UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
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, 2008




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 0-29486


www.merge.com


MERGE
HEALTHCARE INCORPORATED


(Exact
name of Registrant as specified in its charter)




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







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


(Address
of principal executive offices, including zip code)




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




Securities
registered under Section 12(b) of the Exchange Act:




Title
      of Each Class
            Name
      of Each Exchange on Which RegisteredCommon
      Stock, $0.01 par value per share
            NASDAQ
      Global Market




Securities
registered under Section 12(g) of the Exchange 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 oNo x




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




Yes oNo 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 xNo o




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




Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  See the definitions of “accelerated filers”, “large
accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.




Large
      accelerated filero
            Accelerated
      filer ̈
            Non-accelerated
      filerx
            Smaller
      reporting companyo







Indicate
by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Act).Yes oNo x




The
aggregate market value for the Registrant’s voting and non-voting common equity
held by non-affiliates of the Registrant as of June 30, 2008, based upon
the closing sale price of the Common Stock on June 30, 2008, as reported on
the NASDAQ Global Market, was approximately$31,859,032.  Shares
of Common Stock held by each officer and director and by each person who owns
ten percent or more of the outstanding Common Stock have been excluded in that
such persons may be deemed to be affiliates.  This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.




The
number of shares outstanding of the Registrant’s common stock, par value $0.01
per share, as of March 4, 2009:  56,074,339







DOCUMENTS
INCORPORATED BY REFERENCE




Certain of the information required by Part III is incorporated by reference
from the Registrant’s Proxy Statement for its 2009 Annual Meeting of
Shareholders.









INDEX




PART I
            
            
            PAGE NUMBERItem
      1.
            
            Business
            2Item
      1A.
            
            Risk
      Factors
            8Item
      1B.
            
            Unresolved
      Staff Comments
            16Item
      2.
            
            Properties
            16Item
      3.
            
            Legal
      Proceedings
            17Item
      4.
            
            Submission
      of Matters to a Vote of Security Holders
            18PART II
            
            
            18Item 5.
            
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
            18Item
      6.
            
            Selected
      Financial Data
            20Item
      7.
            
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            20Item
      7A.
            
            Quantitative
      and Qualitative Disclosures About Market Risk
            36Item 8.
            
            Financial
      Statements and Supplementary Data
            37Item
      9.
            
            Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure
            69Item
      9A.
            
            Controls
      and Procedures
            69Item
      9B.
            
            Other
      Information
            69PART III
            
            
            70Item 10.
            
            Directors,
      Executive Officers and Corporate Governance
            70Item
      11.
            
            Executive
      Compensation
            70Item
      12.
            
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            70Item
      13.
            
            Certain
      Relationships and Related Transactions, and Director
      Independence
            70Item
      14.
            
            Principal
      Accountant Fees and Services
            70PART IV
            
            
            70Item
      15.
            
            Exhibits,
      Financial Statement Schedules
            70







(i)




PART I




Merge Healthcare Incorporated desires to take advantage of the “safe
harbor” provisions of the Private Securities Litigation Reform Act of 1995 (the
“Reform Act”) and is filing this cautionary statement in connection with the
Reform Act.  This Annual Report on Form 10-K and any other written or
oral statements made by us or on behalf may include forward-looking statements
that reflect our current views with respect to future events and future
financial performance.  Certain statements in this Annual Report on
Form 10-K are “forward-looking statements” within the meaning of Section 27(a)
of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934.  You can identify these forward-looking statements by our use of
the words “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,”
“expects,” “may,” “will,” “would,” “intends,” “estimates” and similar
expressions, whether in the negative or affirmative.  We wish to
caution you that any forward-looking statements made by us or on our behalf are
subject to uncertainties and other factors that could cause such statements to
be wrong.  We cannot guarantee that we actually will achieve these
plans, intentions or expectations.  Actual results or events could
differ materially from the plans, intentions and expectations disclosed in the
forward-looking statements that we make.  Although we believe that the
expectations reflected in the forward-looking statements are reasonable, we
cannot guarantee future results, levels of activity, and/or performance of
achievements.  We do not assume any obligation to update or revise any
forward-looking statements that we make, whether as a result of new information,
future events or otherwise.




Factors that may impact forward-looking statements include, among
others, our abilities to maintain the technological competitiveness of our
current products, develop new products, successfully market our products,
respond to competitive developments, develop and maintain partnerships with
providers of complementary technologies, manage our costs and the challenges
that may come with growth of our business, and attract and retain qualified
sales, technical and management employees.  We are also affected by
the growth and regulation of the medical technology industry, including the
acceptance of enterprise-wide advanced visualization by hospitals, clinics, and
universities, product clearances and approvals by the United Sates Food and Drug
Administration and similar regulatory bodies outside the U.S., and reimbursement
and regulatory practices by Medicare, Medicaid, and private third-party payer
organizations.  We are also affected by the recent downturn in the
U.S. and international economies and as such may be further impacted by the lack
of credit available to our customers.  We are affected by other
factors identified in our filings with the Securities and Exchange Commission,
some of which are set forth in the section entitled “Item 1A Risk Factors” in
this Annual Report on Form 10-K (and many of which we have discussed in prior
filings).  Although we have attempted to list comprehensively these
important factors, we also wish to caution investors that other factors may
prove to be important in the future in affecting our operating
results.  New factors emerge from time to time, and it is not possible
for us to predict all of these factors, nor can we assess the impact each factor
or combination of factors may have on our business.






Item 1.
            BUSINESS




Overview




Merge Healthcare Incorporated, a Delaware corporation, and its
subsidiaries (collectively, “Merge,” “we,” “us,” or “our”), develops medical
imaging and information software solutions and delivers related
services.  Our solutions are designed to automate digital imaging
workflow, which transforms the tasks associated with film-based images and paper
information into computerized processes.  We sell these solutions
through two business units.  Merge Fusion sells directly to hospitals,
imaging centers and specialty clinics located in the United States of America
(“U.S.”), sells directly and through distributors outside the U.S. and also
distributes certain products through the Internet via our
website.  Our Merge OEM business unit primarily sells to original
equipment manufacturers (“OEM”), value added resellers (“VAR”) and distributors
located throughout the world.  Our principal executive offices are
located at 6737 West Washington Street, Suite 2250, Milwaukee,
Wisconsin 53214-5650, and our telephone number there is (414)
977-4000.




We were founded in 1987 and specialized in the transformation of
legacy radiology (film-based) images into filmless digitized images for
distribution and diagnostic interpretation.  We acquired eFilm
Medical, Inc. (“eFilm”) in June 2002 for its diagnostic medical image
workstation software capabilities; RIS Logic, Inc. (“RIS Logic”) in July
2003 for its Radiology Information System (“RIS”) software, which manages
business and clinical workflow for imaging centers; AccuImage Diagnostics Corp.
in January 2005 for its advanced visualization technologies for clinical
specialty medical imaging; and Cedara Software Corp. (“Cedara”) in
June 2005, for its medical imaging software offerings.




~ 2 ~


In the first half of 2008, we faced significant on-going business
challenges and financial instability that arose due to restatements of certain
of our financial statements completed in 2007 and 2006.  Such
challenges included a formal investigation conducted by the Securities and
Exchange Commission (“SEC”), class action and other lawsuits, and concerns about
our ability to continue as a going concern.  Also, although we
continue to believe that the Deficit Reduction Act of 2005 (“DRA”) will
ultimately be a catalyst for our U.S. end-user customers to move to a filmless
environment, the DRA had a negative impact on our target market and our net
sales in 2008.  In addition, we undertook a significant reduction in
force in February of 2008, which included personnel terminations from all parts
of the organization, and exited operations in France in April
2008.  We believe that these matters had an adverse affect on employee
morale, certain customer relationships and our overall reputation in the market
during the first half of 2008.




In June of 2008, we completed a financing agreement with Merrick RIS,
LLC (“Merrick”), which brought a net $16.6 million cash investment and new
executive leadership to Merge.  Beginning on June 5, 2008, the
following actions commenced:




·
            Operations in India were
exited;




·
            Our business unit in Europe (formerly known as “EMEA”), which
      our former management planned to sell, was retained, and portions of its
      operations were allocated between our two other business
      units;




·
            The shareholder lawsuit was dismissed with prejudice in
      November 2008 as part of a settlement costing us $3.0 million;
      and




·
            Our teleradiology business venture was discontinued and the
      technology was repurposed for our Managed Services
      business.




We believe that these initiatives have set us on a positive growth
path as demonstrated by our return to profitability in the third and fourth
quarters of 2008.  However, the recent economic downturn has created
unprecedented market instability, making it difficult to predict future market
trends and operating results.




Financial Information about Segments




For financial information regarding our single segment business as
well as our geographic areas of operation, refer to Item 8, “Note 1 – Basis of
Presentation and Significant Accounting Policies, Segment Reporting” and “Note
15 – Segment Information” of this Annual Report on Form 10-K.




Business




Our business focuses on medical imaging software, which can involve
any aspect of moving medical images and their accompanying information into
electronic media.  Our overall product line consists
of:




·
            Software development toolkits and platforms, which give
      software developers resources to accelerate new product
      development;




·
            Diagnostic workstation software applications, which bring
      specialized reading and review tools to the clinician’s
      desktop;




·
            RIS and related applications, which manage the business
      workflow of an imaging enterprise or radiology
    department;




·
            Picture Archiving and Communication Systems (“PACS”) and
      related applications, which manage the image workflow of an imaging
      enterprise;




·
            Consultative engineering, which provides customer development
      teams with added expertise and technology;
  and




·
            Managed Services, which extends additional image and remote
      information management capabilities to our
  customers.




We generate revenue through licensing software and/or intellectual
property, upgrading and/or renewing those licenses, ongoing service and support
of the solutions, project or hourly professional services, consultative
engineering fees and pay-per-study managed services.  This revenue has
historically involved larger upfront fees; however, given the current economic
conditions, our customers increasingly prefer more flexible pricing
models.




~ 3 ~


Medical imaging is based on a standard called Digital Imaging and
Communications in Medicine (“DICOM”), which ensures that any image acquired from
any DICOM-compliant modality can be displayed, moved and stored within a
standard set of guidelines.  For the past 20 years, we have
participated in the evolution of this ever expanding and evolving standard, and
our customers rely on us for the latest DICOM updates in our toolkits, as well
as in other applications.  DICOM has enabled the information
technology (“IT”) component of medical imaging to stay in step with clinical
technology.  As a result, significant innovation has enabled medical
imaging to expand from general radiology into cardiology, mammography,
dentistry, endoscopy, surgery, veterinary and other medical
specialties.  Our participation with multiple standards committees and
continuous development of our products like our DICOM toolkits have enabled us
to be a part of this innovation.  Innovation in the industry will
continue, as will ongoing adoption of the technology globally.




Our technologies and expertise span all the major digital imaging
modalities, including computed tomography (“CT”), magnetic resonance imaging
(“MRI”), digital x-ray, mammography, ultrasound, echo-cardiology, angiography,
nuclear medicine, positron emission tomography and fluoroscopy.  Our
offerings are used in all aspects of clinical imaging workflow, including: the
capture of a patient’s digital image; the archiving, communication and
manipulation of digital images; analysis of digital images, and the use of
imaging in minimally-invasive surgery.  We have continued to innovate
our product lines and have extended our business into new areas of medical
imaging.  Through our OEM business unit, we have participated in
developing new digital imaging offerings applicable to areas such as veterinary
imaging, dentistry, clinical trials and pharmaceuticals.




Our software is deployed in hospitals and clinics worldwide through
our partners, our direct end-user and eCommerce channels, and is licensed by
many of the world’s largest medical device and healthcare IT
companies.  With global brand recognition for products such as eFilm
WorkstationTM, a downloadable diagnostic imaging application, and MergeCOM-3
DICOM toolkits, we are able to generate a foothold in new international
markets.




OEM Products, Technologies and Services




Our brand leader in the OEM business unit is our Merge-COMTM software
development toolkit line of products.  These toolkits are used by
modality vendors and software providers to economically accelerate the
development of new imaging applications.  The toolkits are available
in most major development languages and platforms and are regularly updated to
meet DICOM industry standards.




As an accompaniment to toolkits, we offer a development platform that
incorporates reusable software libraries.  Our Cedara Open EyesTM
(“Open Eyes”) was created to accelerate our internal development as well as that
of our OEM partners.  Open Eyes includes a suite of underlying
libraries, toolkits and technologies that provide specialized medical imaging
capabilities including:  2D and 3D visualization; segmentation,
registration and fusion; image enhancement and stitching; as well as a suite of
DICOM and data access tools.  Our most recent additions to the
portfolio include specialized toolkits for x-ray console automation and tumor
tracking.  Open Eyes is complemented by additional tools for rapid
development such as the Cedara Clinical Control CenterTM for clinical application
integration and Cedara I-ConnectTM for acquisition console application
development.




Our OEM business unit also offers specialty applications for custom
finishing and distribution by imaging solutions and modality
vendors.  We offer a complete Web-enabled PACS solution, Cedara
I-ReachTM,  as well as a number of PACS review workstations that can be
configured to the requirements of our customers.  In addition, we
develop image acquisition console software such as Cedara I-AcquireTM for
companies that need a workstation to drive the capture of images from imaging
devices such as x-ray or CT scanners.  Many of our clinical
applications, such as Cedara I-Read MammoTM (a universal breast imaging
workstation designed for reading mammography, ultrasound and MRI studies) can be
added by OEMs as plug-ins to their existing PACS workstations or RIS
systems.  Our most recent innovations in this area include Cedara
WebAccessTM, a thin client web viewing application, and Cedara WebSchedulerTM for
vendors that need to incorporate front office capabilities into their
solutions.  Cedara WebAccess serves as the basis for the Merge Mobile
technology discussed below.




In addition to our software products, we provide services to our OEM
customers, including engineering services, professional services and maintenance
and support services.  Our engineering team provides experienced
software development services to customers for the purpose of rapid development
of customized software solutions.  This service leverages experienced
medical imaging staff and our broad technology portfolio.  Other
professional services include installation and training services.  In
connection with our software, we offer annual maintenance and support services
pursuant to which we provide software updates, upgrades and telephone
support.




~ 4 ~




Products and Services Sold Directly to End-Users




The primary solution from our Merge Fusion business unit is Fusion
RIS/PACS MXTM, which automates image and information workflow from the time a
patient imaging procedure is scheduled, through the procedure itself, the image
reading and reporting by a radiologist, the distribution of the report and
finally the generation of a bill for the exam.  This solution contains
several optional modules to enhance the workflow, including a referring
physician web portal, billing and business analytics.  Both the Fusion
RISTM and Fusion PACSTM can be licensed separately in a stand-alone
configuration.  Fusion PACSTM contains an integrated digital
mammography application, also sold as a stand-alone clinical workstation called
Merge MammoTM.




We also offer a line of eCommerce products anchored by eFilm
Workstation, which is one of the most widely used diagnostic workstations in the
world.  eFilm Workstation has received over 100,000 downloads since
2000.  eFilm Workstation is a desktop diagnostic, image and analysis
tool for viewing and interpreting medical images and is used in ways as
disparate as teaching imaging, testing new imaging products, veterinary imaging,
technologist review, remote reading and CD burning of images.  In
2008, we launched the Authentic eFilm Program to thwart piracy of the software,
as well as a new eFilm Application Exchange Program to enhance the integration
of new applications for eFilm Workstation.




We believe that our solutions are differentiated by the tight
integration of all of these elements, as well as the ability to use the
solutions across multiple locations.  As an expansion of our web
portal technology, we announced our new Merge Mobile technology in the fourth
quarter of 2008, an enabling technology that can allow images and information to
be sent to mobile devices such as an iPhoneTM or iTouchTM.




In addition to our software products, we provide our end-user
customers services such as installation, training, maintenance and
support.  In connection with our software, we offer annual maintenance
and support services pursuant to which we provide software updates (including
minor feature enhancements and bug fixes), telephone support and other services
depending on the type of support purchased.  We repurposed our
teleradiology hardware components to launch a disaster recovery service offering
in the fourth quarter of 2008.  Disaster Recovery is the first of our
new Managed Services.  In November 2008, we added Remote Systems
Monitoring to this service offering.




Markets




Our
diverse business model allows Merge to deliver solutions to many different
markets.  Our primary market for our Merge Fusion business is U.S.
imaging practices, particularly outpatient imaging centers, specialty clinics
and small hospitals.  Frost & Sullivan, a leading healthcare
consulting and research firm, estimated that the U.S. Turnkey Radiology PACS
market was valued at $1.2 billion in 2006 and would grow over the 7 year period
between 2005 and 2012 by a compound annual growth rate (“CAGR”) of 7.0%, to
reach a value of about $1.8 billion.  However, more recent reports
indicate slower market growth, and such growth may be further affected by the
recent downturn in overall economic conditions.  The General
Accountability Office (“GAO”) reported a per-beneficiary imaging volume growth
of 3.2% in 2007, as compared to 5.9% annual increases from 2000 –
2006.  Outside the U.S., growth estimates are higher for the direct
market.  For example, Frost and Sullivan expect an 8.3% CAGR in PACS
revenues from 2007 –2014 in Western Europe.  With the World Health Organization
estimating that two-thirds of the world’s population still lacks access to
conventional x-ray equipment, the market opportunity for supporting medical and
health information systems in developing countries increases as their health
infrastructures evolve.




Our OEM
business primarily serves vendors that sell to imaging practices throughout the
world.  The OEM business unit serves a much broader market than the
direct business, as OEM customers incorporate our solutions into imaging
modality equipment, ancillary imaging products, specialized clinical imaging
software and general health IT solutions like electronic medical records
throughout the world.  Beyond the imaging practice vendors, we support
software development efforts by vendors in areas such as surgical navigation,
clinical trials, veterinary imaging, dental imaging and
orthopedics.  We continue to seek to expand our addressable markets by
exploring the use of our solutions in new markets adjacent to the historical
medical imaging sector.




We
believe the following market trends are important to our overall
business:




·
            Overall
      economic climate:  The global markets and economies have
      declined sharply over the past several months.  Our direct
      customers have experienced capital constraints and reduced overall IT
      budgets.  Our focus on demonstrating the return-on-investment of
      our solutions, as well as incorporating
      pay-per-study or monthly subscription pricing models, has partially
      mitigated these issues to date.  Our OEM customers have
      experienced slowdowns in equipment orders.  This has the
      potential to affect certain of our ongoing relationships; although other
      customers may turn to us for consulting engineering help with short term
      product development needs as they develop new offerings with reduced
      internal research and development
teams.




~ 5
~






·
            Impact
      of ongoing government legislation:  As the largest payer for
      healthcare services in virtually every country, reimbursement changes by
      national governments have a large impact on our customers.  In
      the past few years, imaging has seen large negative government
      intervention, such as the DRA, explained below, which reduced imaging
      reimbursement.  However, government intervention can also be
      beneficial, such as when digital mammography received increased
      reimbursement.  We believe our customers are increasingly savvy
      about managing through reimbursement changes, although we continue to
      monitor all proposed reimbursement changes.  On a macro level,
      the movement of the entire U.S. healthcare industry toward a single payer
      or universal coverage requirement would also impact
      reimbursement.  The new presidency of the U.S. has moved quickly
      to advance healthcare legislation, passing both an expansion of the State
      Child Healthcare Insurance Plan (“SCHIP”) and an economic stimulus package
      with a significant amount dedicated to increased insurance
      coverage.  We believe broader healthcare reform legislation will
      take time to be proposed, accepted and implemented, and, therefore, would
      not anticipate a material adverse effect on our business in
      2009.  We cannot predict the possible long-term impact of major
      reimbursement changes.




·
            Innovation
      in web-based products:  Medical imaging is following the general
      IT trend toward more web-based, mobile access to
      information.  In addition, a shortage of radiologists,
      particularly in some subspecialties, has sparked an increase in
      teleradiology services.  Radiologists may read studies from
      several clinics and hospitals.  Referring physicians and
      patients are demanding quick results, which can be accomplished more
      efficiently by web distribution.  These drivers spark interest
      in web-based solutions and solution components.  We continue to
      dedicate significant product development to web products in both our OEM
      and Fusion business units.




·
            Interoperability
      with other health IT systems and vendors:  As medical imaging
      has evolved, vendors, applications and multiple system components have
      continued to proliferate.  It is not uncommon for a radiologist
      to open several applications to complete the reading and reporting on a
      simple x-ray.  Customers are demanding solutions that help
      integrate components for less “desktop clutter”, or at a minimum,
      applications that can operate on one desktop.  On a macro level,
      governments are trying to achieve broader health information transfer,
      which dictates system interoperability.  We believe that
      companies that can create easily integrated applications, or applications
      that help integrate system components, will benefit from this
      trend.




Medical,
Regulatory and Government Standards and Reforms




As a
highly regulated and essential industry worldwide, healthcare is subject to
constant political, technological, economic and regulatory change.  We
believe our products help our customers deal with potential changes in industry
standards and regulations.  However, we cannot predict the impact of
new proposals, healthcare reforms or standards on our business, our financial
condition or our results of operations.  See Item 1A, “Risk Factors”
of this Annual Report on Form 10-K for a description of various industry
standards and regulatory risks.




The
following are examples of some of the issues, standards and regulations that we
have monitored and addressed to protect our enterprise and that of our
customers:




·
            On
      February 8, 2006, President Bush signed into law the
      DRA.  Effective for services provided on or after January 1,
      2007, the DRA lowered the technical reimbursement component for some
      procedures and to some providers.  As a result, according to the
      GAO, advanced imaging procedure reimbursement fell by $1.7 billion in
      2007, despite an overall volume increase of 3.2%.  This
      exemplifies the impact of reimbursement changes on our end-user
      customers.  As a result, we have delivered new products and
      services that help our customers remain profitable under lower
      reimbursement scenarios.  Additional reductions in Medicare
      imaging reimbursement are being considered, and we continue to monitor
      them.




~ 6
~


·
            The
      U.S. Food and Drug Administration (“FDA”), which is responsible for
      assuring the safety and effectiveness of medical devices under the Federal
      Food, Drug and Cosmetic Act (the “Act”), has regulatory jurisdiction over
      computer software applications when they are labeled or intended to be
      used in the diagnosis of disease or other health related
      conditions.  In 2008, the FDA issued a warning to PACS vendors
      about the appropriate display of mammography images.  This
      exemplifies a regulatory action affecting our market.  Our
      mammography solutions were not involved or cited, but we continue to
      monitor the FDA and other applicable global regulatory
      requirements.




Competition




The
markets for our end-user products are highly competitive.  According
to Frost and Sullivan, over 35 active competitors are in the North American PACS
market alone, with the top six vendors generating almost 85% of the market
revenues in 2005.  Many of these competitors are active in the
international markets as well.  In the area of RIS and PACS workflow
applications, we see competitors increasingly focused on integrating RIS and
PACS solutions, as well as adding new clinical applications.  Some
industry consolidation is occurring, and we believe it will continue to
occur.  Our eCommerce product line also faces competitors, some of
which offer their products as “freeware”.




The
largest competitor to our OEM business unit generally is our OEM customers’ own
internal software engineering or research and development
group.  While these internal software engineering groups had been
growing in recent years, several large OEMs recently announced
layoffs.  Competition also continues from toolkit companies, as well
as companies specializing in specific advanced imaging
applications.




Our
ability to compete successfully depends on a number of factors, both within and
beyond our control, including: existing customer relationships; ongoing rapid
product innovation; product quality and performance; price; experienced sales,
marketing and service professionals and product and policy decisions announced
by competitors.




Strategy




In 2008,
we implemented strategic changes and reorganizations to eliminate our ongoing
operational losses.  For the first five months of the year, we pursued
several major strategies, including:




·
            Significant
      investment in launching a teleradiology Pre-Read
  business;




·
            Planned
      disposition of the Europe operations;
and




·
            Off-shore
      product development within the OEM business
  unit.




With the
investment by Merrick in June of 2008 and the subsequent installation of new
senior management, several of those strategies have shifted,
including:




·
            Closure
      of our Indian operations, including the Pre-Read
  business;




·
            Retention
      and expansion of our European operations within our two business
      units;




·
            Cost
      containment and elimination of unprofitable activities;
  and




·
            Expansion
      into Managed Services.




Underlying
these changes, however, Merge continues to build upon our 20-year position as an
innovative medical imaging software and services provider by continuing to
invest in product development and customer service.  New updates were
developed for each existing product line, and several new products were
introduced in 2008.  In addition, we invested in customer support
tools and resources, which allowed us to maintain customer relationships despite
our difficulties in the first half of the year.




We intend
to continue to focus on the following general strategies:




·
            International
      expansion through VAR and distributor
  relationships;




·
            Ongoing
      innovation and intellectual property portfolio
  expansion;




·
            Expansion
      of our Managed Services offerings to include hosted solutions;
      and




·
            Continued
      innovation in web portal and mobile
  technologies.




~ 7
~


Employees




As of
December 31, 2008, we had approximately 250 employees.  We believe our
restructuring activities during the first half of 2008 were made in a timely
manner and have positioned us well to meet the challenges of the current
economic environment.




Sales, Marketing
and Distribution




We employ
quota carrying sales teams at both our Fusion and OEM business
units.  In addition, we have sales teams dedicated to establishing and
maintaining VAR and distributor relationships outside of the U.S.  The
sales teams are complimented by a staff of pre-sales engineers, lead generation
personnel and marketing employees.  These teams have the benefit of
tools and resources that streamline and track the sales process.  We
continue to experience sales turnover at a level that we believe is near the
industry average and have been able to recruit qualified
replacements.




Our
marketing efforts are mainly electronic, utilizing our website and our extensive
email database of customers for our main communication campaigns, as well as
online buyer guides and comparison charts.  In 2008, we established
new web user communities for each of our eCommerce flagship
products:  www.mergecom-3.com for our DICOM toolkits and
http://www.merge.com/na/exchange/ as an applications exchange community for
our eFilm Workstation customers.  These online communities have
enhanced our ability to generate focused communication and ongoing dialogue with
specific customer groups.  Beyond electronic media, we employ
consistent media relations efforts for market communication.  We also
have an active User Group for our Fusion business unit, which has held a
multi-day meeting annually since 2004.  In addition, we participate in
the major radiology and healthcare information system industry trade
shows.




Intellectual
Property Rights




We
currently own 24patents
issued by the intellectual property offices of various
jurisdictions.  We continue to expand our intellectual property
portfolio and have applied for 31 additional patents in the U.S., Canada and
Japan.  There can be no assurance that these patents will afford any
commercial benefits.




We
currently hold 17 registered trademarks in the U.S. or Canada, and have applied
for 2 more trademarks, one in the U.S. and the other in Canada.  These
trademarks help protect the product brand assets of Merge.




During
2008, we ended our litigation against Virtual Radiologic Corporation related to
two of our teleradiology patents.




Available
Information




Our
website address is www.merge.com.  We offer free access to our annual
reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form
8-K, including any amendments to those reports, as filed with or furnished to
the SEC.  We do this through a direct link from the “Investor
Relations” portion of our website to the SEC Internet site at
www.sec.gov.  Materials we file with or furnish to the SEC may also be
read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Room
1580, Washington, D.C. 20549.  Information on the operation of the
Public Reference Room may be obtained by calling the SEC at
1-800-SEC-0330.  Also, the SEC Internet site contains reports, proxy
and information statements, and other information that we file electronically
with the SEC.




Item
      1 A.
            RISK
      FACTORS




Discussion
of our business and operations included in this annual report on Form 10-K
should be read together with the risk factors set forth below.  They
describe various risks and uncertainties to which we are or may become
subject.  These risks and uncertainties, together with other factors
described elsewhere in this report, have the potential to affect our business,
financial condition, results of operations, cash flows, strategies or prospects
in a material and adverse manner.  New risks may emerge at any time,
and we cannot predict those risks or estimate the extent to which they may
affect financial performance.  Each of the risks described below could
adversely impact the value or our securities.  These statements, like
all statements in this report, speak only as of the date of this report (unless
another date is indicated) and we undertake no obligation to update or revise
the statements in light of future developments.




~ 8
~




Our
business could
be harmed by the deteriorating general economic and market conditions that lead
to reduced spending on information technology
products.




As our
business has expanded globally, we have become increasingly subject to the risks
arising from adverse changes in domestic and global economic and political
conditions.  Economic growth in the U.S. and other countries slowed
during the second half of calendar year 2008, which caused our customers to
delay or reduce information technology purchases.  If economic
conditions in the U.S. and other countries continue to deteriorate, customers
may continue to delay or further reduce purchases.  This could result
in additional reductions in sales of our products, longer sales cycles, slower
adoption of new technologies and increased price competition.  In
addition, weakness in the end-user market could negatively affect the cash flow
of our OEM and VAR customers who could, in turn, delay paying their obligations
to us, which would increase our credit risk exposure and cause a decrease in
operating cash flows.  Also, if our OEM and VAR customers experience
excessive financial difficulties and/or insolvency, and we are unable to
successfully transition end-users to purchase our product from other vendors or
directly from us, our sales could decline significantly.  Any of these
events would likely harm our business, results of operations and financial
condition.




Continued
disruption in credit markets and world-wide economic changes may adversely
affect our business, financial condition, and results of
operations.




Recent
disruptions in the financial and credit markets may adversely affect our
business and our financial results.  The tightening of credit markets
may reduce the funds available to our customers to buy our products and
services.  It may also result in customers extending the length of
time in which they pay and may result in our having higher customer receivables
with increased default rates.  General concerns about the fundamental
soundness of domestic and foreign economies may also cause customers to reduce
their purchases, even if they have cash or if credit is available to
them.




Our
future capital needs are uncertain and our ability to access additional
financing may be negatively impacted by the volatility and disruption of the
capital and credit markets and adverse changes in the global
economy.




Our
capital requirements in the future will depend on many factors,
including:




·
            Acceptance
      of and demand for our products;




·
            The
      extent to which we invest in new technology and product
      development;




·
            The
      costs of developing new products, services or
  technologies;




·
            The
      number and method of financing of acquisitions and other strategic
      transactions; and




·
            The
      costs associated with the growth of our business, if
  any.




We intend
to finance our operations and any growth of our business with existing cash and
cash flow from operations.  We believe that our existing cash and
anticipated cash flows from operations will be sufficient to meet our operating
and capital requirements through at least the next twelve months from the date
of filing of this Annual Report on Form 10-K.  If adverse global
economic conditions persist or worsen, however, we could experience a decrease
in cash flow from operations and may need additional financing to fund
operations.  Due to the existing uncertainty in the capital markets
(including debt, private equity, venture capital and traditional bank lending),
access to additional debt or equity may not be available to us on acceptable
terms or at all.  If we cannot raise funds on acceptable terms when
necessary, we may not be able to develop or enhance our products and services,
execute our business plan, take advantage of future opportunities or respond to
competitive pressures or unanticipated customer requirements.




We
may experience significant fluctuations in our revenue growth rate and operating
results.




We may
not be able to accurately forecast our growth rate.  We base our
expense levels and investment plans on sales estimates and review all estimates
on a quarterly basis.  Many of our expenses and investments are fixed,
and we may not be able to adjust our spending quickly enough if our sales are
lower than expected.




Our
revenue growth may not be sustainable, and our percentage growth rates may
decrease or fluctuate significantly.  Our revenue and operating profit
growth depends on the continued growth of demand for the products and services
offered by us or our OEM and VAR customers, and our business is affected by
general economic and business conditions worldwide.  A softening of
demand, whether caused by changes in customer preferences or a weakening of the
U.S. or global economies, may result in decreased revenue or
growth.




~ 9
~






Our net
sales and operating results will also fluctuate for many other reasons,
including due to risks described elsewhere in this section and the
following:  demand for our software solutions and services; our sales
cycle; economic cycles; the level of reimbursements to our end-user customers
from government sponsored healthcare programs (principally, Medicare and
Medicaid); accounting policy changes mandated by regulating entities; delays due
to customers’ internal budgets and procedures for approving capital
expenditures, by competing needs for other capital expenditures and the
deployment of new technologies and personnel resources; our ability to retain
and increase sales to existing customers, attract new customers and satisfy our
customers’ demands; our ability to fulfill orders; the introduction of
competitive products and services; price decreases; changes in the usage of the
Internet and eCommerce including in non-U.S. markets; timing, effectiveness and
costs of expansion and changes in our systems and infrastructure; the outcomes
of legal proceedings and claims; and variations in the mix of products and
services that we sell.




Delays in
the expected sale or installation of our software may have a significant impact
on our anticipated quarterly revenues and consequently, our earnings, since a
significant percentage of our expenses are relatively fixed. Additionally, we
sometimes depend, in part, upon large contracts with a small number of OEM
customers to meet our sales goals in any particular quarter.  Delays
in the expected sale or installation of solutions under these large contracts
may have a significant impact on our quarterly net sales and consequently our
earnings, particularly because a significant percentage of our expenses are
fixed.




The
length of our sales and implementation cycles may adversely affect our future
operating results.




We have
experienced long sales and implementation cycles.  How and when to
implement, replace, expand or substantially modify medical imaging management
software, or to modify or add business processes, are major decisions for our
end-user target market.  The sales cycle for our software ranges from
six to 18 months or more from initial contact to contract
execution.  Our end-user implementation cycle has generally ranged
from three to nine months from contract execution to completion of
implementation.  During the sales and implementation cycles, we will
expend substantial time, effort and resources preparing contract proposals,
negotiating the contract and implementing the software.  We may not
realize any revenues to offset these expenditures.  Additionally, any
decision by our customers to delay or cancel purchases or the implementation of
our software may adversely affect our net sales.




We
have outstanding debt and may incur additional debt in the future.




On June
4, 2008, we closed a financing transaction with Merrick in which we received
gross proceeds of $20.0 million from Merrick in exchange for a $15.0 million
senior secured term note (the “Note”) due June 4, 2010 and 21,085,715 shares of
our Common Stock.  Our ability to repay the principal of the Note and
any additional indebtedness that we may incur is dependent upon our ability to
manage our business operations and generate sufficient cash flows to service
such debt.  There can be no assurance that we will be able to manage
any of these risks successfully.




Our
ownership is concentrated among a small number of stockholders.




Our
ownership is concentrated among a small number of stockholders, including
Merrick, an affiliate of Merrick Ventures, LLC (“Merrick Ventures”) and Michael
W. Ferro, Jr., Chairman and Chief Executive Officer of Merrick Ventures, who is
also Chairman of our Board of Directors.  As of December 31, 2008,
Merrick held approximately 49.9% of our outstanding Common Stock, and Mr. Ferro
and Merrick are thus able to exert substantial control over various corporate
matters including approvals of mergers, sales of assets, issuance of capital
stock and similar transactions.




If
we are unable to successfully identify or effectively integrate acquisitions,
our financial results may be adversely affected.




We have
in the past and may in the future acquire and make investments in companies,
products or technologies that we believe complement or expand our existing
business and assist us in quickly bringing new products to
market.  There can be no assurance that we will be able to identify
suitable candidates for successful acquisitions at acceptable
prices.  In addition, our ability to achieve the expected returns and
synergies from our past and future acquisitions and alliances depends in part
upon our ability to integrate the offerings, technology, administrative
functions, and personnel of these businesses into our business in an efficient
and effective manner.  We cannot predictwhether we will be
successful in integrating acquired businesses or that our acquired businesses
will perform at the levels we anticipate.  In addition, our past and
future acquisitions may be subject us to unanticipated risks or liabilities or
disrupt our operations and divert management’s attention from our day-to-day
operations.


~ 10
~




In making
or attempting to make acquisitions or investments, we face a number of risks,
including risks related to:




·
            Identifying
      suitable candidates, performing appropriate due diligence, identifying
      potential liabilities and negotiating acceptable
  terms;




·
            Reducing
      our working capital and hindering our ability to expand or maintain our
      business, if we make acquisitions using
cash;




·
            The
      potential distraction of our management, diversion of our resources and
      disruption to our business;




·
            Retaining
      and motivating key employees of the acquired
  companies;




·
            Managing
      operations that are distant from our current headquarters and operational
      locations;




·
            Entering
      into geographic markets in which we have little or no prior
      experience;




·
            Competing
      for acquisition opportunities with competitors that are larger than we are
      or have greater financial and other resources than we
  have;




·
            Accurately
      forecasting the financial impact of a
  transaction;




·
            Assuming
      liabilities of acquired companies, including existing or potential
      litigation related to the operation of the business prior to the
      acquisition;




·
            Maintaining
      good relations with the customers and suppliers of the acquired company;
      and




·
            Effectively
      integrating acquired companies and achieving expected
      synergies.




In
addition, any acquired business, products or technologies may not generate
sufficient revenue and net income to offset the associated costs of such
acquisitions, and such acquisitions could result in other adverse
effects.  Moreover, from time to time, we may enter into negotiations
of the acquisition of businesses, products or technologies but be unable or
unwilling to consummate the acquisitions under consideration.  This
can be expensive and could cause significant diversion of managerial attention
and resources.




A
portion of our business relies upon a network of independent contractors and
distributors whose actions could have an adverse effect on our
business.




We obtain
some of our critical information from independent contractors.  In
addition, we rely on a network of VAR's and distributors to sell our offerings
in locations where we do not maintain a sales office or sales
team.  These independent contractors and distributors are not
employees of Merge.  As a result, we are limited in our ability to
monitor and direct their activities.  The loss of a significant number
of these independent contractors or dealers could disrupt our sales, marketing
and distribution efforts.  Furthermore, if any actions or business
practices of these individuals or entities violate our policies or procedures or
otherwise are deemed inappropriate or illegal, we could be subject to
litigation, regulatory sanctions or reputation damage, any of which could
adversely affect our business and we may need to terminate our relationship with
them.




Our
investments in technology may not be sufficient and may not result in an
increase in our revenue or decrease in our operating costs.




As the
technological landscape continues to evolve, it may become increasingly
difficult for us to make timely, cost-effective changes to our offerings in a
manner that adequately differentiates them from those of our
competitors.  We cannot provide any assurance that our investments
have been or will be sufficient to maintain or improve our competitive position
or that the development of new or improved technologies and products by our
competitors will not have a material adverse effect on our
business.




~ 11
~




We
operate in competitive markets, which may adversely affect our market share and
financial results.




Some of
our competitors focus on sub-markets within our targeted industries, while
others have significant financial and information-gathering resources with
recognized brands, technological expertise and market experience.  We
believe that competitors are continuously enhancing their products and services,
developing new products and services and investing in technology to better serve
the needs of their existing customers and to attract new customers.




We face
competition in specific industries and with respect to specific
offerings.  We may also face competition from organizations and
businesses that have not traditionally competed with us, but that could adapt
their products and services to meet the demands of our
customers.  Increased competition may require us to reduce the prices
of our offerings or make additional capital investments which would adversely
affect our margins.  If we are unable or unwilling to do so, we may
lose market share in our target markets and our financial results may be
adversely affected.




We
face aggressive competition in many areas of our business, and our business will
be harmed if we fail to compete effectively.




The
markets for medical imaging solutions are highly competitive and subject to
rapid technological change.  We may be unable to maintain our
competitive position against our current and potential
competitors.  Many of our current and potential competitors have
greater financial, technical, product development, marketing and other resources
than we have, and we may not be able to compete effectively with
them.  In addition, new competitors may emerge and our system and
software solution offerings may be threatened by new technologies or market
trends that reduce the value of our solutions.  Further, our recent
challenges may have weakened our competitive position.




We often
“compete” with our OEM customers’ own internal software engineering
groups.  The size and competency of these groups may create additional
competition for us.  In the area of RIS and PACS workflow
applications, many competitors offer portions of an integrated radiology
solution through their RIS and PACS.  Additionally, certain
competitors are integrating RIS and PACS technologies through development,
partnership and acquisition activities.




The
development and acquisition of additional products, services and technologies,
and the improvement of our existing products and services, require significant
investments in research and development.  For example, our current
product candidates are in various stages of development and may require
significant further research, development, pre-clinical or clinical testing,
regulatory approval and commercialization.  If we fail to successfully
sell new products and update our existing products, our operating results may
decline as our existing products reach the end of their commercial life
cycles.




Headcount
reductions in the first half of 2008 have placed additional strain on our
resources, may impair our operations and may adversely impact our ability to
retain qualified technical, managerial and sales personnel.




To
streamline our operations, reduce costs and bring our staffing and cost
structure in line with our revenue base, we announced workforce reductions in
both February and June 2008.  Total worldwide headcount at December
31, 2008 was approximately 250 persons.  Certain of the employees who
were terminated possessed specific knowledge or expertise, and we may not have
successfully transferred that knowledge or expertise to other
employees.  In that case, the absence of such employees may create
significant operational difficulties.  Further, the reduction in
workforce may have reduced employee morale, and created concern among potential
and existing employees about job security, which may lead to difficulty in
hiring and increased turnover in our current workforce.  As a result,
our ability to respond to unexpected challenges may be impaired, and we may be
unable to take advantage of new opportunities.




Our
performance and future success depends on our ability to attract, integrate and
retain qualified technical, managerial and sales personnel.




We are dependent, in part, upon the services of our senior executives and other
key business and technical personnel.  We do not currently maintain
key-man life insurance on our senior executives.  The loss of the
services of any of our senior executives or key employees could have a material
adverse effect on our business.  Our commercial success will depend
upon, among other things, the successful recruiting and retention of highly
skilled technical, managerial and sales personnel with experience in business
activities such as ours.  Competition for the type of
highly skilled individuals sought by us is intense.  We may not be
able to retain existing key employees or be able to find, attract and retain
skilled personnel on acceptable terms.





~ 12
~




We
may not be able to adequately protect our intellectual property rights or may be
accused of infringing intellectual property rights of third
parties.




We regard
our trademarks, service marks, copyrights, patents, trade secrets, proprietary
technology and similar intellectual property as critical to our
success.  We rely on trademark, copyright and patent law, trade secret
protection and confidentiality and/or license agreements with our employees,
customers and others to protect our proprietary rights.  Effective
intellectual property protection may not be available in every country in which
our products and services are made available.  We also may not be able
to acquire or maintain appropriate intellectual property rights in all countries
where we do business.




We may
not be able to discover or determine the extent of any unauthorized use of our
proprietary rights.  Third parties that license our proprietary rights
also may take actions that diminish the value of our proprietary
rights.  Such claims, whether or not meritorious, may result in the
expenditure of significant financial and managerial resources, injunctions
against us or the payment of damages.  We may need to obtain licenses
from third parties who allege that we have infringed their rights, but such
licenses may not be available on terms acceptable to us or at all.  In
addition, we may not be able to obtain or utilize on terms that are favorable to
us, or at all, licenses or other rights with respect to intellectual property we
do not own in providing services under commercial agreements.  These
risks have been amplified by the increase in third parties whose sole or primary
business is to assert such claims.




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




We
may be subject to product liability claims if people or property is harmed by
the products and services that we sell.




Some of
the products we sell or manufacture may expose us to product liability claims
relating to personal injury, death or environmental or property damage and may
require product recalls or other actions.  Certain third parties,
primarily our customers, also sell products or services using our
products.  This may increase our exposure to product liability
claims.  Although we maintain liability insurance, we cannot be
certain that our coverage will be adequate for liabilities actually incurred or
that insurance will continue to be available to us on economically reasonable
terms or at all.  In addition, some of our agreements with our vendors
and sellers do not indemnify us from product liability.




We
have foreign exchange risk.




The
results of our international operations are exposed to foreign exchange rate
fluctuations.  While the functional currency of most of our
international operations is the U.S. Dollar, we maintain certain account
balances in the local currency.  Upon remeasurement of such accounts
or through normal operations, results may differ materially from expectations,
and we may record significant gains or losses on the remeasurement of such
balances.  As we expand our international operations, our exposure to
exchange rate fluctuations may increase.




We
may not be successful in our efforts to expand into international market
segments.




Our
international activities are significant to our revenues and profits, and we
plan to further expand internationally.  We have relatively little
experience operating in these or future market segments and may not benefit from
any first-to-market advantages or otherwise succeed.  It is costly to
establish, develop and maintain international operations and websites and
promote our brand internationally.  Our international operations may
not be profitable on a sustained basis.




In
addition to risks described elsewhere in this section, our international sales
and operations are subject to a number of risks, including:




·
            Local
      economic and political conditions;




~ 13
~


·
            Foreign
      government regulation of healthcare and government reimbursement of health
      services;




·
            Local
      restrictions on sales or distribution of certain products or services and
      uncertainty regarding liability for products and
  services;




·
            Local
      import, export or other business licensing
  requirements;




·
            Local
      limitations on the repatriation and investment of funds and foreign
      currency exchange restrictions;




·
            Shorter
      payable and longer receivable cycles and the resultant negative impact on
      cash flow;




·
            Local
      laws and regulations regarding data protection, privacy, network security
      and restrictions on pricing;




·
            Difficulty
      in staffing, developing and managing foreign operations as a result of
      distance, language and cultural
differences;




·
            Different
      employee/employer relationships and the existence of workers’ councils and
      labor unions;




·
            Laws
      and policies of the U.S. and other jurisdictions affecting trade, foreign
      investment, loans and taxes; and




·
            Geopolitical
      events, including war and
terrorism.




Litigation
or regulatory actions could adversely affect our financial
condition.




We and
certain of our former officers were defendants in several lawsuits relating to
our accounting and financial disclosure.  These lawsuits and our other
legal matters are described in Part I, Item 3, “Legal Proceedings” of this
Annual Report on Form 10-K.  These lawsuits were settled in 2008
and have been dismissed.




On April
27, 2006, Merge received an informal, non-public inquiry from the SEC requesting
voluntary production of documents and other information.  The inquiry
principally related to our announcement, on March 17, 2006, that we would
investigate allegations of improprieties related to financial reporting and
revise our results of operations for the fiscal quarters ended June 30, 2005,
and September 30, 2005.  On July 10, 2007, SEC Staff advised us that
the SEC had issued a formal order of investigation in this
matter.  Merge is cooperating fully with the SEC.  The SEC
Staff has informed us that the Staff is considering recommending an injunctive
or cease and desist order against us prohibiting violations of the reporting,
record-keeping, and internal control provisions under the Securities Exchange
Act of 1934.  The Staff did not inform us that it is considering
recommending any monetary sanctions against us.  However, the matter
has not yet been finally resolved, and, until such final resolution, we will
continue to incur expenses, including legal fees and other costs, in connection
with the SEC’s investigation.




As a
result of these lawsuits and regulatory matters, we have incurred and may to
continue to incur substantial expenses.




We
may have difficulty and incur significant expense in obtaining directors’ and
officers’ liability insurance.




As a
result of the shareholder derivative and class action litigation, we may have
difficulty finding appropriate directors and officers liability coverage, or, if
appropriate coverage is found, the resulting premiums may be substantially more
expensive than we have incurred in the past.  Our current coverage
renews in June of 2009.  We are currently beginning the process of
obtaining quotes for this renewal coverage.




We
depend on licenses from third parties for rights to some technology we use, and
if we are unable to continue these relationships and maintain our rights to this
technology, our business could suffer.




Some of
the technology used in our software depends upon licenses from third party
vendors.  These licenses typically expire within one to five years,
can be renewed only by mutual consent and may be terminated if we breach the
license and fail to cure the breach within a specified period of
time.  We may not be able to continue using the technology made
available to us under these licenses on commercially reasonable terms or at
all.  As a result, we may have to discontinue, delay or reduce
software shipments until we obtain equivalent technology, which could hurt our
business.  Most of our third party licenses are
nonexclusive.  Our competitors may obtain the same right to use any of
the technology covered by these licenses and use the technology to compete
directly with us.  In addition, if our vendors choose to discontinue
support of the licensed technology in the future or are unsuccessful in their
continued research and development efforts, particularly with regard to the
Microsoft Windows/Intel platform on which most of our products operate, we may
not be able to modify or adapt our own software.





~ 14
~




We
are subject to government regulation, changes to which could negatively impact
our business.




We are
subject to regulation in the U.S. by the FDA, including periodic FDA
inspections, in Canada under Health Canada’s Medical Devices Regulations, and in
other countries by corresponding regulatory authorities.  We may be
required to undertake additional actions in the U.S. to comply with the Act,
regulations promulgated under such act, and any other applicable regulatory
requirements.  For example, the FDA has increased its focus on
regulating computer software intended for the use in a healthcare
setting.  If our software solutions are deemed to be actively
regulated medical devices by the FDA, we could be subject to more extensive
requirements governing pre- and post-marketing activities.  Complying
with these regulations could be time consuming and expensive, and may
include:




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




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




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




A
significant portion of our net sales are derived directly or indirectly from
sales to end-users, including hospitals, diagnostic imaging centers and
specialty clinics, many of which generate some or all of their revenues from
government sponsored healthcare programs (principally, Medicare and
Medicaid).  We believe that the implementation of the reimbursement
reductions contained in the DRA has adversely impacted our end-user customers’
revenues per examination, which has caused some of them to respond by reducing
their investments or postponing investment decisions, including investments in
our software solutions and services, including maintenance.  The risk
of more Medicare imaging reimbursement cuts remains.




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




Changes
in federal and state regulations relating to patient data could depress the
demand for our software and impose significant software redesign costs on
us.




Federal
regulations under the Health Insurance Portability and Accountability Act
(“HIPAA”) impose national health data standards on healthcare providers that
conduct electronic health transactions, healthcare clearinghouses that convert
health data between HIPAA compliant and non-compliant formats and health
plans.  Collectively, these groups are known as covered
entities.  The HIPAA regulations prescribe transaction formats and
code sets for electronic health transactions; protect individual privacy by
limiting the uses and disclosures of individually identifiable health
information and require covered entities to implement administrative, physical
and technological safeguards to ensure the confidentiality, integrity,
availability and security of individually identifiable health information in
electronic form.  Although we are not a covered entity, most of our
customers are, and they require that our software and services adhere to HIPAA
regulations.  Any failure or perception of failure of our software or
services to meet HIPAA regulations could adversely affect demand for our
software and services and force us potentially to expend significant capital,
research and development and other resources to modify our software or services
to address the privacy and security requirements of our clients.




States
and foreign jurisdictions have adopted, or may adopt, privacy standards that are
similar to or more stringent than the federal HIPAA privacy
regulations.  This may lead to different restrictions for handling
individually identifiable health information.  As a result, our
customers may demand IT solutions and services that are adaptable to reflect
different and changing regulatory requirements, which could increase our
development costs.  In the future, federal, state or foreign governmental
authorities may impose new data security regulations or additional restrictions
on the collection, use, transmission and other disclosures of health
information.  We cannot predict the potential impact that these future
rules may have on our business; however, the demand for our software and
services may decrease if we are not able to develop and offer software and
services that can address the regulatory challenges and compliance obligations
facing our clients.




~ 15
~




We
provide our customers with certain warranties which could result in higher costs
than we anticipate.




Software
products as complex as those offered by us and used in a wide range of clinical
and health information systems settings are likely to contain a number of errors
or “bugs,” especially early in their product life cycle.  Our products
include clinical information systems used in patient care settings where a low
tolerance for bugs exists.  Testing of products is difficult due to
the wide range of environments in which systems are installed.  The
discovery of defects or errors in our software products may cause delays in
product delivery, poor client references, payment disputes, contract
cancellations or additional expenses and payments to rectify
problems.  Any of those factors may result in delayed acceptance of,
or the return of, our software products.




Healthcare
industry consolidation could impose pressure on our software prices, reduce our
potential client base and reduce demand for our software.




Manyhospitals
and imaging centers have consolidated to create larger healthcare enterprises
with greater market power.  If this consolidation trend continues, it
could reduce the size of our target market and give the resulting enterprises
greater bargaining power, which may lead to erosion of the prices for our
software.  In addition, when hospitals and imaging centers combine,
they often consolidate infrastructure, and acquisition of our customers could
erode our revenue base.




The
trading price of our Common Stock has been volatile and may fluctuate
substantially in the future.




The price
of our Common Stock has been, and may continue to be, volatile.  The
trading price of our Common Stock may continue to fluctuate widely as a result
of a number of factors, some of which are not in our control,
including:




·
            Our
      ability to meet or exceed the expectations of analysts or
      investors;




·
            Changes
      in our own forecasts or earnings estimates by
  analysts;




·
            Quarter-to-quarter
      variations in our operating
results;




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




·
            General
      conditions in the healthcare IT
industry;




·
            Governmental
      regulatory action and healthcare reform measures, including changes in
      reimbursement rates for imaging
procedures;




·
            Rumors
      about our performance or software
solutions;




·
            Uncertainty
      regarding our ability to service existing
debt;




·
            Price
      and volume fluctuations in the overall stock market, which have
      particularly affected the market prices of many software, healthcare and
      technology companies; and




·
            General
      economic conditions.




In
addition, the market for our Common Stock may experience price and volume
fluctuations unrelated or disproportionate to our operating
performance.  These fluctuations could have a significant impact on
our business due to diminished incentives for management and diminished currency
for acquisitions.




Item
      1B.
            UNRESOLVED
      STAFF COMMENTS




None.




Item
      2.
            PROPERTIES





Our
principal facilities are located in Milwaukee, Wisconsin in an approximate
36,000 square foot office leased through April 2011 at a rate of approximately
$0.4 million per year and in Mississauga, Ontario in an approximate 30,000
square foot office leased through December 2009, at a rate of approximately $0.5
million per year.  We also have locations with leased facilities in
Hudson, Ohio, Shanghai, China and Nuenen, the Netherlands.




~ 16
~




We
actively monitor our real estate needs in light of our current utilization and
projected growth.  We believe that we can acquire any necessary
additional facility capacity on reasonably acceptable terms within a relatively
short timeframe.  We devote capital resources to facility improvements
and expansions as we deem necessary to promote growth and most effectively serve
our customers.




Item
      3.
            LEGAL
      PROCEEDINGS




Between
March 22, 2006 and April 26, 2006, seven putative securities class action
lawsuits were filed in the U.S. District Court for the Eastern District of
Wisconsin, on behalf of a class of persons who acquired shares of our Common
Stock between August 2, 2005 and March 16, 2006.  On November 22,
2006, the Court consolidated the seven cases, appointed the Southwest Carpenters
Pension Trust to be the lead plaintiff and approved the Trust’s choice of its
lead counsel.  The lead plaintiff filed a consolidated amended
complaint on March 21, 2007.  Defendants in the suit included us,
Richard A. Linden, our former President and Chief Executive Officer, Scott T.
Veech, our former Chief Financial Officer, David M. Noshay, our former Senior
Vice President of Strategic Business Development, and KPMG LLP, our independent
public accountants at the time.  The consolidated amended complaint
arose out of our restatement of financial statements, as well as our
investigation of allegations made in anonymous letters received by
us.  The lawsuits allege that we and the other defendants violated
Section 10(b) and that the individuals violated Section 20(a) of the Securities
Exchange Act of 1934, as amended.  The consolidated amended complaint
seeks damages in unspecified amounts.  The defendants filed motions to
dismiss.  On March 31, 2008, the motions to dismiss us, Mr. Linden and
Mr. Veech were denied, and the motions to dismiss Mr. Noshay and KPMG were
granted without prejudice.  On April 30, 2008, we entered into an
agreement in principle with the plaintiff in the consolidated securities class
action suits, to settle, release and dismiss all claims asserted against Merge
and the individual defendants in the litigation.  In exchange, we
agreed to a one-time cash payment of approximately $3.0 million to the
plaintiff, and our primary and one of our excess directors and officers
insurance carriers agreed to a one-time cash payment of approximately $13.0
million to the plaintiff, for a total payment of $16.0 million.  Our
costs were accrued as of June 30, 2008, as payment was contingent upon
completion of a financing transaction, and were recorded as a general and
administrative expense.  The settlement amounts were paid into escrow
in July 2008.  The proposed settlement was preliminarily approved on
July 15, 2008 and was dismissed with prejudice following settlement in November
2008.  There was no admission of wrongdoing or liability by the
defendants in the settlement.




On August
28, 2006, a derivative action was filed in the
Circuit Court of Milwaukee County, Civil Division, against
Messrs. Linden and Veech, William C. Mortimore (our founder, former Chairman and
Chief Strategist, who served as our interim Chief Executive Officer from May 15,
2006 to July 2, 2006) and all of the then-current members of our Board of
Directors.  The plaintiff filed an amended complaint on June 26, 2007,
adding Mr. Noshay as a defendant.  The plaintiff alleged that (a) each
of the individual defendants breached fiduciary duties owed to us by violating
generally accepted accounting principles, willfully ignoring problems with
accounting and internal control practices and procedures and participating in
the dissemination of false financial statements; (b) the company and the
director defendants failed to hold an annual meeting of shareholders for 2006 in
violation of Wisconsin law; (c) Directors Barish, Geras and Hajek violated
insider trading prohibitions and misappropriated material non-public
information; (d) corporate waste and gift by Directors Hajek, Barish, Reck,
Dunham and Lennox, members of the Compensation Committee at the time of the
restatement; and (e) unjust enrichment and insider selling against Messrs.
Linden, Veech, Noshay and Mortimore.  The plaintiff asked for
unspecified amounts in damages and costs, disgorgement of certain compensation
and profits against certain defendants as well as equitable
relief.  In response to this action, our Board of Directors formed a
Special Litigation Committee, which Committee was granted full authority to
investigate the allegations of the derivative complaint and determine whether
pursuit of the claims would be in the company’s best interest.  On
March 3, 2008, the parties to this derivative action entered into a Memorandum
of Understanding to settle all claims asserted in the case.  Under the
settlement, the company would pay fees and expenses of plaintiff’s counsel of
$250,000.  These costs were accrued as of December 31, 2007, and were
paid in July 2008.  The proposed settlement was preliminarily approved
on April 17, 2008 with final approval on June, 27, 2008.  As a result
of this settlement, the Special Litigation Committee was dissolved on August 19,
2008.  There was no admission of wrongdoing or liability by the
defendants in the settlement.




~ 17
~


In March
2008, we received approximately $1.1 million from our primary directors and
officers liability insurance carrier for reimbursement of legal expenses in
connection with the class action and derivative action against Merge and certain
of its current and former directors and officers.  This reimbursement
was recorded as a credit to general and administrative expense.  We do
not anticipate that additional funds will be collected from insurance carriers
related to these defense costs.




On April
27, 2006, Merge received an informal, non-public inquiry from the SEC requesting
voluntary production of documents and other information.  The inquiry
principally related to our announcement, on March 17, 2006, that we would
investigate allegations of improprieties related to financial reporting and
revise our results of operations for the fiscal quarters ended June 30, 2005,
and September 30, 2005.  On July 10, 2007, SEC Staff advised us that
the SEC had issued a formal order of investigation in this
matter.  Merge is cooperating fully with the SEC.  The SEC
Staff has informed Merge that the Staff is considering recommending an
injunctive or cease and desist order against Merge prohibiting violations of the
reporting, record-keeping, and internal control provisions under the Securities
Exchange Act of 1934.  The Staff did not inform us that it is
considering recommending any monetary sanctions against us.  However,
the matter has not yet been finally resolved, and, until such final resolution,
we will continue to incur expenses, including legal fees and other costs, in
connection with the SEC’s investigation.




In
addition to the matters discussed above, we are from time to time parties to
legal proceedings, lawsuits and other claims incident to our business
activities.  Such matters may include, among other things, assertions
of contract breach or intellectual property infringement, product liability
claims, claims for indemnity arising in the course of our business and claims by
persons whose employment has been terminated.  Such matters are
subject to many uncertainties and outcomes are not predictable with
assurance.  Consequently, we are unable to ascertain the ultimate
aggregate amount of monetary liability, amounts which may be covered by
insurance or recoverable from third parties, or the financial impact with
respect to these matters as of the date of this report.




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




None.






PART II




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




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




The
following table sets forth for the periods indicated, the high and low sale
prices of our Common Stock as reported by the NASDAQ:




Common Stock
Market Prices




2008
              
              4th
      Quarter
              
              3rd
      Quarter
              
              2nd
      Quarter
              
              1st
      QuarterHigh
              
              $1.75
              
              $1.60
              
              $1.37
              
              $1.26Low
              
              $0.26
              
              $0.60
              
              $0.26
              
              $0.332007High
              
              $4.43
              
              $6.61
              
              $7.25
              
              $6.73Low
              
              $0.98
              
              $3.88
              
              $4.78
              
              $3.62




According
to the records of American Stock Transfer & Trust Company, our
registrar and transfer agent, we had 288 shareholders of record of Common Stock
as of March 4, 2009.  As of the same date, we estimate that there were
in excess of 5,000 beneficial holders of our Common Stock.




Stock
Price Performance Graph




The graph
below compares the cumulative total return on our common stock with the Russell
2000 Index and the NASDAQ Computer Index (U.S. companies) and for the period
from December 31, 2003 to December 31, 2008.  The comparison
assumes that $100 was invested on December 31, 2003 in our common stock and
in each of the comparison indices, and assumes reinvestment of dividends, where
applicable.  The comparisons shown in the graph below are based upon
historical data.  The stock price performance shown in the graph below
is not indicative of, nor intended to forecast, the potential future performance
of our common stock.




~ 18
~




COMPARISON
OF THE 5 YEAR CUMULATIVE TOTAL RETURNS


FOR
THE FIVE YEAR PERIOD ENDED DECEMBER 31, 2008






www.merge.com




Dividend
Policy




On June
12, 2008, we announced the redemption of all preferred share purchase rights
outstanding as a result of our Shareholder Rights Plan, which was established in
2006.  As provided for in the plan, we redeemed the rights for $0.001
per right.  As a result, shareholders of record on June 23, 2008
received a dividend payment in July 2008 totaling $57,000 and this plan is no
longer in effect.  We currently do not intend to declare or pay any
cash dividends on our Common Stock in the foreseeable future.




Recent Sales of
Unregistered Securities




We did
not sell any shares of our Common Stock in transactions not registered under the
Securities Act of 1933, as amended (the “Securities Act”) during the fourth
quarter of 2008.




~ 19
~




Item
      6.
            SELECTED
      FINANCIAL DATA




The
following selected historical financial data is qualified in its entirety by
reference to, and should be read in conjunction with, our consolidated financial
statements and the related notes thereto appearing elsewhere herein and
Item 7, “Management’s Discussion and Analysis of Financial Condition and
Results of Operations” in this Annual Report on Form 10-K.
  Years Ended December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005(1)
                
                
                2004(in thousands, except for share and per share data)Statements
      of Operations Data:Net sales
                
                $
                56,735
                
                
                $
                59,572
                
                
                $
                74,322
                
                
                $
                82,538
                
                
                $
                25,477Operating income (loss)(2)(3)
                
                
                (21,697
                )
                
                
                (171,238
                )
                
                
                (252,087
                )
                
                
                4,377
                
                
                
                (250
                )Income (loss) before income taxes
                
                
                (23,743
                )
                
                
                (171,808
                )
                
                
                (249,473
                )
                
                
                5,113
                
                
                
                219Income tax expense (benefit)
                
                
                (60
                )
                
                
                (240
                )
                
                
                9,450
                
                
                
                8,373
                
                
                
                (1,444
                )Net income (loss)
                
                
                (23,683
                )
                
                
                (171,568
                )
                
                
                (258,923
                )
                
                
                (3,260
                )
                
                
                1,663Earnings
      (loss) per share:Basic
                
                $
                (0.51
                )
                
                $
                (5.06
                )
                
                $
                (7.68
                )
                
                $
                (0.13
                )
                
                $
                0.13Diluted
                
                
                (0.51
                )
                
                
                (5.06
                )
                
                
                (7.68
                )
                
                
                (0.13
                )
                
                
                0.12Weighted
      average shares outstanding:Basic
                
                
                46,717,546
                
                
                
                33,913,379
                
                
                
                33,701,735
                
                
                
                24,696,762
                
                
                
                13,013,927Diluted
                
                
                46,717,546
                
                
                
                33,913,379
                
                
                
                33,701,735
                
                
                
                24,696,762
                
                
                
                13,827,522December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004(in thousands)Balance
      Sheet Data:Working capital
                
                $
                8,254
                
                
                $
                878
                
                
                $
                27,101
                
                
                $
                56,964
                
                
                $
                22,786Total assets
                
                
                54,737
                
                
                
                61,635
                
                
                
                234,875
                
                
                
                500,045
                
                
                
                85,853Long-term debt obligations
                
                
                14,230
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Shareholders’ equity
                
                
                8,841
                
                
                
                24,405
                
                
                
                189,925
                
                
                
                442,592
                
                
                
                54,949





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


(2)
            For the year ended December 31, 2005 we incurred a charge for
      acquired in-process research and development of $13.0
    million.


(3)
            For the years ended December 31, 2007 and 2006, we incurred charges
      of $122.4 million and $214.1 million, respectively, related to the
      impairment of goodwill.




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




The
discussion below contains “forward-looking statements” within the meaning of the
Private Securities Litigation Reform Act of 1995, Section 27A of the
Securities Act, and Section 21E of the Exchange Act.  We have
used words such as “believes,” “intends,” “anticipates,” “expects” and similar
expressions to identify forward-looking statements.  These statements
are based on information currently available to us and are subject to a number
of risks and uncertainties that may cause our actual results of operations,
financial condition, cash flows, performance, business prospects and
opportunities and the timing of certain events to differ materially from those
expressed in, or implied by, these statements.  These risks,
uncertainties and other factors include, without limitation, those matters
discussed in Item 1A of Part I of this Annual Report on
Form 10-K.  Except as expressly required by the federal
securities laws, we undertake no obligation to update such factors or to
publicly announce the results of any of the forward-looking statements contained
herein to reflect future events, developments, or changed circumstances, or for
any other reason.  The following discussion should be read in
conjunction with our consolidated financial statements and notes thereto
appearing elsewhere in this Annual Report on Form 10-K and Item 1A, “Risk
Factors”.




Management’s Discussion and Analysis is presented in the following
order:




·
              Overview


·
              Revenues
      and Expenses
 ~ 20
~


·
              Results
      of Operations


·
              Liquidity
      and Capital Resources


·
              Material
      Off Balance Sheet Arrangements


·
              Critical
      Accounting Policies


Overview




We
develop medical imaging and information management software and deliver related
services.  We have reorganized and renamed our operating business
units, effective July 1, 2008.  The relevant portions of the EMEA
(formerly known as Merge Europe, Middle East and Africa) operation, which sells
to the end-user healthcare market in Europe, the Middle East and Africa, has
been allocated between the Merge Fusion (formerly known as Merge Healthcare
North America) and Merge OEM (formerly known as Cedara) business
units.  Merge OEM primarily sells software products, developer
toolkits and custom engineering services to OEM’s and VAR’s world
wide.  These customers develop, manufacture or resell medical imaging
software or devices.  Merge Fusion primarily sells directly to the
end-user healthcare market consisting of hospitals, imaging centers and
specialty clinics located in the U.S., Canada and Europe, the Middle East and
Africa and also distributes certain products through the Internet via our
website.




Healthcare
providers continue to be challenged by declining reimbursements, competition and
reduced operating profits brought about by the increasing costs of delivering
healthcare services.  In the U.S., we are focusing our Merge Fusion
sales efforts on single and multi-site imaging centers that complete more than
10,000 studies per year, small to medium sized hospitals (fewer than 400 beds),
and certain specialty clinics, such as orthopaedic practices, that offer imaging
services.  We have aggressively expanded our product offerings through
various acquisitions.




On June
4, 2008, we completed a private placement of our Common Stock pursuant to which
we raised net proceeds of $16.6 million ($20.0 million less issuance costs of
$2.4 million and prepaid interest for two quarters totaling $1.0 million)
through a securities purchase agreement with Merrick, an affiliate of Merrick
Ventures, which was executed on May 21, 2008.  As a result of the
financing, the reorganization of our operating business units, the two
restructuring initiatives completed in February 2008 and June 2008, and our
operating results for the last two quarters of 2008, we believe that we now have
sufficient liquidity to meet our needs going forward.




Revenues and
Expenses




The
following is a brief discussion of our revenues and expenses:




Net
Sales




Net sales
consist of software and other sales, net of estimated returns and allowances,
and professional services and maintenance.  Software and other sales
consist of software and purchased component revenue recognized in sales to OEM
customers, healthcare facilities and imaging centers.  Professional
services and maintenance consists of installation, custom engineering services,
training, consulting, and software maintenance and support.




Cost
of Sales




Cost of
sales consists of purchased components, third-party royalties, costs to service
and support our customers and amortization of patents and purchased and
developed software, including related impairments.  The cost of
software and other includes purchased components and third-party royalties
included in software and hardware sales to our customers.  The cost of
services and maintenance includes headcount and related costs incurred in our
performance of installation, custom engineering services, training, consulting
and software maintenance and support.  Purchased and developed
software is amortized over its estimated useful life.  Each quarter we
test our purchased and developed software for impairment by comparing its fair
value (estimated using undiscounted future cash flows) to the carrying value of
the software.  If the carrying value of the software exceeds its fair
value, we record an impairment charge in the period in which the impairment is
incurred equal to the amount of the difference between the carrying value and
estimated undiscounted future cash flows.




~ 21
~




Sales
and Marketing Expense




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




Research
and Development Expense




Research
and development expense consists of expenses incurred for the development of our
proprietary software and technologies.  The costs reflected in this
category are reduced by software development costs capitalized in accordance
with Statement of Financial Accounting Standard (“SFAS”) No. 86, Accounting
for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed.  The
amortization of capitalized software development costs and any related
impairments are included in cost of sales.  During 2008, we did not
capitalize any software development costs.




General
and Administrative Expense




General
and administrative expense includes costs for information systems, accounting,
administrative support, management personnel, bad debt expense, legal fees and
general corporate matters.




Goodwill
and Trade Name Impairment, Restructuring and Other Expenses


Goodwill
and trade name impairment, restructuring and other expenses consist of
impairment of goodwill and trade names (see Note 3 of the notes to consolidated
financial statements included herein), severance to involuntarily terminated
employees resulting from our restructuring initiatives, loss on disposal of
subsidiaries and impairment of non-cancelable building leases associated with
restructuring activities.




Depreciation,
Amortization and Impairment




Depreciation
and amortization, including any impairment, is assessed on capital equipment,
leasehold improvements and our customer relationships intangible
asset.  Depreciation and amortization are recorded over the respective
asset’s useful life.  We also record impairment of these long-lived
assets whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable based primarily upon whether expected
future undiscounted cash flows are sufficient to support recovery of the
assets.




Other
Income (Expense)


Other
income (expense) is comprised of interest income earned on cash and cash
equivalent balances, interest expense and amortization of costs and discounts
incurred from borrowings, foreign exchange gains or losses on foreign currency
payables and receivables at our Nuenen, Netherlands branch and at our
subsidiaries located in Mississauga, Ontario and Shanghai, China.  In
addition, we also record any other-than-temporary impairment charges recognized
on our equity investments in non-public companies in other income
(expense).




~ 22
~




Results
of Operations




Year
Ended December 31, 2008 Compared to Year Ended December 31,
2007


The following
table sets forth selected, summarized consolidated financial data for the
periods indicated, as well as comparative data showing increases and decreases
between the periods.  All amounts, except percentages, are in
thousands.


Years
      Ended December 31,
                
                
                
                Change2008
                
                
                %
                
                (1)
                
                2007
                
                
                %
                
                (1)
                
                $
                
                
                
                %Net
      sales:Software and other
                
                $
                27,561
                
                
                
                48.6
                %
                
                
                $
                29,590
                
                
                
                49.7
                %
                
                
                $
                (2,029
                )
                
                
                -6.9
                %Services and maintenance
                
                
                29,174
                
                
                
                51.4
                %
                
                
                
                29,982
                
                
                
                50.3
                %
                
                
                
                (808
                )
                
                
                -2.7
                %Total
      net sales
                
                
                56,735
                
                
                
                100.0
                %
                
                
                
                59,572
                
                
                
                100.0
                %
                
                
                
                (2,837
                )
                
                
                -4.8
                %Cost
      of sales:Software and other
                
                
                5,121
                
                
                
                18.6
                %
                
                
                
                6,722
                
                
                
                22.7
                %
                
                
                
                (1,601
                )
                
                
                -23.8
                %Services and maintenance
                
                
                11,672
                
                
                
                40.0
                %
                
                
                
                14,089
                
                
                
                47.0
                %
                
                
                
                (2,417
                )
                
                
                -17.2
                %Amortization and related impairment
                
                
                3,279
                
                
                NM
                
                (2)
                
                
                8,537
                
                
                NM
                
                (2)
                
                
                (5,258
                )
                
                
                -61.6
                %Total
      cost of sales
                
                
                20,072
                
                
                
                35.4
                %
                
                
                
                29,348
                
                
                
                49.3
                %
                
                
                
                (9,276
                )
                
                
                -31.6
                %Gross
      marginSoftware and other
                
                
                19,161
                
                
                
                69.5
                %
                (3)
                
                
                14,331
                
                
                
                48.4
                %
                (3)
                
                
                4,830
                
                
                
                33.7
                %Services and maintenance
                
                
                17,502
                
                
                
                60.0
                %
                
                
                
                15,893
                
                
                
                53.0
                %
                
                
                
                1,609
                
                
                
                10.1
                %Total
      gross margin
                
                
                36,663
                
                
                
                64.6
                %
                
                
                
                30,224
                
                
                
                50.7
                %
                
                
                
                6,439
                
                
                
                21.3
                %Operating
      expenses:Sales and marketing
                
                
                9,313
                
                
                
                16.4
                %
                
                
                
                18,565
                
                
                
                31.2
                %
                
                
                
                (9,252
                )
                
                
                -49.8
                %Product research and development
                
                
                13,240
                
                
                
                23.3
                %
                
                
                
                21,065
                
                
                
                35.4
                %
                
                
                
                (7,825
                )
                
                
                -37.1
                %General and administrative
                
                
                20,461
                
                
                
                36.1
                %
                
                
                
                29,492
                
                
                
                49.5
                %
                
                
                
                (9,031
                )
                
                
                -30.6
                %Goodwill and trade name impairment,restructuring and other expenses
                
                
                11,816
                
                
                
                20.8
                %
                
                
                
                124,131
                
                
                NM
                
                (2)
                
                
                (112,315
                )
                
                
                -90.5
                %Depreciation,
      amortization and impairment
                
                
                3,530
                
                
                
                6.2
                %
                
                
                
                8,209
                
                
                
                13.8
                %
                
                
                
                (4,679
                )
                
                
                -57.0
                %Total
      operating costs and expenses
                
                
                58,360
                
                
                
                102.9
                %
                
                
                
                201,462
                
                
                NM
                
                (2)
                
                
                (143,102
                )
                
                
                -71.0
                %Operating
      loss
                
                
                (21,697
                )
                
                
                -38.2
                %
                
                
                
                (171,238
                )
                
                NM
                
                (2)
                
                
                149,541
                
                
                
                87.3
                %Other
      income (expense), net
                
                
                (2,046
                )
                
                
                -3.6
                %
                
                
                
                (570
                )
                
                
                -1.0
                %
                
                
                
                (1,476
                )
                
                NM
                (2)Loss
      before income taxes
                
                
                (23,743
                )
                
                
                -41.8
                %
                
                
                
                (171,808
                )
                
                NM
                
                (2)
                
                
                148,065
                
                
                
                86.2
                %Income
      tax benefit
                
                
                (60
                )
                
                
                -0.1
                %
                
                
                
                (240
                )
                
                
                -0.4
                %
                
                
                
                180
                
                
                
                -75.0
                %Net
      loss
                
                $
                (23,683
                )
                
                
                -41.7
                %
                
                
                $
                (171,568
                )
                
                NM
                
                (2)
                
                $
                147,885
                
                
                
                86.2
                %


(1)
              Percentages are of total net sales, except for cost of sales and gross
      margin, which are based upon related net sales.(2)
              NM denotes percentage is not meaningful.(3)
              Gross margin for software and other sales includes amortization expense
      recorded in cost of sales.




Net
Sales




Net
sales, by business unit, are indicated (in thousands) as follows:




Years
      Ended December 31,
              
              
              Change2008
              
              
              %
              
              
              2007
              
              
              %
              
              
              $
              
              
              
              %Merge
      OEMSoftware and other
              
              $
              15,505
              
              
              
              27.3
              %
              
              $
              13,051
              
              
              
              21.9
              %
              
              $
              2,454
              
              
              
              18.8
              %Services and maintenance
              
              
              10,325
              
              
              
              18.2
              %
              
              
              8,797
              
              
              
              14.8
              %
              
              
              1,528
              
              
              
              17.4
              %Total net sales
              
              
              25,830
              
              
              
              45.5
              %
              
              
              21,848
              
              
              
              36.7
              %
              
              
              3,982
              
              
              
              18.2
              %Merge
      FusionSoftware and other
              
              
              12,056
              
              
              
              21.2
              %
              
              
              16,539
              
              
              
              27.8
              %
              
              
              (4,483
              )
              
              
              -27.1
              %Services and maintenance
              
              
              18,849
              
              
              
              33.2
              %
              
              
              21,185
              
              
              
              35.6
              %
              
              
              (2,336
              )
              
              
              -11.0
              %Total net sales
              
              
              30,905
              
              
              
              54.5
              %
              
              
              37,724
              
              
              
              63.3
              %
              
              
              (6,819
              )
              
              
              -18.1
              %Total
      net sales
              
              $
              56,735
              
              
              
              
              
              
              $
              59,572
              
              
              
              
              
              
              $
              (2,837
              )




~ 23
~




As a
result of the reorganization of our business units, effective July 1, 2008, we
no longer separately report EMEA revenues.  The relevant portions of
EMEA have been allocated between Merge OEM and Merge Fusion.




Software
and Other Sales.  Net software and other sales for 2008 were
$27.6 million, a decrease of approximately $2.0 million, or 6.9%, from $29.6
million for 2007.  The decrease in software and other sales primarily
resulted from a $4.5 million decrease in revenue recognized on software and
other sales by our Merge Fusion business unit, offset by a $2.5 million increase
in our Merge OEM software and other sales.  The increase in OEM
software and other sales was primarily due to recognition of software revenue
upon delivery of, or relief from delivery of, certain contract elements
associated with contracts signed in 2007 or earlier.  Our Merge Fusion
business unit net sales decreased as a result of the delay of certain product
deliverables during the first two quarters of 2008, the disposal of our French
subsidiary at the beginning of the second quarter of 2008 and the previous
uncertainty regarding the status of our remaining
operations.  Although we believe that the financing transaction
completed in June 2008 and settlement of the two lawsuits are positive events,
it may take time for our customers to fully react, especially in the current
economic environment.  In addition, we anticipate that the revenue
recognized from software and other sales may vary significantly on a
quarter-to-quarter basis.




Service
and Maintenance Sales.  Net service and maintenance sales for
2008 were $29.2 million, a decrease of $0.8 million, or 2.7%, from $30.0 million
for 2007.  Service and maintenance sales recognized through our Merge
Fusion business unit decreased $2.3 million, while service and maintenance sales
recognized through our Merge OEM business unit increased $1.5
million.  The Merge Fusion sales decrease is a result of a decrease in
services to install software products as well as a decrease in renewals
of maintenance contracts of certain customers, primarily due to our customers’
prior viability concerns with respect to us.  Our Merge OEM
business unit experienced increased revenue during 2008 resulting from an
increase in customer contracts involving custom engineering
services.




Gross
Margin


Gross
Margin – Software and Other Sales.Gross
margin on software and other sales was $19.2 million for 2008, an increase of
approximately $4.8 million, or 33.7%, from $14.3 million for
2007.  Gross margin as a percentage of software and other sales
increased to 69.5% for 2008 from 48.4% for 2007.  The increase in
gross margin as a percentage of sales is primarily due to the mix in sales from
our business units and a decrease in amortization expense in
2008.  Sales by our Merge OEM business unit, which typically consist
of software only contracts at higher margins, were 56.3% of software and other
sales during 2008 compared to 44.1% during 2007.  The decrease in
amortization is primarily due to the fact that amortization for 2007 included
impairment of certain of our purchased and capitalized software projects of $4.7
million due to significant risk of technological obsolescence associated with
certain projects, the majority of which were still in development at the time of
impairment, compared to a $0.4 million impairment on purchased software during
2008.  There was also a decrease in recurring amortization associated
with gross purchased and capitalized software costs in 2008 as a result of the
2007 impairment charges.  We expect our gross margin on software and
other sales going forward to fluctuate depending on the mix of sales between the
business units.




Gross
Margin – Services and Maintenance Sales.Gross
margin on services and maintenance sales was $17.5 million for 2008, an increase
of $1.6 million, or 10.1%, from $15.9 million for 2007.  Gross margin
as a percentage of services and maintenance sales increased to 60.0% for 2008
from 53.0% for 2007.  The increase was due to the decrease in salaries
and other related expenses (including travel and entertainment) as a result of
our restructuring activities during February and June of
2008.




Sales
and Marketing


Sales and
marketing expense decreased $9.3 million, or 49.8%, to $9.3 million for 2008
from $18.6 million for 2007.  As a result of ongoing cost reductions
previously discussed, including the restructuring initiatives announced in 2008,
salaries and consultant fees, commissions and other related expenses (including
travel and entertainment) decreased by $6.4 million and share-based compensation
expense decreased by $0.7 million.  In addition, we incurred $0.8
million less in direct marketing costs as a result of cash saving
efforts.  Also, $1.2 million of the decrease was due to a reduction in
sales and marketing expenses at our French subsidiary, which we disposed of in
April 2008.




~ 24
~




Product
Research and Development




Product
research and development expense decreased $7.8 million, or 37.1%, to $13.2
million for 2008 from $21.0 million for 2007.  Decreased expenses for
2008 were primarily attributable to a $7.3 million reduction in salaries,
consultant fees and related expenses (including travel and entertainment) and a
decrease in share-based compensation expense of $0.7 million as a result of our
restructuring initiatives in 2008.  In addition, $0.6 million of the
decrease was due to a reduction in product research and development expenses of
our French subsidiary, which we disposed of in April 2008.  Offsetting
this decrease was the fact that we did not capitalize any software development
costs, which reduce costs in the applicable period, during 2008 compared to $0.8
million of capitalized costs for 2007.




General
and Administrative


General
and administrative expense decreased $9.0 million, or 30.6%, to $20.5 million
for 2008 from $29.5 million for 2007.  Decreased expenses were
primarily attributable to a $4.7 million reduction in our salaries and related
expenses (including travel and entertainment) and a share-based compensation
expense decrease of $1.1 million as a result of our restructuring initiatives in
2008.  Also, legal, accounting and other professional fees, including
the settlement cost of the class action lawsuit and reimbursement of certain
fees from our directors and officers liability insurance carrier, decreased $2.5
million for 2008, due to a decline in activities and costs associated with the
settlement of the class action lawsuit and prior restatement of financial
statements.  Additionally, general and administrative expenses
decreased by $0.4 million for 2008 due to a decrease in costs incurred by our
French subsidiary, which we disposed of in April 2008, and $0.3 million due to a
decrease in costs associated with our Indian subsidiaries, which we disposed of
or shut down in the third quarter of 2008.




Goodwill
and Trade name Impairment, Restructuring and Other Expense


As
discussed in Note 11 to the consolidated financial statements, we recorded $8.8
million of restructuring charges for 2008 related to the initiatives announced
in February 2008 and June 2008.  In addition, as discussed in Note 3
to the consolidated financial statements, we recorded a $1.1 million trade name
impairment charge associated with renaming our Merge OEM business
unit.  We also incurred a $1.7 million charge associated with the
disposal of our French subsidiary during 2008, as discussed in Note 4 to the
consolidated financial statements.  In addition, we recorded a $0.4
million charge during 2008 related to a change in estimate associated with our
ability to sublease a facility for which we had a prior tenant.  As
discussed in Note 3 to the consolidated financial statements, during 2007 we
recorded a goodwill impairment charge of $122.4 million and a trade name
impairment charge of $0.8 million.




Depreciation,
Amortization and Impairment


Depreciation,
amortization and impairment expense decreased $4.7 million, or 57.0 %, to $3.5
million for 2008 from $8.2 million for 2007.  Decreased depreciation,
amortization and impairment expenses were primarily attributable to a $4.3
million impairment of customer relationships during 2007 as well as a decrease
in continuing amortization during 2008 as a result of the 2007 impairment
charge.




Other
Income (Expense), Net




Other
income (expense), net was $2.0 million of expense for 2008 compared to $0.6
million of expense for 2007.  In 2008, we incurred $1.8 million of
interest expense and amortization of issuance costs and note discount applicable
to the $15.0 million note payable issued on June 4, 2008 (as discussed in Note 6
to the consolidated financial statements), and $1.4 million of impairment
charges on our equity investments, offset by $0.3 million in interest income and
$0.9 million in foreign exchange gains.  In 2007, we incurred $1.2
million of impairment charges on our equity investments and $0.5 million in
foreign exchange losses, offset by $1.2 million in interest
income.  The decrease in interest income for 2008 compared to 2007 is
attributed to a decrease in the average balance of our cash and cash equivalents
in 2008 compared to 2007 as well as a decrease in the yield on cash and cash
equivalents.  The foreign exchange gain for 2008 was primarily due to
the strengthening of the U.S. dollar compared to the Canadian dollar in the
fourth quarter of 2008.




Income
Tax Benefit


The net
income tax benefit of (0.3)% recorded during 2008 is primarily attributable to
changes in deferred taxes resulting from the impairment of indefinite lived
trade names, offset by income and capital gains taxes payable in India which we
were not able to offset with either U.S. or Canadian losses.  Our
effective tax rate for the period differed significantly from the statutory rate
primarily due to a valuation allowance for deferred tax assets which we have
concluded are not more-likely-than-not to be realized.  Our effective
tax rate of (0.1)% for 2007 differed significantly from the statutory rate
primarily due to the impairment of nondeductible goodwill and a valuation
allowance for deferred tax assets that are not more-likely-than-not to be
realized.  Our expected effective income tax rate is volatile and may
move up or down with changes in, among other items, operating income and changes
in tax law and regulations of the U.S. and foreign jurisdictions in which we
operate.




~ 25
~




Year
Ended December 31, 2007 Compared to Year Ended December 31,
2006




The
following table sets forth selected, summarized consolidated financial data for
the periods indicated, as well as comparative data showing increases and
decreases between the periods.  All amounts, except percentages, are
in thousands.




Years
      Ended December 31,
              
              
              
              
              Change2007
              
              
              %
              
              (1)
              
              
              2006
              
              
              %
              
              (1)
              
              
              $
              
              
              
              %Net
      sales:Software and other
              
              $
              29,590
              
              
              
              49.7
              %
              
              
              
              $
              40,275
              
              
              
              54.2
              %
              
              
              
              $
              (10,685
              )
              
              
              -26.5
              %Services and maintenance
              
              
              29,982
              
              
              
              50.3
              %
              
              
              
              
              34,047
              
              
              
              45.8
              %
              
              
              
              
              (4,065
              )
              
              
              -11.9
              %Total
      net sales
              
              
              59,572
              
              
              
              100.0
              %
              
              
              
              
              74,322
              
              
              
              100.0
              %
              
              
              
              
              (14,750
              )
              
              
              -19.8
              %Cost
      of sales:Software and other
              
              
              6,722
              
              
              
              22.7
              %
              
              
              
              
              10,651
              
              
              
              26.4
              %
              
              
              
              
              (3,929
              )
              
              
              -36.9
              %Services and maintenance
              
              
              14,089
              
              
              
              47.0
              %
              
              
              
              
              14,472
              
              
              
              42.5
              %
              
              
              
              
              (383
              )
              
              
              -2.6
              %Amortization and related impairment
              
              
              8,537
              
              
              NM
              
              (2)
              
              
              
              5,532
              
              
              NM
              
              (2)
              
              
              
              3,005
              
              
              
              54.3
              %Total
      cost of sales
              
              
              29,348
              
              
              
              49.3
              %
              
              
              
              
              30,655
              
              
              
              41.2
              %
              
              
              
              
              (1,307
              )
              
              
              -4.3
              %Gross
      marginSoftware and other
              
              
              14,331
              
              
              
              48.4
              %
              (3)
              
              
              
              24,092
              
              
              
              59.8
              %
              (3)
              
              
              
              (9,761
              )
              
              
              -40.5
              %Services and maintenance
              
              
              15,893
              
              
              
              53.0
              %
              
              
              
              
              19,575
              
              
              
              57.5
              %
              
              
              
              
              (3,682
              )
              
              
              -18.8
              %Total
      gross margin
              
              
              30,224
              
              
              
              50.7
              %
              
              
              
              
              43,667
              
              
              
              58.8
              %
              
              
              
              
              (13,443
              )
              
              
              -30.8
              %Operating
      expenses:Sales and marketing
              
              
              18,565
              
              
              
              31.2
              %
              
              
              
              
              20,100
              
              
              
              27.0
              %
              
              
              
              
              (1,535
              )
              
              
              -7.6
              %Product research and development
              
              
              21,065
              
              
              
              35.4
              %
              
              
              
              
              19,364
              
              
              
              26.1
              %
              
              
              
              
              1,701
              
              
              
              8.8
              %General and administrative
              
              
              29,492
              
              
              
              49.5
              %
              
              
              
              
              28,752
              
              
              
              38.7
              %
              
              
              
              
              740
              
              
              
              2.6
              %Goodwill and trade name impairment,restructuring and other expenses
              
              
              124,131
              
              
              NM
              
              (2)
              
              
              
              223,505
              
              
              NM
              
              (2)
              
              
              
              (99,374
              )
              
              NM
              
              (2)Depreciation, amortization and impairment
              
              
              8,209
              
              
              
              13.8
              %
              
              
              
              
              4,033
              
              
              
              5.4
              %
              
              
              
              
              4,176
              
              
              
              103.5
              %Total
      operating costs and expenses
              
              
              201,462
              
              
              NM
              
              (2)
              
              
              
              295,754
              
              
              NM
              
              (2)
              
              
              
              (94,292
              )
              
              
              -31.9
              %Operating
      loss
              
              
              (171,238
              )
              
              NM
              
              (2)
              
              
              
              (252,087
              )
              
              NM
              
              (2)
              
              
              
              80,849
              
              
              NM
              
              (2)Other
      income (expense), net
              
              
              (570
              )
              
              
              -1.0
              %
              
              
              
              
              2,614
              
              
              
              3.5
              %
              
              
              
              
              (3,184
              )
              
              
              -121.8
              %Loss
      before income taxes
              
              
              (171,808
              )
              
              NM
              
              (2)
              
              
              
              (249,473
              )
              
              NM
              
              (2)
              
              
              
              77,665
              
              
              NM
              
              (2)Income
      tax expense (benefit)
              
              
              (240
              )
              
              
              -0.4
              %
              
              
              
              
              9,450
              
              
              
              12.7
              %
              
              
              
              
              (9,690
              )
              
              
              -102.5
              %Net
      loss
              
              $
              (171,568
              )
              
              NM
              
              (2)
              
              
              $
              (258,923
              )
              
              NM
              
              (2)
              
              
              $
              87,355
              
              
              NM
              
              (2)







(1)
              Percentages are of total net sales, except for cost of sales and gross
      margin, which are based upon related net sales.(2)
              NM denotes percentage is not meaningful.(3)
              Gross margin for software and other sales includes amortization expense
      recorded in cost of sales.





~ 26
~




Net
Sales




Net
sales, by business unit, are indicated (in thousands) as
follows:




Years
      Ended December 31,
              
              
              Change2007
              
              
              %
              
              
              2006
              
              
              %
              
              
              $
              
              
              
              %Merge
      OEMSoftware and other
              
              $
              13,051
              
              
              
              21.9
              %
              
              $
              11,922
              
              
              
              16.0
              %
              
              $
              1,129
              
              
              
              9.5
              %Services and maintenance
              
              
              8,797
              
              
              
              14.8
              %
              
              
              8,154
              
              
              
              11.0
              %
              
              
              643
              
              
              
              7.9
              %Total net sales
              
              
              21,848
              
              
              
              36.7
              %
              
              
              20,076
              
              
              
              27.0
              %
              
              
              1,772
              
              
              
              8.8
              %Merge
      FusionSoftware and other
              
              
              16,539
              
              
              
              27.8
              %
              
              
              28,353
              (1)
              
              
              38.1
              %
              
              
              (11,814
              )
              
              
              -41.7
              %Services and maintenance
              
              
              21,185
              
              
              
              35.6
              %
              
              
              25,893
              (2)
              
              
              34.8
              %
              
              
              (4,708
              )
              
              
              -18.2
              %Total net sales
              
              
              37,724
              
              
              
              63.3
              %
              
              
              54,246
              
              
              
              73.0
              %
              
              
              (16,522
              )
              
              
              -30.5
              %Total
      net sales
              
              $
              59,572
              
              
              
              
              
              
              $
              74,322
              
              
              
              
              
              
              $
              (14,750
              )







(1)
              Amount includes $11,485 of revenue related to ultimate delivery of certain
      software product functionality on customer contracts entered into in
      previous years.(2)
              Amount includes $4,791 of revenue related to ultimate delivery of certain
      software product functionality on customer contracts entered into in
      previous years.






Software
and Other Sales.Net software and other sales for 2007 were $29.6
million, a decrease of $10.7 million, or 26.5%, from $40.3 million for
2006.  The decrease in software and other sales primarily resulted
from an $11.8 million decrease in revenue recognized on software and other sales
through our Merge Fusion business unit.  During 2006, we recognized
$11.5 million of software and other sales related to customer contracts entered
into in previous years for which revenue was deferred due to delays in
delivering the required product functionality.  Our Merge Fusion
business unit also experienced decreased bookings and revenue during 2007
resulting from our internal delays in the delivery of certain software products and
the impact of the DRA, which caused some of our customers to respond by reducing
their purchases or postponing purchasing decisions.  Software and
other sales for Merge OEM increased $1.1 million, primarily due to $0.9 of
revenue recognized on a significant multi-year contract signed with a single
customer during 2007 for which delivery of the product functionality occurred in
the fourth quarter of 2007.




Service
and Maintenance Sales.Net service and maintenance sales for 2007 were
$30.0 million, a decrease of $4.0 million, or 11.9%, from $34.0 million for
2006.  The decrease in service and maintenance sales primarily
resulted from a $4.7 million decrease in revenue recognized through our Merge
Fusion business unit.  During 2006, we recognized $4.8 million of
service and maintenance sales related to customer contracts entered into in
previous years for which revenue was deferred due to delays in delivering the
required product functionality.  Service and maintenance sales for
Merge OEM increased $0.6 million, primarily due to a renewed focus on customer
contracts involving custom engineering services.




Gross
Margin




Gross
Margin – Software and Other Sales.Gross
margin on software and other sales was $14.3 million for 2007, a decrease of
approximately $9.8 million, or 40.5%, from $24.1 million for
2006.  The decrease is due, in part, to decreased sales and a $4.7
million impairment charge related to our patents and purchased and capitalized
software development costs recorded in 2007, compared to $1.0 million in
2006.  In addition, gross margin on software and other sales, as a
percentage of related sales, was greater than expected for 2006 due to the
inclusion of $11.5 million of software and other sales and $2.6 million of
related costs on customer contracts for the Fusion business entered into in
previous years for which the revenue was previously
deferred.




Gross
Margin – Services and Maintenance Sales.Gross
margin on services and maintenance sales was $15.9 million for 2007, a decrease
of $3.7 million, or 18.8%, from $19.6 million for 2006.  Gross margin
on services and maintenance sales as a percentage of those sales decreased to
53.0% in 2007 from 57.5% in 2006.  Gross margin on services and
maintenance sales, as a percentage of related sales, was greater than expected
for 2006 due to the inclusion of $4.8 million of service and maintenance sales
on customer contracts for the Fusion business unit entered into in previous
years for which the revenue was previously deferred.  There were
minimal services incurred and expensed during 2006 related to such $4.8 million
of sales as costs related to these sales were expensed in the prior periods in
which such costs were incurred.  Offsetting this 2006 impact was an
increase in offshore customer service and support costs during
2007.




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Sales
and Marketing




Sales and
marketing expense decreased $1.5 million, or 7.6%, to $18.6 million in 2007 from
$20.1 million in 2006.  Salaries and related expenses decreased by
$1.4 million primarily as a result of sales and marketing personnel terminations
that occurred in November 2006.




Product
Research and Development


Product
research and development expense increased $1.7 million, or 8.8%, to $21.1
million in 2007 from $19.4 million in 2006.  Increased product
research and development expenses for 2007 were primarily attributable to $5.3
million of costs associated with an increase in our offshore software
development personnel located in Pune, India, which increased from 71 at
December 31, 2006 to a high of 116 during 2007.  In addition,
capitalized software development costs decreased by $1.3 million resulting in an
increase in product research and development expense when compared to
2006.  Partially offsetting the above increases was a $4.9 million
reduction in onshore expenses as a result of our restructuring initiative in
November 2006.




General
and Administrative


General
and administrative expense increased approximately $0.7 million, or 2.6%, to
$29.5 million in 2007 from $28.8 million in 2006.  Increased general
and administrative expenses were primarily attributable to $3.0 million of
compensation and travel costs related to the expansion of our finance,
information technology and executive management teams as well as our new
teleradiology business, a $1.0 million increase in internal accounting related
costs, audit fees and recurring legal fees, $0.4 million increase in other
consulting costs, $0.3 million increase in bad debt expense and $0.3 million of
costs incurred by our India subsidiary, which did not exist in
2006.  The above are offset in part by a $3.6 million decrease in
legal and accounting costs associated with the restatement of our financial
statements and related class action, derivative and other lawsuits and a $0.8
million decrease in stock-based compensation expense.  We incurred
$5.3 million of such legal and accounting expenses in 2007 compared to $8.9
million in 2006.




Goodwill
and Trade Name Impairment, Restructuring and Other Expenses


As
discussed in Note 3 of the notes to consolidated financial statements, we
recorded a goodwill impairment charge of $122.4 million and a trade name
impairment charge of $0.8 million during 2007.  We performed a similar
analysis in the prior year, and, as a result, we recorded a goodwill impairment
charge of $214.1 million and a trade name impairment charge of $6.7 million in
2006.  We also recorded $1.0 million in restructuring charges during
2007 compared to $2.7 million in restructuring charges (primarily severance
costs) in 2006, associated with a restructuring initiative announced in November
2006.




Depreciation,
Amortization and Impairment


Depreciation,
amortization and impairment expense increased $4.2 million, or 103.5%, to $8.2
million in 2007 from $4.0 million in 2006.  As discussed in Note 3 of
the notes to consolidated financial statements, we recorded a customer
relationships impairment charge of $4.3 million during 2007.  For
2006, we did not incur any such charges.




Other
Income (Expense), Net


Other
income (expense) decreased $3.2 million, or 121.8%, to an expense of $0.6
million in 2007 from income of $2.6 million in 2006 primarily due to a $1.3
million decrease in interest income as a result of decreased cash and cash
equivalents.  We also recorded a loss of $1.2 million and $0.2
million, respectively, in 2007 and 2006 due to an other-than-temporary loss
recognized on certain equity investments in non-public companies.  In
addition, other income decreased approximately $0.7 million in 2007 primarily
due to foreign exchange losses on foreign currency payables at our Canadian
operations where the functional currency is the U.S. dollar.




Income
Tax Expense (Benefit)


We
recorded an income tax benefit in 2007 of $0.2 million, an effective tax rate
for 2007 of (0.1)%.  Our effective tax rate for the period differed
significantly from the statutory rate primarily as a result of the impairment of
nondeductible goodwill and the fact we have a full valuation allowance for
deferred tax assets, which we have concluded are not more-likely-than-not to be
realized.  Our effective tax rate for 2006 was approximately
3.8%.  Our effective tax rate for the period differed significantly
from the statutory rate primarily due to the impairment of nondeductible
goodwill and a valuation allowance for deferred tax assets that are not
more-likely-than-not to be realized.




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~




Liquidity
and Capital Resources




Our cash
and cash equivalents were $17.8 million at December 31, 2008, an increase of
$3.8 million, or 27.5%, from our balance of $14.0 million at December 31,
2007.  In addition, working capital was $8.3 million at December 31,
2008, an increase of $7.4 million from working capital of $0.9 million at
December 31, 2007.




On June
4, 2008, we received cash proceeds of $16.6 million, net of transaction costs
and prepaid interest, upon closing of a private placement transaction with
Merrick.  Of the funds received, $3.3 million was used to pay our
portion of the shareholder and derivative lawsuit settlements (see Note 9 of
notes to consolidated financial statements) in the third quarter of 2008, and
$4.0 million was used to pay employee termination costs in the third and fourth
quarters of 2008.  The remainder will be used to fund our operations,
including future payments related to employee termination costs accrued as of
December 31, 2008 (see Note 11 of notes to consolidated financial
statements).




Operating
Cash Flows


Cash used
in operating activities was $13.6 million during 2008, compared to $28.6 million
during 2007.  Our negative operating cash flow in 2008 was primarily
due to the loss from operations, excluding non-cash items, of $8.0 million, the
timing of payments for legal fees (net of insurance recoveries) in connection
with the class action, derivative and other lawsuits (including associated
lawsuit settlement costs of $3.3 million) and restructuring related
payments.  Termination benefits and contract exit costs paid during
2008 associated with our restructuring initiatives totaled $5.5
million.




Investing
Cash Flows


Cash used
in investing activities was $0.3 million during 2008, which was attributable to
purchases of capital equipment of $0.5 million and an increase in restricted
cash of $0.3 million, offset by cash received on the sale of one of our
subsidiaries located in India of $0.5 million.




Financing
Cash Flows


Cash
provided by financing activities was $17.6 million during 2008 and was primarily
attributable to proceeds received from the private placement transaction with
Merrick of $20.0 million less related issuance costs of $2.4
million.




Contractual
Obligations


Total
outstanding commitments as of December 31, 2008 (in thousands), were as
follows:




Payment due by periodLess than
              
              
              
              
              
              
              
              
              More thanContractual Obligations
              
              Total
              
              
              1 Year
              
              
              1 – 3 Years
              
              
              3 – 5 Years
              
              
              5 YearsOperating
      leases
              
              $
              3,197
              
              
              $
              1,924
              
              
              $
              1,123
              
              
              $
              150
              
              
              $
              -Note
      payable (including interest)
              
              
              17,925
              
              
              
              1,950
              
              
              
              15,975
              
              
              
              -
              
              
              
              -Total
              
              $
              21,122
              
              
              $
              3,874
              
              
              $
              17,098
              
              
              $
              150
              
              
              $
              -




The above
obligations include lease payments, net of sub-lease income of $0.2 million,
$0.4 million and $0.3 million in the respective periods indicated, related to
facilities that we have either ceased to use or abandoned as of December 31,
2008.  The note payable bears interest at 13.0% per annum, payable
quarterly in arrears.  The note payable contains various operating and
financial covenants, including a requirement that we have positive adjusted
EBITDA for the last fiscal quarter of 2008 and cumulatively thereafter through
the term of the note payable.




Except
for $0.6 million of restricted cash at December 31, 2008, we do not have any
other significant long-term obligations, contractual obligations, lines of
credit, standby letters of credit, guarantees, standby repurchase obligations or
other commercial commitments.




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~




General




We
believe our current cash and cash equivalent balances will be sufficient to meet
our operating, financing and capital requirements through at least the next 12
months.  However, any projections of future cash inflows and outflows
are subject to uncertainty.  In the event that it is necessary to
raise additional capital to meet our short term or long term liquidity needs,
such capital may be raised through additional debt, equity offerings or sale of
certain assets.  If we raise additional funds through the issuance of
equity, equity-related or debt securities, such securities may have rights,
preferences or privileges senior to those of our Common
Stock.  Furthermore, because of the low trading price of our Common
Stock, the number of shares of any new equity or equity-related securities that
may be issued may result in significant dilution to existing
shareholders.  In addition, the issuance of debt securities could
increase the liquidity risk or perceived liquidity risk that we
face.  We cannot, however, be certain that additional financing, or
funds from asset sales, will be available on acceptable terms.  If
adequate funds are not available or are not available on acceptable terms, we
will likely not be able to take advantage of opportunities, develop or enhance
services or products or respond to competitive pressures.  Any
projections of future cash inflows and outflows are subject to
uncertainty.  In particular, our uses of cash in 2009 and beyond will
depend on a variety of factors such as the costs to implement our business
strategy, the amount of cash that we are required to devote to defend and
address any regulatory proceedings, and potential merger and acquisition
activities.  For a more detailed description of risks and
uncertainties that may affect our liquidity, see Item 1A., “Risk Factors” in
this Annual Report on Form 10-K.




Material Off Balance Sheet
Arrangements




We have
no material off balance sheet arrangements.




Critical
Accounting Policies


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




We have
identified the following accounting policies and estimates as those that we
believe are most critical to our financial condition and results of operations
and that require management’s most subjective and complex judgments in
estimating the effect of inherent uncertainties: revenue recognition, allowance
for sales returns and doubtful accounts, software capitalization, other
long-lived assets, goodwill and other intangible asset valuation, investments,
share-based compensation expense, income taxes, guarantees and loss
contingencies.




Revenue
Recognition


We derive
revenues primarily from the licensing of software, sales of hardware and related
ancillary products, installation, engineering services, training, consulting,
and software maintenance and support.  Inherent to software revenue
recognition are significant management estimates and judgments in the
interpretation and practical application of the complex rules to individual
contracts.  These interpretations generally would not influence the
amount of revenue recognized, but could influence the timing of such
revenues.  Typically, our contracts contain multiple elements, and
while the majority of our contracts contain standard terms and conditions, there
are instances where our contracts contain non-standard terms and
conditions.  As a result, contract interpretation is sometimes
required to determine the appropriate accounting, including whether the
deliverables specified in a multiple element arrangement should be treated as
separate units of accounting for revenue recognition purposes in accordance with
Statement of Position (“SOP”) No. 97-2, Software
Revenue Recognition(“SOP No. 97-2”), or Emerging Issues Task Force
(“EITF”) Issue No. 00-21, Revenue
Arrangements with Multiple Deliverables(“EITF No. 00-21”), and if so,
the relative fair value that should be allocated to each of the elements as well
as when to recognize revenue for each element.




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




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~




We
allocate revenue to each undelivered element in a multiple-element arrangement
based on its respective fair value determined by the price charged when that
element is sold separately.  Specifically, we determine the fair value
of the maintenance portion of an arrangement based on the substantive renewal
price of the maintenance offered to customers, which generally is stated in the
contract.  The fair value of installation, engineering services,
training and consulting is based upon the price charged when these services are
sold separately.  If evidence of the fair value cannot be established
for undelivered elements of a sale, the entire amount of revenue under the
arrangement is deferred until elements without VSOE of fair value have been
delivered or VSOE of fair value can be established.  If evidence of
fair value cannot be established for the maintenance element of a sale, and it
represents the only undelivered element, all elements of the sale are deferred
and recognized ratably over the related maintenance period.




Revenue
from software licenses sold to end-users and VAR’s is recognized upon shipment,
provided that evidence of an arrangement exists, delivery has occurred, fees are
fixed or determinable and collection of the related receivable is
probable.  We assess collectability based on a number of factors,
including past transaction history with the customer and the credit worthiness
of the customer.  We must exercise our judgment when we assess the
probability of collection and the current credit worthiness of each
customer.  If the financial condition of our customers were to
deteriorate, it could affect the timing and the amount of revenue we recognize
on a contract.  In addition, in certain transactions prior to 2007, we
negotiated with customers a provision that included our receipt of ownership in
the customer’s common stock ownership as part of the sale.  We
generally do not request collateral from customers.




Revenue
from software licenses sold via certain term-based contracts that include
software maintenance and support is deferred and recognized ratably over the
contract period as VSOE of fair value for maintenance generally does not
exist.  Revenue from installation, engineering services, training and
consulting services is recognized as services are performed.




Revenue
from sales of RIS, RIS/PACS solution, and other specific arrangements where
professional services are considered essential to the functionality of the
solution sold, is recognized on the percentage-of-completion method, as
prescribed by SOP No. 81-1, Accounting
for Performance on Construction-Type and Certain Production-Type
Contracts.  Percentage of completion is determined by the input
method based upon the amount of labor hours expended compared to the total labor
hours expended plus the estimated amount of labor hours to complete the
project.  Total estimated labor hours are based on management’s best
estimate of the total amount of time it will take to complete a
project.  These estimates require the use of judgment.  A
significant change in one or more of these estimates could affect the
profitability of one or more of our contracts.  We review our contract
estimates periodically to assess revisions in contract values and estimated
labor hours and reflect changes in estimates in the period that such estimates
are revised under the cumulative catch-up method.  At times, we have
had difficulty accurately estimating the number of days required to complete the
consulting and installation services and, accordingly, accurately estimating the
percentages of completion.




Our OEM
software products are typically fully functional upon delivery and do not
require significant modification or alteration.  Fees for services
provided to OEM customers are billed separately from licenses of our software
products.  For sales transactions involving only the delivery of
custom engineering services, we recognize revenue under proportional performance
guidelines of SAB No. 104.  For sales including significant
custom engineering services and software products, revenue is recognized on the
percentage-of-completion method.




Deferred
revenue is comprised of deferrals for license fees, support and maintenance and
other services.  Long-term deferred revenue as of December 31,
2008, represents license fees, support and maintenance and other services to be
earned or provided after January 1, 2010.




We
record reimbursable out-of-pocket expenses in both services and maintenance net
sales and as a direct cost of services and maintenance in accordance with EITF
Issue No. 01-14, Income
Statement Characterization of Reimbursements Received for “Out-of-Pocket”
Expenses Incurred.  In accordance with EITF Issue
No. 00-10, Accounting for
Shipping and Handling Fees, the reimbursement by customers of shipping
and handling costs are recorded in software and other net sales and the
associated cost as a cost of sale.  We account for sales taxes on a
net basis in accordance with EITF No. 06-3, How
Sales Taxes Collected from Customers and Remitted to Governmental Authorities
Should be Presented in the Income Statement (That Is, Gross Versus Net
Presentation).


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~




Allowance
for Doubtful Accounts and Sales Returns




Based
upon past experience and judgment, we establish allowances for doubtful accounts
with respect to our accounts receivable and sales returns.  We
determine collection risk and record allowances for bad debts based on the aging
of accounts and past transaction history with customers.  In addition,
our policy is to allow sales returns when we have preauthorized the
return.  Based on our historical experience of returns and customer
credits, we have determined an allowance for estimated returns and credits in
accordance with Financial Accounting Standards Board (“FASB”) Statement of
Financial Accounting Standards (“SFAS”) No. 48, Revenue Recognition When the Right
of Return Exists.  We monitor our collections, write-offs,
returns and credit experience to assess whether adjustments to our allowance
estimates are necessary.  Changes in trends in any of the factors that
we believe impact the realizability of our receivables or modifications to our
credit standards, collection, return and credit, authorization practices or
other related policies may impact our estimates.




Software
Capitalization


Software
capitalization commences when we determine that projects have achieved
technological feasibility, unless the costs expected to be incurred after
achieving technological feasibility until general release are
immaterial.  Our determination that a project has achieved
technological feasibility does not ensure that the project can be commercially
salable as a product.  Amounts capitalized include direct labor and
estimates of overhead attributable to the projects.




The
useful lives of purchased software and capitalized software are assigned by
management, based upon the expected life of the software.  We also
estimate the realizability of purchased and capitalized values based on
undiscounted projections of future net operating cash flows through the sale of
the respective products.  If we determine in the future that the value
of purchased or capitalized software cannot be recovered, a write down of the
value of the software to its recoverable value may be required.  If
the actual achieved revenues are lower than our estimates or the useful life of
a product is shorter than the estimated useful life, the asset may be deemed to
be impaired, and, accordingly, a write down of the value of the asset or a
shorter amortization period may be required.




Other
Long-Lived Assets


Other
long-lived assets, including patents, property and equipment and customer
relationships, are amortized over their expected lives, which are estimated by
us.  We also make estimates of the impairment of these long-lived
assets whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable based primarily upon whether expected
future undiscounted cash flows are sufficient to support recovery of the
asset.  If the actual useful life of a long-lived asset is shorter
than the useful life estimated by us, the asset may be deemed to be impaired,
and, accordingly, a write down of the value of the asset, generally determined
by a discounted cash flow analysis, or a shorter depreciation or amortization
period, may be required.




Goodwill
and Other Intangible Assets


SFAS No. 142,Goodwill and Other Intangible
Assets(“SFAS No. 142”), requires that goodwill and
indefinite lived intangible assets be reviewed for impairment annually or more
frequently if impairment indicators arise.  Our policy provides that
goodwill and indefinite lived intangible assets will be reviewed for impairment
as of December 31 of each year.  In calculating potential
impairment losses, we evaluate the fair value of goodwill and intangible assets
using either quoted market prices or, if not available, by estimating the
expected present value of their future cash flows.  Identification of,
and assignment of assets and liabilities to, a reporting unit require our
judgment and estimates.  In addition, future cash flows are based upon
our assumptions about future sales activity and market acceptance of our
products.  If these assumptions change, we may be required to write
down the carrying value of the asset to a revised amount.  See Note 3
of the notes to consolidated financial statements for a discussion of the
impairment of goodwill or trade names in the years ended December 31, 2008, 2007
and 2006.




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~




Investments




On
January 1, 2008, we adopted the methods of fair value as described in SFAS
No. 157, Fair
Value Measurements (“SFAS No. 157”) to value our financial assets and
liabilities.  SFAS No. 157 establishes a three-tier fair value
hierarchy, which prioritizes the inputs used in measuring fair
value.  These tiers include: Level 1, defined as observable
inputs such as quoted prices in active markets; Level 2, defined as inputs
other than quoted prices in active markets that are either directly or
indirectly observable; and Level 3, defined as unobservable inputs in which
little or no market data exists, therefore requiring an entity to develop its
own assumptions.  At December 31, 2008, we held certain
securities in a publicly traded entity and private companies which are
classified as non-current assets and are considered financial assets within the
guidelines of SFAS No. 157.  In determining fair value, we utilize
valuation techniques that maximize the use of observable inputs and minimize the
use of unobservable inputs to the extent possible.




The
investment in the publicly traded equity security, over which we do not exert
significant influence, is classified as “available-for-sale” and reported at
fair value.  Unrealized gains and losses (utilizing Level 1 inputs)
are based on changes in quoted market prices and reported within the accumulated
other comprehensive income component of shareholders’ equity.




The
investments in equity securities of private companies, over which we do not
exert significant influence, are reported at cost or fair value (utilizing Level
3 inputs), if an other-than-temporary loss has been determined.  In
calculating potential impairment losses, we evaluate the fair value of
investments by comparing them to certain public company metrics, such as
revenue multiples, information obtained from independent valuations, and
inquiries and estimates made by us.  If assumptions or estimates used
by us change, we may be required to write down the carrying value of the asset
to a revised amount.  Any loss due to impairment in value is recorded
when such loss occurs.




Share-based
Compensation Expense


We use
the modified prospective transition method of SFAS No. 123(R), Share-Based
Payment(“SFAS No. 123(R)”), which is a revision of SFAS No. 123,
Accounting
for Stock-Based Compensation, which we adopted on January 1, 2006, to
account for share-based awards (previously we accounted for such costs under APB
No. 25,Accounting for Stock Issued to Employees).  Under this
transition method, compensation cost includes: (1) compensation cost
for all share-based awards granted prior to, but not yet vested as of
January 1, 2006, based on the grant-date fair value estimated in accordance
with the original provisions of SFAS No. 123; and (2) compensation
cost for all share-based awards granted subsequent to January 1, 2006,
based on the grant-date fair value estimated in accordance with the provisions
of SFAS No. 123(R).  We use the Black-Scholes option pricing
model to estimate the fair value of stock-based awards on the date of grant
utilizing certain assumptions including expected volatility, which we base on
the historical volatility of our stock and other factors, and estimated option
life, which represents the period of time the options granted are expected to be
outstanding and is based, in part, on historical data.  We also
estimate employee terminations (option forfeiture rate), which is based, in
part, on historical data.  Although we believe our assumptions used to
calculate share-based compensation expense are reasonable, these assumptions can
involve complex judgments about future events, which are open to interpretation
and inherent uncertainty.  In addition, significant changes to our
assumptions could significantly impact the amount of expense recorded in a given
period.




Income
Taxes


As part of
the process of preparing our consolidated financial statements, we are required
to estimate income taxes in each of the jurisdictions in which we
operate.  On January 1, 2007, we adopted FASB Interpretation
(“FIN”) No. 48, Accounting
for Uncertainty in Income Taxes - an Interpretation of FASB Statement
No. 109 (“FIN No. 48”).  This interpretation
clarifies the accounting for uncertainty in income taxes recognized in an
enterprise’s financial statements in accordance with SFAS No. 109, Accounting
for Income Taxes.  This interpretation prescribes a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax
return.  The pronouncement also provides guidance on de-recognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.  Pursuant to FIN No. 48, we record as
noncurrent any unrecognized tax benefits that are not expected to be paid within
one year.  In
May 2007, the FASB issued staff position FIN No. 48-1, “Definition
of Settlement in FASB Interpretation No. 48”(“FSP FIN
No. 48-1”) which amended FIN No. 48 to provide guidance about how an
enterprise should determine whether a tax position is effectively settled for
the purpose of recognizing previously unrecognized tax benefits.  Under FSP
FIN No. 48-1, a tax position could be effectively settled through an examination
by a taxing authority.  Since adoption, we have applied FIN No. 48 in
a manner consistent with the provisions of FSP FIN No.
48-1.




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~




The
provision for income taxes is determined in accordance with SFAS
No. 109.  A current liability is recognized for the estimated
taxes payable for the current year.  Deferred tax assets and
liabilities are recognized for the estimated future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax
bases.  Deferred tax assets and liabilities are measured using the
enacted tax rates in effect for the year in which the timing differences are
expected to be recovered or settled.  The effect on deferred tax
assets and liabilities of changes in tax rates or tax laws are recognized in the
provision for income taxes in the period that includes the enactment
date.




Valuation
allowances are established, when necessary, to reduce deferred tax assets to the
amount more-likely-than-not to be realized.  Changes in valuation
allowances will flow through the statement of operations unless related to
deferred tax assets that expire unutilized or are modified through translation,
in which case both the deferred tax asset and related valuation allowance are
similarly adjusted.  Where a valuation allowance was established
through purchase accounting for acquired deferred tax assets, any future change
outside the measurement period will be credited or charged to income tax expense
under SFAS No. 141(R), Business Combinations (“SFAS
No. 141(R)”).  SFAS No. 141(R) is effective for financial statements
issued for fiscal years beginning after December 15, 2008.




The
determination of our provision for income taxes requires significant judgment,
the use of estimates and the interpretation and application of complex tax
laws.  We are subject to income taxes in the U.S. and numerous foreign
jurisdictions.  Significant judgment is required in determining our
worldwide provision for income taxes and recording the related tax assets and
liabilities.  In the ordinary course of our business, there are
transactions and calculations for which the ultimate tax determination is
uncertain.  In spite of our belief that we have appropriate support
for all the positions taken on our tax returns, we acknowledge that certain
positions may be successfully challenged by the taxing
authorities.  We apply the provisions of FIN No. 48 to determine the
appropriate amount of tax benefits to be recognized with respect to uncertain
tax positions.  Unrecognized tax benefits are evaluated quarterly and
adjusted based upon new information, resolution with taxing authorities and
expiration of the statute of limitations.  The provision for income
taxes includes the impact of changes in the FIN No. 48
liability.  Although we believe our recorded tax assets and
liabilities are reasonable, tax laws and regulations are subject to
interpretation and inherent uncertainty; therefore, our assessments can involve
both a series of complex judgments about future events and rely on estimates and
assumptions.  Although we believe these estimates and assumptions are
reasonable, the final determination could be materially different than that
which is reflected in our provision for income taxes and recorded tax assets and
liabilities.




Guarantees


In
accordance with FIN No. 45, Guarantor’s Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others(“FIN No. 45”), we recognize the fair
value of guarantee and indemnification arrangements issued or modified by us, if
these arrangements are within the scope of the interpretation.  In
addition, we must continue to monitor the conditions that are subject to the
guarantees and indemnifications, as required under the previously existing
generally accepted accounting principles, in order to identify if a loss has
occurred.  If we determine it is probable that a loss has occurred,
then any such estimable loss would be recognized under those guarantees and
indemnifications.




Under our
standard Software License, Services and Maintenance Agreement, we agree to
indemnify, defend and hold harmless our licensees from and against certain
losses, damages and costs arising from claims alleging the licensees’ use of our
software infringes the intellectual property rights of a third
party.  Historically, we have not been required to pay material
amounts in connection with claims asserted under these provisions, and,
accordingly, we have not recorded a liability relating to such
provisions.  Under our Software License, Services and Maintenance
Agreement, we also represent and warrant to licensees that our software products
will operate substantially in accordance with published specifications, and that
the services we perform will be undertaken by qualified personnel in a
professional manner conforming to generally accepted industry standards and
practices.  Historically, only minimal costs have been incurred
relating to the satisfaction of product warranty claims.




Other
guarantees include promises to indemnify, defend and hold harmless each of our
executive officers, non-employee directors and certain key employees from and
against losses, damages and costs incurred by each such individual in
administrative, legal or investigative proceedings arising from alleged
wrongdoing by the individual while acting in good faith within the scope of his
or her job duties on our behalf.  Merge and certain of our former
officers are defendants in several lawsuits.  These lawsuits and other
legal matters in which we have become involved are described in Note 9 of the
notes to consolidated financial statements.  We have accrued for
indemnification costs as of December 31, 2008 for certain of our former
officers for their expenses in connection with such matters and may be required
to accrue for additional guarantee related costs in future periods.




~ 34
~




Loss
Contingencies


We have
accrued for costs as of December 31, 2008 and may, in the future, accrue
for costs associated with certain contingencies, including, but not limited to
settlement of legal proceedings and regulatory compliance matters, when such
costs are probable and reasonably estimable.  Liabilities established
to provide for contingencies are adjusted as further information develops,
circumstances change, or contingencies are resolved.




Recent
Accounting Pronouncements


In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities – Including an Amendment of FASB Statement
No. 115 (“SFAS No. 159”), which is effective for fiscal years
beginning after November 15, 2007.  This statement permits
entities to choose to measure many financial instruments and certain other items
at fair value.  This statement also establishes presentation and
disclosure requirements designed to facilitate comparisons between entities that
choose different measurement attributes for similar types of assets and
liabilities.  Unrealized gains and losses on items for which the fair
value option is elected would be reported in earnings.  We have
adopted SFAS No. 159 and have elected not to measure any additional financial
instruments and other items at fair value.




On
December 4, 2007, the FASB issued SFAS No. 141(R) which replaces
SFAS No. 141,Business
Combinations, and applies to all transactions or other events in which an
entity obtains control of one or more businesses.  SFAS No.
141(R) requires the acquiring entity in a business combination to recognize all
(and only) the assets acquired and liabilities assumed in the transaction;
establishes the acquisition-date fair value as the measurement objective for all
assets acquired and liabilities assumed; and requires the acquirer to disclose
additional information needed to evaluate and understand the nature and
financial effect of the business combination.  In addition, under SFAS
No. 141(R), changes in deferred tax asset valuation allowances and acquired
income tax uncertainties in a business combination after the measurement period
will impact income tax expense.  SFAS No. 141(R) is
effective prospectively for fiscal years beginning after December 15, 2008
and may not be applied before that date.  The impact of SFAS No.
141(R) on our financial position and results of operations will be dependent
upon the extent to which we have transactions or events occur that are within
its scope.




In
February 2008, FASB issued Staff Position FAS 157-2 which provides for a
one-year deferral of the effective date of SFAS No. 157 for non-financial assets
and liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis, except those that are recognized or
disclosed at fair value in the financial statements on a recurring
basis.  We are evaluating the impact of SFAS No. 157 as it relates to
our financial position and results of operations.




In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities(“SFAS No. 161”).SFAS No. 161 is intended to
improve financial reporting about derivative instruments and hedging activities
by requiring enhanced disclosures to enable investors to better understand the
effects on an entity’s financial position, financial performance, and cash
flows.  It is effective for financial statements issued for fiscal
years and interim periods beginning after November 15, 2008.  We
expect to adopt SFAS No. 161 and its required disclosures, in our consolidated
financial statements for the fiscal year beginning January 1,
2009.




In April
2008, the FASB issued FSP FAS No. 142-3,Determination of the Useful Life of
Intangible Assets(“FSP No. 142-3”).FSP No. 142-3
amends the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142.  The intent of
FSP No. 142-3 is to improve the consistency between the useful life of a
recognized intangible asset under SFAS No. 142 and the period of expected cash
flows used to measure the fair value of the asset under SFAS No. 141(R),
and other U.S. generally accepted accounting principles.  FSP No.
142-3 is effective for our interim and annual financial statements beginning
after November 15, 2008.  We do not expect the adoption of FSP
No. 142-3 will have a material impact on our financial position or results of
operations.




~ 35
~


In
October 2008, the FASB issued FSP FAS No. 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active (“FSP
No.157-3”).  FSP No. 157-3 clarified the application of SFAS No.
157.  FSP No. 157-3 demonstrated how the fair value of a financial
asset is determined when the market for that financial asset is
inactive.  FSP No. 157-3 was effective upon issuance, including prior
periods for which financial statements had not been issued.  The
implementation of this standard did not have a material impact on our financial
position or results of operations.




Item
      7A.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Interest
Rate Risk


Our cash
and cash equivalents are exposed to financial market risk due to fluctuations in
interest rates, which may affect our interest income.  As of
December 31, 2008, our cash and cash equivalents included money market
funds and short-term deposits, including certain cash that is restricted,
totaling approximately $17.8 million, and earned interest at a weighted average
rate of 2.1% during 2008.  The value of the principal amounts is equal
to the fair value for these instruments.  Due to the short-term nature
of our investment portfolio, our interest income is subject to changes in
short-term interest rates.  At current investment levels, our pre-tax
results of operations would vary by approximately $0.2 million for every 100
basis point change in our weighted average short-term interest
rate.  We do not use our portfolio for trading or other speculative
purposes.




Foreign
Currency Exchange Risk


We have
sales and expenses in Canada, China and Europe that are denominated in
currencies other than the U.S. Dollar and, as a result, have exposure to foreign
currency exchange risk.  Prior to 2007, we periodically entered into
forward exchange contracts to hedge exposures denominated in foreign
currencies.  We do not enter into derivative financial instruments for
trading or speculative purposes.  In the event our exposure to foreign
currency risk increases to levels that we do not deem acceptable, we may choose
to hedge those exposures.









~ 36
~




Item 8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA




Report
of Independent Registered Public Accounting Firm







Board of
Directors and Shareholders


Merge
Healthcare Incorporated


Milwaukee,
Wisconsin




We have
audited the accompanying consolidated balance sheet of Merge Healthcare
Incorporated and subsidiaries (the Company) as of December 31, 2008 and the
related consolidated statement of operations, shareholders’ equity, cash flows,
and comprehensive loss for the year then ended.  These financial
statements are the responsibility of the Company’s management.  Our
responsibility is to express an opinion on these financial statements based on
our audit.




We
conducted our audit 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 audit provides 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 Merge Healthcare
Incorporated at December 31, 2008, and the results of its operations, cash
flows, and comprehensive loss for the year then ended, in conformity with
accounting principles generally accepted in the United States of
America.




/s/ BDO Seidman,
LLP




Chicago,
Illinois


March 11,
2009





~ 37
~




Report of Independent Registered
Public Accounting Firm*





The Board
of Directors and Shareholders


Merge
Healthcare Incorporated:





We have
audited the accompanying consolidated balance sheets of Merge Healthcare
Incorporated and subsidiaries (the Company) as of December 31, 2007 and
2006, and the related consolidated statements of operations, shareholders’
equity, comprehensive loss and cash flows for each of the years in the
three-year period ended December 31, 2007. These consolidated financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these consolidated 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. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes 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 the Company as of
December 31, 2007 and 2006, and the results of its operations and its cash
flows for each of the years in the three-year period ended December 31,
2007, in conformity with U.S. generally accepted accounting
principles.





As
discussed in Note 1 to the consolidated financial statements, effective
January 1, 2007, the Company adopted the provisions of Financial Accounting
Standards Board Interpretation No. 48, Accounting for Uncertainty in Income
Taxes. Also, as discussed in Notes 1 and 6 to the consolidated
financial statements, effective January 1, 2006, the Company adopted the
provisions of Statement of Financial Accounting Standards No. 123 (revised
2004), Share-Based
Payment.





The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has suffered recurring losses
from operations and negative cash flows that raise substantial doubt about its
ability to continue as a going concern. Management’s plans in regard to these
matters are also described in Note 1. The consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.





We
have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the Company’s internal control over
financial reporting as of December 31, 2007, based on criteria established
in Internal Control —
Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO), and our report dated March 31, 2008
expressed an adverse opinion on the Company’s internal control over financial
reporting.








/s/
KPMG LLP


Chicago,
Illinois


March 31,
2008











*This
report is a copy of the previously issued report.











~ 38
~





MERGE
HEALTHCARE INCORPORATED AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except for share data)




December
      31,
              
              
              December
      31,2008
              
              
              2007ASSETSCurrent
      assets:Cash and cash equivalents, including restricted cash of $621 and $363 at
      December 31, 2008and
      December 31, 2007, respectively
              
              $
              17,848
              
              
              $
              14,000Accounts receivable, net of allowance for doubtful accounts and sales
      returns of $1,378and
      $2,209 at December 31, 2008 and December 31, 2007,
      respectively
              
              
              12,779
              
              
              
              11,810Inventory
              
              
              550
              
              
              
              1,754Prepaid expenses
              
              
              1,509
              
              
              
              1,970Deferred income taxes
              
              
              217
              
              
              
              260Other current assets
              
              
              721
              
              
              
              771Total
      current assets
              
              
              33,624
              
              
              
              30,565Property
      and equipment:Computer equipment
              
              
              6,317
              
              
              
              6,776Office equipment
              
              
              1,989
              
              
              
              2,270Leasehold improvements
              
              
              1,272
              
              
              
              2,0009,578
              
              
              
              11,046Less accumulated depreciation
              
              
              7,604
              
              
              
              6,415Net
      property and equipment
              
              
              1,974
              
              
              
              4,631Purchased
      and developed software, net of accumulated amortization of $12,584
      and$10,452 at December 31, 2008 and December 31, 2007,
      respectively
              
              
              5,653
              
              
              
              8,932Customer
      relationships, net of accumulated amortization of $1,259 and $259
      atDecember 31, 2008 and December 31, 2007, respectively
              
              
              2,291
              
              
              
              3,291Trade
      names
              
              
              -
              
              
              
              1,060Deferred
      income taxes
              
              
              4,585
              
              
              
              4,585Investments
              
              
              5,690
              
              
              
              8,156Other
      assets
              
              
              920
              
              
              
              415Total
      assets
              
              $
              54,737
              
              
              $
              61,635LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts payable
              
              $
              3,387
              
              
              $
              7,114Accrued wages
              
              
              1,590
              
              
              
              2,621Restructuring accrual
              
              
              1,173
              
              
              
              131Other accrued liabilities
              
              
              3,070
              
              
              
              2,920Deferred revenue
              
              
              16,150
              
              
              
              16,901Total
      current liabilities
              
              
              25,370
              
              
              
              29,687Note payable
              
              
              14,230
              
              
              
              -Deferred income taxes
              
              
              39
              
              
              
              257Deferred revenue
              
              
              644
              
              
              
              1,787Income taxes payable
              
              
              5,418
              
              
              
              5,338Other
              
              
              195
              
              
              
              161Total
      liabilities
              
              
              45,896
              
              
              
              37,230Shareholders'
      equity:Series B Preferred Stock, $0.01 par value: 1,000,000 shares authorized;
      zero sharesissued and outstanding at December 31, 2008 and December 31,
      2007
              
              
              -
              
              
              
              -Series 3 Special Voting Preferred Stock, no par value: one share
      authorized; one shareissued and outstanding at December 31, 2008 and December 31,
      2007
              
              
              -
              
              
              
              -Common stock, $0.01 par value: 100,000,000 shares
      authorized:  55,506,702 shares and32,237,700 shares issued and outstanding at December 31, 2008 and December
      31, 2007, respectively
              
              
              555
              
              
              
              322Common stock subscribed; 30,271 shares and 0 shares at December 31,
      2008and December 31, 2007, respectively
              
              
              37
              
              
              
              -Additional paid-in capital
              
              
              465,083
              
              
              
              456,371Accumulated deficit
              
              
              (458,641
              )
              
              
              (434,958
              )Accumulated other comprehensive income
              
              
              1,807
              
              
              
              2,670Total
      shareholders' equity
              
              
              8,841
              
              
              
              24,405Total
      liabilities and shareholders' equity
              
              $
              54,737
              
              
              $
              61,635




See
accompanying notes to consolidated financial statements.







~ 39
~





MERGE
HEALTHCARE INCORPORATED AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS


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






Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Net
      sales:Software and other
              
              $
              27,561
              
              
              $
              29,590
              
              
              $
              40,275Services and maintenance
              
              
              29,174
              
              
              
              29,982
              
              
              
              34,047Total
      net sales
              
              
              56,735
              
              
              
              59,572
              
              
              
              74,322Cost
      of sales:Software and other
              
              
              5,121
              
              
              
              6,722
              
              
              
              10,651Services and maintenance
              
              
              11,672
              
              
              
              14,089
              
              
              
              14,472Amortization and impairment
              
              
              3,279
              
              
              
              8,537
              
              
              
              5,532Total
      cost of sales
              
              
              20,072
              
              
              
              29,348
              
              
              
              30,655Gross
      margin
              
              
              36,663
              
              
              
              30,224
              
              
              
              43,667Operating
      costs and expenses:Sales and marketing
              
              
              9,313
              
              
              
              18,565
              
              
              
              20,100Product research and development
              
              
              13,240
              
              
              
              21,065
              
              
              
              19,364General and administrative
              
              
              20,461
              
              
              
              29,492
              
              
              
              28,752Goodwill and trade name impairment, restructuring and other
      expenses
              
              
              11,816
              
              
              
              124,131
              
              
              
              223,505Depreciation, amortization and impairment
              
              
              3,530
              
              
              
              8,209
              
              
              
              4,033Total
      operating costs and expenses
              
              
              58,360
              
              
              
              201,462
              
              
              
              295,754Operating
      loss
              
              
              (21,697
              )
              
              
              (171,238
              )
              
              
              (252,087
              )Other
      income (expense):Interest expense
              
              
              (1,750
              )
              
              
              (89
              )
              
              
              (67
              )Interest income
              
              
              268
              
              
              
              1,233
              
              
              
              2,548Other, net
              
              
              (564
              )
              
              
              (1,714
              )
              
              
              133Total
      other income (expense)
              
              
              (2,046
              )
              
              
              (570
              )
              
              
              2,614Loss
      before income taxes
              
              
              (23,743
              )
              
              
              (171,808
              )
              
              
              (249,473
              )Income
      tax expense (benefit)
              
              
              (60
              )
              
              
              (240
              )
              
              
              9,450Net
      loss
              
              $
              (23,683
              )
              
              $
              (171,568
              )
              
              $
              (258,923
              )Net
      loss per share - basic
              
              $
              (0.51
              )
              
              $
              (5.06
              )
              
              $
              (7.68
              )Weighted
      average number of common shares outstanding - basic
              
              
              46,717,546
              
              
              
              33,913,379
              
              
              
              33,701,735Net
      loss per share - diluted
              
              $
              (0.51
              )
              
              $
              (5.06
              )
              
              $
              (7.68
              )Weighted
      average number of common shares outstanding - diluted
              
              
              46,717,546
              
              
              
              33,913,379
              
              
              
              33,701,735




See
accompanying notes to consolidated financial statements.







~ 40
~





MERGE
HEALTHCARE INCORPORATED


CONSOLIDATED
STATEMENTS OF SHAREHOLDERS’ EQUITY


Years
Ended December 31, 2006, 2007 and 2008


(in
thousands, except for share data)




Preferred
      Stock
              
              
              Common Stock
              
              
              
              
              
              
              
              
              AccumulatedAdditional
              
              
              Deferred
              
              
              
              
              
              Other
              
              
              TotalShares
              
              
              Issued
              
              
              Shares
              
              
              Subscribed
              
              
              Shares
              
              
              Issued
              
              
              Paid-in
              
              
              Stock
              
              
              Accumulated
              
              
              Comprehensive
              
              
              Shareholders’Issued
              
              
              Amount
              
              
              Subscribed
              
              
              Amount
              
              
              Issued
              
              
              Amount
              
              
              Capital
              
              
              Compensation
              
              
              Deficit
              
              
              Income
              
              
              EquityBalance
      at December 31, 2005
              
              
              1
              
              
              $
              -
              
              
              
              706
              
              
              $
              17
              
              
              
              26,500,140
              
              
              $
              265
              
              
              $
              445,954
              
              
              $
              (1,245
              )
              
              $
              (4,467
              )
              
              $
              2,068
              
              
              $
              442,592Exchange
      of exchangeable share rights intoCommon Stock
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,561,085
              
              
              
              26
              
              
              
              (26
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Stock
      issued under ESPP
              
              
              -
              
              
              
              -
              
              
              
              4,536
              
              
              
              16
              
              
              
              706
              
              
              
              -
              
              
              
              17
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              33Exercise
      of stock options
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              229,099
              
              
              
              2
              
              
              
              469
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              471Share-based
      compensation expense
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              5,961
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              5,961Reduction
      of deferred stock compensationfor application of FAS 123R
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,245
              )
              
              
              1,245
              
              
              
              -
              
              
              
              -
              
              
              
              -Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (258,923
              )
              
              
              -
              
              
              
              (258,923
              )Other
      comprehensive loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (209
              )
              
              
              (209
              )Balance
      at December 31, 2006
              
              
              1
              
              
              $
              -
              
              
              
              5,242
              
              
              $
              33
              
              
              
              29,291,030
              
              
              $
              293
              
              
              $
              451,130
              
              
              $
              -
              
              
              $
              (263,390
              )
              
              $
              1,859
              
              
              $
              189,925Exchange
      of exchangeable share rights intoCommon Stock
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,879,672
              
              
              
              29
              
              
              
              (29
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Stock
      issued under ESPP
              
              
              -
              
              
              
              -
              
              
              
              (5,242
              )
              
              
              (33
              )
              
              
              21,494
              
              
              
              -
              
              
              
              121
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              88Exercise
      of stock options
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              45,504
              
              
              
              -
              
              
              
              126
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              126Share-based
      compensation expense
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              5,023
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              5,023Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (171,568
              )
              
              
              -
              
              
              
              (171,568
              )Other
      comprehensive income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              811
              
              
              
              811Balance
      at December 31, 2007
              
              
              1
              
              
              $
              -
              
              
              
              -
              
              
              $
              -
              
              
              
              32,237,700
              
              
              $
              322
              
              
              $
              456,371
              
              
              $
              -
              
              
              $
              (434,958
              )
              
              $
              2,670
              
              
              $
              24,405Exchange
      of exchangeable share rights intoCommon Stock
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              883,180
              
              
              
              9
              
              
              
              (9
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Issuance
      of Common Stock
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              21,085,715
              
              
              
              211
              
              
              
              4,614
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,825Stock
      issued under ESPP
              
              
              -
              
              
              
              -
              
              
              
              30,271
              
              
              
              37
              
              
              
              61,822
              
              
              
              1
              
              
              
              62
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              100Vesting
      of restricted stock
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,238,285
              
              
              
              12
              
              
              
              (12
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Share-based
      compensation expense
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,161
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,161Stock
      dividend
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (57
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (57
              )Treasury
      stock repurchase and retirement
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (47
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (47
              )Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (23,683
              )
              
              
              -
              
              
              
              (23,683
              )Other
      comprehensive loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (863
              )
              
              
              (863
              )Balance
      at December 31, 2008
              
              
              1
              
              
              $
              -
              
              
              
              30,271
              
              
              $
              37
              
              
              
              55,506,702
              
              
              $
              555
              
              
              $
              465,083
              
              
              $
              -
              
              
              $
              (458,641
              )
              
              $
              1,807
              
              
              $
              8,841






See
accompanying notes to consolidated financial statements.




~ 41
~





MERGE
HEALTHCARE INCORPORATED AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Cash
      flows from operating activities:Net
      loss
              
              $
              (23,683
              )
              
              $
              (171,568
              )
              
              $
              (258,923
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation, amortization and impairment
              
              
              6,809
              
              
              
              16,746
              
              
              
              9,565Share-based compensation
              
              
              4,161
              
              
              
              5,009
              
              
              
              5,961Loss on disposal of subsidiaries
              
              
              1,470
              
              
              
              -
              
              
              
              -Amortization of note payable issuance costs & discount
              
              
              604
              
              
              
              -
              
              
              
              -Goodwill and trade name impairment
              
              
              1,060
              
              
              
              123,171
              
              
              
              218,810Other-than-temporary impairment on equity investments
              
              
              1,435
              
              
              
              1,166
              
              
              
              186Provision for doubtful accounts receivable and sales returns, net of
      recoveries
              
              
              316
              
              
              
              1,100
              
              
              
              829Deferred income taxes
              
              
              (175
              )
              
              
              (202
              )
              
              
              11,160Changes
      in operating assets and liabilities:Accounts receivable
              
              
              (1,472
              )
              
              
              3,517
              
              
              
              6,038Inventory
              
              
              1,204
              
              
              
              410
              
              
              
              276Prepaid expenses
              
              
              (54
              )
              
              
              (310
              )
              
              
              986Accounts payable
              
              
              (3,464
              )
              
              
              (1,170
              )
              
              
              2,370Accrued wages
              
              
              (1,032
              )
              
              
              (1,544
              )
              
              
              (1,712
              )Restructuring accrual
              
              
              1,042
              
              
              
              (1,866
              )
              
              
              1,805Other accrued liabilities
              
              
              290
              
              
              
              (750
              )
              
              
              (605
              )Deferred revenue
              
              
              (1,895
              )
              
              
              (3,087
              )
              
              
              (13,040
              )Other
              
              
              (192
              )
              
              
              787
              
              
              
              1,334Net
      cash used in operating activities
              
              
              (13,576
              )
              
              
              (28,591
              )
              
              
              (14,960
              )Cash
      flows from investing activities:Purchases
      of property, equipment, and leasehold improvements
              
              
              (539
              )
              
              
              (2,665
              )
              
              
              (1,252
              )Cash
      received on sale of subsidiary
              
              
              499
              
              
              
              -
              
              
              
              -Change
      in restricted cash
              
              
              (258
              )
              
              
              (200
              )
              
              
              (163
              )Purchased
      technology
              
              
              -
              
              
              
              -
              
              
              
              (367
              )Capitalized
      software development
              
              
              -
              
              
              
              (817
              )
              
              
              (2,257
              )Net
      cash used in investing activities
              
              
              (298
              )
              
              
              (3,682
              )
              
              
              (4,039
              )Cash
      flows from financing activities:Proceeds
      from issuance of note, net of non-cash discount of $510
              
              
              14,490
              
              
              
              -
              
              
              
              -Proceeds
      from issuance of Common Stock
              
              
              5,479
              
              
              
              -
              
              
              
              -Note
      and stock issuance costs paid
              
              
              (2,386
              )
              
              
              -
              
              
              
              -Proceeds
      from exercise of stock options and employee stock purchase
      plan
              
              
              100
              
              
              
              214
              
              
              
              504Repurchase
      of Common Stock
              
              
              (47
              )
              
              
              -
              
              
              
              -Dividends
      paid
              
              
              (57
              )
              
              
              -
              
              
              
              -Net
      cash provided by financing activities
              
              
              17,579
              
              
              
              214
              
              
              
              504Effect
      of exchange rates on cash and cash equivalents
              
              
              (115
              )
              
              
              (86
              )
              
              
              (1
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              3,590
              
              
              
              (32,145
              )
              
              
              (18,496
              )Cash
      and cash equivalents (net of restricted cash), beginning of period1
              
              
              13,637
              
              
              
              45,782
              
              
              
              64,278Cash
      and cash equivalents (net of restricted cash), end of period2
              
              $
              17,227
              
              
              $
              13,637
              
              
              $
              45,782Supplemental
      Disclosures of Cash Flow Information:Cash paid for interest
              
              $
              975
              
              
              $
              -
              
              
              $
              -Cash paid for income taxes, net of refunds
              
              $
              17
              
              
              $
              (247
              )
              
              $
              69Equity securities received in sales transactions
              
              $
              -
              
              
              $
              -
              
              
              $
              2,010




1
              Net of restricted cash of $363, $163, and zero at December 31, 2007,
      December 31, 2006, and December 31, 2005, respectively.2
              Net of restricted cash of $621, $363, and $163 at December 31, 2008,
      December 31, 2007, and December 31, 2006,
  respectively.






See
accompanying notes to consolidated financial statements.





~ 42
~




MERGE
HEALTHCARE INCORPORATED AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE LOSS


(in
thousands)








Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Net
      loss
              
              $
              (23,683
              )
              
              $
              (171,568
              )
              
              $
              (258,923
              )Translation
      adjustment
              
              
              221
              
              
              
              (152
              )
              
              
              (89
              )Unrealized
      gain (loss) on marketable securities, net of income taxes
              
              
              (1,084
              )
              
              
              961
              
              
              
              (58
              )Comprehensive
      net loss
              
              $
              (24,546
              )
              
              $
              (170,759
              )
              
              $
              (259,070
              )




See
accompanying notes to consolidated financial statements.







~ 43
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements
 (In
thousands, except for share and per share data)




(1) Basis of
Presentation and Significant Accounting Policies






Nature
of Operations


Merge
Healthcare Incorporated, a Delaware corporation, and its subsidiaries (which we
sometimes refer to collectively as “Merge,” “we,” “us,” or “our”) develop
medical imaging and information software solutions, and deliver related
services.  Our solutions are designed to automate digital imaging
workflow, which transform the tasks associated with film-based images and paper
information into computerized processes.






Principles
of Consolidation


The
consolidated financial statements include the financial statements of our wholly
owned subsidiaries.  Our principal operating subsidiaries are Cedara
Software Corp. (known as Merge OEM) and Merge eMed, Inc. (known as Merge
Fusion).  All intercompany balances and transactions have been
eliminated in consolidation.




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






Use
of Estimates


Our
consolidated financial statements are prepared in accordance with United States
of America (“U.S.”) generally accepted accounting principles
(“GAAP”).  These accounting principles require us to make certain
estimates, judgments and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements, and the reported amounts of revenues and expenses
during the reporting period.  Estimates are used when accounting for
items and matters such as revenue recognition and allowances for uncollectible
accounts receivable and sales returns, inventory obsolescence, depreciation and
amortization, long-lived and intangible asset valuations, impairment
assessments, restructuring reserves, taxes and related valuation allowance,
income tax provisions, stock-based compensation, and
contingencies.  We believe that the estimates, judgments and
assumptions are reasonable, based on information available at the time they are
made.  Actual results could differ from those estimates.




Reclassifications




Where
appropriate, certain reclassifications have been made to prior year financial
statements to conform to the current year presentation.  Specifically,
we are separately displaying $131 of accrued restructuring charges in the
consolidated balance sheet at December 31, 2007 to conform to current year
presentation.  We are also separately displaying the related changes
of $(1,866) and $1,805 in the consolidated statement of cash flows during the
years ended December 31, 2007 and 2006, respectively, to conform to current year
presentation.




We are
also separately displaying $363 of restricted cash in the consolidated balance
sheet at December 31, 2007 to conform to current year
presentation.  In addition, we are separately displaying $(200) and
$(163) of changes to restricted cash for the years ended December 31, 2007 and
December 31, 2006, respectively, in the consolidated statement of cash flows to
conform to current year presentation.






Segment
Reporting


Financial
Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards
(“SFAS”) No. 131, Disclosures about Segments of an
Enterprise and Related Information (“SFAS No. 131”), establishes
annual and interim reporting standards for operating segments of a
company.  It also requires entity-wide disclosures about the products
and services an entity provides, the material countries in which it holds assets
and reports revenues, and its major customers.  Our chief executive
officer has been identified as the chief operating decision maker in assessing
the performance and the allocation of resources within Merge.  Our
chief executive officer relies on the information derived from our financial
reporting process, which includes revenue by business unit, consolidated
operating results and consolidated assets.  As we do not have discrete
financial information available for our business units, we operate as a single
segment for reporting purposes as prescribed by SFAS No.
131.




We have
reorganized and renamed our operating business units, effective July 1,
2008.  The relevant portions of the EMEA (formerly known as Merge
Europe, Middle East and Africa) operation have been allocated between the
remaining business units of Merge Fusion (formerly known as Merge Healthcare
North America) and Merge OEM
(formerly known as Cedara).  Amounts for prior years have been recast
to reflect this operational change.  As a result, we no longer
separately report EMEA revenues.







~ 44
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





Functional
Currency




The
functional currency of our foreign subsidiaries, with the exception of our
remaining subsidiary in India, is the United States of America dollar (“U.S.
Dollar”).




Foreign
currency denominated revenues and expenses are translated at weighted average
exchange rates throughout the year.  Foreign currency denominated
monetary assets and liabilities are translated at rates prevailing at the
balance sheet dates.  Translation adjustments arising from the use of
differing exchange rates from period to period are included as a component of
other comprehensive loss.  Foreign exchange gains and losses on
transactions during the year are reflected in the consolidated statements of
operations, as a component of other income (expense), net.






Fair
Value of Financial Instruments


Our
financial instruments include cash and cash equivalents, accounts receivable,
marketable and non-marketable securities, accounts payable, note payable and
certain accrued liabilities.  The carrying amounts of these assets and
liabilities approximate fair value due to the short maturity of these
instruments, except for the non-marketable equity securities.  The
carrying value of long-term deferred revenues is not materially different from
the fair value.  The estimated fair values of the non-marketable
equity securities have been determined from information obtained from
independent valuations and management estimates.  The carrying value
of our note payable approximates fair value as determined by an independent
third-party valuation.  See Note 6 for further discussion of this
transaction.






Derivative
Financial Instruments


Fluctuating
foreign exchange rates may negatively impact the accompanying consolidated
financial statements.  Substantially all of our billings are in U.S.
Dollars.  However, due to our Canadian operations, substantial salary
and other expenses are payable in Canadian dollars.  To effectively
manage these market risks, we may enter into foreign currency forward
contracts.  We do not hold or issue derivative instruments for trading
purposes.  We have elected not to apply hedge accounting under the
provision of SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities(“SFAS No. 133”), and accordingly,
recognize any change in fair value through current earnings.




As part
of the financing transaction with Merrick RIS, LLC (“Merrick”) discussed in Note
6, the note payable to Merrick includes change of control and default provisions
that are considered put options.  These put options are classified as
derivative instruments in accordance with SFAS No. 133, and are required to
be bifurcated from the debt instrument and accounted for
separately.  The fair value of these options is recorded in long-term
liabilities as of December 31, 2008.  As of December 31, 2007, we
had no derivative financial instruments outstanding.






Cash
and Cash Equivalents


Cash and
cash equivalents consist of balances with banks (including restricted cash) and
liquid short-term investments with original maturities of ninety days or less
and are carried on the balance sheet at cost plus accrued
interest.  At December 31, 2008, restricted cash consists primarily of
a letter-of-credit related to one of our operating leases, and a rabbi trust
arrangement for one of our former officers that was released in January
2009.






Inventory


Inventory,
consisting principally of raw materials and finished goods (primarily purchased
third-party hardware), is stated at the lower of cost or market.  Cost
is determined using the first-in, first-out method.






Property
and Equipment


Property
and equipment are stated at cost.  Depreciation on property and
equipment is calculated on the straight-line method over the estimated useful
lives of the assets.  Useful lives of our major classes of property
and equipment are two to three years for computer equipment and five to seven
years for office equipment.  Leasehold improvements
are amortized using the straight-line method over the shorter of the estimated
life of the asset or the term of the lease.







~ 45
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





Long-Lived
Assets




We
account for long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets(“SFAS No. 144”).  Long-lived
assets, including property and equipment and customer intangibles, are amortized
over their expected lives, which are estimated by us.  We also make
estimates of the impairment of long-lived assets whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable, based primarily upon whether expected future undiscounted cash
flows are sufficient to support the asset’s recovery.  If the actual
useful life of a long-lived asset is shorter than the useful life estimated by
us, the asset may be deemed to be impaired, and, accordingly, a write-down of
the value of the asset determined by a discounted cash flow analysis, or a
shorter amortization period, may be required.  We have reviewed
long-lived assets with estimable useful lives and determined that their carrying
values as of December 31, 2008 are recoverable in future
periods.






Purchased
and Developed Software


All
research and development costs incurred prior to the point at which management
believes a project has reached technological feasibility are expensed as
incurred.  Software development costs incurred subsequent to reaching
technological feasibility are capitalized and reported at the lower of
unamortized cost or net realizable value in accordance with SFAS No. 86,
Accounting for the Costs
of Computer Software to
Be Sold, Leased, or Otherwise Marketed(“SFAS No. 86”).




Amortization
of purchased and developed software is provided on a product basis over the
expected economic life of the related software, generally five years, using the
straight-line method.  This method generally results in greater
amortization than the method based on the ratio that current gross revenues for
a product bear to the total of current and anticipated future gross revenues for
that product.  We assess the recoverability of purchased and developed
software costs quarterly by determining whether the net book value of such costs
can be recovered through future net operating cash flows based on the sales of
the respective products.






Investments


At
December 31, 2008, we held certain securities in a publicly traded entity
of $318 and private companies of $5,372, which are classified as non-current
assets.  The investment in the publicly traded equity security, over
which we do not exert significant influence, is classified as
“available-for-sale” and reported at fair value.  Unrealized gains and
losses are reported within the accumulated other comprehensive income component
of shareholders’ equity.  The investments in equity securities of
private companies, over which we do not exert significant influence, are
reported at cost or fair value, if an other-than-temporary loss has been
determined.  Any loss due to impairment in value is recorded when such
loss occurs.  We have recorded charges of $1,435, $1,166 and $186,
respectively, in other net income (expense) during the years ended December 31,
2008, 2007 and 2006 due to an other-than-temporary loss recognized on certain
investments.  As of December 31, 2008 and 2007, unrealized gain (loss)
on our available-for-sale security was $(129) and $955,
respectively.






Goodwill
and Other Intangible Assets


SFAS No. 142,
Goodwill and Other Intangible
Assets(“SFAS No. 142”), requires that goodwill and indefinite lived
intangible assets be reviewed for impairment annually, or more frequently if
impairment indicators arise.  Our policy provides that goodwill and
indefinite lived intangible assets will be reviewed for impairment as of
December 31 of each year.  In calculating potential impairment
losses, we evaluate the fair value of goodwill and intangible assets using
either quoted market prices or, if not available, by estimating the expected
present value of their future cash flows.  Identification of, and
assignment of assets and liabilities to, a reporting unit require our judgment
and estimates.  In addition, future cash flows are based upon our
assumptions about future sales activity and market acceptance of our
products.  If these assumptions change, we may be required to write
down the gross value of our remaining indefinite lived intangible assets to a
revised amount.  See Note 3 for a discussion of the impairment of
goodwill and/or trade names during the years ended December 31, 2008, 2007 and
2006.







~ 46
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Warranties




We
generally provide up to twelve months of warranty on our hardware
sales.  We have provided for expected hardware warranty costs based on
our historical experience.  Accrued warranty was $125 and $88 at
December 31, 2008 and 2007, respectively.




Guarantees


In
accordance with FASB Interpretation (“FIN”) No. 45, Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others(“FIN No. 45”), we
recognize the fair value for guarantee and indemnification arrangements issued
or modified by us, if these arrangements are within the scope of the
interpretation.  In addition, we continue to monitor the conditions
that are subject to the guarantees and indemnifications, as required under the
previously existing GAAP, in order to identify if a loss has
occurred.  If we determine it is probable that a loss has occurred,
then any such estimable loss would be recognized under those guarantees and
indemnifications.




Under our
standard Software License, Services and Maintenance Agreement, we agree to
indemnify, defend and hold harmless our licensees from and against certain
losses, damages and costs arising from claims alleging the licensees’ use of our
software infringes the intellectual property rights of a third
party.  Historically, we have not been required to pay material
amounts in connection with claims asserted under these provisions, and,
accordingly, have not recorded a liability relating to such
provisions.  Under our Software License, Services and Maintenance
Agreement, we also represent and warrant to licensees that our software products
operate substantially in accordance with published specifications, and that the
services we perform will be undertaken by qualified personnel in a professional
manner conforming to generally accepted industry standards and
practices.  Historically, only minimal costs have been incurred
relating to the satisfaction of product warranty claims.




Other
guarantees include promises to indemnify, defend and hold harmless each of our
executive officers, non-employee directors and certain key employees from and
against losses, damages and costs incurred by each such individual in
administrative, legal or investigative proceedings arising from alleged
wrongdoing by the individual while acting in good faith within the scope of his
or her job duties on our behalf.  Merge and certain of our former
officers are defendants in several lawsuits which were settled during the year
ended December 31, 2008.  These lawsuits and other legal matters in
which we have become involved are described in Note 9.  We have
accrued for indemnification costs as of December 31, 2008 for certain of
our former officers for their expenses in connection with such matters and may
be required to accrue for additional guarantee related costs in future
periods.




Income
Taxes


On
January 1, 2007, we adopted FIN No. 48,Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement
No. 109 (“FIN No. 48”).  This interpretation
clarifies the accounting for uncertainty in income taxes recognized in an
enterprise’s financial statements in accordance with SFAS No. 109,Accounting for Income Taxes(“SFAS No. 109”).  This
interpretation prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return.  The pronouncement also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosure and transition.  Pursuant to FIN
No. 48, we have recorded any unrecognized tax benefits that are not
expected to be paid within one year as noncurrent.  The impact of
adopting FIN No. 48 had the cumulative effects explained in Note
12.  In May 2007, the FASB issued staff position (“FSP”) FIN
No. 48-1, Definition
of Settlement in FASB Interpretation No. 48 (“FSP FIN
No. 48-1”) which amended FIN No. 48 to provide guidance about how an
enterprise should determine whether a tax position is effectively settled for
the purpose of recognizing previously unrecognized tax
benefits.  Under FSP FIN No. 48-1, a tax position could be
effectively settled through an examination by a taxing
authority.  Since adoption, we have applied FIN No. 48 in a
manner consistent with the provisions of FSP FIN No. 48-1.




As part
of the process of preparing our consolidated financial statements, we are
required to estimate income taxes in each of the jurisdictions in which we
operate.  The provision for income taxes is determined using the asset
and liability approach for accounting for income taxes in accordance with SFAS
No. 109.  A current liability is recognized for the estimated
taxes payable for the current year.  Deferred tax assets and
liabilities are recognized for the estimated future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax
bases.  Deferred tax assets and liabilities are measured using the
enacted tax rates in effect for the year in which the timing differences are
expected to be recovered or settled.  The effect on deferred tax
assets and liabilities of changes in tax rates or tax laws are recognized in the
provision for income taxes in the period that includes the enactment
date.







~ 47
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Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Valuation
allowances are established, when necessary, to reduce deferred tax assets to the
amount more-likely-than-not to be realized.  Changes in valuation
allowances will flow through the statement of operations unless related to
deferred tax assets that expire unutilized or are modified through translation,
in which case both the deferred tax asset and related valuation allowance are
similarly adjusted.  Where a valuation allowance was established
through purchase accounting for acquired deferred tax assets, any future change
outside the measurement period will be credited or charged to income tax expense
under SFAS No. 141(R),Business Combinations (“SFAS No. 141(R)”).  SFAS No. 141(R) is
effective for financial statements issued for fiscal years beginning after
December 15, 2008.




The
determination of our provision for income taxes requires significant judgment,
the use of estimates, and the interpretation and application of complex tax
laws.  We are subject to income taxes in the U.S. and numerous foreign
jurisdictions.  Significant judgment is required in determining our
worldwide provision for income taxes and recording the related tax assets and
liabilities.  In the ordinary course of our business, there are
transactions and calculations for which the ultimate tax determination is
uncertain.  In spite of our belief that we have appropriate support
for all the positions taken on our tax returns, we acknowledge that certain
positions may be successfully challenged by the taxing
authorities.  We apply the provisions of FIN No. 48 to determine the
appropriate amount of tax benefits to be recognized with respect to uncertain
tax positions.  Unrecognized tax benefits are evaluated quarterly and
adjusted based upon new information, resolution with taxing authorities and
expiration of the statute of limitations.  The provision for income
taxes includes the impact of changes in the FIN No. 48
liability.  Although we believe our recorded tax assets and
liabilities are reasonable, tax laws and regulations are subject to
interpretation and inherent uncertainty; therefore, our assessments can involve
both a series of complex judgments about future events and rely on estimates and
assumptions.  Although we believe these estimates and assumptions are
reasonable, the final determination could be materially different than that
which is reflected in our provision for income taxes and recorded tax assets and
liabilities.




Accumulated
Other Comprehensive Income




Foreign
currency translation adjustments and unrealized gains or losses on our
available-for-sale securities, net of applicable taxes, are included in
accumulated other comprehensive income.




The
following are components of accumulated other comprehensive income:




December 31,2008
              
              
              2007Cumulative
      translation adjustment
              
              $
              1,936
              
              
              $
              1,715Net
      unrealized gain (loss) on available-for-sale security
              
              
              (129
              )
              
              
              955Total
      accumulated other comprehensive income
              
              $
              1,807
              
              
              $
              2,670




Revenue
Recognition




Revenues
are derived primarily from the licensing of software, sales of hardware and
related ancillary products, installation and engineering services, training,
consulting, and software maintenance and support.  Inherent to
software revenue recognition are significant management estimates and judgments
in the interpretation and practical application of the complex rules to
individual contracts.  These interpretations generally would not
influence the amount of revenue recognized, but could influence the timing of
such revenues.  Typically, our contracts contain multiple elements,
and while the majority of our contracts contain standard terms and conditions,
there are instances where our contracts contain non-standard terms and
conditions.  As a result, contract interpretation is sometimes
required to determine the appropriate accounting, including whether the
deliverables specified in a multiple-element arrangement should be treated as
separate units of accounting for revenue recognition purposes in accordance with
Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition(“SOP No. 97-2”), or Emerging Issues Task Force (“EITF”) Issue
No. 00-21, Revenue
Arrangements with Multiple Deliverables (“EITF
No. 00-21”), and if so, the relative fair value
that should be allocated to each of the elements and when to recognize revenue
for each element.




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Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




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




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




Revenue
from software licenses sold to end-users and value added resellers is recognized
upon shipment, provided that evidence of an arrangement exists, delivery has
occurred, fees are fixed or determinable and collection of the related
receivable is probable.  We assess collectability based on a number of
factors, including past transaction history with the customer and the credit
worthiness of the customer.  We must exercise our judgment when we
assess the probability of collection and the current credit worthiness of each
customer.  If the financial condition of our customers were to
deteriorate, it could affect the timing and the amount of revenue we recognize
on a contract.  In addition, in certain transactions prior to 2007, we
negotiated with customers a provision that included our receipt of ownership in
the customer’s common stock ownership as part of the sale.  We
generally do not request collateral from customers.




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




Revenue
from sales of Radiology Information Systems (“RIS”), RIS/Picture Archiving and
Communication Systems (“PACS”) solutions and other specific arrangements where
professional services are considered essential to the functionality of the
solution sold, is recognized on the percentage-of-completion method, as
prescribed by AICPA Statement of Position No. 81-1,Accounting for Performance on
Construction-Type and Certain Production-Type
Contracts.  Percentage of completion is determined by the input
method based upon the amount of labor hours expended compared to the total labor
hours expended plus the estimated amount of labor hours to complete the
project.  Total estimated labor hours are based on management’s best
estimate of the total amount of time it will take to complete a
project.  These estimates require the use of judgment.  A
significant change in one or more of these estimates could affect the
profitability of one or more of our contracts.  We review our contract
estimates periodically to assess revisions in contract values and estimated
labor hours, and reflect changes in estimates in the period that such estimates
are revised under the cumulative catch-up method.




Our
Original Equipment Manufacturer (“OEM”) software products are typically fully
functional upon delivery and do not require significant modification or
alteration.  Fees for services to OEM customers are billed separately
from licenses of our software products.  For sales transactions
involving only the delivery of custom engineering services, we recognize revenue
under proportional performance guidelines of SAB No. 104.







~ 49
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





Our
policy is to allow returns when we have preauthorized the
return.  Based on our historical experience of returns and customer
credits, we have provided for an allowance for estimated returns and credits in
accordance with SFAS No. 48, Revenue Recognition When the Right
of Return Exists.




Deferred
revenue is comprised of deferrals for license fees, support and maintenance and
other services.  Long-term deferred revenue as of December 31,
2008 represents license fees, support and maintenance and other services to be
earned or provided beginning January 1, 2010.




We record
reimbursable out-of-pocket expenses in both services and maintenance net sales
and as a direct cost of services and maintenance in accordance with EITF Issue
No. 01-14, Income
Statement Characterization of Reimbursements Received for “Out-of-Pocket”
Expenses Incurred.  In accordance with EITF Issue
No. 00-10, Accounting for
Shipping and Handling Fees, the reimbursement by customers of shipping
and handling costs are recorded in software and other net sales and the
associated cost as a cost of sale.  We account for sales taxes on a
net basis in accordance with EITF No. 06-3, How Sales Taxes Collected from
Customers and Remitted to Governmental Authorities Should be Presented in the
Income Statement (That Is, Gross Versus Net Presentation).






Share-Based
Compensation


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




We
adopted SFAS No. 123(R) using the modified-prospective-transition
method.  Under that transition method, compensation cost includes:
(1) compensation cost for all share-based awards granted prior to, but not
yet vested as of January 1, 2006, based on the grant-date fair value
estimated in accordance with the original provisions of SFAS No. 123, and
(2) compensation cost for all share-based awards granted subsequent to
January 1, 2006, based on the grant-date fair value estimated in accordance
with the provisions of SFAS No. 123(R).  SFAS
No. 123(R) requires that we report the tax benefit from the tax
deduction related to share-based compensation that is in excess of recognized
compensation costs, as a financing cash flow rather than as an operating cash
flow in our consolidated statements of cash flows.






Recent
Accounting Pronouncements


In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities – Including an Amendment of FASB Statement
No. 115 (“SFAS No. 159”), which is effective for fiscal years
beginning after November 15, 2007.  This statement permits
entities to choose to measure many financial instruments and certain other items
at fair value.  This statement also establishes presentation and
disclosure requirements designed to facilitate comparisons between entities that
choose different measurement attributes for similar types of assets and
liabilities.  Unrealized gains and losses on items for which the fair
value option is elected would be reported in earnings.  We have
adopted SFAS No. 159 and have elected not to measure any additional financial
instruments and other items at fair value.




On
December 4, 2007, the FASB issued SFAS No. 141(R) which replaces
SFAS No. 141,Business
Combinations, and applies to all transactions or other events in which an
entity obtains control of one or more businesses.  SFAS No.
141(R) requires the acquiring entity in a business combination to recognize all
(and only) the assets acquired and liabilities assumed in the transaction;
establishes the acquisition-date fair value as the measurement objective for all
assets acquired and liabilities assumed; and requires the acquirer to disclose
additional information needed to evaluate and understand the nature and
financial effect of the business combination.  In addition, under SFAS
No. 141(R), changes in deferred tax asset valuation allowances and acquired
income tax uncertainties in a business combination after the measurement period
will impact income tax expense.  SFAS No. 141(R) is
effective prospectively for fiscal years beginning after December 15, 2008
and may not be applied before that date.  The impact of SFAS No.
141(R) on our financial position and results of operations will be dependent
upon the extent to which we have transactions or events occur that are within
its scope.







~ 50
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 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





In
February 2008, FASB issued Staff Position FAS No. 157-2 which provides for a
one-year deferral of the effective date of SFAS No. 157 for non-financial assets
and liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis, except those that are recognized or
disclosed at fair value in the financial statements on a recurring
basis.  We are evaluating the impact of SFAS No. 157 as it relates to
our financial position and results of operations.




In March
2008, the FASB issued SFAS No. 161, Disclosures
about Derivative Instruments and Hedging Activities(“SFAS No. 161”).SFAS No. 161 is intended to improve financial reporting about derivative
instruments and hedging activities by requiring enhanced disclosures to enable
investors to better understand the effects on an entity’s financial position,
financial performance, and cash flows.  It is effective for financial
statements issued for fiscal years and interim periods beginning after
November 15, 2008.  We expect to adopt SFAS No. 161 and its
required disclosures, in our consolidated financial statements for the fiscal
year beginning January 1, 2009.




In April
2008, the FASB issued FSP FAS No. 142-3,Determination of the Useful Life of Intangible Assets(“FSP No.
142-3”).FSP
No. 142-3 amends the factors that should be considered in developing renewal or
extension assumptions used to determine the useful life of a recognized
intangible asset under SFAS No. 142.  The
intent of FSP No. 142-3 is to improve the consistency between the useful life of
a recognized intangible asset under SFAS No. 142 and the period of expected cash
flows used to measure the fair value of the asset under SFAS No. 141(R),
and other U.S. GAAP.  FSP No. 142-3 is effective for our interim and
annual financial statements beginning after November 15,
2008.  We do not expect the adoption of FSP No. 142-3 will have a
material impact on our financial position or results of operations.




In
October 2008, the FASB issued FASB Staff Position FAS No. 157-3, Determining
the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active (“FSP No. 157-3”).  FSP No. 157-3 clarified
the application of SFAS No. 157.  FSP No. 157-3 demonstrated
how the fair value of a financial asset is determined when the market for that
financial asset is inactive.  FSP No. 157-3 was effective upon
issuance, including prior periods for which financial statements had not been
issued.  The implementation of this standard did not have a material
impact on our financial position or results of operations.  See Note 5
for information and related disclosures regarding the fair value
measurements.




(2) Accounts
Receivable




Substantially
all receivables are derived from sales and related services, support and
maintenance of our products to healthcare providers located throughout the U.S.
and in certain foreign countries as indicated in Note 15.




Our
accounts receivable balance is reported net of an allowance for doubtful
accounts and an allowance for sales returns.  We provide for an
allowance for estimated uncollectible accounts and sales returns based upon
historical experience and management’s judgment.  As of December 31,
2008 and 2007, the allowance for estimated uncollectible accounts and sales
returns was $1,378 and $2,209, respectively.




The
following table shows the changes in our allowance for doubtful accounts and
sales returns.




Description
              
              Balance
      at beginning of period
              
              
              Additions
      due to acquisitions
              
              
              Additions
      charged to revenue and expenses
              
              
              Deductions
              
              
              Balance
      at end of periodFor
      year ended December 31, 2008:Allowance for doubtful accounts and sales returns
              
              $
              2,209
              
              
              $
              -
              
              
              $
              316
              
              
              $
              (1,147
              )
              
              $
              1,378For
      year ended December 31, 2007:Allowance for doubtful accounts and sales returns
              
              $
              2,553
              
              
              $
              -
              
              
              $
              1,100
              
              
              $
              (1,444
              )
              
              $
              2,209For
      year ended December 31, 2006:Allowance for doubtful accounts and sales returns
              
              $
              2,222
              
              
              $
              -
              
              
              $
              829
              
              
              $
              (498
              )
              
              $
              2,553









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Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





(3) Goodwill,
Trade Names and Intangible Assets




Our
intangible assets, other than capitalized software development costs, and
accumulated amortization are summarized as of December 31, 2008 and 2007 as
follows:




Weighted-Average
              
              December
      31, 2008
              
              December
      31, 2007Remaining
      Amortization Period (Years)
              
              Gross
      Carrying Amount
              
              Accumulated
      Amortization
              
              Gross
      Carrying Amount
              
              Accumulated
      AmortizationPurchased
      technology
              
              
              2.4
              
              
              $
              11,424
              
              
              $
              (6,888
              )
              
              $
              12,571
              
              
              $
              (5,518
              )Customer
      relationships
              
              
              2.4
              
              
              
              3,550
              
              
              
              (1,259
              )
              
              
              3,550
              
              
              
              (259
              )Total
              
              
              
              
              
              $
              14,974
              
              
              $
              (8,147
              )
              
              $
              16,121
              
              
              $
              (5,777
              )




We evaluate the realizibility of our
purchased and capitalized software development costs according to SFAS No.
86.  Purchased software amortization expense and patent amortization
expense, which are being recorded in amortization and related impairment cost of
sales over the life of the related intangible asset, was $2,517 and $3,938 and
$3,012 for the years ended December 31, 2008, 2007 and 2006,
respectively.  Included within the expense are purchased software
impairment charges of $398 and $1,091 during the years ended December 31, 2008
and 2007, respectively, as a result of our net realizable value analysis
associated with certain product lines.  Customer relationships, which
is being amortized over the life of the related intangible asset in
depreciation, amortization and impairment included in operating costs and
expenses, was $1,000, $6,220 and $2,287 for the years ended December 31, 2008,
2007 and 2006, respectively.  Included within the customer intangible
expense for the year ended December 31, 2007 is an impairment charge of
$4,252.




Estimated
aggregate amortization expense for purchased software and customer relationships
for the remaining periods is as follows:




For
      the year ended December 31:
              2009
              
              
              2,8252010
              
              
              2,8252011
              
              
              1,177




As of
December 31, 2008, we had gross capitalized software development costs of $6,813
and accumulated amortization of $5,696.  The weighted average
remaining amortization period of capitalized software development costs was 1.6
years as of December 31, 2008.  During the years ended December 31,
2008, 2007 and 2006, we capitalized software development costs of zero, $817 and
$2,257, respectively.  Amortization expense, including impairments,
related to capitalized software development costs of $762, $4,599 and $2,520 was
recorded in amortization and related impairment cost of sales during the years
ended December 31, 2008, 2007 and 2006, respectively.  Impairment of
capitalized software development cost of zero, $3,470 and $982 was recorded
during the years ended December 31, 2008, 2007 and 2006, respectively, as a
result of our net realizable value analysis associated with certain projects
(some of which were still in development at the time of impairment) or as we no
longer anticipated future sales of certain products.




On June
4, 2008, we announced that we were renaming our business units.  As a
result of this action, the Cedara trade name was impaired.  We
recorded a charge of $1,060 during the second quarter of 2008 in trade name
impairment, restructuring and other expense within our consolidated statement of
operations.




During
the years ended December 31, 2007 and 2006, several material events occurred
that resulted in an environment of uncertainty surrounding Merge, and diverted
the attention of certain board members and management from our business
operations for periods of time.  This uncertainty lead us to question
whether we might not be able to recover the intangible assets’ carrying amounts
or that the fair value of our single reporting unit did not support the carrying
value of goodwill.




In accordance with SFAS
No. 144, we evaluated whether or not the circumstances indicated that the
carrying amounts of our property and equipment and customer relationships were
recoverable, based primarily on whether future undiscounted cash flows were
sufficient to support the asset’s recovery.  Also, in accordance with
SFAS No. 142, we performed Step I of the impairment test by estimating fair
value based on a discounted cash flow model.  The
results of Step I of the impairment test indicated that an impairment of our
goodwill had occurred during the years ended December 31, 2007 and 2006, since
the carrying value of our single reporting unit exceeded the reporting unit’s
estimated fair value.  In addition, we also tested our other
indefinite lived intangible asset, trade names, as part of Step I, and concluded
that certain trade names were impaired during the year ended December 31,
2007.  We completed Step II of SFAS No. 142 to measure the amount of
impairment loss relating to goodwill, by comparing the implied fair value of our
reporting unit goodwill with the carrying amount of that
goodwill.  The estimate of fair value of our reporting unit was
reduced by the fair value of all other net assets to determine the implied fair
value of reporting unit goodwill.  During the years ended December 31,
2007 and 2006, the Audit Committee of our Board of Directors determined that
there was an impairment to certain of these assets.   We completed
these assessments of fair value utilizing the assistance of independent
valuation specialists.  As a result of these analyses, we recorded the
following impairment charges during the years ended December 31, 2007 and
2006:




~ 52
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Statement
      of Operations ClassificationAsset
      Impaired
              
              Cost
      of Sales
              
              
              Operating
      Costs and Expenses
              
              
              TotalYear
      ended December 31, 2007Purchased
      software
              
              $
              1,091
              
              
              $
              -
              
              
              $
              1,091Capitalized
      software
              
              
              3,470
              
              
              
              -
              
              
              
              3,470Patents
              
              
              133
              
              
              
              -
              
              
              
              133Customer
      relationships
              
              
              -
              
              
              
              4,252
              
              
              
              4,252Trade
      names
              
              
              -
              
              
              
              800
              
              
              
              800Goodwill
              
              
              -
              
              
              
              122,371
              
              
              
              122,371Total
              
              $
              4,694
              
              
              $
              127,423
              
              
              $
              132,117Year
      ended December 31, 2006Capitalized
      software
              
              $
              982
              
              
              $
              -
              
              
              $
              982Trade
      names
              
              
              -
              
              
              
              6,685
              
              
              
              6,685Goodwill
              
              
              -
              
              
              
              214,095
              
              
              
              214,095Total
              
              $
              982
              
              
              $
              220,780
              
              
              $
              221,762




(4) Other
Long-Lived Assets




On April
11, 2008, we signed an agreement to sell our French subsidiary, Merge Healthcare
France SARL, to local management for no cash consideration.  A loss on
the disposition of the French subsidiary of $1,639 was recognized in the
consolidated statement of operations in trade name impairment, restructuring and
other expense during the year ended December 31, 2008.  This
transaction did not meet the accounting requirements for classification as a
discontinued operation and, therefore, was accounted for as a disposal under
SFAS No. 144.




On August
29, 2008, we sold our Cedara Software Services (India) Private Limited
subsidiary (“CSSI”) located in India for $700.  Included in the sale
were fixed assets with a gross value of $506, and accumulated depreciation of
$90 as of August 29, 2008.  We received cash of $499 (net of fees) at
closing, with the remaining $200 placed in escrow for one year to cover any
remaining liabilities and expenses.  This transaction did not meet the
accounting requirements for classification as a discontinued operation and,
therefore, was accounted for as a disposal under SFAS No. 144.




In
addition, we recorded a $542 charge in depreciation, amortization and impairment
within our consolidated statement of operations during the second quarter of
2008 based on the fair value of certain fixed assets that were held for
sale.  These assets were disposed as of December 31,
2008.




(5) Fair
Value Measurement




On
January 1, 2008, we adopted the methods of fair value as described in SFAS No.
157 to value our financial assets and liabilities.  SFAS No. 157
establishes a three-tier value hierarchy, which prioritizes the inputs used in
measuring fair value.  These tiers include: Level 1, defined as
observable inputs such as quoted prices in active markets; Level 2, defined as
inputs other than quoted prices in active markets that are directly or
indirectly observable; and Level 3, defined as unobservable inputs in which
little or no market data exists, therefore requiring an entity to develop its
own assumptions.  In determining fair value, we utilize techniques
that maximize the use of observableinputs and minimize the
use of unobservable inputs to the extent possible.   In
calculating potential impairment losses, we evaluate the fair value of
investments by comparing them to certain public company metrics such as revenue
multiples, information obtained from independent valuations, and inquiries and
estimates made by us.  Financial assets (non-current investments)
carried at fair value as of December 31, 2008 are classified in one of three
categories as follows:





~ 53
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Level
      1
              
              
              Level
      2
              
              
              Level
      3
              
              
              TotalInvestment
      in publicly traded equity securities
              
              $
              318
              
              
              $
              -
              
              
              $
              -
              
              
              $
              318Investments
      in equity securities of private companies
              
              
              -
              
              
              
              -
              
              
              
              5,372
              
              
              
              5,372Total
              
              $
              318
              
              
              $
              -
              
              
              $
              5,372
              
              
              $
              5,690




The change in the fair value of Level 3 securities in 2008 is primarily due to
the decrease in revenue multiples of comparable public companies, and is as
follows:




2008Balance
      at January 1
              
              $
              6,807Transfer
      in
              
              
              -Impairment
      charge
              
              
              (1,435
              )Balance
      at December 31
              
              $
              5,372




(6) Financing and
Other Transactions with Related Party




On June
4, 2008, we completed a private placement pursuant to which we raised net
proceeds of $16,639 ($20,000 less issuance costs of $2,386 and prepaid interest
for two quarters totaling $975) through a securities purchase agreement with
Merrick, an affiliate of Merrick Ventures, LLC ("Merrick Ventures"), which was
executed on May 21, 2008.  Based on the terms of the private
placement, we received $20,000 from Merrick in exchange for a $15,000 senior
secured term note (the “Note”) due June 4, 2010 and 21,085,715 shares of our
Common Stock.  The Note bears interest at 13.0% per annum, payable
quarterly in arrears.  On closing of the private placement, we were
required to prepay the first two interest payments totaling $975.  We
also incurred $2,386 of issuance costs, including a $750 closing fee paid to
Merrick.




The Note
contains various operating and financial covenants, including a requirement that
we have positive adjusted EBITDA for the last fiscal quarter of 2008 and
cumulatively thereafter through the term of the Note.  The Note also
contains default provisions including, but not limited to, failure to pay,
breach of financial or operating covenants, and bankruptcy or
insolvency.  The Note is a senior secured obligation, will be senior
to any existing and future indebtedness and is secured by all of our U.S. and
Canadian assets.




Merrick
may require us to redeem the Note in full if a change of control
occurs.  If the change of control results in the payment of
consideration to our shareholders equal to or exceeding $1.75 per share, the
redemption price of the Note would be at par.  If such consideration
is less than $1.75 per share, the redemption price would be 120% of par if the
change of control occurs within one year of the closing date, or 118% of par if
the change of control occurs anytime thereafter.  In addition, upon an
event of default, as defined in the Note, the interest rate will increase to
18.5% and Merrick will have the right to require us to redeem the Note at 120%
of its principal amount.  All payments due to Merrick upon redemption
shall be in addition to all accrued but unpaid interest and accrued but unpaid
late charges relating thereto.  The Note may also be voluntarily
prepaid at 120% of par at any time.




In
accordance with SFAS No. 133, the change of control and default provisions
are considered put options which are derivative instruments and are required to
be bifurcated from the debt instrument and accounted for
separately.  The fair value of these options is recorded as long-term
liabilities and changes in the fair value of these liabilities will be recorded
in the condensed consolidated statement of operations.




The fair
values of the equity, Note and put options were determined utilizing the
assistance of independent valuation specialists.  The fair value of
the two put options is $31 as of December 31, 2008.  The proceeds of
$20,000 were reduced by the value of the put options and remaining amount was
allocated to the equity and Note based on the relative fair value of each
instrument.  In addition, the transaction costs of $2,386 were
allocated to the equity and Note using the same relative fair value
allocation.  The closing fees due Merrick were treated as a reduction
of proceeds, and as such, a portion of the closing fees was included as a
discount on the Note.







~ 54
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




We
recorded a note payable of $13,945 and equity of $4,825 (net of related issuance
costs of $654) upon completion of the financing transaction.  The note
discount of $1,055 (of which $545 relates to closing fees due Merrick) and
financing costs of $1,187 (which were recorded as a long-term asset) are being
amortized using the effective interest method at a rate of approximately 21.13%
over the term of the Note.  During the year ended December 31, 2008,
we recorded interest expense of $1,742, including amortization of financing
costs of $319 and amortization of note discount of $285.  As of
December 31, 2008, there was no change in the value of the put option
liabilities.




The
private placement was made pursuant to an exemption from the registration
requirements under the Securities Act of 1933, as amended.  We also
entered into a registration rights agreement in connection with the private
placement pursuant to which we have agreed to register the Common Stock with the
Securities and Exchange Commission for public resale under certain
circumstances.




In
connection with the private placement, Merrick was entitled to designate five
individuals to replace five of the eleven then current directors on our Board of
Directors, which occurred on the closing of the private placement.  We
also agreed that Merrick will continue to have the right to designate five
individuals to be nominated for election to the Board of Directors in the
future, subject to reduction of such designated individuals upon a decrease in
Merrick’s ownership percentage.  As of December 31, 2008, there is no
limit to the number of shares of our Common Stock that Merrick and its
affiliates, including Michael W. Ferro, Jr., Chairman and CEO of Merrick
Ventures, who is also Chairman of our Board of Directors, can
purchase.  As of December 31, 2008, Merrick and its affiliates owned
approximately 49.9% of our Common Stock.




Effective
January 1, 2009, we entered into a one year consulting agreement with Merrick,
which either party may voluntarily terminate with 90 days advance
notice.  The consulting agreement allows us to take advantage of
certain services offered by Merrick including, but not limited to, investor
relations, financial analysis and strategic planning.  We will pay
Merrick $100 per quarter, as well as reimburse Merrick for actual and reasonable
business expenses incurred.  The Board of Directors, pursuant to a
recommendation by the Audit Committee, approved the consulting agreement (with
Michael W. Ferro, Jr. abstaining from the vote).




(7) Shareholders’
Equity




Common
Stock Repurchase Plan




On
September 6, 2006, Merge announced a stock repurchase plan providing for
the purchase of up to $20,000 of our Common Stock over a two-year
period.  This repurchase plan expired on September 6, 2008, and we did
not make any repurchases under the plan.




Series 3
Special Voting Preferred Stock




In
June 2005, Merge issued one share of Series 3 Special Voting Preferred
Stock to Computershare Trust Company of Canada, which serves as a trustee in
voting matters on behalf of the holders of Merge Cedara ExchangeCo Limited
(“ExchangeCo”) exchangeable shares.  As of December 31, 2008,
this share was issued and outstanding.




Series B
Junior Participating Preferred Stock




On
September 6, 2006, Merge announced the implementation of a Shareholder
Rights Plan.  The Shareholder Rights Plan includes the declaration of
a dividend of one preferred share purchase right on each outstanding share of
our Common Stock and the distribution of one such right with respect to each
outstanding exchangeable share of our subsidiary, ExchangeCo.  The
adoption of the plan was intended to discourage discriminatory, coercive or
unfair take-over bids and to provide the Board of Directors time to pursue
alternatives to maximize shareholder value in the event of an unsolicited
take-over bid.  The rights become exercisable upon certain triggering
events caused by a third party, person or group.  Merge may redeem the
rights for $0.001 per right.




On June
12, 2008, we announced the redemption of all preferred share purchase rights
outstanding.  As provided for in the plan, we redeemed the rights for
$0.001 per right.  As a result, shareholders of record on June 23,
2008 received a dividend payment (in the third quarter of 2008) totaling $57 and
this plan is no longer in effect.







~ 55
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)


Exchangeable
Shares




As part
of our business combination with Cedara Software Corp. (“Cedara”) in June 2005,
Merge issued 5,581,517 shares of our Common Stock to the shareholders of Cedara
and granted rights for the issuance of 13,210,168 shares of Common Stock to
shareholders of Cedara that held ExchangeCo exchangeable shares.  The
exchangeable shares are exchangeable on a one-for-one basis for our Common
Stock.  As of December 31, 2008, there were 805,295 exchangeable
shares outstanding.  We have the right to redeem all of the
exchangeable shares at anytime after April 29, 2010 or if less than 10% of
the number of exchangeable shares issued on the effective date of the business
combination remain outstanding, provided that we give sixty days advance written
notice.  On February 13, 2009, we exercised our call right regarding
redemption of the outstanding exchangeable shares, which will occur on April 15,
2009.




(8) Share-Based
Compensation




The
following table summarizes share-based compensation expense related to
share-based awards subject to SFAS No. 123(R) recognized during the
years ended December 31, 2008, 2007 and 2006:




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Share-based
      compensation expense included in the statement of
    operations:Services
      and maintenance (cost of sales)
              
              $
              81
              
              
              $
              414
              
              
              $
              542Sales
      and marketing
              
              
              443
              
              
              
              1,188
              
              
              
              1,047Product
      research and development
              
              
              401
              
              
              
              1,071
              
              
              
              1,186General
      and administrative
              
              
              1,266
              
              
              
              2,336
              
              
              
              3,136Goodwill
      and trade name impairment, restructuring and other
expenses
              
              
              1,970
              
              
              
              -
              
              
              
              -Total
              
              
              4,161
              
              
              
              5,009
              
              
              
              5,911Tax
      benefit
              
              
              -
              
              
              
              -
              
              
              
              1,368Share-based
      compensation expense, net of tax
              
              $
              4,161
              
              
              $
              5,009
              
              
              $
              4,543




There is
a difference between the above amounts and the total amount of share-based
compensation in 2007 and 2006.  These differences were recorded in
additional paid-in capital in the statement of shareholders’ equity during the
years ended December 31, 2007 and 2006 of $14 and $50,
respectively.  These differences are attributed to share-based
compensation incurred by product research and development personnel (who worked
on capitalizable software development projects during these periods).  Such
costs were included in capitalized developed software costs,  and
therefore, not included in expenses recorded in the statements of
operations.




The
$1,970 of expense recorded during the year ended December 31, 2008 relates to
the acceleration of certain stock options and restricted stock for certain
former officers as outlined in the respective individual’s employment agreement
or restricted stock purchase agreement.  In addition, these
individuals, as of their respective separation dates, agreed to voluntarily
forfeit any unexercised vested stock options.




Share-Based
Compensation Plans




We
maintain four share-based employee compensation plans, including our employee
stock purchase plan (“ESPP”), and one director option plan under which we grant
restricted stock awards and options to acquire shares of our Common Stock to
certain employees, non-employees, non-employee directors and to existing stock
option holders in connection with the consolidation of option plans following an
acquisition.




Our 2005
Equity Incentive Plan (“EIP”) provides for awards of Common Stock, non-statutory
stock options, incentive stock options, stock unit and performance unit grants
and stock appreciation rights to eligible participants to equate to a maximum of
10.5 million shares of our Common Stock, of which incentive stock option
grants are limited to 5.0 million shares.  Under the EIP, new stock
option grants have an exercise price equal to the fair market value of our
Common Stock at the date of grant with the exception of the options granted in
2005 to replace existing Cedara options (“Replacement Options”).  The
Replacement Options, which we granted pursuant to a merger agreement with
Cedara, had the same economic terms as the Cedara options that they replaced, as
adjusted for the conversion ratio and currency.  The majority of the
options issued under the EIP vest over a three or four-year
period.  As of December 31, 2008, incentive stock options to
purchase 236,250 shares of our Common Stock, non-statutory stock options to
purchase 4,269,850 shares of our Common Stock and restricted stock awards of
479,997 were outstanding under this plan.







~ 56
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Upon
approval of the EIP, we stated that we did not plan to issue any more options
under our other stock option plans.  Our 1996 Employee Stock Option
Plan provided for the grant of options to purchase a maximum of 3,265,826 shares
of our Common Stock.  Our 1998 Director Stock Option Plan, for our
non-employee directors, provided for the granting of options to purchase a
maximum of 300,000 shares of our Common Stock.  In addition, our
Board of Directors adopted an equity compensation plan in connection with our
acquisition on July 17, 2003 of RIS Logic.  As of
December 31, 2008, options to purchase 190,474 shares of our Common Stock
were outstanding under these plans.




Stock
Options




We use
the Black-Scholes option pricing model to estimate the fair value of stock
option awards on the date of grant utilizing the assumptions noted in the
following table.  We expense the cost of stock option awards on a
straight-line basis over the vesting period.  Expected volatilities
are based on the historical volatility of our stock and other
factors.  We use historical data to estimate option exercises and
employee terminations within the valuation model.  The expected term
of options represents the period of time that options granted are expected to be
outstanding.  The risk-free rate for periods during the contractual
life of the option is based on the U.S. Treasury rates in effect at the grant
date.





Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Dividend
      yield
              
              
              0
              %
              
              
              0
              %
              
              
              0
              %Expected
      volatility
              
              
              60%
      - 100
              %
              
              
              55%
      - 65
              %
              
              
              50%
      - 60
              %Risk-free
      interest rate
              
              
              1.6%
      - 3.2
              %
              
              
              4.2%
      - 4.9
              %
              
              
              4.3%
      - 4.8
              %Expected
      term (in years)
              
              
              4.0
              
              
              
              3.5
      - 4.0
              
              
              
              3.5
      - 4.0Weighted-average
      grant date fair value
              
              $
              0.65
              
              
              $
              3.91
              
              
              $
              3.98




The
assumptions above are based on multiple factors, including the historical
exercise patterns of employees in relatively homogeneous groups with respect to
exercise and post-vesting employment termination behaviors, expected future
exercise patterns for these same homogeneous groups, and the volatility of our
stock price.  SFAS No. 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates.


At
December 31, 2008, there was $2,834 of unrecognized compensation cost
related to stock option share-based payments.  We expect this
compensation cost to be recognized over a weighted-average period of 2.8
years.




Stock
option activity for the year ended December 31, 2008, was as
follows:




Weighted-AverageRemainingNumber
              
              
              Weighted-
              
              
              Contractual
              
              
              Aggregateof
              
              
              Average
              
              
              Term
              
              
              IntrinsicOptions
              
              
              Exercise Price
              
              
              (In Years)
              
              
              ValueOptions
      outstanding, December 31, 2007
              
              
              4,081,060
              
              
              $
              8.52
              
              
              
              4.8
              
              
              $
              1Options
      granted
              
              
              2,950,000
              
              
              
              1.07Options
      exercised
              
              
              -
              
              
              
              -Options
      forfeited and expired
              
              
              (2,334,486
              )
              
              
              8.17Options
      outstanding, December 31, 2008
              
              
              4,696,574
              
              
              $
              4.01
              
              
              
              6.2
              
              
              $
              894Options
      exercisable, December 31, 2008
              
              
              1,352,778
              
              
              $
              9.04
              
              
              
              4.0
              
              
              $
              18Options
      exercisable, December 31, 2007
              
              
              1,831,917
              
              
              $
              10.08
              
              
              
              4.6
              
              
              $
              1Options
      exercisable, December 31, 2006
              
              
              1,382,857
              
              
              $
              10.60
              
              
              
              4.8
              
              
              $
              697







~ 57
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Other
information pertaining to option activity was as follows:




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Total
      fair value of stock options vested
              
              $
              5,384
              
              
              $
              3,155
              
              
              $
              7,289Total
      intrinsic value of stock options exercised
              
              $
              -
              
              
              $
              108
              
              
              $
              1,446




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




Options Outstanding
              
              
              Options ExercisableWeighted-averageremaining
              
              
              Weighted-
              
              
              
              
              
              Weighted-Number of
              
              
              contractual life
              
              
              average
              
              
              Number of
              
              
              averageRange of exercise prices
              
              
              shares
              
              
              in years
              
              
              exercise price
              
              
              shares
              
              
              exercise price$
              0.57
      – $0.68
              
              
              
              1,400,000
              
              
              
              6.1
              
              
              $
              0.65
              
              
              
              25,000
              
              
              $
              0.57$
              1.03
      – $1.47
              
              
              
              1,547,500
              
              
              
              9.2
              
              
              
              1.46
              
              
              
              157,500
              
              
              
              1.46$
              3.75
      – $6.01
              
              
              
              608,855
              
              
              
              3.8
              
              
              
              5.08
              
              
              
              311,259
              
              
              
              5.15$
              6.24
      – $9.78
              
              
              
              677,808
              
              
              
              3.8
              
              
              
              6.84
              
              
              
              422,433
              
              
              
              6.96$
              12.96
      – $24.88
              
              
              
              462,411
              
              
              
              2.5
              
              
              
              17.21
              
              
              
              436,586
              
              
              
              17.064,696,574
              
              
              
              6.2
              
              
              $
              4.01
              
              
              
              1,352,778
              
              
              $
              9.04


Restricted
Stock Awards




We have
also granted restricted stock awards to employees under the EIP.  A
restricted stock award is an award of shares of our Common Stock that is subject
to time-based vesting during a specified period, which is generally three
years.  Restricted stock awards are independent of option grants and
may be subject to forfeiture if employment terminates prior to the vesting of
the awards.  Participants have full voting and dividend rights with
respect to shares of restricted stock.




We
expense the cost of the restricted stock awards, which is determined to be the
fair market value of the restricted stock awards at the date of grant, on a
straight-line basis over the vesting period.  For these purposes, the
fair market value of the restricted stock award is determined based on the
closing price of our Common Stock on the grant date.




The
following table presents a summary of the activity of our restricted stock
awards:




Weighted-AverageNumber
              
              
              Weighted-Average
              
              
              Remaining
                Vestingof
              
              
              Grant-date
              
              
              TermShares
              
              
              Fair
      Value
              
              
              (In Years)Restricted
      stock outstanding, December 31, 2007
              
              
              1,699,995
              
              
              $
              1.50
              
              
              
              2.9Restricted
      stock granted
              
              
              92,500
              
              
              
              0.95Restricted
      stock vested
              
              
              (1,282,498
              )
              
              
              1.48Restricted
      stock forfeited
              
              
              (30,000
              )
              
              
              0.48Restricted
      stock outstanding, December 31, 2008
              
              
              479,997
              
              
              $
              1.50
              
              
              
              1.9




For the
year ended December 31, 2008 the expense for restricted stock awards
included in the consolidated statements of operation was $2,081.  As
of December 31, 2008, there was $435 of unrecognized compensation cost
related to restricted stock award share-based payments.  We expect
this compensation cost to be recognized over a weighted-average period of 1.9
years.







~ 58
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




Employee
Stock Purchase Plan




We
maintain an ESPP that allows eligible employees to purchase shares of our Common
Stock through payroll deductions of up to 10% of eligible compensation on an
after-tax basis.  The eligible employees receive a 5% discount from
the market price at the end of each calendar quarter.  There is no
stock-based compensation expense associated with our ESPP.




Employees
contributed $100, $88, and $33 during the years ended December 31, 2008, 2007,
and 2006, respectively, to purchase shares of our Common Stock under the
employee stock purchase plan.




(9) Commitments
and Contingencies




Between
March 22, 2006 and April 26, 2006, seven putative securities class action
lawsuits were filed in the U.S. District Court for the Eastern District of
Wisconsin, on behalf of a class of persons who acquired shares of our Common
Stock between August 2, 2005 and March 16, 2006.  On November 22,
2006, the Court consolidated the seven cases, appointed the Southwest Carpenters
Pension Trust to be the lead plaintiff and approved the Trust’s choice of its
lead counsel.  The lead plaintiff filed a consolidated amended
complaint on March 21, 2007.  Defendants in the suit included us,
Richard A. Linden, our former President and Chief Executive Officer, Scott T.
Veech, our former Chief Financial Officer, David M. Noshay, our former Senior
Vice President of Strategic Business Development, and KPMG LLP, our independent
public accountants at the time.  The consolidated amended complaint
arose out of our restatement of financial statements, as well as our
investigation of allegations made in anonymous letters received by
us.  The lawsuits allege that we and the other defendants violated
Section 10(b) and that the individuals violated Section 20(a) of the Securities
Exchange Act of 1934, as amended.  The consolidated amended complaint
seeks damages in unspecified amounts.  The defendants filed motions to
dismiss.  On March 31, 2008, the motions to dismiss us, Mr. Linden and
Mr. Veech were denied, and the motions to dismiss Mr. Noshay and KPMG were
granted without prejudice.  On April 30, 2008, we entered into an
agreement in principle with the plaintiff in the consolidated securities class
action suits filed against us.  The agreement in principle provided
for the settlement, release and dismissal of all claims asserted against Merge
and the individual defendants in the litigation.  In exchange, we
agreed to a one time cash payment of $3,025 to the plaintiff and our primary and
one of our excess directors and officers insurance carriers agreed to a one time
cash payment of $12,975 to the plaintiff, for a total payment of
$16,000.  Our costs were accrued as of June 30, 2008, as payment was
contingent upon completion of a financing transaction, and were recorded as a
general and administrative expense.  The settlement amounts were paid
into escrow in July 2008.  The proposed settlement was preliminarily
approved on July 15, 2008 and was dismissed with prejudice following settlement
in November 2008.  There was no admission of wrongdoing or liability
by the defendants in the settlement.




On August
28, 2006, a derivative action was filed in the
Circuit Court of Milwaukee County, Civil Division, against
Messrs. Linden and Veech, William C. Mortimore (our founder, former Chairman and
Chief Strategist, who served as our interim Chief Executive Officer from May 15,
2006 to July 2, 2006) and all of the then-current members of our Board of
Directors.  The plaintiff filed an amended complaint on June 26, 2007,
adding Mr. Noshay as a defendant.  The plaintiff alleged that (a) each
of the individual defendants breached fiduciary duties owed to us by violating
generally accepted accounting principles, willfully ignoring problems with
accounting and internal control practices and procedures and participating in
the dissemination of false financial statements; (b) we and the director
defendants failed to hold an annual meeting of shareholders for 2006 in
violation of Wisconsin law; (c) Directors Barish, Geras and Hajek violated
insider trading prohibitions and that they misappropriated material non-public
information; (d) a claim of corporate waste and gift against Directors Hajek,
Barish, Reck, Dunham and Lennox, members of the Compensation Committee at the
time of the restatement; and (e) claims of unjust enrichment and insider selling
against Messrs. Linden, Veech, Noshay and Mortimore.  The plaintiff
asked for unspecified amounts in damages and costs, disgorgement of certain
compensation and profits against certain defendants as well as equitable
relief.  In response to the filing of this action, our Board of
Directors formed a Special Litigation Committee, which Committee was granted
full authority to investigate the allegations of the derivative complaint and
determine whether pursuit of the claims against any or all of the individual
defendants would be in our best interest.  On March 3, 2008, the
parties to this derivative action entered into a Memorandum of Understanding
providing for the settlement of all claims asserted in the
case.  Under the terms of the settlement, the Board of Directors has
agreed to pay fees and expenses of plaintiff’s counsel of $250.  These
costs were accrued as of December 31, 2007 and were paid in July
2008.  The proposed settlement was preliminarily approved on April 17,
2008 with final approval on June, 27, 2008.  As a result of this
settlement, the Special Litigation Committee was dissolved by the Board of
Directors on August 19, 2008.  There was no admission of wrongdoing or
liability by the defendants in the settlement.







~ 59
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




In March
2008, we received $1,050 from our primary directors and officers liability
insurance carrier for reimbursement of legal expenses in connection with the
class action and derivative action against Merge and some of its current and
former directors and officers.  This reimbursement was recorded as a
credit to general and administrative expense.  We do not anticipate
that additional funds will be collected from the insurance carriers related to
these defense costs.




On April
27, 2006, Merge received an informal, non-public inquiry from the SEC requesting
voluntary production of documents and other information.  The inquiry
principally related to our announcement, on March 17, 2006, that we would
investigate allegations of improprieties related to financial reporting and
revise our results of operations for the fiscal quarters ended June 30, 2005,
and September 30, 2005.  On July 10, 2007, SEC Staff advised us that
the SEC had issued a formal order of investigation in this
matter.  Merge is cooperating fully with the SEC.  The SEC
Staff has informed Merge that the Staff is considering recommending an
injunctive or cease and desist order against Merge prohibiting violations of the
reporting, record-keeping, and internal control provisions under the Securities
Exchange Act of 1934.  The Staff did not inform us that it is
considering recommending any monetary sanctions against us.  However,
the matter has not yet been finally resolved, and, until such final resolution,
we will continue to incur expenses, including legal fees and other costs, in
connection with the SEC’s investigation.




In
addition to the matters discussed above, we are from time to time parties to
legal proceedings, lawsuits and other claims incident to our business
activities.  Such matters may include, among other things, assertions
of contract breach or intellectual property infringement, product liability
claims, claims for indemnity arising in the course of our business and claims by
persons whose employment has been terminated.  Such matters are
subject to many uncertainties and outcomes are not predictable with
assurance.  Consequently, we are unable to ascertain the ultimate
aggregate amount of monetary liability, amounts which may be covered by
insurance or recoverable from third parties, or the financial impact with
respect to these matters as of the date of this report.




(10)Leases




We have
non-cancelable operating leases at various locations.  Our
headquarters in Milwaukee, Wisconsin, has approximately 36,000 square feet and
is leased through April 2011.  We also have a significant
facility in Mississauga, Ontario, Canada, which has approximately 30,000 square
feet and is leased through December 2009.




Total rent expense for the
years ended December 31, 2008, 2007 and 2006 was $1,877, $2,052, and
$1,389, respectively, net of sub-lease income of zero, $168 and $180,
respectively.  Future minimum lease payments under all non-cancelable
operating leases as of December 31, 2008, are:




2009
              
              
              1,1802010
              
              
              6962011
              
              
              3522012
              
              
              582013
              
              
              44Thereafter
              
              
              -Total
      minimum lease payments
              
              $
              2,330




The above
obligations do not include lease payments or sub-lease income related to
facilities that we have either ceased to use or abandoned as of December 31,
2008, as the related obligations for such facilities have been recorded as
restructuring related accruals in our consolidated balance sheet as of December
31, 2008.




(11)Restructuring




We
incurred $8,749, $960, and $2,725 of restructuring charges during the years
ended December 31, 2008, 2007, and 2006, respectively in goodwill and trade
name impairment, restructuring charges and other expenses in our statements of
operations.







~ 60
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)


Fourth Quarter
2006 Initiative




In the
fourth quarter of 2006, we reorganized our operations.  As a result,
approximately 150 individuals (including temporary persons and consultants) were
terminated and we ceased use of our San Francisco and Tokyo
facilities.  The charges recorded in 2006 include contract termination
costs of $59.  The charges recorded in 2007 are also associated with
the 2006 initiative.




During
the year ended December 31, 2008 we completed two separate restructuring and
reorganization initiatives.




First
Quarter 2008 Initiative




On
February 14, 2008, we announced a reduction in our worldwide headcount,
including consultants, by approximately 160 individuals with the majority of
those reductions having been completed on or before the
announcement.  This restructuring plan was designed to better align
our costs with our anticipated revenues going forward and included personnel
terminations from all parts of the organization.  We recognized
restructuring related charges in our consolidated financial statements of
$1,423, consisting of $1,139 in severance and related employee termination costs
and $284 in contract exit costs, primarily consisting of future lease payments
on our Burlington, Massachusetts leased office, which we completely vacated
during the first quarter of 2008.




Second
Quarter 2008 Initiative




On June
4, 2008, we announced a change in executive management, reorganization of our
operating business units and reduction in headcount by approximately 60
individuals.  This restructuring plan was designed primarily to align
our corporate costs and infrastructure with the size of the organization as well
as to align business unit costs with anticipated revenues going
forward.  We recognized restructuring related charges in our
consolidated financial statements of $7,326, consisting of $4,541 in severance
and related employee termination costs, $1,970 of share-based compensation
expense associated with the accelerated vesting of stock options and restricted
stock for certain former officers and $815 in contract exit
costs.  The severance costs are primarily related to payments to
former officers.  The contract exit costs primarily consist of future
lease payments on the Alpharetta, Georgia office, which we completely vacated as
of September 30, 2008 and our Mississauga, Ontario office, of which we abandoned
a portion of the 60,000 square feet of leased space during the second quarter of
2008.   See Note 8 for further discussion of share-based
compensation expense related to certain executive terminations.







~ 61
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





The
following table shows the restructuring activity during the years ended December
31, 2008, 2007 and 2006:




Employee
      Termination Costs
              
              
              Lease
      & Contract Exit Costs
              
              
              TotalPrior
      InitiativesBalance
      at December 31, 2005
              
              $
              17
              
              
              $
              175
              
              
              $
              192Payments
              
              
              (17
              )
              
              
              (175
              )
              
              
              (192
              )Balance
      at December 31, 2006
              
              $
              -
              
              
              $
              -
              
              
              $
              -Fourth
      Quarter 2006 InitiativeBalance
      at December 31, 2005
              
              $
              -
              
              
              $
              -
              
              
              $
              -Charges to expense
              
              
              2,666
              
              
              
              59
              
              
              
              2,725Payments
              
              
              (669
              )
              
              
              (59
              )
              
              
              (728
              )Balance
      at December 31, 2006
              
              $
              1,997
              
              
              $
              -
              
              
              $
              1,997Charges to expense
              
              
              960
              
              
              
              -
              
              
              
              960Payments
              
              
              (2,826
              )
              
              
              -
              
              
              
              (2,826
              )Balance
      at December 31, 2007
              
              $
              131
              
              
              $
              -
              
              
              $
              131Payments
              
              
              (131
              )
              
              
              -
              
              
              
              (131
              )Balance
      at December 31, 2008
              
              $
              -
              
              
              $
              -
              
              
              $
              -First
      Quarter 2008 InitiativeBalance
      at December 31, 2007
              
              $
              -
              
              
              $
              -
              
              
              $
              -Charges to expense
              
              
              1,139
              
              
              
              284
              
              
              
              1,423Payments
              
              
              (1,103
              )
              
              
              -
              
              
              
              (1,103
              )Foreign Exchange
              
              
              (5
              )
              
              
              -
              
              
              
              (5
              )Balance
      at December 31, 2008
              
              $
              31
              
              
              $
              284
              
              
              $
              315Second
      Quarter 2008 InitiativeBalance
      at December 31, 2007
              
              $
              -
              
              
              $
              -
              
              
              $
              -Charges to expense
              
              
              4,541
              
              
              
              815
              
              
              
              5,356Payments
              
              
              (3,959
              )
              
              
              (354
              )
              
              
              (4,313
              )Foreign Exchange
              
              
              (80
              )
              
              
              (90
              )
              
              
              (170
              )Balance
      at December 31, 2008
              
              $
              502
              
              
              $
              371
              
              
              $
              873Total
      balance at December 31, 2008
              
              $
              533
              
              
              $
              655
              
              
              $
              1,188




As of
December 31, 2008, $1,173 of the remaining balance for restructuring costs was
recorded in the restructuring accrual in current liabilities, with the remainder
recorded in other long term liabilities on the consolidated balance
sheet.




(12)Income
Taxes




Components
of loss before income taxes for the years ended December 31, 2008, 2007, and
2006 are as follows:




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006United
      States
              
              $
              (21,594
              )
              
              $
              (135,575
              )
              
              $
              (218,274
              )Foreign
              
              
              (2,149
              )
              
              
              (36,233
              )
              
              
              (31,199
              )$
              (23,743
              )
              
              $
              (171,808
              )
              
              $
              (249,473
              )




~ 62
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




The
provision for income taxes consists of the following for the years ended
December 31, 2008, 2007, and 2006:




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Current:Federal
              
              $
              (216
              )
              
              $
              88
              
              
              $
              313State
              
              
              82
              
              
              
              14
              
              
              
              (60
              )Foreign
              
              
              249
              
              
              
              -
              
              
              
              28Total current
              
              
              115
              
              
              
              102
              
              
              
              281Deferred:Federal
              
              
              82
              
              
              
              (97
              )
              
              
              8,332State
              
              
              (28
              )
              
              
              (35
              )
              
              
              1,619Foreign
              
              
              (229
              )
              
              
              (210
              )
              
              
              (782
              )Total deferred
              
              
              (175
              )
              
              
              (342
              )
              
              
              9,169Total provision
              
              $
              (60
              )
              
              $
              (240
              )
              
              $
              9,450




Actual
income taxes varied from the expected income taxes (computed by applying the
statutory income tax rate of 34% for the years ended December 31, 2008, 2007 and
2006 to income before income taxes) as a result of the following:




Years Ended December 31,2008
              
              
              2007
              
              
              2006Expected
      tax expense (benefit)
              
              $
              (8,073
              )
              
              $
              (58,415
              )
              
              $
              (84,820
              )Total
      increase (decrease) in income taxes resulting from:Nondeductible impairment of goodwill
              
              
              -
              
              
              
              41,606
              
              
              
              72,793Change in valuation allowance allocated to income tax
    expense
              
              
              8,303
              
              
              
              16,120
              
              
              
              21,339Extraterritorial income tax benefit
              
              
              -
              
              
              
              -
              
              
              
              (219
              )Research and experimentation credit
              
              
              (178
              )
              
              
              -
              
              
              
              (209
              )Employee stock options
              
              
              354
              
              
              
              829
              
              
              
              896Nondeductible expenses
              
              
              33
              
              
              
              120
              
              
              
              175State and local income taxes, net of federal income tax
      benefit
              
              
              (188
              )
              
              
              (498
              )
              
              
              (229
              )Foreign income tax rate differential
              
              
              (103
              )
              
              
              560
              
              
              
              (753
              )Other
              
              
              (208
              )
              
              
              (562
              )
              
              
              477Actual
      income tax expense (benefit)
              
              $
              (60
              )
              
              $
              (240
              )
              
              $
              9,450




~ 63
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




The tax
effects of temporary differences that give rise to significant portions of the
deferred tax assets and deferred tax liabilities at December 31, 2008 and 2007
are presented as follows:




December 31,2008
              
              
              2007Deferred
      tax assets:Accrued wages
              
              $
              531
              
              
              $
              668Deferred revenue
              
              
              585
              
              
              
              767Depreciation
              
              
              2,564
              
              
              
              3,191Research and experimentation credit carry forwards
              
              
              3,951
              
              
              
              4,173Other credit carry forwards
              
              
              2,627
              
              
              
              1,853Net operating loss carry forwards
              
              
              21,185
              
              
              
              17,056Foreign net operating loss carry forwards
              
              
              13,658
              
              
              
              17,007Nonqualified stock options
              
              
              1,744
              
              
              
              2,388Other
              
              
              2,716
              
              
              
              2,496Total
      gross deferred tax assets
              
              
              49,561
              
              
              
              49,599Less:
      asset valuation allowance
              
              
              (42,387
              )
              
              
              (40,925
              )Net
      deferred tax asset
              
              
              7,174
              
              
              
              8,674Deferred
      tax liabilities:Software development costs and intangible assets
              
              
              (181
              )
              
              
              (1,615
              )Intangibles—customer contracts & tradenames
              
              
              (764
              )
              
              
              (1,126
              )Other
              
              
              (1,466
              )
              
              
              (1,345
              )Total
      gross deferred liabilities
              
              
              (2,411
              )
              
              
              (4,086
              )Net
      deferred tax asset
              
              $
              4,763
              
              
              $
              4,588Included
      on balance sheet:Current assets: deferred income taxes
              
              $
              217
              
              
              $
              260Non-current asset: deferred income taxes
              
              
              4,585
              
              
              
              4,585Non-current liabilities: deferred income taxes
              
              
              (39
              )
              
              
              (257
              )Net deferred income taxes
              
              $
              4,763
              
              
              $
              4,588




At
December 31, 2008, we had U.S. federal net operating loss, research credit
and foreign tax credit carryforwards of $57,049, $2,311 and $709 respectively,
state net operating loss and research credit carryforwards of $20,630 and $823,
respectively, foreign federal and provincial net operating loss carryforwards of
$39,700 and $39,300, respectively, and foreign federal and provincial research
credit carryforwards of $1,416 and $223, respectively.  The U.S.
federal net operating loss, research credit and foreign tax credit carryforwards
expire in varying amounts beginning in 2009 and continuing through 2028, 2027
and 2018, respectively.  The state net operating loss carryforwards
expire in varying amounts beginning in 2009, and continuing through 2028 and the
credit carrryforwards expire in varying amounts beginning 2012 and continuing
through 2023.  The foreign tax credits expire in varying amounts
beginning in 2012, and continuing through 2016.  The foreign federal
and provincial net operating loss carryforwards expire in varying amounts
beginning in 2009, and continuing through 2028.




Management
has an obligation under SFAS No. 109 to review, at least annually, the
components of our deferred tax assets.  This review is to ascertain
that, based upon the information available at the time of the preparation of
financial statements, it is more likely than not, that we expect to utilize
these future deductions and credits.  In the event that management
determines that it is more likely than not these future deductions, or credits,
will not be utilized, a valuation allowance is recorded, reducing the deferred
tax asset to the amount expected to be realized.




Management’s
analysis for 2008 determined that a valuation allowance of $42,387 is necessary
at December 31, 2008 for a majority of our Canadian and U.S. deferred tax
assets.  This decision is based upon many factors, both quantitative
and qualitative, such as (1) substantial current year losses,
(2) significant unutilized operating loss and credit carryforwards,
(3) limited cash refund carryback opportunities, (4) uncertain future
operating profitability and (5) substantial organization and operating
restructuring.  We also considered the effect of U.S. Internal Revenue
Code (“Code”) Section 382 on our ability to utilize existing net operating loss
and tax credit carryforwards.  Section 382 imposes limits on the
amount of tax attributes that can be utilized where there has been an
ownership change as defined under the Code.  We experienced an
ownership change on June 4, 2008 and determined a majority of our U.S. and state
net operating loss and credit carryforwards will be subject to future
limitation.  The future limitation is in addition to any past
limitations applicable to the net operating loss and credit carryforwards of
previously acquired businesses.  While application of Section 382 is
complex and continues to be fully evaluated with respect to the June 4, 2008
ownership change, the valuation allowance established as of December 31, 2008 is
considered necessary to reduce our deferred tax assets to the amount expected to
be realized, based upon all available information at such
time.




~ 64
~


Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)




The net
increase in the valuation allowance for the years ending December 31, 2008,
2007, and 2006 was $1,462, $10,907 and $21,365, respectively.




There
exist potential tax benefits for us associated with both nonqualified and
incentive stock options.  The income tax benefit of excess tax
benefits related to nonqualified stock option exercises and disqualifying
dispositions of employee incentive stock options during 2008, 2007, and 2006
were zero, zero and $988, respectively.  Under SFAS
No. 123(R) the income tax benefit related to excess tax benefits of
stock-based compensation will be credited to paid-in-capital, when recognized,
by reducing taxes payable.




We
adopted the provisions of FIN No. 48 on January 1,
2007.  The adoption of FIN No. 48 did not result in an adjustment
to retained earnings due to the full valuation allowance maintained on our
deferred tax assets.  The total amount of unrecognized tax benefits as
of December 31, 2008 and December 31, 2007 was $6,485 and $6,070,
respectively.  We recognize interest and penalties in the provision
for income taxes.  Total accrued interest and penalties as of December
31, 2008 were $178 and $56, respectively.  Total accrued interest and
penalties as of December 31, 2007 were $150 and $45,
respectively.  Total interest and penalties included in tax expense
for the year ended December 31, 2008 was $28 and $11,
respectively.  Total interest and penalties included in tax expense
for the year ended December 31, 2007 was $13 and zero,
respectively.




The
following is a tabular reconciliation of the total amounts of unrecognized tax
benefits for the years ended December 31, 2008 and 2007:




December
      31,2008
              
              
              2007Balance
      at January 1
              
              $
              6,070
              
              
              $
              5,747Gross
      increases - tax positions in current year
              
              
              415
              
              
              
              323Balance
      at December 31
              
              $
              6,485
              
              
              $
              6,070




The total
amount of unrecognized tax benefits at December 31, 2008 and December 31, 2007
that, if recognized, would affect the effective tax rate from continuing
operations is $3,384 and $2,970 respectively.  The remainder of
unrecognized tax benefits relate to tax positions of acquired entities taken
prior to their acquisition.  If recognized in fiscal years beginning
after December 15, 2008, the benefit will be credited to income tax expense
under SFAS No. 141(R).  Otherwise, recognition would result in a
decrease to other non-current intangible assets.




We do not
anticipate a significant change to the total amount of unrecognized tax benefits
within the next twelve months.




We file
income tax returns in the U.S., various states and foreign
jurisdictions.  We are not currently under examination in the U.S. and
Canada federal taxing jurisdictions for which years ending after 2004 remain
subject to examination.  Years prior to 2005 remain subject to
examination to the extent net operating loss and tax credit carryforwards have
been utilized after 2004 or remain subject to carryforward.




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




~ 65
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





(13)Earnings Per Share




Basic and
diluted net loss per share is computed by dividing loss available to common
shareholders by the weighted average number of shares of Common Stock
outstanding.  Diluted earnings per share excludes the potential
dilution that could occur based on the exercise of stock options and restricted
stock awards, including those with an exercise price of more than the average
market price of our Common Stock, because such exercise would be
anti-dilutive.  The following table sets forth the computation of
basic and diluted earnings per share for the years ended December 31, 2008,
2007, and 2006.




Years
      Ended December 31,2008
              
              
              2007
              
              
              2006Numerator:Net
      loss
              
              $
              (23,683
              )
              
              $
              (171,568
              )
              
              $
              (258,923
              )Denominator:Weighted
      average number of shares of Common Stock outstanding
              
              
              46,717,546
              
              
              
              33,913,379
              
              
              
              33,701,735Net
      loss per share - basic and diluted
              
              $
              (0.51
              )
              
              $
              (5.06
              )
              
              $
              (7.68
              )




The
weighted average number of shares of Common Stock outstanding used to calculate
basic and diluted net loss includes exchangeable share equivalent securities for
the years ended December 31, 2008, 2007, and 2006, of 1,475,802, 2,307,178,
and 4,749,969, respectively.




As a
result of the loss during the years ended December 31, 2008, 2007 and 2006,
incremental shares from the assumed conversion of employee stock options
totaling zero, 43,996, and 602,696, respectively, have been excluded from the
calculation of diluted loss per share as their inclusion would have been
anti-dilutive.  As a result of the loss during the years ended
December 31, 2008, 2007 and 2006, incremental shares from the assumed
conversion of restricted stock awards totaling 1,086,719, 172,323 and zero,
respectively, have been excluded from the calculation of diluted loss per share
as their inclusion would have been anti-dilutive.




For the
years ended December 31, 2008, 2007, and 2006, options to purchase
3,296,574, 3,850,352, and 1,218,053 shares of our Common Stock, respectively,
had exercise prices greater than the average market price of the shares of
Common Stock, and, therefore, are not included in the above calculations of net
loss per share.




The
following potentially dilutive Common Stock equivalent securities, including
securities that may be considered in the calculation of diluted earnings per
share, were outstanding at December 31, 2008, 2007 and 2006.




December
      31,2008
              
              
              2007
              
              
              2006Stock
      options
              
              
              4,696,574
              
              
              
              4,081,060
              
              
              
              3,571,799Restricted
      stock awards
              
              
              479,997
              
              
              
              1,699,995
              
              
              
              -5,176,571
              
              
              
              5,781,055
              
              
              
              3,571,799




(14) Employee
Benefit Plan




We
maintain defined contribution retirement plans (a 401(k) profit sharing
plan for the U.S. employees and RRSP for the Canadian employees), covering
employees who meet the minimum service requirements and have elected to
participate.  We made matching contributions (under the
401(k) profit sharing plan for the U.S. employees and DPSP for the Canadian
employees) equal to a maximum of 3.0% in the years ended December 31, 2008, 2007
and 2006.  Our matching contributions totaled $386, $730, and $806 for
the years ended December 31, 2008, 2007, and 2006,
respectively.







~ 66
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)


(15) Segment
Information




The
following table provides revenue from our business units for the periods
indicated:




Year
      Ended December 31, 2008Merge
      Fusion
              
              
              Merge
      OEM
              
              
              TotalNet
      sales:Software
      and other
              
              $
              12,056
              
              
              $
              15,505
              
              
              $
              27,561Service
      and maintenance
              
              
              18,849
              
              
              
              10,325
              
              
              
              29,174Total
      net sales
              
              $
              30,905
              
              
              $
              25,830
              
              
              $
              56,735Year
      Ended December 31, 2007Merge
      Fusion
              
              
              Merge
      OEM
              
              
              TotalNet
      sales:Software
      and other
              
              $
              16,539
              
              
              $
              13,051
              
              
              $
              29,590Service
      and maintenance
              
              
              21,185
              
              
              
              8,797
              
              
              
              29,982Total
      net sales
              
              $
              37,724
              
              
              $
              21,848
              
              
              $
              59,572Year
      Ended December 31, 2006Merge
      Fusion
              
              
              Merge
      OEM
              
              
              TotalNet
      sales:Software
      and other
              
              $
              28,353
              
              
              $
              11,922
              
              
              $
              40,275Service
      and maintenance
              
              
              25,893
              
              
              
              8,154
              
              
              
              34,047Total
      net sales
              
              $
              54,246
              
              
              $
              20,076
              
              
              $
              74,322




Cash
in Excess of Federally Insured Amount




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




Net
Sales and Accounts Receivable


The
majority of our clients are OEMs, imaging centers, hospitals and integrated
delivery networks.  If significant adverse macro-economic factors were
to impact these organizations, it could materially adversely affect
us.  Our access to certain software and hardware components is
dependent upon single and sole source suppliers.  The inability of any
supplier to fulfill our supply requirements could affect future
results.




Foreign
sales, denominated in U.S. Dollars, accounted for approximately 24%, 22%, and
18% of our net sales for the years ended December 31, 2008, 2007, and 2006,
respectively.  For the years ended December 31, 2008, 2007, and
2006, sales in foreign currency represented approximately 5%, 6%, and 4%,
respectively, of our net sales.







~ 67
~
 Merge
Healthcare Incorporated and Subsidiaries
 Notes
to Consolidated Financial Statements (continued)
 (In
thousands, except for share and per share data)





The
following tables present certain geographic information, based on location of
customer:




Net Sales
      for the Years Ended December 31,2008
              
              
              2007
              
              
              2006United
      States of America
              
              $
              43,305
              
              
              $
              46,330
              
              
              $
              60,660Japan
              
              
              3,717
              
              
              
              3,232
              
              
              
              3,394Europe
              
              
              6,924
              
              
              
              7,244
              
              
              
              7,024Canada
              
              
              1,206
              
              
              
              1,236
              
              
              
              2,139Other
              
              
              1,583
              
              
              
              1,530
              
              
              
              1,105Total
      net sales
              
              $
              56,735
              
              
              $
              59,572
              
              
              $
              74,322Long-Lived
      Assets at December 31,2008
              
              
              2007United
      States of America
              
              $
              1,762
              
              
              $
              3,044Canada
              
              
              185
              
              
              
              816Europe
              
              
              16
              
              
              
              221India
              
              
              -
              
              
              
              510Other
              
              
              11
              
              
              
              40




Long-lived assets represent property, plant and equipment, net of related
depreciation.Long-lived
assets in service at the China office were not material as of December 31,
2008 and 2007.




(16) Quarterly
Results (unaudited)




2008
      Quarterly ResultsMarch
      31
              
              
              June 30
              
              
              September 30
              
              
              December 31Net
      sales
              
              $
              13,743
              
              
              $
              13,315
              
              
              $
              14,616
              
              
              $
              15,061Gross
      margin
              
              
              8,053
              
              
              
              8,102
              
              
              
              10,032
              
              
              
              10,476Income
      (loss) before income taxes
              
              
              (7,832
              )
              
              
              (18,581
              )
              
              
              697
              
              
              
              1,973Net
      income (loss)
              
              
              (7,832
              )
              
              
              (18,197
              )
              
              
              428
              
              
              
              1,918Basic
      income (loss) per share
              
              $
              (0.23
              )
              
              $
              (0.45
              )
              
              $
              0.01
              
              
              $
              0.03Diluted
      income (loss) per share
              
              
              (0.23
              )
              
              
              (0.45
              )
              
              
              0.01
              
              
              
              0.032007
      Quarterly ResultsMarch
      31
              
              
              June 30
              
              
              September 30
              
              
              December 31Net
      sales
              
              $
              15,874
              
              
              $
              14,036
              
              
              $
              14,054
              
              
              $
              15,608Gross
      margin
              
              
              9,295
              
              
              
              7,508
              
              
              
              3,765
              
              
              
              9,656Loss
      before income taxes
              
              
              (9,707
              )
              
              
              (10,729
              )
              
              
              (141,840
              )
              
              
              (9,532
              )Net
      loss
              
              
              (9,721
              )
              
              
              (10,740
              )
              
              
              (141,554
              )
              
              
              (9,553
              )Basic
      loss per share
              
              $
              (0.29
              )
              
              $
              (0.32
              )
              
              $
              (4.17
              )
              
              $
              (0.28
              )Diluted
      loss per share
              
              
              (0.29
              )
              
              
              (0.32
              )
              
              
              (4.17
              )
              
              
              (0.28
              )





(17) Other
Subsequent Events




We
utilized the services of a third party to review and value our patent
portfolio.  Following this review, we further assessed our patent
portfolio and identified which patents were not necessary to support our
business, and pursued the sale of such patents.  These sales are
expected to close in the first quarter of 2009, resulting in net proceeds of
$510.







~ 68
~





Item
      9.
            CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE




Not
applicable.




Item
      9A.
            CONTROLS
      AND PROCEDURES




(a)
            Disclosure
      Controls and Procedures




Disclosure
controls and procedures are controls and other procedures of a registrant
designed to ensure that information required to be disclosed by the registrant
in the reports that it files or submits under the Exchange Act is properly
recorded, processed, summarized and reported, within the time periods specified
in the SEC’s rules and forms.  Disclosure controls and procedures
include processes to accumulate and evaluate relevant information and
communicate such information to a registrant’s management, including its
principal executive and financial officers, as appropriate, to allow for timely
decisions regarding required disclosures.




A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute assurance that the objectives of the control system are
met.  Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within a company have been
detected.




We
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of December 31, 2008, as required by
Rule 13a-15 of the Exchange Act.  This evaluation was carried out
under the supervision and with the participation of our management, including
our principal executive officer and principal financial
officer.  Based on this evaluation, our principal executive officer
and principal financial officer have concluded that, as of December 31,
2008, our disclosure controls and procedures were effective to ensure
(1) 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 (2) information required to be disclosed by us in our reports that we
file or submit under the Exchange Act 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.




(b)
            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 our financial
statements for external reporting purposes in accordance with GAAP.




Management
assessed the effectiveness of our internal control over financial reporting as
of December 31, 2008, using the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated
Framework.  Based on its assessment, management concluded that
our internal control over financial reporting was effective as of
December 31, 2008.




(c)
            Changes
      in Internal Control Over Financial
Reporting




There
were no changes with respect to our internal control over financial reporting
that materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting during the quarter ended December 31,
2008.




(d)
            Report
      of Independent Registered Public Accounting
Firm




This
Annual Report on Form 10-K does not include an attestation report of our
registered public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
registered public accounting firm pursuant to temporary rules of the SEC that
permit us to provide only management’s report in this Annual Report on Form
10-K.




Item
      9B.
            OTHER
      INFORMATION




None.







~ 69 ~




PART
III




As
permitted by SEC rules, we have omitted certain information required by
Part III from this Report on Form 10-K, because we will file (pursuant to
Section 240.14a-101) our definitive proxy statement for our 2008 annual
shareholder meeting (the “Proxy Statement”) not later than April 30, 2008, and
are, therefore, incorporating by reference in this Annual Report on Form 10-K
such information from the Proxy Statement.




Item
      10.
            DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE






The information required by this Item 10 will be included under the
captions “Election of Directors” and “Information Concerning Directors, Nominees
and Executive Officers” in our Proxy Statement for our 2009 annual meeting of
shareholders.   Information concerning the compliance of our
officers, directors and 10% shareholders with Section 16(a) of the
Securities Exchange Act of 1934 is incorporated by reference to the information
to be contained in the 2009 proxy statement under the caption “Information
Concerning Directors Nominees and Executive Officers -
Section 16(a) Beneficial Ownership Reporting Compliance.”  The
information regarding Audit Committee members and “Audit Committee Financial
Experts” is incorporated by reference to the information to be contained in the
2009 proxy statement under the caption “Information Concerning Directors
Nominees and Executive Officers - Board Committees.”  The information
regarding our Code of Business Ethics is incorporated by reference to the
information to be contained in the 2009 proxy statement under the heading
“Information Concerning Directors Nominees and Executive Officers - Code of
Business Conduct and Ethics.”  The Code of Ethics is included on the
Company’s website, www.merge.com (Investor Relations
link).




Item
      11.
            EXECUTIVE
      COMPENSATION




The
information required by this item is incorporated herein by reference to the
information set forth under the caption “Compensation of Executive Officers and
Directors” in our Proxy Statement.




Item
      12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS




The
information required by this item is incorporated herein by reference to the
information set forth under the caption “Security Ownership and Certain
Beneficial Owners and Management” in our Proxy Statement.




Item
      13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE




The
information required by this item is incorporated herein by reference to the
information set forth under the caption “Related Party Transactions” in our
Proxy Statement.




Item
      14.
            PRINCIPAL
      ACCOUNTING FEES AND SERVICES




The
information required by this item is incorporated herein by reference to the
information set forth under the caption “Accounting Fees and Services” in our
Proxy Statement.






PART IV




Item
      15.
            EXHIBITS
      AND FINANCIAL STATEMENTS SCHEDULES




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




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




·
            Consolidated
      Balance Sheets at December 31, 2008 and
  2007;




·
            Consolidated
      Statements of Operations for each of the three years ended
      December 31, 2008, 2007 and
2006;




·
            Consolidated
      Statements of Shareholders’ Equity for each of the three years ended
      December 31, 2008, 2007 and
2006;




·
            Consolidated
      Statements of Cash Flows for each of the three years ended
      December 31, 2008, 2007 and
2006;




·
            Consolidated
      Statements of Comprehensive Loss for each of the three years ended
      December 31, 2008, 2007 and 2006;
and




·
            Notes
      to Consolidated Financial
Statements.




(b)See
Exhibit Index that follows.







~ 70
~





Exhibit Index




3.1
            
            Certificate
      of Incorporation as filed on October 14, 20083.2
            
            Certificate
      of Merger as filed on December 3, 2008 and effective on December 5,
      20083.3
            
            Bylaws
      of Registrant4.1
            
            Term
      Note, dated June 4, 2008, between Registrant and Merrick RIC, LLC(A)10.1
            
            Registration
      rights Agreement, dated June 4, 2008, by and between Registrant and
      Merrick RIS, LLC(A)10.2
            
            Securities
      Purchase Agreement, dated May 21, 2008, by and among Registrant, the
      subsidiaries listed on the Schedule of Subsidiaries attached thereto, and
      Merrick RIS, LLC(B)10.3
            
            Employment
      Letter Agreement between the Registrant and Justin C. Dearborn entered
      into as of June 4, 2008(C)*10.4
            
            Employment
      Letter Agreement between the Registrant and Steven M. Oreskovich entered
      into as of June 4, 2008(C)*10.5
            
            Employment
      Letter Agreement between the Registrant and Nancy J. Koenig entered into
      as of June 4, 2008(C)*10.6
            
            Employment
      Letter Agreement between the Registrant and Antonia Wells entered into as
      of June 4, 2008(C)*10.7
            
            Amendment
      dated July 1, 2008 to that certain Securities Purchase Agreement, dated
      May 21, 2008, by and among the Registrant, certain of its subsidiaries and
      Merrick RIS, LLC(D)10.8
            
            Consulting
      Agreement, effective as of January 1, 2009, by and between Registrant and
      Merrick RIS, LLC10.9
            
            1996
      Stock Option Plan for Employees of Registrant dated May 13, 1996(E),
      as amended and restated in its entirety as of September 1, 2003(F)*10.10
            
            1998
      Stock Option Plan for Directors(G)*10.11
            
            2000
      Employee Stock Purchase Plan of Registrant effective July 1, 2000(H)*10.12
            
            2003
      Stock Option Plan of Registrant dated June 24, 2003, and effective July
      17, 2003(F)*10.13
            
            2005
      Equity Incentive Plan adopted March 4, 2005, and effective May 24,
      2005(I)*10.14
            
            Form
      of Non-Qualified Stock Option Agreement under Registrant’s 2005 Equity
      Incentive Plan(J)*10.15
            
            Form
      of Incentive Stock Option Agreement under Registrant’s 2005 Equity
      Incentive Plan(J)*10.16
            
            Form
      of Director Non-Qualified Stock Option Agreement under Registrant’s 2005
      Equity Incentive Plan(J)*14.1
            
            Code
      of Ethics14.2
            
            Whistleblower
      Policy21
            
            Subsidiaries
      of Registrant23.1
            
            Consent
      of Independent Registered Public Accounting Firm – BDO Seidman
      LLP23.2
            
            Consent
      of Independent Registered Public Accounting Firm – KPMG
  LLP31.1
            
            Certificate
      of Chief Executive Officer (principal executive officer) Pursuant to Rule
      13a-14(a) under the Securities Exchange Act of 193431.2
            
            Certificate
      of Chief Financial Officer (principal accounting officer) Pursuant to Rule
      13a-14(a) under the Securities Exchange Act of 193432
            
            Certificate
      of Chief Executive Officer (principal executive officer) and Chief
      Financial Officer (principal accounting officer) Pursuant to Section 18
      U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 200299.1
            
            Compensation
      Committee Charter99.2
            
            Nominating
      & Governance Committee Charter






(A)
            Incorporated by reference from the Registrant’s Current Report on Form 8-K
      dated June 6, 2008.(B)
            Incorporated by reference from the Registrant’s Current Report on Form 8-K
      dated May 22, 2008.(C)
            Incorporated by reference from the Registrant’s Current Report on Form 8-K
      dated July 15, 2008.(D)
            Incorporated by reference from the Registrant’s Current Report on Form 8-K
      dated July 7, 2008.(E)
            Incorporated by reference from Registration Statement on Form SB-2 No.
      333-39111) effective January 29, 1998.(F)
            Incorporated by reference from the Registrant’s Quarterly Report on Form
      10-Q for the three and nine months ended September 30,
    2003.(G)
            Incorporated by reference from the Registrant’s Annual Report on Form
      10-KSB for the fiscal year ended December 31, 1997.(H)
            Incorporated by reference from the Registrant’s Proxy Statement for Annual
      Meeting of Shareholders dated May 8, 2000.(I)
            Incorporated by reference from the Registrant’s Registration Statement on
      Form S-8 (No. 333-125386) effective June 1, 2005.(J)
            Incorporated by reference from the Registrant’s Annual Report on Form 10-K
      for the fiscal year ended December 31, 2005.*
            Management contract or compensatory plan or arrangement required to be
      filed as an exhibit to this Annual Report on Form
  10-K.





~ 71
~








SIGNATURES


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




Merge
      Healthcare IncorporatedDate: March
      11, 2009
            By:
            /s/
      Justin C. DearbornJustin
      C. DearbornChief
      Executive Officer(principal
      executive officer)Date: March
      11, 2009
            By:
            /s/
      Steven M. OreskovichSteven
      M. OreskovichChief
      Financial Officer(principal
      financial officerand
      principal accounting officer)






Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.




Date:
      March 11, 2009
            By:
            /s/
      Michael W. Ferro, Jr.Michael
      W. Ferro, Jr.Chairman
      of the BoardDate:
      March 11, 2009
            By:
            /s/
      Dennis BrownDennis
      BrownDirectorDate:
      March 11, 2009
            By:
            /s/
      Justin C. DearbornJustin
      C. DearbornChief
      Executive Officer and DirectorDate:
      March 11, 2009
            By:
            /s/
      Gregg G. HartemayerGregg
      G. HartemayerDirectorDate:
      March 11, 2009
            By:
            /s/
      Richard A. ReckRichard
      A. ReckDirectorDate:
      March 11, 2009
            By:
            /s/
      Neele E. Stearns, Jr.Neele
      E. Stearns, Jr.Director