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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

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|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|- |  | ----------------------------------------------------------------------------------------
|  |  |                                                                                         
|  |  | For the quarterly period ended June 30, 2006                                            
|  |  |                                                                                         
|  |  | OR                                                                                      
|  |  |                                                                                         
|o |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  |  |                                                                                         
|  |  | For the transition period from ________________ to ________________                     



Commission file number: 0-26056

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Image Sensing Systems, Inc.

(Exact name of registrant as specified in its charter)



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



(651) 603-7700

(Registrants telephone number, including area code)



Not Applicable

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

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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

|Yes x | No o
|----- | ----

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

|Large accelerated filer o | Accelerated filer o | Non-accelerated filer x
|------------------------- | ------------------- | -----------------------
|                          |                     |                        

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 July 25, 2006
|--------------------------------------- |  | ----------------------------
|Common Stock, $0.01 par value per share |  | 3,723,704 shares            





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IMAGE SENSING SYSTEMS, INC.



TABLE OF CONTENTS



|              |    | PART I. FINANCIAL INFORMATION                                                                                 | Page No.
|------------- | -- | ------------------------------------------------------------------------------------------------------------- | --------
|              |    |                                                                                                               |         
|              |    |                                                                                                               |         
|Item 1.       |    | Financial Statements:                                                                                         |         
|              |    |                                                                                                               |         
|              |    | Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005                               | 3       
|              |    |                                                                                                               |         
|              |    | Condensed Consolidated Statements of Income for the three- and six-month periods ended June 30, 2006 and 2005 | 4       
|              |    |                                                                                                               |         
|              |    | Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2006 and 2005        | 5       
|              |    |                                                                                                               |         
|              |    | Notes to Condensed Consolidated Financial Statements                                                          | 6       
|              |    |                                                                                                               |         
|Item 2.       |    | Managements Discussion and Analysis of Financial Condition and Results of Operations                         | 9       
|              |    |                                                                                                               |         
|Item 4.       |    | Controls and Procedures                                                                                       | 14      
|              |    |                                                                                                               |         
|              |    | PART II. OTHER INFORMATION                                                                                    |         
|              |    |                                                                                                               |         
|Item 1.       |    | Legal Proceedings                                                                                             | 15      
|              |    |                                                                                                               |         
|Item 4.       |    | Submission of Matters to a Vote of Security Holders                                                           | 15      
|              |    |                                                                                                               |         
|Item 5.       |    | Other Information                                                                                             | 15      
|              |    |                                                                                                               |         
|Item 6.       |    | Exhibits                                                                                                      | 17      
|              |    |                                                                                                               |         
|Signatures    | 18
|              |    |                                                                                                               |         
|Exhibit Index | 19

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PART I - FINANCIAL INFORMATIONItem 1. Financial Statements

IMAGE SENSING SYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS

|                                            | June 30,2006 |  | December 31,2005
|------------------------------------------- | ------------ |  | ----------------
|
|Assets                                      |              |  |                 
|Current assets:                             |              | 
|Cash and cash equivalents                   |              |  | $               
|Short-term investments                      |              |  |                 
|Accounts receivable                         |              |  |                 
|Finished goods inventory                    |              |  |                 
|Investment in FHLB bond                     |              |  |                 
|Prepaid expenses                            |              |  |                 
|Deferred income taxes                       |              |  |                 
|                                            |              |  |                 
|Total current assets                        |              |  |                 
|                                           
|Property and equipment, net                 |              |  |                 
|                                           
|Other assets:                               |              | 
|Capitalized software development costs, net |              |  |                 
|Goodwill                                    |              |  |                 
|                                            |              |  |                 
|                                            |              |  |                 
|                                            |              |  |                 
|                                           
|Total assets                                |              |  | $               
|                                            |              |  |                 
|                                           
|Liabilities and Shareholders Equity       
|Current liabilities:                        |              | 
|Accounts payable                            |              |  | $               
|Accrued compensation                        |              |  |                 
|Income taxes payable                        |              |  |                 
|                                            |              |  |                 
|Total current liabilites                    |              |  |                 
|                                           
|Deferred income taxes                       |              |  |                 
|                                           
|Shareholders equity:                      
|Common stock                                |              |  |                 
|Additional paid-in capital                  |              |  |                 
|Retained earnings                           |              |  |                 
|                                            |              |  |                 
|                                            |              |  |                 
|                                            |              |  |                 
|                                           
|Total liabilities and shareholders equity  |              |  | $               
|                                            |              |  |                 

Note:   The balance sheet at December 31, 2005 has been
derived from the audited financial statements at that date but does not include all of the information and footnotes required by
accounting principles generally accepted in the United States of America for complete financial statements.

See accompanying notes

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IMAGE SENSING SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)

|                                       | Three-Month Periods EndedJune 30 |  | Six-Month Periods EndedJune 30
|-------------------------------------- | -------------------------------- |  | ------------------------------
|
|Revenue:                               |                                  |  |                               
|International sales                    |                                  |  | $                             
|Royalties                              |                                  |  |                               
|                                       |                                  |  |                               
|                                       |                                  |  |                               
|                                      
|Costs of revenue:                     
|Cost of product sold                   |                                  |  |                               
|Royalties                              |                                  |  |                               
|                                       |                                  |  |                               
|                                       |                                  |  |                               
|                                       |                                  |  |                               
|Gross profit                           |                                  |  |                               
|                                      
|Operating expenses:                    |                                  | 
|Selling, marketing and product support |                                  |  |                               
|General and administrative             |                                  |  |                               
|Research and development               |                                  |  |                               
|                                       |                                  |  |                               
|                                       |                                  |  |                               
|                                       |                                  |  |                               
|Income from operations                 |                                  |  |                               
|                                      
|Other income (expense), net            |                                  |  |                               
|                                       |                                  |  |                               
|Income before income taxes             |                                  |  |                               
|Income taxes                           |                                  |  |                               
|                                       |                                  |  |                               
|Net income                             |                                  |  |                               
|                                       |                                  |  |                               
|                                      
|Basic                                  |                                  |  | $                             
|                                       |                                  |  |                               
|Diluted                                |                                  |  | $                             
|                                       |                                  |  |                               
|                                      
|Weighted average number of common      |                                  | 
|shares outstanding:                    |                                  | 
|Basic                                  |                                  |  |                               
|                                       |                                  |  |                               
|Diluted                                |                                  |  |                               
|                                       |                                  |  |                               

See accompanying notes

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IMAGE SENSING SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)

|                                                                                  | Six-Month Periods EndedJune 30
|--------------------------------------------------------------------------------- | ------------------------------
|
|Operating activities:                                                             |                               
|Net income                                                                        |                               
|Adjustments to reconcile net income to net cash provided by operating activities:
|Depreciation and amortization                                                     |                               
|Change in operating assets and liabilities                                        |                               
|                                                                                  |                               
|Net cash provided by operating activities                                         |                               
|                                                                                 
|                                                                                 
|Investing activities:                                                            
|Purchase of property and equipment                                                |                               
|Purchase of short-term investments                                                |                               
|Sale of short-term investments                                                    |                               
|                                                                                  |                               
|Net cash provided by (used in) investing activities                               |                               
|                                                                                 
|                                                                                 
|Financing activities:                                                             |                               
|Proceeds from exercise of stock options                                           |                               
|                                                                                  |                               
|Net cash provided by financing activities                                         |                               
|                                                                                  |                               
|                                                                                 
|Increase in cash and cash equivalents                                             |                               
|                                                                                 
|Cash and cash equivalents, beginning of period                                    |                               
|                                                                                  |                               
|Cash and cash equivalents, end of period                                          |                               
|                                                                                  |                               

See accompanying notes

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IMAGE SENSING SYSTEMS, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

June 30, 2006



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 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- and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to







the consolidated financial statements and footnotes thereto in our Annual Report on Form 10-KSB for the year ended December 31, 2005.



Note B:  Investments



Investments, at cost, consisted of the following at June 30, 2006 and December 31, 2005:



|                                                 |   | June 30,
2006 |  |   | December 31, 2005 | 
|------------------------------------------------ | - | ------------- |  | - | ----------------- | 
|Short-term investments - Auction Rate Securities | $ | 1,800,000     |  | $ |                  | 
|Callable Federal Home Loan Bonds                 |   | 2,300,000     |  |   | 2,300,000         | 
|                                                 |   |               |  |   |                   | 
|Total                                            | $ | 4,100,000     |  | $ | 2,300,000         | 



As of June 30, 2006 and December 31, 2005, investments are classified as available-for-sale. The cost of investments approximate
market value and therefore no amount is recorded in accumulated other comprehensive income. The cost of securities sold is based
on the specific identification method.

There were purchases of investments of $9.9 million and $21.55 million and sales or maturities of investments of $9.9 million and
$19.75 million in the three- and six-month periods ended June 30, 2006, respectively. There were purchases of investments of
$450,000 and $-0- and sales or maturities of investments of $-0- and $3 million for the three- and six-month periods ended June
30, 2005, respectively. There were no realized gains or losses related to sales or unrealized gains and losses during the three-
and six-month periods ended June 30, 2006 or 2005.

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Note C: Net Income Per Common Share



The following table sets forth the computations of basic and diluted net income per common share for the three- and six-month periods ended June 30, 2006 and 2005:



|                                                         |  | Three-Month Periods
Ended June 30, |           | Six-Month Periods
Ended June 30 |  
|-------------------------------------------------------- |  | ---------------------------------- | --------- | ------------------------------- | -
|                                                         |  | 2006                               |           | 2005                            |  
|Numerator:                                               |  |                                    |           |                                 |  
|Net income                                               |  | $                                  | 711,000   |                                 | $
|                                                         |  |                                    |           |                                 |  
|Denominator:                                             |  |                                    |           |                                 |  
|Shares used in basic net income per share calculation    |  |                                    | 3,717,000 |                                 |  
|                                                         |  |                                    |           |                                 |  
|Effect of diluted securities:                            |  |                                    |           |                                 |  
|Employee and director stock options                      |  |                                    | 164,000   |                                 |  
|                                                         |  |                                    |           |                                 |  
|Shares used in diluted net income per share calculations |  |                                    | 3,881,000 |                                 |  
|                                                        
|Basic net income per share                               |  | $                                  | .19       |                                 | $
|                                                         |  |                                    |           |                                 |  
|Diluted net income per share                             |  | $                                  | .18       |                                 | $



Note D: Stock-based Compensation



Commencing January 1, 2006, we adopted Statement of Financial Accounting Standard No. 123(R),Share Based Payment(SFAS
123(R)), which requires all share-based payments, including grants of stock options, to be recognized in the income statement as
an operating expense based on their fair value over the requisite service period. We recorded $94,000 and $137,000 of related
compensation expense for the three- and six-month periods ended June 30, 2006. The related tax benefit from recording this
non-cash expense was approximately $33,000 and $47,000, respectively. The net compensation expense reduced basic and diluted net
income per common share by $0.017 and $0.016 and $0.024 and $0.023, respectively, for the three- and six-month periods ended June
30, 2006. As of June 30, 2006, $34,000 of total unrecognized compensation expense related to outstanding stock option awards is
expected to be recognized over the balance of 2006.



Prior to adopting SFAS 123(R), we accounted for stock-based compensation under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees.
We have applied the modified prospective method in adopting SFAS 123(R). Accordingly, periods
prior to our adoption of SFAS 123(R) have not been restated. The following table illustrates the effect on net income and net
income per share if the fair value based method had been applied to the comparable three- and six- month periods ended June 30,
2005:

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|                                                                                                       |  | Three-month period |         | Six-month period |  
|------------------------------------------------------------------------------------------------------ |  | ------------------ | ------- | ---------------- | -
|Net income, as reported in 2005                                                                        |  | $                  | 610,000 |                  | $
|Add: stock-based consultants compensation included in reported net income, net of related tax effects |  |                    | 6,000   |                  |  
|Less: stock-based compensation determined under the fair value method, net of related tax effects      |  |                    | (54,000 | )                |  
|Pro forma net income, assuming fair value method for all stock-based awards                            |  | $                  | 562,000 |                  | $
|                                                                                                       |  |                    |         |                  |  
|Net income per common share:                                                                           |  |                    |         |                  |  
|Basic  as reported                                                                                    |  | $                  | .17     |                  | $
|Diluted  as reported                                                                                  |  | $                  | .16     |                  | $
|                                                                                                       |  |                    |         |                  |  
|Basic  pro forma                                                                                      |  | $                  | .16     |                  | $
|Diluted  pro forma                                                                                    |  | $                  | .15     |                  | $



We use the Black-Scholes option pricing model to determine the weighted average fair value of options. No options were granted during the three- and six-month periods ended June 30, 2006 and 2005. The following table summarizes stock option activity for 2006:



|                             |  | PlanOptionsAvailableFor Grant |  | Plan OptionsOutstanding |   | Non-PlanOptionsOutstanding |   |        | Weighted Average Exercise PricePer Share |  
|---------------------------- |  | ----------------------------- |  | ----------------------- | - | -------------------------- | - | ------ | ---------------------------------------- | -
|                             |  |                               |  | ISO                     |   | NSO                        |   |        |                                          |  
|Balance at December 31, 2005 |  | 281,200                       |  | 78,400                  |   | 136,432                    |   | 42,000 |                                          | $
|Exercised                    |  |                               |  | (1,100                  | ) | (3,300                     | ) |        |                                          |  
|Balance at March 31, 2006    |  | 281,200                       |  | 77,300                  |   | 133,132                    |   | 42,000 |                                          |  
|Exercised                    |  |                               |  | (1,600                  | ) | (15,499                    | ) |        |                                          |  
|Balance at June 30, 2006     |  | 281,200                       |  | 75,700                  |   | 117,633                    |   | 42,000 |                                          | $

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The Companys stock options generally vest over three to five years of service and have a contractual life of 10 years. We have 281,200 shares authorized for grant under the 2005 Stock Incentive Plan. The following table summarizes information about the stock options outstanding at June 30, 2006:

|                       |  | Options Outstanding |  | Options Exercisable                         | 
|---------------------- |  | ------------------- |  | ------------------------------------------- | 
|Range ofExercise Price |  | Number Outstanding  |  | Weighted Average Remaining Contractual Life | 
|$1.301.99             |  | 86,100              |  | 6.1 years                                   | 
|2.002.99              |  | 83,700              |  | 3.9 years                                   | 
|3.003.99              |  | 39,533              |  | 6.3 years                                   | 
|7.007.93              |  | 26,000              |  | 6.5 years                                   | 
|                       |  | 235,333             |  |                                             | 



|Note E: Subsequent Event
|------------------------



On August 3, 2006, we entered into a Settlement Agreement, Contract Modification and Mutual Release (the Agreement) with Econolite relating to the action filed by Econolite against us in September 2005. Pursuant to the Agreement, we agreed to pay Econolite (1) $200,000 within ten days of execution of the Agreement and (2) an additional $175,000 in the event that Econolite achieves sales of Autoscope products of $33 million in calendar year 2006. In addition, we agreed to modify the royalty calculation set forth in our Manufacturing, Distributing and Technology License Agreement with Econolite to take into account additional overhead expenses that Econolite incurs. Under the Agreement, beginning as of July 1, 2006, Econolite will calculate and pay royalties to us on Solo Pro products so as to split 50/50 net profit on sales of Solo Pro between Econolite and us. Net profit on sales is
defined in the Agreement as sales price to the end user less distribution commission (if any) and Solo Pro purchase price plus 15% of purchase price for overhead. Pursuant to an oral agreement we entered into with Econolite in 2003, we were already taking into account in the royalty calculation 10% of purchase price for overhead. Thus, the Amendment in effect increased the percentage of purchase price for overhead by 5%.



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



Overview:



Image Sensing Systems, Inc. (referred to in this report as we, us, our and the Company) has developed proprietary machine vision technology that converts real world information into digital electronic signals for processing by computer and have applied it to traffic management problems. Our technology uses standard video and computer equipment, combined with proprietary technology, including complex detection algorithms, computer software, special purpose hardware, and a Microsoft Windows®-based graphical user interface that enables standard video cameras to work with the Autoscope® Wide Area Video Vehicle Detection System.

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Autoscope systems are sold to distributors and end users of traffic management products in North America and Latin America by Econolite Control Products, Inc. (Econolite), our exclusive distributor in those locations. We also sell Autoscope products to distributors and end users in Europe and Asia through our European and Hong Kong subsidiaries, respectively. The Autoscope system is used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels.



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



Our success is primarily dependent upon (1) continued governmental funding of Intelligent Transportation Systems, such as machine vision for traffic control; (2) our ability, through Econolite and our sales representatives in Europe and Asia, to successfully market the Autoscope System to individual traffic managers and (3) our ability to develop new machine vision products and applications that enhance the traffic managers ability to cost-effectively improve traffic flow and safety.

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

Critical Accounting Policies:

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



Revenue recognition.Royalty income is recognized based upon a monthly royalty report provided to us by Econolite. This report is prepared by Econolite based on its sales of products we developed and is based on sales delivered and accepted by its customers. We recognize revenue from international sales at the time of delivery and acceptance, the selling price is fixed or determinable and collectibility is reasonably assured. We record provisions against sales revenue for estimated returns and allowances in the period when the related revenue is recorded based upon historical sales returns and changes in customer demands.

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Income taxes.Income taxes are accounted for under the liability method. Deferred income taxes reflect the effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Deferred tax assets are offset by a valuation allowance as deemed necessary based on our estimate of our future sources of taxable income and the expected timing of temporary difference reversals.



Results of Operations: (Comparison of three- and six- month periods ended June 30, 2006 and 2005)



The following tables 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 statement of income from 2005 to 2006:





|For the Quarter                        |  | Three-Month Periods
Ended June 30 |   | Quarter Over |  
|-------------------------------------- |  | --------------------------------- | - | ------------ | -
|                                       |  | 2006                              |   | 2005         |  
|International sales                    |  | 26.4                              | % | 16.7         | %
|Royalties                              |  | 73.6                              |   | 83.3         |  
|Total revenue                          |  | 100.0                             |   | 100.0        |  
|Gross profit - International sales     |  | 59.0                              |   | 64.9         |  
|Gross profit - Royalties               |  | 95.4                              |   | 95.7         |  
|Selling, marketing and product support |  | 23.3                              |   | 26.1         |  
|General and administrative             |  | 16.8                              |   | 15.3         |  
|Research and development               |  | 15.0                              |   | 13.7         |  
|Income from operations                 |  | 30.8                              |   | 35.5         |  
|Other income (expense), net            |  | 2.2                               |   | 2.5          |  
|Income taxes                           |  | 7.7                               |   | 13.7         |  
|Net income                             |  | 20.9                              |   | 24.2         |  

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|For the First Half                     |  | Six-Month Period
Ended June 30 |   | Year Over Year |  
|-------------------------------------- |  | ------------------------------ | - | -------------- | -
|                                       |  | 2006                           |   | 2005           |  
|International sales                    |  | 21.9                           | % | 18.3           | %
|Royalties                              |  | 78.1                           |   | 81.7           |  
|Total revenue                          |  | 100.0                          |   | 100.0          |  
|Gross profit - International sales     |  | 58.4                           |   | 61.2           |  
|Gross profit - Royalties               |  | 95.3                           |   | 95.5           |  
|Selling, marketing and product support |  | 23.6                           |   | 28.5           |  
|General and administrative             |  | 18.9                           |   | 15.2           |  
|Research and development               |  | 16.5                           |   | 13.5           |  
|Income from operations                 |  | 28.2                           |   | 32.1           |  
|Other income (expense), net            |  | 0.4                            |   | 2.3            |  
|Income taxes                           |  | 8.3                            |   | 12.7           |  
|Net income                             |  | 20.3                           |   | 21.7           |  



International sales increased 112.8% for the second quarter of 2006
over the comparable quarter of 2005 and 53.9% for the first half of 2006 over the comparable period of 2005
primarily due to two large sales in the Asian market.  Royalty income increased 19.3% for the quarter and 23.3%
for the first half over comparable periods in 2005 and reflects the increase in Autoscope product sales by
Econolite in the North American market.  Effective July 1, 2006, Econolite will calculate royalties payable to us
based on the formula set forth in  the Settlement Agreement disclosed in Note E to the Financial Statements and
Item 5 of Part II of this Form 10-Q. We expect the change in royalty calculation, adding a 5% overhead amount,
will reduce royalty income by approximately 1.5% per year compared to the amount that would have been due us
under the old formula.  However, royalties to the University of Minnesota ceased on July
11, 2006 as the patent we were licensing from the University expired.  Accordingly, the only costs charged
against revenue subsequent to July 11, 2006 will be the cost of products sold.  We expect that the elimination of
royalties payable to the University of Minnesota will more than offset the reduction in
royalty income from Econolite.

Gross
profit improvements for both international sales and royalties are due to the increases in
sales in these markets. The gross profit margin on international sales decreased to 59.0%
in the second quarter of 2006 from 64.9% in the second quarter of 2005 and to 58.4% in the
first half of 2006 from 61.2% in the first half of 2005 due to the change in mix of
international sales. We had a larger percentage of international sales to distributors,
with lower margins than sales directly to end users, in 2006 than in 2005.

Operating expenses increased 34.7%
and 33.1%, respectively, in the second quarter and first half of 2006 over the comparable
periods in 2005 primarily due to added staff in each category of operating expense along
with related payroll taxes, benefits and infrastructure to support the added staff.
Secondary reasons for the increases were added legal, audit and outside technical
consulting fees in both the second quarter and first half of 2006 compared to 2005 and
expensing of options in accordance with SFAS 123(R) in 2006. Income from operations
increased 17.2% and 13.5% in the second quarter and first half of 2006, respectively, over
comparable periods in 2005 due to increased revenue and gross profit which exceeded the
increases in operating expenses.

Other income (expense) for the second
quarter and first half of 2006 decreased 221.0% and 79.2%, respectively, from the
comparable periods in 2005 primarily due to the Econolite settlement, which was offset in
part by increased interest income resulting from higher interest rates along with more
funds invested in interest bearing securities. Income taxes decreased in the second
quarter and first half of 2006 compared to 2005 primarily due to the absence of income
taxes on earnings in Asia where we are utilizing an operating loss carryforward.

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Net income for the second quarter was $711,000, an increase of 16.6% over the comparable quarter of 2005 and $1,214,000 for the first half of 2006, an increase of 20.6% over the comparable period of 2005, due to the factors discussed above.

Liquidity and Capital Resources:

At June 30, 2006, we had $9,661,000 in cash and cash equivalents, compared to $9,006,000 at December 31, 2005.

Net cash provided by operating activities was $2,649,000 in the first half of 2006, compared to $591,000 in 2005. The primary reasons for the increase was that we received unusually large royalty payments in the first part of 2006 on accounts receivable from Econolite for sales they made in the fourth quarter of 2005, net income increased by $207,000 over 2005 and we had more non-cash charges to operations, primarily stock option expense, in the first half of 2006 than the first half of 2005.   We invested $1,800,000 of the cash generated from operating activities in short-term tax-exempt bonds and $253,000 in equipment. The excess, $655,000, was invested in cash equivalents.

We have a credit agreement that provides up to $1,000,000 in short-term borrowings at the prime rate (effective rate of 8.25% at June 30, 2006), expiring May 31, 2008. Loans would be secured by inventories, accounts receivable and equipment and the bank would have the right of setoff against checking, savings and other accounts we have with the bank. We had no outstanding borrowings under the credit agreement in 2006 or 2005.



We believe that cash and cash equivalents on hand at June 30, 2006, our $1,000,000 revolving line of credit with Wells Fargo Bank Minnesota, N.A. and cash provided by operating activities will satisfy our projected working capital needs, investing activities and other cash requirements in the foreseeable future.

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 (the Exchange Act). 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 discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to:



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

| |  | budget constraints by governmental entities that purchase our products;
| | - | -----------------------------------------------------------------------

| |  | continuing ability of our licensee to pay royalties owed;
| | - | ---------------------------------------------------------

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

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

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

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



| |  | our inability to develop new applications and product enhancements;
| | - | -------------------------------------------------------------------

| |  | our inability to respond to low-cost local competitors in Asia;
| | - | ---------------------------------------------------------------

| |  | our inability to properly manage growth in revenue and/or production requirements;
| | - | ----------------------------------------------------------------------------------

| |  | our inability to retain key scientific and technical personnel;
| | - | ---------------------------------------------------------------

| |  | our inability to achieve and maintain effective internal controls;
| | - | ------------------------------------------------------------------

| |  | 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 1 to our Annual Report on Form 10-KSB for the fiscal year ended December 31, 2005.



|Item 4. | 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 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.

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PART II - OTHER INFORMATION

|Item 1. | Legal Proceedings
|------- | -----------------



On September 15, 2005, Econolite, our exclusive North American manufacturer and distributor, filed a complaint against us in the United States District Court for the Central District of California. Econolite asserted claims for breach of contract and unjust enrichment and claimed damages of at least $684,000. Econolites claims were based on its theory that it had overpaid royalties due to us under our agreement with Econolite and that it is entitled to take into account higher costs it had incurred. On August 3, 2006, we settled the above referenced dispute with Econolite. A description of the Settlement Agreement, Contract Modification and Mutual Release is set forth under Item 5 below and is incorporated herein by reference.





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



We held our Annual Meeting of Shareholders on May 17, 2006, in St. Paul, Minnesota. We solicited proxies and filed our definitive proxy statement with the Securities and Exchange Commission pursuant to Regulation 14A under the Exchange Act. Matters voted on at the meeting were as follows:



| | 1. | Election of directors:
| | -- | ----------------------



|Director               |  | For       |  | Withhold Authority | 
|---------------------- |  | --------- |  | ------------------ | 
|                       |  |           |  |                    | 
|Richard P. Braun       |  | 3,283,300 |  | 105,107            | 
|Michael G. Eleftheriou |  | 3,382,627 |  | 5,780              | 
|Richard Magnuson       |  | 3,191,854 |  | 196,553            | 
|Panos G. Michalopoulos |  | 3,135,522 |  | 252,885            | 
|James Murdakes         |  | 3,074,147 |  | 314,260            | 



| | 2. | Approval of Grant Thornton LLP as our independent registered public accounting firm for fiscal year 2006:
| | -- | ---------------------------------------------------------------------------------------------------------



|For       | Against | Abstain
|--------- | ------- | -------
|          |         |        
|3,388,257 | 150     | 0      



|Item 5. | Other Information
|------- | -----------------



On August 3, 2006, we entered into a Settlement Agreement, Contract Modification and Mutual Release (the Agreement) with Econolite relating the action filed by Econolite against us in the United States District Court for the Central District of California (the Litigation). Pursuant to the

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Agreement, we agreed to pay Econolite (1) $200,000 within ten days of execution of the Agreement and (2) an additional $175,000 in the event that Econolite achieves sales of Autoscope products of $33 million in calendar year 2006. In addition, we agreed to modify the royalty calculation set forth in our Manufacturing, Distributing and Technology License Agreement with Econolite (as amended to date, the Econolite Agreement) to take into account additional overhead expenses that Econolite incurs. Under the Agreement, beginning as of July 1, 2006, Econolite will calculate and pay royalties to us on Solo Pro products so as to split 50/50 net profit on sales of Solo Pro between Econolite and us. Net profit on sales is defined in the Agreement as sales price to the end user less distribution commission (if any) and Solo Pro purchase price plus 15% of purchase price for overhead. Pursuant to
an oral agreement we entered into with Econolite in 2003, we were already taking into account in the royalty calculation 10% of purchase price for overhead. Thus, the Amendment in effect increased the percentage of purchase price for overhead by 5%. The modified royalty calculation will apply to future generations of Solo Pro products for the remaining term of the Econolite Agreement, unless material changes occur in the manufacturing process, in which case the parties agree to re-negotiate the royalty calculation.



Pursuant to the Agreement, Econolite agreed to dismiss with prejudice all claims asserted by it against us in the Litigation within 10 days of receiving our $200,000 payment described above. In addition, we each agreed to release the other party from any and all claims that arise out of the transactions or events described in or forming the basis for the Litigation.

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|Item 6. | Exhibits
|------- | --------



The following exhibits are filed as part of this quarterly report on Form 10-Q for the quarterly period ended June 30, 2006.



Exhibit

|Number | Description
|------ | -----------



|10.1 | Settlement Agreement, Contract Modification and Mutual Release by and between the Company and Econolite Control Products, Inc. entered into on August 3, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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SIGNATURES



Pursuant to 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:  August 9, 2006 |  | By:                        
|                       |  |                            





|                       |  |    
|---------------------- |  | ---
|Dated:  August 9, 2006 |  | By:
|                       |  |    

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EXHIBIT INDEX TO FORM 10-Q





|Exhibit No. | Description
|----------- | -----------



|10.1 | Settlement Agreement, Contract Modification and Mutual Release by and between the Company and Econolite Control Products, Inc. entered into on August 3, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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