Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---

FORM 10-Q

---



x
        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2007ORo
        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from ________________ to ________________




Commission file number:0-26056



---

Image Sensing Systems, Inc.

(Exact name of registrant as specified in its charter)



Minnesota
        41-1519168(State or other jurisdiction of
        (I.R.S. Employerincorporation or organization)
        Identification No.)500 Spruce Tree Centre1600 University Avenue WestSt. Paul, MN
        55104(Address of principal executive offices)
        (Zip Code)




(651) 603-7700

(Registrants telephone number, including area code)



Not Applicable

(Former name, former address and former fiscal year, if changed since last report)



---

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. YesxNoo



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

Large accelerated filero
        Accelerated filero
        Non-accelerated filerx




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



Indicate the number of shares
outstanding of each of the issuers classes of common stock, as of the latest practicable date.



Class
        
        Outstanding at October 8, 2007Common Stock, $0.01 par value per share
        
        3,780,604 shares








---

IMAGE SENSING SYSTEMS, INC.



TABLE OF CONTENTS





Page No.PART I.
        FINANCIAL INFORMATION
        3Item 1.
        Financial Statements:
        3Condensed Consolidated Balance Sheets
        3Condensed Consolidated Statements of Income
        4Condensed Consolidated Statements of Cash Flows
        5Notes To Condensed Consolidated Financial Statements
        6Item 2.
        Managements Discussion and Analysis of Financial Condition and Results of Operations
        9Item 3.
        Quantitative and Qualitative Disclosures About Market Risk
        13Item 4T.
        Controls and Procedures
        13PART II.
        OTHER INFORMATION
        14Item 1.
        Legal Proceedings
        14Item 1A.
        Risk Factors
        14Item 2.
        Unregistered Sales of Equity Securities and Use of Proceeds
        14Item 3.
        Defaults Upon Senior Securities
        14Item 4.
        Submission of Matters to a Vote of Security Holders
        14Item 5.
        Other Information
        14Item 6.
        Exhibits
        14SIGNATURES
        15EXHIBIT INDEX
        16






2



---

Table of Contents

PART I. FINANCIAL INFORMATION



Item 1.
        Financial Statements:




Image Sensing Systems, Inc.

Condensed Consolidated Balance Sheets

as of September 30, 2007 and December 31, 2006

(in thousands)



September 30,
2007
        
        December 31,
2006(Unaudited)
        
        (Note)AssetsCurrent assets:Cash and cash equivalents
        
        $
        14,340
        
        $
        11,626Short-term investments
        
        
        2,000
        
        
        1,800Accounts receivable, net
        
        
        4,288
        
        
        2,957Inventories
        
        
        1,245
        
        
        670Investment in FHLB bond
        
        
        
        
        
        2,300Prepaid expenses
        
        
        220
        
        
        126Deferred income taxes
        
        
        193
        
        
        173Total current assets
        
        
        22,286
        
        
        19,652Property and equipment, net
        
        
        396
        
        
        522Goodwill
        
        
        1,050
        
        
        1,050Total assets
        
        $
        23,732
        
        $
        21,224Liabilities and Shareholders EquityCurrent liabilities:Accounts payable
        
        $
        492
        
        $
        616Accrued compensation
        
        
        398
        
        
        587Accrued warranty and other
        
        
        475
        
        
        449Income taxes payable
        
        
        247
        
        
        231Total current liabilities
        
        
        1,612
        
        
        1,883Deferred income taxes
        
        
        28
        
        
        8Shareholders equity:Common stock
        
        
        38
        
        
        38Additional paid-in capital
        
        
        8,296
        
        
        8,130Accumulated other comprehensive income
        
        
        54
        
        
        16Retained earnings
        
        
        13,704
        
        
        11,14922,092
        
        
        19,333Total liabilities and shareholders equity
        
        $
        23,732
        
        $
        21,224




Note: The balance sheet at December 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.



See accompanying notes.



3



---

Table of Contents

Image Sensing Systems, Inc.

Condensed Consolidated Statements of Income

for the three-month and nine-month periods ended September 30, 2007 and 2006

(Unaudited)

(in thousands, except per share data)



Three-Month Periods EndedSeptember 30,
        
        Nine-Month Periods EndedSeptember 30,2007
        
        2006
        
        2007
        
        2006Revenue:International sales
        
        $
        1,143
        
        $
        398
        
        $
        2,232
        
        $
        1,709Royalties
        
        
        3,041
        
        
        2,598
        
        
        7,636
        
        
        7,2824,184
        
        
        2,996
        
        
        9,868
        
        
        8,991Costs of revenue:Cost of product sold
        
        
        536
        
        
        208
        
        
        951
        
        
        753Royalties
        
        
        
        
        
        1
        
        
        
        
        
        220536
        
        
        209
        
        
        951
        
        
        973Gross profit
        
        
        3,648
        
        
        2,787
        
        
        8,917
        
        
        8,018Operating expenses:Selling, marketing and product support
        
        
        749
        
        
        681
        
        
        2,310
        
        
        2,095General and administrative
        
        
        710
        
        
        416
        
        
        1,832
        
        
        1,549Research and development
        
        
        553
        
        
        590
        
        
        1,681
        
        
        1,5822,012
        
        
        1,687
        
        
        5,823
        
        
        5,226Income from operations
        
        
        1,636
        
        
        1,100
        
        
        3,094
        
        
        2,792Other income (expense), net
        
        
        149
        
        
        (42
        )
        
        429
        
        
        (20
        )Income before income taxes
        
        
        1,785
        
        
        1,058
        
        
        3,523
        
        
        2,772Income taxes
        
        
        488
        
        
        327
        
        
        968
        
        
        827Net income
        
        $
        1,297
        
        $
        731
        
        $
        2,555
        
        $
        1,945Net income per common share:Basic
        
        $
        0.35
        
        $
        0.20
        
        $
        0.68
        
        $
        0.52Diluted
        
        $
        0.34
        
        $
        0.19
        
        $
        0.66
        
        $
        0.50Weighted average number of common shares outstanding:Basic
        
        
        3,780
        
        
        3,733
        
        
        3,777
        
        
        3,718Diluted
        
        
        3,866
        
        
        3,887
        
        
        3,876
        
        
        3,887




See accompanying notes.



4



---

Table of Contents

Image Sensing Systems, Inc.

Condensed Consolidated Statements of Cash Flows

for the nine-month periods ended September 30, 2007 and 2006

(Unaudited)

(in thousands)



Nine-Month Periods EndedSeptember 30,2007
        
        2006Operating activities:Net income
        
        $
        2,555
        
        $
        1,945Adjustments to reconcile net income to net cash provided by operating activitiesDepreciation and amortization
        
        
        197
        
        
        277Stock option expense
        
        
        132
        
        
        166Change in operating assets and liabilities
        
        
        (2,234
        )
        
        1,454Net cash provided by operating activities
        
        
        650
        
        
        3,842Investing activities:Purchases of property and equipment
        
        
        (71
        )
        
        (325
        )Net (purchases) sales of investments
        
        
        2,100
        
        
        (1,800
        )Net cash provided by (used in) investing activities
        
        
        2,029
        
        
        (2,125
        )Financing activities:Proceeds from exercise of stock options
        
        
        35
        
        
        93Net cash provided by financing activities
        
        
        35
        
        
        93Increase in cash and cash equivalents
        
        
        2,714
        
        
        1,810Cash and cash equivalents, beginning of period
        
        
        11,626
        
        
        9,006Cash and cash equivalents, end of period
        
        $
        14,340
        
        $
        10,816






See accompanying notes.



5



---

Table of Contents

IMAGE SENSING SYSTEMS, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

September 30, 2007



Note A:  Basis of Presentation



The accompanying unaudited condensed consolidated financial statements of Image Sensing Systems, Inc. (referred to herein as we, us, our and the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. It is the opinion of management that the unaudited condensed consolidated financial statements include all adjustments consisting of normal recurring accruals considered necessary for a fair presentation. Operating results for the nine-month period ended September 30, 2007 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2007. For further information, refer to the consolidated financial statements and footnotes thereto in our Annual Report on Form 10-K for the year ended December 31, 2006.



Note B:  Investments



Investments, at cost, consisted of the following at September 30, 2007 and December 31, 2006 (in thousands):



September 30,2007
        
        December 31,2006Short-term investments - auction rate securities
        
        $
        2,000
        
        $
        1,800Callable Federal Home Loan Bonds
        
        
        
        
        
        2,300Total
        
        $
        2,000
        
        $
        4,100




As of September 30, 2007 and December 31, 2006, investments are classified as available-for-sale. The cost of investments approximate market value and therefore no amount is recorded in accumulated other comprehensive income. The cost of securities sold is based on the specific identification method.



A $1,100,000 bond matured in the three-month period ended September 30, 2007.





6



---

Table of Contents

Note C: Net Income Per Common Share



The following table sets forth the computations of basic and diluted net income per common share for the three-month and nine-month periods ended September 30, 2007 and 2006 (in thousands, except per share data):



Three-Month Periods EndedSeptember 30,
        
        Nine-Month Periods EndedSeptember 30,2007
        
        2006
        
        2007
        
        2006Numerator:Net income
        
        $
        1,297
        
        $
        731
        
        $
        2,555
        
        $
        1,945Denominator:Shares used in basic net income per common share calculation
        
        
        3,780
        
        
        3,733
        
        
        3,777
        
        
        3,718Effect of diluted securities:Employee and director stock options
        
        
        86
        
        
        154
        
        
        99
        
        
        169Shares used in diluted net income per common share calculations
        
        
        3,866
        
        
        3,887
        
        
        3,876
        
        
        3,887Basic net income per common share
        
        $
        0.35
        
        $
        0.20
        
        $
        0.68
        
        $
        0.52Diluted net income per common share
        
        $
        0.34
        
        $
        0.19
        
        $
        0.66
        
        $
        0.50




Note D: Stock-based Compensation



In 2006, we adopted Statement of Financial Accounting Standard (SFAS) No. 123(R),Share Based Payment, which requires all share-based payments, including grants of stock options, to be recognized in the income statement as an operating expense, based on their fair value over the requisite service period. We recorded $132,000 and $166,000 of related compensation expense included in general and administrative expense for the nine-month periods ended September 30, 2007 and 2006, respectively. Options to purchase 106,000 shares (at a weighted average exercise price of $14.68) were granted for the nine-month period ended September 30, 2006. As of September 30, 2007, $567,000 of total unrecognized compensation expense related to non-vested stock option awards is expected to be recognized over a weighted average period of 2.8 years.



We used the Black-Scholes option pricing model to determine the weighted average fair value of options during the three-month and nine-month periods ended September 30, 2007 and 2006.



Our stock options generally vest over one to five years of service and have a contractual life of four to ten years. We have 157,200 shares available for grants under our 2005 Stock Incentive Plan.



The following table summarizes information about the stock options outstanding at September 30, 2007:



Options Outstanding
        
        Options ExercisableRange ofExercise Price
        
        NumberOutstanding
        
        Weighted Average Remaining Contractual Life
        
        Weighted Average Exercise Price
        
        NumberExercisable
        
        Weighted Average Exercise Price$
        1.30-1.99
        
        
        71,100
        
        
        4.7 years
        
        $
        1.34
        
        
        71,100
        
        
        $
        1.342.00-2.99
        
        
        52,200
        
        
        2.2 years
        
        
        2.38
        
        
        52,200
        
        
        
        2.383.00-3.99
        
        
        38,933
        
        
        5.0 years
        
        
        3.15
        
        
        38,333
        
        
        
        3.137.00-7.93
        
        
        16,000
        
        
        1.6 years
        
        
        7.77
        
        
        16,000
        
        
        
        7.7712.00-12.99
        
        
        18,000
        
        
        9.0 years
        
        
        12.61
        
        
        
        
        
        
        14.00-14.99
        
        
        75,000
        
        
        5.3 years
        
        
        14.19
        
        
        
        
        
        
        15.00-15.99
        
        
        16,000
        
        
        3.7 years
        
        
        15.70
        
        
        
        
        
        
        16.00-16.99
        
        
        15,000
        
        
        5.6 years
        
        
        16.00
        
        
        
        
        
        
        302,233
        
        
        4.5 years
        
        
        7.44
        
        
        177,633
        
        
        
        2.61






7



---

Table of Contents

Note E: Income Taxes



In June 2006, the Financial Accounting Standards Bound (FASB) issued FASB Interpretation (FIN) No. 48,Accounting for Uncertainty in Income Taxesan Interpretation of FASB Statement No. 109(FIN 48).FIN 48 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.FIN 48 clarifies the application of SFAS No. 109 by defining a criterion that an individual tax position must meet for any part of the benefit of that position to be recognized in an enterprises financial statements. Additionally, FIN 48 provides guidance on measurement, derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 was effective for us on January 1, 2007.



We adopted the provisions of FIN 48 on January 1, 2007. Previously, we had accounted for tax contingencies in accordance with SFAS No. 5,Accounting for Contingencies. As required by FIN 48, which clarifies SFAS No. 109,Accounting for Income Taxes, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. At the adoption date, we applied FIN 48 to all tax positions for which the statute of limitations remained open. At January 1, 2007, our
existing reserve for income tax uncertainties was not material. We recognized no additional liabilities for unrecognized tax benefits as a result of the implementation of FIN 48.



We are subject to income taxes in the U.S. federal jurisdiction, various state jurisdictions and certain international tax jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. Generally, the statute of limitations is closed for tax years preceding 2003 for U.S. jurisdictions.



Note F: New Accounting Pronouncements:



On February 15, 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities  Including an Amendment of FASB No. 115. SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value. The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. SFAS No. 159 will be effective for us as of December 31, 2007. We do not anticipate that the adoption of SFAS No. 159 will have a material impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurement but does not require any new fair value measurements. SFAS No. 157 will be effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact this pronouncement will have on our consolidated financial statements.



8



---

Table of Contents

Item 2.
        Managements Discussion and Analysis of Financial Condition and Results of Operations




Overview:

We have developed proprietary machine vision technology that converts real world information into digital electronic signals for processing by computer and have applied it to traffic management problems. We use a proprietary version of machine vision technology and commercially available components and video cameras to create our core family of products - the Autoscope® Video Vehicle Detection System. The Autoscope system is used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels.



Autoscope systems are sold to distributors and end users of traffic management products in North America, the Caribbean and Latin America by Econolite Control Products, Inc. (Econolite), our licensee in those locations. We also sell Autoscope products to distributors and end users in Europe and Asia through our European and Hong Kong subsidiaries, respectively.



The majority of our revenue is derived from royalties received from Econolite, with a second primary source of revenue received from product sales in Europe and Asia. End users of the Autoscope system throughout the world are generally funded by government agencies responsible for traffic management and/or traffic law enforcement.



Our success is primarily dependent upon continued governmental funding of Intelligent Transportation Systems, such as machine vision, for traffic control; our ability, through Econolite and our sales representatives in Europe and Asia, to successfully market the Autoscope System to individual traffic managers; and our ability to develop new machine vision products and applications that enhance the traffic managers ability to cost-effectively improve traffic flow, safety and security.



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



Critical Accounting Policies:

Goodwill.Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or whenever an impairment indicator arises. Our recorded goodwill relates to our subsidiary, Flow Traffic Ltd. (Flow Traffic), and is tested for impairment on December 31 of each year. The impairment test requires us to estimate the fair value of our subsidiary and then compare it to the carrying value of the subsidiary. If the carrying value exceeds the fair value, further analysis is performed to determine if there is an impairment loss. We estimate the fair value by using the income approach, where fair value is dependent on the present value of projected future economic benefits to be derived from our ownership of Flow Traffic. If Flow Traffic does not provide the future economic benefits we project, the fair value of this subsidiary may become impaired,
and we would need to record an impairment loss.



Revenue recognition.Royalty income is recognized based upon a monthly royalty report provided to us by Econolite. This report is prepared by Econolite based on its sales of products we developed and is based on sales delivered and accepted by its customers. We recognize revenue from international sales at the time of delivery and acceptance and when the selling price is fixed or determinable and collectibility is reasonably assured.



9



---

Table of Contents

Results of Operations:

The following tables set forth, for the periods indicated, certain statements of income data as a percent of total revenue; gross profit on product sales and royalties as a percentage of product sales and royalties, respectively; and period-to-period changes of items in the consolidated statements of income from 2007 to 2006:



Three-Month PeriodEnded September 30,
        
        Quarter OverQuarter2007
        
        2006
        
        ChangeInternational sales
        
        27.3
        %
        13.3
        %
        187.2
        %Royalties
        
        72.7
        
        86.7
        
        17.1Total revenue
        
        100.0
        
        100.0
        
        39.7Gross profit - international sales
        
        53.1
        
        47.7
        
        219.5Gross profit  royalties
        
        100.0
        
        100.0
        
        17.1Selling, marketing and product support expenses
        
        17.9
        
        22.7
        
        10.0General and administrative expenses
        
        17.0
        
        13.9
        
        70.7Research and development expenses
        
        13.2
        
        19.7
        
        (6.3
        )Income from operations
        
        39.1
        
        36.7
        
        48.7Other income (expense), net
        
        3.6
        
        (1.4
        )
        NMFIncome taxes
        
        11.7
        
        10.9
        
        49.2Net income
        
        31.0
        
        24.4
        
        77.4






Nine-Month PeriodEnded September 30,
        
        Nine-monthsOver Nine-months2007
        
        2006
        
        ChangeInternational sales
        
        22.6
        %
        19.0
        %
        30.6
        %Royalties
        
        77.4
        
        81.0
        
        4.9Total revenue
        
        100.0
        
        100.0
        
        9.8Gross profit - international sales
        
        57.4
        
        55.9
        
        34.0Gross profit  royalties
        
        100.0
        
        97.0
        
        8.1Selling, marketing and product support expenses
        
        23.4
        
        23.3
        
        10.3General and administrative expenses
        
        18.6
        
        17.2
        
        18.3Research and development expenses
        
        17.0
        
        17.6
        
        6.3Income from operations
        
        31.4
        
        31.1
        
        10.8Other income (expense), net
        
        4.3
        
        (0.2
        )
        NMFIncome taxes
        
        9.8
        
        9.2
        
        17.0Net income
        
        25.9
        
        21.6
        
        31.4




International sales increased 187.2% for the third quarter of 2007 versus the comparable quarter of 2006 and 30.6% for the first nine months of 2007 over the comparable period of 2006. Royalty income increased 17.1% for the 2007 third quarter and 4.9% for the 2007 first nine months versus the comparable periods in 2006. We believe these increases are primarily due to increased acceptance of our Autoscope Terra line of products, which was introduced in April of this year.



10



---

Table of Contents

Gross profit increases for international sales are due to increased sales in international markets. The gross profit margin on international sales increased modestly in the third quarter and first nine months of 2007 from comparable periods in 2006 due to a change in mix of international sales. Increased gross profit on royalties in the third quarter of 2007 versus the comparable period in 2006 related directly to the increased royalties for the quarter. For the first nine months, gross profit on royalties increased 8.1% in 2007 versus 2006 because of higher royalty revenue and the end of royalty expense to the University of Minnesota in July 2006. We anticipate for the rest of 2007 that royalty gross profit margins will be 100% and that gross profit margins on international sales will decrease due to higher manufacturing costs and pricing concessions on non-Terra inventory.



Operating expenses increased 19.3% and 11.4%, respectively, in the third quarter and first nine months of 2007 over the comparable periods in 2006 primarily due to added staff in each category of operating expense along with related payroll taxes, benefits and infrastructure to support the added staff. In addition, we incurred marketing costs in 2007 to promote the launch of the Terra line and increased administrative costs for outside consultants, which contributed to the increase in operating expense. These increases were partially offset by lower legal and stock option expense in 2007 versus 2006. Income from operations increased 48.7% and 10.8% in the third quarter and first nine months of 2007, respectively, versus comparable periods in 2006 due to increased revenue which more than offset increased operating expenses. We anticipate that operating expenses for all of 2007, in absolute dollars, will exceed
2006 levels in each of the categories.



Other income, net for the third quarter and first nine months of 2007 increased significantly over the comparable periods in 2006. This is primarily due to the Econolite settlement made in 2006, which offset most interest income in that year. Other income, net for the third quarter and first nine months of 2007 is substantially all interest income and is predominantly tax-exempt interest. Income taxes increased in the third quarter and first nine months of 2007 compared to 2006 substantially in proportion to the increase in operating income.



Net income for the third quarter of 2007 was $1.3 million, an increase of 77.4% from the comparable quarter of 2006, and $2.6 million for the first nine months of 2007, an increase of 31.4% over the comparable period of 2006, due to the factors discussed above.



Liquidity and Capital Resources:

At September 30, 2007, we had $14.3 million in cash and cash equivalents and $2.0 million in investments, compared to $11.6 million in cash and cash equivalents and $4.1 million in investments at December 31, 2006.



Net cash provided by operating activities was $650,000 in the first nine months of 2007, compared to net cash provided of $3.8 million in 2006. The primary reason for the change was that we received unusually large royalty payments on accounts receivable from Econolite in 2006 for sales it made in the fourth quarter of 2005. Additionally, in the first nine months of 2007, inventory increased by $575,000 primarily due to the Terra product transition.  For investing activities, we sold $2.1 million in investments, net, in 2007 as compared to purchasing $1.8 million in investments, net, in 2006.



We have a credit agreement that provides up to $1.0 million in short-term borrowings at prime rate (effective rate of 7.75% at September 30, 2007), expiring May 31, 2008. Any loans would be secured by inventories, accounts receivable and equipment, and the bank would have the right of setoff against checking, savings and other accounts we have with the bank. We had no outstanding borrowings under the credit agreement in 2007 or 2006. We expect to renew the agreement at substantially the same terms and conditions prior to expiration.



11



---

Table of Contents

We believe that cash and cash equivalents on hand at September 30, 2007, our $1.0 million revolving line of credit and cash provided by operating activities will satisfy our projected working capital needs, investing activities and other cash requirements for the foreseeable future.



Income Taxes:

In June 2006, the Financial Accounting Standards Bound (FASB) issued FASB Interpretation (FIN) No. 48,Accounting for Uncertainty in Income Taxesan Interpretation of FASB Statement No. 109(FIN 48).FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with Statement of Accounting Standard (SFAS) No. 109,Accounting for Income Taxes.FIN 48 clarifies the application of SFAS No. 109 by defining a criterion that an individual tax position must meet for any part of the benefit of that position to be recognized in an enterprises financial statements. Additionally, FIN 48 provides guidance on
measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 was effective for us on January 1, 2007.



We adopted the provisions of FIN 48 on January 1, 2007. Previously, we had accounted for tax contingencies in accordance with SFAS No. 5,Accounting for Contingencies. As required by FIN 48, which clarifies SFAS No. 109,Accounting for Income Taxes, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the relevant tax authority. At the adoption date, we applied FIN 48 to all tax positions for which the statute of limitations remained open. At January 1, 2007, our
existing reserve for income tax uncertainties was not material. We recognized no additional liabilities for unrecognized tax benefits as a result of the implementation of FIN 48.



We are subject to income taxes in the U.S. federal jurisdiction, various state jurisdictions and certain international tax jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. Generally, the statute of limitations is closed for tax years preceding 2003 for U.S. jurisdictions.



Cautionary Statement:

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange of 1934, as amended. These forward-looking statements are intended to be subject to the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements represent our expectations or beliefs concerning future events and can be identified by the use of forward-looking words such as expects, believes, may, will, should, intends, plans, estimates, anticipates or other comparable terminology. Forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from the results discussed in the
forward-looking statements. Factors that might cause such differences include, but are not limited to:




        dependence on a single product for most of our revenue;





        budget constraints of governmental entities that purchase our products;





        continuing ability of our licensee to pay royalties owed;




12



---

Table of Contents


        dependence on third parties for manufacturing and marketing our products;





        dependence on single-source suppliers to meet manufacturing needs;





        failure to secure adequate protection for our intellectual property rights;





        development of a competing product by another business using the underlying technology included in the patent we had licensed from the University of Minnesota, which expired in 2006;





        our ability to develop new applications and product enhancements;





        our ability to effectively respond to low-cost local competitors in Asia and elsewhere;





        our ability to properly manage any growth in revenue and/or production requirements;





        the influence over our voting stock by insiders;





        our ability to hire and retain key scientific and technical personnel;





        our ability to achieve and maintain effective internal controls;





        our ability to predict product, customer and geographic sales mix;





        our ability to successfully manage operating costs;





        our ability to comply with international regulatory restrictions over hazardous substances and electronic waste; and





        conditions beyond our control, such as war, terrorist attacks, health epidemics and economic recession.




We caution that the forward-looking statements made in this report or in other announcements made by us are further qualified by the factors described in our reports and other documents we filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. We encourage you to consider all of these risks, uncertainties and other factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q. As a result of these matters, changes in facts, assumptions not being realized or other circumstances, our actual results may differ materially from the expected results discussed in the forward-looking statements contained in this Quarterly Report on Form 10-Q. The forward-looking statements made in this Quarterly Report on Form 10-Q are made only as of the date of this release, and we undertake no
obligation to update them to reflect subsequent events or circumstances.



Item 3.
        Quantitative and Qualitative Disclosures About Market Risk




Our foreign sales and results of operations are subject to the impact of foreign currency fluctuations. We have not hedged our exposure to translation gains and losses. A 10% adverse change in foreign currency rates would not have a material effect on our results of operations or financial position.



Item 4T.
        Controls and Procedures




Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective.



Changes in Internal Control Over Financial Reporting

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

13



---

Table of Contents

PART II. OTHER INFORMATION



Item 1.
        Legal Proceedings




None.



Item 1A.
        Risk Factors




Some of the risk factors to which we and our business are subject are described in the section entitled Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2006. The risks and uncertainties described in our Annual Report are not the only risks we face. Additional risks and uncertainties not presently known to us or that our management currently deems immaterial also may impair our business operations. If any of the risks described were to occur, our business, financial condition, operating results and cash flows could be materially adversely affected.



Item 2.
        Unregistered Sales of Equity Securities and Use of Proceeds




(a)  None.



Item 3.
        Defaults Upon Senior Securities




None.



Item 4.
        Submission of Matters to a Vote of Security Holders.




None.



Item 5.
        Other Information




None.



Item 6.
        Exhibits




The following exhibits are filed as part of this quarterly report on Form 10-Q for the quarter ended September 30, 2007:



Exhibit

Number
        Description




31.1
        Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




31.2
        Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




32.1
        Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




32.2
        Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.






14



---

Table of Contents

SIGNATURES



In accordance with the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





Image Sensing Systems, Inc.By:Dated:  November 2, 2007
        
        
        /s/ Kenneth R. AubreyKenneth R. AubreyPresident and Chief Executive Officer(principal executive officer)Dated:  November 2, 2007
        
        
        /s/ Gregory R.L. SmithGregory R.L. SmithChief Financial Officer(principal financial and accounting officer)






15



---

Table of Contents

EXHIBIT INDEX





Exhibit No.
        Description




31.1
        Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




31.2
        Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




32.1
        Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




32.2
        Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




16



---