**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, 2006


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.)




4350
      La
      Jolla Village Dr, Suite 900


San
      Diego, CA 92122


(Address
      of principal executive offices)





Issuer’s
      telephone number, including area code: **** (858)
      431-4010





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  ̈ ; (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-K or any amendment to
      this
      Form 10-K  ̈ .





The
      Issuer’s revenues for the fiscal year ended December 31, 2006 were $
      5,617,253





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, 2007, there were 65,864,941 shares of the Issuer's common stock issued
      and outstanding of which 33,241,983 were held by affiliates. The aggregate
      market value of the 33,622,958 shares of voting common stock held by
      non-affiliates of the Issuer based on the closing price on March 23, 2007 was
      $6,724,592.





DOCUMENTS
      INCORPORATED BY REFERENCE: NONE







TABLE
      OF
      CONTENTS





PagePART
                I
            1Item
                1. Description of Business
            1Item
                2. Properties
            12Item
                3. Legal Proceedings
            12Item
                4. Submission of Matters to a Vote of Security Holders
            12PART
                II
            13Item
                5. Market for the Registrant’s Common Stock and Related Security Holder
                Matters
            13Item
                6. Management’s Discussion and Analysis of Financial Condition and Results
                of Operation
            15Item
                7. Financial Statements
            33Item
                8. Changes and Disagreements with Accountants on Accounting and Financial
                Disclosure
            65Item
                8A. Controls and Procedures
            65Item
                8B. Other Information
            65PART
                III
            66Item
                9. Directors, Executive Officers, Promoters and Control Persons;
                Compliance with Section 16(a) of the Exchange Act
            66Item
                10. Executive Compensation
            71Item
                11. Security Ownership of Certain Beneficial Owners and
                Management
            75Item
                12. Certain Relationships and Related Party Transactions
            77Item
                13. Exhibits
            79Item
                14. Principal Accountant Fees and Services
            81


i


**PART
      I**





**ITEM
      1. DESCRIPTION OF BUSINESS**





**General**





Viking
      Systems, Inc. (“Viking” “We, “Our ””)
      designs, manufactures and markets FDA cleared high performance laparoscopic
      vision systems. Viking’s primary product is the 3Di Vision System (the “3Di
      System”), an advanced three dimensional (“3-D”) vision system used by surgeons
      for complex minimally invasive laparoscopic surgery, with an initial focus
      on
      applications in urology, bariatrics, gynecology and general surgery. We also
      manufacture two dimensional (“2-D”) digital cameras that are sold through
      strategic partner and Original Equipment Manufacture (“OEM”)
      programs.





Our
      technology and know-how center on our core technical competencies in optics,
      digital imaging, sensors, surgical robotics 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.





Viking’s
      proprietary solutions for surgery are based on three principles:





·
            That
                3-D vision, providing natural depth perception with a clear view
                of a
                patient’s anatomy, is superior in facilitating the performance of complex
                surgical tasks;





·
            That
                a Head Mounted Display, or HMD is a more ergonomic display solution
                for
                surgeons and interventional physicians than conventional video monitors;
                and





·
            That
                integrating additional information in a voice controlled,
                picture-in-picture format into the surgeon’s view, in conjunction with the
                anatomical view, can facilitate decision making during
                surgery.





As
      of
      December 31, 2006, we had an installed base of more than seventy-three (73)
      3-D
      vision systems worldwide and more than four thousand (4,000) 2-D digital cameras
      and accessories with OEM partners, including Boston Scientific Corporation
      (“Boston Scientific”, NYSE: BSX) and Medtronic, Inc. (“Medtronic”, NYSE: MDT).





The
      base
      price of our products range from $100,000 to $200,000 for 3Di Systems and from
      $3,000 to $27,000 for 2-D digital cameras and components. We had 9 and 24 3Di
      System placements in 2005 and 2006, respectively.


1


**HISTORY**





We
      commenced our current business operations in April 2004, when we acquired a
      proprietary 3-D surgical visualization business and digital platform (the
“Visualization Assets”) for surgical information delivery (InfomatixTM) from
      Vista Medical Technologies, Inc. (“Vista”). Additionally, we entered into a
      license agreement with Vista (the “License Agreement”) with respect to certain
      intellectual property and product rights. In November 2006, we entered into
      a
      Technology Transfer and Settlement Agreement with IVOW, Inc., the new owners
      of
      Vista whereby the intellectual property and product rights were transferred
      to
      Viking and the royalty payments were completed for a final payment of $500,000.
      Total payments to Vista and IVOW related to the intellectual property and
      product rights amounted to $950,000.





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 the following actions as
      part of our plans to commercialize the technology:




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





·
            Rebranded
                the visualization technology product developed from the Visualization
                Assets in the Viking product image;





·
            Completed
                the initial staffing of the commercial organization, including regional
                sales managers, independent sales representatives, international
                distributors, clinical development staff and service and marketing
                personnel;





·
            Demonstrated
                the efficacy and clinical acceptance of the 3Di System in over 30
                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
                two new significant OEM customers, Biomet and Boston Scientific;
                and





·
            Created
                bariatric, urologic and gynecologic clinical advisory boards.





·
            Launched
                a product configuration to accompany the Intuitive Surgical da Vinci
                robotic system.





**PRODUCT
      AND TECHNOLOGY OVERVIEW**





Viking’s
      two primary product lines are the 3Di Systems for hospitals and out-patient
      surgical centers and a line of 2-D digital cameras and components for OEM
      customers.


2


**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 3-D vision by providing depth perception through advanced
                stereo
                optics, high-resolution;





·
            **Ergonomics
                -**The
                HMD (ViView) provides the surgical team with freedom of movement
                and
                natural line of sight, freeing them from the uncomfortable posture
                required to constantly view a remotely-positioned monitor; these
                ergonomic
                features reduce fatigue and help to optimize surgical performance;
                and





·
            ***InfomatixTM*****-**Information is delivered through the proprietary*InfomatixTM*capabilities
                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 CCDs into a lightweight
                and
                ergonomic camera head featuring two convenient accessory control
                buttons.
                The camera utilizes a patented Carl Zeiss, Inc. (“Zeiss”) optical system
                allowing 360° scope rotation while maintaining proper image orientation
                which delivers a high resolution image to each eye as viewed through
                the
                HMD. This results in clear 3-D vision of the most critical anatomical
                structures. The 3-Chip stereo camera system is made up of two components
                including a camera control unit and a camera
                head.





·
            **Digital
                Data Portal ViPort -**The
                ViPort is the data hub of the 3Di System. With the capability to
                support
                up to two video sources (stereo or mono), the ViPort converts any
                video
                signal to digital SVGA and delivers real-time clinical images to
                the
                surgical team wearing HMDs. A user-independent voice controlled module
                on
                the surgeon’s HMD directs Viking’s*InfomatixTM*technology,
                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.





·
            **Head
                Mounted Display -**The
                ViView HMD is a comfortable and lightweight 3D personal monitor which
                serves to improve operating room ergonomics and provides stereo
                visualization. The technological advances of the LCD displays are
                analogous to 3-Chip camera technology. The three-panel HMD allows
                true 3-D
                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.


3





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





**Visualization
      Solutions for OEM Customers**





Viking
      is
      also the strategic visualization supplier of 2-D 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 3-D Surgical Visualization Technology.**





Viking
      believes its technology is at the forefront of commercializing advanced 3-D
      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 3-D
      visualization systems on the market. Although the robotic technologies provided
      by companies such as Intuitive Surgical, Inc. (“Intuitive Surgical”, NASDAQ:
      ISRG) incorporate 3-D vision capabilities into their systems, Viking’s products
      are not in direct competition with these products. Rather, Viking’s strategy is
      to offer standalone 3-D vision capability at a base price of $100,000 to
      $200,000, approximately 1/10 of the price of the robotic systems offered by
      companies such as Intuitive Surgical.


4


**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 2-D visualization systems. Viking’s solution provides
      the benefits of natural 3-D vision by providing depth perception cues and 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 HMD provides a field of view that is more immersive
      and in alignment with the surgeon’s orientation to his instruments. The
      ergonomic benefits reduce surgeon fatigue and strain associated with traditional
      systems that require a physician to constantly view a remotely positioned
      monitor and compromise his or her posture.





*Infomatix* TM is also
      a critical platform of the 3Di System, providing the surgical team with
      additional information to enhance the procedure. Information is available on
      command through a voice-activated technology that enables viewing of secondary
      video and existing diagnostic information without leaving the patient. The
      system also allows access to clinical images from pre-surgical files and
      secondary video in a picture-in-picture format.





**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 3-D
      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:





·
            Colorectal
                surgery,


·
            Ear,
                nose, and throat (“ENT”) and “skull based”
                procedures.


·
            Cardiothoracic
                surgery,


·
            Neurological


·
            Pediatrics


·
            Spinal
                surgery.





**OEM
      Business Provides Recurring Revenues.**





The
      OEM
      business has provided the Company with a recurring source of revenue. We are
      the
      strategic visualization supplier and partner for several leading
      procedure-specific medical device manufacturers such as B. Braun, Richard Wolf,
      Medtronic Boston Scientific and Biomet, Inc. We have sold over four thousand
      2-D
      digital cameras, accessories and unique visualization solutions to its OEM
      partners, and in 2005 and 2006 OEM sales accounted for approximately $2,900,000
      and $3,800,000 in revenue, respectively.


5


**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:





·
            With
                improved technologies, more procedures will continue to adapt to
                MIS
                techniques,


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


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





We
      believe that the clinical benefits and broad potential application of 3-D
      visualization technology provide Viking with an attractive, potentially high
      growth market. The 3Di System combines the visual benefits and clinical outcomes
      of “open” surgical procedures with the opportunity for rapid recovery associated
      with minimally invasive techniques. The technology enables more complicated
      surgical procedures to be performed using less invasive techniques. The
      technology itself is 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 3-D visualization
      and
      information solution specifically directed at complex minimally invasive
      procedures. In addition, we are not aware of any other true 3-D HMD that has
      been cleared for marketing in surgical applications by the FDA.





Viking’s
      competition comes from two directions. The traditional competition is from
      2-D
      and 2-D HD 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 2-D vision systems is between twelve and fifteen
      thousand units per year .
      Karl
      Storz Endoscopy America, Inc., Stryker Corporation (NYSE: SYK), ACMI Corporation
      (recently acquired by Gyrus), Olympus America, Inc. and Smith & Nephew PLC
      (NYSE: SNN) are key competitors supplying 2-D units.





At
      the
      high end of the technology market, fully immersive 3-D vision-enabled robotics,
      in particular the daVinci system, sell for up to $1,500,000 per system and
      require disposables that cost the hospital up to an estimated $2,500 per
      procedure.





Viking
      Systems’ solution provides a higher level of technical sophistication than 2-D
      for MIS procedures, without the high cost and technical complexity of a robotic
      solution. We estimate the opportunity for its 3-D technology and the gap in
      the
      market to be in excess of one thousand four hundred systems per year .
      Currently, this represents a market opportunity of approximately $250
      million.




Viking
      is
      positioning its 3Di System against other 2-D systems with the added benefits
      of
      depth perception, ergonomics and *InfomatixTM* .
      In
      hospital accounts that have purchased a completely automated daVinci system,
      we
      are able to market the 3Di System as a complementary product by positioning
      it
      as an innovative and affordable improvement for operating technique and patient
      care. Because of the limited applications of a daVinci system, adding a Viking
      system to their suite allows surgeons and their patients the benefits and
      improved outcomes of 3-D.


6


**MARKET
      AND BUSINESS DEVELOPMENT PLAN**





Two
      elements of the Company’s market development plan include:




·
            Increasing
                the size of Viking Systems’ 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,


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





**SALES
      AND MARKETING**





Viking
      continues to build a global sales and marketing effort to drive adoption and
      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 to building relationships with key opinion leaders, academic
      centers and managed care organizations. In 2006, we established the direct
      sales
      organization consisting of eight domestic regional sales managers and one
      international sales manager. The domestic direct sales force focuses on selling
      systems into key regional accounts and academic centers. In addition, we signed
      a distribution agreement in 2006 with Platinum Medical, an experienced imaging
      and major medical equipment distributor. Viking focuses its sales effort on
      geographical regions around key population centers.





Internationally,
      Viking has agreements with distributors in Sweden, Italy, Russia, Ukraine,
      The
      Netherlands, Korea, Australia, New Zealand and India and is currently in
      negotiations with distributors for other key countries to complete its
      distribution network in the EU and Asia. There can be no assurance Viking will
      be able to enter into additional distribution agreements





Complementing
      a sales drive into specific procedural specialties, we have an aggressive
      marketing communication strategy that includes exposure through trade shows,
      public relations outreach, clinical studies and publications, validation through
      a clinical advisory board and targeted direct mail and internet based outreach
      programs. Viking’s marketing objective is to create premium brand recognition
      for its solutions, which will support growth of 3Di System placements from
      9 and
      24 in 2005 and 2006, respectively.





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
                3-D
                depth perception to safely and precisely navigate the anatomy of
                a
                patient;


·
            Urological
                surgeons are very 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.


7


**OEM
      MARKET DEVELOPMENT**





Viking’s
      OEM business will continue to leverage its long standing customer relationships
      and focus on adding stable, brand name companies to its customer list. To do
      this, Viking added an experienced professional who has filled the position
      of
      Director of OEM Sales and Marketing to coordinate the strategic partner,
      business development and OEM sales efforts for our unique visualization
      solutions. We believe that there is an expanding market for all types of
      visualization solutions as the trend towards more minimally invasive procedures
      increases. We believe Viking is uniquely positioned to provide a broad range
      of
      solutions to our OEM customers.





**OPERATIONS**





Our
      product development, production and engineering functions are managed in
      Westborough, Massachusetts by Jed Kennedy, who oversees a staff of 16 full-time
      employees, one part-time employee and a part-time consultant. This department
      provides Viking production capability, product development, quality assurance,
      regulatory affairs management, OEM sales management and technical sales support.
      Subject to adequate capital, we plan to increase the size of our engineering
      and
      design staff over the next 12 months in order to accelerate the introduction
      of
      new products.





**PRODUCT
      DEVELOPMENT**





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





Head
      Mounted Display. Our key design goals for the new HMD are to incorporate a
      higher resolution, smaller and lighter weight system. In pursuing these
      initiatives, we will continue to offer the same quality of color fidelity and
      contrast ratio while continuing to migrate from a transmissive to a reflective
      display technology to achieve lighter weight and smaller size.





*InfomatixTM* .
      We are
      working on the development of the next generation of *InfomatixTM* which
      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.





New
      HD
      Digital Platform. Within the last two years, advances in video sensors and
      semiconductors have created the opportunity to significantly advance the level
      of image quality. Our product development plans include a video architecture
      that is independent of image sensor and resolution to serve SD, HD and Mega
      Pixel applications as required. This architecture would be developed with a
      common feature set that could respond to new market opportunities at minimal
      cost and schedule. This effort will include a smaller diameter “chip on a stick”
stereoscope that will be all digital and take advantage of our exclusively
      licensed patents.


8


**PRODUCTION
      AND ENGINEERING**





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 fixturing, test
      equipment and hand tools. Viking outsources all fabrication operations. There
      is
      currently floor space capacity to build and ship over 200 3Di Systems per year,
      in addition to planned OEM shipments. Additional skilled labor is readily
      available in the local market as production volume increases.





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 last time
      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. Viking’s policies and procedures have been audited and
      found to be compliant by the regulatory agencies for both the U.S. and Europe. All
      products have been tested and approved to IEC60601-2-18 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.





**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. We also
      have
      exclusive license rights to five U.S. patents and three non-U.S.
      patents.




In
      connection with the acquisition of the Vista Assets, we entered into the License
      Agreement pursuant to which Viking was granted certain license rights to
      technology under twenty two patents.  Upon execution of the Technology
      Transfer and Settlement Agreement in November 2006 with IVOW, the new owners
      of
      Vista, ownership of fourteen of the patents was transferred to us and we
      retained license rights to the remaining eight 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, supported by Christine Nichols,
      a
      regulatory affairs professional with over 15 years of experience in the medical
      device industry. Ms. Nichols also acts as our management representative as
      required by the Medical Device Directive. Additionally there is one full-time
      inspector who is responsible for the final inspection of all product shipped
      as
      well as incoming material inspections. 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.


9


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 facility was the subject of a routine surveillance audit by the
      FDA
      in February 2003. No adverse findings were noted.




**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 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.


10


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




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




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




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


11


*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 36 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. PROPERTIES**





We
      currently lease and occupy 3,506 square feet of office space in San Diego,
      California for commercial operations and corporate headquarters. The lease
      expires in January 2008. Our Manufacturing and Research and Development facility
      is located in approximately 17,850 square feet located in Westborough,
      Massachusetts. The lease, originally due to expire in October 2007, was recently
      extended for three years and will expire on September 30, 2010. 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**





No
      matters were submitted to Viking Systems’ shareholders for a vote during the
      last quarter of the year ended December 31, 2006.


12


**PART
      II**





**ITEM
      5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED SECURITY HOLDER
      MATTERS**





Our
      common stock is quoted on the OTC “Bulletin Board” under the symbol “VKSY.OB”.
      During the last two 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.





High
                Bid
            Low
                BidFiscal
                Year Ended December 31, 2005First
                Quarter
            $0.80
            $0.55Second
                Quarter
            0.70
            0.38Third
                Quarter
            0.65
            0.38Fourth
                Quarter
            0.50
            0.36Fiscal
                Year Ended December 31, 2006First
                Quarter
            $0.51
            $0.30Second
                Quarter
            0.55
            0.25Third
                Quarter
            0.50
            0.25Fourth
                Quarter
            0.30
            0.07Fiscal
                Year Ended December 31, 2007First
                Quarter
            $0.35
            $0.17Through
                March 19, 2007





**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 issued were issued
      in
      non registered 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:





In
      May
      2005, we issued 18,750 shares of our common stock, at $0.40 per share, to our
      non-employee directors, as compensation.





In
      August
      2005, we issued 200,000 shares of our common stock to Alliance Advisors, LLC
      as
      part of our agreement with this company to be our Investor Relations
      firm.





In
      August
      2005, we issued 20,000 shares of our common stock to Dermaplus, Inc. as part
      of
      our agreement with Alliance Advisors, LLC.





In
      August
      2005, we issued 2,500,000 shares of our common stock, at $0.20 per share, to
      Donald Tucker as he converted a Convertible Secured Note Payable of
      $500,000.


13


In
      March
      2005, we issued 1,291,650 shares of our common stock at $0.40 per share, to
      Donald Tucker as he converted a Convertible Secured Note Payable of $500,000
      and
      interest in the amount of $16,660.





In
      May
      2006, we issued 26,388,889 shares of our common stock to convertible note
      holders who converted $4,750,000 in convertible notes at $0.18 per
      share.




In
      February 2007, we issued 4,000,000 common shares to our Series B preferred
      stock
      holders in conjunction with a waiver, consent and amendment
      agreement.





**Holders**





As
      of
      March 13, 2007 there were 65,864,941 shares of common stock outstanding and
      approximately 121 stockholders of record of common stock.





**Dividends**





We
      have
      accumulated and unpaid preferred stock dividends at December 31, 2006 in the
      amount of $391,014. We have initiated discussions with our Series B preferred
      shareholders and may pay the accrued dividends and future dividends in stock.
      Otherwise, we plan to pay these dividends in 2007 and continue to pay
      approximately $151,000 in preferred dividends on a quarterly basis unless the
      preferred stockholders convert the stock to common shares.





We
      have
      not paid any cash dividends on our common shares 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





**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 Registration
      Statement, the Board of Directors has not extended indemnification rights to
      persons other than directors and officers.


14


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, 1800 South West Temple, Suite
      301,
      Salt Lake City, UT 84115; telephone (801) 484-7222.





**ITEM
      6. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATION**





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 contain descriptions of Viking System’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
      Systems provides high performance 3-D endoscopic vision systems to hospitals
      for
      minimally invasive surgery along with high performance 2-D systems and
      components to OEM customers. We intend to develop a portfolio of targeted
      medical technologies and services that serve the current and emerging needs
      of
      the digital healthcare network. Our focus is to deliver integrated information,
      visualization, and control solutions to the surgical team, enhancing their
      capability and performance in minimally invasive surgery (MIS) and complex
      surgical procedures.





**Liquidity
      and Capital Resources**





Since
      December 31, 2003, Viking System’s principal sources of liquidity have been
      funds raised from the sale of our equity securities and the sale of Convertible
      Notes. At December 31, 2006, we had cash and cash equivalents of $440,465.





In
      March
      of 2006, Viking Systems’ issued a $200,000 note payable to our President and
      CEO, who is 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 secured for the purpose of bridging our cash position until the completion
      of the Series B Preferred equity financing in May 2006.





In
      May,
      2006 the Company issued 8,000 shares of Series B 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 Series B
      Preferred. Proceeds from the sale of Series B Preferred 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 CEO who is also
      a
      significant shareholder and Director. The promissory notes were converted into
      the Debentures issued in February 2007 described below.


15


On
      February 24, 2007, Viking Systems, Inc. (“Viking”) closed upon the sale of
      $5,376,533 of its Secured Convertible Debentures (the “Debentures”) pursuant to
      a Securities Purchase Agreement and related agreements (the “Transaction
      Documents”), among (i) Viking and 13 purchasers (collectively, the
“Investors”). As of February 24, 2007 a total of $5,376,533 of Debentures had
      been sold to 13 Investors. Viking may issue additional Debentures.





Net
      cash
      used in operating activities was approximately $6,276,000 and $5,137,000, for
      the years ended December 31, 2006 and 2005, respectively. The increase in net
      cash used in operating activities during 2006 compared to 2005 was attributable
      primarily to the increased net loss in 2006, which resulted in part due to
      increased operating expenses associated with expanding the Company’s business
      activities. The increase in operating expenses during 2006 compared to 2005
      was
      attributable primarily to an increase of approximately $1,600,000 in selling
      and
      marketing expenditures, increased general and administrative expenditures of
      approximately $1,000,000, and an increase in research and development
      expenditures of approximately $589,000. Increases in use of cash in 2006 for
      the
      purposes of accounts receivables, inventories and other assets were offset
      by
      decreases in the use of cash for the benefit of accounts payables, accrued
      expenses and deferred revenue.





Net
      cash
      used in investing activities was approximately $911,000 and $371,000 in 2006
      and
      2005, respectively. The 2006 total reflects a $540,000 increase over 2005 for
      purchases of property and equipment.





Cash
      flows provided by financing activities were approximately $7,192,000 and
      $5,803,000 in 2006 and 2005, respectively. The cash flows from financing
      activities in 2006 were due mainly to the $7,250,000 proceeds from the preferred
      stock issuance, less offering costs of $436,000. The cash flows from financing
      activities in 2005 were primarily attributable to net proceeds from a private
      placement of convertible debt of approximately $5,651,000 and short term bank
      borrowings of approximately $152,000.





We
      incurred operating losses in 2006 and 2005 in the amount of $6,836,747and
      $4,475,565, respectively, and at December 31, 2006 had an accumulated deficit
      of
      approximately $18,548,000. In January 2005 we obtained a $200,000 line of credit
      from Silicon Valley Bank, and at December 31, 2005 we had borrowed $200,000
      against that line. In addition, we had amounts available under a bank line
      of
      credit facility equal to 80% of our outstanding receivables up to a maximum
      of
      $400,000. In connection with the 2007 financing, this line of credit was
      cancelled by the Company. During 2005, we received net proceeds of $5,651,000
      from the issuance of convertible notes payable.





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 President, CEO
      Director. The promissory notes were converted into convertible debentures in
      connection with the convertible debt financing completed in February
      2007.





We
      believe that these sources of liquidity, including the February 2007 convertible
      debt financing and together with anticipated 2007 product revenues and interest
      income, may be sufficient to operate our business. However, increases in
      expenses or delays in product development or failure to achieve our sales
      projections may adversely impact our cash position and may require cost
      reductions or require the Company 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.


16


**Results
      of Operations**





Viking
      Systems had product sales from operations of approximately $5,617,000 for the
      year ended December 31, 2006 and of approximately $3,835,000 for the year ended
      December 31, 2005, representing an increase of approximately $1,782,000. The
      increase in revenues during 2006 was due to increased sales in both 3Di and
      OEM
      products and service. Sales to individual customers exceeding 10% or more of
      revenues in the year ended December 31, 2006 were to three customers who
      accounted for 21%, 13% and 11% of revenues, respectively.





Gross
      margins were approximately $1,705,000 or 30% for the year ended December 31,
      2006 and $905,000 or 24% for the year ended December 31, 2005, representing
      an
      increase of approximately $800,000. The increase in the 2006 gross margin and
      percentage over 2005 was due to increased sales and a mix of higher margin
      product revenues. Under the Technology Transfer and Settlement Agreement between
      Viking and IVOW, we purchased patents and prepaid the royalties for licensed
      technology for a discount which improved gross margin.





We
      incurred operating expenses of approximately $8,542,000 for the year ended
      December 31, 2006 and approximately $5,381,000 for the year ended December
      31,
      2005, representing an increase of approximately $3,161,000. The increase in
      operating expenses corresponds to the continued efforts to develop market
      awareness of our products, build a sales organization, and to continue our
      research and development efforts to maintain and develop other products.





General
      and administrative expenses were approximately $2,485,000 for the year ended
      December 31, 2006 and approximately $1,528,000 for the year ended December
      31,
      2005, representing an increase of approximately $957,000. The increase in
      general and administrative expense in 2006 was due to increased payroll for
      additional employees and approximately $368,000 in incremental stock-based
      compensation expense associated with the adoption of Statement of Financial
      Accounting Standards No. 123(Revised 2004), *Share-based
      Payment.*





Sales
      and
      marketing expenses were approximately $4,545,000 for the year ended December
      31,
      2006 and $2,930,000 for the year ended December 31, 2005, representing an
      increase of approximately $1,615,000. Viking Systems continued to add employees
      in 2006, resulting in nearly a $1,112,000 increase in sales and marketing
      salaries, commissions, deferred compensation and payroll related costs. Sales
      and marketing travel, entertainment and transportation expense was up
      approximately $192,000, repairs, maintenance and facility costs were up about
      $71,000 and depreciation of trade show and demonstration equipment increased
      over $109,000 in 2006 due to the increase pool of that equipment. Telephone,
      tradeshows and sales meeting expense increased by approximately $190,000. Public
      relations, clinical advisor fees and other marketing and promotional cost
      decreased during 2006 by approximately $92,000.





We
      had
      research and development expenses of approximately $1,512,000 for the year
      ended
      December 31, 2006 and $922,000 for the year ended December 31, 2005,
      representing an increase of approximately $590,000. Research and development
      expenses increased as a result of an increased staff to work on the new OEM
      customer products as well as continuing development of the 3Di Digital Vision
      System and maintenance and enhancement of our 2D OEM camera
      products.


17


We
      had
      interest expenses of approximately $551,000 for the year ended December 31,
      2006
      and $281,000 for the year ended December 31, 2005. Interest expense related
      to the 2005 convertible notes amounted to approximately $271,000 and $281,000
      for the years ended December 31, 2006 and 2005, respectively. During 2006,
      we also incurred approximately $227,000 in interest expense as a delay fee
      in
      connection with the Company’s failure to register certain common shares issued
      to noteholders who converted their shares in 2006.





We
      had
      interest income of $61,162 in 2006 resulting from the proceeds of our 2006
      preferred stock financing being deposited in interest bearing accounts. In
      2006,
      we also recorded a $4,975,824 gain on the extinguishment of debt as a result
      of
      the Company and the noteholders agreeing to modify certain terms of the
      convertible notes totaling $5,250,000. The gain on extinguishment of debt
      resulted from the difference between the deemed reacquisition value of the
      convertible notes on the date conversion terms were modified ($5,250,000) less
      the fair value of the modification of the warrants issued under new conversion
      terms ($274,176). We had no such income in the comparable periods in 2005.





We
      had
      non-cash expense from amortization of debt discount of approximately $8,481,000
      for the year ended December 31, 2006 and approximately $2,773,000 for 2005.
      The
      increase of $5,708,000 is due primarily to the inclusion in 2006 of $5,250,000
      in non-cash expense representing the deemed reacquisition value of convertible
      notes when their conversion terms were modified. In 2006, we also recorded
      a
      gain on the extinguishment of debt by approximately $4,976,000 and adjusted
      the
      fair value of all the Company’s warrants with the recognition of a non-cash
      derivative liability loss of $2,968,000 for the year ended December 31,
      2006.





Viking
      Systems incurred net losses of approximately $8,704,000 for the year ended
      December 31, 2006 and $7,529,000 for the year ended December 31, 2005,
      representing a year-over-year increase in loss of approximately $1,175,000.
      The
      increase in net losses during 2006 was due to the significant cost to execute
      our business, including our sales and marketing plan. In 2006, we recorded
      liquidated damages of $840,000 in connection with certain shares underlying
      the
      Series B preferred securities that had not been registered pursuant to the
      terms
      of the registration rights agreement. In addition to the net loss, we recoded
      an
      accretion of Series B Preferred stock in the amount of $8,391,014, making the
      loss applicable to common shareholders approximately $ 17,095,000.





**Off-Balance
      Sheet Arrangements**





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





**Contractual
      Obligations and Commitments**





At
      December 31, 2005 Viking Systems was obligated under an operating lease for
      the
      Westborough, MA facility, which was originally due to expire in October 2007
      but
      was extended to September 30, 2010. Viking Systems is also obligated under
      an
      operating lease effective February 8, 2006 for office space in San Diego, CA,
      which expires January 31, 2008. On a combined basis under these leases, Viking
      Systems is committed to make payments totaling approximately $274,000, $170,000,
      $160,000 and $120,000 in 2007, 2008, 2009 and 2010, respectively.


18


In
      connection with the acquisition of the assets of Vista Medical Technology,
      Viking Systems entered into a license agreement for the intellectual property
      and product rights used in the operation of the business acquired. In exchange
      for this license grant, Viking Systems was required to pay Vista royalties
      of 5%
      of all original equipment manufacturer (OEM) sales and 10% of all sales of
      the
      3Di System for a period of five (5) years beginning in April 2004. The license
      agreement required minimum royalties of $150,000 in year one, $300,000 in each
      of years two, three and four, and $375,000 in year five. The royalties payable
      by Viking Systems under the license agreement were capped at $4,500,000 in
      the
      aggregate, over the five-year period, and Vista would retain ownership of all
      intellectual property and product rights until these royalty obligations had
      been satisfied, at which time Vista would transfer ownership of such
      intellectual property and product rights to Viking Systems. In November 2006,
      Viking and IVOW, the new owners of Vista entered into a Technology Transfer
      and
      Settlement Agreement whereby IVOW would immediately transfer the ownership
      of
      the intellectual property and technology for a final payment of $500,000 that
      included $150,000 for accrued royalties and $350,000 for intellectual property..
      As of December 31, 2006 and December 31, 2005, Viking Systems had accrued
      royalties related to this agreement of approximately $0 and $75,000,
      respectively. During 2006 and 2005, Viking Systems paid royalties under this
      agreement of approximately $650,000 and $225,000, respectively.





Viking
      Systems has also entered into a royalty agreement with a supplier. The royalty
      agreement requires payments of 4% of sales that use the supplier’s product. As
      of December 31, 2006 and 2005, Viking Systems had accrued royalties related
      to
      this agreement of approximately $19,027 and $12,090, respectively. During 2006
      and 2005, Viking Systems did not pay any royalties under this
      agreement.





Viking
      Systems has a License Agreement with McKinley Optics, which originated as of
      April 15, 2004, whereas Viking has exclusive use of Mr. McKinley’s stereo
      imaging patents. Under this agreement, which expires on August 24, 2008, Viking
      Systems pays McKinley $54,000 per year in equal monthly payments. The McKinley
      patents have been licensed for potential new products and should the license
      agreement not be renewed, there will be no impact on Viking’s current
      business.





Viking
      had an agreement with a bank through which the bank was to advance funds to
      Viking Systems equal to 80% of receivables resulting from sales by Viking
      Systems up to a maximum of $400,000. Funds advanced accrued interest at prime
      plus 3.5%. Upon collection from the customer, the bank retained the funds
      advanced against the receivable being paid, plus the related accrued interest,
      and the remaining amount of the collection is remitted to Viking Systems. The
      agreement originally expired on September 14, 2006 and was extended until it
      was
      cancelled by the Company upon the completion of the February 2007 convertible
      note financing.





Viking
      had a Loan and Security Agreement, dated as of February 9, 2005 and renewed
      on
      September 13, 2005, with Silicon Valley bank, where Viking could borrow up
      to
      $200,000 against a Certificate of Deposit owned by Donald Tucker, a significant
      shareholder. This agreement expired on May 13, 2006.





During
      the first quarter of 2005, we raised $2,850,000 through the issuance of
      convertible notes (the “Notes”). During 2005, $600,000 of these Notes, and
      $400,000 of convertible notes issued during 2004 were converted to Viking
      Systems’ common stock at a conversion rate of $0.20 per share of common stock,
      and $500,000 was converted at a conversion rate of $.40 per share of common
      stock. From August to December 2005, we raised an additional $3,000,000 through
      the issuance of convertible notes that currently carry substantially identical
      terms.


19





During
      March 2006 Viking Systems received $200,000 through the issuance of a note
      payable to a major shareholder.





During
      the second quarter of 2006, we raised $250,000 through the issuance of a
      convertible note (the “Note”). The general terms of this financing are as
      follows:





Maturity
                Date of Notes
            The
                earlier of May 31, 2006 or the closing of a subsequent equity
                financing.Interest
                Rate of Notes
            Ten
                percent per annum.Loan
                Premium
            $12,500,
                due at maturity.Optional
                Conversion
            At
                the sole option of the lender the note may be converted into either
                of the
                following: (i) shares of Viking’s common stock at the lower of $.20 per
                share or the effective price per share of the common stock provided
                for in
                the subsequent financing; or (ii) the preferred stock and other securities
                offered in a subsequent financing.





Warrants
            Viking
                Systems is to issue lender the following Warrants: (i) a Warrant
                to
                purchase the greater of (i) 1,250,000 shares of Viking’s Common Stock and
                (ii) the principal amount of the loan ($250,000) divided by the effective
                price per share of common stock provided for in the Subsequent Financing
                exercisable at $.50 per share, subject to adjustment pursuant to
                the terms
                of the warrant. The warrant shall be for a term of five (5) years
                from the
                date hereof, and (ii)a
                warrant to purchase the greater of (i) 1,250,000 shares of Viking’s common
                stock and (ii) the principal amount of the loan ($250,000) divided
                by the
                effective price per share of common stock provided for in the Subsequent
                Financing exercisable at $.75 per share, subject to adjustment pursuant
                to
                the terms of such Warrant. The warrant shall be for a term of five
                (5)
                years from the date hereof.Registration
                Rights
            The
                common stock of Viking Systems issuable upon the conversion of the
                promissory note and the common stock issuable upon exercise of the
                warrants shall have registration rights that are substantially equivalent
                to the registration rights granted to investors in a subsequent financing.




20





In
      May,
      2006 the Company issued the Series B Preferred 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 Series B Preferred.
      Proceeds from the sale of Series B Preferred consisted of $7,250,000 in cash
      and
      the conversion of $750,000 of convertible notes. Each share of Series B
      Preferred, par value $0.001 per share, with a stated value of
      $1,000 per share (“Stated Value”), is convertible, subject to adjustments,
      into approximately 5,555 shares of common stock and warrants to purchase an
      additional 2,778 shares of common stock at an initial price of $0.35 per
      share.





Following
      is a summary of the Series B Preferred stock rights, preferences and
      privileges:





Dividends
            Holders
                of the Series B Preferred Stock (each a “Holder”) are 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 shall be paid in cash or shares of Viking common stock,
                or a
                combination thereof, pursuant to the terms and conditions of the
                transaction documents. Dividends are payable on the first day following
                the end of each fiscal quarter of the Company. Dividends do not compound;
                provided, that if the Company fails to pay such dividends as required,
                then accrued but unpaid dividends shall bear an interest rate of
                eighteen
                percent (18%) per annum compounding daily. Under certain circumstances,
                if
                dividend payments have not been made, at the Holder’s option, unpaid
                dividends may be accreted to, and increase, the outstanding Stated
                Value.





Voting
                Rights
            The
                holders of the Preferred Stock have no voting rights unless required
                under
                applicable state corporate lawLiquidation
            Upon
                any liquidation, dissolution, or winding-up of Viking, whether voluntary
                or involuntary (a “Liquidation”), the holders of Series B Preferred Stock
                shall be entitled to receive out of the assets, whether capital or
                surplus, of Viking an amount equal to the stated value of the Series
                B
                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 Series B 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 Series B Preferred
                Stock
                shall 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.




21





Conversion
            The
                stated value of the shares of Preferred Stock is initially convertible
                into shares of Viking’s common stock at a price of $.18 per share;
                however, the conversion price is subject to adjustment based upon
                certain
                conditions.  If all shares of Preferred Stock are converted into
                common stock at the initial conversion price, of which there can
                be no
                assurance, approximately 44,444,444 shares of common stock will be
                issued
                in such conversion. “Certain Price and Share Adjustments,” below,
                describes circumstances under which the Conversion Price may be modified.Warrants
            Viking
                Systems shall issue Lender the following Warrants: warrants to purchase
                an
                additional 22,222,222 shares of common stock at an initial price
                of $0.35
                per share.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
                provides for liquidated damages by the Company to the Holders if
                the
                Company is unable to complete the registration, or subsequent
                registrations, or maintain such
                effectiveness.





As
                of December 31, 2006 certain shares underlying the Series B preferred
                securities had not been registered pursuant to the terms of the
                Registration Rights Agreement, The Purchasers of Series B Preferred
                shares
                agreed to waive the registration requirements of the Registration
                Rights
                Agreement and each Purchaser agreed to accept, and the Company agreed
                to
                issue to the Purchasers, an aggregate of 4,000,000 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 Series B preferred shareholders,
                4,000,000 Liquidated Damage Shares were issued in February 2007.
                At
                December 31, 2006 the Company accrued $840,000 in expense related
                to the
                liquidated damages.


22





Certain
                Price and Share Adjustments
            a)Stock
                Dividends and Stock Splits.
                If Viking (A) pays a stock dividend or otherwise makes a distribution
                or
                distributions payable in shares of common stock on shares of common
                stock
                or any other common stock equivalents; (B) subdivides outstanding
                shares
                of common stock into a larger number of shares; (C) combines (including
                by
                way of a reverse stock split) outstanding shares of common stock
                into a
                smaller number of shares; or (D) issues, in the event of a
                reclassification of shares of the common stock, any shares of capital
                stock of Viking, then the conversion price shall be adjusted
                accordingly.
              
              b)Subsequent
                Equity Sales.
                If Viking sells or grants any option to purchase or sells or grants
                any
                right to reprice its securities, or otherwise disposes of or issues
                any
                common stock or common stock equivalents entitling any person to
                acquire
                shares of common stock at an effective price per share that is lower
                than
                the then conversion price of the Series B Preferred Stock (such lower
                price, the “Base
                Conversion Price”
                and such issuances collectively, a “Dilutive
                Issuance”),
                then the conversion price shall be reduced, by multiplying the conversion
                price by a fraction, the numerator of which is the number of shares
                of
                common stock issued and outstanding immediately prior to the Dilutive
                Issuance plus the number of shares of common stock that the actual
                cash
                offering price for such Dilutive Issuance would purchase at the then
                Exercise Price, and the denominator of which shall be the sum of
                the
                number of shares of common stock issued and outstanding immediately
                prior
                to the Dilutive Issuance plus the number of shares of common stock
                so
                issued or issuable in connection with the Dilutive Issuance, but
                in no
                event shall such adjustment reduce the Conversion Price to less than
                $0.05.
              
              c)Subsequent
                Rights Offerings.
                If Viking shall issue rights, options, or warrants to all holders
                of
                common stock entitling them to subscribe for or purchase shares of
                common
                stock at a price per share that is lower than the effective value
                weighted
                average price (“VWAP”), then the conversion price shall be multiplied by a
                fraction of which the denominator shall be the number of shares of
                the
                common stock outstanding on the date of issuance of such rights or
                warrants plus the number of additional shares of common stock offered
                for
                subscription or purchase, and of which the numerator shall be the
                number
                of shares of the common stock outstanding on the date of issuance
                of such
                rights or warrants plus the number of shares which the aggregate
                offering
                price of the total number of shares so offered (assuming delivery
                to
                Viking in full of all consideration payable upon exercise of such
                rights,
                options or warrants) would purchase at such VWAP. Such adjustment
                shall be
                made whenever such rights or warrants are issued, and shall become
                effective immediately after the record date for the determination
                of
                stockholders entitled to receive such rights, options or
                warrants.





23


Redemptions .
      Subject
      to certain conditions, the Company, at any time after the four year anniversary
      of the date that the Company’s registration statement covering the shares of
      common stock issuable upon conversion of the Preferred Stock is declared
      effective by the Securities and Exchange Commission, may redeem shares of
      Preferred Stock at the Stated Value plus any accrued and unpaid dividends and
      any other amounts due in respect of the Preferred Stock.





Pursuant
      to the terms and conditions of the transaction documents, upon the occurrence
      of
      certain events (each a “Triggering Event”), each Holder has the right to require
      the Company to redeem Preferred Stock for cash or for shares of Viking common
      stock. Depending upon the nature of the Triggering Event the Holder
      would:





(1)
      receive in cash for each share of Preferred Stock, the sum of (i) the greater
      of
      (A) 130% of the Stated Value or (B) the product of (a) the VWAP on the Trading
      Day immediately preceding the date of the Triggering Event and (b) the Stated
      Value divided by the then Conversion Price, (ii) all accrued but unpaid
      dividends thereon and (iii) all liquidated damages and other costs, expenses
      or
      amounts due in respect of the Preferred Stock, or





(2)
      either (a) redeem all of the Preferred Stock then held by such Holder for a
      redemption price, in shares of Common Stock, equal to a number of shares of
      Common Stock equal to the sum of (i) the greater of (A) 130% of the Stated
      Value
      or (B) the product of (a) the VWAP on the Trading Day immediately preceding
      the
      date of the Triggering Event and (b) the Stated Value divided by the then
      Conversion Price, (ii) all accrued but unpaid dividends thereon and (iii) all
      liquidated damages and other costs, expenses or amounts due in respect of the
      Preferred Stock divided by 75% of the average of the 10 VWAPs immediately prior
      to the date of election to redeem Preferred Stock for common stock, or (b)
      increase the dividend rate on all of the outstanding Preferred Stock held by
      such Holder to 18% per annum thereafter.





On
      February 24, 2007, Viking Systems, Inc. (“Viking”) closed upon the sale of
      $5,376,533 of its Secured Convertible Debentures (the “Debentures”) pursuant to
      a Securities Purchase Agreement and related agreements (the “Transaction
      Documents”), among (i) Viking and 13 purchasers (collectively, the
“Investors”). As of February 24, 2007 a total of $5,376,533 of Debentures had
      been sold to 13 Investors. Viking may issue additional Debentures. The general
      terms of this financing are as follows:


24





Maturity
                Date of Notes
            Two
                years from the date of issuance and may be accelerated by Investor
                upon
                default by Viking.Interest
                Rate of Notes
            Eight
                percent per annum, payable quarterly and subject to certain conditions,
                Viking may pay interest by issuing the holders of the Debentures
                shares of
                Viking common stock.Security
            The
                Notes are secured by all of the assets of Viking.Optional
                Conversion by Investors
            ***Conversion.***The Debentures may, at the option of the Investors, be converted
                into
                shares of Viking common stock at the price of $.18 per share. In
                the event
                Viking does not achieve certain operation milestones (described in
                the
                Debentures Warrants) during the first three quarters of 2007, the
                conversion price will be reduced to $.12 per share. The conversion
                price
                is also subject to downward adjustment, upon certain conditions pursuant
                to the terms of Security Purchase Agreement, the Debentures and other
                Transaction Documents.Optional
                Redemption by Viking
            Viking
                may not prepay the debentures but it may redeem some or all of the
                Debentures if certain conditions (“Equity Conditions”) are met. The
                Optional Redemption Amount (as defined in the Transaction Documents)
                equals 120% of the principal amount of the Debentures redeemed if
                the
                redemption occurs prior to the first anniversary date of the issuance
                of
                the Debentures, and 140% of the principal amount of the Debentures
                redeemed if the redemption occurs after the first anniversary date
                of the
                issuance of the Debentures but prior to the second anniversary date
                of
                issuanceWarrants
            As
                additional consideration for the Investors purchasing the Debentures,
                Viking has issued the Investors Warrants to purchase shares of Viking
                common stock at the price of $0.18 per share. In the event Viking
                does not
                achieve certain operation milestones (described in the Warrants and
                the
                Debentures) during the first three quarters of 2007, the exercise
                price
                will be reduced to $.12 per share. The exercise price is also subject
                to
                downward adjustment, upon certain conditions pursuant to the terms
                of
                Security Purchase Agreement, the Warrant and other Transaction Documents.
                The Warrants are exercisable for a period of seven years from the
                date of
                issuance. The Warrants provide that each Investor is issued to purchase
                that number of shares of common stock of Viking that equals 50% of
                the
                number of shares issuable upon conversion of the Debentures. Assuming
                $6,000,000 of Debentures are sold, and assuming the Debentures are
                convertible into 33,333,333 shares of Viking common stock, the warrants
                will entitle the holders to purchase an aggregate of approximately
                16,666,667 shares of Viking common stock. Assuming $6,000,000 of
                Debentures are sold, and assuming the Debentures are convertible
                into
                50,000,000 shares of Viking common stock, the warrants will entitle
                the
                holders to purchase an aggregate of approximately 25,000,000 shares
                of
                Viking common stock.


25




Registration
                Rights
            Viking
                has agreed to register with the Securities and Exchange Commission,
                the
                shares of common stock that are issuable upon the conversion of the
                Debentures and the shares of common stock that underlie the Warrants.
                Viking will pay all expenses and cost of registration except for
                commissions. In the event the securities underlying the Debentures
                and
                Warrants are not registered by the dates agreed to in the Transaction
                Documents, Viking will be required to pay liquidated damages to the
                Holders. Such liquidated damages amount to 2% per month but will
                not
                exceed 18% of the face amount of the Debentures.Additional
            Pursuant
                to the Securities Purchase Agreement, the Holders were granted certain
                rights to participate in subsequent financings by
                Viking.




**Plan
      of Operation**





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





**Critical
      Accounting Policies**





This
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations discuss Viking Systems’ Financial Statements, which have been
      prepared in accordance with accounting principles generally accepted in the
      United States.





The
      preparation of our financial statements requires management to make estimates
      and assumptions that affect reported amounts of assets and liabilities and
      the
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. On an ongoing basis, management evaluates its estimates and
      assumptions, including those related to inventory, income taxes, long lived
      asset valuation, revenue recognition and stock based compensation. Management
      bases its estimates and judgments on historical experience of the 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
      Consolidated Financial Statements.





***Inventory.*** Viking
      Systems 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.


26


***Income
      Taxes.*** In
      determining the carrying value of Viking Systems’ net deferred tax assets,
      Viking Systems 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 Systems may record a reduction in the valuation allowance,
      resulting in an income tax benefit in Viking Systems’ Statements of Operations.
      Management evaluates the realizability of the deferred tax assets and assesses
      the valuation allowance quarterly.





***Other
      Long-Lived Asset Valuations.*** Long-lived
      assets such as property, equipment and definite-lived intangibles are reviewed
      for impairment whenever events or changes in circumstances indicate that the
      carrying value of an asset may not be recoverable. 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 year ended December 31, 2006 ands 2005, no
      impairment of long-lived assets was recorded.




***Revenue
      Recognition*** .
      Our
      revenues are derived from the sale of surgical visualization technology products
      to end users, distributors and original equipment manufactures. Revenue from
      the
      sale of products is recognized when a purchase order has been received, the
      product has been shipped, the selling price is fixed or determinable, and
      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. The allocation of fair value for a
      multiple-element arrangement is based on vendor specific objective evidence
      (“VSOE”) or in absence of VSOE for delivered elements, the residual method. In
      the absence of VSOE for undelivered elements, revenue is deferred and
      subsequently recognized over the term of the arrangement. 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 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.




Prior
      to
      2006, Viking Systems accounted for its employee stock-based compensation plans
      using the intrinsic value method, as prescribed by APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      related interpretations. Accordingly, Viking Systems recorded deferred
      compensation costs related to its employee stock options when the current market
      price of the underlying stock exceeded the exercise price of each stock option
      on the measurement date (usually the date of grant).


27


Viking
      Systems recorded and measured deferred compensation for stock options granted
      to
      non-employees, other than members of Viking Systems’ Board of Directors, using
      the fair value based method. Deferred compensation is expensed on a
      straight-line basis over the vesting period of the related stock option. During
      2006 and 2005, Viking Systems did not grant any stock options to employees
      or
      members of Viking Systems’ Board of Directors with exercise prices below the
      market price on the measurement date. Viking Systems granted stock options
      to
      non-employees for services resulting in approximately $218,000 and $159,000
      of
      general and administrative expense during 2006 and 2005,
      respectively.





***Valuation
      of Derivative Liabilities.*** At
      each reporting date, the fair value of 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.





**Recent
      Accounting Pronouncements**


In
        September 2005, the EITF reached a consensus on Issue No. 05-8, Income Tax
        Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature
        (EITF No. 05-8”). Under EITF No. 05-8, issuance of convertible debt with a
        beneficial conversion feature recorded pursuant to EITF 98-5, Accounting
        for
        Convertible Securities with Beneficial Conversion Features or Contingently
        Adjustable Conversion Ratios and EITF 00-27, Application of Issue No. 98-5
        to
        Certain Convertible Instruments results in a temporary difference for purposes
        of applying Statement 109. The deferred taxes recognized for the temporary
        difference should be recorded as an adjustment to paid-in capital. The EITF
        No.
        05-8 Consensus should be applied retrospectively to all instruments with
        a
        beneficial conversion feature accounted for under EITF 98-5 and EITF 00-27
        for
        periods beginning after December 15, 2005. The adoption of EITF 05-8 did
        not
        have a material impact on our financial statements.


In
      February 2006, the Financial Accounting Standards Board (“FASB”) released
      Statement No. 155, *Accounting
      for Certain Hybrid Financial Instruments* ,
      ("SFAS No. 155"). SFAS No.155 is an amendment of Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities, and
      Statement No. 140, *Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities* .
      SFAS No. 155 establishes, among other items, the accounting for certain
      derivative instruments embedded within other types of financial instruments;
      and, eliminates a restriction on the passive derivative instruments that a
      qualifying special-purpose entity may hold. Effective for the Company beginning
      January 1, 2007, SFAS No. 155 is not expected to have a significant
      impact on the Company's financial position, results of operations or cash flows.





In
      March 2006, the FASB released Statement No. 156, *Accounting
      for Servicing of Financial Assets, an amendment of FASB Statement
      No. 140* ,
      ("SFAS No. 156"). SFAS No. 156 amends SFAS No. 140 to require
      that all separately recognized servicing assets and liabilities in accordance
      with SFAS No. 140 be initially measured at fair value, if practicable.
      Furthermore, this standard permits, but does not require, fair value measurement
      for separately recognized servicing assets and liabilities in subsequent
      reporting periods. SFAS No. 156 is also effective for the Company beginning
      January 1, 2007; however, the standard is not expected to have a
      significant impact on the Company's financial position, results of operation
      or
      cash flows.





In
      the
      first quarter of 2006, the Company adopted Statement No. 154 *,
      Accounting for Changes and Error Corrections—a replacement of APB Opinion
      No. 20 and FASB Statement No. 3* ,
      ("SFAS No. 154") which changed the requirements for the accounting for and
      reporting of a voluntary change in accounting principle. The Company also
      adopted Statement No. 151, *Inventory
      Costs—an amendment of ARB No. 43, Chapter 4* ("SFAS No. 151") which, among other changes, requires certain abnormal
      expenditures to be recognized as expenses in the current period versus
      capitalized as a component of inventory. The adoption of SFAS No. 154 did
      not impact the results presented and the impact on any future periods will
      depend on the nature and significance of any future accounting changes subject
      to the provisions of the statement. The adoption of SFAS No. 151 did not
      have any impact on the Company's financial position, results of operations
      or
      cash flows.





In
      June
      2006, the FASB issued Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement No.
      109* ,
      (“FIN
      48”). FIN 48 clarifies the accounting for uncertainty in tax positions and
      requires that a Company recognize in its financial statements the impact of
      a
      tax position, if that position is more likely than not of being sustained on
      audit, based on the technical merits of the position. The provisions of FIN
      48
      are effective for fiscal years beginning after December 15, 2006. The adoption
      of FIN 48 is not expected to have a significant impact on the Company's
      financial position, results of operations or cash flows.


28


In
      September 2006, the FASB issued SFAS No. 157, *Fair
      Value Measurements* (“SFAS
      No. 157”). SFAS No.
      157defines
      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.
      157is
      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.





In
      September 2006, the SEC released Staff Accounting Bulletin No. 108 *,
      Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements* (“SAB
      108”). SAB 108 provides interpretive guidance on the SEC’s views on how the
      effects of the carryover or reversal of prior year misstatements should be
      considered in quantifying a current year misstatement. We adopted SAB 108 during
      the fourth quarter of 2006. The adoption did not have a material impact on
      our
      financial position, cash flows or results of operations.




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.





**Interest
      Rate Risk**





We
      currently have notes payable that accrue interest at a fixed rate. We anticipate
      that a substantial amount of our future debt and the associated interest expense
      will be subject to changes in the level of interest rates. Increases in interest
      rates would result in incremental interest expense.





**Inflation**





Viking
      Systems does not believe that inflation will negatively impact its 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.


29


***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 Systems 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
      probable 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.





***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
      23 ,
      2007
      for the year ended December 31, 2006 includes a going concern qualification
      which stated that our significant operating losses and working capital deficit
      raise substantial doubt about our ability to continue as a going concern.





***We
      have an obligation to pay dividends on our preferred stock.*** We
      have
      accumulated and unpaid preferred stock dividends at December 31, 2006 in the
      amount of $391,014. We have initiated discussions with our Series B preferred
      shareholders and may pay the accrued dividends and future dividends in stock.
      Otherwise, we plan to pay these dividends in 2007 and continue to pay
      approximately $151,000 in preferred dividends on a quarterly basis until such
      point the preferred stockholders convert the stock to common
      shares.





***We
      do not anticipate paying any dividends on our common stock and any gains from
      your investment in our stock will have to come from increases in the price
      of
      such stock.*** **** Except
      for dividend obligations to our Series B preferred shareholders which may have
      to be paid in cash, we currently intend to retain any future earnings for use
      in
      our business and do not anticipate paying any cash dividends on common stock
      in
      the foreseeable future.





**Medical
      Products Industry Operations Risks**





We
      acquired assets and operations from Vista as described in Item 1 above. We
      also
      intend to 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.


30


***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.




***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 microsurgery.




***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 U.S. 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.


31


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 and
      significant 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.


32





**ITEM
      7.**  **FINANCIAL
      STATEMENTS**





**Index
      to Financial Statements**











**Page**Report
                of Independent Registered Public Accounting Firm
            34Balance
                Sheets at December 31, 2006 and 2005
            35Statements
                of Operations for the years ended December 31, 2006 and
                2005
            36Statements
                of Stockholders’ Deficit for the years ended December 31, 2006 and
                2005
            37Statements
                of Cash Flows for the years ended December 31, 2006 and
                2005
            38
                -39Notes
                to Financial Statements
            40
                - 68





33


REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Board of Directors and Stockholders of


Viking
      Systems, Inc.





We
      have
      audited the accompanying balance sheets of Viking Systems, Inc. (the “Company”)
      as of December 31, 2006 and 2005, 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 these financial statements based
      on
      our audit.





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 is not required to have, nor were we engaged to perform, an audit of
      its
      internal control over financial reporting. Our audit included consideration
      of
      internal control over financial reporting as a basis for designing audit
      procedures that are 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 financial statement presentation.  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, 2006 and 2005, and the results of its operations and its cash flows for
      the
      years then ended, in conformity with accounting principles generally accepted
      in
      the United States of America.





As
      discussed in Note 1 to the financial statements, the Company changed its method
      of accounting for stock-based compensation, effective January 1, 2006, as a
      result of the adoption of Statement of Financial Accounting Standards No. 123R, *Share-Based
      Payments* .





The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As discussed in Note 2 to the financial
      statements, the Company has reported recurring losses from operations through
      December 31, 2006 and had a working capital deficit at December 31, 2006. These
      factors raise substantial doubt about the Company’s ability to continue as a
      going concern. Management’s plans as to these matters are described in Note 2.
      The accompanying financial statements do not include any adjustments that might
      result from the outcome of this uncertainty.




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




San
      Diego, California


March
      23,
      2007




34


**VIKING
      SYSTEMS, INC.**


**Balance
      Sheets**


**December
      31, 2006 and 2005**





**Assets****2006**
            
            **2005**Current
                assets:Cash
                and cash equivalents
            
            $
            440,465
            
            $
            434,503Accounts
                receivable
            
            
            855,299
            
            
            248,258Inventories
            
            
            1,117,929
            
            
            567,176Prepaid
                expenses
            
            
            34,208
            
            
            48,148Other
                current assets
            
            
            72,535
            
            
            34,789Total
                current assets
            
            
            2,520,436
            
            
            1,332,874Property
                and equipment, net
            
            
            594,402
            
            
            377,632Intangible
                assets, net
            
            
            350,000
            
            
            -Total
                assets
            
            $
            3,464,838
            
            $
            1,710,506**Liabilities
                and Stockholders' Deficit**Current
                liabilities:Accounts
                payable
            
            $
            1,037,334
            
            $
            515,781Accrued
                expenses
            
            
            1,780,302
            
            
            428,347Deferred
                revenue
            
            
            100,181
            
            
            -Bank
                borrowings
            
            
            -
            
            
            211,200Capital
                lease obligations - current
            
            
            36,649
            
            
            -Notes
                payable
            
            
            350,000
            
            
            -Convertible
                notes payable, related party net
            
            
            -
            
            
            766,918Convertible
                notes payable net
            
            
            -
            
            
            1,502,158Derivative
                liability
            
            
            3,373,676
            
            
            -Total
                current liabilities
            
            
            6,678,142
            
            
            3,424,404Capital
                lease obligations
            
            
            77,253
            
            
            -Commitments
                and contingencies (note 20)Series
                B redeemable preferred stock, $0.001 par value; 8,000 shares authorized,
                issued and outstanding at December 31, 2006No
                shares authorized, issued or outstanding at December 31, 2005 (aggregate
                liquidation preference of $8,391,014 and $0 atDecember
                31, 2006 and 2005, respectively).
            
            
            8,391,014
            
            
            -Stockholders'
                deficit:Preferred
                stock, $.001 par value, 25,000,000 sharesauthorized,
                no shares issued and outstanding
            
            
            -
            
            
            -Common
                stock, $.001 par value, 200,000,000 shares authorized;61,864,941
                and 34,529,052 issued and outstanding at December 31, 2006 and 2005,
                respectively
            
            
            61,865
            
            
            34,528Additional
                paid-in capital
            
            
            6,804,876
            
            
            8,095,714Accumulated
                deficit
            
            
            (18,548,312
            )
            
            (9,844,140
            )Total
                stockholders' deficit
            
            
            (11,681,571
            )
            
            (1,713,898
            )Total
                liabilities and stockholders' deficit
            
            $
            3,464,838
            
            $
            1,710,506




See
      accompanying notes to financial statements.


35


**VIKING
      SYSTEMS, INC.**


**Statements
      of Operations**


**Years
      Ended December 31, 2006 and 2005**





**2006**
            
            **2005**Sales,
                net
            
            $
            5,617,253
            
            $
            3,835,451Cost
                of sales
            
            
            3,912,044
            
            
            2,930,337Gross
                profit
            
            
            1,705,209
            
            
            905,114Operating
                expenses:General
                and administrative
            
            
            2,485,297
            
            
            1,528,411Selling
                and marketing
            
            
            4,544,986
            
            
            2,929,987Research
                and development
            
            
            1,511,723
            
            
            922,281Total
                operating expenses
            
            
            8,542,006
            
            
            5,380,679Operating
                loss
            
            
            (6,836,797
            )
            
            (4,475,565
            )Other
                income (expense):Interest
                income
            
            
            61,162
            
            
            -Interest
                expense
            
            
            (551,099
            )
            
            (280,508
            )Gain
                on extinguishment of debt
            
            
            4,975,824
            
            
            -Amortization
                of debt discount
            
            
            (8,480,878
            )
            
            (2,772,646
            )Accrued
                liquidated damages
            
            
            (840,000
            )
            
            -Gain
                on derivative liability
            
            
            2,967,616
            
            
            -Net
                loss
            
            
            (8,704,172
            )
            
            (7,528,719
            )Accretion
                of Series B Preferred Stock to redemptionvalue
                including accrued dividend
            
            
            (8,391,014
            )
            
            -Net
                loss applicable to common shareholders
            
            $
            (17,095,186
            )
            $
            (7,528,719
            )Net
                loss per commonshare
                - basic and diluted
            
            $
            (0.33
            )
            $
            (0.23
            )Weighted
                average shares - basic and diluted
            
            
            51,322,549
            
            
            32,626,000






See
      accompanying notes to financial statements.


36


**VIKING
      SYSTEMS, INC.**


**Statements
      of Stockholders’ Deficit**


**Years
      Ended December 31, 2006 and 2005**







**Common
                Stock**
            
            
            **Additional**
              **Paid-in**
            
            
            **Accumulated****Shares**
            
            
            **Amount**
            
            
            **Capital**
            
            
            **Deficit**
            
            
            **Total****Balance
                December 31, 2004**
            
            
            **30,608,652**
            
            **$**
            **30,608**
            
            **$**
            **1,282,222**
            
            **$**
            **(2,315,421**
            **)**
            **$**
            **(1,002,591**
            **)**Issuance
                of common stock to related party for conversion of note
                payable
            
            
            3,791,650
            
            
            3,792
            
            
            1,012,868
            
            
            **-**
            
            
            1,016,660Issuance
                of common stock to board of directors for services
            
            
            18,750
            
            
            19
            
            
            7,481
            
            
            **-**
            
            
            7,500Issuance
                of warrants from convertible notes
            
            
            **-**
            
            
            **-**
            
            
            1,948,849
            
            
            **-**
            
            
            1,948,849Beneficial
                conversion feature from convertible notes
            
            
            **-**
            
            
            **-**
            
            
            3,605,971
            
            
            **-**
            
            
            3,605,971Issuance
                of stock options for services
            
            
            **-**
            
            
            **-**
            
            
            158,682
            
            
            **-**
            
            
            158,682Issuance
                of stock for services
            
            
            110,000
            
            
            110
            
            
            79,640
            
            
            **-**
            
            
            79,750Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (7,528,719
            )
            
            (7,528,719
            )**Balance
                December 31, 2005**
            
            
            **34,529,052**
            
            
            **34,529**
            
            
            **8,095,713**
            
            
            **(9,844,140**
            **)**
            
            **(1,713,898**
            **)**Issuance
                of common stock to related party for conversion of note
                payable
            
            
            2,500,000
            
            
            2,500
            
            
            447,500
            
            
            **-**
            
            
            450,000Issuance
                of common stock for conversion of note payable
            
            
            23,888,889
            
            
            23,889
            
            
            4,276,111
            
            
            **-**
            
            
            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
            
            
            837,000
            
            
            837
            
            
            (837
            )
            
            **-**
            
            
            -Stock-based
                compensation
            
            
            -
            
            
            -
            
            
            586,776
            
            
            **-**
            
            
            586,776Issuance
                of stock for services
            
            
            110,000
            
            
            110
            
            
            43,885
            
            
            **-**
            
            
            43,995Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (8,704,172
            )
            
            (8,704,172
            )**Balance
                December 31, 2006**
            
            
            61,864,941
            
            $
            61,865
            
            $
            6,804,876
            
            $
            (18,548,312
            )
            $
            (11,681,571
            )






See
      accompanying notes to financial statements.


37


**VIKING
      SYSTEMS, INC.**


**Statement
      of Cash Flows**


**Years
      Ended December 31, 2006 and 2005**





**2006**
            
            **2005****Cash
                flows from operating activities:**Net
                loss
            
            $
            (8,704,172
            )
            $
            (7,528,719
            )Adjustment
                to reconcile net loss to net cashused
                in operating activities:Depreciation
                and amortization
            
            
            396,013
            
            
            271,591Common
                stock and stock options issued for services
            
            
            44,041
            
            
            245,932Stock-based
                compensation expense
            
            
            586,776
            
            
            -Amortization
                of debt discount
            
            
            8,480,878
            
            
            2,772,646Gain
                on extinguishment of debt
            
            
            (4,975,824
            )
            
            -Gain
                on derivative liability
            
            
            (2,967,616
            )
            
            -Change
                in operating assets and liabilities:Accounts
                receivable
            
            
            (607,041
            )
            
            29,509Inventories
            
            
            (478,780
            )
            
            99,912Prepaids
                and other current assets
            
            
            (23,806
            )
            
            62,605Accounts
                payable
            
            
            521,553
            
            
            (1,025,173
            )Accrued
                expenses
            
            
            1,351,955
            
            
            93,858Deferred
                revenue
            
            
            100,181
            
            
            (159,150
            )Net
                cash used in operating activities
            
            
            (6,275,842
            )
            
            (5,136,989
            )**Cash
                flows from investing activities:**Purchases
                of property and equipment
            
            
            (561,067
            )
            
            (371,136
            )Purchase
                of intangible assets
            
            
            (350,000
            )
            
            -Net
                cash used in investing activities
            
            
            (911,067
            )
            
            (371,136
            )**Cash
                flows from financing activities:**Net
                change in short-term bank borrowings
            
            
            (211,200
            )
            
            151,985Proceeds
                from issuance of preferred stock
            
            
            7,250,000
            
            
            -Proceeds
                from notes payable
            
            
            350,000
            
            
            -Payments
                on related party notes
            
            
            (200,000
            )
            
            -Proceeds
                from issuance of convertible debt
            
            
            250,000
            
            
            3,300,000Proceeds
                from issuance of related-party convertible note payable
            
            
            -
            
            
            2,550,000Proceeds
                from issuance of related-party note payable
            
            
            200,000Payments
                for stock issue costs
            
            
            (436,142
            )
            
            (198,750
            )Payments
                on capital leases
            
            
            (9,787
            )
            
            -Net
                cash provided by financing activities
            
            
            7,192,871
            
            
            5,803,235Net
                increase in cash and cash equivalents
            
            
            5,962
            
            
            295,110Cash
                and cash equivalents at beginning of year
            
            
            434,503
            
            
            139,393Cash
                and cash equivalents at end of year
            
            $
            440,465
            
            $
            434,503**Supplemental
                disclosure of cash flow information:**Cash
                paid during the period for:Interest
            
            $
            345,385
            
            $
            284,078Income
                taxes
            
            $
            1,300
            
            $
            1,300




See
      accompanying notes to financial statements.


38


**VIKING
      SYSTEMS, INC.**


**Statement
      of Cash Flows**


***Continued***





**Years
                  ended December 31,****2006**
              
              
              **2005****Non-cash,
                investing and financing activities:**Conversion
                  of notes payable and interest into common stock
              
              $
              4,300,000
              
              $
              1,016,000Conversion
                  of notes payable, related party into common stock
              
              $
              450,000
              
              $
              -Conversion
                  of notes payable into preferred stock
              
              $
              750,000
              
              $
              -Equipment
                  and software acquired pursuant to capital lease
              
              $
              123,639
              
              $
              -Beneficial
                  conversion feature recorded in connection with convertible notes
                  and
                  preferred stock
              
              $
              4,174,164
              
              $
              3,605,971Derivative
                  liability recorded in connection with preferred stock
              
              $
              3,590,049
              
              $
              -Fair
                  value of warrants issued in connection with convertible
                  notes
              
              $
              49,644
              
              $
              1,948,849


See
      accompanying notes to financial statements.


39


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**





**1.**  **Organization
      and Summary of Significant Accounting Policies**





***Organization
      and Business***


Viking
      Systems, Inc., (“Viking Systems” 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 Systems changed its business focus to the development of software
      applications, hardware sales and leasing, and training and support. As of
      December 31, 2002, Viking Systems discontinued its operations. During 2004,
      Viking Systems 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 Systems 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 consolidated 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.


***Cash
      and Cash Equivalents***


Viking
      Systems considers all highly liquid debt 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 Systems to concentration of credit
      risk consist primarily of trade receivables. In the normal course of business,
      Viking Systems provides credit terms to its customers. Accordingly, Viking
      Systems 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
      Systems maintains its cash in bank deposit accounts which, at times, may exceed
      federally insured limits. Viking Systems 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,
      2006 and 2005, 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
      Systems 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





***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, 2006 and 2005, no
      impairment of long-lived assets was recorded.




40


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**1.**  **Organization
      and Summary of Significant Accounting Policies *(*** ***Continued)***





***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 manufactures. Revenue from
      the
      sale of products is recognized when a purchase order has been received, the
      product has been shipped, the selling price is fixed or determinable, and
      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. The allocation of fair value for a
      multiple-element arrangement is based on vendor specific objective evidence
      (“VSOE”) or in absence of VSOE for delivered elements, the residual method. In
      the absence of VSOE for undelivered elements, revenue is deferred and
      subsequently recognized over the term of the arrangement. 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, 2006 and
        2005,
        advertising expense was $35,375 and $51,110 respectively.
 
 ***Shipping
        and Handling Costs***
 Shipping
        and handling costs are classified as marketing materials and service
        expenses.


***Income
      Taxes***


Viking
      Systems 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.


41


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***







1.  **Organization
      and Summary of Significant Accounting Policies *(*** ***Continued)***


***Earnings
        Per Common and Common Equivalent Share***
 The
        computation of basic earnings 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. In 2006, 44,444,444 shares issuable upon
        conversion of the Preferred Series B shares and 38,670,000 shares issuable
        upon
        exercise of stock options and warrants were excluded from the weighted average
        shares calculation because their effect was anti-dilutive. In 2005, 26,250,000
        shares issuable upon conversion of the convertible notes payable and 13,028,000
        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.





Prior
      to
      2006, Viking Systems accounted for its employee stock-based compensation plans
      using the intrinsic value method, as prescribed by APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      related interpretations. Accordingly, Viking Systems recorded deferred
      compensation costs related to its employee stock options when the current market
      price of the underlying stock exceeded the exercise price of each stock option
      on the measurement date (usually the date of grant). During 2005, Viking Systems
      did not grant any stock options to employees or members of Viking Systems’ Board
      of Directors with exercise prices below the market price on the measurement
      date.




***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.





**2.**  **Going
      Concern**





The
      accompanying financial statements have been prepared under the assumption that
      Viking Systems 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 financial statements for the years ended
      December 31, 2006 and 2005, Viking Systems has a substantial working
      capital deficiency, has recurring net losses, and has incurred net cash outflows
      from operating activities. These factors raise substantial doubt about Viking
      Systems’ ability to continue as a going concern. The financial statements do not
      include any adjustments that might be necessary should Viking Systems be unable
      to continue as a going concern.





Viking
      Systems’ 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. On February 24, 2007, Viking Systems closed upon the sale of
      approximately $5,000,000 of its Secured Convertible Debentures with 13 investors
      to provide additional working capital, carry out key strategic initiatives
      and
      for other general corporate purposes. Viking Systems plans to obtain additional
      financing through the sale of equity securities and the issuance debt, if
      needed. There can be no assurance that such financing will be available on
      acceptable terms, or at all.   42




**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***







3.  **Inventories**





Inventories
      consist of the following at December 31:




**2006**
            
            **2005**Inventories:Parts
                and supplies
            
            $
            558,668
            
            $
            292,277Work-in-progress
            
            
            344,483
            
            
            150,016Finished
                goods
            
            
            310,559
            
            
            124,883Valuation
                reserve
            
            
            (95,782
            )
            
            -$
            1,117,929
            
            $
            567,176





**4.**  **Property
      and Equipment**





Property
      and equipment consists of the following at December 31:




**2006**
            
            
            **2005**Equipment
            
            $
            1,091,931
            
            $
            647,440Furniture
                and fixtures
            
            
            57,023
            
            
            57,023


1,148,954
            
            
            704,463Less
                accumulated depreciation
            
            
            (554,552
            )
            
            (326,831
            )$
            594,402
            
            $
            $
                377,632





Depreciation
      expense was $396,012 and $271,591 for the years ended December 31, 2006 and
      2005, respectively.





**5.**  **Intangible
      Assets**





Intangible
      assets consist of the following at December 31:





**2006**
            
            **2005**Patents
                and other assets
            
            $
            350,000
            
            $
            -Less
                accumulated amortization
            
            
            -
            
            
            -$
            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. Subject to periodic valuation, we expect to amortize
      these assets ratably over five years commencing in 2007.


43





**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***








**6.** **Accrued
      expenses**





Accrued
      expenses consist of the following at December 31:








**2006**
            
            **2005**Accrued
                wages and salaries
            
            $
            352,390
            
            $
            230,773Accrued
                liquidated damages
            
            
            840,000
            
            
            -Accrued
                registration delay fees
            
            
            192,300
            
            
            -Accrued
                board of director fees
            
            
            151,625
            
            
            82,375Other
                accrued expenses
            
            
            243,987
            
            
            115,199$
            1,780,302
            
            $
            428,347





**7.**  **Deferred** **Revenue**





As
      of
      December 31, 2006, Viking Systems had deferred revenue of $100,181, which
      consisted of a sale for which all elements of the agreement were not completed
      by December 31, 2006 and for service plan agreements that are deferred until
      the
      service period has occurred. There were no such balances at December 31,
      2005.





**8.**  **Bank
      Borrowings**





Viking
      Systems had an agreement with a bank through which the bank would advance funds
      to Viking Systems equal to 80% of receivables resulting from sales by Viking
      Systems up to a maximum of $400,000. Funds advanced accrued interest at prime
      plus 3.5%. The agreement originally expired September 14, 2006 but was renewed
      until February 2007 when the Company cancelled the arrangement upon the
      completion of the 2007 convertible debt financing. Upon collection of the
      receivable from the customer, the bank was paid the funds advanced and the
      interest accrued, and the remaining amount of the collection is remitted to
      Viking Systems. As of December 31, 2006, there were no advances from the bank
      and as of December 31, 2005, Viking Systems had $11,200 of advances due to
      the
      bank. These advances were subject to certain affirmative and negative covenants
      and were secured by substantially all of the Company’s assets.




Viking
      Systems had a Loan and Security Agreement, dated February 9, 2005 and renewed
      on
      September 13, 2005, with a bank, under which Viking could borrow up to $200,000
      against a Certificate of Deposit owned by Donald Tucker, the Company’s President
      and CEO, who is also a significant shareholder. As of December 31, 2005 Viking
      Systems had borrowed $200,000. During 2006, the Company repaid the entire
      outstanding balance and the agreement expired on May 13, 2006.   44




**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**9.**  **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 $5,100 for 2006. As of December 31, 2006, the future minimum
      capital lease payments are as follows:




2007
            
            $
            36,6492008
            
            
            44,9642009
            
            
            41,228Total
                minimum lease payments
            
            
            122,841Amount
                representing interest
            
            
            (8,939
            )Present
                value of minimum lease payments
            
            $
            113,902





**10.**  **Notes
      Payable**





During
      December 2006, we issued a $350,000 promissory note to one of our investors.
      The
      promissory notes were converted into the February 2007 Debentures.




**11.**  **Convertible
      Notes Payable**





During
      2005 Viking Systems entered into a securities purchase agreement with 23
      investors 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 $0.20
      per share. Proceeds from the issuance of the convertible notes amounted to
      $5,651,250, net of original issue discount of $105,000 and debt issuance costs
      of $93,750. The notes were subject to certain affirmative and negative covenants
      and were secured by substantially all of the Company’s assets.





Included
      in the total convertible notes issued during 2005 were $1,050,000 of notes
      issued to the Company’s President and CEO who is also a significant stockholder,
      and $1,500,000 of notes issued to a firm in which a former member of the Viking
      Systems board of directors is a partner. During 2005, $400,000 of notes issued
      during 2004 and $600,000 of notes issued during 2005 to the Company’s President
      and CEO were converted into a total of 3,791,650 shares of common
      stock.





In
      connection with the notes, the Company issued 7,187,500 warrants to the
      investors. The warrants are exercisable until September 21, 2009 and were
      originally issued at a purchase price of $0.40 per share. The Company determined
      the fair value of the warrants issued in connection with the convertible notes
      using a Black-Scholes valuation model, and allocated the proceeds from the
      issuance of the notes between the warrants and convertible debt, based on the
      determination of their relative fair values. As a result of the fair value
      allocation of the warrants, Viking Systems recorded debt discount and additional
      paid in capital in the amount of $1,948,849. The recorded debt discount is
      being
      amortized as non-cash interest expense over the term of the debt. As the
      effective conversion price of the notes on the date of issuance was below the
      fair market value of the underlying common stock, Viking Systems recorded
      additional debt discount in the amount of $3,605,971 in connection with the
      beneficial conversion feature (“BCF”) of the notes. The debt discount recorded
      as a result of the beneficial conversion feature is being amortized as non-cash
      interest expense over the term of the debt.





45


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**11.**  **Convertible
      Notes Payable *(*** ***Continued)***


During
        2005 the Company recorded a total of $2,772,646 of interest expense resulting
        from the amortization of warrant, beneficial conversion and original issue
        discounts.
 
 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 $0.18 per share, instead of $0.20.
        Viking has agreed to register with the Securities and Exchange Commission
        and
        applicable state securities agencies, the shares of common stock that are
        issuable upon the conversion of the notes and the shares of common stock
        that
        underlie the warrants.


In
      April
      2006 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 $0.20 per share with
      25%
      warrant coverage with warrants to purchase common stock exercisable at $0.40
      per
      share. The new terms provided conversion into common stock at $0.18 per share
      and 25% warrant coverage with warrants to purchase common stock exercisable
      at
      $0.35 per share. As a result, the Company recorded a $4,975,824 gain on debt
      extinguishment in the current quarter representing 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
      $5,250,000 in convertible notes, the Company issued 26,388,889 shares of common
      stock and 6,694,451 warrants to purchase shares of common stock.





Concurrent
      with the closing of the Series B Preferred Stock transaction (note 10),
      note-holders converted $5,500,000 of debt into equity instruments: $4,750,000
      of
      the notes were converted into 26,388,889 shares of common stock and $750,000
      of
      the notes were converted into 750 shares of Series B Preferred Stock. Each
      share
      of the Series B Stock is convertible, subject to adjustments, into approximately
      5,555 shares of common and 2,778 warrants to purchase common stock.





In
      conjunction with the conversion of the convertible notes, Viking agreed to
      file,
      prior to June 21, 2006, a registration statement covering the shares of common
      stock issued upon the conversion of $4,750,000 of the Notes and shares of common
      stock underlying the warrants of these former Note holders. As a result of
      the
      required terms of the Series B Preferred Stock transaction, the Company unable
      to include the securities of the former Note holders in the first registration
      statement.





We
      have
      agreed to pay all Note purchasers, who elect to receive it, a registration
      delay
      fee of one percent per month of their initial Note principal balance. The delay
      fee began on June 21, 2006 and terminates on the date the Securities and
      Exchange Commission declares effective a registration statement covering the
      securities of the Note purchasers. Based on this agreement, we began accruing
      approximately $34,000 per month and through December 31, 2006, we have accrued
      a
      total of $227,000 for such fees, of which $34,500 has been paid.


46


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**11.**  **Convertible
      Notes Payable *(*** ***Continued)***





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.




As
      of
      December 31, 2006 and 2005 convertible notes payable balances are summarized
      as
      follows:





ConvertibleConvertible
            
            Notes
                Payable,Notes
                Payable
            
            Related
                PartyBalance,
                at December 31, 2004
            
            $
            -
            
            $
            400,000Notes
                issued
            
            
            3,300,000
            
            
            2,550,000Note
                conversions
            
            
            -
            
            
            (1,000,000
            )Unamortized
                warrant andbeneficial
                conversion discount
            
            
            (1,761,430
            )
            
            (1,120,925
            )Unamortized
                original issue discount
            
            
            (36,412
            )
            
            (62,157
            )Net
                balance, at December 31, 2005
            
            
            1,502,158
            
            
            766,918Notes
                issued
            
            
            250,000
            
            
            -Note
                conversions
            
            
            (3,550,000
            )
            
            (1,950,000
            )Repayments
            
            
            -
            
            
            -Amortization
                of debt discount
            
            
            1,797,842
            
            
            1,183,082Net
                balance, at December 31, 2006
            
            $
            -
            
            $
            -


47


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**12.**  **Preferred
      Stock**





In
      May
      2006, our Board of Directors adopted a resolution designating a Series B
      preferred stock consisting of 8,000 shares. All 8,000 shares of Series B
      Preferred Stock (“Preferred Stock”) authorized have been issued. Each share of
      Series B Preferred, par value $0.001 per share, with a “Stated Value”
of $1,000 per share, is convertible, subject to adjustments, into
      approximately 5,555 shares of common stock and warrants to purchase an
      additional 2,778 shares of common stock at an initial price of $0.35 per
      share.





In
      May,
      2006 the Company issued the Series B Preferred for gross proceeds of
      $8,000,000, and incurred approximately $436,143 in issuance costs, which are
      recorded as a reduction of the proceeds of the Series B Preferred. Proceeds
      from the sale of Series B Preferred consisted of $7,250,000 in cash and the
      conversion of $750,000 of convertible notes.





The
      Company has 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. 98-5 *Accounting 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 was recorded as a discount to preferred stock and
      as
      additional paid in capital.


48


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**12.**  **Preferred
      Stock *(*** ***Continued)***





The
      following table summarizes the valuation of the Series B Preferred for the
      year ended December 31, 2006.





Convertible
                preferred stock
            
            $
            8,000,000Less:Issuance
                costs
            
            
            436,142Fair
                value of warrants
            
            
            3,590,050Beneficial
                conversion feature
            
            
            3,973,808Subtotal
            
            $
            -Plus:Accrued
                dividends
            
            
            391,014Accretion
                of discount to redemption value
            
            
            8,000,000Convertible
                preferred stock
            
            $
            8,391,014




The
      Company recorded the accretion of the Series B Preferred discount to its
      redemption value at issuance, since the preferred shares were immediately
      convertible. Total accretion of the discount to the Series B Preferred
      redemption value was recorded as a charge to additional paid in capital and
      to
      the net loss attributable to common stockholders, as of December 31, 2006.
      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 Series B Preferred stock rights, preferences and
      privileges:





Dividends .
      Holders
      of the Series B Preferred Stock (each a “Holder”) are 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 shall
      be
      paid in cash or shares of Viking Systems common stock, or a combination thereof.
      Dividends are payable on the first day following the end of each fiscal quarter
      of the Company. Dividends do not compound; provided, that if the Company fails
      to pay such dividends as required, then accrued but unpaid dividends shall
      bear
      an interest rate of eighteen percent (18%) per annum compounding daily. Under
      certain circumstances, if dividend payments have not been made, at the Holder’s
      option, unpaid dividends may be accreted to, and increase, the outstanding
      Stated Value.


49


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**12.**  **Preferred
      Stock *(*** ***Continued)***





During
      the year ended December 31, 2006, the Company recorded preferred stock dividends
      of approximately $391,014, as an increase to the net loss available to common
      stockholders in the accompanying consolidated statement of operations. All
      dividends accrued to date remain unpaid as of December 31, 2006. The Company
      may
      request that the Preferred B shareholders consent to receive payment of
      dividends in shares of the Company’s stock.





Voting
      Rights .
      The
      holders of the Preferred Stock have 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 Series B Preferred Stock shall be
      entitled to receive out of the assets, whether capital or surplus, of Viking
      an
      amount equal to the stated value of the Series B 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 Series B 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
      Series B Preferred Stock shall 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.





Conversion .
      The
      stated value of the shares of Preferred Stock are initially convertible into
      shares of Viking’s common stock at a price of $.18 per share; however, the
      conversion price is subject to adjustment based upon certain conditions. 
If all shares of Preferred Stock are converted into common stock at the initial
      conversion price, of which there can be no assurance, approximately 44,444,444
      shares of common stock will be issued in such conversion. “Certain Price and
      Share Adjustments,” below, describes circumstances under which the Conversion
      Price may be modified.





Certain
      Price and Share Adjustments .





a)
            Stock
                Dividends and Stock Splits.
                If Viking (A) pays a stock dividend or otherwise makes a distribution
                or
                distributions payable in shares of common stock on shares of common
                stock
                or any other common stock equivalents; (B) subdivides outstanding
                shares
                of common stock into a larger number of shares; (C) combines (including
                by
                way of a reverse stock split) outstanding shares of common stock
                into a
                smaller number of shares; or (D) issues, in the event of a
                reclassification of shares of the common stock, any shares of capital
                stock of Viking, then the conversion price shall be adjusted
                accordingly.


50


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**12.**  **Preferred
      Stock *(*** ***Continued)***





b)  Subsequent
      Equity Sales .
      If
      Viking sells or grants any option to purchase or sells or grants any right
      to
      reprice its securities, or otherwise disposes of or issues any common stock
      or
      common stock equivalents entitling any person to acquire shares of common stock
      at an effective price per share that is lower than the then conversion price
      of
      the Series B Preferred Stock (such lower price, the “Base Conversion Price” and
      such issuances collectively, a “Dilutive Issuance”), then the conversion price
      shall be reduced, by multiplying the conversion price by a fraction, the
      numerator of which is the number of shares of common stock issued and
      outstanding immediately prior to the Dilutive Issuance plus the number of shares
      of common stock that the actual cash offering price for such Dilutive Issuance
      would purchase at the then Exercise Price, and the denominator of which shall
      be
      the sum of the number of shares of common stock issued and outstanding
      immediately prior to the Dilutive Issuance plus the number of shares of common
      stock so issued or issuable in connection with the Dilutive Issuance, but in
      no
      event shall such adjustment reduce the Conversion Price to less than $0.05.




c)  Subsequent
      Rights Offerings .
      If
      Viking shall issue rights, options, or warrants to all holders of common stock
      entitling them to subscribe for or purchase shares of common stock at a price
      per share that is lower than the effective value weighted average price
      (“VWAP”), then the conversion price shall be multiplied by a fraction of which
      the denominator shall be the number of shares of the common stock outstanding
      on
      the date of issuance of such rights or warrants plus the number of additional
      shares of common stock offered for subscription or purchase, and of which the
      numerator shall be the number of shares of the common stock outstanding on
      the
      date of issuance of such rights or warrants plus the number of shares which
      the
      aggregate offering price of the total number of shares so offered (assuming
      delivery to Viking in full of all consideration payable upon exercise of such
      rights, options or warrants) would purchase at such VWAP. Such adjustment shall
      be made whenever such rights or warrants are issued, and shall become effective
      immediately after the record date for the determination of stockholders entitled
      to receive such rights, options or warrants.





Redemptions .
      Subject
      to certain conditions, the Company, at any time after the four year anniversary
      of the date that the Company’s registration statement covering the shares of
      common stock issuable upon conversion of the Preferred Stock is declared
      effective by the Securities and Exchange Commission, may redeem shares of
      Preferred Stock at the Stated Value plus any accrued and unpaid dividends and
      any other amounts due in respect of the Preferred Stock.





Pursuant
      to the terms and conditions of the transaction documents, upon the occurrence
      of
      certain events (each a “Triggering Event”), each Holder has the right to require
      the Company to redeem Preferred Stock for cash or for shares of Viking common
      stock. Depending upon the nature of the Triggering Event the Holder
      would:


51


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**12.**  **Preferred
      Stock *(*** ***Continued)***





(1)  receive
      in cash for each share of Preferred Stock, the sum of (i) the greater of (A)
      130% of the Stated Value or (B) the product of (a) the VWAP on the Trading
      Day
      immediately preceding the date of the Triggering Event and (b) the Stated Value
      divided by the then Conversion Price, (ii) all accrued but unpaid dividends
      thereon and (iii) all liquidated damages and other costs, expenses or amounts
      due in respect of the Preferred Stock, or


(2)
      either (a) redeem all of the Preferred Stock then held by such Holder for a
      redemption price, in shares of Common Stock, equal to a number of shares of
      Common Stock equal to the sum of (i) the greater of (A) 130% of the Stated
      Value
      or (B) the product of (a) the VWAP on the Trading Day immediately preceding
      the
      date of the Triggering Event and (b) the Stated Value divided by the then
      Conversion Price, (ii) all accrued but unpaid dividends thereon and (iii) all
      liquidated damages and other costs, expenses or amounts due in respect of the
      Preferred Stock divided by 75% of the average of the 10 VWAPs immediately prior
      to the date of election to redeem Preferred Stock for common stock, or (b)
      increase the dividend rate on all of the outstanding Preferred Stock held by
      such Holder to 18% per annum thereafter.





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 provides for
      liquidated damages by the Company to the Holders if the Company is unable to
      complete the registration, or subsequent registrations, or maintain 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 Series B preferred securities
      had not been registered pursuant to the terms of the Registration Rights
      Agreement, The Purchasers of Series B Preferred shares agreed to waive the
      registration requirements of the Registration Rights Agreement and each
      Purchaser agreed to accept, and the Company agreed to issue to the Purchasers,
      an aggregate of 4,000,000 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 Series B preferred shareholders, 4,000,000
      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.


52


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**13.**  **Income
      Taxes**





The
      components of the 2006 and 2005 provision for federal and state income tax
      benefit (expense) completed in accordance with statement No. FAS 109 are
      summarized below:





2006
            
            2005CurrentFederal
            
            $
            -
            
            $
            -State
            
            
            (1,300
            )
            
            (1,300
            )DeferredFederal
            
            
            -
            
            
            -State
            
            
            -
            
            
            -$
            (1,300
            )
            $
            (1,300
            )





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




**2006**
            
            
            **2005**Expected
                Income tax benefit at statutory rate
            
            $
            3,482,000
            
            $
            3,011,000Non-deductible
                Derivatives
            
            
            1,187,000
            
            
            -Meals
                and entertainment
            
            
            (27,000
            )
            
            (15,000
            )Gain
                on extinguishment of debt
            
            
            1,992,000
            
            
            -Minimum
                state taxes
            
            
            (900
            )
            
            (1,300
            )Incentive
                stock options
            
            
            (145,000
            )
            
            -Amortization
                of Debt Discount
            
            
            (2,981,000
            )
            
            -Other
            
            
            12,600
            
            
            (27,000
            )Change
                in valuation allowance
            
            
            (3,521,000
            )
            
            (2,969,000
            )$
            (1,300
            )
            $
            (1,300
            )


53


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**13.**  **Income
      Taxes *(*** ***Continued)***





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,




**2006**
            
            
            **2005**Operating
                loss carry forwards
            
            $
            5,639,000
            
            $
            3,774,000Research
                and developmenttax
                credit
            
            
            66,000
            
            
            45,000Basis
                Difference in Fixed Assets
            
            
            67,000
            
            
            46,000Accrued
                liabilities
            
            
            65,000
            
            
            82,000Stock
                options
            
            
            89,000
            
            
            -Less
                valuation allowance
            
            
            (5,926,000
            )
            
            (3,947,000
            )$
            -
            
            $
            -





Viking
      Systems has net operating losses of approximately $14,096,000 and
      $14,094,000 for federal and state, respectively which begins to expire in
      2020 for federal purposes and 2015 for state purposes. The amount of net
      operating loss carry forward that can be used in any one year may be limited
      by
      significant changes in ownership as defined by section 382 of the Internal
      Revenue Code and similar state tax laws. 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 $5,926,000 as of December 31,
      2006 due to the uncertainty of the future realization of the deferred tax asset.
      The net change in valuation allowance for 2006 was an increase of
      $3,521,000.




Due
        to
        the Company being in a net operating loss position, the implementation during
        2006 of EITF 05-8, *Income
        Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion
        Feature*, resulted
        in a difference of $1,542,000 between the expected income taxes at statutory
        rates and the amounts presented herein related to the change in the valuation
        allowance.





**14.**  **Operating
      Leases**





Viking
      Systems leases its office space and certain office equipment under
      non-cancelable operating lease agreements. Future minimum lease payments on
      these leases as of December 31, 2006, are as follows:


**Years
                  Ending December 31,**2007
              
              $
              273,9742008
              
              
              169,8462009
              
              
              160,3802010
              
              
              120,286$
              724,486





Rent
      expense for the years ended December 31, 2006 and 2005 was $275,708 and
      $192,274, respectively.


54


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**15.**  **Related
      Party Transactions**





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 2,500,000 shares of
                common stock.


·
            Had
                an unsecured note payable to Donald E. Tucker, 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
                87,500 warrants to purchase common stock at an exercise price of
                $0.35 per
                share to Donald E. Tucker, a significant shareholder, and the Company's
                President and CEO.


·
            Cancelled
                1,187,500 warrants to purchase common stock at an exercise price
                of $0.40
                per share that were previously issued to Donald E. Tucker, a significant
                shareholder, and the Company's President and
                CEO.





During
      the year ended December 31, 2005, Viking Systems:





·
            Issued
                1,291,650 shares of common stock to a significant stockholder upon
                conversion of related party convertible notes payable of $500,000
                and
                interest of $16,660.


·
            Issued
                2,500,000 shares of common stock to a significant stockholder upon
                conversion of convertible notes payable of
                $500,000.


·
            Issued
                convertible notes payable to a significant stockholder in the amount
                of $1,050,000. At December 31, 2005 the convertible notes payable
                to a
                significant stockholder totaled $450,000. These notes are presented
                on the
                balance sheet net of unamortized debt discount totaling $367,757.


·
            Had
                convertible notes payable, at December 31, 2005 to a firm in which
                a
                member of Viking Systems’ Board of Directors is a partner totaling
                $1,500,000. These notes are presented on the balance sheet net of
                unamortized debt discount totaling
                $815,325.


·
            Entered
                into a Loan and Security Agreement, pursuant to which Viking can
                borrow up
                to $200,000 which is secured by a Certificate of Deposit owned by
                a
                significant shareholder. This agreement expired on May 13, 2006.




55


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**16.**  **Stock-Based
      Compensation**





***Common
      Stock Options***


The
      Company has the *2004
      Stock Incentive Plan* (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 8,600,000 shares and 500,000 shares
      under
      the 2004 Non-Employee Director Stock Ownership Plan. As of December 31, 2006,
      the maximum number of shares available for future grants under the Plan is
      2,804,000 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:


**Shares**
              
              **Weighted**
                **Average**
                **Exercise**
                **Price**
              
              **Aggregate**
                **Intrinsic**
                **Value**Options
                  outstanding January 1, 2005
              
              
              2,816,000
              
              $
              0.26Granted
                  in 2005
              
              
              3,025,000
              
              $
              0.49Cancelled
                  in 2005
              
              
              (135,000
              )
              $
              0.48Options
                  outstanding December 31, 2005
              
              
              5,706,000
              
              $
              0.38Granted
                  in 2006
              
              
              2,860,000
              
              $
              0.39Cancelled
                  in 2006
              
              
              (590,000
              )
              $
              0.50Exercised
                  in 2006
              
              
              (1,000,000
              )
              $
              0.02Options
                  outstanding December 31, 2006
              
              
              6,976,000
              
              $
              0.42
              
              $
              0.19Options
                  exercisable December 31, 2006
              
              
              4,013,000
              
              $
              0.44
              
              $
              0.19


A
        summary
        of the status of non-vested options as of December 31, 2006 is presented
        below:
 
 **Shares**
              
              **Weighted**
                **Average**
                **Grant
                  Date**
                **Fair
                  Value**Non-vested
                  options beginning January 1, 2006
              
              
              3,390,333
              
              $
              0.50Granted
              
              
              2,860,000
              
              
              0.39Vested
              
              
              (3,046,333
              )
              
              0.47Exercised
              
              
              -
              
              
              -Forfeited
              
              
              (241,000
              )
              
              0.50Non-vested
                  options at December 31, 2006
              
              
              2,963,000
              
              $
              0.41
 56


**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
        90.81%, expected term of 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 year ended December 31, 2006, the Company recorded compensation costs
        related to stock options of $586,776. As of December 31, 2006, the Company
        has
        unrecognized compensation costs amounted to $506,563 related to unvested
        stock
        options. This cost is expected to be recognized over a weighted average period
        of approximately 8.7 years.


Had
      compensation cost for the plan been determined based on the fair value of the
      options at the grant dates consistent with the method of SFAS No. 148, *Accounting
      for Stock-Based Compensation - Transition and Disclosure - an Amendment of
      SFAS
      No. 123* ,
      the
      Company’s net earnings and earnings per share would have
      been:




**Year
                Ended**
              **December
                31,****2005**Net
                loss, as reported
            
            $
            (7,528,719
            )Deduct:Total
                stock-based employeecompensation
                expense determinedunder
                fair value based method forall
                awards, net of related tax effects
            
            
            (274,060
            )Pro
                forma net loss
            
            $
            (7,802,779
            )Loss
                per share:
              Basic
                and diluted - as reported
            
            $
            (.23
            )Basic
                and diluted - pro forma
            
            $
            (.24
            )





The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option pricing model with the following
      assumptions:




**2005**Expected
                dividend yield
            
            $
            -Expected
                stock price volatility
            
            
            67-75%Risk-free
                interest rate
            
            
            4.02-4.65%Expected
                life of options
            
            
            10
                years





The
      weighted average fair value of options granted during the year ended December
      31, 2005 was $0.33.


57


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**17.**  **Stock
      Warrants and Derivative Liability**





The
      following table summarizes warrants to purchase common stock outstanding at
      December 31, 2006:




**Shares**
            
            
            **Range
                of**
              **Exercise
                Price**
            
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**Warrants
                outstanding January 1, 2005Granted
            
            
            7,187,500
            
            $
            0.40
            
            $
            0.40
            
            
            3.10Exercised
            
            
            -
            
            $
            -
            
            $
            -
            
            
            -Warrants
                outstanding December 31, 2005
            
            
            7,187,500
            
            $
            0.40
            
            $
            0.40
            
            
            3.10Granted
            
            
            25,694,444
            
            $
            0.35
                -0.75
            
            $
            0.38
            
            
            4.33Exercised
            
            
            -
            
            
            
            
            
            -
            
            
            -Cancelled
            
            
            (1,187,500
            )
            $
            0.40
            
            $
            0.40
            
            
            2.42Warrants
                outstanding December 31, 2006
            
            
            31,694,444
            
            $
            0.35-0.75
            
            $
            0.37
            
            
            3.91


58


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**17.**  **Stock
      Warrants and Derivative Liability *(*** ***Continued)***





Included
      in the total of 25,694,444 warrants issued in 2006 to purchase common shares
      are
      the following:





Warrants
      to purchase 22,222,222 shares at an exercise price of $0.35 per share granted
      to
      purchasers of the Series B Preferred Stock.





Warrants
      to purchase 606,944 shares at an exercise price of $0.35 granted to note holders
      in connection with the modification of convertible debt terms.





Warrants
      to purchase 1,388,889 shares at an exercise price of $0.50 per share, and
      1,388,889 shares of common stock at an exercise price of $0.75 per share in
      connection with a $250,000 bridge financing agreement.





Warrants
      to purchase 87,500 shares granted to the Company’s President and CEO at an
      exercise price of $0.35 per share in connection with an agreement to relinquish
      562,500 previously issued warrants.





During
      2006, the Company recorded the cancellation of 1,187,500 warrants to purchase
      common stock at an exercise price of $0.40 held by the Company’s 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. 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 derivative
        gain in the amount of $2,967,616.




During
      the year ended December 31, 2005, Viking issued warrants to purchase an
      aggregate of 7,187,500 shares of the Company’s common stock, in connection with
      the issuance of convertible notes payable. Such warrants were originally
      exercisable at a price of $.40 per share through September 2008. Pursuant to
      the
      consent of the noteholders, in May, 2006, the warrants were extended until
      September 21, 2009, the purchase price was reduced to $0.35 per share and the
      Company issued an additional 606,944 warrants.





In
      connection with the May 2006 issuance of Series B preferred stock, the Company
      issued warrants to purchase an additional 22,222,222 shares of common stock
      at
      an initial price of $0.35 per share.   59




**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***







**18.
      Common Stock Issued and Issuable For Services**





During
      2005 Viking Systems issued a total of 220,000 shares of common stock as
      compensation for services to non-employees. According to the terms of the
      agreements for these services, the shares are restricted and must be returned
      on
      a pro rata basis in the event that the agreements are terminated prior to
      completion of the services period. Accordingly, the shares are being treated
      as
      unissued until such time as services under the agreement have been provided
      and
      the shares are no longer forfeitable. In each of the years ended December 31,
      2006 and 2005 a total of 110,000 shares have been recorded as issued pursuant
      to
      these agreements.





During,
      2006 the Company entered into an agreement with its investor relations firm
      to
      issue up to 250,000 shares at a quarterly rate of 62,500 shares. The first
      issuance of the stock is expected to be made in 2007. Total expense accrued
      at
      December 31, 2006 in connection with this issuance was approximately $42,700.




**19.**  **Major
      Customers**





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. During the
      year ended December 31, 2005, Viking Systems had sales to three customers that
      accounted for 26%, 21% and 19%, respectively, of total sales. These
      customers owed the Company $290, $110,000, and $107,940 at December 31,
      2006 and $79,728, $43,740, and $51,121 at December 31,
      2005.




**20.**  **Commitments
      and Contingencies**





During
      2004, Viking Systems purchased the assets of the visualization technology
      business of Vista Medical Systems, Inc. (“Vista”), a Delaware **i** n
      connection with the acquisition of assets of visualization technology business
      of Vista Medical Systems, Inc (“Vista”) discussed in Note 1, Viking Systems
      entered into a license agreement for the intellectual property and product
      rights used in the operation of the business acquired. In exchange for this
      license grant, Viking Systems paid Vista royalties of 5% of all original
      equipment manufacturer (OEM) sales and 10% of all sales of the 3Di System over
      the five (5) years following the acquisition. The license agreement contained
      minimum royalties of $150,000 in year one, $300,000 in each of years two, three
      and four, and $375,000 in year five. The royalties payable by Viking Systems
      under the license agreement were capped at $4,500,000 in the aggregate, over
      the
      five-year period. Vista retained ownership of all intellectual property and
      product rights under the license agreement until these royalty obligations
      were
      satisfied, at which time Vista will transfer ownership of such intellectual
      property and product and product rights to Viking Systems. **** In
      November 2006, Viking and IVOW, the new owners of Vista entered into a
      Technology Transfer and Settlement Agreement whereby IVOW would immediately
      transfer the ownership of the intellectual property and technology for a final
      payment of $500,000.


60
  **VIKING
        SYSTEMS, INC.**
 **Notes
        to Financial Statements**
 ***Continued***
 
 **20.**  **Commitments
          and Contingencies  *(Continued)***
 Viking
          Systems has also entered into a royalty agreement with a supplier. The
          royalty
          agreement requires payments of 4% of sales that use the supplier’s product. As
          of December 31, 2006 and 2005, Viking Systems had accrued royalties related
          to
          this agreement of approximately $19,027 and $12,090, respectively. During
          2006
          and 2005, Viking Systems did not pay any royalties under this
          agreement.





Viking
      Systems has a License Agreement with an individual, which originated as of
      April
      15, 2004, whereas Viking has exclusive use of the licensor’s stereo imaging
      patents. Under this agreement, which expires on August 24, 2008, Viking Systems
      pays $54,000 per year in equal monthly payments. The McKinley patents have
      been
      licensed for potential new products and should the license agreement not be
      renewed, there will be no impact on Viking’s current business.




**21.**  **Recent
      Accounting Pronouncements**


In
              September 2005, the Emerging Issue Task Force ("EITF") reached a consensus
              on
              Issue No. 05-8, *Income
              Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion
              Feature* (EITF
              No.
              05-8”) ***.*** Under
              EITF No. 05-8, issuance of convertible debt with a beneficial conversion
              feature
              recorded pursuant to EITF 98-5, *Accounting
              for Convertible Securities with Beneficial Conversion Features or Contingently
              Adjustable Conversion Ratios* and EITF
              00-27, *Application of Issue No. 98-5 to Certain Convertible
              Instruments* results
              in a temporary difference for purposes of applying Statement 109. The
              deferred
              taxes recognized for the temporary difference should be recorded as
              an
              adjustment to paid-in capital. The EITF No. 05-8 Consensus should be
              applied
              retrospectively to all instruments with a beneficial conversion feature
              accounted for under EITF 98-5 and EITF 00-27 for periods beginning
              after
              December 15, 2005. The adoption of EITF 05-8 did not have a material
              impact on
              our financial statements.


In
      February 2006, the Financial Accounting Standards Board (“FASB”) released
      Statement No. 155, *Accounting
      for Certain Hybrid Financial Instruments* ,
      ("SFAS No. 155"). SFAS No.155 is an amendment of Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities, and
      Statement No. 140, Accounting for Transfers and Servicing of Financial
      Assets and Extinguishments of Liabilities. SFAS No. 155 establishes, among
      other items, the accounting for certain derivative instruments embedded within
      other types of financial instruments; and, eliminates a restriction on the
      passive derivative instruments that a qualifying special-purpose entity may
      hold. Effective for the Company beginning January 1, 2007, SFAS
      No. 155 is not expected to have a significant impact on the Company's
      financial position, results of operations or cash flows.





In
      March 2006, the FASB released Statement No. 156, *Accounting
      for Servicing of Financial Assets* ,
      an
      amendment of FASB Statement No. 140, ("SFAS No. 156"). SFAS No.
      156 amends SFAS No. 140 to require that all separately recognized servicing
      assets and liabilities in accordance with SFAS No. 140 be initially
      measured at fair value, if practicable. Furthermore, this standard permits,
      but
      does not require, fair value measurement for separately recognized servicing
      assets and liabilities in subsequent reporting periods. SFAS No. 156 is
      also effective for the Company beginning January 1, 2007; however, the
      standard is not expected to have an impact on the Company's financial position,
      results of operation or cash flows.





In
      the
      first quarter of 2006, the Company adopted Statement No. 154, Accounting *for
      Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB
      Statement No. 3* ,
      ("SFAS No. 154") which changed the requirements for the accounting for and
      reporting of a voluntary change in accounting principle. The Company also
      adopted Statement No. 151, *Inventory
      Costs—an amendment of ARB No. 43* ,
      Chapter
      4 ("SFAS No. 151") which, among other changes, requires certain abnormal
      expenditures to be recognized as expenses in the current period versus
      capitalized as a component of inventory. The adoption of SFAS No. 154 did
      not impact the results presented and the impact on any future periods will
      depend on the nature and significance of any future accounting changes subject
      to the provisions of the statement. The adoption of SFAS No. 151 did not
      have any impact on the Company's financial position, results of operations
      or
      cash flows.


61


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**21.**  **Recent
      Accounting Pronouncements *(*** ***Continued)***


In
        June
        2006, the FASB issued Interpretation No. 48, " *Accounting
        for Uncertainty in Income Taxes - an interpretation of FASB Statement No.
        109* ,"
        (FIN
        48). FIN 48 clarifies the accounting for uncertainty in tax positions and
        requires that a Company recognize in its financial statements the impact
        of a
        tax position, if that position is more likely than not of being sustained
        on
        audit, based on the technical merits of the position. The provisions of FIN
        48
        are effective for fiscal years beginning after December 15, 2006. The adoption
        of FIN 48 is not expected to have a significant impact on the Company's
        financial position, results of operations or cash flows.


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.





In
      September 2006, the SEC released Staff Accounting Bulletin No. 108,
“ *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* ”
(“SAB
      108”). SAB 108 provides interpretive guidance on the SEC’s views on how the
      effects of the carryover or reversal of prior year misstatements should be
      considered in quantifying a current year misstatement. We adopted SAB 108 during
      the fourth quarter of 2006. The adoption did not have a material impact on
      our
      financial position, cash flows or results of operations.




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.


62


**VIKING
      SYSTEMS, INC.**


**Notes
      to Financial Statements**


***Continued***





**22.**  **Subsequent
      Events**




During
      January 2007, we issued a $300,000 promissory
      note to our CEO who is also a significant shareholder and Director. The
      promissory notes were converted into the February 2007 debentures.




In
      February 2007,Viking Systems **** issued
      a
      total of $5,376,533 of Debentures had been sold to 13 Investors. Viking may
      issue additional Debentures. The general terms of this financing are as
      follows:


Maturity
        Date of Notes
 Two
        years
        from the date of issuance and may be accelerated by Investor upon default
        by
        Viking.
 
 Interest
        Rate of Notes
 Eight
        percent per annum, payable quarterly and subject to certain conditions, Viking
        may pay interest by issuing the holders of the Debentures shares of Viking
        common stock.
  Security
 The
        Notes
        are secured by all of the assets of Viking.
 
 Optional
        Conversion by Investors
 ***Conversion.*** The
        Debentures may, at the option of the Investors, be converted into shares
        of
        Viking common stock at the price of $0.18 per share. In the event Viking
        does
        not achieve certain operation milestones (described in the Debentures Warrants)
        during the first three quarters of 2007, the conversion price will be reduced
        to
        $0.12 per share. The conversion price is also subject to downward adjustment,
        upon certain conditions pursuant to the terms of Security Purchase Agreement,
        the Debentures and other Transaction Documents.
  Optional
        Redemption by Viking
 Viking
        may not prepay the debentures but it may redeem some or all of the Debentures
        if
        certain conditions (“Equity Conditions”) are met. The Optional Redemption Amount
        (as defined in the Transaction Documents) equals 120% of the principal amount
        of
        the Debentures redeemed if the redemption occurs prior to the first anniversary
        date of the issuance of the Debentures, and 140% of the principal amount
        of the
        Debentures redeemed if the redemption occurs after the first anniversary
        date of
        the issuance of the Debentures but prior to the second anniversary date of
        issuance
 
 63
 **VIKING
          SYSTEMS, INC.**
 **Notes
          to Financial Statements**
 ***Continued***
 
 **22.**  **Subsequent
          Events  *(Continued)***
 Warrants
 As
        additional consideration for the Investors purchasing the Debentures, Viking has
        issued the Investors Warrants to purchase shares of Viking common stock at
        the
        price of $0.18 per share. In the event Viking does not achieve certain operation
        milestones (described in the Warrants and the Debentures) during the first
        three
        quarters of 2007, the exercise price will be reduced to $0.12 per share.
        The
        exercise price is also subject to downward adjustment, upon certain conditions
        pursuant to the terms of Security Purchase Agreement, the Warrant and other
        Transaction Documents. The Warrants are exercisable for a period of seven
        years
        from the date of issuance. The Warrants provide that each Investor is issued
        to
        purchase that number of shares of common stock of Viking that equals 50%
        of the
        number of shares issuable upon conversion of the Debentures. Assuming $6,000,000
        of Debentures are sold, and assuming the Debentures are convertible into
        33,333,333 shares of Viking common stock, the warrants will entitle the holders
        to purchase an aggregate of approximately 16,666,667 shares of Viking common
        stock. Assuming $6,000,000 of Debentures are sold, and assuming the Debentures
        are convertible into 50,000,000 shares of Viking common stock, the warrants
        will
        entitle the holders to purchase an aggregate of approximately 25,000,000
        shares
        of Viking common stock.
  Registration
        Rights
 Viking
        has agreed to register with the Securities and Exchange Commission, the shares
        of common stock that are issuable upon the conversion of the Debentures and
        the
        shares of common stock that underlie the Warrants. Viking will pay all expenses
        and cost of registration except for commissions. In the event the securities
        underlying the debentures and warrants are not registered by the dates agreed
        to
        in the transaction documents, Viking will be required to pay liquidated damages
        to the Holders. Such liquidated damages amount to 2% per month but will not
        exceed 18% of the face amount of the Debentures.
 
 Additional
 Pursuant
        to the securities purchase agreement, the Holders were granted certain rights
        to
        participate in subsequent financings by Viking.
  In
          February 2007, we received the consent of our Series B Preferred Shareholders
          to
          consummate the convertible debenture financing and executed a consent and
          waiver
          agreement as described below.
 
 Consent,
          Waiver, and Amendment Agreement
 In
          May
          2006, Viking issued shares of its Convertible Series B Preferred Stock
          and
          Warrants to a limited number of accredited investors (the “Preferred Stock
          Transaction”). Pursuant to the terms and conditions of the Preferred Stock
          Transaction, Viking agreed to register the shares of common stock underlying
          the
          Series B Preferred Stock and Warrants issued in the Preferred Stock Transactions
          (the “Preferred Stock Transaction Shares”). Some of the Preferred Stock
          Transaction Shares were registered but other Preferred Stock Transaction
          Shares
          were not registered as a result of the Securities and Exchange Commission’s
          interpretation of Rule 415. The failure to register all of the Preferred
          Stock
          Transaction Shares resulted in a default by Viking of the terms and conditions
          of the Preferred Stock Transaction documents. Viking and the Preferred
          Stockholders have entered into a Consent, Waiver and Amendment Agreement
          pursuant to which:
 
 ·
                Viking
                    has agreed to issue the Preferred Stockholders a total of 4,000,000
                    shares
                    of Viking common stock;
 
 ·
                the
                    Preferred Stockholders agreed to amend certain provisions of
                    the Preferred
                    Stock Transaction documents; and
 
 ·
                the
                    Preferred Stockholders agreed to waiver certain breaches of the
                    Preferred
                    Stock Transaction documents.
  Liquidated
            damages in the amount $840,000 have been accrued as of December 31, 2006
            based
            on the estimated fair value of the four million shares of common stock
            issued
            pursuant to this agreement.


64


**ITEM
      8. CHANGES 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 has 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
      (“Squar Milner Peterson”).





We
      filed
      this Form 8-K as notification that Peterson will no longer be our independent
      registered public auditor and that Squar Milner Peterson succeeds Peterson
      as
      the Company’s independent registered auditor. 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**





Under
      the
      supervision and with the participation of our management, including our Chief
      Executive Officer and Chief Financial Officer, we evaluated the effectiveness
      of
      the design and operations of our disclosure controls and procedures, as defined
      in Rule13a-15(e) under the Securities Exchange Act of 1934. Based on this
      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 are adequately designed to ensure that information
      required to be disclosed in the reports submitted under the Securities and
      Exchange Act of 1934 is recorded, processed, summarized and reported within
      the
      time periods specified in Securities and Exchange Commission ("SEC") rules
      and
      forms.





***The
      Sarbanes-Oxley Act of 2002 (the “Act”)*** imposed
      many requirements regarding corporate governance and financial reporting. One
      requirement under section 404 of the Act, beginning with our annual report
      for
      the year ended December 31, 2007, is for management to report on Viking Systems’
internal controls over financial reporting and for our independent registered
      public accountants to attest to this report for the year ended December 31,
      2008.





**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.


65


**PART
      III**





**ITEM
      9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
      WITH
      SECTION 16(a) OF THE EXCHANGE ACT.**





**Identification
      of Directors and Executive Officers**





The
      current directors and 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
            PositionDonald
                E. Tucker
            Chairman
                of the Board, CEO/PresidentDaniel
                F. Crowley
            Director,
                Audit Committee ChairmanNathan
                J. Harrison, M.D.
            Director,
                Compensation Committee Chairman
              (Interim
                CEO April 12, 2006 through May 22, 2006)Brian
                M. Miller
            DirectorDr.
                Michael J. Manyak
            DirectorGregory
                M. Decker
            Chief
                Financial OfficerJoseph
                Warrino
            SecretaryLonna
                Williams
            Sr.
                VP of Commercial Operations





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





***Donald
      E. Tucker*** .
      Effective May 23, 2006, Donald E. Tucker was appointed Chief Executive Officer,
      President and a director of Viking. Mr. Tucker replaced interim CEO Nathan
      Harrison, MD who continues to serve as a director of Viking. In August 2006,
      Mr.
      Tucker also became chairman of Viking’s board of directors. Mr. Tucker is a
      significant shareholder of Viking, and has recently retired from his employment
      as a senior executive with Accenture, an international consulting company.
      Viking anticipates that employment compensation terms for Mr. Tucker will be
      finalized within the next several weeks. Over his 26 year career with Accenture,
      Mr. Tucker has worked extensively with start-up companies, emerging growth
      businesses, and Fortune 50 companies. Mr. Tucker was the Managing Partner for
      the Accenture Medical Products, Diagnostics and Devices industry segments,
      as
      well as, the Accenture lead partner for the west coast bio/pharmaceutical
      market. Areas of specialization include product and market development,
      logistics/supply chain management, and strategy formulation. Mr. Tucker has
      extensive experience in merger integration, new product launch, and complex
      business change. Mr. Tucker earned a B.S. in Business Management from Northern
      Michigan University.





***Gregory
      M. Decker.*** Effective
      May 31, 2006, Gregory M. Decker was appointed Chief Financial Officer of Viking.
      Mr. Decker served most recently as the Chief Financial Officer of Sensoria
      Corporation, a venture-funded wireless communications company. Mr. Decker has
      more than 20 years of financial and general management experience with telecom
      services, infrastructure and terminal equipment -- in both start-up and Fortune
      500 companies. Prior to joining Sensoria, Mr. Decker was Senior Vice President
      and CFO of NeoPoint, Inc., a developer of wireless “Smartphones” and wireless
      Internet services. Previously, Mr. Decker was the Finance Director for
      Qualcomm’s $1-billion Consumer Products Division, and Controller for Ericsson
      Raynet. He holds a bachelor’s degree from Pomona College and a Masters in
      Business Administration from Harvard’s Graduate School of
      Business.


66


***Daniel
      F. Crowley*** .
      Mr.
      Crowley was appointed a director of Viking in December 2003 and was Chairman
      of
      the Board from March 2005 to August 2006. He has been a private investor and
      business consultant since 2002. Mr. Crowley is a principal in and co-founder
      of
      Spectrum Partners LLC, a business strategy and development advisory firm
      specializing in the transportation and logistics industry with offices in
      Scottsdale, Arizona. Prior to Spectrum Partners LLC, Mr. Crowley was Executive
      VP & CFO at BAX Global from 1998 through 2002. Previous positions include
      senior management positions with Frito-Lay International and Grand Metropolitan
      PLC companies including, The Pillsbury Company and Pearle Vision. Mr. Crowley
      holds a CPA certificate from the State of New York, and a M.B.A. in Finance
      from
      Columbia University.




***Nathan
      J. Harrison, M.D.*** Dr.
      Harrison was appointed a director of Viking in August 2004. Dr. Harrison has
      been the Medical Director of Dunhill Marketing and Insurance, Inc. since
      retiring from clinical practice in 1999. He joined Obstetrics/Gynecology
      Associates Medical Group, Inc. in 1977 and was President from 1981 to 1999.
      Dr.
      Harrison also served as Chief of Staff, Chairman of Obstetrics and Gynecology
      and as a Director of Sharp Memorial Hospital. He also served as a Director
      of
      Sharp Health Care and Sharp Community Medical Group all in San Diego. Prior
      to this, Dr. Harrison was a Flight Surgeon in the U.S. Army. He has been a
      member of the Physicians Advisory Committee for Prudential Insurance, CIGNA
      Insurance and Aetna/US Health, as well as several medical societies. Dr.
      Harrison earned his M.D. from University of Illinois College of Medicine.




***Brian
      Miller.*** Effective October 5, 2006, Brian M. Miller was appointed as a member of the
      Company’s Board of Directors. Mr. Miller currently serves as Executive Vice
      President, Strategic Alliances of Pay By Touch, a San Francisco based company
      offering biometric based payments and personal marketing solutions. He is also
      a
      member of the Board of Directors of Pay By Touch and M-Factor, a provider of
      marketing analytics solutions. Mr. Miller joined Pay By Touch in 2002 after
      a
      28-year career with Accenture where he focused on creating the firm's Custom
      Relationship Management (“CRM”) practice, working in the sales and marketing
      area for important clients such as Disney, Kellogg’s, Hershey, Clorox, Quaker,
      Dial, Wyeth Pharmaceutical and Takeda Pharmaceutical. He was also instrumental
      in establishing key Accenture strategic relationships with Siebel Systems,
      PeopleSoft, and Blue Martini. During his tenure at Accenture, Miller served
      as
      the Managing Partner in several areas of the firm's practice for the West Coast,
      working with important clients such as Lucky Stores, Ralphs, Savemart, Smitty’s,
      Smiths, Fred Meyer, Ross Stores and Duty Free Shops. He also led Accenture's
      Silicon Valley Business Launch Center, helping clients startup new internet
      based companies. Miller received an MBA and a BSE degree in Industrial
      Engineering from the University of Michigan.


67


***Dr.
      Michael J. Manyak.*** Effective
      November 9, 2006, Dr. Michael J. Manyak was appointed as a member of the
      Company’s Board of Directors. Since January 2005, Dr. Manyak has been Vice
      President of Medical Affairs of Cytogen Corporation, a publicly held
      biopharmaceutical company. Dr. Manyak is also Professor of Urology,
      Microbiology, and Tropical Medicine at The George Washington University Medical
      Center (GWUMC) where he was also Chairman of the Department of Urology. After
      completing his urological residency at GWUMC, Dr. Manyak became an American
      Foundation for Urological Disease Scholar at the National Cancer Institute,
      completed a fellowship in Biotechnology in 1988, and joined the urological
      staff
      at GWUMC. Dr. Manyak has also served on the Medicare Coverage Advisory
      Committee for the Center for Medicare and Medicaid Services where he was a
      member of the Imaging Subcommittee. In addition, he received a presidential
      appointment to the National Kidney and Urological Disease Advisory Board. He
      was
      formerly a voting member of the Food and Drug Administration Regulatory Panel
      for Genitourinary and Gastrointestinal Devices. He has been a reviewer for
      the
      National Institutes of Health Special Study Section for Small Business Grants
      and several professional journals. Dr. Manyak holds a B.A. degree in
      Pre-professional Studies from the University of Notre Dame and a M.D. degree
      from the University of the East, Manila, Philippines.





***Joseph
      A. Warrino.*** Mr.
      Warrino was appointed the CFO and Secretary of Viking on April 15, 2004. On
      May
      31, 2006, Mr. Warrino was appointed as Vice President of Administration and
      is
      no longer our Chief Financial Officer. Prior to joining Viking he was Controller
      of Vista Medical Technologies, Inc. From 1999 to 2000 Mr. Warrino was a Division
      Controller and Human Resources Manager of Lakso Packaging, a division of DT
      Industries, Inc. From 1998 to 1999, he was a senior cost accountant for Vista
      Medical Technologies, Inc. and from 1989 to 1998, Mr. Warrino worked as an
      accountant for several different publicly held companies. Mr. Warrino earned
      his
      B.S. degree in accounting from Salem State College and his A.S. degree in
      Management from Middlesex Community College.





***Lonna
      J. Williams.*** In
      September 2004, Ms. Williams joined Viking as Vice President, Sales and
      Marketing for all Viking business units. Ms. Williams was formerly President
      of
      Medical Market Solutions, a health care product consulting firm. She has 20
      years of experience in marketing, sales and business development in medical
      diagnostics, devices, and pharmaceuticals and has held executive level positions
      in several public and privately held companies. Ms. Williams has brought over
      25
      new products to market and commercialized four novel technologies. She has
      held
      senior management positions at Johnson and Johnson/Clinical Diagnostics,
      Hybritech/Eli Lilly, GenProbe, Inc., Quidel Corporation and LifePoint, Inc.
      She
      has been involved in corporate acquisitions and technology licensing and has
      created and implemented business plans, integration and commercialization plans
      supporting the acquisitions. She graduated from the University of Southern
      Colorado.


68




**Key
      Employees**





***John
      "Jed" Kennedy.*** Mr.
      Kennedy is the 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.





**Control
      Persons**





Mr.
      Tucker acquired a voting control position in Viking Systems in December 2003.
      Information about Donald E. Tucker is provided above.





**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
      adopted a code of ethics that applies to all officers, directors and employees
      of Viking Systems, a copy of which was filed as Exhibit 14 to Form 10-KSB for
      the year ended December 31, 2002. To view this code of ethics, please visit
      our
      website at www.vikingsytems.com (the information contained in our website is
      not
      intended to be a part of this filing). 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 this code of ethics, if any, by posting such information
      on
      our website as set forth above.





**Committees
      of the Board of Directors**




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


69


**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 Daniel Crowley (Chairman) and Nathan Harrison, each of
      whom is a non-management member of our board of directors.  Daniel F.
      Crowley is also our audit committee financial expert as currently defined under
      Securities and Exchange Commission rules. We believe that the composition of
      our
      audit committee meets the criteria for independence under, and the functioning
      of our audit committee complies with the applicable requirements of, the
      Sarbanes-Oxley Act of 2002, the current rules of the NASDAQ Stock Market and
      Securities and Exchange Commission rules and regulations. We intend to comply
      with future audit committee requirements as they become applicable to us.





**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 and employee stock purchase plan. The current
      members of the compensation committee are Nathan Harrison (Chairman) and Brian
      Miller, each of whom is a non-management member of our board of directors.
      We
      believe that the composition of our compensation committee meets the criteria
      for independence under, and the functioning of our compensation committee
      complies with the applicable requirements of, the Sarbanes-Oxley Act of 2002,
      the current rules of the NASDAQ Stock Market and Securities and Exchange
      Commission rules and regulations. We intend to comply with future compensation
      committee requirements as they become applicable to us.





**Nominating
      and Corporate Governance Committee.** The
      nominating and corporate governance committee is responsible for making
      recommendations to the board of directors regarding candidates for directorships
      and the size and composition of the board. In addition, the nominating and
      corporate governance committee is responsible for overseeing our corporate
      governance guidelines and reporting and making recommendations to the board
      concerning corporate governance matters. The current members of the nominating
      and governance committee are Michael J. Manyak. (Chairman) and Nathan Harrison.
      We believe that the composition of our nominating and governance committee
      meets
      the criteria for independence under, and the functioning of our nominating
      and
      corporate governance committee complies with the applicable requirements of,
      the
      Sarbanes-Oxley Act of 2002, the current rules of the NASDAQ Stock Market and
      Securities and Exchange Commission rules and regulations. We intend to comply
      with future nominating and corporate governance committee requirements as they
      become applicable to us.


70


**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 dtucker@vikingsystems.com.





**Compliance
      with Section 16(a)**





Section
      16(a) of the Securities Exchange Act of 1934, as amended, requires Viking
      Systems’ directors and executive officers, and persons who beneficially own more
      than 10% of a registered class of Viking Systems’ equity securities, to file
      reports of beneficial ownership and changes in beneficial ownership of Viking
      Systems’ 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 Systems’ Common Stock
      are required by SEC regulations to furnish Viking Systems with copies of all
      Section 16(a) forms that they file. Viking Systems believes that, during the
      year ended December 31, 2006, the Reporting Persons met all applicable Section
      16(a) filing requirements.





**ITEM
      10. EXECUTIVE COMPENSATION**





**Summary
      Compensation Table**





Annual
                Compensation
            Long-Term
                CompensationAwards
            PayoutsName
                and Other Annual Principal Position
            Year
            Salary
            Bonus
            Other
                Annual Compensation
            Stock
                Awards
            Options/
              SAR’s
                (#)
            LTIP
                Payouts
            All
                Other CompensationDonald
                E. Tucker (1)
            2006
            $137,738
            -0-
            -0-
            -0-
            720,000
            -0-
            -0-2005
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-2004
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-Thomas
                B. Marsh (2)
            2006
            $418,344
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-CEO
            2005
            $230,059
            -0-
            -0-
            -0-
            -0-
            -0-
            -0-2004
            $151,600
            18,000(6)
            -0-
            -0-
            320,000
            -0-
            -0-2003
            $-0-
            -0-
            -0-
            -0-
            1,000,000
            -0-
            -0-Nathan
                Harrison, MD (3)
            2006
            -0-
            -0-
            -0-
            -0-
            10,000
            -0-
            -0-Gregory
                M. Decker (4)
            2006
            $102,776
            -0-
            -0-
            -0-
            400,000
            -0-
            -0-John
                Kennedy (5)
            2006
            $220,552
            -0-
            -0-
            -0-
            130,000
            -0-
            -0-2005
            $195,555
            -0-
            -0-
            -0-
            500,000
            -0-
            -0-2004
            $132,385
            18,000(6)
            -0-
            -0-
            280,000
            -0-
            -0-Lonna
                Williams (7)
            2006
            $183,915
            -0-
            -0-
            -0-
            130,000
            -0-
            -0-2005
            $170,620
            -0-
            -0-
            -0-
            500,000
            -0-
            -0-2004
            $44,563
            12,000(6)
            -0-
            -0-
            280,000
            -0-
            -0-Joseph
                Warrino (8)
            2006
            $152,624
            -0-
            -0-
            -0-
            100,000
            -0-
            -0-2005
            $123,394
            -0-
            -0-
            -0-
            200,000
            -0-
            -0-2004
            $65,916
            12,000(6)
            -0-
            -0-
            126,000
            -0-
            -0-


71


The
      following table sets forth certain information concerning compensation for
      services rendered for the past three years to Viking Systems’ Chief Executive
      Officer and to Viking Systems’ most highly compensated officers other than the
      CEO, whose annual salary and bonus exceeded $100,000:





1)
            Donald
                E. Tucker was appointed Chief Executive Officer, President and a
                director
                of Viking effective May 23, 2006. Mr. Tucker replaced interim CEO
                Nathan
                Harrison, MD who continues to serve as a director of Viking. In August
                2006, Mr. Tucker also became chairman of Viking’s board of directors. Mr.
                Tucker is a significant shareholder of
                Viking





2)
            Mr.
                Marsh was appointed as President and CEO of Viking in December 2003
                and
                left the Company as of April 11, 2006. Included in Mr. Marsh’s
                compensation is $330,000 in compensation related to a cashless exercise
                of
                1,000,000 incentive stock options resulting in the issuance of 837,000
                shares to Mr. Marsh.





3)
            Nathan
                Harrison, MD served as the interim CEO for the period of April 11,
                2006 to
                May 23, 2006 and continues to serve as a director of
                Viking.





4)
            Gregory
                M. Decker was appointedChief
                Financial Officer of Viking effective May 31,
                2006.





5)
            Mr.
                Kennedy was appointed as President of the Vision Systems Group in
                April
                2004.





6)
            The
                bonus was earned in 2004 and paid in
                2005.





7)
            Ms.
                Williams joined Viking Systems in September 2004 as VP of sales and
                Marketing and in July 2005 was promoted to Sr. VP of Commercial
                Operations.





8)
            Joseph
                A. Warrino served as the Company’sCFO
                from April 15, 2004 until May 31, 2006. Mr. Warrino continues to
                be the
                Secretary of Viking since April 15, 2004 and is the Company’s General
                Manager.





**Stock
      Options Granted in the Last Fiscal Year**





The
      following table sets forth information on grants of options to purchase shares
      of our common stock in fiscal year 2006 to our officers and
      directors.





Individual
                GrantsName
            Number
                of Securities
              Underlying
                Options
              Granted
            %
                of Total Options
              Granted
                to Employees
              in
                Fiscal Year
            Exercise
                Price ($/Sh)(1)
            Expiration
                DateDonald
                E. Tucker
            720,000
            25.2%
            $.48
            5/23/16Gregory
                M. Decker
            400,000
            14.0%
            $.40
            5/31/16John
                Kennedy
            130,000
            4.5%
            $.35
            1/23/16Lonna
                Williams
            130,000
            4.5%
            $.35
            1/23/16Joseph
                Warrino
            100,000
            3.5%
            $.35
            1/23/16





(1)
            The
                exercise price was equal to 100% of the fair market value on the
                date of
                grant.




72


**Aggregated
      Option Exercises in Last Fiscal Year and Fiscal Year-end Option
      Values**





Securities
                Underlying
              Unexercised
                Options at
              December
                31, 2006
            Value
                of Unexercised
              In-the-Money
                Options
              at
                December 31, 2006 ($)(1)Name
            Shares
                Acquired
              on
                Exercise (#)
            Value
                Realized ($)
            Exercisable
            Unexercisable
            Exercisable
            UnexercisableThomas
                B. Marsh (2)
            837,000
            $330,000
            -0-
            -0-
            -0-
            -0-Donald
                E. Tucker
            -0-
            -0-
            -0-
            720,000
            -0-
            -0-Gregory
                M. Decker
            -0-
            -0-
            40,000
            360,000
            -0-
            -0-John
                Kennedy
            -0-
            -0-
            695,000
            215,000
            -0-
            -0-Lonna
                Williams
            -0-
            -0-
            605,000
            305,000
            -0-
            -0-Joseph
                Warrino
            -0-
            -0-
            316,000
            110,000
            -0-
            -0-


______________


(1)
            Calculated
                on the basis of the fair market value of the underlying securities
                at
                December 31, 2006 minus the exercise price. Viking’s common stock is
                quoted on the Bulletin Board.





(2)
            On
                March 22, 2006 Mr. Marsh acquired 837,000 shares through a cashless
                exercise of his NSO in the amount of 1,000,000 shares. The balance
                of his
                options expired on his departure at the end of his contract on April
                12,
                2006.





**Compensation
      of Directors**





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
      Systems. 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.





In
      addition to an option for 20,000 shares granted under the Non-Employee’s
      Directors Stock Ownership Plan, we had granted Director Daniel F. Crowley an
      option to purchase 200,000 shares of our common stock.




**Employment
      Agreements**





Viking
      Systems has 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
      Systems has entered into an employment agreement with our Sr. VP of Commercial
      Operations, Lonna Williams. The agreement provides for the payment of a base
      salary of $185,000 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.


73


Viking
      Systems has entered into an employment agreement with our President of Vision
      Systems Group, John Kennedy. The agreement provides for the payment of a base
      salary of $195,700 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
      Systems has entered into an employment agreement with our VP of Sales, Eric
      Cohill. The agreement provides for the payment of a base salary of $160,000
      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
      Systems 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.





**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 7,500,000 shares of Viking common stock were available for granting awards
      under the Plan. In May 2006, the Board of Directors and the majority
      shareholders of Viking increased the number of shares available under the Plan
      to 8,600,000. 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. As Viking Systems hired new employees the
      board granted stock options between 10,000 and 30,000 shares per employee.
      In
      conjunction with employment contracts the board granted stock options between
      80,000 and 500,000 shares per employee. Incentive stock options issued to Viking
      officers and employees that remain outstanding at December 31, 2006 amounted
      to
      4,976,000 shares.


74


*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 500,000 shares of Common Stock (subject to adjustment as described
      below) 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.





**ITEM
      11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT**




**Security
      Ownership of Certain Beneficial Owners**





The
      following table sets forth information regarding shares of our common stock
      beneficially owned as of March 23, 2007 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
            Common
                Stock
            Total
                Stock
            %Common
            Options
                Exercisable
            Purchase
                Warrant
            and
                Stock
            Ownership(1)Name
            Stock
            Within
            Exercisable
            Based60
                Days
            Within
                60 Days
            Holdings(1)Donald
                E. Tucker(2)
            29,621,150
            
            930,555
            30,551,705
            45.74%Gregory
                M. Decker(2)
            
            56,000
            
            56,000
            0.08%Joseph
                A. Warrino(2)
            
            336,000
            
            336,000
            0.51%Lonna
                Williams(2)
            25,000
            631,000
            
            656,000
            0.99%John
                Kennedy(2)
            
            721,000
            
            721,000
            1.08%Daniel
                F. Crowley(2)
            7,500
            230,000
            
            237,500
            0.36%Brian
                Miller
            3,533,333
            
            833,333
            4,366,666
            6.55%Nathan
                Harrison, M.D.(2)
            55,000
            30,000
            
            85,000
            0.13%Dr.
                Michael Manyak.(2)All
                officers and directorsas
                a group (9 persons)(2)
            33,241,983
            2,004,000
            1,763,888
            37,009,871
            53.15%St.
                Cloud Capital Partners
            8,333,333
            
            2,083,333
            10,416,666
            15.33%Crestview
                Capital Master, LLC.(3)
            7,444,444
            
            3,472,222
            10,916,666
            15.74%Bushido
                Capital Master Fund, L.P.(3)
            11,064,071
            
            5,157,036
            16,221,107
            22.84%Pierce
                Diversified Strategy Master Fund, LLC(3)
            3,027,778
            
            1,388,889
            4,416,667
            6.57%GSSF
                Master Fund, LP(3)
            3,962,499
            
            1,875,000
            5,837,499
            8.62%Gryphon
                Master Fund, LP(3)
            4,995,833
            
            2,291,667
            7,287,500
            10.69%Midsummer
                Investment, LTD(3)
            23,472,222
            
            11,111,110
            34,583,332
            44.93%Rockmore
                Investment Master Fund, LTD(3)
            4,541,667
            
            2,083,333
            6,625,000
            9.75%CAMOFI
                Master LDC(3)
            6,944,444
            
            3,472,222
            10,416,666
            15.02%The
                Focus Fund(3)
            2,777,777
            
            1,388,888
            4,166,665
            6.20%




75






(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, 2007. 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, 2007 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, 2007, there
                were
                65,864,941 shares of our common stock issued and outstanding.





(2)
            These
                are the officers and directors of
                Viking.





(3)
            “Common
                Stock” represents the number of shares of common stock into which, at the
                current conversion rate, preferred stock and/or convertible debentures
                are
                convertible.





**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 Systems had
      7,376,000 outstanding options as of March 22, 2007.





As
      of
      March 22, 2007, we had warrants outstanding which entitle the holders to
      purchase 47,462,584 shares of our common stock at prices ranging from $0.18
      to
      $0.75 per share.


76




**Equity
      Compensation Plan Information**





The
      following table summarizes information about Viking Systems’ equity compensation
      plans as of December 31, 2006.




Plan
                Category
            Number
                of Securities
              to
                be Issued Upon Exercise
              of
                Outstanding Options,
              Warrants
                and Rights (a)
            Weighted-Average
              Exercise
                Price of
              Outstanding
                Options,
              Warrants
                and Rights (b)
            Number
                of Securities
              Remaining
                Available for
              Future
                Issuance Under
              Equity
                Compensation
              Plans(Excluding
              SecuritiesReflected
                in
              Column
                (a)) (c)Equity
                Compensation plans approved by security holders (1)
            5,096,000
            $0.40
            4,004,000Equity
                compensation plans not approved by security holders (2)
            1,880,000
            $
                0.50
            -Total
            6,976,000
            $
                0.42
            4,004,000





(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
                3,624,000 shares available for purchase by employees under our 2004
                Stock Incentive Plan and 380,000 shares available for purchase by
                employees 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)
            Amount
                represents 1,880,000 in other options granted to non-employee consultants
                outside the Company’s plans.







**ITEM
      12. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS**





**Issuance
      of Preferred Stock**





On
      December 18, 2003, we granted Donald Tucker, Viking Systems’ largest
      shareholder, an option to purchase 5,000,000 shares of our Series A Preferred
      Stock for $400,000. Each share of Series A Preferred Stock was convertible
      into
      four shares of our common stock. Mr. Tucker subsequently exercised his option
      and purchased all 5,000,000 shares of Series A Preferred Stock. In December
      2004, he converted his 5,000,000 shares of Series A Preferred Stock into
      20,000,000 shares of our common stock.


77




**Loan
      Transactions**





Donald
      Tucker, has made several loans to Viking Systems since 2005. Each of such loans
      was unsecured and most was convertible into shares of our common stock or other
      debt securities. Information about such loans is as follows:





Date
                of Loan
            Amount
            Interest
                Rate
            Maturity
                Date
            Conversion
                Rate10/26/04
            $200,000
            10%
            3/31/05
            $.40
                per share(1)12/6/04
            $200,000
            10%
            3/31/05
            $.40
                per share(1)1/12/05
            $
                50,000
            10%
            3/31/05
            $.40
                per share(1)1/21/05
            $
                50,000
            10%
            3/31/05
            $.40
                per share(1)2/5/05
            $500,000
            10%
            3/31/05
            (2)3/16/06
            $200,000
            10%
            5/31/05
            (3)1/26/07
            $300,000
            8%
            2/26/07
            $.18
                per share(4)





(1)
      On
      March 22, 2005, the principal balance of these loans, together with accrued
      interest thereon, was converted into a total of 1,291,650 shares of our common
      stock.




(2)
      On
      March 22, 2005, this loan was converted into another debt instrument. On that
      date Viking entered into a Securities Purchase Agreement and related agreements
      (the "Transaction Documents"), among (i) Viking, (ii) St. Cloud Capital
      Partners, L.P., a Delaware limited partnership ("St. Cloud"), as "Lead Lender"
      and "Collateral Agent" and (iii) St. Cloud, Donald Tucker, Brian Miller, and
      any
      other person signing the signature page of the Securities Purchase Agreement
      as
      an Investor or that becomes an Investor after March 22, 2005, (collectively,
      the
      "Investors"). Pursuant to the Securities Purchase Agreement, Viking has sold
      and
      will sell promissory notes ("Notes") to Investors in the maximum aggregate
      amount of $2,750,000. One of such Investors was Donald F. Tucker who converted
      his February 5, 2005 loan into a $500,000 loan sold pursuant to the Securities
      Purchase Agreement. The material terms of the Securities Purchase Agreement
      and
      other Transaction Documents are set forth in the Management’s Discussion and
      Analysis Section of this Form 10-KSB.





(3)
      On
      March 16, 2006, Donald Tucker loaned Viking Systems $200,000 in an unsecured
      note payable. This note was repaid in June, 2006.





(4)
      On
      February 24, 2007, this loan was converted into another debt instrument. On
      that
      date, Viking closed upon the sale of $5,376,533 of its Secured Convertible
      Debentures (the “Debentures”) pursuant to a Securities Purchase Agreement and
      related agreements (the “Transaction Documents”), among (i) Viking and 13
      purchasers (collectively, the “Investors”). As of February 24, 2007 a total of
      $5,376,533 of Debentures had been sold to 13 Investors.





**Loan
      Guarantee Collateral**





On
      January 27, 2005, we entered into a Loan and Security Agreement with Silicon
      Valley Bank. The Loan Agreement provides for a maximum borrowing of $200,000.
      The loan was secured by the assets of Viking Systems and also secured by a
      $200,000 certificate of deposit owned by Donald Tucker. This agreement was
      terminated in June, 2006.


78


**ITEM
      13.**  **EXHIBITS**


ExhibitNumber
              Exhibit2.1
              Asset
                  Purchase Agreement - Vista Medical Technologies,
                  Inc.(3)3.1
              Articles
                  of Incorporation (1)3.2
              Certificate
                  of Preferences, Rights and Limitations of Series B Variable Dividend
                  Convertible Preferred Stock****(6)3.3
              Bylaws
                  (1)10.1
              Option
                  Agreement - Thomas B. Marsh (3)10.2
              Option
                  Agreement - Daniel F Crowley (3)10.3
              Asset
                  Purchase Agreement - Vista Medical Technologies,
                  Inc.(3)10.4
              Patent
                  and Technology License Agreement (3)10.5
              Stock
                  Incentive Plan (4)10.6
              Non-Employee
                  Stock Option Plan (4)10.7
              Employment
                  Agreement - Thomas B. Marsh (5)10.8
              Employment
                  Agreement - Jed Kennedy (8)10.9
              Employment
                  Agreement - Joe Warrino (8)10.10
              Employment
                  Agreement - Lonna Williams (8)10.11
              Personal
                  Services Agreement G. Andriole (11)10.12
              Personal
                  Services Agreement C. Nizhat (11)10.13
              Lease
                  Agreement (7)10.14
              Registration
                  Rights Agreement (9)10.15.
              Warrants
                  to Purchase Common Stock (9)10.16
              iVOW
                  Settlement Agreement (11)10.17
              Platinum
                  Medical Distribution Agreement (11)10.18
              Lease
                  Agreement (11)10.19
              SECURITIES
                  PURCHASE AGREEMENT10.20
              REGISTRATION
                  RIGHTS AGREEMENT10.21
              COMMON
                  STOCK PURCHASE WARRANT10.22
              SECURITIES
                  PURCHASE AGREEMENT10.23
              SECURED
                  CONVERTIBLE DEBENTURE10.24
              REGISTRATION
                  RIGHTS AGREEMENT10.25
              COMMON
                  STOCK PURCHASE WARRANT10.26
              SECURITY
                  AGREEMENT10.27
              WAIVER
                  AND AMENDMENT AGREEMENT14.1
              Code
                  of Ethics (2)16.1
              Letter
                  from Previous Auditor (10)31.1
              Certification
                  of Chief Executive Officer in accordance with 18 U.S.C. Section
                  1350, as
                  adopted by Section 302 of the Sarbanes- Oxley Act of 2002
                  (10)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
                  (10)32.1
              Certification
                  of Chief Executive Officer in accordance with 18 U.S.C. Section
                  1350, as
                  adopted by Section 906 of the Sarbanes-Oxley Act of 2002
                  (10)32.2
              Certification
                  of Chief Financial Officer in accordance with 18 U.S.C. Section
                  1350, as
                  adopted by Section 906 of the Sarbanes-Oxley Act of 2002
                  (10)
  
 79
 (1)
              Incorporated
                  herein by reference from Registrant’s Form 8-K dated July 25,
                  2006.(2)
              Incorporated
                  by reference from Registrant’s Form 10-KSB for the year ended December 31,
                  2002.(3)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  December 24, 2003(4)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  March 31, 2004.(5)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  July 19, 2004.(6)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  May 22, 2006.(7)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  October 1, 2004.(8)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  October 10, 2005.(9)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K dated
                  March 24, 2005.(10)
              Incorporated
                  herein by Reference from the Registrant’s Current Report on Form 8-K/A
                  dated January 17, 2007.(11)
              Attached
 **ITEM
        14. PRINCIPAL ACCOUNTING FEES AND SERVICES**





**Independent
      Auditors**




Peterson
      & Co., LLP was appointed on December 28, 2005 to audit the consolidated
      financial statements of Viking Systems 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 Systems 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 Systems by Squar, Milner, Peterson, Miranda & Williamson,
      LLP,** **Peterson
      & Co., and Tanner LC**




**Squar,
                    Milner, Peterson, Miranda & Williamson, LLP / Peterson & Co
                    LLP**
                
                **2006**
                
                **2005**(1)
                    Audit Fees
                
                $
                173,818
                
                $
                68,765(2)
                    Tax Fees
                
                $
                0
                
                $
                7,028(3)
                    All Other Fees
                
                $
                0
                
                $
                0
  **Tanner
                    LC**
                
                **2006**
                
                **2005**(1)
                    Audit Fees
                
                $
                21,493
                
                $
                40,000(2)
                    Tax Fees
                
                $
                5,000
                
                $
                5,000(3)
                    All Other Fees
                
                $
                0
                
                $
                0


80






(1)
            Audit
                fees billed to Viking Systems by Squar, Milner, Peterson, Miranda
&
                Williamson, LLP, Peterson & Co and Tanner LC were for all
                professional services performed in connection with the audit of Viking
                Systems’ 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. The
                2006 and
                2005 fees include the estimated costs to complete the respective
                year’s
                audit.





(2)
            Tax
                services include fees for the preparation of federal and state tax
                returns.





(3)
            Neither
                Squar, Milner, Peterson, Miranda & Williamson, LLP, Peterson
                & Co., LLP or Tanner LC billed Viking Systems for other services
                during 2006 and 2005.





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 Peterson & Co., LLP is 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 Audit Committee Chairman, Daniel F. Crowley, 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 Peterson & Co., LLP and
      Tanner LC and believes that the provision of services for activities unrelated
      to the audit is compatible with maintaining both firm’s
      independence.


81





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 26, 2007
            By:   
                /s/ Donald E.
                TuckerCEO/PresidentPrincipal
                Executive OfficerDated:
                March 26, 2007
            By:   
                /s/ Gregory M.
                DeckerCFO/
                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/
                Donald E
                Tucker
            CEO/President
                and Chairman of the Board of Directors
            March
                26, 2007/s/
                Gregory M.
                Decker
            CFO
            March
                26, 2007/s/
                Daniel F.
                Crowley
            Director
            March
                26, 2007/s/
                Brian
                Miller
            Director
            March
                26, 2007/s/
                Nathan Harrison,
                M.D.
            Director
            March
                26, 2007/s/
                Dr. Michael J.
                Manyak
            Director
            March
                26, 2007




82