---

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

# FORM 10-Q

(Mark One)

| |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended June 30, 2006
| |  | ---------------------------------------------------------------------------------------------------------------------------

OR

| |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934


Or the transition period from ___________ to ______________
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

Commission File No. 0-10394

DATA I/O CORPORATION
 (Exact
name of registrant as specified in its charter)

|Washington

(State or other jurisdiction of 
incorporation or organization) | 91-0864123
(I.R.S. Employer 
Identification No.)
|--------------------------------------------------------------------------- | ------------------------------------------------

10525 Willows Road N.E., 
Redmond, Washington, 98052(Address of principal executive offices, including zip code)

(425) 881-6444(Registrants telephone number, including area code)

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

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

|Large accelerated filer | Accelerated filer | Non-accelerated filer
|----------------------- | ----------------- | ---------------------

Indicate  by check  mark  whether
 the  registrant  is a shell  company  (as  defined  in Rule  12b-2  of the  Exchange
 Act).  Yes      No

8,442,231
shares of no par value of the Registrants Common Stock were issued and outstanding
as of August 10, 2006.

---

# DATA I/O CORPORATION

# FORM 10-Q 
For the Quarter Ended June 30, 2006

# INDEX

|                               |  | Page                                                                                 
|------------------------------ |  | -------------------------------------------------------------------------------------
|Part I  Financial Information |  |                                                                                      
|
|Item 1.                        |  | Financial Statements (unaudited)                                                     
|
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results
of Operations
|
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                           
|
|Item 4.                        |  | Controls and Procedures                                                              
|
|Part II  Other Information    |  |                                                                                      
|
|Item 1.                        |  | Legal Proceedings                                                                    
|
|Item 1A.                       |  | Risk Factors                                                                         
|
|Item 2.                        |  | Changes in Securities and Use of Proceeds                                            
|
|Item 3.                        |  | Defaults Upon Senior Securities                                                      
|
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                  
|
|Item 5.                        |  | Other Information                                                                    
|
|Item 6.                        |  | Exhibits                                                                             
|
|24                             | 

2

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# PART I  FINANCIAL
INFORMATION

# Item 1.    Financial
Statements

# DATA I/O CORPORATION 
CONSOLIDATED BALANCE SHEETS

|                                               
|-----------------------------------------------
|
|                                               
|(in thousands, except share data)              
|ASSETS                                         
|CURRENT ASSETS:                                
|Cash and cash equivalents                      
|Marketable securities                          
|Trade accounts receivable, less allowance for  
|doubtful accounts of $184 and $165             
|Inventories                                    
|Other current assets                           
|                                               
|TOTAL CURRENT ASSETS                           
|                                               
|Property and equipment - net                   
|Other assets                                   
|                                               
|TOTAL ASSETS                                   
|                                               
|LIABILITIES AND STOCKHOLDERS' EQUITY           
|CURRENT LIABILITIES:                           
|Accounts payable                               
|Accrued compensation                           
|Deferred revenue                               
|Other accrued liabilities                      
|Accrued costs of business restructuring        
|Income taxes payable                           
|Deferred gain on sale of property              
|                                               
|TOTAL CURRENT LIABILITIES                      
|                                               
|COMMITMENTS                                    
|                                               
|STOCKHOLDERS' EQUITY:                          
|Preferred stock -                              
|Authorized, 5,000,000 shares, including        
|200,000 shares of Series A Junior Participating
|Issued and outstanding, none                   
|Common stock, at stated value -                
|Authorized, 30,000,000 shares                  
|Issued and outstanding, 8,419,624              
|and 8,362,369 shares                           
|Accumulated deficit                            
|Accumulated other comprehensive income         
|                                               
|TOTAL STOCKHOLDERS' EQUITY                     
|                                               
|TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY     
|                                               

See accompanying notes to
consolidated financial statements.

3

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DATA I/O CORPORATION 
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

|                                                           
|-----------------------------------------------------------
|
|
|                                                           
|(in thousands, except per share data)                      
|                                                           
|Net sales                                                  
|Cost of goods sold                                         
|                                                           
|Gross margin                                               
|                                                           
|Operating expenses:                                        
|Research and development                                   
|Selling, general and administrative                        
|Net provision for business restructure                     
|                                                           
|Total operating expenses                                   
|                                                           
|Operating  income (loss)                                   
|                                                           
|Non-operating income (expense):                            
|Interest income                                            
|Interest expense                                           
|Gain on sale                                               
|Foreign currency exchange                                  
|                                                           
|Total non-operating income (expense)                       
|                                                           
|Income (loss) before income taxes                          
|                                                           
|Income tax expense                                         
|                                                           
|Net  income (loss)                                         
|                                                           
|                                                           
|Basic and diluted earnings (loss) per share                
|                                                           
|Weighted average shares outstanding - basic                
|                                                           
|Weighted average and potential shares outstanding - diluted
|                                                           

See accompanying notes to
consolidated financial statements.

4

---

DATA I/O CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                                           
|-----------------------------------------------------------
|For the three months ended                                 
|                                                           
|(in thousands)                                             
|OPERATING ACTIVITIES:                                      
|Net income (loss)                                          
|Adjustments to reconcile net income to net cash provided by
|(used in) operating activities:                            
|Depreciation and amortization                              
|Write-off of assets                                        
|Gain on sale of fixed asset                                
|Equipment transferred to cost of goods sold                
|Amortization of deferred gain on sale                      
|Share-based compensation                                   
|Net change in:                                             
|Deferred revenue                                           
|Trade accounts receivable                                  
|Inventories                                                
|Other current assets                                       
|Accrued costs of business restructuring                    
|Accounts payable and accrued liabilities                   
|Security deposits                                          
|                                                           
|Net cash provided by (used in) operating activities        
|                                                           
|INVESTING ACTIVITIES:                                      
|Purchases of property and equipment                        
|Acquisition of intangibles                                 
|Purchases of marketable securities                         
|Proceeds from sales of marketable securities               
|                                                           
|Net cash provided by (used in) investing activities        
|                                                           
|FINANCING ACTIVITIES:                                      
|Sale of common stock                                       
|Proceeds from exercise of stock options                    
|                                                           
|Net cash provided by (used in) financing activities        
|                                                           
|Increase/(decrease) in cash and cash equivalents           
|                                                           
|Effects of exchange rate changes on cash                   
|Cash and cash equivalents at beginning of year             
|                                                           
|Cash and cash equivalents at end of quarter                
|                                                           

See accompanying notes to
consolidated financial statements.

5

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# DATA I/O CORPORATION 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)

# NOTE 1  FINANCIAL
STATEMENT PREPARATION

Data I/O prepared the financial
statements as of June 30, 2006 and June 30, 2005, according to the rules and regulations
of the Securities and Exchange Commission (SEC). These statements are
unaudited but, in the opinion of management, include all adjustments (consisting of normal
recurring adjustments and accruals) necessary to present fairly the results for the
periods presented. The balance sheet at December 31, 2005 has been derived from the
audited financial statements at that date. We have condensed or omitted certain
information and footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of America
according to such SEC rules and regulations. Operating results for the six months ended
June 30, 2006 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2006. These financial statements should be read in conjunction
with the annual audited financial statements and the accompanying notes included in the
Companys Form 10-K for the year ended December 31, 2005.

Stock-Based Compensation
Expense

On January 1, 2006, the Company
adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
Share-Based Payment, (SFAS 123(R)) which requires the measurement
and recognition of compensation expense for all share-based payment awards, including
employee stock options and employee stock purchases, based on estimated fair values. SFAS
123(R) supersedes the Companys previous accounting under Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees (APB 25)
for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS
123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective method, which requires the
application of the accounting standard as of January 1, 2006, the first day of the
Companys fiscal year 2006. The Companys Consolidated Financial Statements as
of and for the three and six months ended June 30, 2006 reflect the effect of SFAS 123(R).
The total stock-based compensation amount for the three and six months ended June 30, 2006
was $93,000 and $195,000, respectively.

# NOTE 2 
RECLASSIFICATIONS

Certain prior period balances may
have been reclassified to conform to the presentation used in the current period.

# NOTE 3  INVENTORIES

Inventories consisted of the
following components (in thousands):

|                | June 30,
2006 | December 31,
2005
|--------------- | ------------- | -----------------
|                |               |                  
|Raw material    |               | $3,215           
|Work-in-process |               | 712              
|Finished goods  |               | 878              
|                |               |                  
|Inventories     |               | $4,805           
|                |               |                  

6

---

# NOTE 4  PROPERTY
AND EQUIPMENT, NET

Property and equipment consisted of
the following components (in thousands):

|                              | June 30,
2006 | December 31,
2005
|----------------------------- | ------------- | -----------------
|                              |               |                  
|Leasehold improvements        |               | $598             
|Equipment                     |               | 9,961            
|                              |               |                  
|                              |               | 10,559           
|Less accumulated depreciation |               | 8,196            
|                              |               |                  
|Property and equipment - net  |               | $2,363           
|                              |               |                  

# NOTE 5  BUSINESS
RESTRUCTURING

During 2005, we took restructuring
related charges of $96,000 primarily related to severance and completing actions that had
been started in the second half of 2004. This aligned management operations with the
changes made in 2004 to control costs in North America and Europe and the need to build
staff serving China and Eastern Europe. At December 31, 2005, $33,000 remained as accrued
but unpaid restructure charges, which will be paid in 2006.

During the first quarter of 2006, we
paid out approximately $20,000 of the remaining 2005 previously accrued restructure
charges as outlined above. There was no activity during the second quarter of 2006. As of
June 30, 2006, restructuring charges of $13,000 remain accrued, which are expected to be
paid in 2006.

During the third quarter of 2006, as
part of our effort to reduce expenses, we incurred a restructuring charge of approximately
$150,000 which has not yet been paid. The restructuring charge is primarily related to
severance charges incurred at our Redmond, Germany and China offices. In view of our declining
margins and operating results during the first and second quarters of 2006, these actions were
taken to reduce our quarterly revenue breakeven point to approximately $7 million per quarter. This restructure charge
is expected to be paid out in 2006.

# NOTE 6  OTHER
ACCRUED LIABILITIES

Other accrued liabilities consisted
of the following components (in thousands):

|                           | June 30,
2006 | December 31,
2005
|-------------------------- | ------------- | -----------------
|                           |               |                  
|Product warranty liability |               | $465             
|Sales return reserve       |               | 135              
|Other                      |               | 475              
|                           |               |                  
|Other accrued liabilities  |               | $1,075           
|                           |               |                  

The changes in Data I/Os
product warranty liability are as follows (in thousands):

|                             | June 30,
2006
|---------------------------- | -------------
|                             |              
|Liability, beginning balance |              
|Net expenses                 |              
|Warranty claims              |              
|Accrual revisions            |              
|                             |              
|Liability, ending balance    |              
|                             |              

7

---

# NOTE 7  EARNINGS
(LOSS) PER SHARE

Basic earnings (loss) per share is
calculated based on the weighted average number of common shares outstanding during each
period. Diluted earnings per share is calculated based on these same weighted average
shares outstanding plus the effect of potential shares issuable upon assumed exercise of
stock options based on the treasury stock method. Potential shares issuable upon the
exercise of stock options are excluded from the calculation of diluted earnings per share
to the extent their effect would be antidilutive.

The following table sets forth the
computation of basic and diluted earnings per share (in thousands, except per share data):

|                                                    | Three Months Ended
June 30, | Six Months Ended
June 30,
|--------------------------------------------------- | --------------------------- | -------------------------
|                                                    |                             |                          
|
|                                                    |                             |                          
|Numerator for basic and diluted earnings per share: |                             |                          
|Net income (loss)                                   |                             | ($398                    
|                                                    |                             |                          
|Denominator:                                        |                            
|Denominator for basic earnings per share -          |                            
|weighted-average shares                             |                             | 8,415                    
|Employee stock options                              |                             |                         
|                                                    |                             |                          
|Denominator for diluted earnings per share -        |                            
|adjusted weighted-average shares and                |                            
|assumed conversions of stock options                |                             | 8,415                    
|                                                    |                             |                          
|Basic and diluted earnings (loss) per share         |                            
|Total basic and diluted earnings (loss) per share   |                             | ($0.05                   
|                                                    |                             |                          

The computation for the three and six
months ended June 30, 2006 excludes 1,171,824 options to purchase common stock as the
effect of their inclusion was antidilutive. The computation for the three and six months
ended June 30, 2005 excluded 447,265 and 432,220 options respectively to purchase common
stock as these options were antidilutive.

# NOTE 8 
SHARE-BASED COMPENSATION

Effective January 1, 2006, the
Company adopted the provisions of SFAS No. 123(R) which requires the measurement and
recognition of compensation expense for all share-based payment awards made to our
employees and directors including employee stock options, stock awards and employee stock
purchases made under our Employee Stock Purchase Plan (ESPP). Data I/O
previously applied the provisions of APB No. 25 and related Interpretations and provided
the required pro forma disclosures under SFAS No. 123, Accounting for Stock-Based
Compensation. The following table illustrates the effect on net income and net
income per common share for the three and six months ended June 30, 2005. No share-based
compensation expense was reflected in our results of operations for the three and six
month period ended June 30, 2005 as all options were granted with an exercise price equal
to the market value of the underlying common stock on the date of grant. Additionally,
option forfeitures were accounted for as they occurred.

Data I/Os pro forma information
follows (in thousands, except per share data):

|                                                                       | Three Months Ended
   June 30, 2005 | Six Months Ended 
 June 30, 2005
|---------------------------------------------------------------------- | ----------------------------------- | --------------------------------
|                                                                       |                                     |                                 
|Net income - as reported                                               |                                     | $53                             
|Deduct:  Total stock-based employee compensation expense               |                                    
|determined under fair value based method for awards granted, modified, |                                    
|or settled, net of related tax effects                                 |                                     | (95                             
|                                                                       |                                     |                                 
|Net income (loss) - pro forma                                          |                                     | ($42                            
|                                                                       |                                     |                                 
|Basic and diluted income per share - as reported                       |                                     | $0.01                           
|Basic income (loss) per share - pro forma                              |                                     | ($0.01                          
|Diluted earnings (loss) per share - pro forma                          |                                     | $0.00                           

8

---

Data I/O adopted SFAS No. 123(R)
using the modified prospective method beginning January 1, 2006. Accordingly, during the
three and six month period ended June 30, 2006, we recorded share-based compensation
expense for awards granted prior to but not yet vested as of January 1, 2006 as if the
fair value method required for pro forma disclosure under SFAS No. 123 were in effect for
expense recognition purposes adjusted for estimated forfeitures. For share-based awards
granted after January 1, 2006, we have recognized compensation expense based on the
estimated grant date fair value method required under SFAS No. 123(R). For these awards we
have recognized compensation expense using a straight-line amortization method and reduced
for estimated forfeitures. The impact on our results of operations of recording
share-based compensation for the three and six month period ended June 30, 2006 was as
follows (in thousands):

|                                       | Three Months Ended
   June 30, 2006 | Six Months Ended 
 June 30, 2006
|-------------------------------------- | ----------------------------------- | --------------------------------
|                                       |                                     |                                 
|Costs of goods sold                    |                                     | $6                              
|Research and development               |                                     | 21                              
|Selling, general and administrative    |                                     | 66                              
|                                       |                                     |                                 
|Total share-based compensation expense |                                     | $ 93                            
|                                       |                                     |                                 
|Impact on net income (loss) per share: |                                    
|Basic and diluted                      |                                     | ($0.01                          

Approximately $1,500 and $3,000 of
share-based compensation was capitalized within inventory for the three and six months
ended June 30, 2006, respectively.

At June 30, 2006, there were
1,684,632 shares of Common Stock reserved for issuance under Data I/Os employee
stock option plans with 512,808 shares available for grant. Pursuant to the stock option
plans, options are granted to our officers and key employees with exercise prices equal to
the fair market value of the Common Stock at the date of grant and generally vest over
four years. Options granted under the plans generally have a maximum term of six years
from the date of grant. Beginning in the second quarter of 2006, we granted restricted
stock awards and performance-based stock awards to our officers and key employees at fair
market value. The restricted stock awards vest in equal installments over four years. The
performance-based stock awards vest on 12/31/2008 based on obtaining a revenue
growth target of $34,694,935 for the fiscal year ending December 31, 2008.
For purposes of share-based compensation measurement, we assume that the
performance goal will be achieved. If the performance goals are not met, no compensation
cost is recognized and any recognized compensation cost will be reversed. Under our
Employee Stock Purchase Plan (ESPP), 130,491 shares were available for
purchase at June 30, 2006. Under the ESPP, purchase options have been granted every six
months with a six month term and an exercise price equal to the lower of the fair market
value of the Common Stock on the first or last day of the six month period, with a 15%
discount. As of August 1, 2006, ESPP purchase options will be granted on the first day of
the six month period, with a 5% discount and an exercise price equal to the fair market
value on the last day of the six month period.

The fair value of share-based awards
for employee stock option awards and employee stock purchases made under our Employee
Stock Purchase Plan were estimated using the Black-Scholes valuation model. The following
weighted average assumptions were used to calculate the fair value of options granted
during the three and six months ended June 30, 2006 and 2005:

|Employee Stock
Options                  
|----------------------------------------
|                                        
|
|                                        
|
|                                        
|Risk-free interest rates                
|Volatility factors                      
|Expected  life  of the  option  in years
|Expected dividend yield                 

9

---

|Employee Stock
Purchase Plan        
|------------------------------------
|                                    
|
|                                    
|
|                                    
|Risk-free interest rates            
|Volatility factors                  
|Expected life of the option in years
|Expected dividend yield             

The risk-free interest rate used in
the Black-Scholes valuation method is based on the implied yield currently available in
U.S. Treasury securities at maturity with an equivalent term. We have not recently
declared or paid any dividends and do not currently expect to do so in the future. The
expected term of options represents the period that our stock-based awards are expected to
be outstanding and was determined based on historical weighted average holding periods and
projected holding periods for the remaining unexercised shares. Consideration was given to
the contractual terms of our stock-based awards, vesting schedules and expectations of
future employee behavior. Expected volatility is based on the annualized daily historical
volatility of the Companys stock over a representative period and includes
consideration of the implied volatility for comparable entities within our industry.

The weighted average grant date fair
value of options granted under our stock option plans during the three and six month
period ending June 30, 2006 was $2.23 and $2.24, respectively, and $1.60 and $1.61 for the
three and six month period ending June 30, 2005, respectively. The weighted average grant
date fair value of restricted stock awards and performance-based stock awards for the
period ending June 30, 2006 was $3.88. The estimated fair value of purchase rights under
the ESPP plan for the six month periods ending June 30, 2006 and June 30, 2005 was $1.62
and $1.21, respectively.

The following table summarizes stock
option activity under our stock option plans for the three and six month periods ended
June 30, 2006:

|                                | Three Months Ended
June 30, 2006 | Six Months Ended
June 30, 2006
|------------------------------- | -------------------------------- | ------------------------------
|                                |                                  |                               
|
|                                |                                  |                               
|Beginning balance               |                                  | 1,111,738                     
|Granted                         |                                  | 170,000                       
|Exercised                       |                                  | (8,663                        
|Cancelled, expired or forfeited |                                  | (101,251                      
|                                |                                  |                               
|Ending balance outstanding      |                                  | 1,171,824                     
|                                |                                  |                               
|Exercisable                     |                                  | 629,775                       

10

---

The stock options outstanding and
exercisable for equity share-based payment awards under our stock option plans as of June
30, 2006 were in the following exercise price ranges:

|              | Options Outstanding | Options Exercisable
|------------- | ------------------- | -------------------
|              |                     |                    
|
|              |                     |                    
|$1.00 - $1.25 |                     | 181,225            
|$1.25 - $1.89 |                     | 178,278            
|$1.89 - $2.49 |                     | 274,434            
|$2.49 - $3.04 |                     | 289,637            
|$3.04 - $4.56 |                     | 248,250            
|              |                     |                    
|              |                     | 1,171,824          
|              |                     |                    

The aggregate intrinsic value in the
table above represents the total pretax intrinsic value, based on the Company closing
stock price of $3.08 at June 30, 2006, which would have been received by award holders had
all award holders exercised their stock options that were in-the-money as of that date.
The aggregate intrinsic value of awards exercised during the six month period ended June
30, 2006 was $59,800.

There were 21,400 shares of
restricted stock awards and performance-based stock awards that were granted and are
outstanding at June 30, 2006. The unvested share balance at 6/30/2006 is 20,721.

As of June 30, 2006, there was
$1,072,000 of total unrecognized compensation cost related to nonvested share-based
compensation arrangements granted under our stock option plans. That cost is expected to
be recognized over a weighted average period of 2.71 years. As of June 30, 2006, there was
$4,000 of total unrecognized cost related to the employee stock purchase plan which is
expected to be recognized over a weighted average period of one month.

# NOTE 9 
COMPREHENSIVE INCOME (LOSS)

During the second quarter of 2006 and
2005 total comprehensive income (loss) was comprised of the following (in thousands):

|                                         | Three Months Ended
June 30, | Six Months Ended
June 30,
|---------------------------------------- | --------------------------- | -------------------------
|                                         |                             |                          
|
|                                         |                             |                          
|Net income (loss)                        |                             | ($398                    
|Foreign currency translation loss        |                             | 80                       
|Unrealized gain on marketable securities |                             |                         
|                                         |                             |                          
|Total comprehensive income (loss)        |                             | ($318                    
|                                         |                             |                          

# NOTE 10  FOREIGN
CURRENCY TRANSLATION AND DERIVATIVES

Data I/O translates assets and
liabilities of foreign subsidiaries at the exchange rate on the balance sheet date. We
translate revenues, costs and expenses of foreign subsidiaries at average rates of
exchange prevailing during the year. We charge our credit translation adjustments
resulting from this process to other comprehensive income (a component of
stockholders equity), net of taxes. Realized and unrealized gains and losses
resulting from the effects of changes in exchange rates on assets and liabilities
denominated in foreign currencies are included in non-operating expense as foreign
currency transaction gains and losses.

Data I/O accounts for its hedging
activities in accordance with SFAS No. 133, Accounting for Derivatives and Hedging
Activities. This statement establishes accounting and reporting standards for
derivative instruments and requires recognition of derivatives as assets or liabilities in
the statement of financial position and measurement of those instruments at fair value.

Data I/O utilizes forward foreign
exchange contracts to reduce the impact of foreign currency exchange rate risks where
natural hedging strategies cannot be effectively employed. All hedging instruments held by
us are fair value hedges. Generally, these

11

---

contracts have maturities less than
one year and requireus to exchange foreign currencies for U.S. dollars at
maturity. The change in fair value of the open hedge contracts as of June 30, 2006 is an
unrealized loss of $10,433 included in net loss for the six months ended June 30, 2006,
and it is included in accounts payable on the balance sheet as of June 30, 2006.

Data I/O does not hold or issue
derivative financial instruments for trading purposes. The purpose of our hedging
activities is to reduce the risk that the valuation of the underlying assets, liabilities
and firm commitments will be adversely affected by changes in exchange rates. Our
derivative activities do not create foreign currency exchange rate risk because
fluctuations in the value of the instruments used for hedging purposes are offset by
fluctuations in the value of the underlying exposures being hedged.

# NOTE 11  RECENT
ACCOUNTING PRONOUNCEMENTS

In June 2006, the FASB issued
Interpretation No. 48, Accounting for uncertainty in Income Taxes  an
interpretation of FASB Statement No. 109 (FIN 48). This interpretation clarifies the
accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS No. 109, Accounting for Income Taxes. This
Interpretation prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods, disclosure, and
transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Data
I/O is currently evaluating the impact of FIN 48 on its consolidated results of operations
and financial condition.

12

---

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

General

# FORWARD-LOOKING
STATEMENTS

This Quarterly Report on Form 10-Q
includes forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. This Act provides a safe harbor for
forward-looking statements to encourage companies to provide prospective information about
themselves as long as they identify these statements as forward-looking and provide
meaningful cautionary statements identifying important factors that could cause actual
results to differ from the projected results. All statements other than statements of
historical fact made in this Quarterly Report on Form 10-Q are forward-looking. In
particular, statements herein regarding industry prospects or trends; expected level of
expense; future results of operations, breakeven point, or financial position; changes in
gross margin; integration of acquired products and operations; market acceptance of our
newly introduced or upgraded products; development, introduction and shipment of new
products; and any other guidance on future periods are forward-looking statements.
Forward-looking statements reflect managements current expectations and are
inherently uncertain. Although Data I/O believes that the expectations reflected in these
forward-looking statements are reasonable, we cannot guarantee future results, levels of
activity, performance, achievements, or other future events. Moreover, neither Data I/O
nor anyone else assumes responsibility for the accuracy and completeness of these
forward-looking statements. Data I/O is under no duty to update any of these
forward-looking statements after the date of this report. The reader should not place
undue reliance on these forward-looking statements. The discussions above and in the
section in Item 1A. Risk Factors Cautionary Factors That May Affect Future
Results in the Companys Annual report on Form 10-K for the year ended December
31, 2005 describe some, but not all, of the factors that could cause these differences.

# OVERVIEW

Our primary goal is to manage the
business to achieve profitable operations, while developing and enhancing products to
drive revenue and earnings growth. Our challenge continues to be operating in a cyclical
and challenging industry environment, while positioning Data I/O to take advantage of
expected growth in capital spending. We began to see a recovery in growth in capital
spending during 2005. We experienced during the first six months of 2006 a 14% increase in
orders over the same period of 2005. We expect that demand for programming capacity should
continue to show improvement during 2006, in part based on third party forecasted
increased 2006 unit sales for the semiconductor industry, and the business outlook for
target customer segments, which should provide improved business opportunities for Data
I/O.

With our losses during the first two
quarters of 2006, we have launched an initiative to lower the quarterly revenue breakeven
point which rose to a calculated $7.6 million for the second quarter of 2006 due
especially to the lower gross margins as well as the higher development and other
operating expenses. We plan to reduce the breakeven point to approximately $7 million
through a combination of margin improvements and expense reductions to be effected during
the second half of 2006. We have taken actions to improve the effectiveness of our sales
organization. We have taken actions that will reduce expenses by our move to a new much
smaller facility and plan to moderate our development materials and patent related
spending, now that we have launched the new FLX-500 desktop automated programming system.

We are continuing our efforts to
balance increasing costs and strategic investments in our business with the level of
demand and mix of business we expect. We are focusing our research and development efforts
in our strategic growth markets, namely new programming technology, in-system programming
(ISP) ImageWriter technology, and automated programming systems for the
manufacturing environment, particularly the new FLX 500 desktop automated programming
system, and extending the capabilities and support for our FlashCORE architecture and the
ProLINE-RoadRunner and PS families. To better support our customers in their geographic
areas and time zones, we are investing in tools and device support operations in Germany,
India and Shanghai, China.

Our customer focus has been on
strategic high volume manufacturers and programming centers and supporting NAND Flash and
microcontrollers on our newer products to gain new accounts and break into new markets,
such as microcontrollers for the automotive market. We have expanded our China operations
to take advantage of the growth of manufacturing in China. We continue to focus on
building a service business, expanding from our existing service operation model in
Brazil. We also increased our efforts to recapture the Japanese market and have entered
into a distribution agreement with Toyo Corporation in Japan which we launched in the
first quarter of 2006. We worked with Toyo Corporation on introductions, training,
integration and transitions in the second quarter of 2006. We continue our efforts to
partner with selected semiconductor manufacturers to better serve our mutual customers and
announced our second member of the Preferred Partnership Program in the second quarter of
2006.

13

---

# BUSINESS RESTRUCTURING

During 2005, we accrued restructuring
charges that totaled $96,000 with a remaining balance of $33,000 at December 31, 2005. The
restructuring charges related primarily to severance and completing actions that had been
started in the second half of 2004. This aligned management operations with the changes
made in 2004 to control costs in North America and Eastern Europe. During the first
quarter of 2006, approximately $20,000 was paid out and no additional amounts were
accrued. There was no activity during the second quarter of 2006. The balance at June 30,
2006 is $13,000. During the third quarter of 2006, as part of our effort to reduce
expenses, we incurred a restructuring charge of approximately $150,000 which has not yet
been paid. The restructuring charge is primarily related to severance charges incurred at
our Redmond, Germany and China offices. In view of our declining
margins and operating results during the first and second quarters of 2006, these
actions were taken to reduce our quarterly revenue breakeven point to approximately $7 million per quarter.
The balance remaining at June 30, 2006 and the
additional restructure charge during the third quarter of 2006, are expected to be paid
out in 2006.

# CRITICAL ACCOUNTING
POLICY JUDGMENTS AND ESTIMATES

The Companys critical
accounting policies are disclosed in the Companys Form 10-K for the year ended
December 31, 2005 and have not materially changed as of June 30, 2006, with the exception
of the following:

Stock-based Compensation: We estimate
the fair value of stock options using the Black-Scholes valuation model consistent with
the provisions of SFAS 123(R), SEC SAB 107 and our prior period pro forma disclosures of
net earnings, including stock-based compensation (determined under a fair value method as
prescribed by SFAS 123). The Black-Scholes model requires the input of highly subjective
assumptions, including the options expected life and the price volatility of the
underlying stock. The expected stock price volatility assumption was determined using a
combination of historical and implied volatility of the Companys common stock.
Changes in the subjective assumptions required in the valuation model may significantly
affect the estimated value of the awards, the related stock-based compensations expense
and, consequently, our results of operations. Beginning in the second quarter of 2006,
restricted stock awards and performance-based stock awards were granted. The vesting of
the performance-based stock awards is based on attaining a particular revenue growth
target during the three year period ending December 31, 2008. We assume that the
performance goal will be achieved. If the performance goals are not met, no compensation
cost is recognized and any recognized compensation cost will be reversed.

Results of Operations

# NET SALES

|                                  | Three Months Ended | Six Months Ended
|--------------------------------- | ------------------ | ----------------
|                                 
|
|                                 
|Automated programming systems     |                    | $4,111          
|                                 
|Non-automated programming systems |                    | 3,052           
|                                  |                   
|Total programming systems         |                    | $7,163          
|                                  |                   

|              | Three Months Ended | Six Months Ended
|------------- | ------------------ | ----------------
|             
|
|             
|United States |                    | $1,629          
|             
|% of total    |                    | 22.7%           
|             
|International |                    | $5,534          
|             
|% of total    |                    | 77.3%           
|             

14

---

The revenue increase for the second
quarter of 2006 compared to the second quarter of 2005 relates primarily to higher sales
of PS Series and FlashPAK products, offset by lower sales of ProLINE-RoadRunner products
and adapters. We experienced increased sales in the Americas and China, partially offset
by lower sales in Europe. Programming centers, electronic manufacturing services (EMS)
companies and semiconductor factory programming represented our main automation equipment
customers. Orders booked during the second quarter of 2006 totaled $7.3 million, an 11%
increase over the $6.6 million for second quarter of 2005. We increased our backlog of
orders during the second quarter of 2006 from $1.9 million to $2.1 million, with the
increase in unshipped orders being due to orders taken for our new FLX-500 product which
is expected to begin shipping in the third quarter of 2006.

Domestic sales increased
approximately 8.5% in the second quarter of 2006, compared to the second quarter of 2005,
primarily due to additional PS Series product sales especially to programming centers as
well as higher adapter sales. International sales increased approximately 7.6% primarily
as a result of the increase in PS Series sales to EMS and semiconductor factory
programming applications, offset by decreased adapter sales.

In 2006, we introduced our new
FLX-500 desktop automated programming system, which we expect to start shipping in the
third quarter, as well as a new version of our ProLINE-RoadRunner for Siemens X-Series
(SMT) feeder. During 2005, we began shipping other new products including the PS-588
automated programming system and the ImageWriter-300, our ISP solution. We limited our
sales efforts on ImageWriter products in the second quarter while we resolved issues
affecting our customers out-of-box experience. These ImageWriter improvements were
completed and sales efforts resumed at the end of the second quarter of 2006. We expect
these products to increase our revenues; however, partially offsetting this expected
increase is the expected continuing trend of declining sales of our older non-automated
product lines.

For the first six months of 2006
compared to the same period of 2005, sales increased slightly with the second quarter
sales increase offsetting the first quarter sales decline. There has been a significant
product mix shift with higher sales of PS Systems and FlashPAK programmers and lower sales
of ProLINE-RoadRunner products, adapters and older legacy programmer products. China sales
grew 31%, offset by declines in the rest of Asia. Sales in the Americas grew 4%, with
Mexico and Canada sales offsetting the U.S sales decline, European sales declined 5%.
Programming centers, EMS companies and semiconductor factory programming represented our
main automation customer groups in 2006. Order bookings for the first six months of 2006
were up 14% compared to the first six months of 2005. For the first six months of 2006,
order backlog grew from $1.2 to $2.1 million with the increase due to the new FLX-500 and
later customer delivery requirements for follow on PS systems for factory programming.

# GROSS MARGIN

|                        | Three Months Ended | Six Months Ended
|----------------------- | ------------------ | ----------------
|                        |                   
|(in thousands)         
|                       
|Gross Margin            |                    | $3,743          
|Percentage of net sales |                    | 52.3%           
|                       

Gross margins decreased in both
dollars and as a percentage of sales compared to the second quarter of 2005. The overall
gross margin decrease in dollars and as a percentage of sales primarily relates to product
mix shifts and lower average selling prices as well as unfavorable operating variances
during the quarter. The product mix shift relates to decreased sales volume of higher
margin ProLINE-RoadRunner and aftermarket products with offsetting increased sales volume
of lower margin PS Series products and FlashPAK non-automated programmer. The lower
average selling prices related primarily to the effect of increased indirect channel sales
and special customer arrangements. In addition, the second quarter of 2006 had $148,000 of
less favorable or negative operations variances and $152,000 of increased labor and
overhead costs, due primarily to Brazil operations, compared to the second quarter of
2005.

For the first six months of 2006
compared to the same period of 2005, the lower gross margin dollars and gross margin as a
percentage of sales are due to the same factors as discussed for the second quarter. For
the first six months of 2006 there were $239,000 of less favorable or negative operations
variances and $305,000 of increased labor & overhead costs, due primarily to Brazil
operations, compared to the second quarter of 2005.

15

---

# RESEARCH AND DEVELOPMENT

|                         | Three Months Ended | Six Months Ended
|------------------------ | ------------------ | ----------------
|                         |                   
|(in thousands)          
|                        
|Research and development |                    | $1,513          
|Percentage of net sales  |                    | 21.1%           
|                        

Research and development
(R&D) spending for the second quarter and first six months of 2006
compared to the same periods of 2005 increased in dollars and as a percentage of sales due
to the higher spending associated with the development of the FLX-500. We expect that the
spending in R&D should be moderate as the development of new platforms, such as the
FLX-500 and ImageWriter, come to completion and the engineering focus moves from
significant platform development to product enhancements and extensions.

# SELLING, GENERAL AND
ADMINISTRATIVE

|                                  | Three Months Ended | Six Months Ended
|--------------------------------- | ------------------ | ----------------
|                                  |                   
|(in thousands)                   
|                                 
|Selling, general & administrative |                    | $2,626          
|Percentage of net sales           |                    | 36.7%           
|                                 

Selling, general and administrative
(SG&A) expenses were up $248,000 for the second quarter of 2006 compared
to the second quarter of 2005. We experienced increased costs in our China operations of
$72,000, new SG&A related to stock option expense of $66,000, additional sales
personnel costs, and increased external marketing costs $30,000 primarily associated with
the new FLX-500 launch.

For the first six months of 2006
compared with the same period in 2005, SG&A expense changes were basically due to the
factors discussed for the second quarter comparisons above as SG&A expenses were
basically flat for the first quarter of 2006.

# INTEREST

|                 | Three Months Ended | Six Months Ended
|---------------- | ------------------ | ----------------
|                 |                   
|(in thousands)  
|                
|Interest income  |                    | $37             
|Interest expense |                    | $              
|                

Interest income increased in the
second quarter and the first six months of 2006 compared to the same periods in 2005 due
to higher investment returns.

# INCOME TAXES

|                             | Three Months Ended | Six Months Ended
|---------------------------- | ------------------ | ----------------
|                             |                   
|(in thousands)              
|                            
|Income tax expense (benefit) |                    | $26             
|                            

Tax expense recorded for the second
quarter and the first six months of 2006 was due to foreign and state taxes. The tax
effective rate differed from the statutory tax rate primarily due to no benefit being
recognized for current losses and the taxes in countries without local net operating loss
carryforwards. The tax valuation allowance increased by approximately $119,000 during the
quarter. Data I/O has a valuation allowance of $10,090,000 as of June 30, 2006.

16

---

Financial Condition

LIQUIDITY AND CAPITAL RESOURCES

|June 30,
2006   | Change | March 31,
2006 | Change | December 31,
2005
|--------------- | ------ | -------------- | ------ | -----------------
|               
|Working capital |        | $9,457         |        | ($288            
|               

At June 30, 2006, Data I/Os
principal sources of liquidity consisted of existing cash and cash equivalents. Our
working capital decreased by $537,000 and our current ratio decreased from 2.7 at December
31, 2005 to 2.6 at June 30, 2006.

Our cash and cash equivalents
decreased by approximately $700,000 during the six months ended June 30, 2006 primarily
due to the cash used for operating activities totaling approximately $738,000. Cash used
for operations primarily included a $1.2 million increase in inventories offset primarily
by an increase in accounts receivable of approximately $670,000.

We received approximately $139,000 of
cash in investing activities during the six months ended June 30, 2006, which included
proceeds from the sale of marketable securities totaling $804,000 offset by $640,000 used
to purchase property, plant and equipment. We expect that we will continue to make capital
expenditures to support our business and we anticipate that present working capital will
be sufficient to meet our operating requirements throughout at least the next one year
period. Capital expenditures for property, plant and equipment during 2006 are planned to
be approximately $1 million, primarily related to the move to a new smaller leased
headquarters building which was completed in July 2006. Capital expenditures are expected
to be funded by existing and internally generated funds or lease financing.

As a result of our significant
product development, customer support, international expansion and selling and marketing
efforts, we have required substantial working capital to fund our operations. Over the
last few years, we restructured our operations to lower our costs and operating
expenditures in some geographic regions, while investing in other regions, and to lower the
level of revenue required for our net income breakeven point, to preserve our cash
position and to focus on profitable operations. We believe that we have sufficient working
capital available under our operating plan to fund our operations and capital requirements
through at least the next one year period. Any substantial inability to achieve our
current business plan could have a material adverse impact on our financial position,
liquidity, or results of operations and may require us to reduce expenditures and/or seek
additional financing.

Aggregate Contractual
Obligations and Commitments

We have purchase obligations for
inventory and production costs as well as other obligations such as capital expenditures,
service contracts, marketing, and development agreements. Arrangements are considered
purchase obligations if a contract specifies all significant terms, including fixed or
minimum quantities to be purchased, a pricing structure and approximate timing of the
transaction. Most arrangements are cancelable without a significant penalty, and with
short notice, typically less than 90 days. Any amounts reflected on the balance sheet as
accounts payable and accrued liabilities are excluded from the below table. We have no
long-term debt. We have commitments under non-cancelable operating leases and other
agreements, primarily for factory and office space, with initial or remaining terms of one
year or more as follows June 30, 2006 (in thousands):

|                           | Less than
1 Year | 1-3 Years | 3-5 Years | More than
5 Years | Total
|-------------------------- | ---------------- | --------- | --------- | ----------------- | -----
|                           |                  |           |           |                   |      
|Operating leases           |                  | $916      |           | $1,623            |      
|Commitments to suppliers   |                  | 1,897     |           |                  |      
|Other purchase commitments |                  | 145       |           | 5                 |      
|                           |                  |           |           |                   |      
|Total                      |                  | $2,958    |           | $1,628            |      
|                           |                  |           |           |                   |      

# OFF-BALANCE SHEET
ARRANGEMENTS

Except as noted above in aggregate
contractual obligations and commitments, Data I/O had no off-balance sheet arrangements.

17

---

# RECENT ACCOUNTING
PRONOUNCEMENTS

In June 2006, the FASB issued
Interpretation No. 48, Accounting for uncertainty in Income Taxes  an
interpretation of FASB Statement No. 109 (FIN 48). This interpretation clarifies the
accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS No. 109, Accounting for Income Taxes. This
Interpretation prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods, disclosure, and
transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Data
I/O is currently evaluating the impact of FIN 48 on its consolidated results of operations
and financial condition.

# Item 3.    Quantitative and
Qualitative Disclosures About Market Risk

We are exposed to financial market
risks, including fluctuations in foreign exchange rates and interest rates.

# INTEREST RATE RISK

We invest our cash in a variety of short-term
financial instruments, including government bonds, commercial paper and money market
instruments, which are classified as available-for-sale. Our investments are made in
accordance with an investment policy approved by our board of directors. Our portfolio is
diversified and consists primarily of investment grade securities to minimize credit risk.
Cash balances in foreign currencies are operating balances and are invested in demand or
short-term deposits of the local operating bank.

Investments in both fixed rate and
floating rate interest earning instruments carry a degree of interest rate risk. Fixed
rate securities may have their fair market value adversely impacted because of a rise in
interest rates, while floating rate securities may produce less income than expected if
interest rates fall. Due in part to these factors, our future investment income may fall
short of expectations because of changes in interest rates or we may suffer losses in
principal if forced to sell securities that have seen a decline in market value because of
changes in interest rates. We do not attempt to reduce or eliminate our exposure to
interest rate risk through the use of derivative financial instruments due to the
short-term nature of the investments.

The table below provides information
about our marketable securities, including principal cash flows and the related weighted
average interest rates (in thousands):

|                           | Principal  
  Cash Flows  
  For Q3 2006 | Estimated Fair
    Value at   
 June 30, 2006 | Principal    
  Cash Flows    
  to June 30,   
     2006 | Estimated Fair  
   Value at     
 December 31,   
     2005
|-------------------------- | ---------------------------------------- | --------------------------------------------- | --------------------------------------------------------- | ------------------------------------------------------------
|                           |                                          |                                               |                                                           |                                                             
|Taxable Auction Securities |                                          |                                              |                                                           |                                                            
|                           |                                          |                                               |                                                           |                                                             
|Total portfolio value      |                                          | $                                            |                                                           | $                                                          
|                           |                                          |                                               |                                                           |                                                             

# FOREIGN CURRENCY RISK

We have operations in Germany,
Canada, China, and Brazil. Therefore, we are subject to risks typical of an international
business including, but not limited to, differing economic conditions, changes in
political climate, differing tax structures, other regulations and restrictions and
foreign exchange rate volatility. Accordingly, our future results could be materially
adversely affected by changes in these or other factors.

Our sales and corresponding
receivables are substantially in U.S. dollars other than sales made in our subsidiaries in
Germany, Canada, and China. Through our operations in Germany, Canada, China, and Brazil,
we incur certain product costs; research and development; customer service and support
costs; selling, general and administrative expenses in local currencies. We are exposed,
in the normal course of business, to foreign currency risks on these expenditures and on
related foreign currency denominated monetary assets and liabilities. We have evaluated
our exposure to these risks and believe that our only significant exposure to foreign
currencies at the present time is primarily related to Euro-based receivables. We use
forward contracts to hedge and thereby minimize the currency risks associated with certain
transactions denominated in Euros.

If our actual currency requirement or
timing in the period forecasted differs materially from the notional amount of our forward
contracts and/or the natural balancing of receivables and payables in foreign currencies
during a period of currency volatility or if we

18

---

do not continue to manage our
exposure to foreign currency through forward contracts or other means, we could experience
unanticipated foreign currency gains or losses. In addition, our foreign currency risk
management policy subjects us to risks relating to the creditworthiness of the commercial
banks with which we enter into forward contracts. If one of these banks cannot honor its
obligations, we may suffer a loss. We also invest in our international operations, which
will likely result in increased future operating expenses denominated in those local
currencies. In the future, our exposure to foreign currency risks from these other foreign
currencies may increase and if not managed appropriately, we could experience
unanticipated foreign currency gains and losses.

The purpose of our foreign currency
risk management policy is to reduce the effect of exchange rate fluctuation on our results
of operations. Therefore, while our foreign currency risk management policy may reduce our
exposure to losses resulting from unfavorable changes in currency exchange rates, it also
reduces or eliminates our ability to profit from favorable changes in currency exchange
rates.

At June 30, 2006, we had four forward
contracts to sell Euros in exchange for $611,000 with rates ranging from 1.2541 to 1.2605,
all scheduled to be due within the next quarter and the value at that date of $600,000.

# Item 4.    Controls
and Procedures

|(a) |  | Evaluation
of disclosure controls and procedures.
|--- |  | -------------------------------------------------

Under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief Financial
Officer, Data I/O evaluated the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under
the Exchange Act) as of the end of the period covered by this report (the Evaluation
Date).  Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and
procedures were effective in timely alerting them to the material information relating to
Data I/O (or its consolidated subsidiaries) required to be included in our periodic SEC
filings and Form 8-K reports.

|(b) |  | Changes
in internal controls.
|--- |  | -----------------------------

There were no changes made in our
internal controls during the period covered by this report that have materially affected
or are reasonably likely to materially affect our internal control over financial
reporting except as described below.

During the first quarter of 2006, we
implemented a new information system starting with our United States operations. During
the second quarter of 2006, we continued our implementation efforts to prepare for adding
and integrating subsidiary operations as well as making system refinements for the U.S.
operations. Overall, we implemented similar process and system internal controls to those
associated with our previous system and performed testing of the new system and
reconciliations of the results. However changes to significant systems and processes like
these may result in unforeseen or unknown items that may materially affect our internal
control over financial reporting.

# PART II  OTHER
INFORMATION

# Item 1.    Legal Proceedings

None

# Item 1A.    Risk Factors

In addition to the other information
set forth in this report, you should carefully consider the factors discussed in Part I,
Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended
December 31, 2005, which could materially affect our business, financial condition or
future results. The risks described in our Annual Report on Form 10-K are not the only
risks facing our Company. Additional risks and uncertainties not currently known to us or
that we currently deem to be immaterial also may materially adversely affect our business,
financial condition and/or operating results. There are no material changes to the Risk
Factors described in our Annual Report other than changes to the Risk Factors below
entitled Failure to successfully implement a new worldwide information system may
adversely affect our operations and sales and Moving our headquarters and
manufacturing operation may adversely affect our operations and sales. These Risk
Factor items, which were included in our Annual Report, have been changed to reflect
additional discussion of the potential risks.

19

---

Failure to successfully implement
a new worldwide information system may adversely affect our operations and sales.

We have recently acquired and are
currently implementing a new worldwide information system. Our corporate office began use
of the new system in February 2006. We are now in the process of implementing the new
system at our subsidiary locations and additional modules and features in the United
States. Our operations and financial results could be adversely affected if we are unable
to complete the system implementation without significant interruptions in accounting
systems, order entry, billing, manufacturing and other customer support functions. In
addition, the costs associated with the implementation and training could exceed budgeted
amounts and adversely affect our profitability and liquidity. Process changes and system
operation could require additional resources and costs to be incurred on a current and
ongoing basis. System implementation delays could cause difficulties in our complying with
the internal controls assessment, reporting and auditor attestation requirements of
Section 404 of the Sarbanes-Oxley Act of 2002.

Moving our headquarters and
manufacturing operation may adversely affect our operations and sales.

We moved our Redmond headquarters and
manufacturing operation in July 2006 to a smaller location in Redmond, Washington. Costs
associated with the move, preparation and layout of the facility, and acquisition and set
up of systems, furnishings and equipment could adversely affect operating costs and
liquidity. Changes in the facility set up and production processes may impact our ability
to manufacture and ship products and our sales could be adversely affected.

# Item 2.    Changes in
Securities, Use of Proceeds and Issuer Purchases of Equity Securities

None

# Item 3.    Defaults Upon
Senior Securities

None

# Item 4.    Submission of Matters
to a Vote of Security Holders

At our Annual Meeting of Shareholders
held on May 24, 2006, there were present in person or by proxy the holders of 8,066,591
(95.91%) shares of Common Stock of Data I/O thereby constituting a quorum. The following
are the matters approved and the voting results:

| | (a) |  | Election
of a Board of Directors consisting of the following six (6) directors:
| | --- |  | -------------------------------------------------------------------------------

|Name               | Votes For | Votes Withheld
|------------------ | --------- | --------------
|Daniel A. DiLeo    |           | 7,684,299     
|Paul A. Gary       |           | 7,749,031     
|Frederick R. Hume  |           | 7,529,338     
|Edward D. Lazowska |           | 7,749,030     
|Steven M. Quist    |           | 7,487,016     
|William R. Walker  |           | 7,705,652     

| | (b) |  | Approval
to amend the Data I/O Corporation 2000 Stock Compensation Incentive           Plan as
described in the Proxy Statement for the 2006 Annual Meeting. The           amendment
passed as follows: 2,873,276 votes for; 775,045 against; 24,140           abstain and
4,738,500 broker non-votes.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (c) |  | The
proposal to ratify the selection of Grant Thornton LLP as Data I/Os
          independent auditors passed as follows: 7,935,633 for; 68,864 against; 62,094
          abstain; and 344,370 broker non-votes.
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Item 5.    Other Information

None

20

---

# Item 6.    Exhibits

| | (a) |  | Exhibits
| | --- |  | --------

The following list is a subset of the
list of exhibits described below and contains all compensatory plans, contracts or
arrangements in which any director or executive officer of Data I/O is a participant,
unless the method of allocation of benefits thereunder is the same for management and
non-management participants:

|(1) |  | Amended
and Restated 1982 Employee Stock Purchase Plan. See Exhibit 10.18.
|--- |  | --------------------------------------------------------------------------

|(2) |  | Amended
and Restated Retirement Plan and Trust Agreement. See Exhibit 10.2,           10.3, 10.4,
10.8, 10.11, 10.12, and 10.13.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Summary
of Amended and Restated Management Incentive Compensation Plan. See           Exhibit
10.9.
|--- |  | ---------------------------------------------------------------------------------------------------

|(4) |  | Amended
and Restated 1983 Stock Appreciation Rights Plan. See Exhibit 10.1.
|--- |  | ---------------------------------------------------------------------------

|(5) |  | Amended
and Restated 1986 Stock Option Plan. See Exhibit 10.15.
|--- |  | ---------------------------------------------------------------

|(6) |  | Change
in Control Agreements. See Exhibit 10.22 and 10.23.
|--- |  | ----------------------------------------------------------

|(7) |  | 1996
Director Fee Plan. See Exhibit 10.14.
|--- |  | ------------------------------------------

|(8) |  | Letter
Agreement with Frederick R. Hume. See Exhibit 10.17.
|--- |  | -----------------------------------------------------------

|(9) |  | Amended
and Restated 2000 Stock Compensation Incentive Plan. See Exhibit 10.19.
|--- |  | -------------------------------------------------------------------------------

|(10) |  | Form
of Option Agreement. See Exhibit 10.21.
|---- |  | --------------------------------------------

|(11) |  | Data
I/O Corporation Tax Deferral Retirement Plan. See Exhibit 10.20.
|---- |  | ---------------------------------------------------------------------

| | 3 |  | Articles
of Incorporation:
| | - |  | --------------------------

| |  | 3.1 |  | Data
I/Os restated Articles of Incorporation filed November 2, 1987 (Incorporated by
reference                       to Exhibit 3.1 of Data I/Os 1987 Annual Report on Form
10-K (File No. 0-10394)).
| |  | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 3.2 |  | Data
I/Os Bylaws as amended and restated as of February 2006October 2003 (Incorporated by
                      reference to Data I/Os 2005 Annual Report on Form 10-K (File No.
0-10394)).
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 3.3 |  | Certificate
of Designation, Preferences and Rights of Series A Junior Participating Preferred
                      Stock (Incorporated by reference to Exhibit 1 of Data I/Os
Registration Statement on Form 8-A                       filed March 13, 1998 (File No.
0-10394)).
| |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

21

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| | 4 |  | Instruments
Defining the Rights of Security Holders, Including Indentures:
| | - |  | --------------------------------------------------------------------------

| |  | 4.1 |  | Rights
Agreement, dated as of April 4, 1998, between Data I/O Corporation and ChaseMellon
                      Shareholder Services, L.L.C. as Rights Agent, which includes: as
Exhibit A thereto, the Form of                       Right Certificate; and, as Exhibit B
thereto, the Summary of Rights to Purchase Series A Junior
                      Participating Preferred Stock (Incorporated by reference to Data
I/Os Current Report on Form                       8-K filed on March 13, 1998).
| |  | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 4.2 |  | Rights
Agreement, dated as of March 31, 1988, between Data I/O Corporation and First
                      Jersey National Bank, as Rights Agent, as amended by Amendment No.
1 thereto, dated as                       of May 28, 1992 and Amendment No. 2 thereto,
dated as of July 16, 1997 (Incorporated                       by reference to Data I/Os
Report on Form 8-K filed on March 13, 1998).
| |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 4.3 |  | Amendment
No. 1, dated as of February 10, 1999, to Rights Agreement, dated as of April
                      4, 1998, between Data I/O Corporation and ChaseMellon Shareholder
Services, L.L.C. as                       Rights Agent (Incorporated by reference to
Exhibit 4.1 of Data I/Os Form 8-A/A dated                       February 10, 1999).
| |  | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10 |  | Material
Contracts:
| | -- |  | -------------------

| |  | 10.1 |  | Amended
and Restated 1983 Stock Appreciation Rights Plan dated February 3, 1993 (Incorporated
                      by reference to Exhibit 10.23 of Data I/Os 1992 Annual Report on
Form 10-K (File No.                       0-10394)).
| |  | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.2 |  | Amended
and Restated Retirement Plan and Trust Agreement  (Incorporated by reference
                      to Exhibit 10.26 of Data I/Os 1993 Annual Report on Form 10-K
(File No. 0-10394)).
| |  | ---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.3 |  | First
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.21 of Data I/Os 1994 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.4 |  | Second
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.26 of Data I/Os 1995 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.5 |  | Purchase
and Sale Agreement dated as of July 9, 1996 (Relating to the sale of Data I/O
                      Corporations headquarters property in Redmond, Washington
consisting of approximately                       79 acres of land and an approximately
96,000 square foot building.  (Portions of this                       exhibit have been
omitted pursuant to an application for an order granting
                      confidential treatment.  The omitted portions have been separately
filed with the                       Commission) (Incorporated by reference to Exhibit
10.32 of Data I/Os 1996 Annual                       Report on Form 10-K (File No.
0-10394)).
| |  | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.6 |  | Letter
dated as of December 20, 1996, First Amendment and extension of the Closing
                      Date under that certain Purchase and Sale Agreement dated as of
July 9, 1996                       (Portions of this exhibit have been omitted pursuant
to an application for an order                       granting confidential treatment.
 The omitted portions have been separately filed with                       the
Commission) (Incorporated by reference to Exhibit 10.33 of Data I/Os 1996 Annual
                      Report on Form 10-K (File No. 0-10394)).
| |  | ---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.7 |  | Letter
dated as of February 17, 1997, Second Amendment and extension of the Closing
                      Date under that certain Purchase and Sale Agreement dated as of
July 9, 1996                       (Portions of this exhibit have been omitted pursuant
to an application for an order                       granting confidential treatment.
 The omitted portions have been separately filed with                       the
Commission) (Incorporated by reference to Exhibit 10.34 of Data I/Os 1996 Annual
                      Report on Form 10-K (File No. 0-10394)).
| |  | ---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.8 |  | Third
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.35 of Data I/Os 1996 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.9 |  | Amended
and Restated Management Incentive Compensation Plan dated January 1, 1997
                      (Incorporated by reference to Exhibit 10.25 of Data I/Os 1997
Annual Report on Form                       10-K (File No. 0-10394)).
| |  | ---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.10 |  | Amended
and Restated Performance Bonus Plan dated January 1, 1997 (Incorporated by
                      reference to Exhibit 10.26 of Data I/Os 1997 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.11 |  | Fourth
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.27 of Data I/Os 1997 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.12 |  | Fifth
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.28 of Data I/Os 1997 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.13 |  | Sixth
Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by
                      reference to Exhibit 10.29 of Data I/Os 1997 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.14 |  | Amended
and Restated Data I/O Corporation 1996 Director Fee Plan (Incorporated by
                      reference to Exhibit 10.32 of Data I/Os 1997 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.15 |  | Amended
and Restated 1986 Stock Option Plan dated May 12, 1998 (Incorporated by
                      reference to Exhibit 10.37 of Data I/Os 1998 Annual Report on Form
10-K (File No.                       0-10394)).
| |  | ----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

22

---

| |  | 10.16 |  | Letter
Agreement with Fred R. Hume dated January 29, 1999 (Incorporated by reference
                     to Exhibit 10.35 of Data I/Os 1999 Annual Report on Form 10-K (File
No. 0-10394)).
| |  | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.17 |  | Amended
and Restated 1982 Employee Stock Purchase Plan dated May 16, 2003
                     (Incorporated by reference to Data I/Os 2003 Proxy Statement dated
March 31, 2003).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.18 |  | Amended
and Restated 2000 Stock Compensation Incentive Plan dated May 20, 2004
                      (Incorporated by reference to Data I/Os 2004 Proxy Statement dated
April 12, 2004).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.19 |  | Data
I/O Corporation Tax Deferred Retirement Plan, as amended  (Incorporated by
                        reference to Exhibit 10.20 of Data I/Os 2004 Annual Report on
Form 10-K (File No.                         0-10394)).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.20 |  | Form
of Option Agreement (Incorporated by reference to Exhibit 10.21 of Data I/Os 2004 Annual
Report on Form 10-K (File No.                      0-10394)).
| |  | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.21 |  | Change
in Control Agreement with Fred R. Hume dated April 22, 2004 (Incorporated by reference to
Exhibit 10.22 of Data I/Os                      2004 Annual Report on Form 10-K (File
No. 0-10394)).
| |  | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.22 |  | Change
in Control Agreement with Joel S. Hatlen dated April 22, 2004 (Incorporated by reference
to Exhibit 10.23 of Data                      I/Os 2004 Annual Report on Form 10-K (File
No. 0-10394)).
| |  | ----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.23 |  | Harald
Weigelt Employment Agreement (Incorporated by reference to Exhibit 10.23 of Data I/Os
2005 Annual Report on Form 10K                      (File No. 0-10394)).
| |  | ----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.24 |  | Data
I/O Corporation Tax Deferral Retirement Plan, as amended (Incorporated by reference to
Exhibit 10.24 of Data I/Os 2005                      Annual Report on Form 10-K (File
No. 0-10394)).
| |  | ----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.25 |  | Lease
Termination Agreement dated February 28, 2006 (Redmond Headquarters) (Incorporated by
reference to Exhibit 10.25 of                      Data I/Os 2005 Annual Report on Form
10-K (File No. 0-10394)).
| |  | ----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.26 |  | Lease,
Redmond East Business Campus between Data I/O Corporation and Carr Redmond PLCC dated
February 28, 2006 (Incorporated                      by reference to Exhibit 10.26 of
Data I/Os 2005 Annual Report on Form 10-K (File No.                      0-10394)).
| |  | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.27 |  | Amended and Restated 2000 Stock Compensation Incentive Plan dated May 24, 2006
(Incorporated by reference to Data I/Os 2006 Proxy Statement dated April 6, 2006).
| |  | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 10.28 |  | Form of Performance Award Agreement
| |  | ----- |  | -----------------------------------

| |  | 10.29 |  | Form of Restricted Stock Award Agreement
| |  | ----- |  | ----------------------------------------

| | 31 |  | Certification
 Section 302:
| | -- |  | ----------------------------

| |  | 31.1 |  | Chief
Executive Officer Certification
| |  | ---- |  | -------------------------------------

| |  | 31.2 |  | Chief
Financial Officer Certification
| |  | ---- |  | -------------------------------------

| | 32 |  | Certification
 Section 906:
| | -- |  | ----------------------------

| |  | 32.1 |  | Chief
Executive Officer Certification
| |  | ---- |  | -------------------------------------

| |  | 32.2 |  | Chief
Financial Officer Certification
| |  | ---- |  | -------------------------------------

23

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# SIGNATURES

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

|DATED:  August 14, 2006 | DATA I/O CORPORATION
(REGISTRANT)
|----------------------- | ---------------------------------

| | By://S//Joel S. Hatlen                           
                       Joel S. Hatlen                              
                  Vice President - Finance                         
                   Chief Financial Officer                         
                   Secretary and Treasurer                         
  (Principal Financial Officer and Duly Authorized Officer)        
                  By://S//Frederick R. Hume                        
                       Frederick R. Hume                           
                          President                                
                   Chief Executive Officer                         
  (Principal Executive Officer and Duly Authorized Officer)
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

24

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