      | 768    |      |   | 51     |   |   |       | 
|Acquisition related expenses                           |  |                                        | 817    |      |   |       |  |      |       |      |   |       |   |   |       | 
|In-process research and development                    |  |                                        |       |      |   |       |  |      |       |      |   | 4,500  |   |   |       | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|                                                       |  |                                        | 19,844 |      |   | 15,084 |  |      | 14,425 |      |   | 12,966 |   |   | 7,871  | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Income from operations                                 |  |                                        | 4,038  |      |   | 5,212  |  |      | 7,128  |      |   | 130    |   |   | 3,524  | 
|Other income (expense), net                            |  |                                        | (123   | )    |   | 7      |  |      | 43     |      |   | 543    |   |   | 523    | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Income before income taxes                             |  |                                        | 3,915  |      |   | 5,219  |  |      | 7,171  |      |   | 673    |   |   | 4,047  | 
|Income tax expense (benefit)                           |  |                                        | 910    |      |   | 1,354  |  |      | 2,207  | )    |   | (199   | ) |   | 942    | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Net income                                             |  | $                                      | 3,005  |      | $ | 3,865  |  | $    | 4,964  |      | $ | 872    |   | $ | 3,105  | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Net income per share:                                  |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Basic                                                  |  | $                                      | 0.66   |      | $ | 0.97   |  | $    | 1.26   |      | $ | 0.23   |   | $ | 0.83   | 
|Diluted                                                |  |                                        | 0.64   |      |   | 0.95   |  |      | 1.24   |      |   | 0.22   |   |   | 0.80   | 
|                                                       |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Weighted average number of common shares
 outstanding: |  |                                        |        |      |   |        |  |      |        |      |   |        |   |   |        | 
|Basic                                                  |  |                                        | 4,555  |      |   | 3,985  |  |      | 3,943  |      |   | 3,789  |   |   | 3,725  | 
|Diluted                                                |  |                                        | 4,667  |      |   | 4,081  |  |      | 4,001  |      |   | 3,881  |   |   | 3,891  | 

|                                 |  |                  |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|-------------------------------- |  | ---------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ | 
|                                 |  | At
 December 31, |       
|                                 |  |                  |       
|                                 |  | 2010             |        | 2009 |   | 2008   |  | 2007 |        | 2006 |  
|                                 |  |                  |       
|                                 |  | (in
 thousands)  |       
|Consolidated Balance Sheet Data: |  |                  |        |      |   |        |  |      |        |      |   |        |  |   |        | 
|Total assets                     |  | $                | 54,356 |      | $ | 41,150 |  | $    | 36,108 |      | $ | 30,388 |  | $ | 21,224 | 
|Bank debt                        |  |                  |       |      |   | 4,000  |  |      | 3,750  |      |   | 5,000  |  |   |       | 
|Total shareholders equity       |  |                  | 46,021 |      |   | 32,713 |  |      | 28,530 |      |   | 23,225 |  |   | 19,333 | 

19

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Table of Contents

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

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

General. We
provide software based computer enabled detection, or CED, products and
solutions that use advanced signal processing software algorithms to detect and
monitor objects in a designated field of view. Our technology analyzes the
signal from a sophisticated sensor and passes the information along to
management systems, controllers or directly to users. Our core products, the
Autoscope® Video Vehicle Detection System, RTMS® Radar Detection System and
CitySync Automatic Number Plate Recognition (ANPR) System, operate using our
proprietary application software in conjunction with video cameras or radar and
commonly available electronic components. Our systems are used by traffic
managers primarily to improve the flow of vehicle traffic and to enhance safety
at intersections, main thoroughfares, freeways and tunnels and by parking and
toll managers and law enforcement officials to read license plates for various
safety, security, access and enforcement ANPR applications.

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

CitySync Acquisition.
In June 2010, we purchased all of the outstanding equity of CitySync Limited
through which we own its principal product line, the CitySync ANPR system. We
believe the CitySync acquisition expands our addressable market, strengthens
our selling presence in Europe and extends our opportunities for hybrid product
developments. In its fiscal year ended January 31, 2010, CitySync had revenue
of $7.4 million, substantially all of which related to ANPR system sales.

EIS Asset Purchase.
In 2007, we purchased certain assets from EIS Electronic Integrated Systems
Inc., or EIS, including its principal product line, the RTMS system. In its
fiscal year ended September 30, 2007, EIS had revenue of $8.7 million,
substantially all of which related to RTMS sales.

| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Trends and Challenges in Our Business                                                              
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| | We believe
 the growth in our business can be attributed primarily to the following
 global trends:
| |                                                                                                    
| |                                                                                                    | worsening
 traffic caused by increased numbers of vehicles in metropolitan areas without
 corresponding expansions of road infrastructure and the need to automate
 safety, security and access applications for automobiles and trucks, which
 has increased demand for our products;
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | advances in
 information technology, which have made our products easier to market and
 implement;                                                                                                                                                                                    
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | the
 continued funding allocations for centralized traffic management services and
 automated enforcement schemes, which has increased the ability of our primary
 end users to implement our products; and                                                                           
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | general
 increases in the cost-effectiveness of electronics, which make our products
 more affordable for end users.                                                                                                                                                                  
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| | We believe
 our continued growth primarily depends upon:                                           
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | continued
 adoption and governmental funding of intelligent transportation systems, or
 ITS, and other automated applications for traffic control, safety and
 enforcement in developed countries;                                                                                    
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | a propensity
 by traffic engineers to implement lower cost technology-based solutions
 rather than civil engineering solutions such as widening roadways;                                                                                                                             
| |                                                                                                     |                                                                                                                                                                                                                                                                                       
| |                                                                                                    | countries in
 the developing world adopting above-ground detection technology, such as
 video or radar, instead of in-pavement loop technology to manage traffic;                                                                                                                     

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| |   |                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the use of
 CED to provide solutions to security/surveillance and environmental issues
 associated with increasing automobile use in metropolitan areas; and                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                    
| |  | our ability
 to develop new products, such as hybrid CED devices incorporating, for
 example, radar and video technologies, that provide increasingly accurate
 information and enhance the end users ability to cost-effectively manage
 traffic, security/surveillance and environmental issues.

Because
the majority of our end users are governmental entities, we are faced with
challenges related to potential delays in purchase decisions by those entities
and changes in budgetary constraints. These contingencies could result in
significant fluctuations in our revenue between periods. The slow rate at which
the worldwide recession is ending is further adding to the unpredictability of
purchase decisions, creating more delays than usual and decreasing governmental
budgets, and it is likely to continue to negatively affect our revenue. We
believe we will continue to be a beneficiary of the federal stimulus bills
enacted in 2009 and 2010, but it is difficult to determine the level of impact
it has on our operations.

Key Financial Terms
and Metrics

Revenue. We derive revenue from two
sources: (1) royalties received from Econolite for sales of the Autoscope
system in North America, the Caribbean and Latin America and (2) revenue
received from the direct sales of our RTMS and CitySync systems in North America,
the Caribbean and Latin America and all of our systems in Europe and Asia. We
calculate the royalties using a profit sharing model where we split with
Econolite the gross profit on sales of Autoscope product made through
Econolite. This royalty arrangement has the benefit of decreasing our cost of
revenues and our selling, marketing and product support expenses because these
costs and expenses are borne primarily by Econolite. Although this royalty
model has a positive impact on our gross margin, it also negatively impacts our
total revenue, which would be higher if all the sales made by Econolite were
made directly by us. The royalty arrangement is exclusive under a long-term
agreement.

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

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

Non-GAAP Operating Measure. We use
non-GAAP net income, which excludes the impact, net of tax, of amortizing the
intangible assets from the 2007 EIS asset acquisition and the CitySync
acquisition and expenses related to these acquisitions, including earn-out
adjustments and other unusual items, to analyze our business. Management
believes that this non-GAAP operating measure, when shown in conjunction with
GAAP measures, facilitates the comparison of our current operating results to
historical operating results. We use this non-GAAP information to evaluate
short-term and long-term operating trends in our core operations. Further, we
believe that this non-GAAP measure improves managements and investors ability
to compare our financial performance with other companies in the technology
industry. Non-GAAP information is not prepared in accordance with GAAP and
should not be considered a substitute for or an alternative to GAAP financial
measures and may not be computed the same as similarly titled measures used by
other companies.

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Reconciliations
of GAAP net income to non-GAAP net income are as follows (dollars in thousands,
except per share amounts):

| |                                                                        |  |                          |       |      |   |       |   |   |       |  
| | ---------------------------------------------------------------------- |  | ------------------------ | ----- | ---- | - | ----- | - | - | ----- | -
| |                                                                        |  | Years
 ended December 31 |      
| |                                                                        |  |                          |      
| |                                                                        |  | 2010                     |       | 2009 |   | 2008  |  
| |                                                                        |  |                          |       |      |   |       |  
| |                                                                        |  |                          |       |      |   |       |  
| | GAAP net income                                                        |  | $                        | 3,005 |      | $ | 3,865 |   | $ | 4,964 |  
| |                                                                        |  |                          |       |      |   |       |   |   |       |  
| | Adjustments to reconcile to non-GAAP net
 income                       |  |                          |       |      |   |       |   |   |       |  
| | Amortization of intangible assets                                      |  |                          | 1,218 |      |   | 768   |   |   | 768   |  
| | Acquisition related expenses                                           |  |                          | 817   |      |   |      |   |   |      |  
| | Non-recurring foreign tax benefit                                      |  |                          |      |      |   | (236  | ) |   |      |  
| | Withdrawn offering expenses                                            |  |                          |      |      |   |      |   |   | 221   |  
| | Impact on income tax expense of
 amortization and acquisition expenses |  |                          | (414  | )    |   | (261  | ) |   | (336  | )
| |                                                                        |  |                          |       |      |   |       |   |   |       |  
| | Non-GAAP net income                                                    |  | $                        | 4,626 |      | $ | 4,136 |   | $ | 5,617 |  
| |                                                                        |  |                          |       |      |   |       |   |   |       |  
| |                                                                        |  |                          |       |      |   |       |   |   |       |  
| | GAAP diluted earnings per share                                        |  | $                        | 0.64  |      | $ | 0.95  |   | $ | 1.24  |  
| | Non-GAAP diluted earnings per share                                    |  |                          | 0.99  |      |   | 1.01  |   |   | 1.40  |  

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

History. We were incorporated in the state
of Minnesota in December 1984 and began operations by pioneering the commercial
application of wide-area video vehicle detection for traffic management. The
technology underlying our products was initially developed at the University of
Minnesota. In 1989, the University was awarded a patent for that technology,
which it exclusively licensed to us. In 1991, we sub-licensed this technology
to Econolite, a leading manufacturer and seller of traffic control products in
North America and the Caribbean, to manufacture and distribute products
incorporating the technology.

Segments. We currently operate in three
reportable segments: Autoscope, RTMS and CitySync. Autoscope is our machine-vision
product line, and revenue consists of royalties (all of which are received from
Econolite), as well as a portion of international sales. RTMS is our radar
product line acquired in the EIS asset purchase in December 2007. CitySync is our
ANPR product line acquired in the CitySync purchase in
June 2010. All segment revenues are derived from external customers.

Due
to the CitySync acquisition and related changes in how we manage our business,
we may reevaluate our segment definitions in the future.

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

|                                  |  |                                       |        |      |   |          |  |       |        |   |   |        | 
|--------------------------------- |  | ------------------------------------- | ------ | ---- | - | -------- |  | ----- | ------ | - | - | ------ | 
|                                  |  | For the
 year ended December 31, 2010 |       
|                                  |  |                                       |       
|                                  |  | Autoscope                             |        | RTMS |   | CitySync |  | Total |       
|                                  |  |                                       |        |      |   |          |  |       |       
|Revenue                           |  | $                                     | 16,659 |      | $ | 9,819    |  | $     | 5,203  |   | $ | 31,681 | 
|Depreciation                      |  |                                       | 293    |      |   | 173      |  |       | 32     |   |   | 498    | 
|Amortization of intangible assets |  |                                       |       |      |   | 768      |  |       | 450    |   |   | 1,218  | 
|Income (loss) before income taxes |  |                                       | 2,618  |      |   | 1,823    |  |       | (526   | ) |   | 3,915  | 
|Capital expenditures              |  |                                       | 325    |      |   | 77       |  |       | 14     |   |   | 416    | 
|Total assets                      |  |                                       | 26,915 |      |   | 13,202   |  |       | 14,239 |   |   | 54,356 | 

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

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|                                  |  |                                       |        |      |   |        |  |   |        | 
|--------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                  |  | For the
 year ended December 31, 2008 |       
|                                  |  |                                       |       
|                                  |  | Autoscope                             |        | RTMS |   | Total  | 
|                                  |  |                                       |        |      |   |        | 
|Revenue                           |  | $                                     | 18,705 |      | $ | 7,760  |  | $ | 26,465 | 
|Depreciation                      |  |                                       | 242    |      |   | 115    |  |   | 357    | 
|Amortization of intangible assets |  |                                       |       |      |   | 768    |  |   | 768    | 
|Income before income taxes        |  |                                       | 5,939  |      |   | 1,232  |  |   | 7,171  | 
|Capital expenditures              |  |                                       | 273    |      |   | 112    |  |   | 385    | 
|Total assets                      |  |                                       | 24,135 |      |   | 11,973 |  |   | 36,108 | 

The CitySync segment loss
before income taxes includes $817,000 of acquisition related expenses.

Results
of Operations

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

|                                       |  |                          |       |      |  |       |   |  |       |  
|-------------------------------------- |  | ------------------------ | ----- | ---- |  | ----- | - |  | ----- | -
|                                       |  | Year
 Ended December 31, |      
|                                       |  |                          |      
|                                       |  | 2010                     |       | 2009 |  | 2008  |  
|                                       |  |                          |       |      |  |       |  
|Product sales                          |  |                          | 60.5  | %    |  | 50.8  | % |  | 49.7  | %
|Royalties                              |  |                          | 39.5  |      |  | 49.2  |   |  | 50.3  |  
|                                       |  |                          |       |      |  |       |  
|Total revenue                          |  |                          | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|                                       |  |                          |       |      |  |       |  
|Gross marginproduct sales             |  |                          | 59.3  |      |  | 65.6  |   |  | 62.4  |  
|Gross marginroyalties                 |  |                          | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|Selling, marketing and product support |  |                          | 31.0  |      |  | 29.3  |   |  | 25.2  |  
|General and administrative             |  |                          | 13.8  |      |  | 15.4  |   |  | 15.4  |  
|Research and development               |  |                          | 11.5  |      |  | 13.6  |   |  | 11.0  |  
|Amortization of intangibles            |  |                          | 3.8   |      |  | 3.1   |   |  | 2.9   |  
|Acquisition related expenses           |  |                          | 2.6   |      |  | ―     |   |  | ―     |  
|Income from operations                 |  |                          | 12.7  |      |  | 21.2  |   |  | 26.9  |  
|Income tax expense                     |  |                          | 2.9   |      |  | 5.5   |   |  | 8.3   |  
|Net income                             |  |                          | 9.5   |      |  | 15.7  |   |  | 18.8  |  

Year
Ended December 31, 2010 Compared to Year Ended December 31, 2009. Total revenue increased to $31.7 million in
2010 from $24.6 million in 2009, an increase of 28.8%. Royalty income increased
to $12.5 million in 2010 from $12.1 million in 2009, an increase of 3.4%.
Product sales increased to $19.2 million in 2010 from $12.5 million in 2009, an
increase of 53.6%. The increase in product sales was mainly due to the addition
of the CitySync product line in June 2010 and to a lesser extent due to
improved sales of RTMS in international markets. Revenue for the Autoscope
segment increased to $16.7 million in 2010 from $16.2 million in 2009, an
increase of 2.6%. Revenue for the RTMS segment increased to $9.8 million in
2010 from $8.4 million in 2009, an increase of 17.6%. The increase resulted
mainly as a result of improved sales in international markets.

Gross
margins for product sales decreased to 59.3% in 2010 from 65.6% in 2009. The
decrease resulted mainly from the addition of the CitySync product line, which
currently earns lower margins than Autoscope or RTMS, and increased warranty
expense for RTMS, and to a lesser extent from increased pricing competition for
Autoscope internationally. Gross margins on royalty income remained consistent
at 100% in 2010 and 2009. We anticipate that gross margins for our product sales
will be in the proximity of 60% in 2011, while we expect royalty gross margins
will be 100% in 2011.

Selling,
marketing and product support expense increased to $9.8 million or 31.0% of
total revenue in 2010 from $7.2 million or 29.3% of total revenue in 2009. Our
selling, marketing and product support expense increased in 2010 mostly as a
result of the addition of the CitySync organization. Additionally, we invested
in market expansion activities in Europe and Asia, including adding senior management.
We anticipate that selling, marketing and product support expense will increase
both in terms of dollar amount and as a percentage of revenue in 2011, as
compared to 2010, as we realize the full year impact of CitySync related
expense and continue to invest in market expansion activities.

General
and administrative expense increased to $4.4 million or 13.8% of total revenue
in 2010, from $3.8 million or 15.4% of total revenue in 2009. The general and
administrative expenses increased in 2010 mainly as a result of the addition of
the CitySync organization and to a lesser extent due to increased compensation
and benefits. We anticipate that general and administrative expense will
increase in terms of dollar amount in 2011 as compared to 2010.

Research
and development expense increased to $3.6 million or 11.5% of total revenue in
2010, up from $3.3 million or 13.6% of total revenue in 2009. The increase was
mainly related to the addition of the CitySync engineering organization. We
anticipate that research and development expense will increase in terms of
dollar amount in 2011 as compared to 2010.

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Amortization
of intangibles expense was $1.2 million in 2010 and reflects the amortization
of intangible assets acquired in both the EIS asset purchase and the CitySync
acquisition. Assuming there are no changes to our intangible assets, we anticipate
amortization expense will be approximately $1.6 million in 2011.

Other
income (expense) was an expense of $123,000 in 2010, primarily consisting of
interest expense, as opposed to income of $7,000 in 2009 mainly due to higher
debt balances in 2010 including a portion related to CitySync.

Income
before income taxes for the Autoscope segment decreased to $2.6 million in 2010
from $3.8 million in 2009, a decrease of 31.6%. The decrease was mainly due to
increased competition. Income before income taxes for the RTMS segment
increased to $1.8 million in 2010 from $1.4 million in 2009, an increase of
29.1%. The increase was due to higher revenues in the segment, which were
partially offset by increased warranty expense.

Our
income tax effective rate was 23.2% in 2010 compared to 25.9% in 2009. The 2010
effective rate was positively impacted by increased tax credits for research
and development activities. We expect the effective rate in 2011 to be below
30%.

Year
Ended December 31, 2009 Compared to Year Ended December 31, 2008.
Total revenue decreased to $24.6 million in 2009 from $26.5 million in 2008, a
decrease of 7.1%. Royalty income decreased to $12.1 million in 2009 from $13.3
million in 2008, a decrease of 9.1%. We attribute the decrease in royalties to
the economic recession in North America and its negative impact on state and
federal spending. Product sales decreased to $12.5 million in 2009 from $13.1
million in 2008, a decrease of 5.0%. The decrease was mainly due to weakness in
the Asian market in the first half of 2009. Revenue for the Autoscope segment
decreased to $16.2 million in 2009 from $18.7 million in 2008, a decrease of
13.2%. The decrease related to lower royalties and weakness in Asia as discussed
above. Revenue for the RTMS segment increased to $8.4 million in 2009 from $7.8
million in 2008, an increase of 7.6%. The increase resulted mainly as a result
of improved sales in North America.

Gross
margins for product sales increased to 65.6% in 2009 from 62.4% in 2008. The
increase resulted mainly from the increase in RTMS revenue, which typically
earns higher margins than Autoscope, and to a lesser extent from fewer lower of
cost or market adjustments to inventory in 2009 as compared to 2008. Gross
margins on royalty income remained consistent at 100% in 2009 and 2008.

Selling,
marketing and product support expense increased to $7.2 million or 29.3% of
total revenue in 2009 from $6.7 million or 25.2% of total revenue in 2008. The
selling, marketing and product support expense increased in 2009 as we invested
in market expansion activities in Europe and Asia and realized the impact of
headcount additions made late in 2008.

General
and administrative expense decreased to $3.8 million or 15.4% of total revenue
in 2009, down from $4.1 million or 15.4% of total revenue in 2008. The general
and administrative expenses decrease in 2009 resulted mainly from lower
incentive pay expense and higher foreign currency transaction gains, which were
partially offset by increased professional services expense.

Research
and development expense increased to $3.3 million or 13.6% of total revenue in
2009, up from $2.9 million or 11.0% of total revenue in 2008. The increase was
directly related to our investment in video/radar hybrid solutions and tailored
international offerings, development projects to reduce manufacturing costs,
and the realization of the impact of headcount additions made late in 2008.

Amortization
of intangibles expense was $768,000 in 2009 and reflects the amortization of
intangible assets acquired in the EIS asset purchase.

Other
income decreased to $7,000 in 2009 from $43,000 in 2008 mainly due to lower
interest rates. In 2008, other income fell due to lower cash and investment
balances, lower interest rates and interest expense on debt incurred for the
EIS asset purchase.

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

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

Liquidity
and Capital Resources

At
December 31, 2010, we had $8.0 million in cash and cash equivalents and $4.0
million in short-term investments, compared to $14.1 million in cash and cash
equivalents and $3.9 million in short-term investments at December 31, 2009.

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Net
cash provided by operating activities was $33,000 in 2010, compared to $5.4
million and $5.2 million in 2009 and 2008, respectively. In 2010, as compared
to 2009, we had increased accounts and other receivables outstanding, the
majority of which related to CitySync activity. The primary reasons for the
2009 change compared to 2008 were lower net income and increased inventory
balances that were offset by decreased accounts receivable outstanding. In
2010, investment balances were similar to those of 2009. We anticipate that
average receivable collection days in 2011 will be similar to 2010 and that it
will not have a material impact on our liquidity. Our planned additions of
property and equipment are discretionary, and we do not expect them to exceed
historical levels in 2011. We used $8.3 million of cash in 2010 to acquire
CitySync including repaying seller loans. This was mostly offset by our 2010
secondary offering which provided $8.8 million in cash, net of offering
expenses.

In
December 2009, we entered into a term loan agreement for $4.0 million with
Associated Bank, National Association, or Associated Bank, which we fully
repaid in September 2010. We previously had a separate $4.0 million term note
with Associated Bank that originated in May 2008 and was fully repaid in
February 2009.

We
also have a revolving line of credit agreement with Associated Bank. The
revolving line of credit provides for up to $5.0 million at an annual interest
rate equal to the greater of 4.5% or LIBOR plus 2.75%, as reset from time to
time by the bank. Advances on the line of credit cannot exceed a borrowing base
determined under a formula, which is a percentage of the amounts of eligible
receivables. The line of credit currently has no borrowings outstanding and
matures on May 1, 2012. We believe that on an ongoing basis, we will have
regular availability to draw a minimum of $3.0 million on our line of credit
based on our qualifying assets.

In
conjunction with our acquisition of CitySync, the sellers have an earn-out
arrangement over approximately 18 months from the June 2010 date of purchase.
The earn-out is based on achieving certain revenue and minimum gross margins
from the sale of CitySync ANPR systems and it is calculated in two separate
periods, each ending on December 31. In each period there are two tiers and
superior performance could lead to a total earn-out of $2 million or higher, as
the earn-out is not capped. Earn-out payments are due within three months of
the end of an earn-out period. Based on the 2010 results, the sellers are
entitled to receive a $696,000 earn-out for the first period which ran from the
June acquisition date to December 31, 2010. The payment is expected to be made
in March 2011, and a liability has been recorded on our balance sheet as of
December 31, 2010. As part of the recognition of the liability, we recorded an
additional $205,000 in expense as the earn-out exceeded our initial estimate.

In
conjunction with our EIS asset purchase, the sellers had an earn-out
arrangement over approximately three years from the December 2007 date of
purchase. The earn-out ended as of December 31, 2010. The earn-out was based on
earnings before taxes from RTMS sales less related cost of revenue and operating
expenses, excluding depreciation, amortization and interest expenses, and was
calculated annually. For the first two earn-out periods, the sellers of the EIS
assets received a total of $2.7 million in earn-out payments. Based on the 2010
results, the sellers are entitled to receive a $1.7 million earn-out for the
third and final period. The payment is expected to be made in March 2011, and a
liability has been recorded on our balance sheet as of December 31, 2010.

We
believe that cash and cash equivalents on hand at December 31, 2010, along with
the availability of funds under our $5.0 million revolving line of credit and
cash provided by operating activities, will satisfy our projected working
capital needs, payments under the EIS and CitySync earn-outs, investing
activities, and other cash requirements for the foreseeable future.

Off-Balance Sheet Arrangements

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

Critical
Accounting Policies

Goodwill
and Intangible Assets. Goodwill is not amortized
but is tested for impairment annually or whenever an impairment indicator
arises. Our goodwill related to our Flow Traffic subsidiary is tested for
impairment on December 31 of each year. EIS asset purchase (RTMS) related
goodwill is tested on October 1 of each year. CitySync goodwill will be tested
beginning in April 2011.

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

For
Flow Traffic, we estimate the fair value by using a combination of the income
approach, where fair value is dependent on the present value of future economic
benefits to be derived from ownership of Flow Traffic, and the comparable
market transactions method. The future economic benefits are significantly
dependent on sustaining revenue levels for all product lines. For the RTMS
reporting units, we estimate fair value by using a combination of the income
approach, where fair value is dependent on the present value of future economic
benefits to be derived from the RTMS product line, and the market valuation
approach, where the business was compared to guideline public company
price-earning multiples with a significant weighting to companies in the
traffic detection business. The future economic benefits are mainly dependent
on future revenue growth of the RTMS product line. No impairment of goodwill
was recorded as of December 31, 2010, 2009 and 2008. If Flow Traffic and/or the
RTMS reporting units do not provide the future
economic benefits we project, the fair value of these assets may become
impaired, and we would need to record an impairment loss.

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

Earn-outs
related to the EIS asset purchase are recorded as additional goodwill in the
year earned. Intangible assets related to the EIS asset purchase are for trade
names and technology. Earn-outs for the CitySync acquisition were estimated at
the time of the acquisition, based on projected sales and gross margins during
the earn-out period, and recorded on our balance sheet as a liability with an
offsetting increase in goodwill. Actual earn-outs that vary from the initial
estimated liability result in operating expense or income in the applicable
year. Intangible assets related to the CitySync acquisition are for customer
relationships, trade names and technology.

Revenue
Recognition. Royalty income is recognized based
upon a monthly royalty report provided to us by Econolite. This report is
prepared by Econolite based on its sales of products we developed and is based
on sales shipped or delivered to its customers. We recognize revenue from
North American and international sales at the time of shipment or delivery;
the selling price is fixed or determinable; and collectability is reasonably
assured. We record provisions against revenue for estimated returns and
allowances in the period when the related revenue is recorded based upon
historical sales returns and changes in end user demands. The allowance for
doubtful accounts is estimated based on specific identification of delinquent
receivables.

Income
Taxes. Income taxes are accounted for under the
liability method. Deferred income taxes reflect the effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and amounts used for income tax purposes. Deferred tax
assets are offset by a valuation allowance as deemed necessary based on our
estimate of our future sources of taxable income and the expected timing of
temporary difference reversals. Uncertain tax positions are recognized if the
tax position is more likely than not of being sustained on audit based on the
technical merits of the position.

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

Warranties.
We generally provide a standard two-year warranty on product sales. Reserves to
honor warranty claims are estimated and recorded at the time of sale based on
historical claim information and are analyzed and adjusted periodically based
on claim trends.

New
and Recently Adopted Accounting Pronouncements

In
January 2010, the FASB issued Accounting Standards Update (ASU)
No. 2010-06, Improving Disclosures
about Fair Value Measurements (ASU 2010-06). ASU 2010-06 requires
new disclosures regarding transfers in and out of Levels 1 and 2 and activity
in Level 3 fair value measurements. It also clarifies existing disclosure
requirements regarding the level of disaggregation in certain disclosures,
inputs, and valuation techniques used in ASC 820, Fair Value Measurements and Disclosures. We adopted all of
the requirements of this update on January 1, 2010, its effective date,
except for the new requirement regarding activity in Level 3 fair value
measurements which has a later effective date under the provisions of ASU
2010-6 and will become effective on January 1, 2011. Adoption of this
pronouncement has not had, and is not expected to have, a significant effect on
our consolidated financial statements disclosures.

In
September 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of
Financing Receivables and the Allowance for Credit Losses, to
enhance the disclosures required for financing receivables (for example, loans,
trade accounts receivable, notes receivable, and receivables relating to a
lessors leveraged, direct financing, and sales-type leases) and allowances for
credit losses. The amended disclosures are designed to provide more information
to financial statement users regarding the credit quality of a creditors
financing receivables and the adequacy of its allowance for credit losses. We
adopted all of the requirements of the amended guidance on December 31, 2010,
its effective date, except for the disclosures regarding the activity during a
reporting period which will become effective January 1, 2011. Adoption of the
pronouncement has not had, and is not expected to have, a significant effect on
our consolidated financial statement disclosures.

|          |                                                             
|--------- | ------------------------------------------------------------
|Item
 7A. | Quantitative and Qualitative
 Disclosures About Market Risks

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

26

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

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

|                                                                                                                  |  |             |        |      |   |        |  
|----------------------------------------------------------------------------------------------------------------- |  | ----------- | ------ | ---- | - | ------ | -
|                                                                                                                  |  | December 31 |       
|                                                                                                                  |  |             |       
|                                                                                                                  |  | 2010        |        | 2009 |  
|                                                                                                                  |  |             |        |      |  
|ASSETS                                                                                                            |  |             |        |      |   |        |  
|Current assets:                                                                                                   |  |             |        |      |   |        |  
|Cash and cash equivalents                                                                                         |  | $           | 8,021  |      | $ | 14,084 |  
|Investments                                                                                                       |  |             | 3,954  |      |   | 3,935  |  
|Accounts receivable, net of allowance for returns and doubtful
 accounts of $328 ($90 in 2009)                    |  |             | 10,137 |      |   | 5,660  |  
|Inventories                                                                                                       |  |             | 4,649  |      |   | 2,734  |  
|Prepaid expenses and other receivables                                                                            |  |             | 2,017  |      |   | 588    |  
|Deferred income taxes                                                                                             |  |             | 230    |      |   | 137    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total current assets                                                                                              |  |             | 29,008 |      |   | 27,138 |  
|                                                                                                                  |  |             |        |      |   |        |  
|Property and equipment:                                                                                           |  |             |        |      |   |        |  
|Furniture and fixtures                                                                                            |  |             | 380    |      |   | 274    |  
|Leasehold improvements                                                                                            |  |             | 158    |      |   | 92     |  
|Equipment                                                                                                         |  |             | 2,714  |      |   | 2,288  |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             | 3,252  |      |   | 2,654  |  
|Accumulated depreciation                                                                                          |  |             | 2,130  |      |   | 1,656  |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             | 1,122  |      |   | 998    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Deferred income taxes                                                                                             |  |             |       |      |   | 1,676  |  
|Intangible assets                                                                                                 |  |             | 9,513  |      |   | 3,714  |  
|Goodwill                                                                                                          |  |             | 14,713 |      |   | 7,624  |  
|                                                                                                                  |  |             |        |      |   |        |  
|TOTAL ASSETS                                                                                                      |  | $           | 54,356 |      | $ | 41,150 |  
|                                                                                                                  |  |             |        |      |   |        |  
|                                                                                                                  |  |             |        |      |   |        |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                              |  |             |        |      |   |        |  
|Current liabilities:                                                                                              |  |             |        |      |   |        |  
|Accounts payable                                                                                                  |  | $           | 2,094  |      | $ | 953    |  
|Bank debt                                                                                                         |  |             |       |      |   | 4,000  |  
|Accrued compensation                                                                                              |  |             | 1,364  |      |   | 858    |  
|Accrued warranty and other                                                                                        |  |             | 1,467  |      |   | 643    |  
|Earn-outs payable                                                                                                 |  |             | 2,928  |      |   | 1,541  |  
|Income taxes payable                                                                                              |  |             | 17     |      |   | 234    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total current liabilities                                                                                         |  |             | 7,870  |      |   | 8,229  |  
|                                                                                                                  |  |             |        |      |   |        |  
|Deferred income taxes                                                                                             |  |             | 290    |      |   |       |  
|Income taxes payable                                                                                              |  |             | 175    |      |   | 208    |  
|                                                                                                                  |  |             |        |      |   |        |  
|Shareholders equity:                                                                                             |  |             |        |      |   |        |  
|Preferred stock, $.01 par value; 5,000,000 shares authorized, none
 issued or outstanding                         |  |             |       |      |   |       |  
|Common stock, $.01 par value; 20,000,000 shares authorized, 4,878,519
 issued and outstanding (3,985,819 in 2009) |  |             | 49     |      |   | 40     |  
|Additional paid-in capital                                                                                        |  |             | 22,065 |      |   | 11,994 |  
|Accumulated other comprehensive income (loss)                                                                     |  |             | 52     |      |   | (171   | )
|Retained earnings                                                                                                 |  |             | 23,855 |      |   | 20,850 |  
|                                                                                                                  |  |             |        |      |   |        |  
|Total
 shareholders equity                                                                                       |  |             | 46,021 |      |   | 32,713 |  
|                                                                                                                  |  |             |        |      |   |        |  
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                        |  | $           | 54,356 |      | $ | 41,150 |  
|                                                                                                                  |  |             |        |      |   |        |  

See accompanying notes to the consolidated financial
statements.

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

|                                                         |  |                         |        |      |   |        |  |   |        | 
|-------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                                         |  | Years ended December 31 |       
|                                                         |  |                         |       
|                                                         |  | 2010                    |        | 2009 |   | 2008   | 
|                                                         |  |                         |        |      |   |        | 
|Revenue:                                                 |  |                         |        |      |   |        |  |   |        | 
|Product sales                                            |  | $                       | 19,162 |      | $ | 12,483 |  | $ | 13,144 | 
|Royalties                                                |  |                         | 12,519 |      |   | 12,110 |  |   | 13,321 | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|                                                         |  |                         | 31,681 |      |   | 24,593 |  |   | 26,465 | 
|Cost of revenue (exclusive of amortization shown below): |  |                         |        |      |   |        |  |   |        | 
|Product sales                                            |  |                         | 7,799  |      |   | 4,297  |  |   | 4,912  | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Gross profit                                             |  |                         | 23,882 |      |   | 20,296 |  |   | 21,553 | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Operating expenses:                                      |  |                         |        |      |   |        |  |   |        | 
|Selling, marketing and product support                   |  |                         | 9,807  |      |   | 7,201  |  |   | 6,680  | 
|General and administrative                               |  |                         | 4,372  |      |   | 3,779  |  |   | 4,069  | 
|Research and development                                 |  |                         | 3,630  |      |   | 3,336  |  |   | 2,908  | 
|Amortization of intangible assets                        |  |                         | 1,218  |      |   | 768    |  |   | 768    | 
|Acquisition related expenses                             |  |                         | 817    |      |   |       |  |   |       | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|                                                         |  |                         | 19,844 |      |   | 15,084 |  |   | 14,425 | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Income from operations                                   |  |                         | 4,038  |      |   | 5,212  |  |   | 7,128  | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Other income (expense), net                              |  |                         | (123   | )    |   | 7      |  |   | 43     | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Income before income taxes                               |  |                         | 3,915  |      |   | 5,219  |  |   | 7,171  | 
|Income tax expense                                       |  |                         | 910    |      |   | 1,354  |  |   | 2,207  | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Net income                                               |  | $                       | 3,005  |      | $ | 3,865  |  | $ | 4,964  | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Net income per share:                                    |  |                         |        |      |   |        |  |   |        | 
|Basic                                                    |  | $                       | 0.66   |      | $ | 0.97   |  | $ | 1.26   | 
|Diluted                                                  |  |                         | 0.64   |      |   | 0.95   |  |   | 1.24   | 
|                                                         |  |                         |        |      |   |        |  |   |        | 
|Weighted average number of common shares outstanding:    |  |                         |        |      |   |        |  |   |        | 
|Basic                                                    |  |                         | 4,555  |      |   | 3,985  |  |   | 3,943  | 
|Diluted                                                  |  |                         | 4,667  |      |   | 4,081  |  |   | 4,001  | 

See accompanying notes to the
consolidated financial statements.

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

|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|---------------------------------------------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------ | - | - | ------ | -
|                                                                                   |  | Years ended December 31 |        
|                                                                                   |  |                         |        
|                                                                                   |  | 2010                    |         | 2009 |   | 2008   |  
|                                                                                   |  |                         |         |      |   |        |  
|Operating activities:                                                              |  |                         |         |      |   |        |   |   |        |  
|Net income                                                                         |  | $                       | 3,005   |      | $ | 3,865  |   | $ | 4,964  |  
|Adjustments to reconcile net income to net cash provided by operating
 activities: |  |                         |         |      |   |        |   |   |        |  
|Depreciation                                                                       |  |                         | 498     |      |   | 424    |   |   | 357    |  
|Amortization                                                                       |  |                         | 1,218   |      |   | 768    |   |   | 768    |  
|Tax benefit from disqualifying disposition                                         |  |                         | 72      |      |   |       |   |   | 137    |  
|Stock option expense                                                               |  |                         | 342     |      |   | 341    |   |   | 339    |  
|Deferred income taxes                                                              |  |                         | 174     |      |   | 138    |   |   | (133   | )
|Changes in operating assets and liabilities, net of acquisition:                   |  |                         |         |      |   |        |   |   |        |  
|Accounts receivable                                                                |  |                         | (3,711  | )    |   | 960    |   |   | (1,623 | )
|Inventories                                                                        |  |                         | (1,309  | )    |   | (1,126 | ) |   | (29    | )
|Prepaid expenses and other receivables                                             |  |                         | (1,229  | )    |   | (212   | ) |   | (148   | )
|Accounts payable                                                                   |  |                         | 391     |      |   | 702    |   |   | (565   | )
|Accrued liabilities                                                                |  |                         | 832     |      |   | (384   | ) |   | 671    |  
|Income taxes payable                                                               |  |                         | (250    | )    |   | (87    | ) |   | 445    |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Net cash provided by operating activities                                          |  |                         | 33      |      |   | 5,389  |   |   | 5,183  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Investing activities:                                                              |  |                         |         |      |   |        |   |   |        |  
|Cash paid to sellers of CitySync equity                                            |  |                         | (7,871  | )    |   |       |   |   |       |  
|Repayment of CitySync seller loans                                                 |  |                         | (445    | )    |   |       |   |   |       |  
|EIS earn-out payment                                                               |  |                         | (1,541  | )    |   | (1,192 | ) |   |       |  
|Purchase of short-term investments                                                 |  |                         | (8,882  | )    |   | (6,640 | ) |   | (7,400 | )
|Sale of short-term investments                                                     |  |                         | 8,863   |      |   | 6,705  |   |   | 3,400  |  
|Purchases of property and equipment                                                |  |                         | (380    | )    |   | (694   | ) |   | (385   | )
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Net cash used in investing activities                                              |  |                         | (10,256 | )    |   | (1,821 | ) |   | (4,385 | )
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Financing activities:                                                              |  |                         |         |      |   |        |   |   |        |  
|Net proceeds from common stock offering                                            |  |                         | 8,818   |      |   |       |   |   |       |  
|Proceeds from exercise of stock options                                            |  |                         | 121     |      |   | 1      |   |   | 173    |  
|Proceeds from bank debt                                                            |  |                         |        |      |   | 4,000  |   |   |       |  
|Repayment of bank debt                                                             |  |                         | (4,556  | )    |   | (3,750 | ) |   | (1,250 | )
|Cash released from restriction on bank debt                                        |  |                         |        |      |   |       |   |   | 5,263  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Net cash provided by financing activities                                          |  |                         | 4,383   |      |   | 251    |   |   | 4,186  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Effect of exchange rate changes on cash                                            |  |                         | (223    | )    |   | 24     |   |   | (308   | )
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Increase (decrease) in cash and cash equivalents                                   |  |                         | (6,063  | )    |   | 3,795  |   |   | 4,676  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Cash and cash equivalents at beginning of year                                     |  |                         | 14,084  |      |   | 10,289 |   |   | 5,613  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Cash and cash equivalents at end of year                                           |  | $                       | 8,021   |      | $ | 14,084 |   | $ | 10,289 |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Supplemental disclosure:                                                           |  |                         |         |      |   |        |   |   |        |  
|Income taxes paid                                                                  |  | $                       | 1,571   |      | $ | 1,488  |   | $ | 1,680  |  
|Interest expense paid                                                              |  | $                       | 155     |      | $ | 33     |   | $ | 278    |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|Supplemental non-cash disclosure:                                                  |  |                         |         |      |   |        |   |   |        |  
|Common stock issued in connection with CitySync acquisition                        |  | $                       | 727     |      | $ |       |   | $ |       |  
|EIS earn-out payable recorded as additional goodwill                               |  | $                       | 1,665   |      | $ | 1,541  |   | $ | 1,164  |  
|                                                                                   |  |                         |         |      |   |        |   |   |        |  
|See accompanying notes to the consolidated financial
 statements.                  |  |                         |         |      |   |        |   |   |        |  

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

|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|----------------------------------------------------------------- |  | -------------- | --------- | ------------- | - | ---------------------------- |  | ------------------------------------------------- | ------ | ------------------ | - | ----- | - | - | ------ |  | - | ------ | -
|                                                                  |  | Shares
 Issued |           | Common
 Stock |   | Additional
 Paid-In
 Capital |  | Accumulated
 Other
 Comprehensive
 Income
 (Loss) |        | Retained
 Earnings |   | Total |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |  
|Balance at December 31, 2007                                      |  |                | 3,927,806 |               | $ | 39                           |  | $                                                 | 11,004 |                    | $ | 161   |   | $ | 12,021 |  | $ | 23,225 |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Tax benefit from disqualifying disposition                        |  |                |          |               |   |                             |  |                                                   | 137    |                    |   |      |   |   |       |  |   | 137    |  
|Common stock issued for options exercised                         |  |                | 59,000    |               |   | 1                            |  |                                                   | 194    |                    |   |      |   |   |       |  |   | 195    |  
|Common stock retired                                              |  |                | (1,587    | )             |   |                             |  |                                                   | (22    | )                  |   |      |   |   |       |  |   | (22    | )
|Stock option expense                                              |  |                |          |               |   |                             |  |                                                   | 339    |                    |   |      |   |   |       |  |   | 339    |  
|Foreign currency translation adjustment                           |  |                |          |               |   |                             |  |                                                   |       |                    |   | (308  | ) |   |       |  |   | (308   | )
|Net income                                                        |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   | 4,964  |  |   | 4,964  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                                              |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   |       |  |   | 4,656  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2008                                      |  |                | 3,985,219 |               |   | 40                           |  |                                                   | 11,652 |                    |   | (147  | ) |   | 16,985 |  |   | 28,530 |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Common stock issued for options exercised                         |  |                | 600       |               |   |                             |  |                                                   | 1      |                    |   |      |   |   |       |  |   | 1      |  
|Stock option expense                                              |  |                |          |               |   |                             |  |                                                   | 341    |                    |   |      |   |   |       |  |   | 341    |  
|Foreign currency translation adjustment                           |  |                |          |               |   |                             |  |                                                   |       |                    |   | (24   | ) |   |       |  |   | (24    | )
|Net income                                                        |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   | 3,865  |  |   | 3,865  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                                              |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   |       |  |   | 3,841  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2009                                      |  |                | 3,985,819 |               |   | 40                           |  |                                                   | 11,994 |                    |   | (171  | ) |   | 20,850 |  |   | 32,713 |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Tax benefit from disqualifying disposition                        |  |                |          |               |   |                             |  |                                                   | 72     |                    |   |      |   |   |       |  |   | 72     |  
|Common stock issued for options exercised                         |  |                | 37,700    |               |   |                             |  |                                                   | 121    |                    |   |      |   |   |       |  |   | 121    |  
|Common stock issued in secondary offering, net                    |  |                | 798,000   |               |   | 8                            |  |                                                   | 8,810  |                    |   |      |   |   |       |  |   | 8,818  |  
|Common stock issued in CitySync acquisition                       |  |                | 57,000    |               |   | 1                            |  |                                                   | 726    |                    |   |      |   |   |       |  |   | 727    |  
|Stock option expense                                              |  |                |          |               |   |                             |  |                                                   | 342    |                    |   |      |   |   |       |  |   | 342    |  
|Foreign currency translation adjustment                           |  |                |          |               |   |                             |  |                                                   |       |                    |   | 223   |   |   |       |  |   | 223    |  
|Net income                                                        |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   | 3,005  |  |   | 3,005  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Comprehensive income                                              |  |                |          |               |   |                             |  |                                                   |       |                    |   |      |   |   |       |  |   | 3,228  |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|Balance at December 31, 2010                                      |  |                | 4,878,519 |               | $ | 49                           |  | $                                                 | 22,065 |                    | $ | 52    |   | $ | 23,855 |  | $ | 46,021 |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|                                                                  |  |                |           |               |   |                              |  |                                                   |        |                    |   |       |   |   |        |  |   |        |  
|See
 accompanying notes to the consolidated financial statements. | 

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Notes to Consolidated Financial Statements

December 31, 2010

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

DESCRIPTION OF BUSINESS

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

PRINCIPLES OF CONSOLIDATION

The
consolidated financial statements include the accounts of Image Sensing
Systems, Inc. and its wholly-owned subsidiaries: Flow Traffic Ltd. (Flow
Traffic) located in Hong Kong; Image Sensing Systems Holdings Limited
(ISS/Holdings) and Image Sensing Systems Europe Ltd. (ISS/Europe), both located
in the United Kingdom; Image Sensing Systems Europe Limited SP.Z.O.O.
(ISS/Poland), located in Poland; ISS Image Sensing Systems Canada Ltd
(ISS/Canada) and ISS Canada Sales Corp. (Canada Sales Corp.), both located in
Ontario, Canada; and CitySync Limited (CitySync), located in the United
Kingdom. All significant inter-company transactions and accounts have been
eliminated in consolidation.

REVENUE RECOGNITION

Royalty
income is recognized based upon a monthly royalty report provided to us by
Econolite Control Products, Inc. (Econolite), a licensee that sells one of our
products in North America, the Caribbean and Latin America. The royalty is
calculated using a profit sharing model where we split evenly the gross profit
on sales of our Autoscope product made by Econolite. The royalty report is
prepared by Econolite based on its sales of licensed products shipped or delivered to its customers.

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

CASH AND CASH EQUIVALENTS

We
consider all highly liquid investments with an original maturity of three
months or less to be cash equivalents. Cash equivalents consist of money market
funds. Cash located in foreign banks was $3.3 million and $3.6 million at
December 31, 2010 and 2009, respectively. We hold our cash and cash equivalents
with financial institutions and, at times, the amounts of our balances may be
in excess of insurance limits.

INVESTMENTS

Investments
and marketable securities held at December 31, 2010 and 2009 that do not
qualify as cash equivalents have been designated as available for sale.

ACCOUNTS RECEIVABLE

We
grant credit to customers in the normal course of business and generally do not
require collateral. Management performs on-going credit evaluations of
customers. We have fixed payment terms with each of our customers that vary in
length. Accounts receivable that are outstanding longer than the fixed payment
term are considered past due. We determine an allowance for doubtful accounts
by considering a number of factors, including any on-going technical problems
with product in the field, the length of time trade accounts receivable are
past due, our previous loss history with the customer and the customers
current ability to pay. We write off accounts receivable when they become
uncollectible, and payments subsequently received on such receivables are
credited to the allowance for doubtful accounts.

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INVENTORIES

Inventories
are primarily electronic components and finished goods and are valued at the
lower of cost or market on the first-in, first-out (FIFO) method. Adjustments
to record inventory at the lower of cost or market are charged to cost of
revenue in the period incurred and totaled $23,000, $6,000 and $211,000 for the
years ended December 31, 2010, 2009 and 2008, respectively.

PROPERTY AND EQUIPMENT

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

INCOME TAXES

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

FAIR VALUE MEASUREMENTS

Fair
value is determined on the exchange price that would be received for an asset
or paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction
between market participants. Each major asset and liability category is
measured at fair value on either a recurring or nonrecurring basis using a
three-tier fair value hierarchy which prioritizes the inputs used in fair value
measurements. The three-tier hierarchy for inputs used in measuring fair value
is as follows:

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

INTANGIBLE ASSETS

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

GOODWILL

Goodwill
is not amortized but is tested for impairment annually or whenever an
impairment indicator arises. Our goodwill related to our Flow Traffic
subsidiary is tested for impairment on December 31 of each year. EIS asset
purchase related goodwill is tested on October 1 of each year. CitySync
goodwill will be tested beginning in April 2011. There is a two-step process
for impairment testing of goodwill. The first step, used to identify potential
impairment, compares the fair value of a reporting unit with its carrying
amount, including goodwill. The second step, if necessary, measures the amount
of the impairment by comparing the estimated fair value of the goodwill and
intangible assets to their respective carrying values. If an impairment is
identified, the carrying value of the asset is adjusted to estimated fair
value.

During
our annual impairment testing, we reconcile our market value, based on the
value of our common stock, to the estimated combined fair value of our
reporting units, to ensure that goodwill is not impaired. For Flow Traffic, we
estimate the fair value by using a combination of the income approach, where
fair value is dependent on the present value of future economic benefits to be
derived from ownership of Flow Traffic, and the comparable market transactions
method. The future economic benefits are significantly dependent on sustaining
revenue levels for all product lines. For the RTMS reporting unit, we estimate
fair value by using a combination of the income approach, where fair value is
dependent on the present value of future economic benefits to be derived from
the RTMS product line, and the market valuation approach, where the business
was compared to guideline public company price-earning multiples with a
significant weighting to companies in the traffic detection business. The
future economic benefits are mainly dependent on future revenue growth of the
RTMS product line. At December 31, 2008, we performed a reconciliation, as our market
capitalization was similar to our consolidated shareholders equity. We
determined that no goodwill impairment existed at December 31, 2010, 2009 and
2008, as the fair value of each reporting unit exceeded its carrying value.

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IMPAIRMENT OF LONG-LIVED
ASSETS

Long-lived
assets are reviewed for impairment when indicators of impairment are present.
Impairment is recognized when the undiscounted cash flows estimated to be
generated by those assets are less than the assets carrying amount. No such
losses were recorded during the years ended December 31, 2010, 2009 or 2008.

USE OF ESTIMATES

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

RESEARCH AND DEVELOPMENT

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

WARRANTIES

We
generally provide a standard two-year warranty on product sales. Reserves to
honor warranty claims are estimated and recorded at the time of sale based on
historical claim information and are analyzed and adjusted periodically based
on claim trends.

ADVERTISING

Advertising
costs are charged to operations in the period incurred and totaled $153,000,
$151,000 and $196,000 for the years ended December 31, 2010, 2009 and 2008,
respectively.

FOREIGN CURRENCY

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

NET INCOME PER SHARE

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

For
the years ended December 31, 2010, 2009 and 2008, respectively, 112,000, 96,000
and 58,000 common share equivalents were included in the computation of diluted
net income per share.

At
December 31, 2010, 2009 and 2008, the exercise prices of 133,000, 36,000 and
253,500 outstanding options, respectively, were greater than the average market
price of the common shares during the period and were excluded from the
calculation of diluted net income per share.

STOCK OPTIONS

We
recognize compensation expense for share-based awards using the fair value of
the option at the time of the grant and amortizing the fair value over the estimated
service period on the straight-line attribute method. Unrecognized compensation
costs were $761,000 at December 31, 2010, with a weighted average remaining
life of 2.4 years.

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NEW ACCOUNTING PRONOUNCEMENTS

In
January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-06, Improving Disclosures about Fair Value Measurements
(ASU 2010-06). ASU 2010-06 requires new disclosures regarding transfers in
and out of Levels 1 and 2 and activity in
Level 3 fair value measurements. It also clarifies existing disclosure
requirements regarding the level of disaggregation in certain disclosures,
inputs, and valuation techniques used in ASC 820, Fair Value Measurements and Disclosures. We adopted all of
the requirements of this update on January 1, 2010, its effective date, except
for the new requirement regarding activity in Level 3 fair value measurements
which has a later effective date under the provisions of ASU 2010-6 and will
become effective on January 1, 2011. Adoption of this pronouncement has not
had, and is not expected to have, a significant effect on our consolidated
financial statements disclosures.

In
September 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the
Allowance for Credit Losses, to enhance the disclosures required for
financing receivables (for example, loans, trade accounts receivable, notes
receivable, and receivables relating to a lessors leveraged, direct financing,
and sales-type leases) and allowances for credit losses. The amended
disclosures are designed to provide more information to financial statement
users regarding the credit quality of a creditors financing receivables and
the adequacy of its allowance for credit losses. We adopted all of the
requirements of the amended guidance on December 31, 2010, its effective date,
except for the disclosures regarding the activity during a reporting period
which will become effective January 1, 2011. Adoption of the pronouncement has
not had, and is not expected to have, a significant effect on our consolidated
financial statement disclosures.

RECLASSIFICATIONS

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

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

Investments
and marketable securities held at December 31, 2010 and 2009 that do not
qualify as cash equivalents have been designated as available for sale. The
estimated fair value of the investments held at December 31, 2010 and 2009 was
determined using Level 1 measurements.

Our
current portfolio is composed of high-grade municipal bonds, federal notes and
commercial paper. The maximum term to maturity or time to next reset is six
months.

Investments
consisted of the following (in thousands):

|                  |  |              |       |      |   |       | 
|----------------- |  | ------------ | ----- | ---- | - | ----- | 
|                  |  | December 31, |      
|                  |  |              |      
|                  |  | 2010         |       | 2009 |  
|                  |  |              |       |      |  
|Federal
 notes    |  | $            | 422   |      | $ |      | 
|Municipal
 bonds  |  |              | 2,217 |      |   | 3,935 | 
|Commercial
 paper |  |              | 1,315 |      |   |      | 
|                  |  |              |       |      |   |       | 
|                  |  |              |       |      |   |       | 
|Total             |  | $            | 3,954 |      | $ | 3,935 | 
|                  |  |              |       |      |   |       | 

Proceeds
from maturities and sales of investments totaled $8.9 million, $6.7 million and
$3.4 million for the years ended December 31, 2010, 2009 and 2008,
respectively. Realized gains or losses related to sales during the years ended
December 31, 2010 and 2009 were immaterial and are included in interest income.

|   |            
|-- | -----------
|3. | INVENTORIES

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

|                       |  |              |       |      |   |       | 
|---------------------- |  | ------------ | ----- | ---- | - | ----- | 
|                       |  | December 31, |      
|                       |  |              |      
|                       |  | 2010         |       | 2009 |  
|                       |  |              |       |      |  
|Electronic
 components |  | $            | 2,114 |      | $ | 1,733 | 
|Finished
 goods        |  |              | 2,535 |      |   | 1,001 | 
|                       |  |              |       |      |   |       | 
|Total                  |  | $            | 4,649 |      | $ | 2,734 | 
|                       |  |              |       |      |   |       | 

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

On
June 21, 2010, we purchased all of the outstanding equity of CitySync Limited,
a privately-held developer and marketer of automatic number plate recognition
(ANPR) products. We believe the CitySync acquisition expands our addressable
market, strengthens our selling presence in Europe and extends the
opportunities for hybrid product developments. The purchase price was $7.9
million in cash plus 57,000 shares of our common stock, valued using the
closing price on the day before the acquisition, totaling approximately
$727,000. In conjunction with the purchase, we repaid seller loans, including
accrued interest, of $601,000. Following the acquisition, CitySync became a
wholly-owned subsidiary of ISS/Europe.

As
part of the purchase agreement, the sellers are eligible to receive an earn-out
based on the performance of the business for the next 18 months. Earn-outs will
be calculated as of each calendar year end and paid within 90 days thereof. The
earn-out is based on achieving certain revenue and minimum gross margins from
the sale of CitySync ANPR systems, and it is calculated in two separate periods,
each ending on December 31. In each period there are two tiers, and superior
performance could lead to a total earn-out of $2 million or higher, as the
earn-out is not capped. The 2010 earn-out achieved was $696,000. We had
initially determined the fair value of the 2010 earn-out to be $491,000 as of
June 30, 2010, and therefore we incurred an additional $205,000 that is
recognized in the consolidated statements of income under the caption
Acquisition related expenses. The estimate of the 2011 earn-out fair value of
$519,000 is unchanged.

At
June 30, 2010, we preliminarily estimated the value of goodwill from the
CitySync acquisition at $3.3 million and revised our estimate to $5.3 million
as of September 30, 2010. This estimate did not change as of December 31, 2010,
and management has determined the goodwill is no longer subject to look-back
adjustments.

The
purchase price was allocated on the basis of estimated fair value at the date
of the purchase. The final purchase price allocation is as follows (in
thousands):

|                                  |  |   |        |  
|--------------------------------- |  | - | ------ | -
|Consideration transferred:        |  |   |        |  
|Cash                              |  | $ | 7,871  |  
|Fair value of common stock        |  |   | 727    |  
|Estimated
 fair value of earn-out |  |   | 1,010  |  
|                                  |  |   |        |  
|Total purchase price              |  |   | 9,608  |  
|                                  |  |   |        |  
|Allocation:                       |  |   |        |  
|Net tangible current assets       |  |   | (1,684 | )
|Property and equipment            |  |   | (242   | )
|Liabilities                       |  |   | 2,450  |  
|Deferred income taxes             |  |   | 1,876  |  
|Developed technology              |  |   | (3,300 | )
|Trade names                       |  |   | (1,900 | )
|Other
 intangibles                |  |   | (1,500 | )
|                                  |  |   |        |  
|Goodwill                          |  | $ | 5,308  |  
|                                  |  |   |        |  

In
conjunction with the acquisition, all of the shares of common stock issued in
connection with the transaction were placed in escrow to secure potential
indemnification obligations. Any shares remaining in escrow on December 31,
2012 will be released to the sellers.

The
results of CitySync operations are included in the accompanying financial
statements since the date of the acquisition. The following pro forma summary
presents the results of operations as if the acquisition had occurred on January
1, 2009. The table below includes our results for the periods as shown and for
CitySync based on a January fiscal year. The pro forma results are not
necessarily indicative of the results that would have been achieved had the
CitySync acquisition taken place on that date (in thousands, except per share
amounts):

|                      |  |                          |        |      |   |        | 
|--------------------- |  | ------------------------ | ------ | ---- | - | ------ | 
|                      |  | Year Ended
 December 31, |       
|                      |  |                          |       
|                      |  | 2010                     |        | 2009 |  
|                      |  |                          |        |      |  
|Total
 revenue        |  | $                        | 34,088 |      | $ | 32,034 | 
|                      |  |                          |        |      |   |        | 
|Net income            |  |                          | 2,508  |      |   | 2,937  | 
|                     
|Net income per share: |  |                          |        |      |   |        | 
|Basic                 |  | $                        | 0.55   |      | $ | 0.73   | 
|                      |  |                          |        |      |   |        | 
|Diluted               |  | $                        | 0.53   |      | $ | 0.71   | 
|                      |  |                          |        |      |   |        | 

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In
2007, we purchased certain assets of EIS Electronic Integrated Systems, Inc.
(EIS), including its RTMS radar product line. As part of the purchase
agreement, the sellers are eligible to receive an earn-out based on the
performance of the EIS assets purchased for approximately three years after the
December 2007 purchase date. Earn-outs were calculated annually for 2008, 2009
and 2010. Earn-out payments related to the EIS asset purchase were recorded as
additional goodwill when earned. In 2009, the sellers were entitled to a $1.5
million earn-out for the second earn-out period, which was paid in March 2010.
For 2010, the final earn-out period, the sellers are entitled to a $1.7 million
earn-out, which is expected to be paid in March 2011.

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

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic (Autoscope
segment), $8.2 million related to the EIS asset purchase (RTMS segment) and $5.4
million related to our acquisition of CitySync (CitySync segment). Because the
goodwill and intangible assets related to the CitySync acquisition are
accounted for in Great Britain Pounds, they are impacted by period-end rates of
exchange to United States Dollars and therefore may vary in different reporting
periods.

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

|                                          |  |              |        |      |   |        |  
|----------------------------------------- |  | ------------ | ------ | ---- | - | ------ | -
|                                          |  | December 31, |       
|                                          |  |              |       
|                                          |  | 2010         |        | 2009 |  
|                                          |  |              |        |      |  
|Developed technology (8 to 9 year life)   |  | $            | 7,364  |      | $ | 3,900  |  
|Trade names (5 to 8 year life)            |  |              | 3,193  |      |   | 1,200  |  
|Other intangibles (3 to 8 year life)      |  |              | 1,774  |      |   | 200    |  
|Less: Accumulated amortization            |  |              | (2,818 | )    |   | (1,586 | )
|                                          |  |              |        |      |   |        |  
|Total identifiable intangible assets, net |  | $            | 9,513  |      | $ | 3,714  |  
|                                          |  |              |        |      |   |        |  

We
expect to recognize amortization expense for the intangible assets in the above
table in each of our years ending December 31 of $1.6 million in each of 2011
and 2012, and $1.3 million in each of 2013, 2014 and 2015. The weighted average
amortization period remaining for intangible assets is 6.5 years. Goodwill and
intangible assets related to the EIS asset purchase are deductible for tax
purposes over 15 years.

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

We
have a revolving line of credit and had term loans with our bank. These credit
agreements were initially entered into on May 1, 2008 and replaced all prior
bank agreements, including the repayment of loans under the previous
agreements.

The
revolving line of credit agreement with Associated Bank, National Association,
or Associated Bank, provides up to $5.0 million in short-term borrowings at the
banks prime rate expiring May 1, 2012. Any loans are secured by inventories,
accounts receivable and equipment, and Associated Bank has the right of setoff
against our checking, savings and other accounts. There was no outstanding
balance under the line at December 31, 2010 and 2009.

In
December 2009, we entered into a term loan agreement for $4.0 million with
Associated Bank, which was fully repaid in September 2010. We previously had a
separate $4.0 million term note with Associated Bank that originated in May
2008 and was fully repaid in February 2009.

|   |           
|-- | ----------
|7. | WARRANTIES

Warranty
liability and related activity consisted of the following (in thousands):

|                                                      |  |                          |      |      |   |      |   |   |     |  
|----------------------------------------------------- |  | ------------------------ | ---- | ---- | - | ---- | - | - | --- | -
|                                                      |  | Years Ended December 31, |     
|                                                      |  |                          |     
|                                                      |  | 2010                     |      | 2009 |   | 2008 |  
|                                                      |  |                          |      |      |   |      |  
|Warranty
 liability at beginning of year              |  | $                        | 289  |      | $ | 217  |   | $ | 157 |  
|Provisions
 for estimated future warranty obligations |  |                          | 484  |      |   | 175  |   |   | 153 |  
|Costs
 incurred for warranties honored                |  |                          | (149 | )    |   | (103 | ) |   | (93 | )
|                                                      |  |                          |      |      |   |      |   |   |     |  
|Warranty
 liability at end of year                    |  | $                        | 624  |      | $ | 289  |   | $ | 217 |  
|                                                      |  |                          |      |      |   |      |   |   |     |  

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|   |                  
|-- | -----------------
|8. | LEASE COMMITMENTS

We
rent office space and equipment under operating lease agreements expiring at
various dates through January 2015. Our leases currently provide for monthly
payments of $90,000, which is inclusive of our proportionate share of operating
expenses that exceed a base rent. Rent expense for office facilities was
$777,000 in 2010, $585,000 in 2009 and $555,000 in 2008.

Future
minimum annual lease payments under noncancelable operating leases for the
years ending December 31, 2011, 2012, 2013, 2014 and 2015 are $556,000,
$376,000, $353,000, $261,000 and $16,000, respectively.

|   |             
|-- | ------------
|9. | INCOME TAXES

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

|                                                |  |              |        |      |   |       |  
|----------------------------------------------- |  | ------------ | ------ | ---- | - | ----- | -
|                                                |  | December 31, |       
|                                                |  |              |       
|                                                |  | 2010         |        | 2009 |  
|                                                |  |              |        |      |  
|Current deferred tax assets (liabilities):      |  |              |        |      |   |       |  
|Accrued compensation                            |  | $            | 55     |      | $ | 47    |  
|Prepaid expenses                                |  |              | (67    | )    |   | (48   | )
|Bad debt reserves                               |  |              | 75     |      |   | 27    |  
|Warranty reserves                               |  |              | 143    |      |   | 45    |  
|Other                                           |  |              | 24     |      |   | 66    |  
|Foreign net operating loss carryforwards        |  |              |       |      |   | 55    |  
|Less valuation allowance                        |  |              |       |      |   | (55   | )
|                                                |  |              |        |      |   |       |  
|                                                |  |              | 230    |      |   | 137   |  
|Non-current deferred tax assets
 (liabilities): |  |              |        |      |   |       |  
|Intangible asset amortization - EIS             |  |              | 1,369  |      |   | 1,525 |  
|Intangible asset amortization - CitySync        |  |              | (1,840 | )    |   |      |  
|Stock option expense (non-qualified)            |  |              | 164    |      |   | 131   |  
|Other                                           |  |              | 17     |      |   | 20    |  
|                                                |  |              |        |      |   |       |  
|                                                |  |              | (290   | )    |   | 1,676 |  
|                                                |  |              |        |      |   |       |  
|Net deferred tax assets (liabilities)           |  | $            | (60    | )    | $ | 1,813 |  
|                                                |  |              |        |      |   |       |  

Deferred
tax assets have been offset by a valuation allowance as deemed necessary based
on our estimates of future sources of taxable income and the expected timing of
temporary difference reversals.

There
were $4.4 million, $3.3 million and $2.0 million in undistributed earnings of
our wholly-owned foreign subsidiaries at December 31, 2010, 2009 and 2008,
respectively. We have not provided any additional federal or state income taxes
or foreign withholding taxes on the undistributed earnings, as such earnings
have been indefinitely reinvested in the business.

We
realize an income tax benefit from the exercise or early disposition of certain
stock options. This benefit results in a decrease in current income taxes
payable and an increase in additional paid-in capital.

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The
components of income tax expense are as follows (in thousands):

|                         |  |                          |     |      |   |       |   |   |       |  
|------------------------ |  | ------------------------ | --- | ---- | - | ----- | - | - | ----- | -
|                         |  | Years Ended December 31, |    
|                         |  |                          |    
|                         |  | 2010                     |     | 2009 |   | 2008  |  
|                         |  |                          |     |      |   |       |  
|Current:                 |  |                          |     |      |   |       |   |   |       |  
|Federal                  |  | $                        | 983 |      | $ | 1,222 |   | $ | 1,738 |  
|State                    |  |                          | (65 | )    |   | 23    |   |   | 38    |  
|Foreign                  |  |                          | 25  |      |   | (29   | ) |   | 564   |  
|                         |  |                          |     |      |   |       |   |   |       |  
|                         |  |                          | 943 |      |   | 1,216 |   |   | 2,340 |  
|                         |  |                          |     |      |   |       |   |   |       |  
|Deferred:                |  |                          |     |      |   |       |   |   |       |  
|Federal                  |  |                          | (32 | )    |   | 82    |   |   | (59   | )
|State                    |  |                          | (1  | )    |   | 5     |   |   | (23   | )
|Foreign                  |  |                          |    |      |   | 51    |   |   | (51   | )
|                         |  |                          |     |      |   |       |   |   |       |  
|                         |  |                          | (33 | )    |   | 138   |   |   | (133  | )
|                         |  |                          |     |      |   |       |   |   |       |  
|Total income tax expense |  | $                        | 910 |      | $ | 1,354 |   | $ | 2,207 |  
|                         |  |                          |     |      |   |       |   |   |       |  

Income
before taxes for the foreign operations was $1.1 million, $1.3 million and $1.7
million for the years ended December 31, 2010, 2009 and 2008.

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

|                                                  |  |                          |       |      |   |       |   |   |       |  
|------------------------------------------------- |  | ------------------------ | ----- | ---- | - | ----- | - | - | ----- | -
|                                                  |  | Years Ended December 31, |      
|                                                  |  |                          |      
|                                                  |  | 2010                     |       | 2009 |   | 2008  |  
|                                                  |  |                          |       |      |   |       |  
|Federal tax statutory rate                        |  | $                        | 1,331 |      | $ | 1,774 |   | $ | 2,438 |  
|State taxes, net of federal benefit               |  |                          | (47   | )    |   | 18    |   |   | 10    |  
|Research and development tax credits              |  |                          | (454  | )    |   | (301  | ) |   | (120  | )
|Non-deductible acquisition expenses and
 earn-out |  |                          | 238   |      |   |      |   |   |      |  
|Domestic production activity deduction            |  |                          | (111  | )    |   | (62   | ) |   | (83   | )
|Effect of lower rates on foreign income           |  |                          | (43   | )    |   | (58   | ) |   | (125  | )
|Reduction in valuation allowance                  |  |                          | (55   | )    |   |      |   |   | (77   | )
|Stock option expense                              |  |                          | 75    |      |   | 74    |   |   | 66    |  
|Adjustment of prior year tax credits and
 refunds |  |                          | (64   | )    |   | (77   | ) |   | (50   | )
|Uncertain tax positions                           |  |                          | (33   | )    |   | (38   | ) |   | 96    |  
|Other                                             |  |                          | 73    |      |   | (46   | ) |   | 52    |  
|                                                  |  |                          |       |      |   |       |   |   |       |  
|                                                  |  | $                        | 910   |      | $ | 1,354 |   | $ | 2,207 |  
|                                                  |  |                          |       |      |   |       |   |   |       |  

A
reconciliation of the beginning and ending amount of the tax liability for
uncertain tax benefits is as follows (in thousands):

|                                                            |  |   |     |  
|----------------------------------------------------------- |  | - | --- | -
|Balance at January 1, 2009                                  |  | $ | 246 |  
|Additions for current year tax positions                    |  |   |    |  
|Reductions as a result of lapses in statute
 of limitations |  |   | (38 | )
|                                                            |  |   |     |  
|Balance at December 31, 2009                                |  |   | 208 |  
|                                                            |  |   |     |  
|Additions for current year tax positions                    |  |   |    |  
|Reductions as a result of lapses in statute
 of limitations |  |   | (33 | )
|                                                            |  |   |     |  
|Balance at December 31, 2010                                |  | $ | 175 |  
|                                                            |  |   |     |  

We
are subject to income taxes in the U.S. federal jurisdiction and various state
and foreign jurisdictions. Tax regulations within each jurisdiction are subject
to the interpretation of the related tax laws and require significant judgment
to apply. Generally, we are subject to U.S. federal, state, local and foreign
tax examinations by taxing authorities for years after the fiscal year ended
December 31, 2006.

|    |          
|--- | ---------
|10. | LICENSING

We
have sublicensed the exclusive right to manufacture and market the Autoscope
technology in North America, the Caribbean and Latin America to Econolite
Control Products, Inc. (Econolite) and receive royalties from Econolite on
sales of the Autoscope system in those territories as well as in non-exclusive
territories as allowed from time to time. We may terminate our agreement with
Econolite if a minimum annual sales level is not met or Econolite fails to make
royalty payments as required by the agreement. The agreements term runs to
2028, unless terminated by either party upon three years notice.

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We
recognized royalty income from this agreement of $12.5 million, $12.1 million
and $13.3 million in 2010, 2009 and 2008, respectively.

|    |                      
|--- | ---------------------
|11. | REVENUE BY
 GEOGRAPHY

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

|              |  |      |  |      |   |      |  |  |    |  
|------------- |  | ---- |  | ---- | - | ---- |  |  | -- | -
|              |  | 2010 |  | 2009 |   | 2008 | 
|              |  |      |  |      |   |      | 
|Asia Pacific  |  |      |  | 11   | % |      |  |  | 10 | %
|Europe        |  |      |  | 26   | % |      |  |  | 15 | %
|North America |  |      |  | 63   | % |      |  |  | 75 | %

No
country other than the United States had revenue in excess of 10% of our total
revenue. The aggregate net book value of long-lived assets held outside of the
United States, not including goodwill and intangible assets, was $401,000 and
$288,000 at December 31, 2010 and 2009, respectively.

|    |                                                        
|--- | -------------------------------------------------------
|12. | SIGNIFICANT
 CUSTOMERS AND CONCENTRATION OF CREDIT RISK

Royalty
income from Econolite comprised 40%, 49% and 50% of revenue in the years ended
December 31, 2010, 2009 and 2008, respectively. Accounts receivable from
Econolite were $2.6 million and $2.2 million at December 31, 2010 and 2009,
respectively. Major disruptions in the manufacturing and distribution of our
products by Econolite or the inability of Econolite to make payments on their
accounts receivable with us could have a material adverse effect on our
business, financial condition and results of operations. Not including
Econolite, one international customer comprised 15% of accounts receivable at
December 31, 2010 and a separate international customer comprised 10% of
accounts receivable at December 31, 2009.

|    |                  
|--- | -----------------
|13. | RETIREMENT
 PLANS

Substantially all of our
employees in the United States are eligible to participate in a qualified
defined contribution 401(k) plan in which participants may elect to have a
specified portion of their salary contributed to the plan and we may make
discretionary contributions to the plan. Flow Traffic and CitySync are
obligated to contribute to certain employee pension plans. We made
contributions totaling $131,000, $98,000 and $97,000 to the plans for 2010,
2009 and 2008, respectively.

|    |                          
|--- | -------------------------
|14. | EQUITY AND
 STOCK OPTIONS

In
April 2010, we sold 798,000 shares of our common stock to investors at $12.25
per share under a registration statement on Form S-3 declared effective by the
Securities and Exchange Commission in December 2009. Net of underwriting fees
and other offering expenses, we received $8.8 million in cash from the stock
sale.

In
February 1995 and April 2005, we adopted the 1995 Long-Term Incentive and Stock
Option Plan (the 1995 Plan) and the 2005 Stock Incentive Plan (the 2005 Plan),
respectively, which provide for the granting of incentive (ISO) and
non-qualified (NQO) stock options, stock appreciation rights, restricted stock
awards and performance awards to our officers, directors, employees,
consultants and independent contractors. The 1995 Plan terminated in February
2005, although the options granted under the 1995 Plan remain outstanding
according to their terms. Options granted under the Plans generally vest over
three to five years based on service, and have a contractual term of six to ten
years and are amortized to expense on a straight-line basis. The following
table summarizes stock option activity for 2010, 2009 and 2008:

|                              |  |                                    |         |                           |  |                               |   |                                              |         |   |  |         |   |   |       | 
|----------------------------- |  | ---------------------------------- | ------- | ------------------------- |  | ----------------------------- | - | -------------------------------------------- | ------- | - |  | ------- | - | - | ----- | 
|                              |  | Plan
 Options Available
 For Grant |         | Plan Options
 Outstanding |  | Non-Plan
 Options Outstanding |   | Weighted
 Average
 Exercise Price
 Per Share |        
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   | 
|                              |  |                                    |         | ISO                       |  | NQO                           |   |                                              |         |   | 
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   | 
|Balance at December 31,
 2007 |  |                                    | 122,200 |                           |  | 119,615                       |   |                                              | 175,618 |   |  | 42,000  |   | $ | 8.47  | 
|Granted                       |  |                                    | (95,500 | )                         |  | 48,130                        |   |                                              | 47,370  |   |  |        |   |   | 13.58 | 
|Exercised                     |  |                                    |        |                           |  | (13,000                       | ) |                                              | (10,000 | ) |  | (36,000 | ) |   | 3.31  | 
|Plan addition                 |  |                                    | 138,800 |                           |  |                              |   |                                              |        |   |  |        |   |   |       | 
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   |  |         |   |   |       | 
|Balance at December 31,
 2008 |  |                                    | 165,500 |                           |  | 154,745                       |   |                                              | 212,988 |   |  | 6,000   |   | $ | 10.59 | 
|Granted                       |  |                                    | (68,000 | )                         |  | 19,000                        |   |                                              | 49,000  |   |  |        |   |   | 8.62  | 
|Exercised                     |  |                                    |        |                           |  | (600                          | ) |                                              |        |   |  |        |   |   | 1.30  | 
|Plan addition                 |  |                                    | 10,000  |                           |  | (10,000                       | ) |                                              |        |   |  |        |   |   | 9.22  | 
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   |  |         |   |   |       | 
|Balance at December 31,
 2009 |  |                                    | 107,500 |                           |  | 163,145                       |   |                                              | 261,988 |   |  | 6,000   |   | $ | 8.10  | 
|Granted                       |  |                                    | (85,000 | )                         |  | 40,300                        |   |                                              | 44,700  |   |  |        |   |   | 12.33 | 
|Exercised                     |  |                                    |        |                           |  | (20,200                       | ) |                                              | (11,500 | ) |  | (6,000  | ) |   | 3.31  | 
|Plan addition                 |  |                                    | 135,000 |                           |  |                              |   |                                              |        |   |  |        |   |   |      | 
|Forfeited                     |  |                                    | 15,000  |                           |  | (7,000                        | ) |                                              | (8,000  | ) |  |        |   |   | 6.69  | 
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   |  |         |   |   |       | 
|Balance at December 31,
 2010 |  |                                    | 172,500 |                           |  | 176,245                       |   |                                              | 287,188 |   |  |        |   | $ | 9.11  | 
|                              |  |                                    |         |                           |  |                               |   |                                              |         |   |  |         |   |   |       | 

39

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Table of Contents

The
following table summarizes information about the stock options outstanding at
December 31, 2010:

|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 
|------------------------ |  | ------------------- | ------- | ----------------------------------------------- |  | ---------------------------------- |  | --------------------------- | ----- | ------------------- | - | ---------------------------------- |  | --------------------------- | ------- |  | - | ----- |  | - | --------- | 
|                         |  | Options Outstanding |         | Options Exercisable                             | 
|                         |  |                     |         |                                                 | 
|Range of
 Exercise Price |  | Number
 Outstanding |         | Weighted
 Average
 Remaining
 Contractual
 Life |  | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |       | Number
 Exercisable |   | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |        
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |        
|$1.30-1.99               |  |                     | 46,000  |                                                 |  | 1.5
 years                         |  | $                           | 1.36  |                     | $ | 497,147                            |  |                             | 46,000  |  | $ | 1.36  |  | $ | 497,147   | 
|3.00-3.99                |  |                     | 38,933  |                                                 |  | 1.8
 years                         |  |                             | 3.15  |                     |   | 351,080                            |  |                             | 38,933  |  |   | 3.15  |  |   | 351,080   | 
|8.00-8.99                |  |                     | 48,000  |                                                 |  | 5.9
 years                         |  |                             | 8.63  |                     |   | 169,755                            |  |                             | 13,500  |  |   | 8.58  |  |   | 48,400    | 
|9.00-9.99                |  |                     | 172,500 |                                                 |  | 4.4
 years                         |  |                             | 9.20  |                     |   | 511,371                            |  |                             | 55,125  |  |   | 9.16  |  |   | 165,811   | 
|11.00-11.99              |  |                     | 15,000  |                                                 |  | 5.8
 years                         |  |                             | 11.19 |                     |   |                                   |  |                             |        |  |   |      |  |   |          | 
|12.00-12.99              |  |                     | 115,000 |                                                 |  | 4.9
 years                         |  |                             | 12.53 |                     |   |                                   |  |                             | 31,500  |  |   | 12.51 |  |   |          | 
|15.00-15.99              |  |                     | 28,000  |                                                 |  | 1.0
 years                         |  |                             | 15.30 |                     |   |                                   |  |                             | 28,000  |  |   | 15.30 |  |   |          | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 
|                         |  |                     | 463,433 |                                                 |  | 4.0
 years                         |  | $                           | 9.11  |                     | $ | 1,529,353                          |  |                             | 213,058 |  | $ | 7.64  |  | $ | 1,062,438 | 
|                         |  |                     |         |                                                 |  |                                    |  |                             |       |                     |   |                                    |  |                             |         |  |   |       |  |   |           | 

The
fair value of the 85,000, 68,000 and 95,500 options granted during 2010, 2009
and 2008, respectively, was $348,000, $279,000 and $388,000.

The
total intrinsic value of options exercised during 2010, 2009 and 2008 was
$352,000, $7,000 and $292,000, respectively. The total fair value of option
shares vested during 2010, 2009 and 2008 was $716,000, $578,000 and $807,000,
respectively. The fair value of each option granted is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions used during 2010, 2009 and 2008, respectively:
zero dividend yield; expected volatility of 78%, 45% and 41%; risk-free
interest rate of 2.84%, 3.19% and 3.68%; and expected life of 3.68, 3.0 and 3.5
years. The expected life of the options is based on evaluations of historical
and expected future exercise behavior. The risk-free interest rate is based on
the U.S. Treasury rates at the date of grant, with maturity dates approximately
equal to the expected life at the grant date. Volatility is based on historical
volatility of our stock over the past three years. We have not historically
paid any dividends and do not expect to in the foreseeable future. We
recognized stock option expense of $342,000, $341,000 and $339,000 in the years
ended December 31, 2010, 2009 and 2008, respectively, and the expense is
included within general and administrative expense on the consolidated
statements of income.

There
were 213,058, 181,383 and 183,633 options exercisable at December 31, 2010,
2009 and 2008, respectively. The weighted average exercise price of these
options was $7.64, $6.39 and $2.94 at December 31, 2010, 2009 and 2008,
respectively.

|    |                     
|--- | --------------------
|15. | SEGMENT
 INFORMATION

We
currently operate in three reportable segments: Autoscope, RTMS and CitySync.
Autoscope is our machine-vision product line, and revenue consists of royalties
(all of which are received from Econolite), as well as a portion of
international sales. RTMS is our radar product line acquired in the EIS asset
purchase in December 2007. CitySync is our ANPR product line
acquired in the CitySync purchase in June 2010. All segment revenues are
derived from external customers.

Due
to the CitySync acquisition and related changes in how we manage our business,
we may reevaluate our segment definitions in the future.

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

|                                   |  |                                      |        |      |   |          |  |       |        |   |   |        | 
|---------------------------------- |  | ------------------------------------ | ------ | ---- | - | -------- |  | ----- | ------ | - | - | ------ | 
|                                   |  | For the year ended December 31, 2010 |       
|                                   |  |                                      |       
|                                   |  | Autoscope                            |        | RTMS |   | CitySync |  | Total |       
|                                   |  |                                      |        |      |   |          |  |       |       
|Revenue                            |  | $                                    | 16,659 |      | $ | 9,819    |  | $     | 5,203  |   | $ | 31,681 | 
|Depreciation                       |  |                                      | 293    |      |   | 173      |  |       | 32     |   |   | 498    | 
|Amortization of intangible
 assets |  |                                      |       |      |   | 768      |  |       | 450    |   |   | 1,218  | 
|Income (loss) before income
 taxes |  |                                      | 2,618  |      |   | 1,823    |  |       | (526   | ) |   | 3,915  | 
|Capital expenditures               |  |                                      | 325    |      |   | 77       |  |       | 14     |   |   | 416    | 
|Total assets                       |  |                                      | 26,915 |      |   | 13,202   |  |       | 14,239 |   |   | 54,356 | 
|                                   |  |                                      |        |      |   |          |  |       |        |   |   |        | 

40

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Table of Contents

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

|                                   |  |                                      |        |      |   |        |       |   |        | 
|---------------------------------- |  | ------------------------------------ | ------ | ---- | - | ------ | ----- | - | ------ | 
|                                   |  | For the year ended December 31, 2008 |       
|                                   |  |                                      |       
|                                   |  | Autoscope                            |        | RTMS |   |        | Total |  
|                                   |  |                                      |        |      |   |        |       |  
|Revenue                            |  | $                                    | 18,705 |      | $ | 7,760  |       | $ | 26,465 | 
|Depreciation                       |  |                                      | 242    |      |   | 115    |       |   | 357    | 
|Amortization of intangible
 assets |  |                                      |       |      |   | 768    |       |   | 768    | 
|Income before income taxes         |  |                                      | 5,939  |      |   | 1,232  |       |   | 7,171  | 
|Capital expenditures               |  |                                      | 273    |      |   | 112    |       |   | 385    | 
|Total assets                       |  |                                      | 24,135 |      |   | 11,973 |       |   | 36,108 | 

The CitySync segment loss
before income taxes includes $817,000 of acquisition related expenses.

|    |                            
|--- | ---------------------------
|16. | RELATED
 PARTY TRANSACTIONS

Dan Manor, who was a named
executive officer in 2010, is a beneficiary of the earn-out for the EIS asset
purchase as further described in Note 4.

41

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Table of Contents

Report of Independent Registered Public
Accounting Firm

Board of Directors and
Shareholders
Image Sensing Systems, Inc.

We
have audited the accompanying consolidated balance sheets of Image Sensing
Systems, Inc. (a Minnesota Corporation) and subsidiaries (the Company) as of
December 31, 2010 and 2009, and the related consolidated statements of income,
shareholders equity and comprehensive income, and cash flows for each of the
three years in the period ended December 31, 2010. These consolidated financial
statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Companys internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In
our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Image Sensing
Systems, Inc. and subsidiaries as of December 31, 2010 and 2009, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2010 in conformity with accounting principles
generally accepted in the United States of America.

|                      
|----------------------
|/s/ GRANT THORNTON LLP
|                      
|Minneapolis, Minnesota
|March 24, 2011        

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

None.

|          |                        
|--------- | -----------------------
|Item
 9A. | Controls and Procedures

Evaluation of disclosure controls and procedures

We
maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange
Act)), that are designed to reasonably ensure that information required to be
disclosed by us in the reports we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms and that such information is accumulated and
communicated to our management, including our principal executive officer and
principal financial officer, or persons performing similar functions, as
appropriate to allow timely decisions regarding required disclosure. Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated the effectiveness
of the design and operation of our disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective.

Managements report on internal control over financial
reporting

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

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

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

Management
assessed the effectiveness of our internal control over financial reporting as
of December 31, 2010. In making this assessment, management used the criteria
set forth by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) in Internal ControlIntegrated
Framework. Based on this assessment, management has concluded that
our internal control over financial reporting was effective as of December 31,
2010.

Changes in internal control over financial reporting

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

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

None.

43

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Table of Contents

PART III

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

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

The
sections entitled Proposal I - Election of Directors, Audit Committee and
Section 16(a) Beneficial Ownership Reporting Compliance in our definitive
proxy statement for our 2011 annual meeting of shareholders are incorporated
into this Annual Report on Form 10-K by reference.

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

The
sections entitled Executive Compensation and Compensation of Directors in
our definitive proxy statement for the 2011 annual meeting of shareholders are
incorporated into this Annual Report on Form 10-K by reference.

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

Equity Compensation Plan Information

The
following table provides information as of December 31, 2010 about our shares
of common stock subject to outstanding awards or available for future awards
under our equity compensation plans and arrangements.

|                                                      |  |                                                                                                 |         |                                                                                 |   |                                                                                                                                                           |  |  |         | 
|----------------------------------------------------- |  | ----------------------------------------------------------------------------------------------- | ------- | ------------------------------------------------------------------------------- | - | --------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ------- | 
|Plan
 Category                                        |  | Number
 of securities to
 be issued upon exercise
 of outstanding options,
 warrants and rights |         | Weighted-average
 exercise
 price of outstanding
 options, warrants and
 rights |   | Number
 of securities remaining
 available for future issuance
 under equity compensation plans
 (excluding securities reflected in
 the first column)(2) | 
|                                                      |  |                                                                                                 |         |                                                                                 |   |                                                                                                                                                           | 
|Equity compensation plans approved by shareholders(1) |  |                                                                                                 | 463,433 |                                                                                 | $ | 9.11                                                                                                                                                      |  |  | 172,500 | 

|                                                                                                                                                                                                                                                                                                     
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                     
|(1) Includes shares underlying stock options granted under the Image Sensing
 Systems, Inc. 1995 Long-Term Incentive and Stock Option Plan (1995 Plan) and
 non-qualified stock options granted outside the 1995 Plan between 1996 and
 2000 to current and former members of the Board of Directors.
|                                                                                                                                                                                                                                                                                                     
|(2) The 172,500 shares available for grant
 under the 2005 Stock Incentive Plan may become the subject of future awards
 in the form of stock options, stock appreciation rights, restricted stock,
 performance awards or other stock-based awards.                                                 

The
section entitled Security Ownership of Certain Beneficial Owners and
Management in our definitive proxy statement for the 2011 annual meeting of
shareholders is incorporated into this Form Annual Report on 10-K by reference.

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

The
section entitled Certain Relationships and Related Transactions in our
definitive proxy statement for the 2011 annual meeting of shareholders is
incorporated into this Annual Report on Form 10-K by reference.

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

The
sections entitled Audit Fees, Audit-Related Fees, Tax Fees, All Other
Fees and Policy on Audit Committee Pre-Approval of Audit and Permissible
Non-Audit Services Provided by Our Independent Registered Public Accounting
Firm in our definitive proxy statement for our 2011 annual meeting of
shareholders are incorporated into this Annual Report on Form 10-K by
reference.

44

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Table of Contents

PART IV

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

(a)
Documents filed as part of this report:

| |    |                                                                                                                                                                                          
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | Financial statements                                                                                                                                                                     
| |    |                                                                                                                                                                                          
| |    | The following consolidated
 financial statements are included in Part II, Item 8. Financial Statements
 and Supplementary Data:                                                        
| |    |                                                                                                                                                                                          
| |    | Consolidated Balance Sheets
 as of December 31, 2010 and 2009                                                                                                                            
| |    | Consolidated Statements of
 Income for the years ended December 31, 2010, 2009 and 2008                                                                                                  
| |    | Consolidated Statements of
 Cash Flow for the years ended December 31, 2010, 2009 and 2008                                                                                               
| |    | Consolidated Statements of
 Shareholders Equity and Comprehensive Income for the years ended December
 31, 2010, 2009 and 2008                                                          
| |    | Notes to Consolidated Financial Statements                                                                                                                                               
| |    | Report of Independent
 Registered Public Accounting Firm                                                                                                                                 
| |    |                                                                                                                                                                                          
| | 2. | Financial Statement
 Schedules:                                                                                                                                                          
| |    |                                                                                                                                                                                          
| |    | All financial statement
 schedules have been omitted because they are not required or not applicable,
 or the information is included in the Consolidated Financial Statements or
 Notes.
| |    |                                                                                                                                                                                          
| | 3. | The following documents are
 filed as exhibits to this report:                                                                                                                           

|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|----------- | ----------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. | Description
|            |            
|            | 1.1         | Underwriting Agreement by
 and among ISS, Wedbush Securities Inc. and Craig-Hallum Capital Group Inc.
 dated April 15, 2010, incorporated by reference to Exhibit 1.1 to ISS Current
 Report on Form 8-K dated April 15, 2010.                                                                                                                                                                                                                                                                                                                                          
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 2.1*        | Asset Purchase Agreement
 dated December 6, 2007 by and among Image Sensing Systems, Inc. (ISS), EIS
 Electronic Integrated Systems Inc., Dan Manor and the other parties named
 therein, incorporated by reference to Exhibit 2.1 to ISS Annual Report on
 Form 10-K for the year ended December 31, 2007 (2007 Form 10-K). (Schedules
 to this Agreement have not been filed in reliance on Item 601(b)(2) of
 Regulation S-K of the Securities and Exchange Commission (SEC). ISS will
 furnish supplementally copies of such schedules to the SEC upon its request.)
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 2.2         | Share Purchase Agreement
 dated June 21, 2010 by and among ISS, Image Sensing Systems Europe Limited,
 CitySync Limited and three shareholders of CitySync Limited, incorporated by
 reference to Exhibit 2.1 to ISS Quarterly Report on Form 10-Q for the
 quarter ended June 30, 2010.                                                                                                                                                                                                                                                                                
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.1         | Restated Articles of
 Incorporation of ISS, incorporated by reference to Exhibit 3.1 to ISS
 Registration Statement on Form SB-2 (Registration No. 33-90298C) filed on
 March 14, 1995, as amended (Registration Statement).                                                                                                                                                                                                                                                                                                                                            
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.2         | Articles of Amendment to
 Articles of Incorporation of ISS, incorporated by reference to Exhibit 3.2 to
 ISS Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001.                                                                                                                                                                                                                                                                                                                                                                                       
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 3.3         | Bylaws of ISS, incorporated
 by reference to Exhibit 3.3 to ISS Registration Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 4.1         | Specimen form of ISS
 common stock certificate, incorporated by reference to Exhibit 4.1 to ISS
 Registration Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                               
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.1        | Form of Distributor
 Agreement, incorporated by reference to Exhibit 10.1 to ISS Registration
 Statement.                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|            |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|            | 10.2**      | 1995 Long-Term Incentive
 and Stock Option Plan, amended and restated through May 17, 2001,
 incorporated by reference to Exhibit 10.10 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 2001.                                                                                                                                                                                                                                                                                                                                                      

45

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Table of Contents

| |         |                                                                                                                                                                                                                                                                                                                                                               
| | ------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.3**  | Employment Agreement
 between ISS and Kenneth R. Aubrey, dated December 12, 2006, effective on or
 about January 15, 2007 (in
 capacity as President) and effective on or about June 1, 2007 (in capacity of
 President and Chief Executive Officer), incorporated by reference to Exhibit
 10.1 to ISS Current Report on Form 8-K dated December 14, 2006.  
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.4**  | Employment Agreement
 between ISS and Gregory R. L. Smith, dated December 8, 2006, incorporated by
 reference to Exhibit 10.1 to ISS Current Report on Form 8-K dated December
 8, 2006.                                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.5    | Amendment VII to Office
 Lease Agreement dated April 26, 2007 by and between ISS and Spruce Tree Centre
 L.L.P., incorporated by reference to Exhibit 10.11 to ISS Annual Report on
 Form 10-K for the year ended December 31, 2007 (2007 Form 10-K).                                                                                                        
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.6    | Modification to
 Manufacturing, Distributing and Technology License Agreement dated September
 1, 2000 by and between ISS and Econolite Control Products, Inc. (Econolite),
 incorporated by reference to Exhibit 10.12 to ISS 2007 Form 10-K.                                                                                                               
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.7**  | Image Sensing Systems, Inc.
 2005 Stock Incentive Plan, incorporated by reference to Appendix A to ISS
 proxy statement filed with the SEC on April 19, 2005.                                                                                                                                                                                                
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.8    | Manufacturing, Distributing
 and Technology License Agreement dated June 11, 1991 by and between ISS and
 Econolite Control Products, Inc. (Econolite), incorporated by reference to
 Exhibit 10.1 to the Registration Statement.                                                                                                                             
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.09   | Extension and Second
 Modification to License Agreement dated July 13, 2001 by and between ISS and
 Econolite, incorporated by reference to Exhibit 10.12 to ISS Annual Report
 on Form 10-KSB for the year ended December 31, 2001.                                                                                                                         
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.10   | Office Lease Agreement
 dated November 24, 1998 by and between ISS and Spruce Tree Centre L.L.P.,
 incorporated by reference to Exhibit 10.18 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 1998.                                                                                                                                     
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.11   | Production Agreement dated
 February 14, 2002 by and among ISS, Wireless Technology, Inc. and Econolite,
 incorporated by reference to Exhibit 10.20 to ISS Annual Report on Form
 10-KSB for the year ended December 31, 2001.                                                                                                                              
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.12   | Extension and Third
 Modification to Manufacturing Distributing and Technology License Agreement
 dated July 3, 2008 by and between ISS and Econolite, incorporated by
 reference to Exhibit 10.1 to ISS Current Report on Form 8-K dated July 3,
 2008.                                                                                                     
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.13** | Employment Agreement dated
 December 6, 2007 by and between ISS Image Sensing Systems Canada Ltd. and Dan
 Manor, incorporated by reference to Exhibit 99.1 to ISS 2007 Form 10-K.                                                                                                                                                                           
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.14   | Loan Agreement dated May 1,
 2008 by and between ISS and Associated Bank, National Association (Associated
 Bank), incorporated by reference to Exhibit 10.19 to ISS Registration
 Statement on Form S-1 filed on May 12, 2008 (Form S-1).                                                                                                                   
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.15   | Security Agreement dated
 May 1, 2008 by and between ISS and Associated Bank, incorporated by reference
 to Exhibit 10.20 to ISS Form S-1.                                                                                                                                                                                                                   
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.16   | Promissory Note (Line of
 Credit) dated May 1, 2008 in the original principal amount of $5,000,000
 issued by ISS to Associated Bank, incorporated by reference to Exhibit 10.21
 to ISS Form S-1.                                                                                                                                                           
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.17   | Promissory Note (Loan)
 dated May 1, 2008 in the original principal amount of $3,000,000 issued by
 ISS to Associated Bank, incorporated by reference to Exhibit 10.22 to ISS
 Form S-1.                                                                                                                                                                     
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.18   | Modification Agreement
 dated December 28, 2009 by and between ISS and Associated Bank under which
 ISS and Associated Bank amended the Loan Agreement dated as of May 1, 2008 by
 and between ISS and Associated Bank, incorporated by reference to Exhibit
 10.18 to ISS Annual Report on Form 10-K for the year ended December 31, 2009
 (2009 Form 10-K).
| |         |                                                                                                                                                                                                                                                                                                                                                               
| | 10.19   | Promissory Note (Loan)
 dated December 28, 2009 in the original principal amount of $4,000,000 issued
 by ISS to Associated Bank, incorporated by reference to Exhibit 10.19 to the
 2009 Form 10-K.                                                                                                                                                          

46

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Table of Contents

| |       |                                                                                                                                                                                                                                               
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.20 | Lease dated February 1,
 2010 between CitySync Limited and Nortrust Nominees Limited, incorporated by
 reference to Exhibit 10.1 to ISS Quarterly Report on Form 10-Q for the
 quarter ended June 30, 2010.                                  
| |       |                                                                                                                                                                                                                                               
| | 10.21 | Third Modification Agreement
 dated December 28, 2010 by and between ISS and Associated Bank under which
 ISS and Associated Bank amended the Loan Agreement dated as of May 1, 2008 by
 and between ISS and Associated Bank (filed herewith).
| |       |                                                                                                                                                                                                                                               
| | 21    | List of Subsidiaries of ISS.                                                                                                                                                                                                                  
| |       |                                                                                                                                                                                                                                               
| | 23.1  | Consent of Independent
 Registered Public Accounting Firm.                                                                                                                                                                                    
| |       |                                                                                                                                                                                                                                               
| | 24    | Power of Attorney (included
 on signature page).                                                                                                                                                                                              
| |       |                                                                                                                                                                                                                                               
| | 31.1  | Certification of Chief
 Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                          
| |       |                                                                                                                                                                                                                                               
| | 31.2  | Certification of Chief
 Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                          
| |       |                                                                                                                                                                                                                                               
| | 32.1  | Certification of Chief
 Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                          
| |       |                                                                                                                                                                                                                                               
| | 32.2  | Certification of Chief Financial
 Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                          
| |       |                                                                                                                                                                                                                                               
| | 99.1  | Extension of Modification
 to Manufacturing, Distributing and Technology License Agreement dated May 31,
 2002 by and between ISS and Econolite, incorporated by reference to Exhibit
 99.2 to ISS 2007 Form 10-K.                           
| |       |                                                                                                                                                                                                                                               
| | 99.2  | Letter agreement dated June
 19, 1997 by and between ISS and Econolite, incorporated by reference to
 Exhibit 99.3 to ISS 2007 Form 10-K.                                                                                                    

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

47

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Table of Contents

Signatures

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

Image Sensing Systems, Inc.

|                                       |  |                      
|-------------------------------------- |  | ---------------------
|/s/ Kenneth R. Aubrey                  |  | Date:
 March 24, 2011
|                                       |  |                      
|Kenneth R. Aubrey                      |  |                      
|President and Chief
 Executive Officer |  |                      
|(Principal Executive
 Officer)         |  |                      

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

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

|                                                        |  |                      
|------------------------------------------------------- |  | ---------------------
|/s/ Kenneth R. Aubrey                                   |  | Date:
 March 24, 2011
|                                                        |  |                      
|Kenneth R. Aubrey                                       |  |                      
|President and Chief
 Executive Officer                  |  |                      
|(Principal Executive
 Officer)                          |  |                      
|                                                        |  |                      
|/s/ Gregory R. L. Smith                                 |  | Date:
 March 24, 2011
|                                                        |  |                      
|Gregory R. L. Smith                                     |  |                      
|Chief Financial Officer                                 |  |                      
|(Principal Financial and
 Principal Accounting Officer) |  |                      
|                                                        |  |                      
|/s/ James Murdakes                                      |  | Date:
 March 24, 2011
|                                                        |  |                      
|James Murdakes                                          |  |                      
|Chairman of the Board of
 Directors                     |  |                      
|                                                        |  |                      
|/s/ James W. Bracke                                     |  | Date:
 March 24, 2011
|                                                        |  |                      
|James W. Bracke                                         |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ Michael G. Eleftheriou                              |  | Date:
 March 24, 2011
|                                                        |  |                      
|Michael G. Eleftheriou                                  |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ Panos G. Michalopoulos                              |  | Date:
 March 24, 2011
|                                                        |  |                      
|Panos G. Michalopoulos                                  |  |                      
|Director                                                |  |                      
|                                                        |  |                      
|/s/ Sven A. Wehrwein                                    |  | Date:
 March 24, 2011
|                                                        |  |                      
|Sven A. Wehrwein                                        |  |                      
|Director                                                |  |                      

48

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