UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549




FORM
10-K




x


FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2008


OR


 ̈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 000-49636




Viking Systems, Inc.


(Exact
name of registrant as specified in its charter)




Delaware
              
              86-0913802(State
      or other jurisdiction of
                incorporation
      or organization)
              
              (I.R.S.
      Employer
                Identification
      No.)


134
Flanders Road,


Westborough,
MA, 01581


(Address
of principal executive offices)( Zip Code)




(508)
366-3668


(Registrant’s
telephone number, including area code)




Securities
registered pursuant to Section 12(b) of the Act:


Title
      of each class:
            
            Name
      of each exchange on which registeredNone
            
            N/A




Securities
registered pursuant to Section 12(g) of the Act:


$.001
Par Value Common Stock




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.    Yes    ̈    No   x




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the
Act.    Yes    ̈    No   x




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




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




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
definition of “large accelerated filer, “accelerated filer”, and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):


Large
      accelerated filer     ̈
                      
                      Accelerated filer  
       ̈
                      
                      Non-accelerated
      filer    ̈
                      
                      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 Act).    Yes    ̈    No   x




The
aggregate market value of the voting stock, consisting solely of common stock,
held by non-affiliates of the registrant on June 30, 2008 was
approximately $11,732,410 (based on a total of 23,943,694 shares of the
registrant’s common stock held by non-affiliates on June 30, 2008, at the
closing price of $0.49 per share). Shares of voting stock held by each officer
and director have been excluded in that such persons may be deemed to be
affiliates. This assumption regarding affiliate status is not necessarily a
conclusive determination for other purposes.




The
number of outstanding shares of the registrant’s common stock on March 31, 2009
was 42,715,110.




DOCUMENTS INCORPORATED BY REFERENCE:
NONE














TABLE OF
CONTENTS





PagePART
      IItem
      1. Business
              1Item
      1A.  Risk Factors
              9Item
      2. Properties
              13Item
      3. Legal Proceedings
              13Item
      4. Submission of Matters to a Vote of Security Holders
              13PART
      IIItem
      5. Market for Registrant’s Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
              14Item
      6. Selected Financial Data
              15Item
      7. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
              16Item
      7A. Quantitative and Qualitative Disclosures About Market
    Risk
              22Item
      8. Financial Statements
              23Item
      9. Changes In and Disagreements with Accountants on Accounting and
      Financial Disclosure
              52Item
      9A(T). Controls and Procedures
              52Item
      9B. Other Information
              53PART
      IIIItem
      10. Directors, Executive Officers and Corporate Governance
              53Item
      11. Executive Compensation
              56Item
      12. Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters
              59Item
      13. Certain Relationships and Related Transactions and Director
      Independence
              62Item
      14. Principal Accounting Fees and Services
              63Item
      15. Exhibits
              63




i





PART
I





ITEM
1. BUSINESS





General





We are a
leading worldwide developer, manufacturer and marketer of visualization
solutions for complex, minimally-invasive surgery.  We partner with
medical device companies and healthcare facilities to provide surgeons with
proprietary visualization systems enabling minimally-invasive surgical
procedures, which reduce patient trauma and recovery time.





We sell
our proprietary visualization system, (3Di Vision System) under the Viking
brand directly to hospitals and outpatient surgical centers in the United States
and outside the United States through our distributor network.  We
also sell our CardioCam/MiniCam product through these channels..  Our
3Di System is an advanced three dimensional (“3D”) vision system used by
surgeons for complex minimally invasive laparoscopic surgery, with applications
in urologic, gynecologic, bariatric, cardiac, neurologic and general
surgery.  CardioCam is a unique
product designed to provide a stable, high resolution video stream of the open
field in cardiac surgery or other procedures.





We also
manufacture two dimensional (“2D”) digital cameras that are sold to third-party
companies who sell to end users through their Original Design Manufacturer
(“ODM”) programs and Original Equipment Manufacturer (“OEM”)
programs.





Our
technology and know-how center on our core technical competencies in optics,
digital imaging, sensors, and image management. Our focus is to deliver advanced
visualization solutions to the surgical team, enhancing their capability and
performance in complex minimally invasive surgical procedures.




As of
December 31, 2008, we believe more than 100 of our proprietary visualization
systems were in service worldwide.  Moreover, we have sold more than 1,300
2D digital cameras to ODM/OEM partners, including Boston Scientific
Corporation (“Boston Scientific”) and Medtronic, Inc.
(“Medtronic”).   Our ODM products are jointly designed with our
partners to meet their exact specifications for their particular
market.




HISTORY





We
commenced our current business operations in April 2004, when we acquired a
proprietary 2D and 3D surgical visualization business (the “Visualization
Assets”) and a digital platform for surgical information delivery (InfomatixTM)
from Vista Medical Technologies, Inc. (“Vista”).





Effective
July 25, 2006, we changed our domicile from the State of Nevada to the State of
Delaware by way of a reincorporation merger. Our Certificate of Incorporation
and Bylaws as a Delaware corporation are similar to the Articles of
Incorporation and Bylaws we had as a Nevada Corporation.




Since the
acquisition of the assets from Vista in 2004, we have taken many actions to
commercialize the technology, including the following:




·
            Completed
      the development of the 3Di System, which was launched at the American
      College of Surgeons Clinical Congress in October
  2004;





·
            Rebranded
      the visualization technology product developed from the Visualization
      Assets:





·
            Established
      an international, independent distribution network for the 3Di
      systems;





·
            Demonstrated
      the clinical acceptance of the 3Di System in hundreds of urology,
      gynecology, and general surgery procedures, including many complex
      minimally invasive surgical procedures, such as laparoscopic radical
      prostatectomy, laparoscopic bariatric surgery, laparoscopic pyeloplasty,
      laparoscopic pelvic floor reconstruction and laparoscopic
      hysterectomy;





·
            In
      2006, we demonstrated the effective use of the 3Di system with integrated
      images from compatible surgical devices, including real-time ultrasound,
      fluoroscopy, surgical navigation, ablation, immunoscintography and other
      diagnostic information;





1





·
              Added significant
      ODM/OEM partners such as B. Braun and Boston
Scientific;·
              Launched
      a 3D display product configuration compatible with the Intuitive Surgical
      da Vinci robotic system enabling the tableside assistant the same 3D view
      as the primary surgeon;




·
            Launched
      a high definition endoscopic video system in December 2007 for the ODM/OEM
      marketplace; and




·
            Launched
      CardioCam/MiniCam, a 2D, 7 millimeter flexible camera, at the Society of
      Thoracic Surgeons annual meeting in January
  2008.





PRODUCT
AND TECHNOLOGY OVERVIEW





Our
two primary product lines are the 3Di Systems sold direct in the United States
and through our distributor network outside of the United States to hospitals
and out-patient surgical centers and a line of 2D digital cameras and components
sold to our ODM/OEM partners.





Viking
3Di Vision System





Successful
surgeries and positive patient outcomes depend on the surgical team having both
the correct surgical skills and the most conducive surgical environment. Our 3Di
System is designed to deliver three key benefits that aid in creating the
environment a surgical team needs for success:





·
            Depth Perception -
      Natural 3D vision is presented using advanced stereo optics with
      high-resolution to provide three dimensional depth
    perception;





·
            Ergonomics -The
      Personal Head Display (“PHD”) provides the surgical team with freedom of
      movement and natural line of sight, freeing them from the uncomfortable
      posture required to constantly view a remotely-positioned
      monitor.  These ergonomic features reduce fatigue and help to
      optimize surgical performance; and





·
            InfomatixTM- Information that we
      believe can be delivered through the proprietary InfomatixTMcapabilities
      that enable on-demand presentation of critical information directly to the
      surgical team’s field of view through voice activated technology. Due to
      our limited resources, we have put the development of Informatix on hold,
      and we can provide no assurance as to when, or if, Informatix will be
      completed.





There are
five key technology components that make up our 3Di System:





·
            Camera -Our 3Di digital
      camera incorporates dual 3-Chip charge-coupled devices “CCDs” into a
      lightweight and ergonomic camera head featuring two convenient accessory
      control buttons. The camera utilizes a proprietary optical system allowing
      360° scope rotation while maintaining proper image orientation, which
      delivers a high resolution image to each eye as viewed through the PHD.
      This results in clear 3D vision of the most critical anatomical
      structures. The 3-Chip, red, green and blue, stereo camera system is made
      up of two components including a camera control unit and a camera
      head.





·
            Endosite Controller -The Endosite controller is the data hub of the 3Di System. With the
      capability to support up to two video sources, stereo or mono, the
      Endosite converts any video signal to a digital XGA format and delivers
      real-time clinical images to the surgical team wearing PHDs. A
      user-independent voice controlled module on the surgeon’s PHD directs our
      InfomatixTMtechnology, which we anticipate will provide integrated information
      capabilities, including on-demand presentation of critical images and
      clinical data to the surgical team’s visual field. This capability is
      extended to the control of the 3Di Video Recorder for the capture of both
      image and video records of the surgery for insurance, training and patient
      medical records.





·
            Personal Head Display -The PHD is a comfortable and lightweight 3D personal monitor that
      serves to improve operating room ergonomics and provide stereo
      visualization. The technological advances of the liquid crystal displays
      “LCDs” are analogous to 3-Chip camera technology. The three-panel PHD
      allows true 3D visualization by employing three individual LCDs for each
      eye to display red, green and blue, resulting in vast improvements in
      image contrast and brightness with superior color
      reproduction.





·
            Illumination - Our
      300-watt Xenon light source provides brilliant light to any minimally
      invasive procedure providing uncompromising illumination for proper tissue
      distinction. Additional features include extended-use lamp life of 500
      hours, an easy access lamp module and built-in safety
      features.





2





·
            StereoScopes -
      StereoScopes in the 3Di System provide the advantage of a proprietary
      optical path to transfer optimal image resolution and illumination.
      Available in 10mm diameter, 0° and 30° angle of view configurations,
      StereoScopes deliver a wide angle, fixed focal length scope to fit a large
      range of procedures.





Visualization
Solutions for OEM Customers





We also
supply 2D digital cameras and components for several procedure-specific medical
device manufacturers such as Medtronic, Boston Scientific, B. Braun Medical,
Inc. (“B. Braun”), Biomet, Inc. and Richard Wolf Medical Instruments Corporation
(“Richard Wolf”). As the procedural business of our customers continues to shift
to minimally invasive techniques, we intend to introduce new products, services
and capabilities to respond to this important business segment. We are committed
to the growth of our OEM business and believe our engineering capabilities and
advanced technologies make us an ideal partner of choice for companies operating
in this sector.





BUSINESS
AND MARKET OPPORTUNITY





FDA-Cleared,
Advanced and Affordable 3D Surgical Visualization Technology.





We
believe our technology is at the forefront of advanced 3D visualization
solutions for complex minimally invasive surgeries. As minimally invasive
surgeries gain popularity with both physicians and patients due to improved
outcomes, faster recovery times and lower post-operative care costs, surgeons
seek tools and techniques that make procedures faster and easier. We believe
that there are currently no comparable, FDA-cleared, 3D visualization systems on
the market at our price points.





Significant
Clinical and Workflow Benefits Associated with Improved Surgical
Visualization.





Our 3Di
System provides the surgical team significant clinical and workflow benefits not
currently available from 2D visualization systems. Our solution provides the
benefits of natural 3D vision by providing depth perception cues and a sense of
spatial relativity. The image is not a computer model or digital rendering; it
is stereoscopic vision that closely approximates the surgeon’s visual acuity in
open surgery. This is particularly important in complex and lengthy minimally
invasive procedures that require safe and precise navigation of a patient’s
anatomy. In addition, the PHD provides a field of view that is more immersive
than traditional two dimensional views and is in alignment with the
surgeon’s orientation to his or her instruments. The ergonomic benefits help to
reduce surgeon fatigue and strain associated with traditional 2D systems that
require a physician to constantly view a remotely positioned monitor and
compromise his or her posture.





InfomatixTM is also
a proprietary future platform for the 3Di System which, when completed, we
anticipate will provide the surgical team with additional information to enhance
its ability to perform. We anticipate information will be available on command
through a voice-activated technology that will enable viewing of secondary video
and existing diagnostic information without leaving the patient. We anticipate
that, upon completion, the system will be able to be configured to access
clinical images from pre-surgical files and secondary video in a
picture-in-picture format.  Due to our limited resources, we have put
the development of Informatix on hold, and we can provide no assurance as to
when, or if, Informatix will be completed.





Practical
Benefits of our 3Di System Expand Market Opportunities in an Environment that
Places a Premium on Innovative Technologies.





We
believe that the clinical benefits and potential applications of 3D
visualization technology provide us with attractive market opportunities. The
3Di System combines the visual benefits of an open procedure with the clinical
outcomes associated with minimally invasive surgery and enables more complicated
surgical procedures to be performed using less invasive techniques. It expands
the market or procedures available for use by these systems. Moreover, in
addition to our current procedural focus, there are several other procedural
specialties that offer significant expansion opportunities for the technology.
The expansion segments include:




·
            Functional
      Endoscopic Sinus Surgery


·
            Cardiothoracic
      surgery


·
            Neuro
      Endoscopy


·
              Pediatric
      Endoscopy
 ·
              Minimally
      invasive spine surgery


3


CardioCam/MiniCam
Provides Product for Cardiac Market





The
CardioCam/MiniCam is a unique product targeted primarily for the cardiac
market.  It is designed to provide a stable, high resolution video
stream of the open field in cardiac surgery or other procedures. As incisions in
cardiac surgery become smaller and smaller, it is increasingly difficult for
cardiac surgeons to document procedures by conventional means including
head-mounted or overhead cameras. The CardioCam/Minicam is designed to be
positioned unobtrusively in the sterile field to capture the entire procedure
for archiving or for displaying in the operating suite, where it is accessible
to the entire team.




ODM/OEM
Business Provides Recurring Revenues





The
ODM/OEM business has provided us with a recurring source of revenue and has been
a source of growth. We are the strategic visualization supplier and partner for
several leading procedure-specific medical device manufacturers such as B.
Braun, Richard Wolf, Boston Scientific, Medtronic and Biomet, Inc. We have sold
over four thousand 2D digital cameras, accessories and unique visualization
solutions to our ODM/OEM partners, and in 2007 and 2008 ODM/OEM sales accounted
for approximately $5,235,000 and $5,137,000 in revenue,
respectively.





MARKET
OPPORTUNITY





We
believe the primary market for our products is complex, minimally invasive
surgery (“MIS”) that relies heavily on the use of endoscopic instruments,
enabling instrumentation and visualization technologies. We believe that the key
growth drivers in MIS include the following:





·
            Improved
      patient outcomes;


·
            Economic
      benefits associated with shorter hospital
stays;


·
            Proactive
      and informed patients will continue to seek out minimally invasive
      surgeries;


·
            Patients
      will make restorative health care choices to maintain a healthy lifestyle;
      and


·
            With
      improved technologies, especially articulating instruments and downsized
      instruments, more procedures will continue to be adapted to MIS
      techniques.





We
believe that the clinical benefits and broad potential application of 3D
visualization technology provide us with an attractive, potentially high growth
market. The 3Di System combines the visual benefits with the opportunity for
rapid recovery associated with minimally invasive techniques. The technology
itself is believed to be a driver of expanding procedural
applications.





MARKET
SEGMENTATION, COMPETITION AND PRODUCT POSITIONING OF 3Di SYSTEM





Although
competition exists for aspects of our visualization product line, we believe
that no single company offers a complete and independent 3D visualization and
information solution specifically directed at complex minimally invasive
procedures. In addition, we are not aware of any other true 3D PHD that has
been cleared for marketing in surgical applications by the FDA.





We
believe our competition comes from 2D vision systems where the prices per system
range from $20,000 to $80,000 and represent the low or standard end of the
market. The worldwide medical market for standard 2D vision systems is
approximately thirty thousand units per year.  Karl Storz GmbH,
Stryker Corporation, Olympus, Inc., Conmed Corporation, Richard
Wolf  and Smith & Nephew PLC are key competitors supplying 2D
units.





A
separate high end segment of the visualization technology market is fully
immersive 3D-vision-enabled robotics, in particular Intuitive Surgical’s daVinci
System, which generally sells for up to $1,500,000 per system and requires
disposables that cost the hospital up to an estimated $1,500 to $3,000 per
procedure.  We do not compete in this segment. Although the robotic
technologies provided by companies such as Intuitive Surgical, Inc., with its
proprietary da Vinci system, incorporate 3D vision capabilities into their
systems, our products are not in direct competition with these products. Rather,
our strategy is to offer standalone 3D vision capability at a base price of
$100,000 to $150,000.




Our 3Di
solution provides a higher level of technical sophistication than 2D for MIS
procedures, without the high cost and technical complexity of a robotic
solution. We estimate the opportunity for our 3D technology to be 1,400 systems
per year, assuming 5% penetration. We believe that  this currently
represents a market opportunity of approximately $100 million
annually.
  Our 3Di
System is positioned against other 2D systems with the added benefits of depth
perception, ergonomics and, eventually,InfomatixTM. In hospital
accounts that have purchased a robotic daVinci system, we market the 3Di System
as a complementary product by positioning it as an innovative and affordable
improvement for operating technique and patient care.


4







OEM
MARKET DEVELOPMENT





We
anticipate the trend of converting open surgical procedures to minimally
invasive techniques will continue to grow at a double digit rate for the
foreseeable future. The common element of minimally invasive techniques is that
the surgeon must rely on a means other than direct visualization to operate
effectively. We believe we are uniquely positioned to provide a broad range of
direct visualization solutions to the OEM marketplace. We believe we will be
able to leverage our long-standing customer relationships and build our customer
list by adding stable, brand name companies as well as emerging companies
developing novel techniques to our customer list further enabling the conversion
to minimally invasive techniques with all types of visualization
solutions.








SALES
AND MARKETING





Our
global sales and marketing effort is designed to drive adoption and to develop a
premium Viking branded image for our products. We focus on implementing a
multi-tiered sales initiative, developing the market segments of interest and
building relationships with key opinion leaders and academic
centers.





In the
fourth quarter of 2007, we changed our sales approach  to stay within
our financial resources.  We eliminated most of our direct sales force
in the United States to conserve cash.  In the United States, we
primarily sell directly through our Westborough, Massachusetts location under
the direction of a long-service senior sales executive and support
staff.  This group develops customer contacts, demonstrates equipment
and follows up on sales made to assure customer satisfaction.  These
efforts are supported by technical resources from our Westborough, MA
headquarters manufacturing facility.





Outside
the United States, we have agreements with distributors in Europe, Asia, the
Middle East, Australia and Canada.  These sales are supported by a
senior sales executive based in the United States, a clinical specialist located
in the United Kingdom, and our Westborough, MA personnel.





Although
these activities have been significantly scaled down since 2007, our marketing
strategy includes exposure through trade shows, encouraging clinical studies and
publications, and working with prominent academic healthcare institutions on new
product development opportunities. Our marketing objective is to create premium
brand recognition for our solutions, which we believe will support growth of 3Di
system placements.





To date,
we have experienced the most success in the specialty segments of urology,
bariatrics and laparoscopic gynecology. Using urology as an example, we believe
that the adoption drivers are compelling for a number of reasons, including the
following:





·
            Minimally
      invasive urological procedures are complex and, as demonstrated by the
      adoption of surgical robotic systems, urological surgeons require 3D depth
      perception to more safely and precisely navigate the anatomy of a
      patient;


·
            Urological
      surgeons are influential in purchasing
  decisions;


·
            The
      3Di System provides a much lower cost alternative to hospital
      administration and is a more flexible alternative to a robot;
      and


·
            Procedures
      in urology are well defined and we believe we can address the
      visualization requirements for most urological
  procedures.






OPERATIONS
 
 We manage
our product development, production and engineering functions in our
Westborough, Massachusetts headquarters facility by Jed Kennedy, our President
and COO, who oversees a staff of 18 full-time employees and several consultants.
These personnel provide us with production capability, product development,
quality assurance, regulatory affairs management and technical sales
support.


5





Production
processes that are conducted at our Westborough facility include final assembly,
test and integration services of surgical video systems. Equipment used in the
production and engineering process consists of benches, custom fixtures, test
equipment and hand tools. We outsource all fabrication operations. There is
currently floor space capacity to build and ship planned OEM shipments, as well
a build over 200 3Di systems per year. Additional skilled labor is readily
available in the local market as production volume increases.





We
utilize sole source component technology from Matsushita Electric Industrial
Co., Ltd. (Panasonic), Toshiba Teli Corporation, Ltd. and Creative Display
Systems, LLC. We maintain a good relationship with all three suppliers and it
has been their policy to notify us well in advance of the end of life of a
particular component so that we are able to make the necessary final orders
and/or design modifications to support the replacement technology.





All
development projects are performed in compliance with FDA guidelines and the
Medical Device Directive, the regulatory requirements of the European Union for
medical devices. Our policies and procedures have been audited and found to be
compliant by the regulatory agencies for both the United States and Europe.
All products have been tested and approved to safety standards established by
the International Electrotechnical Commission, by Intertek ETL, a nationally
recognized testing laboratory in the United States.




With the
t upgrade of our enterprise planning software and information technology
infrastructure completed during 2008, we believe the current systems and
facilities will accommodate our growth projected for the next several years. Our
Westborough facility is ISO 13485 certified and FDA compliant.





PRODUCT
DEVELOPMENT





Our
product development priorities include supporting the development phase of new
OEM customer programs, supporting the clinical expansion process, upgrading and
enhancing our core platform products, and developing new products to expand our
product line. We are dedicated to providing the highest quality and best video
image on the market, in addition to delivering that image in
3D.  During 2008 and 2007 we incurred $757,186 and $1,974,457,
respectively on research and development related expenses.





The
following initiatives are most important to our product development
roadmap:





OEM
Product Development





For the
OEM market, we have developed improved 2D high definition products to enhance
image quality.  We are also completing development work under an
engineering services contract that has provided approximately $700,000 of
revenue through 2008 with approximately $120,000 remaining that we anticipate
recognizing in 2009.  It is the parties’ stated intentions that this
development agreement will lead to a multi-year supply agreement whereby we
manufacture and supply products to the other party.  No assurance can
be made that we will enter into a supply agreement as a result of this
engineering contract.





In 2007
we developed our first disposable product for a startup company that is
addressing the atrial fibrillation market. The first production orders were
received and filled in 2008.





In 2008
we launched our CardioCam/MiniCam product for video streaming of the open field
in cardiac surgery and other procedures.





“Viking”
Brand Product Development:





We will
focus on enhancing and optimizing the 3Di system and the CardioCam system
already in the market.  We also are continuing to evaluate the
technologies available and refine the pathway for our next generation
system.  While we improve visualization, we intend also to explore
providing a complete advanced minimally invasive surgical solution rather than a
visualization only system.




InfomatixTM:
 
 We have
put on hold the development of the next generation of InfomatixTMwhich will enable
the system to not only display live imagery from video sources but will also
include the ability to interface effectively with image guidance, various forms
of patient monitoring equipment and allow the surgeon to view pre-staged
surgical images intraoperatively. This effort will also include expanded digital
video and image recording capability and interfaces to hospital administration
systems moving to electronic medical records. We intend to revisit this project
when resources permit.


6





INTELLECTUAL
PROPERTY





Our
technology base was built through internal research and development and by
license and acquisition. We hold fourteen patents and non-exclusive license
rights to four U.S. patents and four international patents.





On August
5, 2008, we licensed our patent portfolio to Intuitive Surgical, Inc. pursuant
to an exclusive license agreement (the “License Agreement”).  The
License Agreement provides Intuitive Surgical with perpetual, exclusive rights
to use all of our current patents in the medical robotics field, as defined in
the License Agreement.  We maintained the right to sell
non-stereoscopic products and our current stereoscopic products that utilize the
licensed patents in the medical robotics field.  We received $1
million for the license.





QUALITY
ASSURANCE AND REGULATORY AFFAIRS





All of
the medical devices we develop are regulated by the FDA in the United States.
The nature of the FDA requirements applicable to medical devices depends on
their classification by the FDA. Our current products are classified as Class II
medical devices. A device classified as a Class II device usually requires, at a
minimum, FDA 510(k) clearance. The 3Di System was cleared to be marketed in the
United States via 510(k) number K021290 on June 28, 2002.





Our
regulatory function is managed by Jed Kennedy and supported by a regulatory
affairs consultant with over 15 years of experience in the medical device
industry. The consultant also acts as our management representative as required
by the Medical Device Directive. Additionally, we have two full-time employees
performing quality control functions. Also, to comply with quality
requirements, we rely on our suppliers’ quality systems and ISO registrations as
well as historical data to support our material acceptance.





We use
the following criteria to prioritize and guide the decision making process in
our Quality organization:





·
            Patient
      and user safety;





·
            Comply
      with all applicable U.S. and international standards for medical device
      manufacture;





·
            Highest
      quality product based on the product specification;
  and





·
            On-time
      delivery.





Our
Westborough, MA facility was the subject of a routine surveillance audit by the
FDA in February 2003. No adverse findings were noted. To ensure our compliance
with ISO standards, “Notified Body” inspections of our facility occur
annually.  Our last Notified Body review was in June 2008 and resulted
in a recommendation that we maintain our certification.




Governmental
Regulation of Medical Devices




The
manufacture and sale of medical devices intended for commercial distribution are
subject to extensive governmental regulation in the United States.  Medical
devices are regulated in the United States primarily by the FDA and, to a lesser
extent, by certain state agencies.  Generally, medical devices require
pre-market clearance or pre-market approval prior to commercial
distribution.  In addition, certain material changes or modifications to,
and changes in the intended use of, medical devices also are subject to FDA
review and clearance or approval.  The FDA regulates the research, testing,
manufacture, safety, effectiveness, labeling, storage, record keeping, promotion
and distribution of medical devices in the United States and the export of
unapproved medical devices from the United States to other countries. 
Non-compliance with applicable requirements can result in failure of the
government to grant pre-market clearance or approval for devices, withdrawal or
suspension of approval, total or partial suspension of production, fines,
injunctions, civil penalties, refunds, recall or seizure of products and
criminal prosecution.


7


Device Classes





In the
United States, medical devices are classified into one of three classes, Class
I, II or III, on the basis of the controls deemed by the FDA to be necessary to
reasonably ensure their safety and effectiveness.  Our current products are
classified as Class II devices.




Class I
devices are subject to general controls, such as establishment registration and
product listing, labeling, adulteration and misbranding provisions and medical
device reporting requirements and, unless exempt, to pre-market notification and
adherence to “good manufacturing practice” standards.  Class II devices are
subject to general controls and special controls, such as performance standards,
post-market surveillance, patient registries and FDA guidelines. 
Generally, Class III devices are those that must receive pre-market approval by
the FDA to ensure their safety and effectiveness.  Examples of Class III
products include life-sustaining, life-supporting and implantable or new devices
which have not been found to be substantially equivalent to legally marketed
devices.  Class III devices ordinarily require clinical testing to ensure
safety and effectiveness and FDA clearance prior to marketing and
distribution.  The FDA also has the authority to require clinical testing
of Class I and Class II devices.  A pre-market approval application must be
filed if a proposed device is not substantially equivalent to a legally marketed
predicate device or if it is a Class III device for which the FDA has called for
such application.  A pre-market approval application typically takes
several years to be approved by the FDA.





Device
Approval





Generally,
before a new device can be introduced into the market in the United States, the
manufacturer or distributor must obtain FDA clearance of a 510(k) notification
or submission and approval of a pre-market approval application.  If a
medical device manufacturer or distributor can establish that a device is
“substantially equivalent” to a legally marketed Class I or Class II device, or
to a Class III device for which the FDA has not called for a pre-market
approval, the manufacturer or distributor may market the device upon receipt of
an FDA order determining such a device substantially equivalent to a predicate
device.  The 510(k) notification may need to be supported by appropriate
performance, clinical or testing data establishing the claim of substantial
equivalence.  The FDA requires a rigorous demonstration of substantial
equivalence.




Following
submission of the 510(k) notification, the manufacturer or distributor may not
place the device into commercial distribution until an FDA substantial
equivalence order permitting the marketing of a device is received by the person
who submitted the 510(k) notification.  At this time, the FDA typically
responds to the submission of a 510(k) notification within 90 to 200 days. 
An FDA letter may declare that the device is substantially equivalent to a
legally marketed device and allow the proposed device to be marketed in the
United States.  The FDA, however, may determine that the proposed device is
not substantially equivalent or require further information, including clinical
data, to make a determination regarding substantial equivalence.  Such
determination or request for additional information will delay market
introduction of the product that is the subject of the 510(k)
notification.





Investigational
Device Exemption Application





All
clinical investigations involving the use of an unapproved or uncleared device
on humans to determine the safety or effectiveness of the device must be
conducted in accordance with the FDA’s investigational device exemption
regulations.  If the device presents a “significant risk,” the manufacturer
or distributor of the device is required to file an investigational device
exemption application with the FDA prior to commencing human clinical
trials.  This application must be supported by data, typically the result
of animal and bench testing.  If the application is approved by the FDA,
human clinical trials may begin at a specific number of investigational sites
with a maximum number of patients, as approved by the FDA.  If the device
presents a “non-significant risk,” approval by an institutional review board
prior to commencing human clinical trials is required, as well as compliance
with labeling, record keeping, monitoring and other requirements.  However,
the FDA can disagree with a non-significant risk device finding.




Any
products which we manufacture or distribute are subject to continuing regulation
by the FDA, which includes record keeping requirements, reporting of adverse
experience with the use of the device, “good manufacturing” requirements and
post-market surveillance, and may include post-market registry and other actions
deemed necessary by the FDA.  A new 510(k), pre-market approval or
pre-market approval supplement is also required when a medical device
manufacturer makes a change or modification to a legally marketed device that
could significantly affect the safety or effectiveness of the device, or where
there is a major change or modification in the intended use of the device or a
new indication for use of the device.  When any change or modification is
made to a device or its intended use, the manufacturer is expected to make the
initial determination as to whether the change or modification is of a kind that
would necessitate the filing of a new 510(k), pre-market approval or pre-market
approval supplement.


8


Foreign
Requirements





The sale
of medical device products outside of the United States is subject to foreign
regulatory requirements that vary from country to country.  The time
required to obtain approvals required by foreign countries may be longer or
shorter than that required for FDA clearance, and requirements for licensing may
differ from FDA requirements.  Our failure to comply with regulatory
requirements would jeopardize our ability to market our products.  The
current regulatory environment in Europe for medical devices differs
significantly from that in the United States.  Since June 1998, all medical
devices sold in the European Union must bear the CE mark.  Devices are now
classified by manufacturers according to the risks they represent with a
classification system giving Class III as the highest risk devices and Class I
as the lowest.  Once the device has been classified, the manufacturer can
follow one of a series of conformity assessment routes, typically through a
registered quality system, and demonstrate compliance to a “European Notified
Body.”  After that, the CE mark may be applied to the device. Maintenance
of the system is ensured through annual on-site audits by the notified body and
a post-market surveillance system requiring the manufacturer to submit serious
complaints to the appropriate governmental authority.





Employees





As of
April 7, 2009, we have 21 employees.  None of our employees are
represented by a collective bargaining agreement, nor have we experienced work
stoppages. We believe our relations with our employees are good.





ITEM
1A. RISK FACTORS





Forward
Looking Statements




This
annual report on Form 10-K contains and incorporates by reference certain
“forward-looking statements” with respect to results of our operations and
businesses. All statements, other than statements of historical facts, included
in this annual report on Form 10-K, including those regarding market trends, our
financial position, business strategy, projected costs, and plans and objectives
of management for future operations, are forward-looking statements. In general,
such statements are identified by the use of forward- looking words or phrases
including, but not limited to, “intended,” “will,” “should,” “may,” “expects,”
“expected,” “anticipates,” and “anticipated” or the negative thereof or
variations thereon or similar terminology. These forward-looking statements are
based on our current expectations. Although we believe that the expectations
reflected in such forward-looking statements are reasonable, there can be no
assurance that such expectations will prove to be correct and our actual results
could differ materially. These forward-looking statements represent our judgment
as of the date of this annual report on Form 10-K. We disclaim, however, any
intent or obligation to update our forward-looking statements, except as
required by law.





Risks
Related to our Business





Our
Independent Auditors have expressed substantial doubt about our ability to
continue as a going concern.





In their
report dated April 15, 2009, our independent registered public accounting
firm, Squar, Milner, Peterson, Miranda & Williamson, LLP, stated that our
financial statements for the year ended December 31, 2008 were prepared assuming
that we would continue as a going concern.  Our ability to continue as a
going concern is an issue raised as a result of our significant operating losses
and negative operating cash flows.  During the years ended
December 31, 2008 and 2007, we incurred net losses of $5,752,057 and
$923,290, respectively, and we incurred negative cash flows from operating
activities of $2,615,399 and $6,792,845, respectively.  We will need
to generate significant revenue in order to achieve profitability and we may
never become profitable.  The going concern explanatory paragraph in
the independent auditor's report emphasizes the uncertainty related to our
business as well as the level of risk associated with an investment in our
common stock.





We
require additional financing and our inability to raise additional capital on
acceptable terms in the future may have a material adverse effect on our
business and financial condition.





We
believe that it is likely that we will need to seek a business combination or
additional financing in order to fund our operations and carry out our business
plan for the next twelve months. The overall weakening of the economy and
increased financial instability of many borrowers has resulted in a general
tightening of capital availability.  Many lending and investing
institutions that have traditionally been sources of capital have experienced
significant losses and a lack of liquidity. These conditions may adversely
impact our ability to raise capital. There can be no assurance that a business
combination or such financing will be available on acceptable terms, or at all.
We do not have any arrangements with any bank or financial institution to
provide additional financing and there can be no assurance that any such
arrangement, if required or otherwise sought, would be available on terms deemed
to be commercially acceptable and in our best interests. Also, if we raise
additional funds by selling equity or equity-based securities, the percentage
ownership of our existing stockholders will be reduced and such equity
securities may have rights, preferences or privileges senior to those of the
holders of our common stock. Any inability to obtain additional cash as needed
could have a material adverse effect on our financial position, results of
operations and ability to continue operations.





9


As part
of managing our business, we frequently forecast our future cash flow and cash
position.  Such projections include assumptions regarding fulfillment
of existing orders, receipt and fulfillment of future orders and ultimately the
receipt of cash.  These forecasts also include assumptions regarding
the timing of payments related to existing and future liabilities and inventory
procurement.   If forecasted orders do not materialize or
existing orders were cancelled or reduced, this could have a material adverse
impact on our projected cash position and our ability to continue our
operations.





The
recent deterioration of the economy and credit markets may adversely affect our
future results of operations.





Our
operations and performance depend to some degree on general economic conditions
and their impact on our customers’ finances and purchase
decisions.  As a result of recent economic events, potential customers
may elect to defer purchases of capital equipment items, such as the products we
manufacture and supply.  Additionally, the credit markets and the
financial services industry have been experiencing a period of upheaval
characterized by the bankruptcy, failure, collapse or sale of various financial
institutions and an unprecedented level of intervention from the United States
government. While the ultimate outcome of these events cannot be predicted, it
may have a material adverse effect on our customers’ ability to fund their
operations thus adversely impacting their ability to purchase our products or to
pay for our products on a timely basis, if at all.  These and other
economic factors could have a material adverse effect on demand for our
products, the collection of payments for our products and on our financial
condition and operating results.





We
will likely face significant competition which could adversely affect our
revenues, results of operations and financial condition.





The
market for medical products and services is highly competitive and new offerings
and technologies are becoming available regularly.  Many of our competitors
are substantially larger and more experienced than we are.  In
addition, they have longer operating histories and have materially greater
financial and other resources than we do.  If we cannot compete in the
marketplace, we may have difficulty selling our products and generating
revenues.  Additionally, competition may drive down the prices of our
products, which could adversely affect our cost of goods sold and our
profitability, if any.  We cannot guarantee that we will compete
successfully against our potential competitors.





We
depend upon our executive officers and key personnel.





Our
performance depends substantially on the performance of our executive officers
and other key personnel.  Our future success will depend to a large
extent on retaining our employees and our ability to attract, train, retain and
motivate sufficient qualified employees to fill vacancies created by attrition
or expansion of our operations.  The loss of the services of any of
our executive officers or key personnel could have a material adverse effect on
our business, revenues, and results of operations or financial
condition.





Competition
for talented personnel is intense, and we may not be able to continue to
attract, train, retain or motivate other highly qualified technical and
managerial personnel in the future.   In addition, market
conditions may require us to pay higher compensation to qualified management and
technical personnel than we currently anticipate.  Any inability to
attract and retain qualified management and technical personnel in the future
could have a material adverse effect on our business, prospects, financial
condition, and/or results of operations.





We
rely on a small number of customers and cannot be certain they will consistently
purchase our products in the future.




Sales to
individual customers exceeding 10% or more of revenues in the year ended
December 31, 2008 were to three customers who accounted for 30%, 19% and 11% of
revenues, respectively. Sales to individual customers exceeding 10% or more of
revenues in the year ended December 31, 2007 were to four customers who
accounted for 20%, 14% 11% and 10% of revenues, respectively. No other customer
accounted for more than 10% of our revenues during those periods.  In
the future, a small number of customers may continue to represent a significant
portion of our total revenues in any given period. We cannot be certain that
such customers will consistently purchase our products at any particular rate
over any subsequent period.  A loss of any of these customers could
adversely affect our financial performance.


10


We are subject to significant
domestic and international regulations and may not be able to obtain necessary
regulatory clearances to sell our products.





The
manufacture and sale of medical devices intended for commercial distribution are
subject to extensive governmental regulation.  Our failure to comply with
regulatory requirements would jeopardize our ability to market our
products.  Noncompliance with applicable requirements can result in failure
of the regulatory agency to grant pre-market clearance or approval for devices,
withdrawal or suspension of approval, total or partial suspension of production,
fines, injunctions, civil penalties, refunds, recall or seizure of products and
criminal prosecution. Medical devices are regulated in the United States
primarily by the FDA and, to a lesser extent, by state agencies.  Sales of
medical device products outside the United States are subject to foreign
regulatory requirements that vary from country to country.  Generally,
medical devices require pre-market clearance or pre-market approval prior to
commercial distribution.  A determination that information available on the
medical device is not sufficient to grant the needed clearance or approval will
delay market introduction of the product.  In addition, material changes or
modifications to, and changes in intended use of, medical devices also are
subject to FDA review and clearance or approval.  The FDA regulates the
research, testing, manufacture, safety, effectiveness, labeling, storage, record
keeping, promotion and distribution of medical devices in the United States and
the export of unapproved medical devices from the United States to other
countries.  The time required to obtain approvals required by foreign
countries may be longer or shorter than that required for FDA clearance, and
requirements for licensing may differ from FDA requirements.  The current
regulatory environment in Europe for medical devices differs significantly from
that in the United States.





We
must be able to adapt to rapidly changing technology trends and evolving
industry standards or we risk our products becoming obsolete.





The
medical device market in which we compete is characterized by intensive
development efforts and rapidly advancing technology.  Our future success
will depend, in large part, upon our ability to anticipate and keep pace with
advancing technology and competing innovations.  We may not be successful
in identifying, developing and marketing new products or enhancing our existing
products. We believe that a number of large companies, with significantly
greater financial, manufacturing, marketing, distribution and technical
resources and experience than ours, are focusing on the development of
visualization products for minimally invasive surgery.




Our operating results may be
adversely affected by the level of reimbursements for surgical procedures using
our products.





The level
of payments for the surgical procedures, in which our products are involved,
either by Medicare or private insurance companies may have a significant impact
on future operating results.  We could be adversely affected by changes in
payment policies of government or private health care payers, particularly to
the extent any such changes affect payment for the procedure in which our
products are intended to be used.  It is a continuing trend in United
States health care for such payments to be under continual scrutiny and downward
pressure.  We believe that reimbursement in the future will be subject to
increased restrictions, both in the United States and in foreign markets and
that the overall escalating cost of medical products and services has led to and
will continue to lead to increased pressures on the health care industry, both
foreign and domestic, to reduce the cost of products and services, including
products which we offer.





We expect
that our products typically will be used by hospitals and surgical centers,
which bill various third-party payers, such as governmental programs and private
insurance plans, for the health care services provided to their patients. 
Third-party payers carefully review and increasingly challenge the prices
charged for medical products and services or negotiate a flat rate fee in
advance.  Payment rates from private companies also vary depending on the
procedure performed, the third-party payer, the insurance plan and other
factors.  Medicare compensates hospitals at a predetermined fixed amount
for the costs associated with an in-patient hospitalization based on the
patient’s discharge diagnosis and compensates physicians at a pre-determined
fixed amount based on the procedure performed, regardless of the actual costs
incurred by the hospital or physician in furnishing the care and unrelated to
the specific devices or systems used in that procedure.  Medicare and other
third-party payers are increasingly scrutinizing whether to cover new products
and the level of payment for new procedures.  The flat fee reimbursement
trend is causing hospitals to control costs strictly in the context of a managed
care system in which health care providers contract to provide comprehensive
health care for a fixed cost per person.  We are unable to predict what
changes will be made in the reimbursement methods utilized by such third-party
payers.





If we
obtain the necessary foreign regulatory registrations or approvals, market
acceptance of our products in international markets would be dependent, in part,
upon the acceptance by the prevailing health care financing system in each
country.  Health care financing systems in international markets vary
significantly by country and include both government sponsored health care
programs and private insurance.  We cannot assure you that these financing
systems will endorse the use of our products.


11





We may be subject to product
liability claims and have limited insurance coverage.





By
engaging in the medical devices business, we will face an inherent business
risk of exposure to product liability claims in the event that the use of our
products results in personal injury or death.  Also, in the event that any
of our products proves to be defective, we may be required to recall or redesign
such products. We will need to maintain adequate product liability
insurance coverage.  If we are able to maintain insurance, of which there
can be no assurance, our coverage limits may not be adequate to protect us from
any liabilities we might incur in connection with the development, manufacture
and sale of our products.  Product liability insurance is expensive and in
the future may not be available to us on acceptable terms, if at all.  A
successful product liability claim or series of claims brought against us in
excess of our insurance coverage or a product recall would negatively impact our
business.





Risks
Related to our Stock





Investors who purchase shares of our
common stock should be aware of the possibility of a total loss of their
investment.





An
investment in our common stock involves a substantial degree of risk.
 Before making an investment decision, you should give careful
consideration to the risk factors described in this section in addition to the
other information contained in this annual report.  The risk factors
described herein, however, may not reflect all of the risks associated with our
business or an investment in our common stock.  You should invest in our
Company only if you can afford to lose your entire investment.





Our
current management, along with a select few investors, possess a majority of our
common stock and they may be able to control our Company
indefinitely.





A few of
our stockholders have significant control over our voting stock which may make
it difficult to complete some corporate transactions without their support and
may prevent a change in control.  As of March 31, 2009, our directors
and executive officers as a whole, may beneficially own approximately 18,612,916
shares or  43.6% of our outstanding common stock, and assuming that
the warrants and options (exercisable as of 60 days from March 31, 2009) were
exercised, may beneficially own approximately 35,132,832 shares
or  59.3% of our outstanding common stock.  Certain of our
officers and directors disclaim beneficial ownership of certain shares included
in the description above. As of March 31, 2009, all of the warrants and options
included in the above calculation were at exercise prices above the quoted
market price of our common stock.





The
above-described significant stockholders may have considerable influence over
the outcome of all matters submitted to our stockholders for approval, including
the election of directors. In addition, this ownership could discourage the
acquisition of our common stock by potential investors and could have an
anti-takeover effect, possibly depressing the trading price of our common
stock.




Penny stock” rules may make
buying or selling our securities difficult, which may make our stock less liquid
and make it harder for investors to buy and sell our
securities.





Our
common stock currently trades on the Over-the-Counter Bulletin
Board.  If the market price per share of our common stock is less than
$5.00, the shares may be “penny stocks” as defined in the Securities Exchange
Act of 1934, as amended, referred to as the Exchange Act.  As a
result, an investor may find it more difficult to dispose of or obtain accurate
quotations as to the price of these securities.  In addition, “penny
stock” rules adopted by the SEC under the Exchange Act subject the sale of these
securities to regulations which impose sales practice requirements on
broker-dealers.  For example, broker-dealers selling penny stocks
must, prior to effecting the transaction, provide their customers with a
document that discloses the risks of investing in penny stocks.





Furthermore,
if the person purchasing the securities is someone other than an accredited
investor or an established customer of the broker-dealer, the broker-dealer must
also approve the potential customer’s account by obtaining information
concerning the customer’s financial situation, investment experience and
investment objectives.  The broker-dealer must also make a
determination whether the customer has sufficient knowledge and experience in
financial matters to be reasonably expected to be capable of evaluating the risk
of transactions in penny stocks. Accordingly, the SEC’s rules may limit the
number of potential purchasers of shares of our common
stock.  Moreover, various state securities laws impose restrictions on
transferring “penny stocks,” and, as a result, investors in our securities may
have their ability to sell their securities impaired.


12





If an active, liquid trading market
for our common stock does not develop, you may not be able to sell your shares
quickly or at or above the price you paid for it.




Although
our common stock currently trades on the Over-the-Counter Bulletin Board, an
active and liquid trading market for our common stock has not yet and may not
ever develop or be sustained.  You may not be able to sell your shares
quickly or at or above the price you paid for our stock if trading in our stock
is not active.





We do not expect to pay dividends in
the foreseeable future.




We do not
anticipate paying cash dividends on our common stock in the foreseeable future.
Any payment of cash dividends will depend on our financial condition, results of
operations, capital requirements and other factors and will be at the discretion
of our board of directors.





ITEM
2. DESCRIPTION OF PROPERTY





We lease
a 17,850 square foot facility in Westborough, Massachusetts.  This
facility houses our corporate headquarters, manufacturing, and research and
development.  The lease expires on September 30,
2010.  Under this lease we are committed to make payments totaling
approximately $246,000 and $184,000 in 2009 and 2010, respectively. We believe
that this facility will be adequate to meet our needs through December 2009 and
we believe that we will be able to obtain additional space, as needed, on
commercially reasonable terms when our lease ends.





ITEM
3. LEGAL PROCEEDINGS





We are
not a party to any legal proceedings.





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





There
were no matters submitted to a vote of our security holders during the fourth
quarter of the fiscal year ended December 31, 2008.















13


PART
II





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





Our
common stock is quoted on the OTCBB under the symbol “VKNG.OB.”   The
following table sets forth the high and low bid prices for our common stock for
each quarter during the last two fiscal years. The prices reported below reflect
inter-dealer prices and are without adjustments for retail markups, markdowns or
commissions, and may not necessarily represent actual
transactions.  All prices have been adjusted to reflect a 1 for 50
reverse stock split effective January 7, 2008.





High
                
                LowFiscal
      Year Ended December 31, 2007First
      Quarter
                $15.50
                
                $9.50Second
      Quarter
                $11.50
                
                $8.00Third
      Quarter
                $11.50
                
                $8.00Fourth
      Quarter
                $10.50
                
                $0.25Fiscal
      Year Ended December 31, 2008First
      Quarter
                $0.75
                
                $0.25Second
      Quarter
                $0.51
                
                $0.25Third
      Quarter
                $0.49
                
                $0.26Fourth
      Quarter
                $0.30
                
                $0.15Fiscal
      Year Ending December 31, 2009First
      Quarter
                $0.20
                
                $0.06





Shares
Issued in Unregistered Transactions





All of
the following shares of common stock were issued in unregistered transactions in
reliance on Section 4(2) of the Securities Act of 1933, as amended (the
“Securities Act”).





On
January 4, 2008 the Company completed execution of a Recapitalization Plan (the
“Recapitalization Plan”).  In this connection the Company issued an
aggregate of 41,157,906 shares of unregistered common stock.





In
October 2008, we issued 158,500 shares of common stock in settlement of amounts
owed for professional services.  In aggregate, the shares were valued
at $47,549.





Holders





As of
March 31, 2009, there were approximately 125 stockholders of record of our
common stock.





Dividends





We had
accumulated and unpaid preferred stock dividends at December 31, 2007 in the
amount of $1,025,241.  These accumulated and unpaid dividends were
extinguished in connection with our recapitalization completed in January 2008.
No dividends were owed at December 31, 2008.





We have
not paid any cash dividends on our common stock since our inception and do not
anticipate or contemplate paying dividends in the foreseeable
future.


14





Equity
Compensation Plan Information





Information
with respect to shares of our common stock that may be issued under our equity
compensation plans is set forth in Item 12 of this annual report entitled
“Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters.





ITEM
6. SELECTED FINANCIAL DATA





As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.























15


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





The
following discussion of our financial condition and results of operations should
be read in conjunction with our Financial Statements and Notes thereto, and the
other financial information included elsewhere in this annual report on Form
10-K. This Management’s Discussion and Analysis of Financial Condition and
Results of Operations contains descriptions of our expectations regarding future
trends affecting our business. These forward-looking statements and other
forward-looking statements made elsewhere in this annual report on Form 10-K are
made in reliance upon safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. The following discussion sets forth certain
factors we believe could cause actual results to differ materially from those
contemplated by the forward-looking statements.





Overview





We are a
worldwide developer, manufacturer and marketer of visualization solutions for
complex minimally invasive surgery.  We partner with medical device
companies and healthcare facilities to provide surgeons with proprietary
visualization systems enabling minimally invasive surgical procedures, which
reduce patient trauma and recovery time.





We
manufacture two dimensional (“2D”) digital cameras that are sold to third-party
companies who sell to end users through their Original Design Manufacturer
(“ODM”) programs and Original Equipment Manufacturer (“OEM”)
programs.




We sell
our proprietary visualization system, (3Di Vision System) under the Viking
brand directly to hospitals and outpatient surgical centers in the United States
and outside the United States through our distributor network.  We
also sell our CardioCam/MiniCam product through these channels.





Liquidity
and Capital Resources





On
January 4, 2008, we completed execution of a Recapitalization Plan (the
“Recapitalization Plan”).   In November 2007, we received approval,
subject to finalization of certain terms and execution of final documentation,
from 100% of the stockholders of our Series B Variable Dividend Convertible
Preferred Stock (the “Preferred Stock”) and our 8% Secured Convertible
Debentures due February 23, 2009 (the “Debentures”), of the Recapitalization
Plan.  The Recapitalization Plan called for an additional investment
of $2.5 to $3.0 million (the “New Investment”) and a redistribution of our
common stock among the current holders of our common stock, Preferred Stock,
Debentures and the investors providing the New Investment.




In
consummating the Recapitalization Plan, the redistribution of our capital was
accomplished on January 4, 2008 through the following: (i) a 1 for 50 “reverse
split” of our outstanding common stock, (ii) our entry into a Recapitalization
Agreement with the applicable holders, pursuant to which the holders of the
Preferred Stock and Debentures exchanged their respective securities (including
warrants that were issued in connection with the Preferred Stock and the
Debentures) for shares of our common stock and warrants which may be exercised
for common stock; and (iii) our entry into a Securities Purchase Agreement with
those parties making the New Investment of $2.6 million pursuant to which they
were issued shares of our common stock and warrants which may be exercised for
shares of our common stock.   As part of the recapitalization, we
executed a Securities Purchase Agreement and completed a sale of 14,560,037
shares of our common stock for $0.178571 per share, or aggregate consideration
of $2,600,000, of which we received net proceeds of $2,600,000.





In
October 2007, our board of directors approved a revised strategic direction
for our Company.  This strategy included focusing on our ODM/OEM
business while significantly reducing expenses associated with our 3Di Vision
Systems business.  We continued our 3Di Vision Systems business on a
reduced basis by utilizing our independent sales representatives and our
existing distributor network.  The revised strategic direction of
October 2007 enabled us to reduce expenses, primarily associated with the 3Di
Vision Systems business, that are not expected to contribute
to positive cash flow in the near term,  including the elimination of
our U.S. direct sales force and a reduction in related clinical and marketing
expenses.





In
2008, the board of directors re-evaluated this decision in light of our
subsequent experience and considered various modifications to the business
strategy.  The board determined to seek additional investment in our
3Di technology followed by investment in our U.S. distribution
channels.  However, we cannot implement these initiatives until we
either enter into a business combination or raise substantial capital
resources.   In November 2008 we engaged an investment banking firm to
assist our management in exploring business combinations and/or raising
additional capital.  This process continues.


16





Absent a
business combination, we believe that it is likely that we will need to raise
additional capital to execute our business plan and continue our operations for
the next twelve months.   Such financing may not be available on
acceptable terms, or at all. We do not have any arrangements with any bank,
financial institutions or investors to provide additional financing and there
can be no assurance that any such arrangement, if required or otherwise sought,
would be available on terms deemed to be commercially acceptable and in our best
interests. If we fail to secure such financing and we are not generating
positive cash flow, we will consider other options, including curtailing
operations or seeking bankruptcy protection.





We
financed our operations since inception principally through private sales of
equity securities and convertible debt. From January 1, 2004 through December
31, 2008, we have raised net proceeds of $10,750,000 through the sale of common
and preferred stock in private placements and approximately $13,600,000 through
the issuance of convertible notes and debentures. As of December 31, 2008, we
had cash of $168,767.





Net cash
used in operating activities was $2,615,399 and $6,792,845 during the years
ended December 31, 2008 and 2007, respectively. The decrease in net cash used in
operating activities during 2008 compared with 2007 was attributable primarily
to the receipt of $1 million from a technology license agreement during the
third quarter of 2008 and a smaller operating loss in 2008 due primarily to our
cost cutting efforts.





Net cash
provided by financing activities was $2,547,823 and $7,407,274 during the year
ended December 31, 2008 and 2007, respectively. The net cash provided by
financing activities in 2008 resulted from selling common stock in connection
with our Recapitalization Plan while the cash provided during 2007 resulted
primarily from the proceeds of selling convertible debentures.





Net cash
used in investing activities was $80,755 and $737,796 during the years ended
December 31, 2008 and 2007, respectively. The lower level of cash used in
investing activities in 2008 was primarily attributable to lower purchases in
2008 of demonstration equipment of our 3Di product line in support of our sales
and marketing efforts than during 2007.





On August
5, 2008, we licensed our patent portfolio to Intuitive Surgical, Inc. pursuant
to an exclusive license agreement (the “License Agreement”).  The
License Agreement provides Intuitive Surgical with perpetual, exclusive rights
to use all of our current patents in the medical robotics field, as defined in
the License Agreement.  We maintained the right to sell
non-stereoscopic products and our current stereoscopic products that utilize the
licensed patents in the medical robotics field.  We received $1
million for the license.





Results
of Operations




Sales. We had sales of $6,426,996
for the year ended December 31, 2008 and $8,466,203 for the year ended December
31, 2007, representing a decrease of approximately 24%.





The
decrease in sales during 2008 as compared with the prior year was primarily due
to lower sales of our 3Di product.  The decline in 3Di systems sales is a
result of the transition from a sales force orientation to indirect sales
through our distribution channels.





Sales to
individual customers exceeding 10% or more of revenues in the year ended
December 31, 2008 were to three customers who accounted for 30%, 19% and 11% of
revenues, respectively. Sales to individual customers exceeding 10% or more of
revenues in the year ended December 31, 2007 were to four customers who
accounted for 20%, 14% 11% and 10% of revenues, respectively.





Gross  Profit.
For the year ended December 31, 2008, gross profit amounted to $645,141, or 10%
of revenue compared with $1,867,447, or 22% of revenue, for
2007.  Gross profit was adversely impacted during 2008 due to the
recording of approximately $312,000 of inventory reserves for slow moving and
obsolete inventory.





Excluding
the charge for slow moving and obsolete inventory, gross margin was
approximately 16% of revenue for the year ended December 31,
2008.  This decrease in gross margin percentage is due to the
higher per unit production cost associated with lower volumes as compared with
2007 and lower sales of non-OEM products which typically carry higher gross
margins.





Operating
Expenses.  We incurred operating expenses of $5,279,068 for the
year ended December 31, 2008 compared with $9,400,901 for the year ended
December 31, 2007.  Excluding non-cash stock-based compensation
expense, total operating expenses for 2008 and 2007 were approximately
$4,192,000 and $ 9,147,000 respectively. This represents a decrease of
54% in operating expenses.  This decrease is primarily a
result of 2008 having a full year of the cost reductions implemented in the
fourth quarter of 2007.


17





General and
Administrative Expense.  General and administrative expenses
include costs for administrative personnel, legal and accounting expenses and
various public company expenses. General and administrative expenses were
$2,923,129 for the year ended December 31, 2008 and $3,103,763 for the year
ended December 31, 2007, representing a decrease of $180,634.  General
and administrative expenses for the years ended December 31, 2008 and 2007
included non-cash stock-based compensation expense of $1,086,390 and $253,592
respectively.  Excluding such charges, general and administrative
expense decreased  $1,013,432, or 36% in 2008 as compared with
2007.  This decrease is due to lower legal expense, headcount and
related salaries, the elimination of certain patent licensing fees, and the
elimination of our San Diego office during the fourth quarter of
2007.





Sales and
Marketing Expense. Sales and marketing expenses were $1,598,753 for the
year ended December 31, 2008 and $4,322,681 for the year ended December 31,
2007.  This represents a decrease of $2,723,928 or 63%.Our fourth quarter
2007 restructuring significantly reduced our marketing expense and the direct
sales force for the 3Di systems. Additionally, 2008 contains approximately
$250,000 of bad debt expense related to accounts where collection of amounts
invoiced is considered doubtful.





Research and
Development Expense.  We had research and development expenses
of $757,186 for the year ended December 31, 2008 and $1,974,457 for the year
ended December 31, 2007, representing a decrease of $1,217,271. The reduction in research
and development expense occurred primarily due to the reduction of personnel
focused on research and development activities.  Additionally, we
temporarily eliminated certain expenses and activities related to the next
generation 3Di system.  We also classified certain internal labor
costs directly related to a 3D vision development contract as cost of sales and
matched against the related revenue during 2008 whereas during 2007 such
reclassification of internal labor to cost of sales was
insignificant.





Other Income and
Expenses. For the year ended December 31, 2008, we recorded net
non-operating expense of $1,118,130.  During the first quarter of
2008, we recorded a charge of $2,703,776 related to the Recapitalization Plan
transaction.  This charge was partially offset by the reversal of
approximately $271,000 related to accrued fees associated with our failure to
file a registration statement for common stock and warrants issued during
2006.





Also
during 2008, we recorded license fee income of $1,000,000 and a non-cash gain
of  $307,061 related to the decrease in value of our derivative
instruments.





Subsequent
to the Recapitalization Plan, all of our outstanding derivative instruments
(warrants) were classified as equity instruments and, as such, are no longer
revalued at each balance sheet date.





Interest
expense for the year ended December 31, 2008 amounted to $4,860 compared with
$946,978 for the year ended December 31, 2007. Interest expense for 2007 is
primarily related to the interest on the Debentures and fees for failure to
register common shares related to the convertible notes that were converted to
common stock in May 2006.  Also during 2007, we recorded non-cash
amortization of debt discount of $2,193,469 related to the discount recorded on
the debentures issued during 2007.





We also
had accrued liquidated damages in the amount of approximately $1,162,864 for the
year ended December 31, 2007.  This represented the contractual amount
owed to the holders of Preferred Stock for a lapse in the effectiveness of
the registration of the common stock underlying the Preferred Stock and the
amounts owed under the Debentures for failure to register the common stock
underlying those securities.  All liquidated damage amounts owing
under the terms of the Preferred Stock and Debentures were eliminated as part of
the recapitalization completed in January 2008.





We
recorded a non-cash gain on the valuation of our derivative liabilities in the
amount of $307,061 for the year ended December 31, 2008 compared with
$11,001,103 for the year ended December 31, 2007. The valuation of our
derivative liabilities related to the estimated value of outstanding derivative
instruments (warrants and the conversion feature of the
Debentures).   During 2007, the gain on derivative included the
following three elements: 1) a charge of $2,445,582 related to the estimated
value at issuance of the Debenture conversion feature and associated warrants,
2) a charge of $5,850,960 related the estimated increase in value of derivatives
due to a modification of their terms in October 2007, and 3) a gain of
$19,297,645 related to a decrease in value of our common stock at December 31,
2007.


18





Operating
Loss Before Non-Cash Charges





A
reconciliation of net loss in accordance with generally accepted accounting
principles (“GAAP”) to the non-GAAP measure of operating loss before non-cash
charges is as follows:




Year
      Ended
                            December
      302008
                          
                          
                          2007Net
      loss, as reported
                          
                          $
                          (5,752,057
                          )
                          
                          $
                          (923,290
                          )Adjustments:Total
      other (income)/expense
                          
                          
                          1,118,130
                          
                          
                          
                          (6,610,164
                          )Non-cash
      stock option expense
                          
                          
                          1,086,390
                          
                          
                          
                          253,592Depreciation,
      amortization and other non cash charges
                          
                          
                          493,508
                          
                          
                          
                          570,300Operating
      loss before non-cash charges
                          
                          $
                          (3,054,029
                          )
                          
                          $
                          (6,709,562
                          )








Off-Balance
Sheet Arrangements





We do not
have any off-balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources that are material to investors.





Contractual
Obligations and Commitments





We have
obligations pertaining to the operating lease for our Westborough, MA facility
through September 30, 2010. Under this lease we are committed to make payments
totaling approximately $246,000 and $184,000 in 2009 and 2010,
respectively.





We have a
royalty agreement with a medical device company. The royalty agreement requires
payments of 4% of sales that use the licensed intellectual property. As of
December 31, 2008 and 2007, we had accrued royalties related to this agreement
of $26,002 and $25,429 respectively. During 2008 and 2007, we did not pay any
royalties under this agreement.





Use
of Estimates and Critical Accounting Policies





Both this
Management's Discussion and Analysis and our Plan of Operation discuss our
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States.





The
preparation of our financial statements requires management to make estimates
and assumptions that affect reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. On an ongoing basis, management evaluates its estimates and
assumptions, including those related to inventory, income taxes, long lived
asset valuation, revenue recognition, and stock based compensation. Management
bases its estimates and judgments on historical experience of operations and on
various other factors that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.





Management
believes the following critical accounting policies, among others, will affect
its more significant judgments and estimates used in the preparation of our
Financial Statements.





Inventory.Parts and supplies inventories are stated at the lower of cost or market.
Cost is determined using the standard cost method which approximates actual
cost. Work-in-process and finished goods are stated at the lower of the
accumulated manufacturing costs or market.We
reduce the stated value of our inventory for obsolescence or impairment in an
amount equal to the difference between the cost of the inventory and the
estimated market value, based upon assumptions about future demand and market
conditions. If actual future demand or market conditions are less favorable than
those projected by management, additional reductions in stated value may be
required.


19





Income Taxes.In determining the carrying value of our net deferred tax assets, we must
assess the likelihood of sufficient future taxable income in certain tax
jurisdictions, based on estimates and assumptions, to realize the benefit of
these assets. If these estimates and assumptions change in the future, we may
record a reduction in the valuation allowance, resulting in an income tax
benefit in our Statements of Operations. Management evaluates the realizability
of the deferred tax assets and assesses the valuation allowance
quarterly.





Effective
January 1, 2007, we adopted the provisions of Financial Accounting Standards
Board (“FASB”) Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109. The implementation
of FIN 48 had no impact on our financial statements.





We are
primarily subject to U.S. federal and state income tax. Tax years subsequent to
December 31, 2003 remain open to examination by U.S. federal and state tax
authorities. In addition, our policy is to recognize interest and penalties
related to income tax matters in income tax expense. As of December 31, 2008, we
had no accruals for interest or penalties related to income tax
matters.





Amortization and
Impairment of Long Lived Assets.Long lived assets, such as property,
equipment and intangible assets are recorded at historical cost. We amortize our
intangible assets using the straight-line method over their estimated useful
lives, usually two to five years. We review intangible assets subject to
amortization periodically to determine if any adverse conditions exist or a
change in circumstances has occurred that would indicate impairment or a change
in the remaining useful life of the applicable asset. Conditions that would
indicate impairment and trigger a more frequent impairment assessment include,
but are not limited to a significant adverse change in the legal factors or
business climate that could affect the value of an asset, or an adverse action
or assessment by a regulator. If the carrying amount of an asset exceeds its
estimated fair value, an impairment charge is recognized for the amount by which
the carrying amount exceeds the estimated fair value of the asset. Assets to be
disposed of are reported at the lower of the carrying amount or fair value, less
the estimated costs to sell. In addition, depreciation of the asset ceases.
During the years ended December 31, 2008 and 2007, no impairment of long-lived
assets was recorded.





Revenue
Recognition. Our revenues are derived from the sale of surgical
visualization technology products to end users, distributors and original
equipment manufacturers. Revenue from the sale of products is recognized when
evidence of an arrangement exists, the product has been shipped, the selling
price is fixed or determinable,  collection is reasonably assured and
when both title and risk of loss transfer to the customer, provided that no
significant obligations remain. If installation is included as part of the
contract, revenue is not recognized until installation has occurred, or until
any remaining installation obligation is deemed to be perfunctory. Shipping and
handling costs are included in cost of sales.





For the
sale of products and services as part of a multiple-element arrangement, we
allocate revenue from multiple-element arrangements to the elements based on the
relative fair value of each element. For sales of extended warranties with a
separate contract price, Viking defers revenue equal to the separately stated
price. Revenue associated with undelivered elements is deferred and recorded
when delivery occurs.





Stock-Based
Compensation. On January 1, 2006, we adopted Statement of Financial
Accounting Standards (“SFAS”) No.123 (Revised 2004), “Share Based Payment,”
(“SFAS 123R”), using the modified prospective method. In accordance with SFAS
123R, which requires the measurement and recognition of compensation expense for
all share-based payment awards to employees and directors based on estimated
fair values. The Company uses the Black-Scholes option valuation model to
estimate the fair value of its stock options at the date of grant. The
Black-Scholes option valuation model requires the input of subjective
assumptions to calculate the value of stock options. The Company uses historical
data among other information to estimate the expected price volatility, the
expected annual dividend, the expected option life and the expected forfeiture
rate.





Recent
Accounting Pronouncements




In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value
Measurements (“SFAS 157”). SFAS 157 defines fair value as used in numerous
accounting pronouncements, establishes a framework for measuring fair value
under U.S. GAAP, and expands disclosures related to the use of fair value
measures in financial statements. SFAS 157 does not expand the use of fair value
measurements in financial statements, but standardizes its definition and
guidance in U.S. GAAP. SFAS 157 emphasizes that fair value is a market-based
measurement and not an entity-specific measurement, based on an exchange
transaction in which the entity sells an asset or transfers a liability (exit
price). SFAS 157 establishes a fair value hierarchy from observable market data
as the highest level to an entity’s own fair value assumptions about market
participant assumptions as the lowest level. In February 2008, the FASB issued
FSP FAS 157-2, to defer the effective date of SFAS 157 for all nonfinancial
assets and liabilities, except those items recognized or disclosed at fair value
on an annual or more frequently recurring basis, until years beginning after
November 15, 2008. The adoption of SFAS 157 for our financial assets and
liabilities as of January 1, 2008 did not have a material effect on our
financial statements. We are currently reviewing the adoption requirements
related to our nonfinancial assets and liabilities and have not yet determined
the impact, if any, on our financial position or results of
operations.


20





In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities - Including an amendment to FASB Statement No.
115 (“SFAS 159”). This statement permits companies to choose to measure many
financial instruments and other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement is expected to expand the use of fair value
measurement of accounting for financial instruments. This statement applies to
all entities, including not for profit. The fair value option established by
this statement permits all entities to measure eligible items at fair value at
specified election dates. We adopted SFAS 159 as of January 1, 2008. Upon
adoption, we did not elect the fair value option for any of the eligible
financial instruments, and as such, the adoption of SFAS 159 did not have a
material effect on our condensed financial statements.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133,” (“SFAS 161”),
which requires enhanced disclosures about an entity’s derivative and hedging
activities and thereby improves the transparency of financial reporting.
Disclosing the fair values of derivative instruments and their gains and losses
in a tabular format provides a more complete picture of the location in an
entity’s financial statements of both the derivative positions existing at
period end and the effect of using derivatives during the reporting period.
Entities are required to provide enhanced disclosures about (a) how and why an
entity uses derivative instruments, (b) how derivative instruments and related
hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash flows.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008. Early adoption is permitted.
We do not expect SFAS 161 to have a material impact on our financial
statements.





In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of
Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also
requires expanded disclosure related to the determination of intangible asset
useful lives. FSP FAS 142-3 is effective for fiscal years beginning after
December 15, 2008. Earlier adoption is not permitted. We do not expect FSP FAS
142-3 to have a material impact on its financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Policies” (“SFAS 162”), which reorganizes the GAAP hierarchy. The
purpose of the new standard is to improve financial reporting by providing a
consistent framework for determining what accounting principles should be used
when preparing the U.S. GAAP financial statements. The standard is effective 60
days after the SEC’s approval of the PCAOB’s amendments to AU Section 411. The
adoption of SFAS 162 will not have an impact on our financial position or
results of operations.





In May
2008, the FASB issued FSP Accounting Principles Board Opinion (“APB”) No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”), which requires
the issuer of certain convertible debt instruments that may be settled in cash
(or other assets) on conversion to separately account for the liability (debt)
and equity (conversion option) components of the instrument in a manner that
reflects the issuer’s nonconvertible debt borrowing rate. FSP APB 14-1 will be
effective for the Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP APB 14-1 on
our  financial position, cash flows, and results of
operations.





In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP
EITF 03-6-1”), which requires entities to apply the two-class method of
computing basic and diluted earnings per share for participating securities that
include awards that accrue cash dividends (whether paid or unpaid) any time
common shareholders receive dividends and those dividends do not need to be
returned to the entity if the employee forfeits the award. FSP EITF 03-6-1 will
be effective for the Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP EITF 03-6-1
on our  financial position, cash flows, and results of
operations.


21





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued (SFAS) No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51( “SFAS 160”).
SFAS 160 establishes accounting and reporting standards for ownership
interests in subsidiaries held by parties other than the parent, the amount of
consolidated net income attributable to the parent and to the noncontrolling
interest, changes in a parent’s ownership interest, and the valuation of
retained noncontrolling equity investments when a subsidiary is deconsolidated.
SFAS 160 also establishes disclosure requirements that clearly identify and
distinguish between the interests of the parent and the interests of the
noncontrolling owners. SFAS 160 is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2008,
with early adoption prohibited. The accounting provisions of SFAS 160 will be
effective for the Company beginning January 1, 2009. We are currently
evaluating the impact, if any, this statement will have on our financial
position, cash flows, or results of operations, but believe it is unlikely to
have a material impact.





In June
2008, the FASB ratified EITF Issue No. 07-5, “ Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity's Own Stock” (“EITF
07-5”). EITF 07-5 is effective for financial statements issued for fiscal years
beginning after December 15, 2008, andinterim periods within
those fiscal years. Early application is not permitted. Paragraph 11(a) of SFAS
No. 133 - specifies that a contract thatwould otherwise meet
the definition of a derivative but is both (a) indexed to the Company's own
stock and (b) classified in stockholders' equityin the statement of
financial position would not be considered a derivative financial instrument.
EITF 07-5 provides a new two-step model to beapplied in determining
whether a financial instrument or an embedded feature is indexed to an issuer's
own stock and thus able to qualify for theSFAS No. 133 paragraph
11(a) scope exception. We are currently
evaluating the impact of adopting EITF 07-5 on our financial position, cash
flows, and results of operations.







Interest
Rate Risk





As part
of our January 2008 Recapitalization, on January 4 2008, we entered into a
Recapitalization Agreement with applicable security holders, pursuant to which
the holders of our Preferred Stock and outstanding Debentures exchanged their
respective securities (including warrants that were issued in connection with
the Preferred Stock and the Debentures) for shares of our common stock and
warrants which may be exercised for common stock. As a result, we are not
subject to interest rate risk.





Inflation





We do not
believe that inflation will negatively impact our business plans.











ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.















22


ITEM 8. FINANCIAL
STATEMENTS





Index to Financial
Statements


PageReport
      of Independent Registered Public Accounting Firm
                24Balance
      Sheets at December 31, 2008 and 2007
                25Statements
      of Operations for the years ended December 31, 2008 and
    2007
                26Statements
      of Stockholders’ Equity (Deficit) for the years ended December 31, 2008
      and 2007
                27Statements
      of Cash Flows for the years ended December 31, 2008 and
    2007
                28Notes
      to Financial Statements
                30




























23











REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders


Viking
Systems, Inc.




We have
audited the accompanying balance sheets of Viking Systems, Inc. as of
December 31, 2008 and 2007, and the related statements of operations,
stockholders’ equity (deficit), and cash flows for the years then ended. These
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on the financial statements based on our
audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. The Company was not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting.  Our audits included consideration
of internal control over financial reporting as a basis for designing audit
procedures that were appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the Company’s internal control
over financial reporting.  Accordingly, we express no such
opinion.  An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall presentation of the financial
statements.  We believe that our audits provide a reasonable basis for
our opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Viking Systems, Inc. as of December
31, 2008 and 2007, and the results of their operations and their cash flows for
the years then ended, in conformity with accounting principles generally
accepted in the United States of America.




The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 2 to the financial
statements, the Company has incurred significant recurring net losses
and negative cash flows from operating activities through December 31,
2008.  These factors raise substantial doubt about the Company’s
ability to continue as a going concern. Management’s plans as to these matters
are described in Note 2. The accompanying financial statements do not include
any adjustments that might result from the outcome of this
uncertainty.




/s/
SQUAR, MILNER, PETERSON, MIRANDA & WILLIAMSON, LLP




San
Diego, California


April 15,
2009


24


VIKING
SYSTEMS, INC.


Balance
Sheets


December
31, 2008 and 2007








Assets2008
                                
                                
                                2007Current
      assets:Cash
      and cash equivalents
                                
                                $
                                168,767
                                
                                
                                $
                                317,098Accounts
      receivable, net
                                
                                
                                837,229
                                
                                
                                
                                1,371,913Inventories
                                
                                
                                2,104,764
                                
                                
                                
                                1,816,621Prepaid
      expenses
                                
                                
                                151,048
                                
                                
                                
                                64,324Other
      current assets
                                
                                
                                -
                                
                                
                                
                                108,512Total
      current assets
                                
                                
                                3,261,808
                                
                                
                                
                                3,678,468Property
      and equipment, net
                                
                                
                                223,609
                                
                                
                                
                                583,372Other
      non-current assets
                                
                                
                                -
                                
                                
                                
                                127,500Intangible
      assets, net
                                
                                
                                210,000
                                
                                
                                
                                280,000Total
      assets
                                
                                $
                                3,695,417
                                
                                
                                $
                                4,669,340Liabilities
      and Stockholders' Equity (Deficit)Current
      liabilities:Accounts
      payable
                                
                                $
                                1,432,460
                                
                                
                                $
                                1,828,831Accrued
      expenses
                                
                                
                                794,219
                                
                                
                                
                                2,662,687Deferred
      revenue
                                
                                
                                51,254
                                
                                
                                
                                232,331Capital
      lease obligations – current
                                
                                
                                31,821
                                
                                
                                
                                38,541Convertible
      debentures, related party net
                                
                                
                                -
                                
                                
                                
                                506,531Convertible
      debentures, net
                                
                                
                                -
                                
                                
                                
                                1,637,707Derivative
      liability
                                
                                
                                -
                                
                                
                                
                                349,105Total
      current liabilities
                                
                                
                                2,309,754
                                
                                
                                
                                7,255,733Capital
      lease obligations
                                
                                
                                -
                                
                                
                                
                                35,364Commitments
      and contingencies (Note 21)Preferred
      Stock, 25,000,000 shares authorizedSeries
      B redeemable preferred stock, $0.001 par value; 0, and 7,789 shares
      outstanding at December 31, 2008 and 2007, respectively (aggregate
      liquidation preference of  $0at
      December 31, 2008 and $8,814,241 at December  31,
      2007)
                                
                                
                                -
                                
                                
                                
                                8,814,241Stockholders’
      Equity (Deficit):Common
      stock, $0.001 par value, 400,000,000 shares authorized;and
      42,715,110 issued and 1,398,704  outstanding at December 31,
      2008 and2007,
      respectively
                                
                                
                                42,715
                                
                                
                                
                                1,399Additional
      paid-in capital
                                
                                
                                26,566,607
                                
                                
                                
                                8,034,205Accumulated
      deficit
                                
                                $
                                (25,223,659
                                )
                                
                                
                                (19,471,602
                                )Total
      stockholders' equity (deficit)
                                
                                
                                1,385,663
                                
                                
                                
                                (11,435,998
                                )Total
      liabilities and stockholders' equity (deficit)
                                
                                $
                                3,695,417
                                
                                
                                $
                                4,669,340




See
accompanying notes to financial statements which are an integral part of the
financial statements.


25


VIKING
SYSTEMS, INC.


Statements
of Operations


Years
Ended December 31, 2008 and 2007







2008
                                  
                                  
                                  2007Sales,
      net
                                  
                                  $
                                  6,426,996
                                  
                                  
                                  $
                                  8,466,203Cost
      of sales
                                  
                                  
                                  5,781,855
                                  
                                  
                                  
                                  6,598,756Gross
      profit
                                  
                                  
                                  645,141
                                  
                                  
                                  
                                  1,867,447Operating
      expenses:Selling
      and marketing
                                  
                                  
                                  1,598,753
                                  
                                  
                                  
                                  4,322,681Research
      and development
                                  
                                  
                                  757,186
                                  
                                  
                                  
                                  1,974,457General
      and administrative
                                  
                                  
                                  2,923,129
                                  
                                  
                                  
                                  3,103,763Total
      operating expenses
                                  
                                  
                                  5,279,068
                                  
                                  
                                  
                                  9,400,901Operating
      loss
                                  
                                  
                                  (4,633,927
                                  )
                                  
                                  
                                  (7,533,454
                                  )Other
      income (expense):Interest
      income
                                  
                                  
                                  20,650
                                  
                                  
                                  
                                  45,664Interest
      expense
                                  
                                  
                                  (4,860
                                  )
                                  
                                  
                                  (946,978
                                  )License
      fee
                                  
                                  
                                  1,000,000
                                  
                                  
                                  
                                  -Loss
      on recapitalization transaction
                                  
                                  
                                  (2,703,776
                                  )
                                  
                                  
                                  -Other
      income
                                  
                                  
                                  273,097
                                  
                                  
                                  
                                  -Amortization
      of debt discount and debt issuance costs
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,193,469
                                  )Accrued
      liquidated damages
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (1,162,864
                                  )Loss
      on disposal of property and equipment
                                  
                                  
                                  (10,302
                                  )
                                  
                                  
                                  (133,292
                                  )Gain
      on derivative liability
                                  
                                  
                                  307,061
                                  
                                  
                                  
                                  11,001,103Total
      other income (expense)
                                  
                                  
                                  (1,118,130
                                  )
                                  
                                  
                                  6,610,164Net
      loss
                                  
                                  
                                  (5,752,057
                                  )
                                  
                                  
                                  (923,290
                                  )Accretion
      of Series B Redeemable Preferred Stock to redemptionvalue
      including accrued dividend
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (643,289
                                  )Net
      loss applicable to common shareholders
                                  
                                  $
                                  (5,752,057
                                  )
                                  
                                  $
                                  (1,566,579
                                  )Net
      loss per common share - basic and diluted
                                  
                                  $
                                  (0.14
                                  )
                                  
                                  $
                                  (1.17
                                  )Weighted
      average shares outstanding - basic and diluted
                                  
                                  
                                  42,231,808
                                  
                                  
                                  
                                  1,342,503






See
accompanying notes to financial statements which are an integral part of the
financial statements.


26


VIKING
SYSTEMS, INC.


Statements
of Stockholders’ Equity (Deficit)


Years
Ended December 31, 2008 and 2007







Common
      Stock
                    
                    
                    Additional
                      Paid-in
                    
                    
                    AccumulatedShares
                    
                    
                    Amount
                    
                    
                    Capital
                    
                    
                    Deficit
                    
                    
                    TotalBalance
      December 31, 2006
                    
                    
                    1,237,322
                    
                    
                    $
                    1,237
                    
                    
                    $
                    6,865,504
                    
                    
                    $
                    (18,548,312
                    )
                    
                    $
                    (11,681,571
                    )





Issuance
      of common stock for preferred stock liquidated damages
                    
                    
                    80,000
                    
                    
                    
                    80
                    
                    
                    
                    839,920
                    
                    
                    
                    -
                    
                    
                    
                    840,000Issuance
      of common stock for debenture liquidated damages
                    
                    
                    47,791
                    
                    
                    
                    48
                    
                    
                    
                    430,075
                    
                    
                    
                    -
                    
                    
                    
                    430,123Issuance
      of common stock for conversion of preferred stock and
      dividends
                    
                    
                    24,591
                    
                    
                    
                    25
                    
                    
                    
                    220,037
                    
                    
                    
                    -
                    
                    
                    
                    220,062Exercise
      of stock options
                    
                    
                    4,000
                    
                    
                    
                    4
                    
                    
                    
                    3,996
                    
                    
                    
                    -
                    
                    
                    
                    4,000Accretion
      of preferred dividends
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (643,289
                    )
                    
                    
                    -
                    
                    
                    
                    (643,289
                    )Stock-based
      compensation
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    253,592
                    
                    
                    
                    -
                    
                    
                    
                    253,592Issuance
      of stock for services
                    
                    
                    5,000
                    
                    
                    
                    5
                    
                    
                    
                    64,370
                    
                    
                    
                    -
                    
                    
                    
                    64,375Net
      loss
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (923,290
                    )
                    
                    
                    (923,290
                    )Balance
      December 31, 2007
                    
                    
                    1,398,704
                    
                    
                    $
                    1,399
                    
                    
                    $
                    8,034,205
                    
                    
                    $
                    (19,471,602
                    )
                    
                    $
                    (11,435,998
                    )




Issuance
      of common stock for exchange of debentures
                    
                    
                    22,400,020
                    
                    
                    
                    22,400
                    
                    
                    
                    3,978,244
                    
                    
                    
                    -
                    
                    
                    
                    4,000,644Issuance
      of common stock for exchange of preferred stock
                    
                    
                    4,197,849
                    
                    
                    
                    4,198
                    
                    
                    
                    8,810,044
                    
                    
                    
                    -
                    
                    
                    
                    8,814,241Issuance
      of common stock, net
                    
                    
                    14,560,037
                    
                    
                    
                    14,560
                    
                    
                    
                    2,528,585
                    
                    
                    
                    -
                    
                    
                    
                    2,543,145Non-cash
      exchange of warrants at recapitalization
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    2,039,705
                    
                    
                    
                    -
                    
                    
                    
                    2,039,705Reclassification
      of warrants from derivative liability to equity at
      recapitalization
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    42,044
                    
                    
                    
                    -
                    
                    
                    
                    42,044Stock-based
      compensation
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,086,390
                    
                    
                    
                    -
                    
                    
                    
                    1,086,390Issuance
      of stock for services
                    
                    
                    158,500
                    
                    
                    
                    158
                    
                    
                    
                    47,391
                    
                    
                    
                    -
                    
                    
                    
                    47,549Net
      loss
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (5,752,057
                    )
                    
                    
                    (5,752,057
                    )Balance
      December 31, 2008
                    
                    
                    42,715,110
                    
                    
                    $
                    42,715
                    
                    
                    $
                    26,566,607
                    
                    
                    $
                    (25,223,659
                    )
                    
                    $
                    1,385,663













See
accompanying notes to financial statements which are an integral part of the
financial statements.


27


VIKING
SYSTEMS, INC.


Statement
of Cash Flows


Years
Ended December 31, 2008 and 2007







2008
                                      
                                      
                                      2007Cash
      flows from operating activities:Net
      loss
                                      
                                      $
                                      (5,752,057
                                      )
                                      
                                      $
                                      (923,290
                                      )Adjustment
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
                                      
                                      
                                      485,959
                                      
                                      
                                      
                                      548,625Common
      stock  issued for services
                                      
                                      
                                      7,549
                                      
                                      
                                      
                                      21,675Common
      stock issued for payment of Debenture interest and liquidated
      damages
                                      
                                      
                                      -
                                      
                                      
                                      
                                      430,123Stock-based
      compensation expense
                                      
                                      
                                      1,086,390
                                      
                                      
                                      
                                      253,592Amortization
      of debt discount and debt issuance costs
                                      
                                      
                                      -
                                      
                                      
                                      
                                      2,193,469Loss
      on recapitalization transaction
                                      
                                      
                                      2,703,776
                                      
                                      
                                      
                                      -Loss
      on disposal of property and equipment
                                      
                                      
                                      10,302
                                      
                                      
                                      
                                      133,292Gain
      on derivative liability
                                      
                                      
                                      (307,061
                                      )
                                      
                                      
                                      (11,001,103
                                      )Change in operating assets and liabilities:Accounts
      receivable
                                      
                                      
                                      534,684
                                      
                                      
                                      
                                      (516,615
                                      )Inventories
                                      
                                      
                                      (273,886
                                      )
                                      
                                      
                                      (561,783
                                      )Prepaids
      and other current assets
                                      
                                      
                                      21,788
                                      
                                      
                                      
                                      (66,093
                                      )Accounts
      payable
                                      
                                      
                                      (396,371
                                      )
                                      
                                      
                                      791,497Accrued
      expenses
                                      
                                      
                                      (555,395
                                      )
                                      
                                      
                                      1,771,616Deferred
      revenue
                                      
                                      
                                      (181,077
                                      )
                                      
                                      
                                      132,150Net
      cash used in operating activities
                                      
                                      
                                      (2,615,399
                                      )
                                      
                                      
                                      (6,792,845
                                      )Cash
      flows from investing activities:Purchases
      of property and equipment
                                      
                                      
                                      (80,755
                                      )
                                      
                                      
                                      (737,796
                                      )Net
      cash used in investing activities
                                      
                                      
                                      (80,755
                                      )
                                      
                                      
                                      (737,796
                                      )Cash
      flows from financing activities:Net
      proceeds from issuance of common stock
                                      
                                      
                                      2,589,907
                                      
                                      
                                      
                                      -Proceeds
      from exercise of stock options
                                      
                                      
                                      -
                                      
                                      
                                      
                                      4,000Proceeds
      from issuance of convertible debt
                                      
                                      
                                      -
                                      
                                      
                                      
                                      7,275,000Proceeds
      from issuance of related-party note payable
                                      
                                      
                                      -
                                      
                                      
                                      
                                      300,000Payments
      for debt and stock issue costs
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (131,729
                                      )Payments
      on capital leases
                                      
                                      
                                      (42,084
                                      )
                                      
                                      
                                      (39,997
                                      )Net
      cash provided by financing activities
                                      
                                      
                                      2,547,823
                                      
                                      
                                      
                                      7,407,274Net
      decrease in cash and cash equivalents
                                      
                                      
                                      (148,331
                                      )
                                      
                                      
                                      (123,367
                                      )Cash
      and cash equivalents at beginning of year
                                      
                                      
                                      317,098
                                      
                                      
                                      
                                      440,465Cash
      and cash equivalents at end of year
                                      
                                      $
                                      168,767
                                      
                                      
                                      $
                                      317,098Supplemental
      disclosure of cash flow information:Cash
      paid during the period for:Interest
                                      
                                      $
                                      4,860
                                      
                                      
                                      $
                                      179,612Income
      taxes
                                      
                                      $
                                      2,720
                                      
                                      
                                      $
                                      1,791




See
accompanying notes to financial statements which are an integral part of the
financial statements.


28


VIKING
SYSTEMS, INC.


Statement
of Cash Flows


Continued







Non-cash,
investing and financing activities:





During
the year ended December 31, 2008, the Company:




●
            Issued
      22,400,020 shares of common stock in exchange for all outstanding
      convertible debentures and related accrued interest and liquidated
      damages.





●
            Issued
      4,197,849 shares of common stock in exchange for all outstanding Preferred
      Stock and related accrued dividends, interest on unpaid dividends and
      liquidated damages.





●
            Issued
      warrants to purchase 11,200,011 shares of the Company’s common stock to
      the former convertible debenture holders in exchange for their then
      outstanding warrants to purchase 443,141 shares of common
      stock.





●
            Issued
      warrants to purchase 2,098,027 shares of the Company’s common stock to the
      former Preferred Stockholders in exchange for their then outstanding
      warrants to purchase 666,667 shares of common
  stock.




●
            Issued
      158,500 shares of common stock in settlement of amounts owed for
      professional services valued at $47,549, of which $40,000 was accrued at
      December 31, 2007 and $7,549 was expensed in
  2008.





During
the year ended December 31, 2007, the Company:





●
            
            Converted
      $350,000 principal amount of notes payable issued in December 2006 plus
      $6,534 in accrued but unpaid interest under such notes into $356,534
      of  the Company’s 8% Secured Convertible Debentures due February
      23, 2009.●
            
            Converted
      $300,000 principal amount of notes payable issued in 2007 held by related
      party Donald Tucker, at the time a significant shareholder and the
      Company's President, Chief Executive Officer, and Director into $300,000
      original principal amount of the Company’s 8% Secured Convertible
      Debentures due February 23, 2009.●
            
            Issued
      80,000 shares of common stock with a fair value of $840,000 for liquidated
      damages to holders of the Company’s Series B Preferred stock in connection
      with the Company’s February 2007 issuance of its 8% Secured Convertible
      Debentures due February 23, 2009.●
            
            Issued
      24,591 shares of common stock with a fair value of $220,062 in connection
      with the conversion of 211 shares of the Company’s Series B Preferred
      stock plus accrued but unpaid dividends on the stock that was
      converted.●
            
            Recorded
      derivative liability of $10,422,113 in connection with the Company’s
      issuances in February and July 2007 of its 8% Secured Convertible
      Debentures due February 23, 2009.●
            
            Issued
      47,791 shares of common stock with a fair value of $430,123 as payment for
      interest and liquidated damages on the Company's convertible
      debt.●
            
            Issued
      5,000 shares of common stock with a fair value of $64,375 to a firm as
      partial compensation for public and investor relations
      services.




●
            
            Increase
      in liquidation preference of Series B Redeemable Preferred Stock of
      $643,289 through accretion of
dividend.






See
accompanying notes to financial statements which are an integral part of the
financial statements.


29


VIKING
SYSTEMS, INC.


Notes
to Financial Statements








1.         
Organization and Basis of Presentation





Organization
and Business


Viking
Systems, Inc., (“Viking” or the “Company”) was organized as a corporation in the
state of Nevada on May 28, 1998, for the purpose of providing training and
curriculum for the information technology industry. During 2001, Viking changed
its business focus to the development of software applications, hardware sales
and leasing, and training and support. As of December 31, 2002, Viking
discontinued its operations. During 2004, Viking purchased the assets of the
visualization technology business of Vista Medical Technologies Inc. (“Vista”),
a Delaware Corporation, involved in the development, manufacture, and sale of
medical devices and related technology. Viking has continued to develop,
manufacture, and sell the products associated with Vista’s visualization
technology business. In 2006, the Company changed its state of incorporation to
Delaware.





Basis of
Presentation


The
accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America. The
preparation of these financial statements requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities, revenue
and expenses.  Management bases its estimates on historical experience
and on various other assumptions that it believes to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.





Reverse
Stock Split


Effective
January 4, 2008, the Company completed a 1 for 50 reverse stock
split.  All common stock share data, including warrants and stock
options to purchase common stock have been restated for all periods presented to
give effect to the reverse stock split.  Additionally per share prices
and number of shares related to convertible conversion securities have also been
restated.  Per share amounts, including loss per share, have been
increased by a factor of 50 and shares have been divided by 50.








2.Liquidity and Going
Concern




The
accompanying financial statements have been prepared on a going concern basis,
which contemplates, among other things, the realization of assets and the
satisfaction of liabilities in the ordinary course of business.  For
the year ended December 31, 2008, the Company has recorded a net loss of
$5,752,057 and cash used in operating activities was $2,615,399.  As
of December 31, 2008, the Company had $168,767 of cash and cash equivalents
and a net working capital balance of $952,054.





Management
believes that the Company’s existing cash resources, combined with projected
cash flows from operations are not likely be sufficient to execute its business
plan and continue operations for the next twelve months.  Management
has taken steps to reduce the Company’s operating expenses, and continues to
implement changes in its strategic direction aimed at achieving profitability
and positive cash flow.    In addition, management continues to
explore various strategic alternatives, including business combinations, private
placements of debt or equity securities and strategic licensing or other
arrangements.  In this regard, in August 2008, the Company entered
into a technology licensing arrangement pursuant to which we received proceeds
of $1.0 million.    In November 2008, the Company engaged an
investment banking firm to assist management in exploring business combinations
and/or raising additional capital.  This process is ongoing. However,
no assurances can be given that the Company will be successful in executing a
business combination or in obtaining additional financing on acceptable terms,
on a timely basis, or at all, in which case, the Company may be forced to make
further cut backs, or cease operations.  The financial statements do
not include any adjustments that might be necessary should we be unable to
continue as a going concern.








3.  Summary
of Significant Accounting Policies





Cash
and Cash Equivalents


Viking
considers all highly liquid instruments with an original maturity of three
months or less to be cash equivalents.





30





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued











Financial
Instruments


The
Company’s financial instruments as of December 31, 2008 and 2007 consist
primarily of cash and cash equivalents, accounts receivable and accounts
payable. As of December 31, 2007 the Company’s financial instruments also
included convertible debentures. The recorded values of cash and cash
equivalents, accounts receivable and accounts payable approximate their fair
values based on their short-term nature.  The recorded values of
convertible debentures approximate their fair values, as interest approximates
market rates.





Concentration
Risk


Financial
instruments which potentially subject Viking  to concentration of
credit risk consist primarily of accounts receivable and cash. In the normal
course of business, Viking  provides credit terms to its customers.
Accordingly, Viking  performs ongoing credit evaluations of its
customers and maintains allowances for possible losses which, when realized,
have been within the range of management’s expectations.  Viking had
accounts receivable due from three customers representing greater than 10% of
total accounts receivable at December 31, 2008 amounting to $285,789, $175,000
and $134,000.  Viking had trade receivables due from two customers
representing greater than 10% of total accounts receivable at December 31, 2007
amounting to $411,350 and $210,207.





Viking  maintains
its cash in bank deposit accounts which, at times, may exceed the current
Federal Deposit Insurance Corporation limit of
$250,000.  Viking  has not experienced any losses in such
accounts and believes it is not exposed to any significant credit risk related
to its cash and cash equivalents.





Accounts
Receivable


Accounts
receivable are carried at original invoice amount less an estimate made for
doubtful receivables based on a review of all outstanding amounts on a monthly
basis. Specific reserves are estimated by management based on certain
assumptions and variables, including the customer’s financial condition, age of
the customer’s receivables, and changes in payment histories. As of December 31,
2008 an allowance in the amount of $171,576 was considered necessary and at
December 31, 2007 no allowance for doubtful receivables was considered
necessary.





Inventories


Parts and
supplies inventories are stated at the lower of cost or market. Cost is
determined using the standard cost method. Work-in-process and finished goods
are stated at the lower of the accumulated manufacturing costs or market.Viking reduces
the stated value of its inventory for obsolescence or impairment in an amount
equal to the difference between the cost of the inventory and the estimated
market value, based upon assumptions about future demand and market conditions.
If actual future demand or market conditions are less favorable than those
projected by management, additional reductions in stated value may be required.
During the year ended December 31, 2008 the Company increased its inventory
valuation reserve by $312,711.





Amortization
and Impairment of Long Lived Assets


Long
lived assets, such as property, equipment and intangible assets are recorded at
historical cost. The Company amortizes its intangible assets using the
straight-line method over their estimated useful lives, usually two to five
years. Viking reviews intangible assets subject to amortization periodically to
determine if any adverse conditions exist or a change in circumstances has
occurred that would indicate impairment or a change in the remaining useful
life. Conditions that would indicate impairment and trigger a more frequent
impairment assessment include, but are not limited to, a significant adverse
change in the legal factors or business climate that could affect the value of
an asset, or an adverse action or assessment by a regulator. If the carrying
amount of an asset exceeds its estimated fair value, an impairment charge is
recognized for the amount by which the carrying amount exceeds the estimated
fair value of the asset. Assets to be disposed of are reported at the lower of
the carrying amount or fair value, less the estimated costs to sell. In
addition, depreciation of the asset ceases. During the years ended December 31,
2008 and 2007, no impairment of long-lived assets was recorded.




Property
and Equipment


Property
and equipment are recorded at cost, less accumulated depreciation. Depreciation
is calculated using the straight-line method over the useful lives of the
assets, which range from one to four years. Expenditures for maintenance and
repairs are  expensed when incurred and betterments are capitalized.
Gains and losses on sale of property and equipment are reflected in
operations.


31


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued











Derivative
Financial Instruments


The
Company accounts for derivative instruments in accordance with the provisions of
SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities, and its related
interpretations, and complies with SFAS No. 138, Accounting for Certain Derivative
Instruments and Hedging Activities—an amendment of FASB Statement
No. 133.  SFAS No. 133 and SFAS No. 138
establish accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities.




The
Company does not use derivative instruments to hedge exposures to cash flow,
market or foreign currency risk. Terms of convertible debt and equity
instruments are reviewed to determine whether or not they contain embedded
derivative instruments that are required under SFAS No. 133 to be accounted for
separately from the host contract, and recorded on the balance sheet at fair
value. The fair value of derivative liabilities is required to be revalued at
each reporting date, with corresponding changes in fair value recorded in
current period operating results.





Freestanding
warrants issued by the Company in connection with the issuance or sale of debt
and equity instruments are considered to be derivative instruments, and are
evaluated and accounted for in accordance with the provisions of the Emerging
Issues Task Force Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock(“EITF No. 00-19”). Pursuant to EITF No. 00-19, an evaluation of
specifically identified conditions is made to determine whether the fair value
of warrants issued is required to be classified as equity or as a derivative
liability.





Revenue
Recognition


The
Company’s revenues are derived from the sale of surgical visualization
technology products to end users, distributors and original equipment
manufacturers. Revenue from the sale of products is recognized when evidence of
an arrangement exists, the product has been shipped, the selling price is fixed
or determinable, collection is reasonably assured and when both title and risk
of loss transfer to the customer, provided that no significant obligations
remain. If installation is included as part of the contract, revenue is not
recognized until installation has occurred, or until any remaining installation
obligation is deemed to be perfunctory. Shipping and handling costs are included
in cost of sales.





For the
sale of products and services as part of a multiple-element arrangement, the
Company allocates revenue from multiple-element arrangements to the elements
based on the relative fair value of each element. For sales of extended
warranties with a separate contract price, Viking defers revenue equal to the
separately stated price. Revenue associated with undelivered elements is
deferred and recorded when delivery occurs.





For
development contracts, the Company recognizes revenue using the
percentage-of-completion method based on contract costs incurred to date
compared with total estimated contract costs.





Advertising
Costs


Advertising
costs are expensed as incurred and are classified as selling and marketing
expenses. For the years ended December 31, 2008 and 2007, advertising expense
was $9,939 and $41,059 respectively.





Shipping
and Handling Costs


Shipping
and handling costs are classified as selling and marketing
expenses. .  For the years ended December 31, 2008 and 2007,
shipping and handling expense was $83,053 and $120,951,
respectively.








32


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued







Income
Taxes


Viking accounts
for income taxes using the asset and liability method. Under the asset and
liability method, deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
recognized against deferred tax assets when it is more likely than not that the
assets will not be realized.





Use
of Estimates in the Preparation of Financial Statements


The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.





Loss
Per Common and Common Equivalent Share


The
computation of basic and diluted loss per common share is computed using the
weighted average number of common shares outstanding during the
year.





Due to
the net losses for the year ended December 31, 2008 and 2007, potentially
dilutive securities have been excluded in the calculation of diluted loss per
share because their inclusion would be anti-dilutive. Accordingly, basic and
diluted loss per share are the same within each respective year. For the
purposes of this calculation, the net loss 2007 has been adjusted for dividends
on preferred stock accrued during that period.




The
following potentially dilutive common shares were excluded from the calculation
of diluted net loss per common share because their effect was antidilutive for
the periods presented:




Year Ended
      December 31,2008
                          
                          
                          2007Convertible
      Debentures
                          
                          
                          -
                          
                          
                          
                          1,329,422Convertible
      Preferred Stock
                          
                          
                          -
                          
                          
                          
                          1,067,534Warrants
                          
                          
                          27,985,020
                          
                          
                          
                          1,299,252Stock
      Options
                          
                          
                          6,354,440
                          
                          
                          
                          154,840Total
                          
                          
                          34,339,460
                          
                          
                          
                          3,851,048








Stock-Based
Compensation


On January 1, 2006, we
adopted Statement of Financial Accounting Standards (“SFAS”) No.123 (Revised
2004), “Share Based Payment,” (“SFAS 123R”), using the modified prospective
method. In accordance with SFAS 123R,which requires the measurement and
recognition of compensation expense for all share-based payment awards to
employees and directors based on estimated fair values. The Company uses the
Black-Scholes option valuation model to estimate the fair value of its stock
options at the date of grant. The Black-Scholes option valuation model requires
the input of subjective assumptions to calculate the value of stock options. The
Company uses historical data among other information to estimate the expected
price volatility, the expected annual dividend, the expected option life and the
expected forfeiture rate. That cost is recognized
over the period during which an employee is required to provide service in
exchange for the award - the requisite service.


33


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued







Reclassifications


Certain
reclassifications have been made to prior years’ financial statements to conform
to the current year presentation. These reclassifications had no effect on
previously reported results of operations or accumulated deficit.




4.           Recapitalization





On
January 4, 2008, the Company completed execution of a Recapitalization Plan (the
“Recapitalization Plan”).  This Recapitalization Plan was developed
during the fourth quarter of 2007. In November 2007, Viking received approval,
subject to finalization of  certain terms and execution of final
documentation, from 100% of the holders of its Series B Variable Dividend
Convertible Preferred Stock (the “Preferred Stock”) and Viking’s 8% Secured
Convertible Debentures due February 23, 2009 (the “Debentures”), of the
Recapitalization Plan.  The Recapitalization Plan called for an
additional investment of between $2.5 and $3.0 million in the common stock of
Viking  (the “New Investment”) and a redistribution of Viking’s common
stock among the current holders of Viking’s common stock, Preferred Stock,
Debentures and the investors providing the New Investment.




In
consummating the Recapitalization Plan, the redistribution of Viking’s capital
was accomplished on January 4, 2008, through the following: (i) a 1:50 “reverse
split” of Viking’s common stock, (ii) entry of Viking into a Recapitalization
Agreement with the applicable holders, pursuant to which the holders of the
Preferred Stock and Debentures exchanged their respective Viking securities
(including warrants that were issued in connection with the Preferred Stock and
the Debentures) for shares of Viking’s common stock and warrants which may be
exercised for common stock; and (iii) entry of Viking into a Securities Purchase
Agreement with those parties making the New Investment of $2.6 million pursuant
to which they were issued shares of Viking’s common stock and warrants which may
be exercised for shares of Viking’s common stock.   As part of the
recapitalization, Viking executed the Securities Purchase Agreement and
completed a sale of 14,560,037 shares of our common stock for $0.178571 per
share or aggregate consideration of $2,600,000.








Following
the consummation of the Recapitalization Plan, the equity ownership of the
Company was as follows:




POST-RECAPITALIZATION
      EQUITY (excluding warrants)Stockholder by type
                        
                        Ownership
                          of
                          Outstanding
                          Common
                          Stock
                        
                        
                        Percent
      Ownership
                          Common
                          StockPre-Recapitalization
      common stockholders
                        
                        
                        1,398,704
                        
                        
                        
                        3.3%Pre-Recapitalization
      preferred stockholders
                        
                        
                        4,197,849
                        
                        
                        
                        9.9%Pre-Recapitalization  debenture
      holders
                        
                        
                        22,400,020
                        
                        
                        
                        52.6%New
      investment ($2.6 million)
                        
                        
                        14,560,037
                        
                        
                        
                        34.2%Total—all
      holders
                        
                        
                        42,556,610
                        
                        
                        
                        100.0%




The total
outstanding debentures of $7,976,533 face amount with a carrying value of
$2,144,238 at December 31, 2007, plus all related interest and liquidated
damages, were exchanged for 22,400,020 shares of common
stock.  Additionally all warrants to purchase 443,141 shares of the
Company’s common stock issued with the Debentures were exchanged for warrants to
purchase 11,200,011 shares of the Company’s common stock.  The
warrants have an exercise price of $0.18 and a five year term.





All of
the Company’s outstanding Preferred Stock, 7,789 shares with a carrying value of
$8,814,241 at December 31, 2007, plus all related liquidated damages, were
exchanged for 4,197,849 shares of the Company’s common stock.  No gain was
recorded on the exchange of the Preferred Stock as the book value was
reclassified to common stock (par value totaling $4,198) and the remainder of
$8,810,043  reclassified to additional paid-in capital. 
Additionally, all warrants to purchase 666,667 shares of the Company’s common
stock issued in connection with Preferred Stock were exchanged for warrants to
purchase 2,098,027 shares of the Company’s common stock.  The warrants
have an exercise price of $0.18 and a five year term.


34





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








On
January 4, 2008, pursuant to a Securities Purchase Agreement, the Company
completed a sale of 14,560,037 shares of its common stock for $0.178571 per
share or aggregate consideration of $2,600,000, of which the Company received
proceeds of $2,600,000. Pursuant to the Securities Purchase Agreement, the
Company issued to the investors providing the New Investment warrants to
purchase up to 14,560,037 shares of common stock. The warrants have a term of
five years and are exercisable for shares of common stock at a price of $0.18
per share.




The
purchasers of the common stock pursuant to the Securities Purchase Agreement
were three institutional investors and William C. Bopp,  at the time
the Company’s Chairman of the Board (currently Chairman and Chief Executive
Officer), who paid $1,750,000 for 9,800,024 shares of common stock and warrants
that may be exercised for 9,800,024 shares of common
stock.







Loss
on Recapitalization


In
connection with the January 4, 2008 Recapitalization, the Company recorded a
non-cash charge of $2,703,776.  We determined the fair value of the
common stock issued in exchange for the Debentures based on the $0.18 price for
common shares sold as part of the Recapitalization.  The
charge comprises the following;





Year
      EndedDecember
      31, 2008Debentures
      then outstanding
                            
                            $
                            7,976,533Less
      unamortized debt discount
                            
                            
                            (5,832,295
                            )Net
      carrying value at time of recapitalization
                            
                            
                            2,144,238Fair
      value of common stock exchanged for Debentures
                            
                            
                            4,000,644Loss
      on conversion of debentures into common stock
                            
                            
                            
                            
                            
                            $
                            (1,856,406
                            )Write-off
      unamortized debt issue costs
                            
                            
                            
                            
                            
                            
                            (80,738
                            )Estimated
      fair value of warrants issued to Debenture and Preferred Stockholders in
      excess of  estimated fair value of warrants
      cancelled
                            
                            
                            
                            
                            
                            
                            (2,039,705
                            )Accrued
      obligations extinguished/forgiven in connection with
      Recapitalization:Debenture
      interest
                            
                            $
                            302,306Liquidated
      damages
                            
                            
                            849,178Interest
      on unpaid Preferred Stock dividends
                            
                            
                            121,589Total
      gain from extinguished obligations
                            
                            
                            
                            
                            
                            
                            1,273,073Total
      loss on Recapitalization transaction
                            
                            
                            
                            
                            
                            $
                            (2,703,776
                            )





35


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued





5.         
Inventories





Inventories
consist of the following at December 31:




2008
                        
                        
                        2007Inventories:Parts
      and supplies
                        
                        $
                        1,208,720
                        
                        
                        $
                        992,338Work-in-progress
                        
                        
                        426,779
                        
                        
                        
                        548,268Finished
      goods
                        
                        
                        945,816
                        
                        
                        
                        439,855Valuation
      reserve
                        
                        
                        (476,551
                        )
                        
                        
                        (163,840
                        )$
                        2,104,764
                        
                        
                        $
                        1,816,621




6.         
Property and Equipment





Property
and equipment consists of the following at December 31:




2008
                        
                        
                        2007Equipment
                        
                        $
                        133,026
                        
                        
                        $
                        994,918Furniture
      and fixtures
                        
                        
                        947,451
                        
                        
                        
                        142,5871,080,477
                        
                        
                        
                        1,137,505Less
      accumulated depreciation
                        
                        
                        (856,868
                        )
                        
                        
                        (554,133
                        )$
                        223,609
                        
                        
                        $
                        583,372







Depreciation
expense was $415,959 and $478,625 for the years ended December 31, 2008 and
2007, respectively.  During 2008, the Company disposed of certain
fixed assets with a cost of approximately $122,000 with accumulated depreciation
of $111,000, resulting in a loss of approximately $10,000.  During
2007, the Company disposed of certain fixed assets with a cost of approximately
$566,000 with accumulated depreciation of $433,000, resulting in a loss of
approximately $133,000.




7.    
Other Non-current Assets





Other
non-current assets consists of the following at December 31:




2008
                        
                        
                        2007Debt
      issuance costs, net
                        
                        $
                        -
                        
                        
                        $
                        80,738Deferred
      stock issuance costs
                        
                        
                        -
                        
                        
                        
                        46,762$
                        -
                        
                        
                        $
                        127,500





36





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued





8.  Intangible
Assets





Intangible
assets consist of the following at December 31:





2008
                      
                      
                      2007Patents
      and other assets
                      
                      $
                      350,000
                      
                      
                      $
                      350,000Less
      accumulated amortization
                      
                      
                      (140,000
                      )
                      
                      
                      (70,000$
                      210,000
                      
                      
                      $
                      280,000





In
November 2006, as part of a Technology Transfer and Settlement Agreement, the
Company paid $350,000 for the ownership of intellectual property including
fourteen patents and non-exclusive license rights to four U.S. patents and four
international patents. These assets are being amortized over five years using
the straight line method.  Amortization expense amounted to $70,000
for both 2008 and 2007.  The estimated amortization expense for the
future yeas is $70,000 for 2009, 2010 and 2011.





On August
5, 2008, we licensed our patent portfolio to Intuitive Surgical, Inc. pursuant
to an exclusive license agreement (the “License Agreement”).  The
License Agreement provides Intuitive Surgical with perpetual, exclusive rights
to use all of our patents in the medical robotics field, as defined in the
License Agreement.  We maintained the right to sell non-stereoscopic
products and our current stereoscopic products that utilize the licensed patents
in the medical robotics field.  We received $1 million for the
license. The license fee was recorded in other income and expense for the year
ended December 31, 2008.





9.          
Accrued expenses





Accrued
expenses consist of the following at December 31:





2008
                      
                      
                      2007Wages
      and salaries
                      
                      $
                      241,358
                      
                      
                      $
                      388,382Liquidated
      damages
                      
                      
                      -
                      
                      
                      
                      849,178Registration
      delay fees
                      
                      
                      161,574
                      
                      
                      
                      434,214Board
      of director fees
                      
                      
                      192,013
                      
                      
                      
                      251,100Professional
      and consulting fees
                      
                      
                      88,918
                      
                      
                      
                      201,577Interest
      on unpaid preferred dividends
                      
                      
                      -
                      
                      
                      
                      121,589Debenture
      interest
                      
                      
                      -
                      
                      
                      
                      302,306Other
      accrued expenses
                      
                      
                      110,356
                      
                      
                      
                      114,341$
                      794,219
                      
                      
                      $
                      2,662,687




Accrued
expenses of $1,273,073 at December 31, 2007 were eliminated on January 4, 2008
in connection with the Recapitalization. See Note 4.


37


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








10.         
Deferred Revenue





As of
December 31, 2008 and 2007, Viking had deferred revenue of $51,254 and $232,331,
respectively, which consisted of sales for which all elements of the agreements
were not completed and for service plan agreements that are deferred until the
service period has occurred.





11.        
Capital Lease Obligations





During
the year ended December 31, 2006, the Company entered into two capital lease
agreements totaling approximately $123,000 for the purchase for certain computer
equipment and software. Depreciation expense recorded for the leases amounted to
approximately $55,000 and $15,300 for the years ended December 31, 2008 and
2007, respectively.  As of December 31, 2008, the future minimum
capital lease payments are as follows:




2009
                          
                          $
                          36,365Total
      minimum lease payments
                          
                          
                          36,365Amount
      representing interest
                          
                          
                          (4,544
                          )Present
      value of minimum lease payments
                          
                          $
                          31,821





12.        
Notes and Debentures




Promissory
Notes


During
January 2007, the Company issued a $300,000 promissory note to, our then
President and Chief Executive Officer who was also at the time a significant
shareholder and director. This promissory note and a $350,000 note to another
party issued in December 2006, including accrued but unpaid interest thereon,
were converted into the February 2007 debentures described below, which as of
January 4, 2008, were exchanged, including all accrued and unpaid interest
thereon, for shares of the Company’s common stock in the
Recapitalization.





Debentures


As of
January 4, 2008 all Debentures outstanding at December 31, 2007, plus accrued
and unpaid interest thereon, were exchanged for shares of the Company's common
stock in the Recapitalization.





In
February 2007, the Company issued a total of $5,376,533 of 8% secured
convertible debentures due February 23, 2009.  Net proceeds from the
issuance of these debentures consisted of $4,675,000 in cash, net of $45,000 of
offering costs retained by certain of the investors, and conversion of $656,533
of notes payable and accrued interest. In July 2007, an additional $2,600,000 of
such debentures were sold on the same terms and conditions as in February
2007.  The Company refers to these debentures, collectively, as the
“Debentures.”





Registration
Rights.  The Company agreed to register with the Securities and
Exchange Commission the shares of common stock issuable upon the conversion of
the Debentures and exercise of the warrants.  The Company agreed to
pay all expenses and cost of registration except for commissions. The Company
failed to meet its registration obligations, and under the terms of the
operative agreements could have been obligated to pay liquidated damages to the
holders of up to 2% per month but not in excess of 18% of the face amount of the
Debentures. On July 19, 2007, Viking and the Debenture holders at that time
entered into a Consent, Waiver and Amendment Agreement dated June 22, 2007,
pursuant to which Viking agreed to issue to the Debenture holders a total of
47,791 shares of common stock in lieu of the payment of (i) accrued but unpaid
cash liquidated damages and (ii) the payment of accrued interest on the
Debentures through June 30, 2007. These shares were issued in July
2007.





The
parties to the Consent, Waiver and Amendment Agreement also agreed to amend the
registration obligations for the debentures issued in February
2007.  This deferred the registration obligation until 30 days after
the date on which the Company receives a registration demand from investors
holding a majority of the debentures issued in February.  No such
demand has been received. The registration rights of the debentures issued in
July 2007 were not amended and as a result, the  Company accrued
liquidated damages on the $2.6 million of debentures issued in
July.  At December 31, 2007, the Company had accrued $302,306 related
to interest and $260,000 related to the liquidated damages associated with the
Debentures.





38


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








Reset of Conversion
Price.  In October 2007, the Company determined it did not meet
the operational milestones contained in the Debentures for the quarter ended
September 30, 2007.  As a result, the conversion price of the
Debentures and the exercise price of the related warrants were reset from $9.00
to $6.00 effective October 4, 2007.  This reset triggered additional
changes to the conversion price of the Preferred Stock and its related
warrants.  These modifications resulted in a 2007 loss on derivatives
of $5,850,960.





The
following table sets forth the effect in 2007 on the Debentures, Preferred Stock
and the warrants associated with each as a result of the Company's not meeting
one of the operational milestones, pursuant to the adjustment provisions
contained in the agreements governing these securities (all data restated for 1
for 50 reverse stock split):





Conversion
      or Exercise
                Price
      ($)
              Number
      of Shares of Viking
                Common
      Stock Issuable
                Upon
      Conversion/ExerciseName
      of Security
              Old
              New
              Old
              NewDebentures
              9.00
              6.00
              86,281
              1,329,422Warrants
      (associated with Debentures)
              9.00
              6.00
              443,141
              443,141Preferred
      Stock
              9.00
              7.30
              865,888
              1,067,534Warrants
      (associated with Preferred Stock)
              9.00
              6.00
              444,444
              666,667





Defaults.   The
Company was in default under the terms of the Debentures at December 31, 2007
and accordingly, the entire carrying value of $2,144,238 was classified as a
current liability at December 31, 2007.  Viking did not pay interest
due on the Debentures for the quarters ended September 30 and December 31, 2007
and did not meet the registration requirements related to the
Debentures.  The Company did not receive notice of default from any
holders of the debentures.  See Note 4 regarding recapitalization of
the Company and extinguishment of all amounts owed under the Debentures in
January 2008.





Additional
Information.  The Debentures were assessed under SFAS No. 133
and management determined that the conversion option represented an embedded
derivative liability. Accordingly, the Company bifurcated the embedded
conversion option and accounted for it as a derivative liability. In accordance
with SFAS No. 133, the embedded conversion option of the Debenture was revalued
at each period end and the change in fair value was reflected as a gain (loss)
for the period. The proceeds received on issuance of the February 2007
Debentures were first allocated to the fair value of the bifurcated conversion
option and the fair value of the derivative liability resulting from the
warrants issued in connection with these Debentures. The aggregate fair values
of the embedded conversion option and the warrant derivative liability totaled
$6,859,608. Of this total, $5,376,533 was recorded as a discount to the face
amount of the February 2007 Debentures and $1,483,075 was recorded as a loss on
derivative liability.





The
proceeds received from issuance of the July 2007 Debentures were also first
allocated to the conversion option and also the related warrants issued in
connection with such debentures.  The aggregate fair value of the
conversion option and the warrants was $3,562,507, with $2,600,000 recorded as a
discount to these Debentures and $962,507 recorded as a loss on derivative
liability.


39


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued







Included
in the Debentures was an aggregate of $2,400,000 representing the face value of
$500,000 from the February 2007 Debentures and $1,900,000 from the July 2007
Debentures to members of the Company’s board of directors as of December 31,
2007 who were considered related parties.





The
recorded discount was being accreted as interest expense using the effective
interest method over the term of the Debentures. The carrying value of the
Debentures would have accreted up to the face value over the contractual life of
the Debentures. The Company recorded accretion of the discount $2,144,238
during the year ended December 31, 2007. The amount recorded on the balance
sheet at December 31, 2007 was calculated as follows:





Convertible
      Debentures
                    
                    
                    Convertible
                      Debentures
      –
                      Related
      party
                    
                    
                    TotalFace
      value of the February 2007 Debentures
                    
                    $
                    4,876,533
                    
                    
                    $
                    500,000
                    
                    
                    $
                    5,376,533Discount
      recorded related to valuation of conversion feature
                    
                    
                    (4,876,533
                    )
                    
                    
                    (500,000
                    )
                    
                    
                    (5,376,533
                    )Face
      value of  the July 2007 Debentures
                    
                    
                    700,000
                    
                    
                    
                    1,900,000
                    
                    
                    
                    2,600,000Discount
      recorded related to valuation of conversion feature
                    
                    
                    (700,000
                    )
                    
                    
                    (1,900,000
                    )
                    
                    
                    (2,600,000
                    )Accretion
      of discount
                    
                    
                    1,637,707
                    
                    
                    
                    506,531
                    
                    
                    
                    2,144,238Carrying
      value at December 31, 2007
                    
                    $
                    1,637,707
                    
                    
                    $
                    506,531
                    
                    
                    $
                    2,144,238






13.         
Preferred Stock





As of
January 4, 2008 all Preferred stock outstanding at December 31, 2007, plus
accrued and unpaid liquidated damages and dividends thereon, were exchanged for
shares of the Company's common stock in the Recapitalization





In May
2006, the Company’s board of directors adopted a resolution designating a Series
B preferred stock (“Preferred Stock”) consisting of 8,000 shares. All 8,000
shares of Preferred Stock authorized were issued in May, 2006. The Company
issued the Preferred Stock for gross proceeds of $8,000,000, and incurred
approximately $436,143 in issuance costs, which was recorded as a reduction of
the proceeds of the Preferred Stock. Proceeds from the sale of Preferred Stock
consisted of $7,250,000 in cash and the conversion of $750,000 of convertible
notes.  Each share of Preferred Stock, with a “Stated Value” of
$1,000 per share, was convertible, subject to adjustments, into
approximately 111 shares of common stock ($9.00 per share) and warrants to
purchase an additional 56 shares of common stock at an initial price of $17.50
per share. See Note 12 regarding changes to conversion and exercise prices in
October 2007.


40


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued







The
following table summarizes the valuation of the Series B Preferred from
issuance in 2006 through December 31, 2007:





Convertible
      preferred stock
                        
                        $
                        8,000,000Issuance
      costs
                        
                        
                        (436,142)Fair
      value of warrants
                        
                        
                        (3,590,050)Beneficial
      conversion feature
                        
                        
                        (3,973,808)Subtotal
                        
                        $
                        -Accrued
      dividends
                        
                        
                        391,014Accretion
      of discount to redemption value
                        
                        
                        8,000,000Carrying
      value at December 31, 2006
                        
                        $
                        8,391,014Accrued
      dividends
                        
                        
                        643,289Conversion
      of shares to common stock
                        
                        
                        (211,000
                        )Dividends
      on Converted preferred shares to common stock
                        
                        
                        (9,062
                        )Carrying
      value at December 31, 2007
                        
                        $
                        8,814,241




The
Company recorded the accretion of the Preferred Stock discount to its redemption
value at issuance, since the preferred shares were immediately convertible.
Total accretion of the discount to the Preferred Stock redemption value was
recorded as a charge to additional paid in capital and to the net loss
attributable to common stockholders. In addition, the Company accreted the
dividend on the Preferred Stock as a charge to additional paid in
capital.





Conversion. The
stated value of the shares of Preferred Stock was initially convertible into
shares of Viking’s common stock at a price of $9.00 per share; however, the
conversion price was subject to adjustment based upon certain conditions. 
The price was reduced to $6.00 in October 2007.





Registration Rights
The Company and the Holders entered into a “Registration Rights Agreement” on
May 22, 2006. Among other things, the Company was obligated to file a
registration statement on Form SB-2 and cause such registration statement
to become effective within 90 days (or 120 days in the event of a “full review”
by the Securities and Exchange Commission). The agreement provided for
liquidated damages by the Company to the Holders if the Company did not complete
the registration, or subsequent registrations, or maintain effectiveness of such
effectiveness. The Company’s initial registration statement became effective
within 90 days and a subsequent registration statement was filed and was not
approved with the Securities and Exchange Commission.





A
registration statement covering certain of the shares of common stock required
to be registered for resale by the holders of the Preferred Stock was declared
effective on August 10, 2006.  As of May 11, 2007, the effectiveness
of such registration statement lapsed.  As a result, on or about July
11, 2007, the Preferred Stock holders had the right to additional dividends
and/or redemption in exchange for common stock, and were entitled to liquidated
damages. The Company has accrued $589,178 at December 31, 2007 for such
liquidated damages. The Company prepared and filed a post-effective amendment to
the registration statement which was declared effective on September 28,
2007.





41





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued







14.  Income
Taxes





The
components of the 2008 and 2007 provision for federal and state income tax
benefit (expense) completed in accordance with statement SFAS No. 109
“Accounting for Income Taxes (“SFA No. 109”) are summarized
below:





2008
                      
                      
                      2007CurrentFederal
                      
                      $
                      -
                      
                      
                      $
                      -State
                      
                      
                      (2,500
                      )
                      
                      
                      (1,800
                      )DeferredFederal
                      
                      
                      -
                      
                      
                      
                      -State
                      
                      
                      -
                      
                      
                      
                      -$
                      (2,500
                      )
                      
                      $
                      (1,800
                      )







The
difference between income taxes at statutory rates and the amount presented in
the financial statements is a result of the following:




2008
                      
                      
                      2007Expected
      income tax benefit at statutory rate
                      
                      $
                      2,300,800
                      
                      
                      $
                      369,400Non-deductible
      derivatives
                      
                      
                      123,000
                      
                      
                      
                      4,400,000Meals
      and entertainment
                      
                      
                      (10,000
                      )
                      
                      
                      (29,000
                      )Non-deductible
      elements of loss on Recapitalization
                      
                      
                      (2,913,000
                      )
                      
                      
                      -Minimum
      state taxes
                      
                      
                      (1,700
                      )
                      
                      
                      (1,200
                      )Non
      deductible stock options
                      
                      
                      (268,000
                      )
                      
                      
                      (34,000
                      )Amortization
      of debt discount
                      
                      
                      -
                      
                      
                      
                      (877,000
                      )Return
      to provision difference
                      
                      
                      78,000
                      
                      
                      
                      (363,000Delay
      fee reversal and non-deductible liquidated damages
                      
                      
                      109,000
                      
                      
                      
                      (377,000Change
      in valuation allowance
                      
                      
                      579,400
                      
                      
                      
                      (3,090,000
                      )$
                      (2,500
                      )
                      
                      $
                      (1,800
                      )





Deferred
income tax benefit reflects the impact of timing differences between amounts of
assets and liabilities for financial reporting purposes and amounts as measured
by income tax laws. Deferred tax assets are as follows at December
31,




2008
                      
                      
                      2007Basis
      difference in fixed assets
                      
                      $
                      117,000
                      
                      
                      $
                      90,000Accrued
      liabilities
                      
                      
                      102,000
                      
                      
                      
                      104,000Stock
      options
                      
                      
                      324,000
                      
                      
                      
                      157,000Inventory
      reserve
                      
                      
                      191,000
                      
                      
                      
                      66,000Bad
      debt reserve
                      
                      
                      69,000
                      
                      
                      
                      -Intangible
      asset basis difference
                      
                      
                      32,000
                      
                      
                      
                      17,000Less
      valuation allowance
                      
                      
                      (835,000
                      )
                      
                      
                      (434,000
                      )$
                      -
                      
                      
                      $
                      -




42


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








On
July 13, 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income
Taxes – An Interpretation of FASB Statement No. 109 (“FIN 48”),
which clarifies the accounting for uncertainty in income taxes recognized in an
entity’s financial statements in accordance with SFAS No. 109 and
prescribes a recognition threshold and measurement attributes for financial
statement disclosure of tax positions taken or expected to be taken on a tax
return.  Under FIN 48, the impact of an uncertain income tax position on
the income tax return must be recognized at the largest amount that is
more-likely–than-not to be sustained upon audit by the relevant taxing
authority.  An uncertain income tax position will not be recognized if it
has less than a 50% likelihood of being sustained.  Additionally, FIN 48
provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition.  FIN 48 is
effective for fiscal years beginning after December 15, 2006.




The
Company adopted the provisions of FIN 48 on January 1, 2007.  As of
December 31, 2008 the Company had not yet completed its analysis of the
deferred tax assets for its net operating losses of approximately $18 million
and research and development credits of approximately $297,000 generated through
2008.   The future utilization of the Company’s net operating loss and
research and development credit carryforwards to offset future taxable income
may be subject to an annual limitation as a result of ownership changes that may
have occurred previously or that could occur in the future.  The Company
has not yet determined whether such an ownership change has
occurred.  In order to make this determination, the Company will need
to complete a Section 382 analysis regarding the limitation of the net
operating loss and research and development credits. Until this analysis has
been performed the Company has removed the deferred tax assets associated with
these carryforwards from its deferred tax asset schedule and has recorded a
corresponding decrease to their valuation allowance.




The
Company recognizes interest and/or penalties related to uncertain
tax positions in income tax expenses. To the extent accrued interest
and penalties do not ultimately become payable, amounts accrued will be reduced
and reflected as a reduction of the overall income tax provision in the period
that such determination is made. There was no interest or penalties related to
income tax matters during the years ended December 31, 2007 and
2008.




SFAS No.
109 requires that the Company reduce its deferred tax assets by a valuation
allowance if, based on the weight of available evidence, it is not more likely
than not that all or a portion of the deferred tax assets will be realized. The
ultimate realization of deferred tax assets is dependent upon the generation of
future taxable income during the periods in which those temporary difference
become deductible. Management has provided a valuation allowance in the amount
of $835,000 as of December 31, 2008 due to the uncertainty of the future
realization of the deferred tax asset.







15.  Operating
Leases





Viking
leases its Westborough, MA facility and certain office equipment under
non-cancelable operating lease agreements. Future minimum lease payments on
these leases as of December 31, 2008, are as follows:





Years
      Ending December 31,2009
                  
                  
                  246,0002010
                  
                  
                  184,000$
                  430,000





Rent
expense for the years ended December 31, 2008 and 2007 was $245,835 and
$302,459, respectively.




43


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








16.         
Related Party Transactions





During
the year ended December 31, 2008, the following related party transactions
occurred





William
C. Bopp, Chairman and CEO and Winder Hughes, member of the Company’s board of
directors, participated in the Recapitalization Plan. Mr. Hughes participation
was through an investment fund that he manages, Focus Fund.





Exchange
      Transaction Summary:
              
              Debentures
      Exchanged
              
              Common
              
              
              
              NewFace
              
              Carrying
              
              Stock
              
              Warrants
              
              WarrantsRelated
      Party
              
              Amount
              
              Value
              
              Issued
              
              Exchanged
              
              IssuedWilliam
      C. Bopp, Chairman and CEO
              $
              1,400,000
              $
              259,300
              
              3,931,536
              
              3,888,889
              
              1,965,768Winder
      Hughes, Director
              $
              1,000,000
              $
              247,231
              
              2,808,240
              
              2,777,777
              
              1,404,120New
      Investment Summary:
              
              
              
              CommonAmount
              
              Stock
              
              AssociatedRelated
      Party
              
              Invested
              
              Purchased
              
              WarrantsWilliam
      C. Bopp, Chairman and CEO
              $
              1,750,000
              
              9,800,024
              
              9,800,024Winder
      Hughes, Director
              $
              250,000
              
              1,400,004
              
              1,400,004





During
the year ended December 31, 2007, the following related party transactions
occurred:




●
            In
      July 2007, the Company issued $1,400,000 of the Debentures to William C.
      Bopp, an unrelated party at that time, In October 2007, Mr. Bopp was
      appointed Chairman of the board of directors.  In January 2008
      Mr. Bopp was appointed Chief Executive Officer of the
    Company.●
            In
      February 2007 and in July 2007, the Company issued $500,000 ($1,000,000 in
      aggregate) of the Debentures to the Focus Fund.  This fund is
      managed by Winder Hughes.  Mr. Hughes was appointed to the
      Company’s board of directors in October 2007.●
            On
      January 26, 2007, the Company issued a $300,000 promissory note to Donald
      E. Tucker, at the time the Company’s President, CEO and director, who was
      also a significant shareholder. The promissory note was subsequently
      converted into Debentures in February 2007.●
            During
      June 2007, the Company received $200,000 from Brian Miller, at the time a
      shareholder and director, as a deposit which was subsequently converted
      into Debentures in July 2007.






17.  Stock-Based
Compensation





Common
Stock Options


The
Company maintains the 2004 Stock Incentive Plan (the “
2004 Plan ”)under which officers and key employees may be granted
options to purchase shares of the Company’s authorized but unissued common
stock. The maximum number of shares of the Company’s common stock that were
available for issuance under the 2004 Plan was 172,000 shares.





During
the first quarter of 2008, shareholders approved  the Viking Systems,
Inc. 2008 Equity Incentive Plan (the “2008 Equity Plan”).  The 2008 Equity
Plan is intended as the successor to our 2004 Plan. No additional
awards  will be granted under the 2004 Plan. All outstanding awards
granted under the 2004 Plan will remain subject to the terms of the 2004 Plan,
except that our board of directors may elect to extend one or more of the
features of the 2008 Equity Plan to options granted under the 2004 Plan. All
awards granted after the Effective Date will be subject to the terms of the 2008
Equity Plan.The maximum
number of shares that may be issued pursuant to the 2008 Equity Plan is
6,720,000 shares plus such number of shares that are issuable pursuant to awards
outstanding under the 2004 Plan as of the effective date and which would have
otherwise reverted to the share reserve of the 2004 Plan.


44


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








17.  Stock-Based
Compensation (Continued)





The
Company also has the 2004 Non-Employee Directors Stock Ownership Plan which
provides for the grant to non-employee directors of non-qualified stock options
and restricted stock.  The maximum number of shares of the Company’s
common stock that were available for issuance  under the 2004
Non-Employee Director Stock Ownership was 10,000.





During
the first quarter of 2008, shareholders approved  the Viking Systems,
Inc. 2008 Non-Employee Directors’ Stock Option Plan (the “Directors’ Plan,” ).
The Company has reserved a total of 1,500,000 shares of common stock for
issuance under the Directors’ Plan.





During
the year ended December 31, 2008, 6,725,000 shares were issued under the 2008
Equity Plan and 150,000 shares were issued under the Directors’ Plan. Under the
2008 Plan, the option exercise price is equal to the fair market value of the
Company’s common stock at the date of grant. Options currently expire no later
than 10 years from the grant date and generally vest within four years. Proceeds
received by the Company from exercises of stock options are credited to common
stock and additional paid-in capital.




During
the year ended 2008 under the 2004 Plan, six employees surrendered 79,000
previously issued stock options and 6,400 options previously granted were
forfeited. In
connection with the surrender of stock options during the first quarter
of 2008, the Company recognized the remaining non-cash stock option
compensation of $410,258 related to these stock options. During
the year ended December 31, 2008 under the 2008 Plan, 590,000 options previously
granted were forfeited.  At December 31, 2008, 515,560 shares remain
available for grant under the 2008 Equity Plan.




Additional
information with respect to the summary of the plans’ stock option activity
noted above is as follows:








Shares
                                
                                
                                Weighted
                                  Average
                                  Exercise
                                  Price
                                
                                
                                Aggregate
                                  Intrinsic
                                  Value
                                
                                
                                Weighted
                                  Average
                                  Remaining
      Contractual
                                  LifeOptions
      outstanding December 31, 2006
                                
                                
                                139,520
                                
                                
                                $
                                21.00Granted
      in 2007
                                
                                
                                70,400
                                
                                
                                $
                                11.50Cancelled
      in 2007
                                
                                
                                (51,080
                                )
                                
                                $
                                16.50Exercised
      in 2007
                                
                                
                                (4,000
                                )
                                
                                $
                                1.00Options
      outstanding December 31, 2007
                                
                                
                                154,840
                                
                                
                                $
                                18.50
                                
                                
                                $
                                -
                                
                                
                                
                                7.63Granted
                                
                                
                                6,875,000
                                
                                
                                
                                0.33
                                
                                
                                
                                
                                
                                
                                
                                8.38Cancelled
      and expired
                                
                                
                                (596,400
                                )
                                
                                
                                0.52Surrendered
                                
                                
                                (79,000
                                )
                                
                                
                                13.18Options
      outstanding December 31, 2008
                                
                                
                                6,354,440
                                
                                
                                
                                0.58
                                
                                
                                
                                
                                
                                
                                
                                9.11Options
      exercisable December 31, 2008
                                
                                
                                842,840
                                
                                
                                $
                                2.20
                                
                                
                                $
                                -
                                
                                
                                
                                8.76





45





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








A summary
of the status of non-vested options as of December 31, 2008 is presented
below:





Shares
                      
                      
                      Weighted
                        Average
                        Grant
      Date
                        Fair
      ValueNon-vested
      options beginning January 1, 2008
                      
                      
                      56,400
                      
                      
                      $
                      13.00Granted
                      
                      
                      6,875,000
                      
                      
                      
                      0.33Vested
                      
                      
                      (775,960
                      )
                      
                      
                      0.36Exercised
                      
                      
                      -
                      
                      
                      
                      -Forfeited
                      
                      
                      (643,840
                      )
                      
                      
                      0.52Non-vested
      options at December 31, 2008
                      
                      
                      5,511,600
                      
                      
                      $
                      0.34





Those
options exercisable at December 31, 2008 range in price from $0.26 to
$30.00.  The weighted average grant date fair value for options
granted for during 2008 and 2007 amounted to $0.33 and $7.94, respectively. The
total intrinsic value of options exercised during the years ended December 31,
2008 and 2007 was $0 and $32,000, respectively.




The fair
value of stock options at date of grant was estimated using the Black-Scholes
model with the following assumptions: expected volatility ranging from 76.89% to
133%, expected term of 7.0 to 10 years, risk-free interest rate ranging from
3.33% to 5.23%, and expected dividend yield of 0%. Expected volatility is based
on the historical volatilities of the Company’s common stock. The expected life
of employee stock options is determined using historical data of employee
exercises and represents the period of time that stock options are expected to
be outstanding. The risk free interest rate is based on U.S. Treasury constant
maturing for the expected life of the stock option.





During
the years ended December 31, 2008 and 2007, the Company recorded compensation
costs related to stock options of $1,086,390 and $253,592, respectively.
Historically the Company had used a 15% forfeiture rate in determining
compensation costs associated with stock option grants.  Due to the
Company’s reduction in force in October 2007, the actual forfeiture rate
significantly exceeded the 15% assumption.  As a result, during the
fourth quarter of 2007, the Company adjusted the amount of stock option
compensation expense  recorded based on actual forfeitures and reduced
the assumed future forfeiture rate on remaining unvested stock options to
0%.  The assumed future forfeiture rate of 0% was used as
approximately 90% of all unvested stock options are held by only three
employees.  The net result of these adjustments was a reduction in
stock option compensation expense during 2007 of approximately
$115,000.  Options granted during 2008 included a 15% forfeiture rte
assumption.





As of
December 31, 2008, the Company had unrecognized compensation costs of $1,122,495
related to unvested stock options, net of forecasted
forfeitures.





46


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








18.  Stock
Warrants and Derivative Liability





The
following table summarizes warrants to purchase common stock outstanding for the
two years ended December 31, 2008:




Shares
                                                        
                                                        
                                                        Range
      of
                                                          Exercise
      Price
                                                        
                                                        
                                                        Weighted
                                                          Average
                                                          Exercise
                                                          Price
                                                        
                                                        
                                                        Weighted
                                                          Average
                                                          Remaining
                                                          Contractual
                                                          LifeWarrants
      outstanding December 31, 2006
                                                        
                                                        
                                                        633,889
                                                        
                                                        
                                                        $
                                                        17.00-37.50
                                                        
                                                        
                                                        $
                                                        18.50Granted
      (in connection with issuance of Debentures)
                                                        
                                                        
                                                        443,141
                                                        
                                                        
                                                        $
                                                        9.00
                                                        
                                                        
                                                        $
                                                        9.00
                                                        
                                                        
                                                        
                                                        6.16Contractual
      modification  - Feb. 2007 (A)Additional
      warrants from contractual reset  - October 2007
    (B)
                                                        
                                                        
                                                        222,222
                                                        
                                                        
                                                        $
                                                        6.00
                                                        
                                                        
                                                        
                                                        6.00
                                                        
                                                        
                                                        
                                                        -Cancelled
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -Warrants
      outstanding December 31, 2007
                                                        
                                                        
                                                        1,299,252
                                                        
                                                        
                                                        $
                                                        6.00-37.50
                                                        
                                                        
                                                        $
                                                        8.21
                                                        
                                                        
                                                        
                                                        5.12Expired
                                                        
                                                        
                                                        (62,500
                                                        )
                                                        
                                                        $
                                                        0.35
                                                        
                                                        
                                                        $
                                                        0.35Cancelled
      in Recapitalization
                                                        
                                                        
                                                        (1,109,808
                                                        )
                                                        
                                                        $
                                                        6.00
                                                        
                                                        
                                                        $
                                                        6.00Exchanged/issued
      for cancelled warrants
                                                        
                                                        
                                                        13,298,038
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.18Issued
      in connection with Recapitalization sale of common stock
                                                        
                                                        
                                                        14,560,037
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.18Outstanding
      December 31, 2008
                                                        
                                                        
                                                        27,985,020
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        4.0








(A)
            In
      May 2006, the Company granted warrants to purchase a total of 444,444
      shares of common stock to the purchasers of the Preferred Stock at an
      initial exercise price of $17.50, which was subsequently reduced to $9.00
      in connection with the issuance of the Debentures in February 2007. The
      life of these warrants also increased from five years to seven
      years.




(B)
            See
      Note 12 regarding contractual adjustment in October 2007 to reduce the
      exercise price to $6.00 on 887,585 warrants and increase the number shares
      issuable under such warrants by an additional
  222,222.





47


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued





Evaluation
of criteria under Emerging Issues Task Force (“EITF”) Issue 00-19, “Accounting for Derivative
Instruments Indexed to and Potentially Settled in, a Company’s own
Stock,” resulted in the determination that the fair value of warrants to
purchase common stock issued in connection with the Preferred Stock, and all
other issued and outstanding warrants, should be classified as derivative
liabilities. In accordance with EITF 00-19, warrants classified as
derivative liabilities are marked to market value each reporting period with the
corresponding non-cash gain or loss reflected in the current
period.





During
the first quarter of 2008, the Company recorded a non-cash gain of $307,061
related to the decrease in value of the Company’s derivative instruments from
January 1, 2008 to January 4, 2008 when all such derivates were cancelled in
connection the Recapitalization Plan.





The
classification criteria of EITF 00-19 were evaluated in relation to the new
warrants issued in connection with the Recapitalization. Management determined
that equity classification of the warrants was appropriate. The estimated fair
value of the new warrants of $2,039,705, along with the remaining carrying value
of the old warrants of $42,044 were recorded as an increase to additional
paid-in capital.





Changes
in the derivative liability balance during 2007 comprises the
following:





Year
      Ended
                        December
      31, 2007Beginning
      balance, January 1, 2007
                      
                      $
                      3,373,676Fair
      value of derivatives (conversion feature and warrants) upon issuance of
      Debentures:Fair
      value attributed to debt discount
                      
                      $
                      7,976,532Excess
      fair value, charged to earnings
                      
                      $
                      2,445,582Total
                      
                      
                      10,422,114Increase
      due to modifications of derivative terms
                      
                      
                      5,850,960Changes
      in estimated value during the year
                      
                      
                      (19,297,645
                      )Derivative
      liability balance at December 31, 2007
                      
                      $
                      349,105





For the
year ended December 31, 2007 the gain on derivative liability comprises the
following:





Year
      Ended
                      December
      31, 2007Excess
      of fair value of derivative liability recorded upon issuance
                      of
      Debentures related to conversion feature and warrants over
                      amount
      attributed to debt discount
                    
                    $
                    (2,445,582)Modifications
      of  derivatives due to October 2007 reset
                    
                    
                    (5,850,960)Changes
      in estimated value during the year
                    
                    
                    19,297,645Net
      gain on derivative liability
                    
                    $
                    11,001,103





48


VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








19.        
Common Stock Issued and Issuable For Services





During
2008, the Company issued a total of 158,500 shares of common stock in settlement
of amounts owed for professional services.  Total expense recognized
was $47,550, with $40,000 accrued and recognized during 2007 and the remaining
$7,550 recorded during 2008.





The
Company entered into an agreement in 2006 with its investor relations firm to
issue up to 5,000 shares. The issuance of the stock was made in 2007. Total
expense recognized in connection with this agreement was $64,375 with $42,700
recorded in 2007 and the remainder recorded during 2006.




20.        
Major Customers





During
the year ended December 31, 2008, Viking had sales to three customers that
accounted for 30%, 19% and 11%, respectively, of total sales. During the year
ended December 31, 2007, Viking had sales to four customers that accounted for
20%, 14%, 11% and 10%, respectively, of total sales. These customers owed
the Company $134,000, $286,000, and $175,000 at December 31, 2008 and
210,000, $411,000, $79,000 and $3,500 at December 31, 2007.





21.        
Commitments and Contingencies





In the
normal course of business, the Company is party to a variety of agreements
pursuant to which it may be obligated to indemnify the other party. It is not
possible to predict the maximum potential amount of future payments under these
types of agreements due to the conditional nature of the Company’s obligations
and the unique facts and circumstances involved in each particular agreement.
Historically, payments made by the Company under these types of agreements have
not had a material effect on its business, results of operations or financial
condition.





In
conjunction with the conversion of $4,750,000 of convertible notes into common
stock in 2006, Viking agreed to file a registration statement covering the
shares of common stock issued upon such conversion and covering the warrants
originally issued with those notes. Such shares and warrants were not
registered. Effective June 2006, Viking offered to pay to note holders, who
elect to receive it, a registration delay fee of one percent per month of their
initial principal balance. At December 31, 2007, the Company had accrued
$434,214 related to this matter. Effective February 15, 2008, the Securities and
Exchange Commission made revisions to its rules regarding the trading of
restricted securities. Additionally, certain holders of the convertible notes
did not respond to the Company’s 2006 proposal to pay a delay fee related to
this proposed filing.  The Company has reversed amounts accrued
related to parties that did not respond to the 2006 proposal and ceased accruing
further delay fees effective February 15, 2008.  At December 31, 2008,
the Company has accrued $161,574 related to this matter.





Viking
has also entered into a royalty agreement with a medical device company. The
royalty agreement requires payments of 4% of sales that use their intellectual
property. As of December 31, 2008 and 2007, Viking had accrued royalties related
to this agreement of approximately $26,000 and $25,000, respectively. During
2008 and 2007, Viking did not pay any royalties under this
agreement.





22.         
Recent Accounting Pronouncements





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value
Measurements (“SFAS 157”). SFAS 157 defines fair value as used in numerous
accounting pronouncements, establishes a framework for measuring fair value
under U.S. GAAP, and expands disclosures related to the use of fair value
measures in financial statements. SFAS 157 does not expand the use of fair value
measurements in financial statements, but standardizes its definition and
guidance in U.S. GAAP. SFAS 157 emphasizes that fair value is a market-based
measurement and not an entity-specific measurement, based on an exchange
transaction in which the entity sells an asset or transfers a liability (exit
price). SFAS 157 establishes a fair value hierarchy from observable market data
as the highest level to an entity’s own fair value assumptions about market
participant assumptions as the lowest level. In February 2008, the FASB issued
FSP FAS 157-2, to defer the effective date of SFAS 157 for all nonfinancial
assets  and liabilities, except those items recognized or disclosed at
fair value on an annual or more frequently recurring basis, until years
beginning after November 15, 2008. The adoption of SFAS 157 for our financial
assets and liabilities as of January 1, 2008 did not have a material effect on
our financial statements. We are currently reviewing the adoption requirements
related to our nonfinancial assets and liabilities and have not yet determined
the impact, if any, on our financial position or results of
operations.


49





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities - Including an amendment to FASB Statement No.
115 (“SFAS 159”). This statement permits companies to choose to measure many
financial instruments and other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement is expected to expand the use of fair value
measurement of accounting for financial instruments. This statement applies to
all entities, including not for profit. The fair value option established by
this statement permits all entities to measure eligible items at fair value at
specified election dates. We adopted SFAS 159 as of January 1, 2008. Upon
adoption, we did not elect the fair value option for any of the eligible
financial instruments, and as such, the adoption of SFAS 159 did not have a
material effect on our condensed financial statements.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133,” (“SFAS 161”),
which requires enhanced disclosures about an entity’s derivative and hedging
activities and thereby improves the transparency of financial reporting.
Disclosing the fair values of derivative instruments and their gains and losses
in a tabular format provides a more complete picture of the location in an
entity’s financial statements of both the derivative positions existing at
period end and the effect of using derivatives during the reporting period.
Entities are required to provide enhanced disclosures about (a) how and why an
entity uses derivative instruments, (b) how derivative instruments and related
hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash flows.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008. Early adoption is permitted.
We do not expect SFAS 161 to have a material impact on our financial
statements.





In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of
Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also
requires expanded disclosure related to the determination of intangible asset
useful lives. FSP FAS 142-3 is effective for fiscal years beginning after
December 15, 2008. Earlier adoption is not permitted. We do not expect FSP FAS
142-3 to have a material impact on its financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Policies” (“SFAS 162”), which reorganizes the GAAP hierarchy. The
purpose of the new standard is to improve financial reporting by providing a
consistent framework for determining what accounting principles should be used
when preparing the U.S. GAAP financial statements. The standard is effective 60
days after the SEC’s approval of the PCAOB’s amendments to AU Section 411. The
adoption of SFAS 162 will not have an impact on our financial position or
results of operations.





In May
2008, the FASB issued FSP Accounting Principles Board Opinion (“APB”) No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”), which requires
the issuer of certain convertible debt instruments that may be settled in cash
(or other assets) on conversion to separately account for the liability (debt)
and equity (conversion option) components of the instrument in a manner that
reflects the issuer’s nonconvertible debt borrowing rate. FSP APB 14-1 will be
effective for the Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP APB 14-1 on
our  financial position, cash flows, and results of
operations.





50





VIKING
SYSTEMS, INC.


Notes
to Financial Statements


Continued








In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP
EITF 03-6-1”), which requires entities to apply the two-class method of
computing basic and diluted earnings per share for participating securities that
include awards that accrue cash dividends (whether paid or unpaid) any time
common shareholders receive dividends and those dividends do not need to be
returned to the entity if the employee forfeits the award. FSP EITF 03-6-1 will
be effective for the Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP EITF 03-6-1
on our  financial position, cash flows, and results of
operations.





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued (SFAS) No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51( “SFAS 160”).
SFAS 160 establishes accounting and reporting standards for ownership
interests in subsidiaries held by parties other than the parent, the amount of
consolidated net income attributable to the parent and to the noncontrolling
interest, changes in a parent’s ownership interest, and the valuation of
retained noncontrolling equity investments when a subsidiary is deconsolidated.
SFAS 160 also establishes disclosure requirements that clearly identify and
distinguish between the interests of the parent and the interests of the
noncontrolling owners. SFAS 160 is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2008,
with early adoption prohibited. The accounting provisions of SFAS 160 will be
effective for the Company beginning January 1, 2009. We are currently
evaluating the impact, if any, this statement will have on our financial
position, cash flows, or results of operations, but believe it is unlikely to
have a material impact.





In June
2008, the FASB ratified EITF Issue No. 07-5, “ Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity's Own Stock” (“EITF
07-5”). EITF 07-5 is effective for financial statements issued for fiscal years
beginning after December 15, 2008, andinterim periods within
those fiscal years. Early application is not permitted. Paragraph 11(a) of SFAS
No. 133 - specifies that a contract thatwould otherwise meet
the definition of a derivative but is both (a) indexed to the Company's own
stock and (b) classified in stockholders' equityin the statement of
financial position would not be considered a derivative financial instrument.
EITF 07-5 provides a new two-step model to beapplied in determining
whether a financial instrument or an embedded feature is indexed to an issuer's
own stock and thus able to qualify for theSFAS No. 133 paragraph
11(a) scope exception. We are currently
evaluating the impact of adopting EITF 07-5 on our financial position, cash
flows, and results of operations.

























51





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





None.








ITEM
9A(T). CONTROLS AND PROCEDURES





Management’s
Report on Disclosure Controls and Procedures





We seek
to improve and strengthen our control processes to ensure that all of our
controls and procedures are adequate and effective. We believe that a control
system, no matter how well designed and operated, can only provide reasonable,
not absolute, assurance that the objectives of the controls system are met. In
reaching a reasonable level of assurance, management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. In addition, the design of any system of controls also
is based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time, a control may
become inadequate because of changes in conditions, or the degree of compliance
with policies or procedures may deteriorate. No evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company will be detected.





As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Rule 13a-15(b) of 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 annual report, our disclosure controls and procedures were effective
at the reasonable assurance level discussed above.





There
were no changes in our internal controls over financial reporting identified in
connection with the evaluation required by paragraph (d) of Exchange Act Rules
13a-15 or 15d that occurred during the last quarter that have materially
affected, or are reasonably likely to materially affect our internal control
over financial reporting.





Management’s
Annual Report on Internal Control Over Financial Reporting





Our Chief
Executive Officer and our Executive Vice President and Chief Financial Officer
are responsible for establishing and maintaining adequate internal control over
financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))
for our Company. Internal control over financial reporting is a process designed
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  Our management
conducted an assessment of the effectiveness of our internal control over
financial reporting as of December 31, 2008 based on criteria established in
“Internal Control—Integrated Framework” issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Based on this assessment, our
management concluded that, as of December 31, 2008, our internal control over
financial reporting was effective.




This
annual report does not include an attestation report of our registered
independent public accounting firm regarding internal control over financial
reporting. Management’s report was not subject to attestation by our registered
independent public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.


52


ITEM
9B. OTHER INFORMATION





None.





PART
III





ITEM
10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





Identification
of Directors and Executive Officers





The
current directors and executive officers of Viking who will serve until the next
annual meeting of shareholders or until their successors are elected or
appointed and qualified, are set forth below:





Name
            Age
            PositionWilliam
      C. Bopp
            65
            Chairman
      of the Board, Chief Executive OfficerJ.
      Winder Hughes
            50
            DirectorWilliam
      Tumber
            74
            Director,
      Audit Committee and Compensation Committee ChairmanJohn
      “Jed” Kennedy
            51
            Director,
      President and Chief Operating OfficerRobert
      Mathews
            45
            Executive
      Vice President and Chief Financial
Officer





Background
information about Viking Systems’ officers and directors is as
follows:





William
C. Bopp


Effective
January 4, 2008, Mr. William C. Bopp, was appointed Chief Executive Officer of
Viking Systems, Inc. Mr. Bopp has served as Chairman of the Board since October
11, 2007. Prior to joining Viking, Mr. Bopp was a private investor. Previously,
he served as Senior Vice President and Chief Financial Officer at Alaris Medical
Systems, Inc., a developer, manufacturer and marketer of infusion devices and
related disposable products. Mr. Bopp joined Alaris in March 1999, as Vice
President and Chief Financial Officer. He was elected to the position of Senior
Vice President and Chief Financial Officer in November 1999. Alaris was acquired
for approximately $2.0 billion by Cardinal Health, Inc. in July 2004, and Mr.
Bopp assisted for an additional year with the integration of Alaris into
Cardinal Health before retiring in 2005. Mr. Bopp was formerly Executive Vice
President and Chief Financial Officer of C.R. Bard, Inc. Since 1980, he held
positions of increasing responsibility with Bard, currently a $2.0 billion
developer, manufacturer and marketer of health care products. From 1995 through
1998, he also served as a member of the board of directors of Bard and a member
of the Board’s Finance Committee. Mr. Bopp is a graduate of Harvard College,
Cambridge, MA, and completed his MBA in Finance, from the Harvard Business
School.




J.
Winder Hughes


Mr.
Hughes was appointed to our board of directors in October 2007.  Since
1995, Mr. Hughes has served as the managing partner of Hughes Capital Investors,
LLC, which manages private assets and raises money for small public
companies.  He formed the Focus Fund, LP in 2000 (with Hughes Capital as
the fund manager), which is a highly-concentrated equity partnership that
focuses on publicly-traded emerging growth companies.  From 1983 to 1995,
Mr. Hughes was an Investment Executive, first with Kidder Peabody & Co. and
subsequently with Prudential Securities.  He is a graduate of the
University of North Carolina at Chapel Hill, where he received a BA in
Economics, minor in English.





William
Tumber


Mr.
Tumber was appointed to our board of directors in February 2008.  From
2000 to 2004, Mr. Tumber served on the board of directors of Alaris Medical
Systems, Inc., a manufacturer of infusion devices and related disposables which
was acquired in 2004 for $2 billion by Cardinal Health, Inc. Previously, during
his 20 years with medical device company C. R. Bard, Inc., Mr. Tumber held
divisional positions including VP of Human Resources, VP of Manufacturing,
Division President, as well as serving as Corporate Group Vice President
responsible for all of Bard's surgical businesses. He retired from Bard in 1999.
Before joining Bard, Mr. Tumber worked at General Electric for over 20
years.  While at General Electric, he held a variety of positions of
increasing responsibility which included technical recruiting, human resources,
and Plant Manager of a 300-person electronic assembly facility.


53





John
"Jed" Kennedy


Mr.
Kennedy was appointed President and Chief Operating Officer of our Company, as
well as a member of our board of directors in October 2007.  Prior to
October 2007, Mr. Kennedy was the President of the Vision Systems Group at
Viking Systems. Mr. Kennedy joined Vista Medical Technologies, Inc. in January
1997 as Vice President of Research and Development. He was appointed Vice
President/General Manager of Westborough Operations in January 2000 before being
appointed Executive Vice President and COO in December 2000. Prior to joining
Vista Medical Technologies, Inc., Mr. Kennedy held various positions in
Manufacturing, Quality Engineering and Product Development at Smith & Nephew
Endoscopy from 1984 through January 1997. From 1996 through January 1997, he was
the Group Director of Product Development responsible for managing all
Divisional Product Development activities. From 1993 through 1996, Mr. Kennedy
was Director of Research and Development and was responsible for the management
of four technology product development groups. Prior to 1984, he held various
engineering positions at Honeywell's Electro-Optics and Avionics divisions. Mr.
Kennedy received a B.S. in Manufacturing Engineering from Boston University in
1979.





Robert
Mathews


Mr.
Mathews joined our Company as Executive Vice President and Chief Financial
Officer in June 2007.  Prior to joining our Company, he was Senior
Vice President and Chief Financial Officer at Cardinal Health’s Clinical
Technologies and Services (CTS) segment, where he was responsible for the global
finance function across all of CTS businesses from 2004 to 2005. Before joining
Cardinal Health, Mr. Mathews was with Alaris Medical System from 1996 to 2004,
where he served as Vice President of Finance, Chief Accounting Officer, and
an executive committee member. Mr. Mathews began his career at Price
Waterhouse Coopers, where he worked from 1987 to 1996.  Mr. Mathews
earned his Bachelor of Science degree from San Diego State University where he
majored in business administration with an emphasis in accounting.




Director
Independence





We
utilize the NASDAQ independence rules for determining which of our directors are
independent. The Board has determined that two of its four members are
independent pursuant to NASDAQ Rule 4200(15). The independent directors are
Messrs. Hughes and Tumber. The board of directors has an Audit Committee
comprised of Messrs. Tumber (Chair) and Hughes, both independent directors under
NASDAQ Rule 4200(15).  The Compensation Committee is comprised of
Messrs. Tumber (Chair) and Hughes, both independent directors under NASDAQ Rule
4200(15).




Other
Involvement in Certain Legal Proceedings





None of
our directors or executive officers have been involved in any
bankruptcy  or criminal proceedings, nor have there been any judgments
or injunctions brought against any of our directors or executive officers during
the last five years that we consider material to the evaluation of the ability
and integrity of any director or executive officer.





Code
of Ethics





We previously adopted a code of ethics
that applies to all officers, directors and employees of Viking , a copy of
which was filed as Exhibit 14 to Form 10-KSB for the year ended December 31,
2002.  A copy of our Code of Ethics may be viewed on our website atwww.vikingsystems.comand can be obtained free of charge by
contacting our office, c/o Viking Systems, Inc.,134 Flanders Road,Westborough, MA, 01581.





On March
28, 2008 we adopted the “Viking Systems, Inc. Code of Ethics for Financial
Professionals” that applies to our principal executive officer and all
finance and accounting employees.   This policy was filed as
Exhibit 14.1 to Form 10-KSB for the year ended December 31, 2007. We intend to
satisfy the disclosure requirements under Item 5.05 of Form 8−K regarding an
amendment to, or waiver from, a provision of  our  Code of
Ethics for Financial Professionals, if any, by posting such information on our
website.




Committees
of the Board of Directors




Our board
of directors has an audit committee and a compensation committee, each of which
has the composition and responsibilities described below:





Audit
Committee.    The audit committee provides assistance
to the board of directors in fulfilling its legal and fiduciary obligations in
matters involving our accounting, auditing, financial reporting, internal
control and legal compliance functions by approving the services performed by
our independent accountants and reviewing their reports regarding our accounting
practices and systems of internal accounting controls. The audit committee also
oversees the audit efforts of our independent accountants and takes those
actions as it deems necessary to satisfy itself that the accountants are
independent of management. The audit committee currently consists
of William Tumber (Chairman) and  J. Winder Hughes, each of whom
is an independent member of our board of directors.


54





Compensation
Committee.   The compensation committee determines
our general compensation policies and the compensation provided to our directors
and officers. The compensation committee also reviews and determines bonuses for
our officers and other employees. In addition, the compensation committee
reviews and determines equity-based compensation for our directors, officers,
employees and consultants and administers our stock option plans. The current
members of the compensation committee are William Tumber (Chairman) and J.
Winder Hughes, each of whom is an independent member of our board of
directors.





Nominating
Committee.   We do not currently have a standing
nominating committee.  The board of directors has determined that, due
to its current size, formation of a separate nominating committee would not be
an efficient use of resources.  The board intends to form a Nominating
Committee in the future.  All directors currently participate in
consideration of directors nominees.  The board will consider
suggestions from stockholders for names of possible future nominees delivered in
writing and received one hundred and twenty (120) days in advance of our Annual
Meeting of Stockholders. Such recommendations should provide all information
relating to such person that the stockholder desires to nominate that is
required to be disclosed in solicitation of proxies pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended.





Communications
with Board Members





We have
not adopted a formal process by which stockholders may communicate with the
board of directors. Until a formal process occurs, stockholders may contact our
CEO at wbopp@vikingsystems.com.





Compliance
with Section 16(a)





Section
16(a) of the Securities Exchange Act of 1934, as amended, requires our directors
and executive officers, and persons who beneficially own more than 10% of a
registered class of our equity securities, to file reports of beneficial
ownership and changes in beneficial ownership of our securities with the SEC on
Forms 3 (Initial Statement of Beneficial Ownership), 4 (Statement of Changes of
Beneficial Ownership of Securities) and 5 (Annual Statement of Beneficial
Ownership of Securities). Directors, executive officers and beneficial owners of
more than 10% of our common stock (collectively, the “Reporting Persons”) are
required by SEC regulations to furnish us with copies of all Section 16(a) forms
that they file. Based upon reports provided to us, we believe that, during the
year ended December 31, 2008, Reporting Persons met all applicable Section 16(a)
filing requirements.


55


ITEM
11. EXECUTIVE COMPENSATION




Summary
Compensation




The
following table sets forth information concerning annual and long-term
compensation provided to our Chief Executive Officer and each of the Company’s
other most highly compensated executive officers who were serving as executive
officers at December 31, 2008.  The compensation described in this
table does not include medical, group life insurance, or other benefits which
are available generally to all of our salaried employees.





Summary
Compensation Table for the Fiscal Years Ended December 31, 2008 and December 31,
2007




Name
      and Principal Position
                            Year
                            Salary
      ($)
                            Option
                              Awards
      ($) (4)
                            Bonus
      ($)
                            Total
      ($)William
      C. Bopp, Chairman and Chief
                            2008
                            32,250
                            271,192
                            0
                            303,442Executive
      Officer (1)
                            2007
                            0
                            0
                            0
                            0John
      Kennedy, President, Chief
                            2008
                            247,668
                            65,325
                            0
                            312,993Operating
      Officer and Director (2)
                            2007
                            195,700
                            123,116
                            0
                            318,816Robert
      Mathews, Executive VP and
                            2008
                            210,000
                            368,431
                            0
                            578,431Chief Financial
      Officer (3)
                            2007
                            107,423
                            34,185
                            32,226
                            173,834


______________





(1)
            Mr.
      Bopp was appointed Chairman of our board of directors on October 11,
      2007.  He was appointed to serve as our Chief Executive Officer
      on January 4, 2008.  His annual salary was set at
      $39,000.  Effective November 2, 2008, Mr. Bopp agreed to reduce
      his annual salary to $1.(2)
            Mr.
      Kennedy has served as a Director since October 11, 2007.  He was
      appointed to serve as our President and Chief Operating Officer on October
      12, 2007.  Prior to his appointment as President and Chief
      Operating Officer, Mr. Kennedy served as the President of our Vision
      Systems Group.  During 2008, Mr. Kennedy’s annual salary was
      increased to $240,000, retroactive to his promotion date of October 12,
      2007.(3)
            Mr.
      Mathews has served as our Executive Vice President and Chief Financial
      Officer since June 13, 2007.  Mr. Mathews received a base salary
      for 2007 of $210,000 on an annualized basis, with a bonus for 2007 equal
      to 30% of his salary (pro-rated for a partial year).  While
      guaranteed upon the employment of Mr. Mathews, we have not yet paid the
      prorated 2007 bonus to Mr. Mathews.(4)
            The
      amounts in this column represent the dollar amount recognized for
      financial statement reporting purposes with respect to the fiscal year in
      accordance with SFAS 123(R). These amounts may reflect options granted in
      years prior to 2007. See Note 17 of the Notes to our Financial Statements
      contained elsewhere in this annual report on Form 10-K for a discussion of
      all assumptions made by us in determining the SFAS 123(R) values of our
      equity awards.





Employment
Agreements with Our Named Executive Officers





On
January 4, 2008, we entered into an employment agreement with our Chief
Executive Officer, William C. Bopp.  Under the terms of Mr. Bopp’s
employment agreement, as amended, he will receive annual compensation of $1,
along with benefits comparable to those provided to our other
executives.  Mr. Bopp was granted a stock option under our 2008 Equity
Incentive Plan which has  a term of ten years and may be exercised to
acquire 2,100,00 shares of our common stock.   The employment
agreement is for an initial two-year term, and renews automatically, unless
terminated by either us or Mr. Bopp.





On August
6, 2008, we entered into change of control agreements with John Kennedy, our
President and Chief Operating Officer and Robert Mathews, our Executive Vice
President and Chief  Financial Officer.  The agreements,
which are substantially the same, provide each officer with certain separation
benefits in the event of a change of control of our Company. Under each
agreement, if at any time during the two year period following a change of
control, as defined in the agreement, the officer is terminated other than for
cause or if the agreement is terminated by the officer for good reason, as
defined in the agreement, the officer will receive separation pay equal to one
year’s base salary and bonus, and other health and welfare benefits for 18
months.


56





Option
Grants to Our Named Executive Officers





All
      OtherOption
                                  Awards:
                                
                                
                                
                                
                                
                                Grant
                                  Date#
      of shares
                                  underlying
                                
                                
                                Exercise
                                  Price
                                
                                
                                Fair
      Value
                                  ofName
                                
                                Grant  date
                                
                                Options(1)
                                
                                
                                ($/sh)
                                
                                
                                Award
      ($)(2)William
      C. Bopp, Chairman and Chief Executive Officer
                                
                                2/27/2008
                                
                                
                                2,100,000
                                
                                
                                
                                0.33
                                
                                
                                $
                                542,384Jed
      Kennedy, President, Chief Operating Officer and Director
                                
                                2/27/2008
                                
                                
                                1,000,000
                                
                                
                                
                                0.33
                                
                                
                                $
                                261,300Robert
      Mathews, Executive VP and Chief Financial Officer
                                
                                2/27/2008
                                
                                
                                1,000,000
                                
                                
                                
                                0.33
                                
                                
                                $
                                258,279





(1)
              Options
      expire on February 26, 2018.  Options granted to Mr. Bopp and
      Mr. Mathews were 25% vested at the grant date with 25% vesting on February
      27, 2009 and 6.25% vesting each of the eight calendar quarters March 31,
      2009 through December 31, 2010.  Stock options granted to Mr.
      Kennedy during 2008 vest 25% on February 27, 2009 and 6.25% per quarter
      beginning March 31, 2009 through December 31,
  2011.





(2)
            The
      value of an option award is based on the fair value as of the grant date
      of such award determined pursuant to SFAS 123(R). See Note 17 of the Notes
      to our Financial Statements contained elsewhere in this report on Form
      10-K for a discussion of all assumptions made by us in determining the
      SFAS 123(R) value of equity awards.








Outstanding
Equity Awards at Fiscal Year-End




The
following table sets forth information regarding outstanding equity awards held
by our named executive officers as of December 31, 2008.





Outstanding
Equity Awards at Fiscal Year-End Table for the Fiscal Year Ended December 31,
2008




Name
                                          
                                          #
      of Securities
                                            Underlying
                                            Unexercised
                                            Options
                                            (#
      exercisable)
                                          
                                          
                                          #
      of Securities
                                            Underlying
                                            Unexercised
                                            Options
                                            (#
      unexercisable)
                                          
                                          
                                          Option
                                            Exercise
                                            Price
                                            ($)
                                          
                                          
                                          Option
                                            Expiration
                                            DateWilliam
      C. Bopp, Chairman and Chief Executive Officer
                                          
                                          
                                          525,000
                                          
                                          
                                          
                                          1,575,000
                                          (1)
                                          
                                          
                                          0.33
                                          
                                          
                                          
                                          2/26/2018John
      “Jed” Kennedy, President, Chief Operating Officer and
    Director
                                          
                                          
                                          0
                                          
                                          
                                          
                                          1,000,000
                                          (1)
                                          
                                          
                                          0.33
                                          
                                          
                                          
                                          2/26/20183,000
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          17.50
                                          
                                          
                                          
                                          4/23/20082,600
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          25.00
                                          
                                          
                                          
                                          12/31/200910,000
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          20.00
                                          
                                          
                                          
                                          10/10/20162,600
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          17.50
                                          
                                          
                                          
                                          1/23/2016Robert
      Mathews, Executive VP and Chief Financial Officer
                                          
                                          
                                          250,000
                                          
                                          
                                          
                                          750,000
                                          (1)
                                          
                                          
                                          0.33
                                          
                                          
                                          
                                          2/26/2018




(1)
            See
      note 1 to table above entitled“Option Grants to Our Named
      Executive Officers”regarding vesting of these stock option
      grants.






57





Director
Compensation





The
following table sets forth information concerning  the compensation
provided to each person who served as a member of our board of directors during
the fiscal year ended December 31, 2008, other than those persons who are also
named executive officers included in the Summary Compensation Table
above.





Director
Compensation Table for the Fiscal Year Ended December 31, 2008





Name
                
                Fees
                  Earned
      or
                  Paid
      in
                  Cash
      ($)
                
                
                Stock
                  Awards
      ($)
                
                
                TotalJ.
      Winder Hughes (1)
                
                $
                16,375
                
                
                $
                -
                
                
                $
                16,375Richard
      M. Kipperman (2)
                
                $
                0
                
                
                $
                7,549
                
                
                $
                7,549William
      Tumber (3)
                
                $
                19,833
                
                
                $
                31,321
                
                
                $
                51,154


______________


(1)
            Mr.
      Hughes has served as a director of our Company since October 11,
      2007.(2)
            Mr.
      Kipperman served as a director of our Company from October 30, 2007 to
      February 27, 2008.  Effective upon Mr. Kipperman’s election to
      the board of directors, we entered into a Provisional Director Agreement
      with Mr. Kipperman, pursuant to which Mr. Kipperman was paid $20,000 for
      services provided from October 30, 2007 to November 30, 2007, after which
      time he was paid $400 per hour for services rendered.  During
      2008, we expensed $7,549 in connection with services provided by Mr.
      Kipperman and issued 8,500 shares of our common stock to Mr. Kipperman in
      lieu of a cash payment.(3)
            William
      Tumber has served as a director of our Company since February 27,
      2008.





Narrative
to Director Compensation





Non
Employee Directors’ Cash Compensation





During
2007, our directors’ cash compensation was structured as
follows:  $1,500 quarterly retainers, $3,000 for attendance at each
board meeting, $1,000 for telephonic attendance at board meetings, $500 for each
committee meeting attended and $375 for each telephonic board call that was not
an official meeting.





Effective
February 2008, our board of directors approved the following cash compensation
structure: $1,500 quarterly retainers, $3,000 for attendance at each board
meeting, $1,000 for telephonic attendance at board meetings and $500 for each
committee meeting attended.  Additionally, the Audit Committee and
Compensation Committee chairpersons will receive quarterly fees of $1,500 and
$1,000, respectively.





Effective
October 1, 2008, our outside directors agreed to suspend cash compensation
through March 31, 2009.





Non
Employee Directors’ Stock Option Awards





In April
2004, we adopted a compensation plan for our board of directors. Pursuant to the
plan, we typically grant an initial option of 20,000 shares to each non-employee
director at the time he or she was appointed a director of our Company. The
options vested one year from the date of grant. Beginning in the second year of
their term, we typically granted each non-employee director an annual option of
10,000 shares of our common stock.  No options were granted to
directors during 2007.





Under the
2008 Non-Employee Directors’ Stock Option Plan that was adopted by our board of
directors on January 3, 2008, each person who is elected or appointed to be a
non-employee director for the first time after the effective date of the
directors’ plan will be granted an option to purchase 150,000 shares of common
stock upon such election or appointment. In addition, each non-employee director
who continues to serve as a non-employee director automatically will be granted
an option to purchase 75,000 shares of common stock on April 30 of each year
commencing in 2009.   Provided, however; that if a person who is
first elected as a non-employee director after the effective date of the
directors’ plan has not been serving as a non-employee director for the entire
period since the preceding annual meeting of stockholders (or, in the event no
annual meeting was held in the preceding year, the twelve month period prior to
the April 30 annual grant date), then the number of shares subject to such
annual grant shall be reduced pro rata for each full quarter prior to the date
of grant during such period for which such person did not serve as a non-
employee director. The options will vest 100% on the one year anniversary of the
date of grant provided that the non-employee director continues to provide
services to us or one of our affiliates. Options granted under the directors'
plan will have an exercise price equal to 100% of the fair market value of the
common stock on the grant date and a term of ten years.  150,000
options were granted to directors during 2008.


58





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




Security
Ownership of Certain Beneficial Owners





The
following table sets forth information regarding shares of our common stock
beneficially owned as of March 31, 2009 by: (i) each of our officers and
directors; (ii) all officers and directors as a group; and (iii) each person
known by us to beneficially own five percent or more of the outstanding shares
of our common stock.


Name
                          
                          Common
                            Stock
                          
                          
                          Common
      Stock
                            Options
      Exercisable
                            Within
                            60
      Days
                          
                          
                          Common
      Stock
                                Purchase
                                Warrant
                              Exercisable
                            Within
      60 Days
                          
                          
                          Total
      Stock
                            and
      Stock
                            Based
                            Holdings(1)
                          
                          
                          %
                            Ownership(1)William
      C. Bopp
                          
                          
                          14,397,727
                          
                          
                          
                          1,181,250
                          
                          
                          
                          11,765,792
                          
                          
                          
                          27,344,769
                          
                          
                          
                          49.1%J.
      Winder Hughes
                          
                          
                          4,215,189
                          
                          
                          
                          -
                          
                          
                          
                          2,804,124
                          
                          
                          
                          7,019,313
                          
                          
                          
                          15.4%William
      Tumber
                          
                          
                          -
                          
                          
                          
                          150,000
                          
                          
                          
                          -
                          
                          
                          
                          150,000
                          
                          
                          
                          0.3%John
      Kennedy
                          
                          
                          -
                          
                          
                          
                          312,500
                          
                          
                          
                          -
                          
                          
                          
                          312,500
                          
                          
                          
                          0.7%Robert
      Mathews
                          
                          
                          -
                          
                          
                          
                          562,500
                          
                          
                          
                          -
                          
                          
                          
                          562,500
                          
                          
                          
                          1.3%All
      officers and directorsas
      a group ( 5 persons)
                          
                          
                          18,612,916
                          
                          
                          
                          2,206,250
                          
                          
                          
                          14,569,916
                          
                          
                          
                          35,389,082
                          
                          
                          
                          59.5%Midsummer
      Investment, LTD
                          
                          
                          8,344,620
                          
                          
                          
                          -
                          
                          
                          
                          5,551,035
                          
                          
                          
                          13,895,655
                          
                          
                          
                          28.8%CAMOFI
      Master LDC  (2)
                          
                          
                          3,521,411
                          
                          
                          
                          -
                          
                          
                          
                          1,755,150
                          
                          
                          
                          5,276,561
                          
                          
                          
                          11.9%


________________




(1)
            For
      purposes of this table “beneficial ownership” is determined in accordance
      with Rule 13d-3 under the Securities Exchange Act of 1934, pursuant to
      which a person or group of persons is deemed to have “beneficial
      ownership” of any common shares that such person or group has the right to
      acquire within 60 days after March 31, 2009. For purposes of computing the
      percentage of outstanding common shares held by each person or group of
      persons named above, any shares that such person or group has the right to
      acquire within 60 days after March 31, 2009 are deemed outstanding but are
      not deemed to be outstanding for purposes of computing the percentage
      ownership of any other person or group. As of March 31, 2009, there were
      42,715,110 shares of our common stock issued and
    outstanding.





(2)
              Does
      not include 1,055,312 shares beneficially owned by CAMHZN Master LDC
      (“CAMHZN”) comprised of 704,282 shares of common stock and 351,030 shares
      of common stock issuable upon exercise of a warrant, which, aggregated
      with the shares in the table above would total 6,331,873 shares, or
      approximately 14.2% of the common stock.  The shares held by
      CAMOFI Master LDC (“CAMOFI”) and CAMHZN may be deemed to be beneficially
      owned by Centrecourt Asset Management LLC, a Delaware limited liability
      company (“Centrecourt”), and by Richard Smithline, based upon a Schedule
      13G dated January 4, 2008, and filed with the SEC.  CAMOFI,
      CAMHZN, Centrecourt and Mr. Smith do not affirm to be a “group” as defined
      under Section 13 of the Exchange
Act.





59





Outstanding
Options and Warrants





The only
outstanding options to purchase shares of our common stock are the options
granted to our employees, directors, and consultants. We had 6,354,440
outstanding options as of March 31, 2009.





As of
March 31, 2009, we had warrants outstanding which entitle the holders to
purchase 27,985,917 shares of our common stock at prices ranging from $0.18 to
$0.75 per share.




Equity
Compensation Plan Information





The
following table summarizes information about our equity compensation plans as of
December 31, 2008.




Plan
      Category
                        
                        Number
      of Securities
                          to
      be Issued Upon
                          Exercise
      of
                          Outstanding
                          Options,
      Warrants
                          and
      Rights (a)
                        
                        
                        Weighted-Average
                          Exercise
      Price of
                          Outstanding
                          Options,
      Warrants
                          and
      Rights (b)
                        
                        
                        Number
      of Securities
                          Remaining
      Available
                          for
      Future Issuance
                          Under
      Equity
                          Compensation
                          Plans
      (Excluding
                          Securities Reflected
                          in
      Column (a)) (c)Equity
      Compensation plans approved by security holders (1)
                        
                        
                        6,320,840
                        
                        
                        $
                        0.44
                        
                        
                        
                        2,067,160Equity
      compensation plans not approved by security holders (2)
                        
                        
                        33,600
                        
                        
                        $
                        27.69
                        
                        
                        
                        -Total
                        
                        
                        6,354,440
                        
                        
                        $
                        0.58
                        
                        
                        
                        2,067,160


______________


(1)
            Amounts
      include outstanding options to employees, officers and directors under our
      2008 Equity Plan and its predecessor plan (the 2004 Stock Incentive Plan)
      and the 2008 Directors’ Plan and its predecessor plan (the 2004
      Non-Employee Director Stock Ownership Plan). The amount in column
      (c) includes 717,160 shares available for award under our
      2008 Equity Plan and its predecessor plan and 1,350,000 shares available
      for awards under our 2008 Directors’ Plan. These plans provide for grants
      and awards in the form of stock options, shares of restricted stock, and
      stock appreciation rights.





(2)
            Represents
      stock options granted to non-employee consultants outside the Company’s
      plans.








2008
Equity Incentive Plan





During
the first quarter of 2008, shareholders approved  our 2008 Equity
Incentive Plan (the “2008 Equity Plan”). The maximum number of shares that may
be issued pursuant to the 2008 Equity Plan is 6,720,000 shares plus such number
of shares that are issuable pursuant to awards outstanding under the 2004 Plan
as of the effective date and which would have otherwise reverted to the share
reserve of the 2004 Plan.  During the year ended December 31, 2008,
6,715,000 shares were issued under the 2008 Equity Plan.  Options
currently expire no later than 10 years from the grant date and generally vest
within five years. Proceeds received by us from exercises of stock options are
credited to common stock and additional paid-in capital.





All of
our key employees (and key employees of our subsidiaries and affiliates in which
we have a significant equity interest) are eligible to receive awards under the
2008 Equity Plan.  This plan permits the granting of:





·
            stock
      options, including “incentive stock options” meeting the requirements of
      Section 422 of the Internal Revenue Code and stock options that do not
      meet these requirements (options that do not meet these requirements are
      called “nonqualified stock
options”);





·
            stock
      appreciation rights, or “SARs”;





·
            restricted
      stock; and





60





·
            stock.





At
December 31, 2008, a total of 717,160 shares of our common stock were available
for granting awards under the 2008 Equity Plan. The Compensation Committee of
the board of directors administers the 2008 Equity Plan. The maximum term of any
option granted under the Plan is limited to 10 years. The exercise price per
share under any stock option or the grant price of any SAR cannot be less than
the Fair Market Value that is defined in the Plan.





We have
issued options to all employees. The number of stock options issued to our
officers and employees that remain outstanding at December 31, 2008 amounted to
6,354,440 shares.





Non-Employee
Director Plans





During
the first quarter of 2008, shareholders approved  our 2008
Non-Employee Directors’ Stock Option Plan (the “Directors’ Plan,” ). We have
reserved a total of 1,500,000 shares of our common stock for issuance under the
Directors’ Plan.  During the year ended December 31, 2008, 150,000
shares were issued under the Directors’ Plan.





Under the
Directors’ Plan, each person who is elected or appointed to be a non-employee
director for the first time after the effective date of the Directors’ Plan will
be granted an option to purchase 150,000 shares of common stock upon such
election or appointment.  In addition, each non-employee director who
continues to serve as a non-employee director automatically will be granted an
option to purchase 75,000 shares of common stock on April 30 of each year
commencing in 2009.  However, if a person who is first elected as a
non-employee director after the effective date of the Directors’ Plan has not
been serving as a non-employee director for the entire period since the
preceding annual meeting of stockholders (or, in the event no annual meeting was
held in the preceding year, the twelve month period prior to the April 30 annual
grant date), then the number of shares subject to such annual grant will be
reduced pro rata for each full quarter prior to the date of grant during such
period for which such person did not serve as a non-employee
director.  All options will vest one hundred percent (100%) on the one
year anniversary of the date of grant provided that the non-employee director
continues to provide services to us or one of our
affiliates.





Options
granted under the Directors’ Plan will have an exercise price equal to 100% of
the fair market value of the common stock on the grant date and a term of 10
years.  As long as a non-employee director continues to serve with us
or with an affiliate of ours, whether in the capacity of a director, an employee
or a consultant, the non-employee’s option will continue.  Options
will terminate three months after his or her service
terminates.  However, if such termination is due to the his or her
disability, the exercise period will be extended by 12 months unless the term of
the option expires prior to that date in accordance with the terms of the
individual’s option agreement.  If such termination is due to the
optionholder’s death or if the optionholder dies within three months after his
or her service terminates, the exercise period will be extended by 18 months
following death unless the term of the option expires prior to that date in
accordance with the terms of the individual’s option agreement.





At
December 31, 2008, 157,600 stock options were outstanding under the directors’
plans.





61


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





During
the year ended December 31, 2008, the following related party transactions
occurred:





William
C. Bopp, Chairman and CEO and Winder Hughes, member of our board of directors,
participated in our January 2008 Recapitalization Plan. Mr. Hughes’
participation was through an investment fund that he manages, the Focus
Fund.





Exchange
      Transaction Summary:
            
            Debentures
      Exchanged
            
            Common
            
            
            
            NewFace
            
            Carrying
            
            Stock
            
            Warrants
            
            WarrantsRelated
      Party
            
            Amount
            
            Value
            
            Issued
            
            Exchanged
            
            IssuedWilliam
      C. Bopp, Chairman and CEO (1)
            $
            1,400,000
            $
            259,300
            
            3,931,536
            
            3,888,889
            
            1,965,768Winder
      Hughes, Director (2)
            $
            1,000,000
            $
            247,231
            
            2,808,240
            
            2,777,777
            
            1,404,120New
      Investment Summary:
            
            
            
            CommonAmount
            
            Stock
            
            AssociatedRelated
      Party
            
            Invested
            
            Purchased
            
            WarrantsWilliam
      C. Bopp, Chairman and CEO
            $
            1,750,000
            
            9,800,024
            
            9,800,024Winder
      Hughes, Director
            $
            250,000
            
            1,400,004
            
            1,400,004











______________


(1)
            Mr.
      Bopp has served as our Chief Executive Officer since January 4,
      2008.  He was appointed Chairman of the Board on October 11,
      2007.(2)
            Mr.
      Hughes has served as a Director since October 11,
  2007.











62


ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES





Independent
Auditors




Fees
billed by Squar, Milner, Peterson, Miranda & Williamson, LLP,  and
Peterson & Co. LLP




Squar,
      Milner, Peterson, Miranda & Williamson, LLP / Peterson & Co
      LLP
                  
                  2008
                  
                  
                  2007(1)
      Audit Fees
                  
                  $
                  136,700
                  
                  
                  $
                  147,377(2)
      Tax Fees
                  
                  $
                  11,643
                  
                  
                  $
                  16,541(3)
      All Other Fees
                  
                  $
                  0
                  
                  
                  $
                  0


______________


(1)
            Audit
      fees billed to Viking by Squar, Milner, Peterson, Miranda &
      Williamson, LLP/Peterson & Co were for all professional services
      performed in connection with the audit of our annual financial statements,
      reviews of financial statements included in our Forms 10-Q for those
      periods as well as services rendered in connection with registration
      statements.(2)
            Tax
      services include fees for the preparation of federal and state tax
      returns.(3)
            Squar,
      Milner, Peterson, Miranda & Williamson, LLP/Peterson & Co.,
      LLP did not bill us for other services during 2008 and
      2007.





All audit
and non-audit services and fees are pre-approved by the Audit Committee or by
the Chairman of the Audit Committee pursuant to delegated
authority.




Effective
May 6, 2003, the Securities and Exchange Commission adopted rules that require
that before independent auditors are engaged by us to render any auditing or
permitted non-audit related service, the engagement be:





●
            approved
      by our Audit Committee; or





●
            entered
      into pursuant to pre-approval policies and procedures established by the
      Audit Committee, provided the policies and procedures are detailed as to
      the particular service, the Audit Committee is informed of each service,
      and such policies and procedures do not include delegation of the Audit
      Committee’s responsibilities to
management.





Under the
direction of our Audit Committee Chairman our Audit Committee pre-approves all
services provided by our independent auditors. All of the above services and
fees were reviewed and approved by the Audit Committee either before or after
the respective services were rendered. The Audit Committee has considered the
nature and amount of fees billed by Squar, Milner, Peterson, Miranda and
Williamson,, LLP/ Peterson and  & Co., LLP and believes that the
provision of services for activities unrelated to the audit is compatible with
maintaining the firm’s independence.


63


ITEM 15.  EXHIBITS.




Number
                                                  Description of Exhibits3.1
                                                  Certificate
      of Incorporation dated June 8, 2006 (included as Exhibit 3.1 to the
      Registrant's Annual Report on Form 10-KSB for the fiscal year ended
      December 31, 2007, and incorporated herein by
  reference).3.2
                                                  Bylaws
      (included as Exhibit 3.3 to the Registrant's Annual Report on Form 10-KSB
      for the fiscal year ended December 31, 2007, and incorporated herein by
      reference).4.1
                                                  Certificate
      of Preferences, Rights and Limitations of Series B Variable Dividend
      Convertible Preferred Stock (included as Exhibit 4.01 to the Form 8-K
      filed May 25, 2006, and incorporated herein by
  reference).10.1
                                                  Stock
      Incentive Plan, dated March 31, 2004 (included as Exhibit 10.1 to the Form
      8-K filed April 1, 2004, and incorporated herein by
      reference).10.2
                                                  2004
      Non-Employee Director Stock Ownership Plan dated December 29, 2005
      (included as Exhibit 10.2 to the Form 8-K filed April 1, 2004, and
      incorporated herein by reference).10.3
                                                  Employment
      Agreement between the Company and John Kennedy, dated October 10, 2005
      (included as Exhibit 10.3 to the Form 8-K filed October 27, 2005, and
      incorporated herein by reference).10.4
                                                  Independent
      Sales Agent Agreement between the Company and Platinum Medical Inc., dated
      November 21, 2006 (included as Exhibit 10.17 to the Registrant's Annual
      Report on Form 10-KSB for the fiscal year ended December 31, 2006, and
      incorporated herein by reference).10.5
                                                  Lease
      between the Company and Robert F. Tambone as Trustee of MAT Realty Trust,
      dated September 23, 2004 (included as Exhibit 10.1 to the Form 8-K filed
      October 1, 2004, and incorporated herein by reference).10.6
                                                  First
      Amendment to Lease between the Company and Robert F. Tambone as Trustee of
      MAT Realty Trust, dated February 5, 2007 (included as exhibit 10.18 to the
      Registrant's Annual Report on Form 10-KSB for the fiscal year ended
      December 31, 2006, and incorporated herein by
  reference).10.7
                                                  Securities
      Purchase Agreement between the Company and various investors, dated
      February 23, 2007 (included as Exhibit 10.1 to the Form 8-K filed February
      27, 2007, and incorporated herein by reference).10.8
                                                  Amendment
      to Securities Purchase Agreement between the Company and various
      investors, dated July 19, 2007 (included as Exhibit 10.11 to the Form 8-K
      filed August 2, 2007, and incorporated herein by
    reference).10.9
                                                  Securities
      Purchase Agreement between the Company and various investors, dated July
      31, 2007 (included as Exhibit 10.1 to the Form 8-K filed August 2, 2007,
      and incorporated herein by reference).10.10
                                                  Registration
      Rights Agreement between the Company and various investors, dated February
      23, 2007 (included as Exhibit 10.1 to the Form 8-K filed February 27,
      2007, and incorporated herein by reference).10.11
                                                  Amendment
      No. 1 to Registration Rights Agreement between the Company and various
      investors, dated July 19, 2007 (included as Exhibit 10.7 to the Form 8-K
      filed August 2, 2007, and incorporated herein by
    reference).10.12
                                                  Common
      Stock Purchase Warrant, dated February 23, 2007 (included as Exhibit 10.4
      to the Form 8-K filed February 27, 2007, and incorporated herein by
      reference).10.13
                                                  8%
      Secured Convertible Debenture, dated July 31, 2007 (included as Exhibit
      10.2 to the Form 8-K filed August 2, 2007, and incorporated herein by
      reference).10.14
                                                  Consent,
      Waiver and Amendment Agreement, dated February 23, 2007 (included as
      Exhibit 10.6 to the Form 8-K filed February 27, 2007, and incorporated
      herein by reference).10.15
                                                  Revised
      Consent, Waiver and Amendment Agreement, dated July 22, 2007 (included as
      Exhibit 10.10 to the Form 8-K filed August 2, 2007, and incorporate herein
      by reference).10.16
                                                  Consent,
      Waiver and Amendment Agreement, dated July 19, 2007 (included as Exhibit
      10.6 to the Form 8-K filed August 2, 2007, and incorporated herein by
      reference).10.17
                                                  Security
      Agreement between the Company and various investors, dated February 23,
      2007 (included as Exhibit 10.5 to the Form 8-K filed February 27, 2007,
      and incorporated herein by reference).10.18
                                                  Amendment
      No. 1 to Security Agreement between the Company and various investors,
      dated July 19, 2007 (included as Exhibit 10.2 to the Form 8-K filed August
      2, 2007, and incorporated herein by
reference).





64




10.19
            Recapitalization
      Agreement between the Company and Securityholders, dated December 31, 2007
      (included as exhibit 99.1 to the Form 8-K filed January 7, 2008, and
      incorporated herein by reference).10.20
            Securities
      Purchase Agreement between the Company and various investors, dated
      January 4, 2008 (included as Exhibit 99.2 to the Form 8-K filed January 7,
      2008, and incorporated herein by reference).10.21
            Executive
      Employment Agreement between the Company and William C. Bopp, dated
      January 4, 2008 (included as Exhibit 99.3 to the Form 8-K filed January 7,
      2008, and incorporated herein by reference).10.22
            Amendment
      to Executive Employment Agreement between the Company and William C. Bopp,
      dated February 27, 2008 (included as Exhibit 99.2 to the Form 8-K filed
      February 29, 2008, and incorporated herein by
  reference)..14.1
            Code
      of Ethics Regarding Financial Professionals (included as exhibit 14.1 to
      the Registrant's Annual Report on Form 10-KSB for the fiscal year ended
      December 31, 2007, and incorporated herein by
  reference).31.1
            Certification
      of the Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002 (incorporated herein).31.2
            Certification
      of the Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002 (incorporated herein).32.1
            Certification
      of the Chief Executive Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 (incorporated herein).32.2
            Certification
      of the Chief Financial Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 (incorporated
  herein).






65





SIGNATURES







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





Viking
      Systems, Inc.Dated:
      April 15, 2009
            By: /s/ William C.
      BoppChief
      Executive Officer(Principal
      Executive Officer)Dated:
      April 15, 2009
            By:   
      /s/ Robert
      MathewsExecutive
      Vice President and
              Chief
      Financial Officer
              (Principal
      Financial Officer)




In
accordance with the Securities Exchange Act, this report has been signed below
by the following persons on behalf of Viking Systems and in the capacities and
on the dates indicated.





Signature
            Capacity
            Date/s/
      William C. Bopp
            Chief
      Executive Officer
              and
      Chairman of the Board of Directors
            April
      15, 2009/s/
      Robert Mathews
            Executive
      Vice President
              and
      Chief Financial Officer
            April
      15, 2009/s/
      John Kennedy
            Director,
      President
              and
      Chief Operating Officer
            April
      15, 2009/s/
      J. Winder Hughes, III
            Director
            April
      15, 2009/s/
      William
      Tumber
            Director
            April
      15, 2009







66