UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington,
D.C. 20549

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

|  |                                                                                        
|- | ---------------------------------------------------------------------------------------
|x | QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  |                                                                                        
|  | For the quarterly period
ended September 30, 2009                                      
|  |                                                                                        
|  | 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
incorporation or organization)  | (I.R.S.
Employer
Identification No.)
|                                                                |                                     
|500 Spruce Tree Centre
1600 University Avenue West
St. Paul, MN | 55104                               
|(Address
of principal executive offices)                        | (Zip
Code)                          

(651) 603-7700
(Registrants telephone
number, including area code)

Not Applicable (Former name, former address
and former fiscal year, if changed since last report)


| |  | 
| |  | 
| |  | 

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

Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 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 o     No
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 o     No
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 3, 2009
|Common
Stock, $0.01 par value per share |  | 3,985,819
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 |  | 9       
|              |  |                                                                                       |  |         
|Item 3.       |  | Quantitative
and Qualitative Disclosures About Market Risks                           |  | 15      
|              |  |                                                                                       |  |         
|Item 4T.      |  | Controls
and Procedures                                                               |  | 16      
|              |  |                                                                                       |  |         
|PART II.      |  | OTHER
INFORMATION                                                                     |  | 16      
|              |  |                                                                                       |  |         
|Item 1.       |  | Legal
Proceedings                                                                     |  | 16      
|              |  |                                                                                       |  |         
|Item 1A.      |  | Risk
Factors                                                                          |  | 16      
|              |  |                                                                                       |  |         
|Item 2.       |  | Unregistered
Sales of Equity Securities and Use of Proceeds                           |  | 16      
|              |  |                                                                                       |  |         
|Item 3.       |  | Defaults
Upon Senior Securities                                                       |  | 16      
|              |  |                                                                                       |  |         
|Item 4.       |  | Submission
of Matters to a Vote of Security Holders                                   |  | 16      
|              |  |                                                                                       |  |         
|Item 5.       |  | Other
Information                                                                     |  | 16      
|              |  |                                                                                       |  |         
|Item 6.       |  | Exhibits                                                                              |  | 17      
|              |  |                                                                                       |  |         
|SIGNATURES    |  | 18                                                                                   
|              |  |                                                                                       |  |         
|EXHIBIT
INDEX |  | 19                                                                                   

---

PART I. FINANCIAL INFORMATION

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

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

|                                                 |  |                    |        |                   |   |        |  
|------------------------------------------------ |  | ------------------ | ------ | ----------------- | - | ------ | -
|                                                 |  | September 30,
2009 |        | December 31,
2008 |  
|Assets                                           |  |                    |        |                   |   |        |  
|Current assets:                                  |  |                    |        |                   |   |        |  
|Cash and cash equivalents                        |  | $                  | 7,861  |                   | $ | 10,289 |  
|Short-term investments, net (restricted in 2008) |  |                    | 3,940  |                   |   | 4,000  |  
|Accounts receivable, net                         |  |                    | 6,498  |                   |   | 6,620  |  
|Inventories                                      |  |                    | 2,862  |                   |   | 1,608  |  
|Prepaid expenses                                 |  |                    | 822    |                   |   | 376    |  
|Deferred income taxes                            |  |                    | 325    |                   |   | 376    |  
|Total current assets                             |  |                    | 22,308 |                   |   | 23,269 |  
|                                                 |  |                    |        |                   |   |        |  
|Property and equipment,
net                      |  |                    | 869    |                   |   | 728    |  
|                                                 |  |                    |        |                   |   |        |  
|Deferred income taxes                            |  |                    | 1,575  |                   |   | 1,575  |  
|Goodwill and intangible
assets                   |  |                    | 9,989  |                   |   | 10,536 |  
|Total assets                                     |  | $                  | 34,741 |                   | $ | 36,108 |  
|                                                 |  |                    |        |                   |   |        |  
|Liabilities
and Shareholders Equity             |  |                    |        |                   |   |        |  
|Current liabilities:                             |  |                    |        |                   |   |        |  
|Accounts payable                                 |  | $                  | 833    |                   | $ | 251    |  
|Bank debt, current portion                       |  |                    |       |                   |   | 1,000  |  
|Accrued compensation                             |  |                    | 703    |                   |   | 1,091  |  
|Accrued warranty and other                       |  |                    | 742    |                   |   | 793    |  
|EIS earn-out payable                             |  |                    |       |                   |   | 1,164  |  
|Income taxes payable                             |  |                    | 667    |                   |   | 283    |  
|Total current liabilities                        |  |                    | 2,945  |                   |   | 4,582  |  
|                                                 |  |                    |        |                   |   |        |  
|Bank debt, long-term                             |  |                    |       |                   |   | 2,750  |  
|Income taxes payable                             |  |                    | 204    |                   |   | 246    |  
|                                                 |  |                    |        |                   |   |        |  
|Shareholders equity:                            |  |                    |        |                   |   |        |  
|Common stock                                     |  |                    | 40     |                   |   | 40     |  
|Additional paid-in capital                       |  |                    | 11,919 |                   |   | 11,652 |  
|Accumulated other comprehensive loss             |  |                    | (343   | )                 |   | (147   | )
|Retained earnings                                |  |                    | 19,976 |                   |   | 16,985 |  
|                                                 |  |                    | 31,592 |                   |   | 28,530 |  
|Total
liabilities and shareholders equity       |  | $                  | 34,741 |                   | $ | 36,108 |  

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, |  
|                                                       |  | 2009                                     |       | 2008                                    |   | 2009  |   | 2008 |       
|Revenue:                                               |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|International sales                                    |  | $                                        | 1,755 |                                         | $ | 1,420 |   | $    | 4,096  |  | $ | 4,221  | 
|North American sales                                   |  |                                          | 1,679 |                                         |   | 920   |   |      | 4,729  |  |   | 4,468  | 
|Royalties                                              |  |                                          | 3,389 |                                         |   | 3,742 |   |      | 9,068  |  |   | 10,007 | 
|                                                       |  |                                          | 6,823 |                                         |   | 6,082 |   |      | 17,893 |  |   | 18,696 | 
|                                                       |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Costs of revenue:                                      |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|International sales                                    |  |                                          | 578   |                                         |   | 397   |   |      | 1,298  |  |   | 1,638  | 
|North American sales                                   |  |                                          | 691   |                                         |   | 463   |   |      | 1,649  |  |   | 1,830  | 
|                                                       |  |                                          | 1,269 |                                         |   | 860   |   |      | 2,947  |  |   | 3,468  | 
|Gross profit                                           |  |                                          | 5,554 |                                         |   | 5,222 |   |      | 14,946 |  |   | 15,228 | 
|                                                       |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Operating expenses:                                    |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Selling, marketing and product support                 |  |                                          | 1,721 |                                         |   | 1,695 |   |      | 5,272  |  |   | 4,688  | 
|General and administrative                             |  |                                          | 796   |                                         |   | 980   |   |      | 2,574  |  |   | 2,883  | 
|Research and development                               |  |                                          | 868   |                                         |   | 701   |   |      | 2,541  |  |   | 2,167  | 
|Amortization of intangible assets                      |  |                                          | 192   |                                         |   | 192   |   |      | 576    |  |   | 576    | 
|                                                       |  |                                          | 3,577 |                                         |   | 3,568 |   |      | 10,963 |  |   | 10,314 | 
|Income from
 operations                                |  |                                          | 1,977 |                                         |   | 1,654 |   |      | 3,983  |  |   | 4,914  | 
|                                                       |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Other income
 (expense), net                           |  |                                          | 9     |                                         |   | (6    | ) |      | 18     |  |   | 58     | 
|Income
 before income taxes                            |  |                                          | 1,986 |                                         |   | 1,648 |   |      | 4,001  |  |   | 4,972  | 
|Income taxes                                           |  |                                          | 426   |                                         |   | 486   |   |      | 1,010  |  |   | 1,539  | 
|Net income                                             |  | $                                        | 1,560 |                                         | $ | 1,162 |   | $    | 2,991  |  | $ | 3,433  | 
|                                                       |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Net income
 per common share:                          |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Basic                                                  |  | $                                        | 0.39  |                                         | $ | 0.29  |   | $    | 0.75   |  | $ | 0.87   | 
|Diluted                                                |  | $                                        | 0.38  |                                         | $ | 0.29  |   | $    | 0.74   |  | $ | 0.86   | 
|                                                       |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Weighted
 average number of common shares outstanding: |  |                                          |       |                                         |   |       |   |      |        |  |   |        | 
|Basic                                                  |  |                                          | 3,986 |                                         |   | 3,942 |   |      | 3,985  |  |   | 3,933  | 
|Diluted                                                |  |                                          | 4,073 |                                         |   | 4,005 |   |      | 4,065  |  |   | 4,010  | 

See
accompanying notes.

- 2 -

---

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

|                                                                                  |  |                                       |        |      |   |        |  
|--------------------------------------------------------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------ | -
|                                                                                  |  | Nine-Month Periods EndedSeptember 30, |       
|                                                                                  |  | 2009                                  |        | 2008 |  
|Operating activities:                                                             |  |                                       |        |      |   |        |  
|Net income                                                                        |  | $                                     | 2,991  |      | $ | 3,433  |  
|Adjustments to reconcile net income to net
 cash provided by operating activities |  |                                       |        |      |   |        |  
|Depreciation and amortization                                                     |  |                                       | 906    |      |   | 863    |  
|Stock option expense                                                              |  |                                       | 266    |      |   | 246    |  
|Change in operating assets and liabilities                                        |  |                                       | (1,217 | )    |   | (1,215 | )
|Net cash provided by operating activities                                         |  |                                       | 2,946  |      |   | 3,327  |  
|                                                                                  |  |                                       |        |      |   |        |  
|Investing activities:                                                             |  |                                       |        |      |   |        |  
|Net purchases of property and equipment                                           |  |                                       | (496   | )    |   | (239   | )
|Payment of EIS earn-out                                                           |  |                                       | (1,192 | )    |   |       |  
|Net (purchases) sales of investments                                              |  |                                       | 60     |      |   | (5,400 | )
|Net cash used in investing activities                                             |  |                                       | (1,628 | )    |   | (5,639 | )
|                                                                                  |  |                                       |        |      |   |        |  
|Financing activities:                                                             |  |                                       |        |      |   |        |  
|Proceeds from exercise of stock options                                           |  |                                       | 4      |      |   | 109    |  
|Repayment of bank debt                                                            |  |                                       | (3,750 | )    |   | (1,000 | )
|Cash released from restriction                                                    |  |                                       |       |      |   | 5,263  |  
|Net cash provided by (used in) financing
 activities                              |  |                                       | (3,746 | )    |   | 4,372  |  
|                                                                                  |  |                                       |        |      |   |        |  
|Increase (decrease) in cash and cash
 equivalents                                 |  |                                       | (2,428 | )    |   | 2,060  |  
|                                                                                  |  |                                       |        |      |   |        |  
|Cash and cash equivalents, beginning of
 period                                   |  |                                       | 10,289 |      |   | 5,613  |  
|Cash and cash equivalents, end of period                                          |  | $                                     | 7,861  |      | $ | 7,673  |  

See
accompanying notes.

- 3 -

---

IMAGE SENSING SYSTEMS, INC.

Notes to Condensed
Consolidated Financial Statements 
(Unaudited) 
September 30, 2009

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-month and nine-month periods
ended September 30, 2009 are not necessarily indicative of the results that may
be expected for the year ending December 31, 2009. 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, 2008.

We evaluated
our quarter ended September 30, 2009 consolidated financial statements for
subsequent events through November 12, 2009, the date the financial statements
were available to be issued. We are not aware of any subsequent events which
would require recognition or disclosure in the financial statements

Note B: Investments

Investments
and marketable securities held at September 30, 2009 that do not qualify as
cash equivalents have been designated as available for sale in accordance
with Accounting Standards Codification (ASC) 320, Investment - Debt and Equity Securities. The estimated fair
value of the investments held at September 30, 2009 was determined under ASC
820, Fair Value Measurements and Disclosures,
using level 1 measurements.

At December
31, 2008, we held $4.0 million (par value) of investments comprised of auction
rate securities, or ARS, which were designated as trading under SFAS No. 115.
The balance of investments at December 31, 2008, consisted of the combination
of the fair value of ARS as determined under SFAS No. 157 and the fair value of
the settlement rights that we received from the broker/dealer under a
settlement agreement reached in November 2008. The settlement rights allowed us
to put the ARS to the broker/dealer at par between the dates of January 2, 2009
and January 2, 2011. In January 2009, our ARS were purchased by the
broker/dealer at par.

Note C: Acquisition

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 the three years after the December 2007
purchase date. Earn-outs will be calculated and paid annually. Based on target
achievement, the sellers would receive $2.0 million annually or a total of $6.0
million. 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 related to the
EIS asset purchase will be recorded as additional goodwill when earned. In
2008, the sellers earned an earn-out of approximately $1.2 million, which was
paid in 2009.

- 4 -

---

EIS was named
in a U.S. lawsuit in 2006 for infringement of a patent. This lawsuit was
dismissed upon appeal in August 2009 and is no longer contested by the
plaintiff. We incurred no expense over the life of the lawsuit as EIS was
responsible for costs of defense.

Note D: Goodwill and intangible assets

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic Ltd. and
$5.0 million related to the EIS asset purchase, consisting of $3.8 million
recorded at the purchase date and an additional $1.2 million recognized for
earn-out consideration earned for 2008.

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

|                                           |  |                   |        |                  |   |       |  
|------------------------------------------ |  | ----------------- | ------ | ---------------- | - | ----- | -
|                                           |  | September 30,2009 |        | December 31,2008 |  
|Developed technology (8 year life)         |  | $                 | 3,900  |                  | $ | 3,900 |  
|Trade names (5 year life)                  |  |                   | 1,200  |                  |   | 1,200 |  
|Other intangibles (5 year life)            |  |                   | 200    |                  |   | 200   |  
|Less: Accumulated amortization             |  |                   | (1,395 | )                |   | (819  | )
|Total
 identifiable intangible assets, net |  | $                 | 3,905  |                  | $ | 4,481 |  

We expect to
continue to recognize amortization expense for the intangible assets in the
above table of $768,000 in each of our years ending December 31, 2009, 2010 and
2011 and of $749,000 in 2012. 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, 2009.

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, 2009 and
2008 (in thousands, except per share data):

|                                                                 |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|---------------------------------------------------------------- |  | ---------------------------------------- | ----- | --------------------------------------- | - | ----- |  | ---- | ----- |  | - | ----- | 
|                                                                 |  | Three-Month Periods
 Ended September 30, |       | Nine-Month Periods Ended
 September 30, |  
|                                                                 |  | 2009                                     |       | 2008                                    |   | 2009  |  | 2008 |      
|Numerator:                                                       |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Net income                                                       |  | $                                        | 1,560 |                                         | $ | 1,162 |  | $    | 2,991 |  | $ | 3,433 | 
|Denominator:                                                     |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Shares used in basic net income per common
 share calculation    |  |                                          | 3,986 |                                         |   | 3,942 |  |      | 3,985 |  |   | 3,933 | 
|Effect of diluted securities:                                    |  |                                          |       |                                         |   |       |  |      |       |  |   |       | 
|Employee and director stock options                              |  |                                          | 87    |                                         |   | 63    |  |      | 80    |  |   | 77    | 
|Shares used in diluted net income per
 common share calculations |  |                                          | 4,073 |                                         |   | 4,005 |  |      | 4,065 |  |   | 4,010 | 
|Basic net
 income per common share                               |  | $                                        | 0.39  |                                         | $ | 0.29  |  | $    | 0.75  |  | $ | 0.87  | 
|Diluted net
 income per common share                             |  | $                                        | 0.38  |                                         | $ | 0.29  |  | $    | 0.74  |  | $ | 0.86  | 

Our
comprehensive income for the three-month periods ended September 30, 2009 and
2008 was $1.5 million and $1.0 million, respectively, and for the nine-month
periods ended September 30, 2009 and 2008 was $2.8 million and $3.1 million,
respectively. In each period, the main difference between net income and
comprehensive income arose from foreign currency translation adjustments.

- 5 -

---

Note F: Stock-based Compensation

We recorded
$266,000 and $246,000 of stock-based compensation in general and administrative
expense for the nine-month periods ended September 30, 2009 and 2008,
respectively. Options to purchase -0- and 31,500 shares, at a weighted average
exercise price of $-0- and $14.37, and options to purchase 68,000 and 62,500
shares, at a weighted average exercise price of $8.62 and $15.10, were granted
during the three-month and nine-month periods ended September 30, 2009 and
2008, respectively. In addition, in June 2009, under a shareholder approved
plan, we exchanged options to purchase 168,500 shares with exercise prices
ranging from $12.37 to $17.50 on a one-for-one basis for options at an exercise
price of $9.22. As of September 30, 2009, $868,000 of total unrecognized
compensation expense related to non-vested stock option awards is expected to
be recognized over a weighted average period of 3.0 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,
2009 and 2008.

The Companys
stock options generally vest over three to five years of service and have a
contractual life of six to ten years. As of September 30, 2009, we had 107,500
shares available for grants under the 2005 Stock Incentive Plan.

The following
table summarizes information about the stock options outstanding at September
30, 2009:

|                         |             |                     |  |                                                 |  |                                   |  |                     |       |                                   |  |         |  |   |       | 
|------------------------ | ----------- | ------------------- |  | ----------------------------------------------- |  | --------------------------------- |  | ------------------- | ----- | --------------------------------- |  | ------- |  | - | ----- | 
|                         |             | 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   |                     |  | 58,500                                          |  | 2.7 years                         |  | $                   | 1.34  |                                   |  | 58,500  |  | $ | 1.34  | 
|                         | 2.00-2.99   |                     |  | 16,200                                          |  | 2.4 years                         |  |                     | 2.35  |                                   |  | 16,200  |  |   | 2.35  | 
|                         | 3.00-3.99   |                     |  | 38,933                                          |  | 3.0 years                         |  |                     | 3.15  |                                   |  | 38,933  |  |   | 3.15  | 
|                         | 7.00-7.99   |                     |  | 10,000                                          |  | 2.1 years                         |  |                     | 7.30  |                                   |  | 6,000   |  |   | 7.50  | 
|                         | 8.00-8.99   |                     |  | 48,000                                          |  | 7.1 years                         |  |                     | 8.63  |                                   |  |        |  |   |      | 
|                         | 9.00-9.99   |                     |  | 174,500                                         |  | 5.6 years                         |  |                     | 9.20  |                                   |  |        |  |   |      | 
|                         | 12.00-12.99 |                     |  | 49,000                                          |  | 5.4 years                         |  |                     | 12.46 |                                   |  | 19,750  |  |   | 12.52 | 
|                         | 15.00-15.99 |                     |  | 36,000                                          |  | 2.2 years                         |  |                     | 15.31 |                                   |  | 36,000  |  |   | 15.31 | 
|                         |             |                     |  | 431,133                                         |  | 4.6 years                         |  |                     | 8.10  |                                   |  | 175,383 |  |   | 6.17  | 

Note G: Income Taxes

In the three
month period ending September 30, 2009, our effective tax rate was
substantially lower than other periods in 2009 and 2008 due to the recognition
of $236,000 in foreign tax credits whose status was uncertain prior to the
quarter.

Note H: Segment Information

We currently
operate in two reportable segments: Autoscope and RTMS. 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
international sales. RTMS is our radar product line acquired in the EIS asset
purchase in 2007, and revenue consists of all North American sales and a
portion of international sales. All segment revenues are derived from external
customers.

- 6 -

---

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,
2009 and 2008 (in thousands):

|                                                                                                                                                                                                      |  |           |        |      |   |        |  |      |       |      |   |        |   |   |        |  |   |        | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ---- | ----- | ---- | - | ------ | - | - | ------ |  | - | ------ | 
|                                                                                                                                                                                                      |  | Autoscope |        | RTMS |   | Total  | 
|                                                                                                                                                                                                      |  | 2009      |        | 2008 |   | 2009   |  | 2008 |       | 2009 |   | 2008   |  
|Revenue                                                                                                                                                                                               |  | $         | 4,374  |      | $ | 4,893  |  | $    | 2,449 |      | $ | 1,189  |   | $ | 6,823  |  | $ | 6,082  | 
|Depreciation                                                                                                                                                                                          |  |           | 90     |      |   | 67     |  |      | 34    |      |   | 31     |   |   | 124    |  |   | 98     | 
|Amortization
 of intangible assets                                                                                                                                                                    |  |           |       |      |   |       |  |      | 192   |      |   | 192    |   |   | 192    |  |   | 192    | 
|Income
 (loss) before income taxes                                                                                                                                                                    |  |           | 1,512  |      |   | 1,952  |  |      | 474   |      |   | (304   | ) |   | 1,986  |  |   | 1,648  | 
|Capital
 expenditures                                                                                                                                                                                 |  |           | 72     |      |   | 46     |  |      | 84    |      |   | 5      |   |   | 156    |  |   | 51     | 
|Total assets                                                                                                                                                                                          |  | $         | 24,786 |      | $ | 22,664 |  | $    | 9,955 |      | $ | 10,461 |   | $ | 34,741 |  | $ | 33,125 | 
|                                                                                                                                                                                                      |  |           |        |      |   |        |  |      |       |      |   |        |   |   |        |  |   |        | 
|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, 2009 and 2008 (in thousands):
|                                                                                                                                                                                                      |  |           |        |      |   |        |  |      |       |      |   |        |   |   |        |  |   |        | 
|                                                                                                                                                                                                      |  | Autoscope |        | RTMS |   | Total  | 
|                                                                                                                                                                                                      |  | 2009      |        | 2008 |   | 2009   |  | 2008 |       | 2009 |   | 2008   |  
|Revenue                                                                                                                                                                                               |  | $         | 11,784 |      | $ | 13,293 |  | $    | 6,109 |      | $ | 5,403  |   | $ | 17,893 |  | $ | 18,696 | 
|Depreciation                                                                                                                                                                                          |  |           | 237    |      |   | 200    |  |      | 93    |      |   | 87     |   |   | 330    |  |   | 287    | 
|Amortization
 of intangible assets                                                                                                                                                                    |  |           |       |      |   |       |  |      | 576   |      |   | 576    |   |   | 576    |  |   | 576    | 
|Income
 before income taxes                                                                                                                                                                           |  |           | 3,066  |      |   | 4,572  |  |      | 935   |      |   | 400    |   |   | 4,001  |  |   | 4,972  | 
|Capital
 expenditures                                                                                                                                                                                 |  |           | 357    |      |   | 186    |  |      | 139   |      |   | 53     |   |   | 496    |  |   | 239    | 
|Total assets                                                                                                                                                                                          |  | $         | 24,786 |      | $ | 22,664 |  | $    | 9,955 |      | $ | 10,461 |   | $ | 34,741 |  | $ | 33,125 | 

Note I: 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, 2009, we had future commitments through December 2009 to
purchase $600,000 of British pounds at rates approximating 1.66.

The fair value
of the Companys derivative instruments is estimated in accordance with the
framework for measuring fair value contained in ASC 820, and it 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, as defined in ASC 820, 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, 2009, as the unrealized loss was immaterial.

Note J: New Accounting Pronouncements

Effective
September 15, 2009, we adopted ASC 105-10 making the Financial Accounting
Standards Board (FASB) ASC the single source of authoritative nongovernmental
U.S. generally accepted accounting principles (GAAP). Rules and interpretive releases
of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of
authoritative GAAP for SEC registrants. All other accounting literature not
included in the ASC is non-authoritative. The Codification did not have a
significant impact on our consolidated financial statements or disclosures.

In December 2007,
the FASB issued ASC 805, Business
Combinations. ASC 805 will significantly change the accounting for
business combinations. Under ASC 805, an acquiring entity will be required to
recognize all the assets acquired and liabilities assumed in a transaction at
the acquisition-date fair value with limited exceptions. ASC 805 will change
the accounting treatment for certain specific items. ASC 805 also includes a
substantial number of new disclosure requirements. ASC 805 applies to us
prospectively for business combinations beginning in 2009, and this adoption
did not have a material impact on our consolidated financial statements.

- 7 -

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In December
2007, the FASB issued ASC 810, Consolidation.
ASC 810 establishes new accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary. ASC 810
also includes expanded disclosure requirements regarding the interests of the
parent and its noncontrolling interest. ASC 810 is effective for fiscal years,
and interim periods within those fiscal years, beginning on or after December
15, 2008. The adoption of ASC 810 did not have a material impact on our
consolidated financial statements.

In May 2009,
the FASB issued ASC 855, Subsequent Events,
to incorporate the accounting and disclosure requirements for subsequent events
into GAAP. ASC 855 introduces
new terminology, defines a date through which management must evaluate
subsequent events, and lists the circumstances under which an entity must
recognize and disclose events or transactions occurring after the balance sheet
date. It is effective prospectively for interim or annual reporting periods
ending after June 15, 2009. We adopted ASC 855 as of the required effective
date and have applied its provisions. The adoption of ASC 855 did not have a
material effect on our consolidated financial statements.

In June 2009,
the FASB amended 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 lack certain characteristics. Among other
things 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 its consolidated financial
statements and related disclosures. It is effective prospectively for interim
or annual reporting periods beginning after December 15, 2009. We do not
believe that the adoption of this portion of ASC 810 will have a significant
effect on our consolidated financial statements.

- 8 -

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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 and the RTMS® Radar Detection System,
operate using our proprietary software in conjunction with video cameras or
radar and commonly available electronic components. Each of these systems is
used by traffic managers primarily to improve the flow of vehicle traffic and
to enhance safety at intersections, main thoroughfares, freeways and tunnels.

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

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 historical 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, which increased demand for
 our products;                                                                                                               
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | advances in
 information technology, which have made our products easier to market and
 implement;                                                                                                                                                                                                 
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | the
 continuing rise in funding allocations in large cities for centralized
 traffic management services, which increased the ability of our primary end
 users to implement our products; and                                                                                                     
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | general
 increases in the cost-effectiveness of electronics, which make our products
 more affordable for end users.                                                                                                                                                                               
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|We believe
 our future growth primarily depends upon:                                                         
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | continued
 adoption and governmental funding of intelligent transportation systems, or
 ITS, for traffic control in developed countries;                                                                                                                                                           
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | countries in
 the developing world adopting above-ground detection technology, such as
 video or radar, instead of in-pavement loop technology to manage traffic;                                                                                                                                  
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | the use of
 CED to provide solutions to security/surveillance and environmental issues
 associated with increasing automobile use in metropolitan areas; and                                                                                                                                       
|                                                                                                               |   |                                                                                                                                                                                                                                                                                                    
|                                                                                                               |  | our ability
 to develop new products, such as hybrid CED devices incorporating, for
 example, radar and video technologies, that provide increasingly accurate
 information and enhance the end users ability to cost-effectively manage
 traffic, security/surveillance and environmental issues.

- 9 -

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Because our
principal 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 current worldwide recession is
further adding to the unpredictability of purchase decisions, creating more
delays than usual and decreasing governmental budgets, and it is likely to
negatively affect our total 2009 revenue. We believe we may be a beneficiary of
the federal stimulus bill enacted early in 2009, but it is too early to
determine the level or timing of impact to our operations.

Key Financial Terms
and Metrics

Revenue. Revenue
historically has been derived 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 direct sales of Autoscope 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. Our acquisition of the RTMS product line in 2007, which
we assemble, gives us an additional source of revenue that has increased our
overall revenue and lessened fluctuations in our revenue from period to period
due to our ownership of more than one product line and the higher volumes it
brings, notwithstanding normal seasonality.

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 direct product sales consists primarily of the amount
charged by our third party contractors to manufacture the Autoscope and RTMS
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.

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 is non-cash expense for
intangible asset amortization.

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.

- 10 -

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Segments. We
currently operate in two reportable segments: Autoscope and RTMS. 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
2007, and revenue consists of all North American sales and a portion of
international sales. All segment revenues are derived from external customers
(see Note H).

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
2009 to 2008:

|                                                 |  |                                          |       |                               |  |       |   |  |       |  
|------------------------------------------------ |  | ---------------------------------------- | ----- | ----------------------------- |  | ----- | - |  | ----- | -
|                                                 |  | Three-Month Periods
 Ended September 30, |       | Quarter Over
 Quarter
 Change | 
|                                                 |  | 2009                                     |       | 2008                          |  |      
|International
 sales                             |  |                                          | 25.7  | %                             |  | 23.3  | % |  | 23.6  | %
|North
 American sales                            |  |                                          | 24.6  |                               |  | 15.1  |   |  | 82.5  |  
|Royalties                                        |  |                                          | 49.7  |                               |  | 61.6  |   |  | (9.4  | )
|Total
 revenue                                   |  |                                          | 100.0 |                               |  | 100.0 |   |  | 12.2  |  
|Gross profit
  international sales              |  |                                          | 67.1  |                               |  | 72.0  |   |  | 15.1  |  
|Gross profit
  North American sales             |  |                                          | 58.8  |                               |  | 49.7  |   |  | 116.2 |  
|Gross profit
  royalties                        |  |                                          | 100.0 |                               |  | 100.0 |   |  | (9.4  | )
|Selling,
 marketing and product support expenses |  |                                          | 25.2  |                               |  | 27.9  |   |  | 1.5   |  
|General and
 administrative expenses             |  |                                          | 11.7  |                               |  | 16.1  |   |  | (18.8 | )
|Research and
 development expenses               |  |                                          | 12.7  |                               |  | 11.5  |   |  | 23.8  |  
|Amortization
 of intangible assets               |  |                                          | 2.8   |                               |  | 3.2   |   |  | n/m   |  
|Income from
 operations                          |  |                                          | 29.0  |                               |  | 27.2  |   |  | 19.5  |  
|Other income
 (expense), net                     |  |                                          | 0.1   |                               |  | (0.1  | ) |  | n/m   |  
|Income taxes                                     |  |                                          | 6.2   |                               |  | 8.0   |   |  | (12.3 | )
|Net income                                       |  |                                          | 22.9  |                               |  | 19.1  |   |  | 34.3  |  

|                                                 |  |                                         |       |                           |  |       |   |  |       |   
|------------------------------------------------ |  | --------------------------------------- | ----- | ------------------------- |  | ----- | - |  | ----- | --
|                                                 |  | Nine-Month Periods
 Ended September 30, |       | Period Over
 PeriodChange | 
|                                                 |  | 2009                                    |       | 2008                      |  |      
|International
 sales                             |  |                                         | 22.9  | %                         |  | 22.6  | % |  | (3.0  | )%
|North
 American sales                            |  |                                         | 26.4  |                           |  | 23.9  |   |  | 5.8   |   
|Royalties                                        |  |                                         | 50.7  |                           |  | 53.5  |   |  | (9.4  | ) 
|Total
 revenue                                   |  |                                         | 100.0 |                           |  | 100.0 |   |  | (4.3  | ) 
|Gross profit
  international sales              |  |                                         | 68.3  |                           |  | 61.2  |   |  | 8.3   |   
|Gross profit
  North American sales             |  |                                         | 65.1  |                           |  | 59.0  |   |  | 16.8  |   
|Gross profit
  royalties                        |  |                                         | 100.0 |                           |  | 100.0 |   |  | (9.4  | ) 
|Selling,
 marketing and product support expenses |  |                                         | 29.5  |                           |  | 25.1  |   |  | 12.5  |   
|General and
 administrative expenses             |  |                                         | 14.4  |                           |  | 15.4  |   |  | (10.7 | ) 
|Research and
 development expenses               |  |                                         | 14.2  |                           |  | 11.6  |   |  | 17.3  |   
|Amortization
 of intangible assets               |  |                                         | 3.2   |                           |  | 3.1   |   |  | n/m   |   
|Income from
 operations                          |  |                                         | 22.3  |                           |  | 26.3  |   |  | (18.9 | ) 
|Other
 income, net                               |  |                                         | 0.1   |                           |  | 0.3   |   |  | (69.0 | ) 
|Income taxes                                     |  |                                         | 5.6   |                           |  | 8.2   |   |  | (34.4 | ) 
|Net income                                       |  |                                         | 16.7  |                           |  | 18.4  |   |  | (12.9 | ) 

- 11 -

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Total revenue
increased to $6.8 million in the three-month period ended September 30, 2009
from $6.1 million in the same period in 2008, an increase of 12.2%, and
decreased to $17.9 million in the first nine months of 2009 from $18.7 million
in the same period in 2008, a decrease of 4.3%. Royalties decreased to $3.4
million in the third quarter of 2009 from $3.7 million in same period in 2008,
a 9.4% decrease, and they decreased to $9.1 million in the first nine months of
2009 from $10.0 million in the same period in 2008, also a decrease of 9.4%. We
attribute the decrease in royalties to the economic recession in North America
and its negative impact on state and federal spending. North American sales,
which are sales of RTMS in North America, increased to $1.7 million in the
third quarter of 2009 from $920,000 in the same period in 2008, an increase of
82.5%, and to $4.7 million in the first nine months of 2009 from $4.5 million
in the same period in 2008, an increase of 5.8%, also reflecting the difficult
economic environment in North America which was first evident for RTMS in the
2008 third quarter. International sales, which include both Autoscope and RTMS
sales outside of North America, increased to $1.8 million in the third quarter
of 2009 from $1.4 million in the third quarter of 2008, an increase of 23.6%,
and decreased to $4.1 million in the first nine months of 2009 from $4.2
million in the first nine months of 2008, a decrease of 3.0%. The nine month
decrease was due mainly to weakness in the Asian market in the first half of
2009.

Gross margins
for international sales decreased to 67.1% in the three months ended September
30, 2009 from 72.0% in the same period in 2008, and increased to 68.3% in the
first nine months of 2009 from 61.2% in the same period in 2008. Gross margins
for North American sales increased to 58.8% in the third quarter of 2009 from
49.7% in the third quarter of 2008 and to 65.1% in the first nine months of
2009 from 59.0% in the first nine months of 2008. The increases resulted mainly
from a positive revenue mix shift and to a lesser extent from positive currency
exchange rates and fewer lower of cost or market inventory adjustments recorded
in 2009 as compared to 2008. Gross margins on royalty income remained
consistent at 100.0% in each of the periods of 2009 and 2008.

Selling,
marketing and product support expense were $1.7 million, or 25.2% of total
revenue, in the three months ended September 30, 2009 and were $1.7 million, or
27.9% of total revenue, in the third quarter of 2008, and increased to $5.3
million, or 29.5% of total revenue, in the first nine months of 2009 from $4.6
million, or 25.1% of total revenue, in the first nine months of 2008. The
nine-month increase related mostly to an investment in market expansion
activities in Eastern Europe and Asia and the realization of the impact of
headcount additions made late in 2008. We anticipate that for the fourth
quarter of 2009, the dollar amount of our selling, marketing and product
support expense will remain at levels similar to or below those of the 2009
third quarter.

General and
administrative expense decreased to $796,000, or 11.7% of total revenue, in the
three months ended September 30, 2009, from $980,000, or 16.1% of total
revenue, in the same period in 2008, and to $2.6 million, or 14.4% of total
revenue, in the first nine months of 2009, from $2.9 million, or 15.4% of total
revenue, in the same period in 2008. The 2009 decrease in costs resulted mainly
from lower incentive pay expense and foreign currency transaction gains which
were partially offset by increased professional services expenses.
Additionally, in 2008 we expensed $221,000 related to our withdrawn stock
offering. We anticipate that for the fourth quarter of 2009, the dollar amount
of our general and administrative expense will be slightly higher than those of
the 2009 third quarter.

Research and
development expense increased to $868,000, or 12.7% of total revenue, in the
third quarter of 2009, up from $701,000, or 11.5% of total revenue, in the same
period in 2008, and to $2.5 million, or 14.2% of total revenue, in the first
nine months of 2009, up from $2.2 million, or 11.6% of total revenue, in the
same period in 2008. The increase was directly related to our investment in
video/radar hybrid solutions and tailored international offerings, development
projects to reduce manufacturing costs, and the realization of the impact of
headcount additions made late in 2008. We anticipate that for the fourth
quarter of 2009, the dollar amount of our research and development expense will
remain at levels similar to that of the third quarter of 2009.

Amortization
of intangibles expense was $192,000 in the third quarter of 2009 and $576,000
in the first nine months of 2009, the same as in these periods in 2008, and
reflects the amortization of intangible assets acquired in the EIS asset
purchase. Assuming there are no changes to our intangible assets, we anticipate
amortization expense will be $768,000 for all of 2009.

Other income
was $18,000 in the first nine months of 2009 as compared to other income of
$58,000 in the same period in 2008. In 2009, interest on bank debt offset most
interest income as we moved into securities that had lower yields than in 2008.

- 12 -

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Income tax
expense was $426,000, or 21.5% of pretax income, in the third quarter of 2009,
compared to $486,000, or 29.5% of pretax income, in the comparable quarter of
2008, and was $1.0 million, or 25.2% of pretax income, in the first nine months
of 2009, compared to $1.5 million, or 31.0% of pretax income, in the comparable
period of 2008. The 2009 effective rate was positively impacted by the
realization of $236,000 in foreign tax credits whose status was uncertain prior
to the third quarter of 2009. We anticipate an effective tax rate below 30% for
all of 2009.

Liquidity and Capital Resources

At September
30, 2009, we had $7.9 million in cash and cash equivalents and $3.9 million in
short-term investments, compared to $10.3 million in cash and cash equivalents
and $4.0 million in short-term investments at December 31, 2008. Our
investments held at December 31, 2008 were auction rate securities that were
redeemed at par in January 2009.

Net cash
provided by operating activities was $2.9 million in the first nine months of
2009, compared to $3.3 million in 2008. The decrease in 2009 versus 2008 was
mainly a result of lower net income. We anticipate that average receivable
collection days in 2009 will increase over 2008 but that the increase will not
have a material impact on our liquidity. Our planned additions of property and
equipment are discretionary, and we do not expect them to significantly exceed
historical levels in 2009. In addition to equipment purchases, in 2009 we paid
our 2008 earn-out liability of $1.2 million to the sellers of the EIS assets.
We also retired our bank debt in full in February 2009, paying a total of $3.75
million during the quarter ended March 31, 2009.

We have a
revolving line of credit agreement with our bank, 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 receivables. The line
of credit currently has no borrowings outstanding and matures on May 1, 2011.
We believe, on an ongoing basis, we have regular availability to draw a minimum
of $3.0 million on our line of credit based on qualifying assets.

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 from RTMS sales less related cost of revenue and operating
expenses, depreciation and amortization, 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. The first earn-out period ran from December 6, 2007 to December 31,
2008. Based on the results for RTMS for the first earn-out period, which ended
December 31, 2008, the sellers of the EIS assets were entitled to receive a
$1.2 million earn-out payment, which was paid in March and April 2009. Based on
results through September 30, 2009, it appears likely that the sellers will be
entitled to an earn-out for the second earn-out period, which runs from January 1, 2009 to December 31, 2009, although this
contingency will not be determinable and payable until December 31, 2009. 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.

EIS was named
in a U.S. lawsuit in 2006 for infringement of a patent. This lawsuit was
dismissed upon appeal in August 2009 and is no longer contested by the
plaintiff. We incurred no expense over the life of the lawsuit as EIS was
responsible for costs of defense.

We believe
that cash and cash equivalents on hand at September 30, 2009, along with the
availability of funds under our $5.0 million revolving line of credit and cash
provided by operating activities, will satisfy our projected working capital
needs, payments under the EIS earn-out, 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.

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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, 2008. The accounting policies used in preparing our interim 2009
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

Effective
September 15, 2009, we adopted Accounting Standards Codification (ASC) 105-10
making the Financial Accounting Standards Board (FASB) ASC the single source
of authoritative nongovernmental U.S. generally accepted accounting principles
(GAAP). Rules and interpretive releases
of the Securities and Exchange Commission (SEC)
 under authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. All
other accounting literature not included in the ASC is non-authoritative. The
Codification did not have a significant impact on our consolidated financial
statements or disclosures.

In December
2007, the FASB issued ASC 805, Business
Combinations. ASC 805 will significantly change the accounting for
business combinations. Under ASC 805, an acquiring entity will be required to
recognize all the assets acquired and liabilities assumed in a transaction at
the acquisition-date fair value with limited exceptions. ASC 805 will change
the accounting treatment for certain specific items. ASC 805 also includes a
substantial number of new disclosure requirements. ASC 805 applies to us
prospectively for business combinations beginning in 2009, and this adoption
did not have a material impact on our consolidated financial statements.

In December
2007, the FASB issued ASC 810, Consolidation.
ASC 810 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. ASC 810 also includes expanded disclosure requirements regarding
the interests of the parent and its noncontrolling interest. ASC 810 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. The adoption of ASC 810 did not have a
material impact on our consolidated financial statements.

In May 2009,
the FASB issued ASC 855, Subsequent Events,
to incorporate the accounting and disclosure requirements for subsequent events
into GAAP. ASC 855 introduces
new terminology, defines a date through which management must evaluate
subsequent events, and lists the circumstances under which an entity must
recognize and disclose events or transactions occurring after the balance sheet
date. It is effective prospectively for interim or annual reporting periods
ending after June 15, 2009. We adopted ASC 855 as of the required effective
date and have applied its provisions. The adoption of ASC 855 did not have a
material effect on our consolidated financial statements.

In June 2009,
the FASB amended 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 lack certain characteristics. Among other
things 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 its consolidated financial
statements and related disclosures. It is effective prospectively for interim
or annual reporting periods beginning after December 15, 2009. We do not
believe that the adoption of this portion of ASC 810 will have a significant
effect on our consolidated financial statements.

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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;                                                                                                                               
| |   |                                                                                                                                                                                          
| |  | dependence
 on third parties for manufacturing and marketing our products;                                                                                                               
| |   |                                                                                                                                                                                          
| |  | dependence
 on single-source suppliers to meet manufacturing needs;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | failure to
 secure adequate protection for our intellectual property rights;                                                                                                             
| |   |                                                                                                                                                                                          
| |  | development
 of a competing product by another business using the underlying technology
 included in the patent we had licensed from the University of Minnesota,
 which expired in 2006;
| |   |                                                                                                                                                                                          
| |  | our
 inability to develop new applications and product enhancements;                                                                                                                     
| |   |                                                                                                                                                                                          
| |  | our
 inability to respond to low-cost local competitors in Asia and elsewhere;                                                                                                           
| |   |                                                                                                                                                                                          
| |  | our
 inability to properly manage any growth in revenue and/or production
 requirements;                                                                                                 
| |   |                                                                                                                                                                                          
| |  | the
 influence over our voting stock by insiders;                                                                                                                                        
| |   |                                                                                                                                                                                          
| |  | our
 inability to hire and 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 1A. to our Annual Report on Form 10-K for the fiscal year ended December
31, 2008.

|        |                                                             
|------- | ------------------------------------------------------------
|Item 3. | Quantitative and
 Qualitative Disclosures About Market Risks

Our foreign
sales and results of operations are subject to the impact of foreign currency fluctuations.
We have not historically hedged our exposure to translation gains and losses.
Beginning in 2009, we have entered into a limited number of hedges that we
anticipate will decrease our overall translation exposure. A 10% adverse change
in foreign currency rates would not have a material effect on our results of
operations or financial position.

We entered
into a number of currency hedging arrangements in 2009. The purpose of the
hedging was to lock in what we believe to be favorable rates on certain
currencies and to increase our predictability on certain expenses at our
foreign subsidiaries. All hedging activity is intended to qualify for hedge
accounting under ASC 815, Derivatives and
Hedging. We believe all contracts will be utilized to provide funds
to cover operating expenses.

- 15 -

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|         |                        
|-------- | -----------------------
|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 was 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.

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, 2008. 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. | Submission of Matters to a
 Vote of Security Holders        
|        |                                                             
|None.   |                                                             
|        |                                                             
|Item 5. | Other Information                                           
|        |                                                             
|None.   |                                                             

- 16 -

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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 September 30, 2009:

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

- 17 -

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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, 2009 | By:                          | /s/ Kenneth R. Aubrey                        
|                         |                              | Kenneth R. Aubrey                            
|                         |                              | President and Chief
 Executive Officer       
|                         |                              | (principal executive
 officer)               
|                         |                              |                                              
|Dated: November 12, 2009 | By:                          | /s/ Gregory R. L. Smith                      
|                         |                              | Gregory R. L. Smith                          
|                         |                              | Chief Financial Officer                      
|                         |                              | (principal financial and
 accounting officer)

- 18 -

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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.

- 19 -

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