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

| |           | 
| | --------- | 
| |           | 
| |           | 
| | FORM 10-Q | 
| |           | 
| |           | 

|  |                                                                                          
|- | -----------------------------------------------------------------------------------------
|x | QUARTERLY
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|  |                                                                                          
|  | For the quarterly period
 ended September 30, 2010                                       
|  |                                                                                          
|  | OR                                                                                       
|  |                                                                                          
|o | TRANSITION
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  |                                                                                          
|  | For the transition period
 from ________________ to ________________                     

|                                                        |                                  | 
|------------------------------------------------------- | -------------------------------- | 
|                                                        | Commission
 file number: 0-26056 | 
|                                                        |                                  | 
|                                                        |                                  | 
|                                                        |                                  | 
|Image
Sensing Systems, Inc.                            
|(Exact
 name of registrant as specified in its charter)

|                                                                                    |  |                     
|----------------------------------------------------------------------------------- |  | --------------------
|Minnesota                                                                           |  | 41-1519168          
|(State
 or other jurisdiction of                                                    |  | (I.R.S.
 Employer   
|incorporation
 or organization)                                                     |  | Identification
 No.)
|                                                                                    |  |                     
|500 Spruce Tree Centre                                                              |  |                     
|1600 University Avenue West                                                         |  |                     
|St. Paul, MN                                                                        |  | 55104               
|(Address of principal executive offices)                                            |  | (Zip Code)          
|                                                                                    |  |                     
|(651) 603-7700                                                                     
|(Registrants
 telephone number, including area code)                              
|                                                                                   
|Not Applicable                                                                     
|(Former
 name, former address and former fiscal year, if changed since last report)

| |  | 
| |  | 
| |  | 

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 whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes oNo o

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

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

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

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 November 4, 2010
|Common
 Stock, $0.01 par value per share |  | 4,868,519
 shares               







IMAGE SENSING
SYSTEMS, INC.

TABLE OF CONTENTS

|               |  |                                                                                        |  |         
|-------------- |  | -------------------------------------------------------------------------------------- |  | --------
|               |  |                                                                                        |  | Page No.
|               |  |                                                                                        |  |         
|PART
 I.       |  | FINANCIAL
 INFORMATION                                                                 |  | 1       
|               |  |                                                                                        |  |         
|Item
 1.       |  | Financial
 Statements (unaudited):                                                     |  | 1       
|               |  |                                                                                        |  |         
|               |  | Condensed
 Consolidated Balance Sheets                                                 |  | 1       
|               |  |                                                                                        |  |         
|               |  | Condensed
 Consolidated Statements of Income                                           |  | 2       
|               |  |                                                                                        |  |         
|               |  | Condensed
 Consolidated Statements of Cash Flows                                       |  | 3       
|               |  |                                                                                        |  |         
|               |  | Notes
 to Condensed Consolidated Financial Statements                                  |  | 4       
|               |  |                                                                                        |  |         
|Item
 2.       |  | Managements
 Discussion and Analysis of Financial Condition and Results of Operations |  | 10      
|               |  |                                                                                        |  |         
|Item
 3.       |  | Quantitative
 and Qualitative Disclosures About Market Risk                            |  | 17      
|               |  |                                                                                        |  |         
|Item
 4T.      |  | Controls
 and Procedures                                                               |  | 17      
|               |  |                                                                                        |  |         
|PART
 II.      |  | OTHER
 INFORMATION                                                                     |  | 18      
|               |  |                                                                                        |  |         
|Item
 1.       |  | Legal
 Proceedings                                                                     |  | 18      
|               |  |                                                                                        |  |         
|Item
 1A.      |  | Risk
 Factors                                                                          |  | 18      
|               |  |                                                                                        |  |         
|Item
 2.       |  | Unregistered
 Sales of Equity Securities and Use of Proceeds                           |  | 18      
|               |  |                                                                                        |  |         
|Item
 3.       |  | Defaults
 Upon Senior Securities                                                       |  | 18      
|               |  |                                                                                        |  |         
|Item
 4.       |  | [Removed
 and Reserved]                                                                |  | 18      
|               |  |                                                                                        |  |         
|Item
 5.       |  | Other
 Information                                                                     |  | 18      
|               |  |                                                                                        |  |         
|Item
 6.       |  | Exhibits                                                                               |  | 18      
|               |  |                                                                                        |  |         
|SIGNATURES     |  | 19                                                                                    
|               |  |                                                                                        |  |         
|EXHIBIT
 INDEX |  | 20                                                                                    

---



PART I. FINANCIAL INFORMATION

|        |                                  
|------- | ---------------------------------
|Item 1. | Financial Statements (unaudited):

Image Sensing Systems, Inc.
Condensed Consolidated Balance Sheets
(Unaudited)
(in thousands)

|                                            |  |                     |        |                    |   |        |  
|------------------------------------------- |  | ------------------- | ------ | ------------------ | - | ------ | -
|                                            |  | September 30,
 2010 |        | December 31,
 2009 |  
|Assets                                      |  |                     |        |                    |   |        |  
|Current assets:                             |  |                     |        |                    |   |        |  
|Cash and cash equivalents                   |  | $                   | 9,361  |                    | $ | 14,084 |  
|Investments                                 |  |                     | 3,590  |                    |   | 3,935  |  
|Accounts receivable, net                    |  |                     | 7,876  |                    |   | 5,660  |  
|Inventories                                 |  |                     | 3,529  |                    |   | 2,734  |  
|Prepaid expenses                            |  |                     | 1,368  |                    |   | 588    |  
|Deferred income taxes                       |  |                     | 328    |                    |   | 328    |  
|Total current assets                        |  |                     | 26,052 |                    |   | 27,329 |  
|                                            |  |                     |        |                    |   |        |  
|Property and equipment,
 net                |  |                     | 1,095  |                    |   | 998    |  
|                                            |  |                     |        |                    |   |        |  
|Deferred income taxes                       |  |                     |       |                    |   | 1,485  |  
|Goodwill and intangible
 assets             |  |                     | 22,536 |                    |   | 11,338 |  
|Total assets                                |  | $                   | 49,683 |                    | $ | 41,150 |  
|                                            |  |                     |        |                    |   |        |  
|Liabilities
 and Shareholders Equity       |  |                     |        |                    |   |        |  
|Current liabilities:                        |  |                     |        |                    |   |        |  
|Accounts payable                            |  | $                   | 1,451  |                    | $ | 953    |  
|Bank debt                                   |  |                     |       |                    |   | 4,000  |  
|Accrued compensation                        |  |                     | 1,036  |                    |   | 858    |  
|Accrued warranty and other                  |  |                     | 1,182  |                    |   | 643    |  
|Earn-out payable                            |  |                     | 1,010  |                    |   | 1,541  |  
|Income taxes payable                        |  |                     | 10     |                    |   | 234    |  
|Total current liabilities                   |  |                     | 4,689  |                    |   | 8,229  |  
|                                            |  |                     |        |                    |   |        |  
|Deferred income taxes                       |  |                     | 391    |                    |   |       |  
|Income taxes payable                        |  |                     | 186    |                    |   | 208    |  
|                                            |  |                     |        |                    |   |        |  
|Shareholders equity:                       |  |                     |        |                    |   |        |  
|Common stock                                |  |                     | 49     |                    |   | 40     |  
|Additional paid-in capital                  |  |                     | 21,867 |                    |   | 11,994 |  
|Accumulated other comprehensive loss        |  |                     | (245   | )                  |   | (171   | )
|Retained earnings                           |  |                     | 22,746 |                    |   | 20,850 |  
|                                            |  |                     | 44,417 |                    |   | 32,713 |  
|Total liabilities and
 shareholders equity |  | $                   | 49,683 |                    | $ | 41,150 |  

See accompanying notes.

- 1 -

---



Image Sensing Systems, Inc.
Condensed Consolidated Statements of Income
(Unaudited)
(in thousands, except per share data)

|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|------------------------------------------------------ |  | ---------------------------------------- | ----- | --------------------------------------- | - | ----- |  | ---- | ------ | - | - | ------ | 
|                                                       |  | Three-Month Periods Ended
 September 30, |       | Nine-Month Periods Ended
 September 30, |  
|                                                       |  | 2010                                     |       | 2009                                    |   | 2010  |  | 2009 |       
|Revenue:                                               |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Product sales                                          |  | $                                        | 5,677 |                                         | $ | 3,434 |  | $    | 11,886 |   | $ | 8,825  | 
|Royalties                                              |  |                                          | 3,444 |                                         |   | 3,389 |  |      | 9,222  |   |   | 9,068  | 
|                                                       |  |                                          | 9,121 |                                         |   | 6,823 |  |      | 21,108 |   |   | 17,893 | 
|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Costs of
 revenue:                                     |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Product sales                                          |  |                                          | 1,950 |                                         |   | 1,269 |  |      | 4,392  |   |   | 2,947  | 
|Gross profit                                           |  |                                          | 7,171 |                                         |   | 5,554 |  |      | 16,716 |   |   | 14,946 | 
|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Operating
 expenses:                                   |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Selling, marketing and product support                 |  |                                          | 2,791 |                                         |   | 1,721 |  |      | 6,793  |   |   | 5,272  | 
|General and administrative                             |  |                                          | 1,307 |                                         |   | 796   |  |      | 3,283  |   |   | 2,574  | 
|Research and development                               |  |                                          | 989   |                                         |   | 868   |  |      | 2,600  |   |   | 2,541  | 
|Acquisition related expenses                           |  |                                          |      |                                         |   |      |  |      | 527    |   |   |       | 
|Amortization of intangible assets                      |  |                                          | 411   |                                         |   | 192   |  |      | 819    |   |   | 576    | 
|                                                       |  |                                          | 5,498 |                                         |   | 3,577 |  |      | 14,022 |   |   | 10,963 | 
|Income from operations                                 |  |                                          | 1,673 |                                         |   | 1,977 |  |      | 2,694  |   |   | 3,983  | 
|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Other income (expense),
 net                           |  |                                          | (74   | )                                       |   | 9     |  |      | (146   | ) |   | 18     | 
|Income before income taxes                             |  |                                          | 1,599 |                                         |   | 1,986 |  |      | 2,548  |   |   | 4,001  | 
|Income taxes                                           |  |                                          | 472   |                                         |   | 426   |  |      | 652    |   |   | 1,010  | 
|Net income                                             |  | $                                        | 1,127 |                                         | $ | 1,560 |  | $    | 1,896  |   | $ | 2,991  | 
|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Net income per common
 share:                          |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Basic                                                  |  | $                                        | 0.23  |                                         | $ | 0.39  |  | $    | 0.42   |   | $ | 0.75   | 
|Diluted                                                |  | $                                        | 0.23  |                                         | $ | 0.38  |  | $    | 0.41   |   | $ | 0.74   | 
|                                                       |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Weighted average number of
 common shares outstanding: |  |                                          |       |                                         |   |       |  |      |        |   |   |        | 
|Basic                                                  |  |                                          | 4,805 |                                         |   | 3,986 |  |      | 4,471  |   |   | 3,985  | 
|Diluted                                                |  |                                          | 4,911 |                                         |   | 4,073 |  |      | 4,584  |   |   | 4,065  | 

See accompanying notes.

- 2 -

---



Image Sensing Systems, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited) 
(in thousands)

|                                                                                  |  |                                         |        |      |   |        |  
|--------------------------------------------------------------------------------- |  | --------------------------------------- | ------ | ---- | - | ------ | -
|                                                                                  |  | Nine-Month Periods Ended
 September 30, |       
|                                                                                  |  | 2010                                    |        | 2009 |  
|Operating
 activities:                                                            |  |                                         |        |      |   |        |  
|Net income                                                                        |  | $                                       | 1,896  |      | $ | 2,991  |  
|Adjustments to reconcile net income to net cash provided by operating
 activities |  |                                         |        |      |   |        |  
|Depreciation and amortization                                                     |  |                                         | 1,157  |      |   | 906    |  
|Stock option expense                                                              |  |                                         | 251    |      |   | 266    |  
|Change in operating assets and liabilities, net of acquisition                    |  |                                         | (2,640 | )    |   | (1,217 | )
|Net cash provided by operating activities                                         |  |                                         | 664    |      |   | 2,946  |  
|                                                                                  |  |                                         |        |      |   |        |  
|Investing activities:                                                             |  |                                         |        |      |   |        |  
|Net purchases of property and equipment                                           |  |                                         | (224   | )    |   | (496   | )
|Purchase of CitySync                                                              |  |                                         | (7,871 | )    |   |       |  
|Repayment of CitySync seller loans                                                |  |                                         | (445   | )    |   |       |  
|Payment of EIS earn-out                                                           |  |                                         | (1,541 | )    |   | (1,192 | )
|Net sales of investments                                                          |  |                                         | 345    |      |   | 60     |  
|Net cash used in investing activities                                             |  |                                         | (9,736 | )    |   | (1,628 | )
|                                                                                  |  |                                         |        |      |   |        |  
|Financing activities:                                                             |  |                                         |        |      |   |        |  
|Proceeds from exercise of stock options                                           |  |                                         | 87     |      |   | 4      |  
|Repayment of bank debt                                                            |  |                                         | (4,556 | )    |   | (3,750 | )
|Net proceeds from common stock offering                                           |  |                                         | 8,818  |      |   |       |  
|Net cash provided by (used in) financing activities                               |  |                                         | 4,349  |      |   | (3,746 | )
|                                                                                  |  |                                         |        |      |   |        |  
|Decrease in cash and cash equivalents                                             |  |                                         | (4,723 | )    |   | (2,428 | )
|                                                                                  |  |                                         |        |      |   |        |  
|Cash and cash equivalents, beginning of period                                    |  |                                         | 14,084 |      |   | 10,289 |  
|Cash and cash equivalents, end of period                                          |  | $                                       | 9,361  |      | $ | 7,861  |  

See accompanying notes.

- 3 -

---



IMAGE SENSING SYSTEMS, INC.

Notes to
Condensed Consolidated Financial Statements 
(Unaudited) 
September 30, 2010

Note A: Basis of Presentation

The
accompanying unaudited condensed consolidated financial statements of Image
Sensing Systems, Inc. (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 the Quarterly Report
on 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 three-month and
nine-month periods ended September 30, 2010 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2010. 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, 2009.

Note B: Acquisitions

On June 21,
2010, we purchased all of the outstanding equity of CitySync Limited (CitySync), a
privately-held developer and marketer of automatic number plate recognition
(ANPR) products. We believe the CitySync acquisition expands our addressable
market, strengthens our selling presence in Europe and extends the
opportunities for hybrid product developments. The purchase price was $7.9
million in cash plus 57,000 shares of our common stock, valued using the
closing price on the day before the acquisition, totaling approximately
$727,000. In conjunction with the purchase, we repaid seller loans, including
accrued interest, of $601,000. As part of the purchase agreement, the sellers
are eligible to receive an earn-out based on the performance of the business
for 18 months after the purchase date. Earn-outs will be calculated as of each calendar year
end and paid within 90 days thereof. The earn-out is based on achieving certain
revenue and minimum gross margins from the sale of CitySync ANPR systems and it
is calculated in two separate periods, each ending on December 31. In each
period there are two tiers, and superior performance could lead to a total
earn-out of $2 million or higher, as the earn-out is not capped. We have
determined the fair value of the earn-out to be $1.0 million and have recorded
a liability and additional purchase price in that amount as of June 30, 2010.
The determination of the fair value was based on a probabilistic calculation
where we assigned probabilities to achieving each of the tiers in each of the
periods and then discounted the total to net present value. Following the
acquisition, CitySync became a wholly-owned subsidiary of ISS/Europe.

At June 30,
2010, we preliminarily estimated the value of goodwill from the CitySync
acquisition at $3.3 million. As required under purchase accounting rules, we
have updated this estimate, although the estimate and other allocations are
still preliminary pending further study of asset valuations. The details of the
updated goodwill estimate are as follows (in thousands):

|                                                                                                       |  |   |       | 
|------------------------------------------------------------------------------------------------------ |  | - | ----- | 
|Initial goodwill estimate                                                                              |  | $ | 3,347 | 
|Recognition of deferred tax liability for
 timing differences related to intangible asset amortization |  |   | 1,876 | 
|Inventory valuation adjustments                                                                        |  |   | 66    | 
|Other                                                                                                  |  |   | 12    | 
|Goodwill estimate at September 30, 2010                                                                |  | $ | 5,301 | 

- 4 -

---



The purchase
price was allocated on the basis of estimated fair value at the date of the
purchase. The purchase price allocation, which is preliminary pending further
study of the fair values assigned, was as follows (in thousands):

|                                 |  |   |        |  
|-------------------------------- |  | - | ------ | -
|Purchase
 price:                 |  |   |        |  
|Cash                             |  | $ | 7,871  |  
|Fair value of common stock       |  |   | 727    |  
|Estimated fair value of earn-out |  |   | 1,010  |  
|Total purchase price             |  |   | 9,608  |  
|                                 |  |   |        |  
|Allocation:                      |  |   |        |  
|Net tangible current assets      |  |   | (1,691 | )
|Property and equipment           |  |   | (242   | )
|Liabilities                      |  |   | 2,450  |  
|Deferred income taxes            |  |   | 1,876  |  
|Developed technology             |  |   | (3,300 | )
|Trade names                      |  |   | (1,900 | )
|Other intangibles                |  |   | (1,500 | )
|Goodwill estimate                |  | $ | 5,301  |  

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

The results of
CitySync operations are included in the accompanying financial statements since
the date of the acquisition. The following pro forma summary presents the
results of operations as if the acquisition had occurred on January 1, 2009.
The table below includes our results for the periods as shown and for CitySync
based on a January 31 fiscal year end.

The pro forma
results are not necessarily indicative of the results that would have been
achieved had the CitySync acquisition taken place on that date (in thousands,
except per share amounts):

|                       |  |                                    |       |                                   |   |        |  |      |        |  |   |        | 
|---------------------- |  | ---------------------------------- | ----- | --------------------------------- | - | ------ |  | ---- | ------ |  | - | ------ | 
|                       |  | Three-Months
 Ended
 September 30, |       | Nine-Months
 Ended
 September 30, |  
|                       |  | 2010                               |       | 2009                              |   | 2010   |  | 2009 |       
|                      
|Total
 revenue         |  | $                                  | 9,121 |                                   | $ | 10,085 |  | $    | 23,515 |  | $ | 23,753 | 
|                      
|Net income             |  |                                    | 1,127 |                                   |   | 2,387  |  |      | 1,399  |  |   | 2,546  | 
|                       |  |                                    |       |                                   |   |        |  |      |        |  |   |        | 
|Net income
 per share: |  |                                    |       |                                   |   |        |  |      |        |  |   |        | 
|Basic                  |  | $                                  | 0.23  |                                   | $ | 0.54   |  | $    | 0.31   |  | $ | 0.63   | 
|Diluted                |  | $                                  | 0.23  |                                   | $ | 0.56   |  | $    | 0.30   |  | $ | 0.62   | 

In 2007, we
purchased certain assets of EIS Electronic Integrated Systems, Inc. (EIS),
including its RTMS radar product line. As part of the purchase agreement, the
sellers are eligible to receive an earn-out based on the performance of the EIS
assets purchased for approximately three years after the December 2007 purchase
date. Earn-outs are calculated and paid annually. Based on target achievement,
the sellers would receive $2.0 million annually or a total of $6.0 million. If
we are acquired or sell substantially all of our assets before December 6,
2010, we must pay EIS $6.0 million less earn-out amounts previously paid as an
acceleration of potential earn-out payments under the EIS asset purchase
agreement. Earn-out payments related to the EIS asset purchase are recorded as
additional goodwill when earned. In 2009 and 2008, the sellers earned an
earn-out of approximately $1.5 million and $1.2 million, respectively, which
were paid in March of the subsequent year.

- 5 -

---



Note C: Goodwill and Intangible Assets

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic Ltd.; $6.6
million related to the EIS asset purchase, consisting of $3.8 million recorded
at the purchase date and an additional $2.7 million recognized for earn-out
consideration earned in 2009 and 2008; and $5.3 million related to our
acquisition of CitySync. See Note B above for activity related to CitySync acquisition
goodwill.

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

|                                           |  |                     |        |                    |   |        |  
|------------------------------------------ |  | ------------------- | ------ | ------------------ | - | ------ | -
|                                           |  | September 30,
 2010 |        | December 31,
 2009 |  
|Developed technology (8 year life)         |  | $                   | 7,200  |                    | $ | 3,900  |  
|Trade names (5 to 9 year life)             |  |                     | 3,100  |                    |   | 1,200  |  
|Other intangibles (3 to 8 year life)       |  |                     | 1,700  |                    |   | 200    |  
|Less: Accumulated amortization             |  |                     | (2,389 | )                  |   | (1,586 | )
|Total
 identifiable intangible assets, net |  | $                   | 9,611  |                    | $ | 3,714  |  

We expect to
recognize amortization expense for the intangible assets in the above table in
each of our years ending December 31 of $1.2 million in 2010, $1.6 million in
each of 2011 and 2012, and $1.3 million in each of 2013 and 2014. Goodwill and
intangible assets related to the EIS asset purchase are deductible for tax
purposes over 15 years.

We monitor on
a quarterly basis our carrying value, the market capitalization of our stock
and other variables to determine whether a triggering event has occurred that
would require an interim impairment evaluation of our goodwill. We have
concluded that no triggering events have occurred during the quarter ended
September 30, 2010.

Note D: Bank Debt

As of
September 30, 2010, we had repaid all outstanding bank debt under our term loan
in the U.S. and our bank line of credit in the U.K.

Note E: Net Income Per Common Share and Comprehensive Income (Loss)

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, 2010 and
2009 (in thousands, except per share data):

|                                                                 |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|---------------------------------------------------------------- |  | ---------------------------------------- | ----- | --------------------------------------- | - | ----- |  | ---- | ----- |  | - | ----- | 
|                                                                 |  | Three-Month Periods
 Ended September 30, |       | Nine-Month Periods Ended
 September 30, |  
|                                                                 |  | 2010                                     |       | 2009                                    |   | 2010  |  | 2009 |      
|Numerator:                                                       |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Net income                                                       |  | $                                        | 1,127 |                                         | $ | 1,560 |  | $    | 1,896 |  | $ | 2,991 | 
|Denominator:                                                     |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Shares used in basic net income per common
 share calculation    |  |                                          | 4,805 |                                         |   | 3,986 |  |      | 4,471 |  |   | 3,985 | 
|Effect of diluted securities:                                    |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Contingent shares in escrow                                      |  |                                          | 56    |                                         |   |      |  |      | 38    |  |   |      | 
|Employee and director stock options                              |  |                                          | 50    |                                         |   | 87    |  |      | 75    |  |   | 80    | 
|Shares used in diluted net income per
 common share calculations |  |                                          | 4,911 |                                         |   | 4,073 |  |      | 4,584 |  |   | 4,065 | 
|Basic net
 income per common share                               |  | $                                        | 0.23  |                                         | $ | 0.39  |  | $    | 0.42  |  | $ | 0.75  | 
|Diluted net
 income per common share                             |  | $                                        | 0.23  |                                         | $ | 0.38  |  | $    | 0.41  |  | $ | 0.74  | 

Our
comprehensive income for the three-month periods ended September 30, 2010 and
2009 was $1.3 million and $1.5 million, respectively, and for the nine-month
periods ended September 30, 2010 and 2009 was $1.8 million and $2.8 million,
respectively. In each period, the main difference between net income and
comprehensive income arose from foreign currency translation adjustments.

- 6 -

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Note F: Equity and Stock-based Compensation

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

We recorded
$251,000 and $266,000 of stock-based compensation in general and administrative
expense for the nine-month periods ended September 30, 2010 and 2009,
respectively. No options were granted in the third quarter of either 2010 or
2009. Options to purchase 68,000 shares at a weighted average exercise price of
$8.62 were granted during the nine-month period ended September 30, 2009. As of
September 30, 2010, $750,000 of total unrecognized compensation expense related
to non-vested stock option awards is expected to be recognized over a weighted
average period of 2.3 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,
2010 and 2009, respectively.

The Companys
stock options generally vest over three to five years of service and have a
contractual life of six to 10 years. As of September 30, 2010, we had 197,500
shares available for grants under the 2005 Stock Incentive Plan.

The following
table summarizes information about the stock options outstanding at September
30, 2010:

|                         |             |                     |  |                                                 |  |                                   |  |                     |       |                                   |  |         |  |   |       |  | 
|------------------------ | ----------- | ------------------- |  | ----------------------------------------------- |  | --------------------------------- |  | ------------------- | ----- | --------------------------------- |  | ------- |  | - | ----- |  | 
|                         |             | Options Outstanding |  | Options Exercisable                             | 
|Range of
 Exercise Price |             | Number
 Outstanding |  | Weighted
 Average
 Remaining
 Contractual
 Life |  | Weighted
 Average
 Exercise Price |  | Number
 Exercisable |       | Weighted
 Average
 Exercise Price | 
|$                        | 1.30-1.99   |                     |  | 46,000                                          |  | 1.7 years                         |  | $                   | 1.36  |                                   |  | 46,000  |  | $ | 1.36  | 
|                         | 2.00-2.99   |                     |  | 16,200                                          |  | 1.4 years                         |  |                     | 2.35  |                                   |  | 16,200  |  |   | 2.35  | 
|                         | 3.00-3.99   |                     |  | 38,933                                          |  | 2.0 years                         |  |                     | 3.15  |                                   |  | 38,933  |  |   | 3.15  | 
|                         | 8.00-8.99   |                     |  | 48,000                                          |  | 6.1 years                         |  |                     | 8.63  |                                   |  | 13,500  |  |   | 8.58  | 
|                         | 9.00-9.99   |                     |  | 172,500                                         |  | 4.6 years                         |  |                     | 9.20  |                                   |  | 55,125  |  |   | 9.16  | 
|                         | 12.00-12.99 |                     |  | 105,000                                         |  | 5.1 years                         |  |                     | 12.58 |                                   |  | 31,500  |  |   | 12.51 | 
|                         | 15.00-15.99 |                     |  | 28,000                                          |  | 1.3 years                         |  |                     | 15.30 |                                   |  | 28,000  |  |   | 15.30 | 
|                         |             |                     |  | 454,633                                         |  | 4.0 years                         |  |                     | 8.74  |                                   |  | 229,258 |  |   | 7.27  | 

Note G: Segment Information

We operate in
three reportable segments: Autoscope, RTMS and ANPR. Autoscope is our machine-vision
product line, and revenue consists of royalties (all of which are received from
Econolite Control Products, Inc.), as well as a portion of product sales. RTMS
is our radar product line acquired in the EIS asset purchase in 2007 and ANPR
is our automatic number plate recognition product line acquired in the CitySync
purchase in June 2010. Included within the ANPR segment are the acquisition related expenses incurred in 2010. All segment revenues are derived from external
customers.

The following
table sets forth selected unaudited financial information for each of the
Companys reportable segments for the three-month periods ended September 30,
2010 and 2009 (in thousands):

|                                   |  |           |        |      |   |        |      |      |        |      |   |       |  |      |        |      |   |   |  |   |        |  |   |        | 
|---------------------------------- |  | --------- | ------ | ---- | - | ------ | ---- | ---- | ------ | ---- | - | ----- |  | ---- | ------ | ---- | - | - |  | - | ------ |  | - | ------ | 
|                                   |  | Autoscope |        | RTMS |   |        | ANPR |      | Total  |     
|                                   |  | 2010      |        | 2009 |   | 2010   |      | 2009 |        | 2010 |   | 2009  |  | 2010 |        | 2009 |  
|Revenue                            |  | $         | 4,784  |      | $ | 4,374  |      | $    | 2,487  |      | $ | 2,449 |  | $    | 1,850  |      | $ |  |  | $ | 9,121  |  | $ | 6,823  | 
|Depreciation                       |  |           | 38     |      |   | 90     |      |      | 43     |      |   | 34    |  |      | 12     |      |   |  |  |   | 93     |  |   | 124    | 
|Amortization
 of intangible assets |  |           |       |      |   |       |      |      | 192    |      |   | 192   |  |      | 219    |      |   |  |  |   | 411    |  |   | 192    | 
|Income
 before income taxes        |  |           | 938    |      |   | 1,512  |      |      | 501    |      |   | 474   |  |      | 160    |      |   |  |  |   | 1,599  |  |   | 1,986  | 
|Capital
 expenditures              |  |           | 5      |      |   | 72     |      |      |       |      |   | 84    |  |      |       |      |   |  |  |   | 5      |  |   | 156    | 
|Total assets                       |  | $         | 25,443 |      | $ | 24,786 |      | $    | 11,274 |      | $ | 9,955 |  | $    | 12,966 |      | $ |  |  | $ | 49,683 |  | $ | 34,741 | 

- 7 -

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The following
table sets forth selected unaudited financial information for each of the Companys
reportable segments for the nine-month periods ended September 30, 2010 and
2009 (in thousands):

|                                   |  |           |        |      |   |        |  |       |        |      |   |       |  |      |        |      |   |   |  |   |        |  |   |        | 
|---------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ----- | ------ | ---- | - | ----- |  | ---- | ------ | ---- | - | - |  | - | ------ |  | - | ------ | 
|                                   |  | Autoscope |        | RTMS |   | ANPR   |  | Total |       
|                                   |  | 2010      |        | 2009 |   | 2010   |  | 2009  |        | 2010 |   | 2009  |  | 2010 |        | 2009 |  
|Revenue                            |  | $         | 11,990 |      | $ | 11,784 |  | $     | 6,959  |      | $ | 6,109 |  | $    | 2,159  |      | $ |  |  | $ | 21,108 |  | $ | 17,893 | 
|Depreciation                       |  |           | 198    |      |   | 237    |  |       | 128    |      |   | 93    |  |      | 12     |      |   |  |  |   | 338    |  |   | 330    | 
|Amortization
 of intangible assets |  |           |       |      |   |       |  |       | 576    |      |   | 576   |  |      | 243    |      |   |  |  |   | 819    |  |   | 576    | 
|Income
 before income taxes        |  |           | 1,784  |      |   | 3,066  |  |       | 1,074  |      |   | 935   |  |      | (310)  |      |   |  |  |   | 2,548  |  |   | 4,001  | 
|Capital
 expenditures              |  |           | 174    |      |   | 357    |  |       | 50     |      |   | 139   |  |      |       |      |   |  |  |   | 224    |  |   | 496    | 
|Total assets                       |  | $         | 25,443 |      | $ | 24,786 |  | $     | 11,274 |      | $ | 9,955 |  | $    | 12,966 |      | $ |  |  | $ | 49,683 |  | $ | 34,741 | 

Note H: Derivative Instruments

We have
purchased foreign currency forward contracts with our bank to reduce the
exposure and volatility arising from fluctuations in foreign currency exchange
rates as it relates to payroll and inventory purchases in certain foreign
locations. These contracts have been designated as effective cash flow hedges.
At September 30, 2010, we had future commitments through November 2010 to
purchase $600,000 of Canadian dollars at rates ranging from approximately .9291
to .9296.

The fair value
of the Companys derivative instruments is estimated in accordance with the
framework for measuring fair value and is recorded as either an asset or
liability in the balance sheet based on changes in the current spot rate as
compared to the exchange rates specified in the contracts. For these
instruments, the effective portion of the gain or loss on the derivative is
reported as a component of other comprehensive income and is reclassified into
earnings in the same period or periods during which the hedged transaction
affects earnings. Gains and losses on the derivative representing either hedge
ineffectiveness or hedge components excluded from the assessment of
effectiveness are recognized in current earnings. The fair value measurement of
the Companys derivative instruments is estimated using Level 2 inputs, which
are inputs other than quoted prices that are directly or indirectly observable
for the asset or liability. We did not record any unrealized gain or losses on
our derivative instruments as of September 30, 2010, as the amount was
immaterial.

Note I: New Accounting Pronouncements

In June 2009,
the Financial Accounting Standards Board (FASB) amended Accounting Standards
Codification (ASC) 810, Consolidation,
to improve how enterprises disclose their involvement with variable interest
entities (VIE), which are special-purpose entities and other entities whose
equity at risk is insufficient or lacks certain characteristics. Among other
things, the amended guidance in ASC 810 changes how an entity determines
whether it is the primary beneficiary of a VIE and whether that VIE should be
consolidated. ASC 810 requires an entity to provide significantly more
disclosures about its involvement with a VIE. Companies must comprehensively
review involvements with potential VIEs, including those previously considered
to be qualifying special-purpose entities, to determine the effect on their
consolidated financial statements and related disclosures. The amended guidance
in ASC 810 is effective prospectively at the beginning of an entitys first
annual reporting period beginning after December 15, 2009 and for interim
periods within the first annual reporting period. The adoption of the amended
guidance in ASC 810 did not have a significant effect on our consolidated
financial statements.

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

- 8 -

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In September 2010, the
FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing
Receivables and the Allowance for Credit Losses, to enhance the
disclosures required for financing receivables (for example, loans, trade
accounts receivable, notes receivable, and receivables relating to a lessors
leveraged, direct financing, and sales-type leases) and allowances for credit
losses. The amended disclosures are designed to provide more information to
financial statement users regarding the credit quality of a creditors
financing receivables and the adequacy of its allowance for credit losses. The
amended guidance is effective for period-end balances beginning with the first
interim or annual reporting period ending on or after December 15, 2010.
The amended guidance is effective for activity during a reporting period
beginning on or after December 15, 2010. We expect the amended guidance to
impact our disclosures in future periods, but to otherwise not have a
significant effect on our consolidated financial statements.

- 9 -

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

Overview

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

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

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

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

Trends
and Challenges in Our Business

We believe the
growth in our business can be attributed primarily to the following global
trends:

| |   |                                                                                                                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | worsening traffic caused by
 increased numbers of vehicles in metropolitan areas without corresponding
 expansions of road infrastructure and the need to automate safety, security
 and access applications for automobiles and trucks, which has increased
 demand for our products;
| |   |                                                                                                                                                                                                                                                                                       
| |  | advances in information
 technology, which have made our products easier to market and implement;                                                                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                       
| |  | the continued funding
 allocations for centralized traffic management services and automated
 enforcement schemes, which has increased the ability of our primary end users
 to implement our products; and                                                                           
| |   |                                                                                                                                                                                                                                                                                       
| |  | general increases in the
 cost-effectiveness of electronics, which make our products more affordable
 for end users.                                                                                                                                                                  

- 10 -

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|                                                         |   |                                                                                                                                                                                                                                                                                                    
|-------------------------------------------------------- | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|We believe
 our continued growth primarily depends upon:
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | continued adoption and
 governmental funding of intelligent transportation systems, or ITS, and other
 automated applications for traffic control, safety and enforcement in
 developed countries;                                                                                                 
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | a propensity by traffic
 engineers to implement lower cost technology-based solutions rather than
 civil engineering solutions such as widening roadways;                                                                                                                                          
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | countries in the developing
 world adopting above-ground detection technology, such as video or radar,
 instead of in-pavement loop technology to manage traffic;                                                                                                                                  
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | use of CED to provide
 solutions to security/surveillance and environmental issues associated with
 increasing automobile use in metropolitan areas; and                                                                                                                                           
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | our ability to develop new
 products, such as hybrid CED devices incorporating, for example, radar and
 video technologies, that provide increasingly accurate information and
 enhance the end users ability to cost-effectively manage traffic,
 security/surveillance and environmental issues.

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

Key
Financial Terms and Metrics

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

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

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

- 11 -

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

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

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

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

The
following table sets forth selected unaudited financial information for each of
the Companys reportable segments for the three-month periods ended September
30, 2010 and 2009 (in thousands):

|                                  |  |           |        |      |   |        |  |       |        |      |   |       |  |      |        |      |   |   |  |   |        |  |   |        | 
|--------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ----- | ------ | ---- | - | ----- |  | ---- | ------ | ---- | - | - |  | - | ------ |  | - | ------ | 
|                                  |  | Autoscope |        | RTMS |   | ANPR   |  | Total |       
|                                  |  | 2010      |        | 2009 |   | 2010   |  | 2009  |        | 2010 |   | 2009  |  | 2010 |        | 2009 |  
|Revenue                           |  | $         | 4,784  |      | $ | 4,374  |  | $     | 2,487  |      | $ | 2,449 |  | $    | 1,850  |      | $ |  |  | $ | 9,121  |  | $ | 6,823  | 
|Depreciation                      |  |           | 38     |      |   | 90     |  |       | 43     |      |   | 34    |  |      | 12     |      |   |  |  |   | 93     |  |   | 124    | 
|Amortization of intangible assets |  |           |       |      |   |       |  |       | 192    |      |   | 192   |  |      | 219    |      |   |  |  |   | 411    |  |   | 192    | 
|Income before income taxes        |  |           | 938    |      |   | 1,512  |  |       | 501    |      |   | 474   |  |      | 160    |      |   |  |  |   | 1,599  |  |   | 1,986  | 
|Capital expenditures              |  |           | 5      |      |   | 72     |  |       |       |      |   | 84    |  |      |       |      |   |  |  |   | 5      |  |   | 156    | 
|Total assets                      |  | $         | 25,443 |      | $ | 24,786 |  | $     | 11,274 |      | $ | 9,955 |  | $    | 12,966 |      | $ |  |  | $ | 49,683 |  | $ | 34,741 | 

The following table sets
forth selected unaudited financial information for each of the Companys
reportable segments for the nine-month periods ended September 30, 2010 and
2009 (in thousands):

|                                  |  |           |        |      |   |        |  |       |        |      |   |       |  |      |        |      |   |   |  |   |        |  |   |        | 
|--------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ----- | ------ | ---- | - | ----- |  | ---- | ------ | ---- | - | - |  | - | ------ |  | - | ------ | 
|                                  |  | Autoscope |        | RTMS |   | ANPR   |  | Total |       
|                                  |  | 2010      |        | 2009 |   | 2010   |  | 2009  |        | 2010 |   | 2009  |  | 2010 |        | 2009 |  
|Revenue                           |  | $         | 11,990 |      | $ | 11,784 |  | $     | 6,959  |      | $ | 6,109 |  | $    | 2,159  |      | $ |  |  | $ | 21,108 |  | $ | 17,893 | 
|Depreciation                      |  |           | 198    |      |   | 237    |  |       | 128    |      |   | 93    |  |      | 12     |      |   |  |  |   | 338    |  |   | 330    | 
|Amortization of intangible assets |  |           |       |      |   |       |  |       | 576    |      |   | 576   |  |      | 243    |      |   |  |  |   | 819    |  |   | 576    | 
|Income before income taxes        |  |           | 1,784  |      |   | 3,066  |  |       | 1,074  |      |   | 935   |  |      | (310)  |      |   |  |  |   | 2,548  |  |   | 4,001  | 
|Capital expenditures              |  |           | 174    |      |   | 357    |  |       | 50     |      |   | 139   |  |      |       |      |   |  |  |   | 224    |  |   | 496    | 
|Total assets                      |  | $         | 25,443 |      | $ | 24,786 |  | $     | 11,274 |      | $ | 9,955 |  | $    | 12,966 |      | $ |  |  | $ | 49,683 |  | $ | 34,741 | 

- 12 -

---



Results of Operations

The following table sets
forth, for the periods indicated, (1) certain statements of income data as a
percent of total revenue, (2) gross profit on product sales and royalties as a
percentage of product sales and royalties, respectively, and (3)
period-to-period changes of items in the consolidated statements of income from
2010 to 2009:

|                                                 |  |                                           |       |                           |  |       |   |  |       |  
|------------------------------------------------ |  | ----------------------------------------- | ----- | ------------------------- |  | ----- | - |  | ----- | -
|                                                 |  | Three-Month Periods 
 Ended September 30, |       | Quarter OverQuarterChange | 
|                                                 |  |                                           |      
|                                                 |  | 2010                                      |       | 2009                      |  |      
|Product sales                                    |  |                                           | 62.2  | %                         |  | 50.3  | % |  | 65.3  | %
|Royalties                                        |  |                                           | 37.8  |                           |  | 49.7  |   |  | 1.6   |  
|Total revenue                                    |  |                                           | 100.0 |                           |  | 100.0 |   |  | 33.7  |  
|Gross profit  product
 sales                    |  |                                           | 65.7  |                           |  | 67.1  |   |  | 72.1  |  
|Gross profit  royalties                         |  |                                           | 100.0 |                           |  | 100.0 |   |  | 1.6   |  
|Selling, marketing and
 product support expenses |  |                                           | 30.6  |                           |  | 25.2  |   |  | 62.2  |  
|General and administrative
 expenses             |  |                                           | 14.3  |                           |  | 11.7  |   |  | 64.2  |  
|Research and development expenses                |  |                                           | 10.8  |                           |  | 12.7  |   |  | 13.9  |  
|Amortization of intangible
 assets               |  |                                           | 4.5   |                           |  | 2.8   |   |  | 114.1 |  
|Income from operations                           |  |                                           | 18.3  |                           |  | 29.0  |   |  | (15.4 | )
|Other income (expense),
 net                     |  |                                           | (0.8  | )                         |  | 0.1   |   |  | n/m   |  
|Income taxes                                     |  |                                           | 5.2   |                           |  | 6.2   |   |  | 10.8  |  
|Net income                                       |  |                                           | 12.4  |                           |  | 22.9  |   |  | (27.8 | )

|                                                 |  |                                         |       |                               |  |       |   |  |       |  
|------------------------------------------------ |  | --------------------------------------- | ----- | ----------------------------- |  | ----- | - |  | ----- | -
|                                                 |  | Nine-Month Periods
 Ended September 30, |       | Period Over 
 Period 
 Change | 
|                                                 |  |                                         |      
|                                                 |  | 2010                                    |       | 2009                          |  |      
|Product sales                                    |  |                                         | 56.3  | %                             |  | 49.3  | % |  | 34.7  | %
|Royalties                                        |  |                                         | 43.7  |                               |  | 50.7  |   |  | 1.7   |  
|Total revenue                                    |  |                                         | 100.0 |                               |  | 100.0 |   |  | 18.0  |  
|Gross profit  product
 sales                    |  |                                         | 63.0  |                               |  | 66.6  |   |  | 27.5  |  
|Gross profit  royalties                         |  |                                         | 100.0 |                               |  | 100.0 |   |  | 1.7   |  
|Selling, marketing and
 product support expenses |  |                                         | 32.2  |                               |  | 29.5  |   |  | 28.9  |  
|General and administrative
 expenses             |  |                                         | 15.6  |                               |  | 14.4  |   |  | 27.5  |  
|Research and development
 expenses               |  |                                         | 12.3  |                               |  | 14.2  |   |  | 2.3   |  
|Acquisition related
 expenses                    |  |                                         | 2.5   |                               |  |      |   |  | n/m   |  
|Amortization of intangible
 assets               |  |                                         | 3.9   |                               |  | 3.2   |   |  | 42.2  |  
|Income from operations                           |  |                                         | 12.8  |                               |  | 22.3  |   |  | (32.4 | )
|Other income (expense),
 net                     |  |                                         | (0.7  | )                             |  | 0.1   |   |  | n/m   |  
|Income taxes                                     |  |                                         | 3.1   |                               |  | 5.6   |   |  | (35.4 | )
|Net income                                       |  |                                         | 9.0   |                               |  | 16.7  |   |  | (36.6 | )

Total revenue increased to
$9.1 million in the three-month period ended September 30, 2010 from $6.8
million in the same period in 2009, an increase of 33.7%, and to $21.1 million
in the first nine months of 2010 from $17.9 million in the same period in 2009,
an increase of 18.0%. Royalties were flat at $3.4 million in the three month
periods of 2010 and 2009, and they increased to $9.2 million in the first nine
months of 2010 from $9.1 million in the same period in 2009, an increase of
1.7%. We attribute the relative flatness in royalties to the ongoing economic
recession in North America and its negative impact on state and federal
spending. Product sales increased to $5.7 million in the third quarter of 2010
from $3.4 million in the same period in 2009, an increase of 65.3%, and
increased to $11.9 million in the first nine months of 2010 from $8.8 million
in the same period in 2009, an increase of 34.7%. The increases are mainly due
to the impact of the CitySync acquisition and to a lesser extent by improved
sales in international markets.

- 13 -

---



On a segment basis, revenue
for the Autoscope segment increased to $4.8 million in the three-month period
ended September 30, 2010 from $4.4 million in the same period in 2009, and
increased to $12.0 million in the first nine months of 2010 from $11.8 million
in the same period in 2009. The increase reflects improved sales in
international markets. Revenue for the RTMS segment was $2.5 million in both
the third quarter of 2010 and the same period in 2009, and increased to $7.0
million in the first nine months of 2010 from $6.1 million in the same period
in 2009. The increase resulted mainly as a result of improved sales in Asia.
International sales increased to
$3.6 million in the third quarter up from $1.8 million in the same period of
2009 and increased to $6.6 million in the first nine months of 2010 from $4.1
million in the same period in 2009. The increases are mainly due to the
CitySync acquisition and due to improved sales, especially in Asia.

Gross margins for product
sales decreased to 65.7% in the three months ended September 30, 2010 from
67.1% in the same period in 2009, and to 63.0% in the first nine months of 2010
from 66.6% in the same period in 2009. The decreases resulted mainly from a
negative revenue mix shift in 2010 to both lower margin products and to higher
third-party equipment content. Gross margins on royalty income remained
consistent at 100.0% in each of the periods of 2010 and 2009.

Selling, marketing and
product support expense increased to $2.8 million, or 30.6% of total revenue,
in the three months ended September 30, 2010 from $1.7 million, or 25.2% of
total revenue, in the third quarter of 2009, and to $6.8 million, or 32.2% of
total revenue, in the first nine months of 2010 from $5.3 million, or 29.5% of
total revenue, in the first nine months of 2009. The change reflects the first
full quarter of CitySync related expenses. Additionally, the increase relates
to investments in market expansion activities in Europe and Asia and increased
product support expenses. We anticipate that for the remainder of 2010, the
dollar amount of our quarterly selling, marketing and product support expense
will increase from the 2010 third quarter level.

General and administrative
expense increased to $1.3 million, or 14.3% of total revenue, in the three
months ended September 30, 2010, from $796,000, or 11.7% of total revenue, in
the same period in 2009, and to $3.3 million, or 15.6% of total revenue, in the
first nine months of 2010, from to $2.6 million, or 14.4% of total revenue, in
the same period in 2009. The 2010 increase in costs resulted mainly from adding
CitySync related expenses and also due to lower exchange gains relative to
2009. We anticipate that for the remainder of 2010, the dollar amount of our
quarterly general and administrative expense will be consistent with that of
the third quarter of 2010.

Research and development
expense increased to $989,000, or 10.8% of total revenue, in the third quarter
of 2010, from $868,000, or 12.7% of total revenue, in the same period in 2009,
and to $2.6 million, or 12.3% of total revenue, in the first nine months of
2010, from $2.5 million, or 14.2% of total revenue, in the same period in 2009.
We anticipate that for the remainder of 2010, the dollar amount of our
quarterly research and development expense will be consistent with that of the
third quarter of 2010.

Amortization of intangibles
expense increased over 2009 levels due to the impact of amortization of
intangible assets from the CitySync acquisition. Assuming there are no changes
to our intangible assets, we anticipate amortization expense will be $1.2
million for all of 2010.

Other expense was $74,000
and $146,000 in the third quarter and first nine months of 2010, respectively,
as compared to other income of $9,000 and $18,000, respectively, in the same
periods in 2009. In 2009, bank debt was outstanding for only a portion of the
first quarter.

Income before income taxes
for the Autoscope segment decreased to $938,000 in the third quarter of
2010, compared to $1.5 million in the comparable quarter of 2009, and to $1.8
million in the first nine months of 2010, compared to $3.1 million in the
comparable period of 2009. The decreases were mainly due to lower gross margins and increased market expansion activities in international markets in the
segment. Income before income taxes for the RTMS
segment increased to $501,000 in the third quarter of 2010, compared to income
of $474,000 in the comparable quarter of 2009, and increased to $1.1 million in
the first nine months of 2010, compared to $935,000 in the comparable period of
2009. The increase for the nine-month period was mainly due to increased sales
volumes.

- 14 -

---



Income tax expense was
$472,000, or 29.5% of pretax income, in the third quarter of 2010, compared to
$426,000, or 21.5% of pretax income, in the comparable quarter of 2009, and was
$652,000, or 25.6% of pretax income, in the first nine months of 2010, compared
to $1.0 million, or 25.2% of pretax income, in the comparable period of 2009.
The 2009 third quarter rate was favorably impacted by revisions to estimated
tax credits. We anticipate an effective tax rate below 30% for all of 2010.

Liquidity and Capital Resources

At September 30, 2010, we
had $9.4 million in cash and cash equivalents and $3.6 million in short-term
investments, compared to $14.1 million in cash and cash equivalents and $3.9
million in short-term investments at December 31, 2009.

Net cash provided by operating
activities in the nine-month period ended September 30, 2010 was $664,000,
compared to $2.9 million in the same period of 2009. The decrease in 2010 was
due to lower net income in 2010 and a combination of a lower change in
receivables in the 2010 period as compared to 2009 and a greater change in
payables and accruals in the 2010 period as compared to 2009. We anticipate
that average receivable collection days in 2010 will be similar to 2009 and
will not have a material impact on our liquidity. In the nine-month period
ended September 30, 2010, we used $7.9 million in cash to purchase the
outstanding equity of CitySync and we also repaid $445,000 in CitySync seller
loans. We also repaid our bank term note and CitySync related bank line in the
2010 period. In addition to equipment purchases, in 2010 we paid our 2009
earn-out liability of $1.5 million to the sellers of the EIS assets. Our
planned additions of property and equipment are discretionary, and we expect
them to be below historical levels in 2010. These outflows were partially was
offset by the proceeds from our offering of common stock which netted us $8.8
million in cash.

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

We also have a revolving line
of credit agreement with Associated Bank. The revolving line of credit provides
for up to $5.0 million at an annual interest rate equal to the greater of 4.5%
or LIBOR plus 2.75%, as reset from time to time by the bank. Advances on the
line of credit cannot exceed a borrowing base determined under a formula, which
is a percentage of the amounts of eligible receivables. The line of credit
currently has no borrowings outstanding and matures on May 1, 2011. We believe
that on an ongoing basis, we will have regular availability to draw a minimum
of $3.0 million on our line of credit based on our qualifying assets.

In conjunction with our
acquisition of CitySync, the sellers have an earn-out arrangement over
approximately 18 months from the June 2010 date of purchase. The earn-out is
based on achieving certain revenue and minimum gross margins from the sale of
CitySync ANPR systems and it is calculated in two separate periods, each ending
on December 31. In each period there are two tiers and superior performance
could lead to a total earn-out of $2 million or higher, as the earn-out is not
capped. Earn-out payments are due within three months of the end of an earn-out
period.

In conjunction with our EIS
asset purchase, the sellers have an earn-out arrangement over approximately
three years from the December 2007 date of purchase. The earn-out is based on
earnings before taxes from RTMS sales less related cost of revenue and
operating expenses, excluding depreciation, amortization and interest expenses,
and it is calculated annually. If the earnings are at target levels, the
sellers would receive $2.0 million annually, or $6.0 million in total. Superior
performance of the assets could lead to an earn-out in excess of $2 million, as
the earn-out is not capped. Earn-out payments generally are due within three
months of the end of an earn-out period. For the first earn-out period, the
sellers of the EIS assets received a $1.2 million earn-out payment. For the
second earn-out period, which was fiscal 2009, the sellers received a $1.5
million earn-out, which was paid in March 2010. If we are acquired or sell
substantially all of our assets before December 6, 2010, we must pay EIS $6.0
million less earn-out amounts previously paid as an acceleration of potential
earn-out payments under the EIS asset purchase agreement.

- 15 -

---



We believe that cash and
cash equivalents on hand at September 30, 2010, along with cash provided by
operating activities, will satisfy our projected working capital needs,
payments under the CitySync and EIS earn-outs, investing activities, and other
cash requirements for the foreseeable future.

Off-Balance Sheet Arrangements

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

Critical Accounting Policies

Our significant accounting
policies are described in Note 1 to the Consolidated Financial Statements in
our Annual Report on Form 10-K for the year ended December 31, 2009. The accounting
policies used in preparing our interim 2010 Condensed Consolidated Financial
Statements set forth elsewhere in this Quarterly Report on Form 10-Q are the
same as those described in our Annual Report on Form 10-K.

New and Recently Adopted Accounting Pronouncements

New and recently adopted
pronouncements are set forth in Note I in the Notes to Condensed Consolidated
Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.

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. 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, or anticipates or
other comparable terminology. Forward-looking statements are subject to risks
and uncertainties that may cause our actual results to differ materially from
the results described in the forward-looking statements. Factors that might
cause such differences include, but are not limited to:

| |   |                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | historical dependence on a
 single product for most of our revenue;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | budget constraints by
 governmental entities that purchase our products, including constraints
 caused by declining tax revenue;                                                         
| |   |                                                                                                                                                                                          
| |  | continuing ability of our
 licensee to pay royalties owed;                                                                                                                               
| |   |                                                                                                                                                                                          
| |  | the mix of and margin on
 the products we sell;                                                                                                                                          
| |   |                                                                                                                                                                                          
| |  | dependence on third
 parties for manufacturing and marketing our products;                                                                                                               
| |   |                                                                                                                                                                                          
| |  | dependence on
 single-source suppliers to meet manufacturing needs;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | our increased
 international presence;                                                                                                                                                   
| |   |                                                                                                                                                                                          
| |  | 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 inability to develop
 new applications and product enhancements;                                                                                                                     

- 16 -

---



| |   |                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------
| |  | unanticipated delays,
 costs and expenses inherent in the development and marketing of new products,
 including ANPR and hybrid products;
| |   |                                                                                                                                          
| |  | our inability to respond
 to low-cost local competitors in Asia and elsewhere;                                                           
| |   |                                                                                                                                          
| |  | our inability to properly
 manage a growth in revenue and/or production requirements;                                                    
| |   |                                                                                                                                          
| |  | the influence over our
 voting stock by affiliates;                                                                                      
| |   |                                                                                                                                          
| |  | our inability to hire and
 retain key scientific and technical personnel;                                                                
| |   |                                                                                                                                          
| |  | our inability to achieve
 and maintain effective internal controls;                                                                      
| |   |                                                                                                                                          
| |  | our inability to
 successfully integrate acquisitions;                                                                                   
| |   |                                                                                                                                          
| |  | our inability 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 risk factors set forth in Item 1A. to our
Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

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

|         |                        
|-------- | -----------------------
|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.

- 17 -

---



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, 2009. 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
|        |                                                             
|None.   |                                                             
|        |                                                             
|Item 3. | Defaults Upon Senior Securities                             
|        |                                                             
|None.   |                                                             
|        |                                                             
|Item 4. | [Removed and Reserved.]                                     
|        |                                                             
|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 quarterly period
ended September 30, 2010:

|                 |  |                                                                                                     
|---------------- |  | ----------------------------------------------------------------------------------------------------
|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.

- 18 -

---



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.
|                         |                              |                                                                
|Dated: November 12, 2010 | By:                          | /s/ Kenneth R. Aubrey                                          
|                         |                              | Kenneth R. Aubrey                                              
|                         |                              | President and Chief
 Executive Officer                         
|                         |                              | (principal executive
 officer)                                 
|                         |                              |                                                                
|Dated: November 12, 2010 | By:                          | /s/ Gregory R.L. Smith                                         
|                         |                              | Gregory R.L. Smith                                             
|                         |                              | Chief Financial Officer                                        
|                         |                              | (principal financial
 officer and principal accounting officer)

- 19 -

---



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.

- 20 -

---