U.S.
SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-KSB





ý ANNUAL REPORT PURSUANT
TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934


For the
fiscal year ended December 31, 2007


OR


 ̈ TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934


Commission
file number 000-49636





VIKING SYSTEMS,
INC.


(Name of
Small Business Issuer as specified in its charter)





Delaware
            
            86-0913802(State
      or other jurisdiction of
            
            (I.R.S.
      employerincorporation
      or organization
            
            identification
      No.)





134
Flanders Road,


Westborough,
MA, 01581


(Address
of principal executive offices)





Issuer’s
telephone number, including area code:(508)
366-3668





Securities
registered pursuant to Section 12(b) of the Exchange Act: None





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


$.001 Par
Value Common Stock





Check
whether the Issuer (1) has filed all reports required to be filed by Section 13
or 15(d) of the Exchange Act 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. (1) Yes ý No  ̈





Check if
there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of Issuer’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB  ̈.





The
Issuer’s revenues for the fiscal year ended December 31, 2007 were $8,466,203.





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


Yes  ̈ No ý





As of
March 23, 2008, there were 42,556,610 shares of the Issuer's common stock issued
and outstanding of which 26,957,536 were held by affiliates. The aggregate
market value of the 26,957,536 shares of voting common stock held by
non-affiliates of the Issuer based on the closing price on March 23, 2008 was
$8,087,261.





DOCUMENTS
INCORPORATED BY REFERENCE: NONE








TABLE OF
CONTENTS





PagePART
      I
            1Item
      1. Description of Business
            8Item
      2. Description of Property
            8Item
      3. Legal Proceedings
            8Item
      4. Submission of Matters to a Vote of Security Holders
            8PART
      II
            9Item
      5. Market for the Registrant’s Common Equity and Related Stockholder
      Matters and Small Business Issuer Purchases of Equity
      Securities
            9Item
      6. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            11Item
      7. Financial Statements
            19Item
      8. Changes In and Disagreements with Accountants on Accounting and
      Financial Disclosure
            45Item
      8A. Controls and Procedures
            45Item
      8B. Other Information
            46PART
      III
            46Item
      9. Directors, Executive Officers, Promoters, Control Persons and Corporate
      Governance; Compliance with Section 16(a) of the Exchange
    Act
            46Item
      10. Executive Compensation
            49Item
      11. Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters
            52Item
      12. Certain Relationships and Related Transactions and Director
      Independence
            53Item
      13. Exhibits
            54Item
      14. Principal Accountant Fees and Services
            55




i


PART
I





ITEM
1. DESCRIPTION OF BUSINESS





General





Viking
Systems, Inc. (the  “Company” or “ Viking”) is a leading worldwide
developer, manufacturer and marketer of visualization solutions for complex
minimally invasive surgery.  Viking partners 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 (the “3Di
System”)  under the Viking brand to hospitals and outpatient surgical
centers through a network of independent sales representatives in the United
States and outside the United States through our distributor
network.  We also sell our CardioCam 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.





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






As of
December 31, 2007, we believe more than 100 proprietary visualization systems
were in service worldwide.  Moreover, we have sold more than 1300 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.




The base
price of our products range from $20,000 to $150,000 for Viking branded products
and from $100 to $15,000 for products targeted for the OEM 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, 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
      a 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 (“LRP”), laparoscopic bariatric surgery, laparoscopic
      pyeloplasty, laparoscopic pelvic floor reconstruction and laparoscopic
      hysterectomy;





·
            In
      2006, 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;





·
            Added  significant
      ODM/OEM partners such as, Biomet and Boston
  Scientific;




1




·
            Launched
      a 3 dimensional display product configuration compatible with the
      Intuitive Surgical da Vinci robotic system enabling the tableside
      assistant the same 3 dimensional view as the primary
    surgeon;




·
              Launched
      a high definition endoscopic video system in December of 2007 for the
      ODM/OEM marketplace; and
  ·
                Launched
      CardioCam, a 2D, 7 millimeter tubular camera, at the Society of Thoracic
      Surgeons annual meeting in January
2008.
 PRODUCT
AND TECHNOLOGY OVERVIEW





Viking’s
two primary product lines are the 3Di Systems sold through independent sales
representatives and our distributor network 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 are critically dependent on the surgical
team having both the correct surgical skills and the most conducive surgical
environment. Viking’s 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.





·
            InfomatixTM- Information 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.





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





·
            Camera -The 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
      Viking’s InfomatixTMtechnology, which provides 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 which
      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 - Viking’s
      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.





·
            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.




2


Visualization
Solutions for OEM Customers





Viking is
also the strategic visualization supplier of 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,
Viking intends to introduce new products, services and capabilities to respond
to this important business segment. Viking is committed to the growth of its OEM
business and believes its engineering capabilities and advanced technologies
make it an ideal partner of choice for companies operating in this
sector.





BUSINESS
AND COMPETITIVE ADVANTAGES





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





Viking
believes its technology is at the forefront of advanced 3D visualization
solutions for complex minimally invasive surgeries. As minimally invasive
surgeries rapidly 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.
Viking believes that there are currently no comparable FDA-cleared 3D
visualization systems on the market. Although the robotic technologies provided
by companies such as Intuitive Surgical, Inc. (“Intuitive Surgical”), with its
proprietary da Vinci system, incorporate 3D vision capabilities into their
systems, Viking’s products are not in direct competition with these products.
Rather, Viking’s strategy is to offer standalone 3D vision capability at a base
price of $100,000 to $150,000.





Significant
Clinical and Workflow Benefits Associated with Improved Surgical
Visualization.





The 3Di
System provides the surgical team significant clinical and workflow benefits not
currently available from 2D visualization systems. Viking’s 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 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 the 3Di System Expand the 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 Viking’s 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
Provides Product for Cardiac Market





The
CardioCam is a unique product targeted 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 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
grown significantly. 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 2006 and 2007 ODM/OEM sales accounted
for approximately $3,800,000 and $5,500,000 in revenue,
respectively.





MARKET
OPPORTUNITY





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 Viking 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 the 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.





Viking’s
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 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.





Viking’s
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 1400 systems
per year, assuming 5% penetration. Currently, this represents a market
opportunity of approximately $100 million annually.




Viking’s
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


3Di
MARKET AND BUSINESS DEVELOPMENT PLAN





Within
the limits of our current cash flow, the elements of our market development plan
include:




·
            Increasing
      the size of Viking’s sales and marketing organization in both domestic and
      international markets;


·
            Executing
      a strategy to develop the awareness and clinical evidence to drive
      adoption in the targeted market segments;
and


·
            Identifying
      companion technologies and technological enhancements to facilitate the
      use of our technology.





SALES
AND MARKETING





Viking’s
global sales and marketing effort is designed to drive adoption and to develop a
premium Viking branded image for our products. Viking is focused 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 focused our sales within our financial
resources.  Our direct sales force in the United States was eliminated
to conserve cash.  In the United States, we are developing a network
of independent representatives managed by a long-service senior sales
executive.  This group develops customer contacts, demonstrates
equipment and follows up on sales made by Viking to assure customer
satisfaction.  These efforts are supported by technical resources from
our Westborough, MA headquarters manufacturing facility.





Outside
the U.S., 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, 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. Viking’s marketing objective is to create
premium brand recognition for our solutions, which 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 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 Viking believes it can address the
      visualization requirements for most urological
  procedures.





OEM
MARKET DEVELOPMENT





The trend
of converting open surgical procedures to minimally invasive techniques is
anticipated to 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 Viking is 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.





OPERATIONS





Our
product development, production and engineering functions are managed in our
Westborough, Massachusetts headquarters facility by Jed Kennedy, President and
COO, who oversees a staff of 20 full-time employees, one part-time employee and
a part-time consultant. These personnel provide Viking production capability,
product development, quality assurance, regulatory affairs management and
technical sales support.





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. Viking outsources 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.





5


Viking
utilizes sole source component technology from Matsushita Electric Industrial
Co., Ltd. (Panasonic), Toshiba Teli Corporation, Ltd. and Creative Display
Systems, LLC. Viking maintains 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 Viking is 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. Viking’s 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
planned upgrade of our enterprise planning software and information technology
infrastructure, the current systems and facilities will accommodate the growth
projected for the next several years. Our Westborough facility is ISO 13485
certified and FDA compliant.





PRODUCT
DEVELOPMENT





Viking’s
product development priorities include supporting the development phase of new
OEM customer programs, supporting the clinical expansion process, upgrading and
enhancing Viking’s core platform products, and developing new products to expand
the product line. Viking is dedicated to providing the highest quality and best
video image on the market, in addition to delivering that image in 3D. The
following initiatives are most important to our product development
roadmap.





For the
OEM market, we are developing improved 2D HD (high definition) products to
enhance image quality.  We are also doing development work under an
engineering services contract that we anticipate will provide about $500,000 of
development revenue, primarily in 2008, and which has the potential to develop
into a multi-year supply agreement.  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.  Although there can be no
assurances, we believe the first production order will call for initial
deliveries in the third quarter of 2008.





In the
“Viking” brand product line, we have the following initiatives:





We will
focus on enhancing and optimizing the 3Di system and the CardioCam system
already in the market.  We also intend to evaluate the technologies
available and develop 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.





INTELLECTUAL
PROPERTY





Viking’s
technology base was built through internal research and development and by
license and acquisition. Viking holds fourteen patents and non-exclusive license
rights to four U.S. patents and four international patents.




QUALITY
ASSURANCE AND REGULATORY AFFAIRS





All
medical devices developed by Viking are regulated by the FDA in the U.S. 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
U.S. via 510(k) number K021290 on June 28, 2002.





Viking’s
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, there are three full-time
employees performing quality control functions. Also,  to comply with
quality requirements, Viking relies on its suppliers’ quality systems and ISO
registrations as well as historical data to support Viking’s material
acceptance.





6


The
following criteria are used to prioritize and guide the decision making process
in Viking’s 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.





Viking’s
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 2007 and resulted
in a recommendation that we maintain our certification.




Governmental
Regulation: Medical Devices




Our
business plan calls for us to engage in the business of marketing 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.




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.




7


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.





Foreign Requirements. Sales
of medical device products outside the United States are 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 the
date of this Form 10-KSB, we have 28 full time 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
2. DESCRIPTION OF PROPERTY





We lease
one facility incorporating approximately 17,850 square feet 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, $246,000 and $184,000 in 2008, 2009
and 2010, respectively. We believe we will be able to obtain additional space,
as needed, on commercially reasonable terms.





ITEM
3. LEGAL PROCEEDINGS





We are
not a party to any legal proceedings.





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





On
November 19, 2007, stockholders representing a majority of the shares of common
stock eligible to vote executed a written consent approving a 1 for 50 reverse
stock split of our common stock.  715,672 shares of common stock
(adjusted retroactively for the reverse split), or approximately 51.2%, were
voted in favor of authorization of the reverse stock split.




8





PART
II





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





During
2006 and 2007 our common stock was quoted on the OTC “Bulletin Board” under the
symbol “VKSY.OB”. Effective January 7, 2008, in connection with a 1 for 50
reverse stock split, the symbol was changed to “VKNG.OB”.  During the
last three years, there has only been limited trading in our common stock. 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.  Prices are adjusted for the January 2008 1
for 50 reverse stock split.





High Bid
            
            Low BidFiscal
      Year Ended December 31, 2006First
      Quarter
            $25.50
            
            $15.00Second
      Quarter
            $27.50
            
            $12.50Third
      Quarter
            $25.00
            
            $12.50Fourth
      Quarter
            $15.00
            
            $  3.50Fiscal
      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 Ending December 31, 2008First
      Quarter
            $0.80
            
            $0.25Through
      March 23, 2008





Shares
Issued in Unregistered Transactions





We issued
shares of our common stock in unregistered transactions during the last three
fiscal years. 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”). The shares of common stock issued were
as follows (all common share and related price data are adjusted for the January
2008 1 for 50 reverse stock split) :





In May
2005, we issued 375 shares of our common stock, at $10.00 per share, to our
non-employee directors, as compensation.





In August
2005, we issued 4,000 shares of our common stock to a company as part of our
agreement with them to be our investor relations firm.





In August
2005, we issued an additional 400 shares of our common stock to another company
as part of our investor relations agreement.





In March
2005, we issued 25,833 shares of our common stock at $20.00 per share, to Donald
Tucker (former chairman and CEO) as he converted a Convertible Secured Note
Payable of $500,000 and interest in the amount of $16,660





In August
2005, we issued 50,000 shares of our common stock, at $10.00 per share, to
Donald Tucker (former chairman and  CEO) as he converted a Convertible
Secured Note Payable of $500,000.





In May
2006, we issued 527,777 shares at $9.00 per share of our common stock to
convertible note holders who converted $4,750,000 in convertible
notes.




9


In
February 2007, we issued 80,000 common shares to our Series B preferred stock
holders in conjunction with a waiver, consent and amendment
agreement.




In
several transactions during 2007, we issued 24,591 shares of common stock in
connection with the conversion of 211 shares of our Series B Preferred stock
plus accrued but unpaid dividends on the stock that was
converted.
  In July
2007, we issued 47,790 shares of common stock as payment for interest and
liquidated damages on our convertible debt.
  In
October 2007, we issued 5,000 shares to a firm as partial compensation for
public and investor relations services.





Holders





As of
March 23, 2008, there were 42,556,610 shares of common stock outstanding and
approximately 125 stockholders of record of 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.





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.





Purchases
of Equity Securities by the Small Business Issuer and Affiliated
Purchasers





None





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  separate section of this report
commencing on Page 52.





Limitation
on Directors’ Liability, Charter Provisions and Other Matters





We are a
Delaware corporation. Our Certificate of Incorporation provides to the fullest
extent permitted under Section 145 of the General Corporation Law of the State
of Delaware, that our directors or officers shall not be personally liable to us
or our shareholders for damages for breach of such director’s or officer’s
fiduciary duty. The effect of this provision of our Certificate of Incorporation
is to eliminate our rights and our shareholders’ rights (through shareholders’
derivative suits on behalf of our company) to recover damages against a director
or officer for breach of the fiduciary duty of care as a director or officer
(including breaches resulting from negligent or grossly negligent behavior),
except under certain situations defined by statute. We believe that the
indemnification provisions in our Certificate of Incorporation, as amended, are
necessary to attract and retain qualified persons as directors and
officers.




Our
Bylaws also provide that the Board of Directors may also authorize us to
indemnify our employees or agents, and to advance the reasonable expenses of
such persons, to the same extent, following the same determinations, and upon
the same conditions as are required for the indemnification of, and advancement
of, expenses to our directors and officers. As of the date of this filing, the
Board of Directors has not extended indemnification rights to persons other than
directors and officers.





Insofar
as indemnification for liabilities arising under the Securities Act of 1933 may
be permitted to directors, officers or persons controlling us pursuant to the
foregoing provisions, or otherwise, we have been advised that in the opinion of
the Securities and Exchange Commission, such indemnification is against public
policy as expressed in the Securities Act of 1933 and is, therefore,
unenforceable.





Our
transfer agent is Fidelity Transfer Company, 8915 South 700 East, Suite 102,
Sandy Utah 84070. Their telephone number is (801) 562-1300.





10





ITEM
6. 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 Form 10-KSB Report. This
Management’s Discussion and Analysis of Financial Condition and Results of
Operations contains descriptions of Viking’s expectations regarding future
trends affecting our business. These forward-looking statements and other
forward-looking statements made elsewhere in this document 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





Viking is
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
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 to hospitals and outpatient surgical centers through a network of
independent sales representatives in the United States and outside the United
States through our distributor network.  We also sell our CardioCam
product through these channels.





Liquidity
and Capital Resources





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 Debentues) 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, of which Viking received net proceeds of
$2,600,000.





In
October 2007, Viking’s board of directors  approved a revised
strategic direction for Viking.  This strategy includes focus on
Viking’s Original Development Manufacturing (“ODM”)/Original Equipment
Manufacturing (“OEM”) business and significantly reducing the expenses
associated with our 3Di Vision Systems business with such business continuing on
a reduced basis through Viking’s independent sales representatives and our
existing distributor network.





Viking
believes that this revised strategic direction enables it to eliminate expenses,
primarily associated with the 3Di Vision Systems business, that are not expected
to contribute to positive cash flow in the near
term.  Viking has initiated several cost cutting measures aimed at
eliminating expenses, including a significant reduction in force including the
elimination of Viking’s U.S. direct sales force and a reduction in related
clinical and marketing expenses.  Due to the recapitalization and the
revised business strategy, Viking believes it now has the financial structure to
operate the company and execute its business plan for 2008.  Viking
may need additional capital to pursue future growth opportunities.





11





We
financed our operations principally through private sales of equity securities
and convertible debt. From January 1, 2004 through December 31, 2007, we have
raised net proceeds of $8,150,000 through the sale of common and preferred stock
in private placements and approximately $13,600,000 through the issuance of
convertible debentures. As of December 31, 2007, we had cash of
$317,098.





Net cash
used in operating activities was $6,792,845 and $6,275,842 during the years
ended December 31, 2007 and 2006, respectively. The increase in net cash used in
operating activities during 2007 compared with 2006 was attributable primarily
to a larger operating loss in 2007 and cash consumed in increasing our
inventories in response to the growth in Viking's business.





Net cash
used in investing activities was $737,796 and $911,067 during the years ended
December 31, 2007 and 2006, respectively. The lower level of cash used in
investing activities in 2007 was primarily attributable to higher purchases of
demonstration equipment of our 3Di product line in support of our sales and
marketing efforts during 2006.





Net cash
provided by financing activities was $7,407,274 and $7,192,871 during the years
ended December 31, 2007 and 2006, respectively. The net cash provided by
financing activities in 2007 was primarily from the $7,275,000 in proceeds
received from issuance of the Debentures. The net cash provided by financing
activities in 2006 primarily consisted of $7,250,000 in net proceeds from
issuance of the Preferred Stock.





In March
of 2006, Viking issued a $200,000 note payable to our then President and CEO,
who was also a significant shareholder, and in April 2006 we received $250,000
from the issuance of a short term convertible note payable. These loans were
obtained for the purpose of bridging our cash position until our issuance of the
Preferred Stock in May 2006.





In May,
2006 Viking issued 8,000 shares of Preferred Stock for gross proceeds of
$8,000,000, and incurred approximately $436,143 in issuance costs, which are
recorded as a discount to the carrying value 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.





During
December 2006, we issued a $350,000 promissory note to one of our investors and
in January 2007, we issued a $300,000 promissory note to our then CEO who was
also a significant shareholder and Director. The promissory notes were converted
into the Debentures issued in February 2007, as described below.





In
February 2007, we issued $5,376,533 of the Debentures to 13
purchasers.  Viking issued an additional $2,600,000 in Debentures in
July 2007 to 4 purchasers with substantially the same terms as the February 2007
Debentures.





Increases
in expenses or delays in product development or failure to achieve our sales
projections may adversely impact our cash position and may require us to seek
additional financing. There can be no assurance that such financing will be
available on acceptable terms, or at all. We do not have any arrangements with
any bank or financial institution to secure 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.





Results
of Operations





Sales.  Viking
had product sales from operations of approximately $8,466,000 for the year ended
December 31, 2007 and of approximately $5,617,000 for the year ended December
31, 2006, representing an increase of approximately 51%. The increase in
revenues during 2007 was due to increased sales in both 3Di and OEM products and
service. Systems related sales increased approximately $1,159,000 and OEM
related sales increased approximately $1,690,000. 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. Gross profit was approximately $1,867,000 or 22% for the year
ended December 31, 2007 and approximately $1,705,000 or 30% for the year ended
December 31, 2006, representing an increase of approximately $162,000. The
increase in the 2007 gross profit was due to higher sales.  The
decrease in gross margin percentage as compared with 2006 was due to a sales mix
during 2007 of lower margin products.





Operating
Expenses.  We incurred operating expenses of approximately
$9,401,000 for the year ended December 31, 2007 and approximately $8,542,000 for
the year ended December 31, 2006, representing an increase of approximately
$859,000. During the first nine months of 2007, operating expenses increased
approximately $1,419,000 as compared with the first nine months of
2006.  During the fourth quarter of 2007, we implemented cost
reductions thereby decreasing the full year 2007 operating expense increase to
$859,000. The full year increase in operating expenses primarily relates to the
efforts prior to the cost reductions to develop market awareness of our
products, build a direct sales organization and pursue an
acquisition.





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
approximately $3,104,000 for the year ended December 31, 2007 and approximately
$2,485,000 for the year ended December 31, 2006, representing an increase of
approximately $619,000.  The increase is primarily due to increased
legal expense.  Legal expense for the year included approximately
$400,000 of costs associated with the proposed acquisition of Tuebingen
Scientific that we were unable to complete and approximately $110,000 related to
the recapitalization activities.  We currently anticipate our general
and administrative expense, excluding non-cash stock based compensation charges,
to be in the range of $500,000 to $600,000, per quarter during
2008.





12


Sales and
Marketing Expense. Sales and marketing expenses were approximately
$4,323,000 for the year ended December 31, 2007 and approximately $4,545,000 for
the year ended December 31, 2006.  Due to reductions in our marketing
efforts and the elimination in October 2007 of our 3Di direct sales force, we
currently anticipate our sales and marketing expense to be in the range of
$400,000 to $500,000 per quarter in 2008.





Research and
Development Expense.  We had research and development expenses
of approximately $1,974,000 for the year ended December 31, 2007 and $1,512,000
for the year ended December 31, 2006, representing an increase of approximately
$462,000. The year-over-year increase is primarily due to hiring of additional
engineering personnel to support new development projects, the development of
the HD generation of the 3Di system, including the new Personal Head Display
(“PHD”) which was launched in May 2007 and the development of our 2D HD OEM
product.  We currently anticipate our research and development expense
to be in the range of $300,000 to $400,000 per quarter during 2008.





Other Income and
Expenses.  Interest expense amounted to approximately $947,000
for the year ended December 31, 2007 compared with $551,000 for the year ended
December 31, 2006. 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.   Interest expense was higher for 2007 as compared with
2006 due to higher average debt balances in 2007 due to the issuance of
debentures in February and July of 2007.





We had a
$4,975,824 gain on the extinguishment of debt during 2006. We had no similar
gain during 2007. The gain on extinguishment of debt resulted from the
modification of convertible notes in 2006.  The gain represents the
difference between the deemed reacquisition value of the convertible notes on
the date conversion terms were modified in 2006 ($5,250,000) less the fair value
of the modification of the warrants issued under the new conversion terms
($274,176).





We had
non-cash amortization of debt discount of approximately $2,193,000 for the year
ended December 31, 2007 related to the discount recorded on the debentures
issued during 2007.   This compares with approximately $8,481,000
of debt discount amortization for 2006. The amount for 2006 includes $5,250,000
in non-cash expense representing the deemed reacquisition value of convertible
notes due to modification of their conversion terms which was amortized over the
extended life of the convertible notes during 2006.





We also
had accrued liquidated damages in the amount of approximately $1,163,000 for the
year ended December 31, 2007 compared with approximately $840,000 for the year
ended December 31, 2006.  The 2006 amount represents the value of the
common stock issued to the holders of Preferred Stock as consideration for the
failure to timely register all of the common stock underlying the convertible
Preferred Stock during 2006.  The 2007 amount represents 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 approximately $11,001,000 for the year ended December 31, 2007
compared with an approximate $2,968,000 gain during 2006. The valuation of our
derivative liabilities relates to the estimated value of outstanding derivative
instruments (warrants and the conversion feature of the
Debentures).   During 2007, the gain on derivative was comprised
of 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 the Company’s common stock at
December 31, 2007.





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.





13





Contractual
Obligations and Commitments





We are
obligated under an operating lease for the Westborough, MA facility through
September 30, 2010. Under this lease we are committed to make payments totaling
approximately $246,000, $246,000 and $184,000 in 2008, 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 th their intellectual property. As of December
31, 2007 and 2006, we had accrued royalties related to this agreement of
approximately $25,429 and $19,027, respectively. During 2007 and 2006, we did
not pay any royalties under this agreement.





Plan
of Operation





Our
current business plan is described in “Item 1 - Description of
Business”





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, stock based compensation and derivative
liabilities. 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.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.





Income Taxes.In determining the carrying value of Viking's net deferred tax assets,
Viking 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, Viking
may record a reduction in the valuation allowance, resulting in an income tax
benefit in Viking's 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 the Company's 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, 2007, 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, 2007 and 2006, no impairment of long-lived
assets was recorded.





14


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, Viking measures the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the award.
That cost is recognized over the period during which an employee is required to
provide service in exchange for the award - the requisite service period. We
determine the grant-date fair value of employee share options using the
Black-Scholes option-pricing model.





Valuation of
Derivative Liabilities. At each balance sheet date, the fair value
of all warrants and other derivative liabilities are remeasured, and any changes
in the fair value are recorded as a gain or loss on derivatives in the statement
of operations. We estimate the value of the derivatives using the Black-Scholes
option pricing model.  Utilization of this model requires use of
assumptions including volatility and discount rates.  We use the
historical volatility rates of our common stock and the risk free interest rate
is based on U.S. Treasury constant maturing for the expected life of the
derivative.





Recent
Accounting Pronouncements




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. The Company is
currently evaluating the impact, if any, this statement will have on its
financial position, cash flows, or results of operations,but believe it is
unlikely to have a material impact.




In
December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standards (SFAS) No. 141R (revised), “Business Combinations”. The
standard changes the accounting for business combinations including the
measurement of acquirer shares issued in consideration for a business
combination, the recognition of contingent consideration, the accounting for
pre-acquisition gain and loss contingencies, the recognition of capitalized
in-process research and development, the accounting for acquisition-related
restructuring cost accruals, the treatment of acquisition related transaction
costs and the recognition of changes in the acquirer’s income tax valuation
allowance. SFAS 141R is effective for fiscal years beginning after
December 15, 2008, with early adoption prohibited. The Company is currently
evaluating the impact, if any, this statement will have on its financial
position, cash flows, or results of operations, but believe it is unlikely to
have a material impact..




On
February 15, 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial
Accounting Standards( SFAS) No. 159, “ The Fair Value Option for Financial
Assets and Financial Liabilities”. SFAS No. 159 permits all
entities to choose, at specified election dates, to measure eligible items at
fair value (the “fair value option”). A business entity shall report unrealized
gains and losses on items for which the fair value option has been elected in
earnings, or another performance indicator if the business entity does not
report earnings, at each subsequent reporting date. Upfront costs and fees
related to items for which the fair value option is elected shall be recognized
in earnings as incurred and not deferred. SFAS No. 159 is effective for
fiscal years beginning after November 15, 2007, with early adoption
permitted. The accounting provisions of SFAS No. 159 will be effective for
the Company beginning January 1, 2008. The Company is currently evaluating
the impact of adopting SFAS 157 but does not believe that the adoption of
SFAS 157 will have a material impact on its financial position, cash flows,
or results of operations.




15


In
September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standards (SFAS) No. 157, “ Fair Value Measurements.”
This Statement defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles (GAAP), and
expands disclosures about fair value measurements. This Statement applies in
those instances where other accounting pronouncements that require or
permit fair value measurements, the board of directors having previously
concluded in those accounting pronouncements that fair value is the relevant
measurement attribute. Accordingly, this statement does not require any new fair
value measurements. However, for some entities, the application of this
Statement will change current practice. We are required to adopt SFAS 157 no
later than the fiscal year beginning after November 15, 2007. The
accounting provisions of SFAS No. 157 will be effective for the Company
beginning January 1, 2008. The Company is currently evaluating the impact
of adopting SFAS 157 but does not believe that the adoption of
SFAS 157 will have a material impact on its financial position, cash flows,
or results of operations.





Interest Rate
Risk





At
December 31, 2007 we had outstanding debentures that accrued interest at a fixed
rate. In January 2008, the debentures were exchanged for common stock as part of
our recapitalization.





Inflation





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





Forward
Outlook and Risks




This Form
10-KSB contains and incorporates by reference certain “forward-looking
statements” within the meaning of Section 27A of the Securities Act and Section
21E of the Exchange Act with respect to results of our operations and
businesses. All statements, other than statements of historical facts, included
in this Form 10-KSB, 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. Because
forward-looking statements involve risks and uncertainties, our actual results
could differ materially. Important factors that could cause actual results to
differ materially from our expectations are disclosed hereunder and elsewhere in
this Form 10-KSB. These forward-looking statements represent our judgment as of
the date of this Form 10-KSB. All subsequent written and oral forward-looking
statements attributable to Viking are expressly qualified in their entirety by
the Cautionary Statements. We disclaim, however, any intent or obligation to
update our forward-looking statements.





Operating
History. We were inactive in 2002 and 2003. We commenced active
operations by acquiring assets from Vista in April 2004, and 2005 was our first
full year of operation. Potential investors should be aware that there is only a
limited basis upon which to evaluate our prospects for achieving our intended
business objectives. We have limited resources and have had limited revenues
since our formation.





Possibility of
Total Loss of Investment. An investment in Viking is an extremely high
risk investment, and should not be made unless the investor has no need for
current income from the invested funds and unless the investor can afford a
total loss of his or her investment.





Additional
Financing Requirements. It is possible that we will be required to seek
additional financing in order to fund our operations and carry out our business
plan. There can be no assurance that such financing will be available on
acceptable terms, or at all. We do not have any arrangements with any bank or
financial institution to secure 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.





We are Controlled
by a Limited Number of Stockholders.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 23, 2008, our directors and
executive officers as a whole, may beneficially own approximately 18,612,916
shares or  43.7% of our outstanding common stock, and assuming that
the warrants and options (exercisable as of 60 days from March 23, 2008) were
exercised, may beneficially own approximately 33,957,832 shares
or  58.6% of our outstanding common stock.  Certain of our
officers and directors disclaim beneficial ownership of certain shares included
in the description above.





16


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.




SEC Rules
Governing the Trading of "penny stocks" Limit the Trading and Liquidity of our
Common Stock, which may Adversely Affect the Trading Price of our Common
Stock.Our
common stock currently trades on the OTC Bulletin Board. Since our common stock
continues to trade below $5.00 per share, our common stock is considered a
“penny stock” and is subject to SEC rules and regulations that impose
limitations upon the manner in which our shares can be publicly traded. These
regulations require the delivery, prior to any transaction involving a penny
stock, of a disclosure document explaining the penny stock market and the
associated risks. Under these regulations, brokers who recommend penny stocks to
persons other than established customers or certain accredited investors must
make a special written suitability determination for the purchaser and receive
the purchaser’s written agreement to a transaction prior to sale. These
regulations have the effect of limiting the trading activity of our common stock
and reducing the liquidity of an investment in our common stock.





Limited Public
Market for Securities. There is a limited public market for our common
stock and we can give no assurance that a more active market will develop, or if
developed, that it will be sustained.





Auditor’s Opinion
has a Going Concern Qualification. The report of our independent
registered public accounting firm dated March 31, 2008 for the year ended
December 31, 2007 includes a going concern explanatory paragraph which
states that our significant operating losses and negative operating cash
flows raise substantial doubt about our ability to continue as a going
concern.





Medical
Products Industry Operations Risks





We
acquired assets and operations from Vista as described in Item 1 above. We also
may attempt to acquire additional medical products and operations from time to
time as opportunities become available. Our operations in the medical product
industry subject us to various risks which include, but are not limited, to the
following:





We Operate in a
Competitive Market. The market for medical products and services is
competitive and new offerings and technologies are becoming available
regularly. We cannot guarantee that we will compete successfully against
our potential competitors, especially those with significantly greater financial
resources or brand name recognition.





If We Fail to
Retain Key Personnel and Hire, Train and Retain Additional Qualified and
Experienced Employees, We May Not Be Able to Compete Effectively.Our future success will
depend to a large extent on retaining our employees and recruiting sufficient
qualified employees to fill vacancies created by attrition or expansion of our
operations.  There is a highly competitive labor market for such staff and
there is no assurance that we will be able to attract and retain an adequate
number of suitable employees.





We Are Subject To
Significant Domestic and International Regulation and May Not Be Able To Obtain
Necessary Regulatory Clearances to Sell Our Products. We sell medical
devices.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.




17


We Expect to
Encounter Rapid Technological Change and Significant Competition.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.




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.











18





ITEM 7. FINANCIAL
STATEMENTS





Index
to Financial Statements





PageReport
      of Independent Registered Public Accounting Firm
            20Balance
      Sheets at December 31, 2007 and 2006
            21Statements
      of Operations for the years ended December 31, 2007 and
    2006
            22Statements
      of Stockholders’ Deficit for the years ended December 31, 2007 and
      2006
            23Statements
      of Cash Flows for the years ended December 31, 2007 and
    2006
            24Notes
      to Financial Statements
            26





19




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, 2007 and 2006, and the related statements of operations,
stockholders’ 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, 2007 and 2006, 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 3 to the financial
statements, the Company has incurred significant recurring net losses
and negative cash flows from operating activities through December 31,
2007.  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 3. 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


March 31,
2008




20


VIKING
SYSTEMS, INC.


Balance
Sheets


December
31, 2007 and 2006








Assets2007
            
            
            2006Current
      assets:Cash
      and cash equivalents
            
            $
            317,098
            
            
            $
            440,465Accounts
      receivable
            
            
            1,371,913
            
            
            
            855,299Inventories
            
            
            1,816,621
            
            
            
            1,117,929Prepaid
      expenses
            
            
            64,324
            
            
            
            34,208Other
      current assets
            
            
            108,512
            
            
            
            72,535Total
      current assets
            
            
            3,678,468
            
            
            
            2,520,436Property
      and equipment, net
            
            
            583,372
            
            
            
            594,402Other
      non-current assets
            
            
            127,500
            
            
            
            -Intangible
      assets, net
            
            
            280,000
            
            
            
            350,000Total
      assets
            
            $
            4,669,340
            
            
            $
            3,464,838Liabilities
      and Stockholders' DeficitCurrent
      liabilities:Accounts
      payable
            
            $
            1,828,831
            
            
            $
            1,037,334Accrued
      expenses
            
            
            2,662,687
            
            
            
            1,780,302Deferred
      revenue
            
            
            232,331
            
            
            
            100,181Capital
      lease obligations - current
            
            
            38,541
            
            
            
            36,649Notes
      payable
            
            
            -
            
            
            
            350,000Convertible
      debentures, related party net
            
            
            506,531
            
            
            
            -Convertible
      debentures, net
            
            
            1,637,707
            
            
            
            -Derivative
      liability
            
            
            349,105
            
            
            
            3,373,676Total
      current liabilities
            
            
            7,255,733
            
            
            
            6,678,142Capital
      lease obligations
            
            
            35,364
            
            
            
            77,253Commitments
      and contingencies (Notes 14 and 20)Preferred
      Stock, 25,000,000 shares authorized
              Series
      B redeemable preferred stock, $0.001 par value; 7,789, and 8,000 shares
      outstanding at December 31, 2007 and 2006,respectively
      (aggregate liquidation preference of  $8,814,241 at December 31,
      2007 and $8,391,014 at December  31, 2006)
            
            
            8,814,241
            
            
            
            8,391,014Stockholders’
      Deficit:Common
      stock, $.001 par value, 400,000,000 shares authorized;1,398,681
      and 1,237,299  issued and outstanding at December 31, 2007
      and
              2006,
      respectively
            
            
            1,399
            
            
            
            1,237Additional
      paid-in capital
            
            
            8,034,205
            
            
            
            6,865,504Accumulated
      deficit
            
            
            (19,471,602
            )
            
            
            (18,548,312
            )Total
      stockholders' deficit
            
            
            (11,435,998
            )
            
            
            (11,681,571
            )Total
      liabilities and stockholders' deficit
            
            $
            4,669,340
            
            
            $
            3,464,838








21


VIKING
SYSTEMS, INC.


Statements
of Operations


Years
Ended December 31, 2007 and 2006







2007
            
            
            2006Sales,
      net
            
            $
            8,466,203
            
            
            $
            5,617,253Cost
      of sales
            
            
            6,598,756
            
            
            
            3,912,044Gross
      profit
            
            
            1,867,447
            
            
            
            1,705,209Operating
      expenses:General
      and administrative
            
            
            3,103,763
            
            
            
            2,485,297Selling
      and marketing
            
            
            4,322,681
            
            
            
            4,544,986Research
      and development
            
            
            1,974,457
            
            
            
            1,511,723Total
      operating expenses
            
            
            9,400,901
            
            
            
            8,542,006Operating
      loss
            
            
            (7,533,454
            )
            
            
            (6,836,797
            )Other
      income (expense):Interest
      income
            
            
            45,664
            
            
            
            61,162Interest
      expense
            
            
            (946,978
            )
            
            
            (551,099
            )Gain
      on extinguishment of debt
            
            
            -
            
            
            
            4,975,824Amortization
      of debt discount and debt issuance costs
            
            
            (2,193,469
            )
            
            
            (8,480,878
            )Accrued
      liquidated damages
            
            
            (1,162,864
            )
            
            
            (840,000
            )Loss
      on disposal of property and equipment
            
            
            (133,292
            )
            
            
            -Gain
      on derivative liability
            
            
            11,001,103
            
            
            
            2,967,616Net
      loss
            
            
            (923,290
            )
            
            
            (8,704,172
            )Accretion
      of Series B Redeemable Preferred Stock to redemptionvalue
      including accrued dividend
            
            
            (643,289
            )
            
            
            (8,391,014
            )Net
      loss applicable to common shareholders
            
            $
            (1,566,579
            )
            
            $
            (17,095,186
            )Net
      loss per commonshare - basic and diluted
            
            $
            (1.17
            )
            
            $
            (16.65
            )Weighted
      average shares outstanding - basic and diluted
            
            
            1,342,503
            
            
            
            1,026,451















22




VIKING
SYSTEMS, INC.


Statements
of Stockholders’ Deficit


Years
Ended December 31, 2007 and 2006







Common
    Stock
            
            
            Additional
              Paid-in
            
            
            AccumulatedShares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            TotalBalance
      December 31, 2005
            
            
            690,581
            
            
            $
            691
            
            
            $
            8,129,551
            
            
            $
            (9,844,140
            )
            
            $
            (1,713,898
            )Issuance
      of common stock to related party for conversion of note
      payable
            
            
            50,000
            
            
            
            50
            
            
            
            449,950
            
            
            
            -
            
            
            
            450,000Issuance
      of common stock for conversion of note payable
            
            
            477,778
            
            
            
            478
            
            
            
            4,299,522
            
            
            
            -
            
            
            
            4,300,000Beneficial
      conversion feature from issuance of convertible notes
            
            
            -
            
            
            
            -
            
            
            
            250,000
            
            
            
            -
            
            
            
            250,000Accretion
      of preferred stock to redemption value
            
            
            -
            
            
            
            -
            
            
            
            (8,391,014
            )
            
            
            -
            
            
            
            (8,391,014
            )Reclassification
      of previous outstanding warrants
              to
      a derivative liability
            
            
            -
            
            
            
            -
            
            
            
            (2,751,242
            )
            
            
            -
            
            
            
            (2,751,242
            )Modification
      of warrant terms
            
            
            -
            
            
            
            -
            
            
            
            274,176
            
            
            
            -
            
            
            
            274,176Beneficial
      conversion feature on issuance of preferred stock
            
            
            -
            
            
            
            -
            
            
            
            3,973,808
            
            
            
            -
            
            
            
            3,973,808Exercise
      of stock options by former officer
            
            
            16,740
            
            
            
            16
            
            
            
            (16
            )
            
            
            -
            
            
            
            -Stock-based
      compensation
            
            
            -
            
            
            
            -
            
            
            
            586,776
            
            
            
            -
            
            
            
            586,776Issuance
      of stock for services
            
            
            2,200
            
            
            
            2
            
            
            
            43,993
            
            
            
            -
            
            
            
            43,995Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (8,704,172
            )
            
            
            (8,704,172
            )Balance
      December 31, 2006
            
            
            1,237,299
            
            
            $
            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
            
            
            1,398,681
            
            
            $
            1,399
            
            
            $
            8,034,205
            
            
            $
            (19,471,602
            )
            
            $
            (11,435,998
            )








23


VIKING
SYSTEMS, INC.


Statement
of Cash Flows


Years
Ended December 31, 2007 and 2006







2007
            
            
            2006Cash
      flows from operating activities:Net
      loss
            
            $
            (923,290
            )
            
            $
            (8,704,172
            )Adjustment
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
            
            
            548,625
            
            
            
            396,013Common
      stock and stock options issued for services
            
            
            21,675
            
            
            
            44,041Common
      stock issued for payment of Debenture interest and liquidated
      damages
            
            
            430,123
            
            
            
            -Stock-based
      compensation expense
            
            
            253,592
            
            
            
            586,776Amortization
      of debt discount and debt issuance costs
            
            
            2,193,469
            
            
            
            8,480,878Loss
      on disposal of property and equipment
            
            
            133,292
            
            
            
            -Gain
      on extinguishment of debt
            
            
            -
            
            
            
            (4,975,824
            )Gain
      on derivative liability
            
            
            (11,001,103
            )
            
            
            (2,967,616
            )Change in operating assets and liabilities:Accounts
      receivable
            
            
            (516,615
            )
            
            
            (607,041
            )Inventories
            
            
            (561,783
            )
            
            
            (478,780
            )Prepaids
      and other current assets
            
            
            (66,093
            )
            
            
            (23,806
            )Accounts
      payable
            
            
            791,497
            
            
            
            521,553Accrued
      expenses
            
            
            1,771,616
            
            
            
            1,351,955Deferred
      revenue
            
            
            132,150
            
            
            
            100,181Net
      cash used in operating activities
            
            
            (6,792,845
            )
            
            
            (6,275,842
            )Cash
      flows from investing activities:Purchases
      of property and equipment
            
            
            (737,796
            )
            
            
            (561,067
            )Purchase
      of intangible assets
            
            
            -
            
            
            
            (350,000
            )Net
      cash used in investing activities
            
            
            (737,796
            )
            
            
            (911,067
            )Cash
      flows from financing activities:Net
      change in short-term bank borrowings
            
            
            -
            
            
            
            (211,200
            )Proceeds
      from issuance of preferred stock
            
            
            -
            
            
            
            7,250,000Proceeds
      from notes payable
            
            
            -
            
            
            
            350,000Payments
      on related party notes
            
            
            -
            
            
            
            (200,000
            )Proceeds
      from exercise of stock options
            
            
            4,000
            
            
            
            -Proceeds
      from issuance of convertible debt
            
            
            7,275,000
            
            
            
            250,000Proceeds
      from issuance of related-party note payable
            
            
            300,000
            
            
            
            200,000Payments
      for debt and stock issue costs
            
            
            (131,729
            )
            
            
            (436,142
            )Payments
      on capital leases
            
            
            (39,997
            )
            
            
            (9,787
            )Net
      cash provided by financing activities
            
            
            7,407,274
            
            
            
            7,192,871Net
      (decrease) increase in cash and cash equivalents
            
            
            (123,367
            )
            
            
            5,962Cash
      and cash equivalents at beginning of year
            
            
            440,465
            
            
            
            434,503Cash
      and cash equivalents at end of year
            
            $
            317,098
            
            
            $
            440,465Supplemental
      disclosure of cash flow information:Cash
      paid during the period for:Interest
            
            $
            179,612
            
            
            $
            345,385Income
      taxes
            
            $
            1,791
            
            
            $
            1,300




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


24


VIKING
SYSTEMS, INC.


Statement
of Cash Flows


Continued


Non-cash,
investing and financing activities:





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.




During
theyear
ended December 31, 2006, the Company:





●
            
            Converted
      $4,300,000 of convertible notes payable into 477,778 shares of common
      stock.●
            
            Converted
      $450,000 of convertible notes payable held by Donald Tucker, at the time a
      significant shareholder and our  President and Chief Executive
      Officer, into 50,000 shares of common stock.●
            
            Converted
      $750,000 of convertible notes payable into 750 shares of Series B
      Preferred stock.●
            
            Issued
      16,740 shares of common stock pursuant to a cashless exercise of 20,000
      non-qualified stock options issued in December 2003.●
            
            Acquired
      computer equipment and software through capital leases in the amount of
      $123,639.●
            
            Increase
      in liquidation preference of Series B Redeemable Preferred Stock of
      $391,014 through accretion of
dividend.








25




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 Systems, 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 us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenue and
expenses. We base our estimates on historical experience and on various other
assumptions that we believe 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.





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 Debentues) 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, of which Viking received net
proceeds of $2,600,000.   See Note 22 for further information
regarding the Recapitalization Plan including unaudited pro forma financial
data.





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.




26


VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 2.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.





Financial
Instruments


The
Company’s financial instruments consist primarily of cash, accounts receivable,
accounts payable, and notes payable. These financial instruments are stated at
their respective carrying values, which approximate their fair
values.





Concentration
Risk


Financial
instruments which potentially subject Viking  to concentration of
credit risk consist primarily of trade receivables. 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  maintains
its cash in bank deposit accounts which, at times, may exceed federally insured
limits. Viking  has not experienced any losses in such accounts and
believes it is not exposed to any significant credit risk on 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,
2007 and 2006, 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.




27




VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 
  2.Summary of Significant Accounting
Policies(Continued)
 
 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. 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, 2007 and 2006, 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.
 
 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
 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.
 
 Advertising
Costs
 Advertising
costs are expensed as incurred. For the years ended December 31, 2007 and 2006,
advertising expense was $41,059 and $35,375 respectively.
 
 Shipping
and Handling Costs
 Shipping
and handling costs are classified as selling and marketing
expenses.
  28
  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.
 
 Common
stock equivalents are not included in the diluted earnings per share calculation
when their effect is antidilutive. For 2007, 1,067,534 shares issuable upon
conversion of the Preferred Series B shares, 1,329,422 shares issuable upon
conversion of the Convertible Debentures and 1,397,692 shares issuable upon
exercise of stock options and warrants were excluded from the weighted average
shares calculation because their effect was anti-dilutive. For 2006, 888,889
shares issuable upon conversion of the Preferred Series B shares and 773,400
shares issuable upon exercise of stock options and warrants were excluded from
the weighted average shares calculation because their effect was
anti-dilutive.
 
 Stock-Based
Compensation
 On
January 1, 2006 the Company 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, the
Company measures the cost of employee services received in exchange for an award
of equity instruments based on the grant-date fair value of the award. That cost
is recognized over the period during which an employee is required to provide
service in exchange for the award - the requisite service period. The Company
determines the grant-date fair value of employee share options using the
Black-Scholes option-pricing model.
 
 Under the
modified prospective approach, SFAS 123R applies to new awards and to awards
that were outstanding on January 1, 2006 that are subsequently modified,
repurchased or cancelled. Under the modified prospective approach, compensation
cost recognized during the year ended December 31, 2006 includes compensation
cost for all share-based payments granted prior to, but not yet vested on,
January 1, 2006, based on the grant-date fair value estimated in accordance with
the pro forma provisions of SFAS 123, and compensation cost for all share-based
payments granted subsequent to January 1, 2006, based on the grant-date fair
value estimated in accordance with the provisions of SFAS 123R. Prior periods
were not restated to reflect the impact of adopting the new
standard.
  29
 VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 2.Summary of Significant
Accounting Policies (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.
  3.Going
Concern
 
 The
accompanying financial statements have been prepared under the assumption that
Viking will continue as a going concern. Such assumption contemplates the
realization of assets and satisfaction of liabilities in the normal course of
business. As shown in the accompanying financial statements, Viking
has incurred recurring net losses totaling approximately $19.5 million
through December 31, 2007, and has incurred net cash outflows from operating
activities during the years ended December 31, 2007 and 2006 of approximately
$6.8 million and $6.3 miilion, respectively.  These factors raise
substantial doubt about Viking’s ability to continue as a going concern. The
financial statements do not include any adjustments that might be necessary
should Viking be unable to continue as a going concern.
 
 Viking’s  continuation
as a going concern is dependent upon its ability to generate sufficient cash
flow to meet its obligations on a timely basis, to obtain additional financing
as may be required, and ultimately to attain profitability.  The
Company completed the execution of its Recapitalization Plan in January 2008(See
Note 22).  Viking may need  to obtain additional financing
through the sale of equity securities and/or the issuance debt, if needed. There
can be no assurance that such financing will be available on acceptable terms,
or at all.
 
 4.Inventories
 
 Inventories
consist of the following at December 31:
  2007
                
                
                2006Inventories:Parts
      and supplies
                
                $
                992,338
                
                
                $
                558,669Work-in-progress
                
                
                548,268
                
                
                
                344,483Finished
      goods
                
                
                439,855
                
                
                
                310,559Valuation
      reserve
                
                
                (163,840
                )
                
                
                (95,782
                )$
                1,816,621
                
                
                $
                1,117,929
  5.Property and
Equipment
 
 Property
and equipment consists of the following at December 31:
  2007
                  
                  
                  2006Equipment
                  
                  $
                  994,918
                  
                  
                  $
                  1,091,931Furniture
      and fixtures
                  
                  
                  142,587
                  
                  
                  
                  57,0231,137,505
                  
                  
                  
                  1,148,954Less
      accumulated depreciation
                  
                  
                  (554,133
                  )
                  
                  
                  (554,552
                  )$
                  583,372
                  
                  
                  $
                  594,402
 30
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Depreciation
expense was $478,625 and $396,012 for the years ended December 31, 2007 and
2006, respectively.  During 2007, the Company disposed of certain
fixed assets with a cost of approximately $566,000 and accumulated depreciation
of $433,000, resulting in a loss of approximately $133,000.
  6.Other Non-current
Assets
 
 Other
non-current assets consists of the following at December 31:
  2007
                
                
                2006Debt
      issuance costs, net
                
                $
                80,738
                
                
                $
                -Deferred
      stock issuance costs
                
                
                46,762
                
                
                
                -$
                127,500
                
                
                $
                -
  7.Intangible
Assets
 
 Intangible
assets consist of the following at December 31:
 
 2007
                
                
                2006Patents
      and other assets
                
                $
                350,000
                
                
                $
                350,000Less
      accumulated amortization
                
                
                (70,000
                )
                
                
                -$
                280,000
                
                
                $
                350,000
 
 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.
 
 8.Accrued
expenses
 
 Accrued
expenses consist of the following at December 31:
 
 2007
                
                
                2006Wages
      and salaries
                
                $
                388,382
                
                
                $
                352,390Liquidated
      damages
                
                
                849,178
                
                
                
                840,000Registration
      delay fees
                
                
                434,214
                
                
                
                192,300Board
      of director fees
                
                
                251,100
                
                
                
                151,625Interest
      on unpaid preferred dividends
                
                
                121,589
                
                
                
                -Debenture
      interest
                
                
                302,306
                
                
                
                -Other
      accrued expenses
                
                
                315,918
                
                
                
                243,987$
                2,662,687
                
                
                $
                1,780,302
  Accrued expenses of
$1,273,073 at December 31, 2007 were eliminated on January 4, 2008 in connection
with the Recapitalization. See Note 22.
  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 have not been 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 and 2006 we had accrued $434,214 and $192,300,
respectively, related to this matter.
  31
 VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 
  9.Deferred
Revenue
 
 As of
December 31, 2007 and 2006, Viking Systems had deferred revenue of $232,331 and
$100,181, 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.
 
 10.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 $15,300 and $5,100 for the years ended December 31, 2007 and 2006,
respectively.  As of December 31, 2007, the future minimum capital
lease payments are as follows:
  2008
                
                $
                41,2172009
                
                
                36,365Total
      minimum lease payments
                
                
                77,582Amount
      representing interest
                
                
                (3,677
                )Present
      value of minimum lease payments
                
                $
                73,905
 
 11.Notes and
Debentures
  Promissory
Notes
 During
January 2007, we issued a $300,000 promissory note to Donald Tucker, our then
President and Chief Executive Officer who was also at the time a significant
shareholder and one of our directors. 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 (See
Note 22).
 
 Debentures
 In
February 2007, we 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.  We refer to these debentures, collectively, as the
“Debentures.”  The general terms of the Debentures were as
follows:
 
 Maturity
Date.  The Debentures were due February 28, 2009, subject to
acceleration rights which holders had in the event of default.
 
 Interest
Rate.  Eight percent per annum, payable quarterly and, subject
to certain conditions, we could pay interest by issuing shares of our common
stock.
 
 Security.  The
Debentures were secured by all of the assets of Viking.
 
 Optional
Redemption.  We were not permitted to prepay the Debentures,
but we could redeem some or all of them if certain conditions are
met.  If we redeemed the Debentures before the first anniversary date
of their issuance, the holders were entitled to be paid an amount equal to 120%
of the principal amount of the Debentures being redeemed.  If we
redeemed the debentures after the first anniversary date of their issuance but
before the second anniversary date of their issuance, the holders were entitled
to be paid an amount equal to 140% of the principal amount of the Debentures
being redeemed. The Debentures were not optionally redeemed.
  Warrants.  As
additional consideration, we issued to the purchasers of the Debentures,
warrants to purchase shares of our common stock at an initial exercise price of
$9.00 per share. In October 2007, the exercise price was reduced to $6.00 per
share. The warrants had an expiration date of  February 23,
2014.  The warrants provided that each holder was able to purchase
that number of shares of common stock that equals 50% of the number of shares of
common stock issuable upon conversion of the Debentures prior to
adjustments.
  32
 VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Registration
Rights.  We agreed to register with the Commission the shares
of common stock issuable upon the conversion of the Debentures and exercise of
the warrants.  We agreed to pay all expenses and cost of registration
except for commissions. We failed to meet our registration obligations, and
under the terms of the operative agreements we 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.
 
 Optional Conversion by
Investors.  The holder of each Debenture had the option to
convert the Debenture into shares of our common stock.
 
 Reset of Conversion
Price.  In October 2007 we determined we 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 loss on derivatives of
$5,850,960.  See Note 17.
 
 The
following table sets forth the effect 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 is classified as a
current liability at December 31, 2007.  We 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.  We did not receive notice of default from any holders of
the debentures.  See Note 22 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.
  33
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Included
in the Debentures is 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 and are considered related parties.
 
 The
recorded discount is being accreted as interest expense using the effective
interest method over the term of the Debentures. The carrying value of the
Debentures will accrete 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 has been calculated as follows:
 
 Convertible
      Debentures
                
                
                Convetible
                  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
  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 (See Note 22).
  Convertible
Notes Payable
 
 During
2005 Viking Systems entered into a securities purchase agreement for the
issuance of convertible debentures in the amount of $5,850,000. The notes bore
interest at 10%, matured on March 21, 2006 and were convertible into the
Company’s common stock, at the holders’ option, at $10.00 per share. In
connection with the notes, the Company issued 143,750 warrants to the
investors.  On April 22, 2006, the holders of convertible notes with
an aggregate principal balance of $4,750,000 agreed to extend the term of the
notes until May 31, 2006, and to convert the notes into common shares at $9.00
per share, instead of $10.00. The Company and note holders agreed to modify
certain terms of convertible notes totaling $5,250,000. The revised conversion
terms were sufficiently different from the initial conversion terms of the
notes, requiring the Company to account for the change in conversion terms as a
substantial modification of terms in accordance with EITF Issue No. 96-19,
“Debtor’s Accounting and
Modification on Exchange of Debt Instruments”.
 
 The
original notes converted into common stock at a rate of $10.00 per share with
25% warrant coverage with warrants to purchase common stock exercisable at
$20.00 per share. The new terms provided conversion into common stock at $9.00
per share and 25% warrant coverage with warrants to purchase common stock
exercisable at $17.50 per share. As a result, the Company recorded a $4,975,824
gain on debt extinguishment, the difference between the deemed reacquisition
value of the convertible notes on the date the conversion terms were modified
($5,250,000) less the fair value of the modification of the warrants issued
under the new conversion terms ($274,176). Upon conversion of $4,750,000 in
convertible notes, the Company issued 527,778 shares of common stock and 133,889
warrants to purchase shares of common stock.
 
 Concurrent
with the closing of the Series B Preferred Stock transaction, noteholders
converted $5,500,000 of debt into equity instruments: $4,750,000 of the notes
were converted into 527,778 shares of common stock and $750,000 of the notes
were converted into 750 shares of Series B Preferred Stock.
 
 In April
2006, the Company received $250,000 through the issuance of a convertible
note.  The note accrued interest at 10% per annum and was unsecured. In May
2006, the noteholder converted the note into 250 shares of Series B Preferred
Stock. In connection with the issuance of this note, the Company recorded debt
discount and additional paid in capital in the amount of $250,000 based on the
intrinsic value of the beneficial conversion feature. The entire discount amount
was amortized as other expense during the three months ended June 30,
2006.
  34
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 12.Preferred
Stock
 
 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 11 regarding changes to conversion and exercise prices in
October 2007.
 
 The
Company recorded the redeemable convertible preferred stock as mezzanine equity
on the accompanying balance sheet in accordance with the provisions of Emerging
Issues Task Force (“EITF”) Topic D-98: Classification and Measurement of
Redeemable Securities (“EITF Topic D-98”).
 
 In
accordance with EITF Issue No. 98-5Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios, and EITF Issue No. 00-27 Application of Issue No. 98-5 to
Certain Convertible Instruments, proceeds from the issuance of the
Preferred Stock were allocated to the fair value of warrants issued in
connection with the issuance of the Preferred Stock, and to the intrinsic value
of the beneficial conversion feature (“BCF”), based on their respective relative
fair values. Based on this allocation, the fair value of the warrants totaling
$3,590,050 was recorded as a discount to preferred stock and an increase to
warrant derivative liability, and the intrinsic value of the BCF totaling
$3,973,808 was recorded as a discount to preferred stock and as additional paid
in capital.
 
 The
following table summarizes the valuation of the Series B Preferred for the
years ended December 31, 2006 and 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.
 
 Following
is a summary of the Preferred Stock rights, preferences and privileges prior to
the Recapitalization:
 
 Dividends. Holders of
the Preferred Stock (each a “Holder”) were entitled to receive cumulative
dividends at the rate per share of (i) up to and including May 22, 2009, 8% per
annum, (ii) from May 22, 2009 through and including May 22, 2010, 11% per annum,
and (iii) after May 22, 2011, 14% per annum. Dividends were payable in cash or
shares of Viking Systems common stock, or a combination thereof.
 
 Voting Rights. The
holders of the Preferred Stock had no voting rights unless required under
applicable state corporate law.
 
 Liquidation. Upon any
liquidation, dissolution, or winding-up of Viking, whether voluntary or
involuntary (a “Liquidation”), the holders of Preferred Stock were entitled to
receive out of the assets, whether capital or surplus, of Viking an amount equal
to the stated value of the Preferred Stock ($1,000 per share), plus any accrued
and unpaid dividends thereon and any other fees or liquidated damages owing
thereon, for each share of Preferred Stock before any distribution or payment
shall be made to the holders of any junior securities, and if the assets of
Viking shall be insufficient to pay in full such amounts, then the entire assets
to be distributed to the holders of the Preferred Stock were to be ratably
distributed among the holders in accordance with the respective amounts that
would be payable on such shares if all amounts payable thereon were paid in
full.
  35
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Conversion. The
stated value of the shares of Preferred Stock is initially convertible into
shares of Viking’s common stock at a price of $9.00 per share; however, the
conversion price is 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. Our 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.
 
 As of
December 31, 2006 certain shares underlying the Preferred Stock had not been
registered pursuant to the terms of the Registration Rights Agreement, The
holders of Preferred Stock agreed to waive the registration requirements of the
Registration Rights Agreement and accept an aggregate of 80,000 shares of Common
Stock (“Liquidated Damage Shares”) in lieu of cash liquidated damages under the
Registration Rights Agreement as to the Unregistered Shares. Pursuant to the
terms of the Consent, Waiver and Amendment Agreement with the holders of
Preferred Stock, 80,000 Liquidated Damage Shares were issued in February 2007.
At December 31, 2006 the Company accrued $840,000 in expense related to the
liquidated damages based on the estimated fair value of the Liquidated Damage
Shares.
  As
discussed above, 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. We have accrued $589,178 at December 31, 2007
for such liquidated damages. We prepared and filed a post-effective amendment to
the registration statement which was declared effective on September 28,
2007.
  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 (See Note
22).
  13.Income Taxes
 
 The
components of the 2007 and 2006 provision for federal and state income tax
benefit (expense) completed in accordance with statement No. FAS 109 are
summarized below:
 
 2007
                
                
                2006CurrentFederal
                
                $
                -
                
                
                $
                -State
                
                
                (1,800
                )
                
                
                (1,300
                )DeferredFederal
                
                
                -
                
                
                
                -State
                
                
                -
                
                
                
                -$
                (1,800
                )
                
                $
                (1,300
                )
  36
 VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 The
difference between income taxes at statutory rates and the amount presented in
the financial statements is a result of the following:
  2007
                
                
                2006Expected
      Income tax benefit at statutory rate
                
                $
                369,400
                
                
                $
                3,482,000Non-deductible
      derivatives
                
                
                4,400,000
                
                
                
                1,187,000Meals
      and entertainment
                
                
                (29,000
                )
                
                
                (27,000
                )Gain
      on extinguishment of debt
                
                
                -
                
                
                
                1,992,000Minimum
      state taxes
                
                
                (1,200
                )
                
                
                (900
                )Incentive
      stock options
                
                
                (34,000
                )
                
                
                (145,000
                )Amortization
      of debt discount
                
                
                (877,000
                )
                
                
                (2,981,000
                )Return
      to provision difference
                
                
                (363,000
                )
                
                
                -Non-deductible
      liquidated damages
                
                
                (377,000
                )
                
                
                -Other
                
                
                -
                
                
                
                12,600Change
      in valuation allowance
                
                
                (3,090,000
                )
                
                
                (3,521,000
                )$
                (1,800
                )
                
                $
                (1,300
                )
 
 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,
  2007
                
                
                2006Operating
      loss carry forwards
                
                $
                -
                
                
                $
                5,639,000Research
      and development tax credit
                
                
                -
                
                
                
                66,000Basis
      Difference in Fixed Assets
                
                
                90,000
                
                
                
                67,000Accrued
      liabilities
                
                
                104,000
                
                
                
                65,000Stock
      options
                
                
                157,000
                
                
                
                89,000Inventory
      reserve
                
                
                66,000
                
                
                
                -Intangible
      asset basis difference
                
                
                17,000
                
                
                
                -Less
      valuation allowance
                
                
                (434,000
                )
                
                
                (5,926,000
                )$
                -
                
                
                $
                -
  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, Accounting for Income Taxes ,
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, 2007 the Company has not yet completed its analysis of the
deferred tax assets for its net operating losses of approximately $21 million
and research and development credits of approximately $170,000 generated through
2007.   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 year ended December 31, 2007.
  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 $434,000 as of December 31, 2007 due to the uncertainty of the
future realization of the deferred tax asset.
  37
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
  14.Operating
Leases
 
 Viking
Systems 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, 2007, are as follows:
 
 Years
      Ending December 31,2008
                
                $
                246,0002009
                
                
                246,0002010
                
                
                184,000$
                676,000
 
 Rent
expense for the years ended December 31, 2007 and 2006 was $302,459 and
$275,708, respectively.
  15.Related Party
Transactions
 
 During
the year ended December 31, 2007, the following related party transactions
occurred:
  ●
                In
      July 2007 we 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, we issued $500,000 ($1,000,000 in
      aggregate) of the Debentures to the Focus Fund.  This fund is
      managed by J. Winder Hughes.  Mr. Hughes was appointed to the
      Company’s board of directors in October 2007.●
                We
      issued a $300,000 promissory note to Donald E. Tucker, at the time our
      President, CEO and director, who was also a significant shareholder. The
      promissory note was subsequently converted into Debentures in February
      2007.●
                During June 2007, we
      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.
  During
the year ended December 31, 2006, Viking Systems:
  ●
                Converted
      a $450,000 related party note payable to Donald E. Tucker, a significant
      shareholder, and the Company’s President and CEO, into 50,000 shares of
      common stock.●
                Had
      an unsecured note payable to Donald E. Tucker, at the time a significant
      shareholder, and the Company’s President and CEO, in the amount of
      $200,000. This note was repaid on June 14, 2006.●
                Issued
      1,750 warrants to purchase common stock at an exercise price of $17.50 per
      share to Donald E. Tucker, at the time a significant shareholder, and the
      Company's President and CEO.●
                Cancelled
      23,750 warrants to purchase common stock at an exercise price of $20.00
      per share that were previously issued to Donald E. Tucker, at the time a
      significant shareholder, and the Company's President and
      CEO.
  16.Stock-Based
Compensation
 
 Common
Stock Options
 The
Company maintains the 2004
Stock Incentive Plan (the “Plan”) under which officers and key employees
may be granted options to purchase shares of the Company’s authorized but
unissued common stock. 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 Company believes that such
awards better align the interests of its employees and directors with those of
its shareholders. The maximum number of shares of the Company’s common stock
available for issuance under the 2004 Stock Incentive Plan is 172,000 shares and
10,000 shares under the 2004 Non-Employee Director Stock Ownership Plan. As of
December 31, 2007, the maximum number of shares available for future grants
under the Plan is 53,160 shares. Under the 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 five years. Proceeds received by the Company from
exercises of stock options are credited to common stock and additional paid-in
capital. Additional information with respect to the Plan’s stock option activity
is as follows:
  38
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 16.Stock-Based Compensation
(Continued)
 
  Shares
                
                
                Weighted
                  Average
                  Exercise
                  Price
                
                
                Aggregate
                  Intrinsic
                  Value
                
                Weighted
                  Average
                  Remaining Contractual
                  LifeOptions
      outstanding January 1, 2006
                
                
                114,120
                
                
                $
                19.00Granted
      in 2006
                
                
                57,200
                
                
                $
                19.50Cancelled
      in 2006
                
                
                (11,800
                )
                
                $
                25.00Exercised
                
                
                (20,000
                )
                
                $
                1.00Options
      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
                
                $
                -
                
                7.63Options
      exercisable December 31, 2007
                
                
                98,440
                
                
                $
                22.00
                
                $
                -
                
                3.88
 
 A summary
of the status of non-vested options as of December 31, 2007 is presented
below:
 
 Shares
                
                
                Weighted
                  Average
                  Grant
      Date
                  Fair
      ValueNon-vested
      options beginning January 1, 2007
                
                
                59,260
                
                
                $
                20.50Granted
                
                
                70,400
                
                
                
                11.50Vested
                
                
                (22,180
                )
                
                
                22.00Exercised
                
                
                (4,000
                )
                
                
                1.00Forfeited
                
                
                (47,080
                )
                
                
                16.50Non-vested
      options at December 31, 2007
                
                
                56,400
                
                
                $
                13.00
 
 Those
options exercisable at December 31, 2007 range in price from $10.00 to
$25.00.  The weighted average grant date fair value for options
granted for during 2007 and 2006 amounted to $7.53 and $7.94, respectively. The
total intrinsic value of options exercised during the years ended December 31,
2007 and 2006 was $32,000 and $380,000, respectively.
  39
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 16.Stock-Based Compensation
(Continued)
  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
112.28%, expected term of 7.5 to 10 years, risk-free interest rate ranging from
4.30% 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, 2007 and 2006, the Company recorded compensation
costs related to stock options of $253,592 and $586,776. 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
of approximately $115,000.
 
 As of
December 31, 2007, the Company has unrecognized compensation costs of $431,063
related to unvested stock options.  Approximately $412,000 of this
amount will be recognized in the first quarter of 2008 as the employees holding
these stock options surrendered them to the Company during that
quarter.
 
 17.Stock Warrants and
Derivative Liability
 
 The
following table summarizes warrants to purchase common stock outstanding for the
two years ended December 31, 2007:
  Shares
                
                
                Range
      of
                  Exercise
      Price
                
                
                Weighted
                  Average
                  Exercise
                  Price
                
                
                Weighted
                  Average
                  Remaining
                  Contractual
                  LifeWarrants
      outstanding December 31, 2005
                
                
                143,750
                
                
                $
                20.00
                
                
                $
                20.00
                
                
                
                3.10Granted
                
                
                513,889
                
                
                $
                17.50
      -37.50
                
                
                $
                19.00
                
                
                
                4.33Exercised
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Cancelled
                
                
                (23,750
                )
                
                $
                20.00
                
                
                $
                20.00
                
                
                
                2.42Warrants
      outstanding December 31, 2006
                
                
                633,889
                
                
                $
                17.00-37.50
                
                
                $
                18.50
                
                
                
                3.91
  Granted
      (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
                
                
                
                5.12
  (A)
                In
      May 2006, we 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 11 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.
 
 40
 
 VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Included
in the table are warrants resulting from the following
transactions:
 
 Warrants
granted during 2006 in the initial amount of  444,444 shares with an
initial exercise price of $17.50 per share granted to purchasers of the Series B
Preferred Stock.
 
 Warrants
granted during 2006 to purchase 12,139 shares at an exercise price
of  $17.50 granted to note holders in connection with the modification
of convertible debt terms.
 
 Warrants
granted during 2006 to purchase 27,778 shares at an exercise price of $25.00 per
share, and 27,778 shares of common stock at an exercise price of $37.50 per
share in connection with a $250,000 bridge financing agreement.
 
 Warrants
granted during 2006 to purchase 1,750 shares granted to the Company’s then
President and CEO at an exercise price of $17.50 per share in connection with an
agreement to relinquish 11,250 previously issued warrants.
 
 During
2006, the Company recorded the cancellation of 23,750 warrants to purchase
common stock at an exercise price of $20.00 held by the Company’s then President
and CEO.
  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.
 
 Changes
in the derivative liability balance 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
                
                $
                7,976,531Excess
      fair value, charged to earnings
                
                $
                2,445,582Total
                
                
                10,422,113Increase
      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
                
                $
                349,104
 
 For the
year ended December 31, 2007 the gain on derivative liability is comprised of
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
 
 The fair
value of the warrants on December 31, 2006 was $3,373,676, resulting in a
decrease in the fair value of the warrants and the recording of a gain on
derivative liability in the amount of $2,967,616 during the year ended
December 31, 2006.
 
 41
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 
  18.Common Stock Issued and
Issuable For Services
 
 During,
2006 the Company entered into an agreement 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 $42,700 and $21,675 for
the years ended December 31, 2007 and 2006, respectively.
  19.Major
Customers
 
 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. During the
year ended December 31, 2006, Viking Systems had sales to three customers that
accounted for 21%, 13% and 11%, respectively, of total sales. These
customers owed the Company $210,000, $411,000, $79,000 and $3,500 at
December 31, 2007 and $290, $110,000, and $107,940 at December 31,
2006.
 
 20.Commitments and
Contingencies
 
 In the
normal course of business, the Company is party to a variety of agreements
pursuant to which we 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 our obligations and the
unique facts and circumstances involved in each particular agreement.
Historically, payments made by us under these types of agreements have not had a
material effect on our business, results of operations or financial
condition.
 
 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, 2007 and 2006, Viking had accrued royalties related
to this agreement of approximately $25,000 and $19,000, respectively. During
2007 and 2006, Viking did not pay any royalties under this
agreement.
  21.Recent Accounting
Pronouncements
 
 In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for
measuring fair value, and expands disclosures about fair value measurements.
This Statement focuses on creating consistency and comparability in fair value
measurements. SFAS No. 157 is effective for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years.  We
are currently evaluating the impact of adopting SFAS 157 on our financial
statements., but believe it is unlikely to adversely effect the Company’s
financial position, results of operations or cash flows.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS No. 159”) which permits entities
to choose to measure many financial instruments and certain other items at fair
value that are not currently required to be measured at fair value. SFAS No. 159
will be effective for us on January 1, 2008. We are currently evaluating the
impact of adopting SFAS No. 159 on our financial position, cash flows, and
results of operations, but believe it is unlikely to have a material adverse
impact.
 
 In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 141(R), “Business
Combinations” (“SFAS No. 141R).  SFAS 141R retains the fundamental
requirements in SFAS 141 that the acquisition method of accounting (which SFAS
141 called the purchase method) be used for all business combinations and for an acquirer to be
identified for each business combination. SFAS 141R also establishes principles
and requirements for how the acquirer: (a) recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any non-controlling interest in the acquiree; (b) improves the
completeness of the information reported about a business combination by
changing the requirements for recognizing assets acquired and liabilities
assumed arising from contingencies; (c) recognizes and measures the
goodwill acquired in the business combination or a gain from a bargain purchase;
and (d) determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination. SFAS No. 141R applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008.
Early application is not permitted. The Company has not yet determined the
impact, if any,  SFAS No. 141R will have on its consolidated financial
statements, but believes any impact will not be material.
  In December 2007, the
FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated
Financial Statements” (“SFAS NO. 160”). SFAS No. 160 amends ARB 51 to establish
accounting and reporting standards for the non-controlling
(minority) interest in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a non-controlling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statements and establishes a single method of
accounting for changes in a parent’s ownership interest in a subsidiary that do
not result in deconsolidation. SFAS No. 160 is effective for fiscal years
beginning on or after December 15, 2008. The Company has not yet determined
the impact, if any, that SFAS No. 160 will have on its consolidated financial
statements, but believes any impact will not be material.
  42
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 22.Subsequent
Events
  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 the Company received
approval, subject to finalization of certain terms and execution of final
documentation, from 100% of the holders of its Preferred Stock and 100% of the
holders of 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 the Company (the “New Investment”) and a
redistribution of the Company’s common stock among the current holders of the
Company’s common stock, Preferred Stock, Debentures and the investors providing
the New Investment.
  In
consummating the Recapitalization Plan, the redistribution of the Company’s
ownership was accomplished on January 4, 2008, through the following: (i) a 1:50
“reverse split” of the Company’s common stock, (ii) entry of the Company into a
Recapitalization Agreement with the applicable holders, pursuant to which the
holders of the Preferred Stock and the Debentures exchanged their respective
Company securities (including warrants that were issued in connection with the
Preferred Stock and the Debentures) for shares of the Company’s common stock and
warrants which may be exercised for common stock; and (iii) entry of the Company
into a Securities Purchase Agreement with those parties making the New
Investment of $2.6 million pursuant to which they were issued shares of the
Company’s common stock and warrants which may be exercised for shares of the
Company’s common stock.   As part of the recapitalization the Company
executed the Securities Purchase Agreement and 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 net proceeds of
$2,600,000.
  Following
the consummation of the Recapitalization Plan, the equity ownership of the
Company is as follows:
  POST-RECAPITALIZATION EQUITY (excluding
      warrants)Stockholder
      by type
                
                Ownership
      of
                  Outstanding
                  Common
      Stock
                
                
                Percent
      Ownership
                  Common
      StockPre-Recapitalization
      common stockholders
                
                
                1,398,681
                
                
                
                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
                
                
                42,556,587
                
                
                
                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
$8,391,014 at December 31, 2007, plus all related liquidated damages, were
exchanged for 4,197,849 shares of the Company’s common
stock.  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.
  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
net 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 CEO), who tendered
$1,750,000 for 9,800,024 shares of common stock and warrants which may be
exercised for 9,800,024 shares of common stock.
 
 43
  VIKING
SYSTEMS, INC.
 Notes
to Financial Statements
 Continued
 Pro-Forma
Balance Sheet Data:
 The
following selected financial data under the column titled pro forma, has been
adjusted to present the impact of the Recapitalization as if it had occurred on
December 31, 2007.  It includes the proceeds from the New Investment,
the exchange of the Debentures and Preferred Stock for common shares, the
exchange of warrants to purchase common stock, and the elimination of accrued
interest, dividends and liquated damages related to the securities
exchanged:
 
 As
      Reported
                
                
                (unaudited)At
      December 31, 2007
                
                
                Pro
      FormaCash
                
                $
                317,098
                
                
                $
                2,917,098Total
      current assets
                
                $
                3,678,468
                
                
                $
                6,278,468Other
      non-current assets
                
                $
                127,500
                
                
                $
                -Total
      Assets
                
                $
                4,669,340
                
                
                $
                7,141,840Accrued
      liabilities
                
                $
                2,662,687
                
                
                $
                1,389,614Notes
      payable
                
                $
                2,144,238
                
                
                $
                -Derivative
      liabilities
                
                $
                349,105
                
                
                $
                -Total
      current liabilities
                
                $
                7,255,733
                
                
                $
                3,489,317Preferred
      Stock
                
                $
                8,814,241
                
                
                $
                -Common  Stock
                
                $
                1,399
                
                
                $
                42,557Additional
      Paid-in Capital
                
                $
                8,034,205
                
                
                $
                23,439,292Accumulated
      deficit
                
                $
                (19,471,602
                )
                
                $
                (19,817,928
                )Total
      Liabilities and Stockholders' Deficit
                
                $
                4,669,340
                
                
                $
                7,141,840
 
 44
  ITEM
8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
 
 On
November 27, 2006 we filed a Form 8-K, which was amended with Form 8-K/A filings
on December 29, 2006 and January 19, 2007 indicating that on November 27, 2006
we were informed by Peterson & Co., LLP (“Peterson”), our independent
registered public accounting firm that Peterson consummated a merger with Squar,
Milner, Miranda & Williamson, LLP (“Squar Milner”). Squar Milner, which is
located in Newport Beach, California, is also registered with the Public Company
Accounting Oversight Board (United States). The name of the post-merger firm is
Squar, Milner, Peterson, Miranda & Williamson, LLP. There were no
disagreements with the former accountant on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or
procedure.
 
 ITEM
8A. 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 principal 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 report, our disclosure controls and procedures were effective at
the reasonable assurance level discussed above.
 
 There
were 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.  In our third quarter report on Form 10-QSB
we reported that deficiencies in our controls led our principal executive
officer and chief financial officer to conclude that our disclosure controls
were not effective at the reasonable level of assurance. Since then we have
improved our internal review process, improved communication among those
responsible for financial accounting and disclosure and have begun
formalizing key processes and procedures.
 
 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 Viking. 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 the company’s internal control
over financial reporting as of December 31, 2007 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, the
company’s management concluded that, as of December 31, 2007, the company’s
internal control over financial reporting was effective.
  This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by the Company’s registered
public accounting firm pursuant to temporary rules of the Securities and
Exchange Commission that permit the Company to provide only management’s report
in this annual report.
 
 45
 
 ITEM
8B. OTHER INFORMATION
 
 We must
disclose under this item any information required to be disclosed in a report on
Form 8-K during the fourth quarter of the year covered by this Form 10-KSB, but
not reported, whether or not otherwise required by this Form 10-KSB. If
disclosure of such information is made under this item, it need not be repeated
in a report on Form 8-K which would otherwise be required to be filed with
respect to such information or in a subsequent report on Form 10-KSB.  No
additional disclosure is required under this item.
 
 PART
III
 
 ITEM
9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE
GOVERNANCE; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.
 
 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
                64
                Chairman
      of the Board, Chief Executive OfficerJ.
      Winder Hughes
                49
                DirectorWilliam
      Tumber
                73
                Director,
      Audit Committee and Compensation Committee ChairmanJohn
      “Jed” Kennedy
                50
                Director,
      President and Chief Operating OfficerRobert
      Mathews
                44
                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. Since October 11, 2007 Mr. Bopp has served as Chairman of
the Board and he will continue in this role. Prior to joining Viking, Mr. Bopp
was a private investor. Previously he was with Alaris Medical Systems, Inc., a
developer, manufacturer and marketer of infusion devices and related disposable
products, where he had been senior vice president and chief financial officer.
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 Finance Committee
of the Board. Mr. Bopp is a graduate of Harvard College, Cambridge, MA, and
completed his MBA, Finance, from the Harvard Business School.
  J.
Winder Hughes
 Mr.
Hughes was appointed to the board of directors in October 2007.  Mr.
Hughes is the managing partner, since 1995, of Hughes Capital Investors, LLC
which manages private assets and raises money for small public companies. 
He formed the Focus Fund, LP is 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—Chapel Hill with a BA in Economics, minor in
English.
 
 William
Tumber
 Mr.
Tumber was appointed to the 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., 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, Tumber worked for over 20 years at General Electric. He
held a variety of positions of increasing responsibility which included
technical recruiting, human relations, and Plant Manager of a 300-person
electronic assembly facilit
  46
  John "Jed"
Kennedy.Mr. Kennedy was appointed to the board of directors, President
and Chief Operating Officer of the Company in October 2007.  Prior to
that Mr. Kennedy was President, Vision Systems Group at Viking Systems. Mr.
Kennedy joined Vista Medical 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, 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, Research and Development 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 the Company as Executive Vice President and Chief Financial
Officer in June 2007.  Prior to joining the 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.  Mr. Mathews was vice president of finance, chief accounting
officer, and executive committee member. Mr. Mathews began his career at
PriceWaterhouse (1987 to 1996) and 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
 
 There
have been no events under any bankruptcy act, no criminal proceedings and any
judgments or injunctions material to the evaluation of the ability and integrity
of any director or executive officer during the last five years.
 
 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. On March 28, 2008 we adopted  the
“Viking Systems, Inc. Code of Ethics for Financial Professional”  that
applies to our principal executive officer and all finance and accounting
employees.   This policy is filed as Exhibit 14.1 to this Form
10-KSB. 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.
  47
  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.   Viking does 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 Viking’s
directors and executive officers, and persons who beneficially own more than 10%
of a registered class of Viking equity securities, to file reports of beneficial
ownership and changes in beneficial ownership of Viking’s 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 Viking’s common stock (collectively, the
“Reporting Persons”) are required by SEC regulations to furnish Viking with
copies of all Section 16(a) forms that they file. Based upon reports provided to
us, Viking believes that, during the year ended December 31, 2007, Reporting
Persons met all applicable Section 16(a) filing requirements, except as follows:
Form 3 filings for William C. Bopp, J. Winder Hughes, John Kennedy, Robert
Mathews, and  John Conaton were filed late.  A Form 3 was
not filed for Richard Kipperman.  Additionally, a Form 4 was not filed
regarding the February 2007 purchase of Viking Debentures by Donald Tucker, our
former Chairman of the Board of Directors, President and Chief Executive
Officer.
  48
  ITEM
10. EXECUTIVE COMPENSATION
  EXECUTIVE
COMPENSATION
  Summary
Compensation Table
  The
following table sets forth information concerning annual and long-term
compensation provided to each person who served as the Company’s Chief Executive
Officer during the fiscal year ended December 31, 2007, each of the Company’s
other most highly compensated executive officers as of December 31,
2007.  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.
  Non-EquityOption
                Incentive
      Plan
                All
      OtherName and Principal Position
                Year
                Salary
      ($)
                Awards
      ($) (4)
                Compensation
      ($)
                Compensation
      ($)
                Total
      ($)John
      “Jed” Kennedy,
                2007
                195,700
                123,116
                -
                -
                318,816President, Chief
      Operating Officer and Director (1)
                2006
                195,700
                88,013
                -
                -
                283,713Robert
      Mathews, Executive VP and Chief Financial Officer(2)
                2007
                107,423
                34,185
                32,226
                -
                173,834Donald
      Tucker, Former CEO, President and Director(3)
                2007
                198,461
                12,039
                -
                25,602
                236,1022006
                137,738
                8,899
                -
                -
                146,637
  (1)
                Mr.
      Kennedy has served as a Director of the Company since October 11,
      2007.  He was appointed the Company’s President and Chief
      Operating Officer on October 12, 2007.  Prior to his appointment
      as the Company’s President and Chief Operating Officer, Mr. Kennedy served
      as the President, Vision Systems Group of the
  Company.
 (2)
                Mr.
      Mathews has served as 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)
 (3)
                Mr.
      Tucker served as the Company’s Chief Executive Officer, President and
      Director beginning in May 2006.  In August 2006, he also became
      Chairman of the Board.  Effective October 12, 2007, Mr. Tucker
      resigned as our Chief Executive Officer and President, and effective
      November 7, 2007, Mr. Tucker resigned as a Director of the
      Company.   Other compensation paid to Mr. Tucker in 2007
      included $25,602 in accrued vacation time paid upon his resignation from
      the Company.(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 16 of the notes to our consolidated
      financial statements contained elsewhere in the 2007 Annual Report on Form
      10-KSB for a discussion of all assumptions made by us in determining the
      FAS 123(R) values of its equity
awards.
  49
  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, 2007.
  #
      of Securites
                
                
                #
      of SecuritesUnderlying
                
                
                Underlying
                
                
                OptionUnexercised
      Options
                
                
                Unexercised
      Options
                
                
                Exercise
                  Price
                
                OptionExpirationName
                
                (#
      exercisable)
                
                
                (#
      unexercisable)
                
                
                ($)
                
                DateJohn
      “Jed” Kennedy,President,Chief
      Operating Officer and Director
                
                
                3,000
                
                
                -
                
                
                
                17.50
                
                4/23/20082,600
                
                
                -
                
                
                
                25.00
                
                12/31/200910,000
                
                
                -
                
                
                
                20.00
                
                10/10/20152,600
                
                
                -
                
                
                
                17.50
                
                1/23/2016Robert
      Mathews, Executive VP and Chief Financial Officer
                
                
                -
                
                
                
                31,000
                
                
                
                12.00
                
                7/15/2017-Donald
      Tucker, Former CEO, President and Director
                
                
                2,880
                
                
                
                -
                
                
                
                24.00
                
                5/23/2016
  Compensation
of  Non-Employee Directors
 
 The
following table sets forth information concerning annual compensation provided
to each person who served as a member of the Company’s Board of Directors during
the fiscal year ended December 31, 2007, other than those persons who also
served as an executive officer of the Company during such fiscal year and are
included in the Summary Compensation Table above under “Executive
Compensation.”
  Fees
      Earnedor
      Paid inName
              
              Cash
      ($)William
      C. Bopp (1)
              
              $
              6,375J.
      Winder Hughes (2)
              
              $
              6,000Richard
      M Kipperman (3)
              
              $
              20,000Daniel
      F. Crowley (4)
              
              $
              17,375Brian
      M. Miller (5)
              
              $
              17,500Nathan
      J. Harrison (6)
              
              $
              18,125Michael
      J. Manyak (7)
              
              $
              16,875
  (1)
              Mr.
      Bopp has served as the Company’s 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 of the Company since October 11,
      2007.(3)
              Mr.
      Kipperman served as a Director of the Company from October 30, 2007 to
      February 27, 2008.  Effective upon Mr. Kipperman’s election to
      the Board of Directors, the Company and Mr. Kipperman entered into a
      Provisional Director Agreement 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.(4)
              Mr.
      Crowley served as a Director of the Company from December 2003 and was
      Chairman of the Board from March 2005 to August 2006.  He
      resigned from the Board on October 6, 2007.(5)
              Mr.
      Miller served as a Director of the Company from October 5, 2006, to
      November 5, 2007.(6)
              Dr.
      Harrison served as a Director of the Company from August 2004, to October
      6, 2007.(7)
              Dr.
      Manyak served as a Director of the Company from November 9, 2006, to
      October 6, 2007.
 
 50
 
 Non
Employee Directors’ cash compensation
 During
2007, 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, the 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.
  Non
Employee Directors’ stock option awards
 In April
2004, we adopted a compensation plan for our Board of Directors. Pursuant to
such plan we typically grant an initial option of 20,000 shares to each
non-employee director at the time he or she is appointed a director of Viking.
The options vest one year from the date of grant. Beginning in the second year
of their term, each non-employee director is also typically granted 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 with 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 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 ten
years.
 
 Employment
Agreements
 
 On
January 4, 2008, the company entered into an employment agreement with its Chief
Executive Officer, William C. Bopp.  Under the terms of Mr. Bopp’s
employment agreement, as amended, he will receive annual compensation of
$39,000, along with benefits comparable to those provided to other Company
executives.  Mr. Bopp was granted a stock option under the Company’s
2008 Equity Incentive Plan which has  a term of ten years and may be
exercised to acquire 2,100,00 shares of the Company’s common
stock.   The employment agreement is for an initial two-year
term, and renews automatically, unless terminated by either the Company or Mr.
Bopp.
  Viking
has entered into an employment agreement with our President and Chief Operating
Officer, John Kennedy. Pursuant
to the employment agreement between the Company and Mr. Kennedy dated October
10, 2005, Mr. Kennedy currently receives annual compensation in the amount of
$240,000 base salary per year plus participation in a bonus plan that includes
both cash and stock options based on Company and individual performance as
determined from time to time by the Compensation Committee of the Board of
Directors.    Mr. Kennedy’s employment agreement also
provides that if Mr. Kennedy is terminated without good cause or if Mr. Kennedy
terminates his employment with good reason, not in connection with a change of
control, he is eligible for severance payments equal to nine months of his then
current base salary, 50% of his target bonus on a pro rated basis, continuation
of health insurance for nine months following termination and acceleration of
vesting of all equity awards for a period equal to nine months following
termination.  His Employment Agreement provides further that if Mr.
Kennedy is terminated in connection with a change of control, he will receive a
lump sum equal to nine months of his base salary at the time of termination plus
50% of his target bonus on a pro rated basis, acceleration of vesting of various
equity awards held by him and health and welfare benefits for nine months
following termination.
 
 Viking
entered into an employment agreement with our former CFO and current General
Manager, Joseph Warrino. The agreement provides for the payment of a base salary
of $150,000 per year plus participation in bonus plan that includes both cash
and stock options based on Company and individual performance as determined from
time to time by the Compensation Committee.
 
 Viking
has entered into an employment agreement with our VP of Clinical Development,
Robert Tierney. The agreement provides for the payment of a base salary of
$150,000 per year plus participation in bonus plan that includes both cash and
stock options based on Company and individual performance as determined from
time to time by the Compensation Committee.
  51
  Equity
Compensation Plan Information
 
 2004 Stock Incentive
Plan. All key employees of Viking (and its subsidiaries and
affiliates in which Viking has a significant equity interest) are eligible to
receive awards under the Plan. The 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
 
 ·
              performance
      awards payable in stock.
 
 A total
of 172,000 shares of Viking common stock were available for granting awards
under the Plan. The Compensation Committee of the Board of Directors administers
the 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 some employees. Stock options issued to Viking officers and
employees that remain outstanding at December 31, 2007 amounted to 119,340
shares.
 
 2004 Non-Employee Directors Stock
Ownership Plan. The 2004 Director Plan provides for the grant to
non-employee directors of non-qualified stock options and restricted stock. The
2004 Director Plan provides that up to a total of 10,000 shares of Common
Stock  will be available for the granting of awards there under. If
any shares subject to awards granted under the 2004 Director Plan, or to which
any award relates, are forfeited or if an award otherwise terminates, expires or
is cancelled prior to the delivery of all of the shares issuable pursuant to the
award, such shares (assuming the holder of the award did not receive dividends
on the shares or exercise other indicia of ownership) will be available for the
granting of new awards under the 2004 Director Plan. At December 31, 2007, 2,400
shares were outstanding under this plan.
  ITEM
11. 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 23, 2008 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.
  Common
      Stock
                Options
      Exercisable
              
              
              Common
      Stock
                Purchase
                Warrant
              
              
              Total
      Stock
                and
      StockCommon
              
              
              Within
              
              
              Exercisable
              
              
              Based
              
              
              %Name
              
              Stock
              
              
              60
      Days
              
              
              Within
      60 Days
              
              
              Holdings(1)
              
              
              Ownership(1)William
      C. Bopp
              
              
              14,397,727
              
              
              
              525,000
              
              
              
              11,765,792
              
              
              
              26,688,519
              
              
              
              48.7%J.
      Winder Hughes
              
              
              4,215,189
              
              
              
              -
              
              
              
              2,804,124
              
              
              
              7,019,313
              
              
              
              15.5%William
      Tumber
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              0.0%John
      Kennedy
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              0.0%Robert
      Mathews
              
              
              -
              
              
              
              250,000
              
              
              
              -
              
              
              
              250,000
              
              
              
              0.6%All
      officers and directorsas
      a group ( 5 persons) (2)
              
              
              18,612,916
              
              
              
              775,000
              
              
              
              14,569,916
              
              
              
              33,957,832
              
              
              
              58.5%Midsummer
      Investment, LTD
              
              
              8,344,620
              
              
              
              -
              
              
              
              5,551,035
              
              
              
              13,895,655
              
              
              
              28.9%CAMOFI
      Master LDC  (3)
              
              
              3,521,411
              
              
              
              -
              
              
              
              351,030
              
              
              
              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 23, 2008. 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 23, 2008 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 23, 2008, there were
      42,556,610 shares of our common stock issued and
    outstanding.
 (2)
              These
      are the officers and directors of Viking.(3)
              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.
  52
  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. Viking had 6,790,340
outstanding options as of March 23, 2008.
 
 As of
March 23, 2008, we had warrants outstanding which entitle the holders to
purchase 28,048,420 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 Viking’s equity compensation plans
as of December 31, 2007.
  Plan
      Category
              
              Number
      of Securities
                to
      be Issued Upon
                Exerciseof
                Outstanding
                Options,Warrants
                and
      Rights (a)
              
              
              Weighted-Average
                Exercise
      Price of
                Outstanding
                Options,Warrants
                and
      Rights (b)
              
              
              Number
      of Securities
                Remaining
      Available
                forFuture
      Issuance
                UnderEquity
                Compensation
                Plans
      (Excluding
                Securities Reflected
                inColumn
      (a)) (c)Equity
      Compensation plans approved by security holders (1)
              
              
              121,240
              
              
              $
              18.50
              
              
              
              60,760Equity
      compensation plans not approved by security holders (2)
              
              
              33,600
              
              
              $
              19.32
              
              
              
              -Total
              
              
              154,840
              
              
              $
              27.68
              
              
              
              60,760
 ______________
 (1)
              Amounts
      include outstanding options to employees, officers and directors under our
      2004 Stock Incentive Plan and the 2004 Non-Employee Director Stock
      Ownership Plan. The amount in column (c) includes 53,160 shares
      available for award  under our 2004 Stock Incentive Plan and
      7,600 shares available for awards under our 2004 Non-Employee Director
      Stock Ownership 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.
 ITEM
12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
 
 The
issuance of the Debentures during 2007 included the related party transactions
set forth in the table below. In January 2008, these loans were part of the
Company’s recapitalization transaction. The underlying notes and all amounts due
under the debentures were exchanged for shares of the Company’s common
stock.  See Note 9 to the financial statements contained herein
regarding the terms Debenture terms and the terms of recapitalization and
exchange transactions.
  Name
              
              Amount
              
              Date
              
              WarrantsWilliam
      C. Bopp (1)
              
              $
              1,400,000
              
              7/31/2007
              
              
              77,778J.
      Winder Hughes (2)
              
              $
              500,000
              
              2/24/2007
              
              
              27,778J.
      Winder Hughes (2)
              
              $
              500,000
              
              7/31/2007
              
              
              27,778Brian
      Miller (3)
              
              $
              200,000
              
              7/31/2007
              
              
              11,111Donald
      Tucker (4)
              
              $
              300,000
              
              2/24/07
              
              
              16,667
  (1)
              Mr.
      Bopp has served as the Company’s 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 of the Company since October 11,
      2007.
 (3)
              Mr.
      Miller served as a Director of the Company from October 5, 2006, to
      November 5, 2007.
 (4)
              Mr.
      Tucker served as the Company’s Chief Executive Officer, President and
      Director beginning in May 2006.  In August 2006, he also became
      Chairman of the Board.  Effective October 12, 2007, Mr. Tucker
      resigned as our Chief Executive Officer and President, and effective
      November 7, 2007, Mr. Tucker resigned as a Director of the
      Company.  This loan was originally made on January 26 of 2007
      and converted to a  Debenture when those securities were issued
      in February 2007.
  53
 
 ITEM
13.   EXHIBITS
  ExhibitNumber
                Exhibit3.1
                Articles
      of Incorporation (8)3.2
                Certificate
      of Preferences, Rights and Limitations of Series B Variable Dividend
      Convertible Preferred Stock (1)3.3
                Bylaws
      (8)10.1
                Patent
      and Technology License Agreement (2)10.2
                Stock
      Incentive Plan (3)10.3
                Non-Employee
      Stock Option Plan (3)10.4
                Employment
      Agreement - Jed Kennedy (4)10.5
                Platinum
      Medical Distribution Agreement (4)10.6
                Lease
      Agreement (4)10.7
                Securities
      Purchase Agreement (5)10.8
                Registration
      Rights Agreement (5)10.9
                Common
      Stock Purchase Warrant (5)10.10
                Securities
      Purchase Agreement (5)10.11
                Secured
      Convertible Debenture (5)10.12
                Registration
      Rights Agreement (5)10.13
                Common
      Stock Purchase Warrant (5)10.14
                Security
      Agreement (5)10.15
                Waiver
      And Amendment Agreement (5)10.16
                Recapitalization
      Agreement (6)10.17
                Securities
      Purchase Agreement (6)10.18
                Executive
      Employment Agreement-William C. Bopp (6)10.19
                Amendment
      to Executive Employment Agreement-William C. Bopp (7)14.1
                Code
      of Ethics Regarding Financial Personnel (8)31.1
                Certification
      of Principal Executive Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 302 of the Sarbanes- Oxley Act of 2002
      (8)31.2
                Certification
      of Principal Financial Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 302 of the Sarbanes-Oxley Act of 2002
      (8)32.1
                Certification
      of Principal Executive Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 906 of the Sarbanes-Oxley Act of 2002
      (8)32.2
                Certification
      of Principal Financial Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 906 of the Sarbanes-Oxley Act of 2002
      (8)
  _________________
 (1)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      May 22, 2006.(2)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      December 24, 2003(3)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      March 31, 2004.(4)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      October 10, 2005.(5)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      July 19, 2007.(6)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      January 7, 2008.(7)
                Incorporated
      herein by Reference from the Registrant’s Current Report on Form 8-K dated
      February 27, 2008.(8)
                Attached
 54
  ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 Independent
Auditors
  Peterson
& Co., LLP was appointed on December 28, 2005 to audit the consolidated
financial statements of Viking for the year ending December 31, 2005 and to
report the results of their audit to the Audit Committee of the Board of
Directors. Tanner LC served as the auditor for Viking for the year ending
December 31, 2004 and provided services during 2005. On November 27, 2006 we
filed a Form 8-K indicating that on November 27, 2006 we were informed by
Peterson & Co., LLP (“Peterson”) that Peterson has consummated a merger with
Squar, Milner, Miranda & Williamson, LLP (“Squar Milner”) who is also
registered with the Public Company Accounting Oversight Board (United States).
The name of the post-merger firm is Squar, Milner, Peterson, Miranda &
Williamson, LLP (“Squar Milner Peterson”).
 
 Fees
billed to Viking by Squar, Milner, Peterson, Miranda & Williamson,
LLP,  and Peterson & Co. LLP
  Squar,
      Milner, Peterson, Miranda & Williamson, LLP / Peterson & Co
      LLP
              
              2007
              
              
              2006(1)
      Audit Fees
              
              $
              147,377
              
              
              $
              142,931(2)
      Tax Fees
              
              $
              16,541
              
              
              $
              6,853(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 Viking’ annual financial
      statements, reviews of financial statements included in the Company’s
      Forms 10-QSB 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 Viking for other services during 2007 and
      2006.
 
 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.
  55
 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:
      March 31, 2008
              By:   
      /s/ William C.
      BoppChief
      Executive Officer(Principal
      Executive Officer)Dated:
      March 31, 2008
              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
              March
      31, 2008/s/
      Robert Mathews
              Executive
      Vice President
                and
      Chief Financial Officer
              March
      31 , 2008/s/
      John Kennedy
              Director,
      President
                and
      Chief Operating Officer
              March
      31, 2008/s/
      J. Winder Hughes, III
              Director
              March
      31, 2008/s/
      William
      Tumber
              Director
              March
      31, 2008
  56