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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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AMENDMENT NO. 1

TO

FORM 10-Q/A



|x | Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------

For the Quarterly Period ended June 30, 2004



OR



| ̈ | Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
|- | -----------------------------------------------------------------------------------------

for the Transition Period From
 To
.



Commission File Number: 0-21371



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APPLIED IMAGING CORP.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0120490                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



120 Baytech Drive,

San Jose, California 95134

(Address of principal executive offices including zip code)



(408) 719-6400

(Registrants telephone number, including area code)



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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 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)    Yes ̈No  x



As of July 30, 2004 there were 19,072,502 shares of the Registrants Common Stock outstanding.



EXPLANATORY NOTE



THIS AMENDMENT NO. 1 TO OUR QUARTERLY REPORT ON FORM 10-Q IS BEING FILED FOR THE PURPOSE OF REFLECTING THE RESTATEMENT OF OUR CONSOLIDATED FINANCIAL
STATEMENTS AS OF AND FOR THE PERIODS ENDED JUNE 30, 2004 AND JUNE 30, 2003. THE RESTATEMENT RESULTS FROM APPLIED IMAGINGS AUDIT COMMITTEE INVESTIGATION, AS DESCRIBED HEREIN AND AS PREVIOUSLY ANNOUNCED IN ITS FORM 8-K FILED ON NOVEMBER 15,
2004. WE HAVE MADE NO FURTHER CHANGES TO THE PREVIOUSLY FILED FORM 10-Q TO REFLECT ANY SUBSEQUENT INFORMATION OR DEVELOPMENTS.



APPLIED IMAGING HAS NOT AMENDED ITS ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 2002 OR QUARTERLY REPORTS ON FORM 10-Q FOR THE
PERIODS AFFECTED BY THE RESTATEMENT DURING THE YEARS ENDED DECEMBER 31, 2003 OR 2002. INSTEAD, APPLIED IMAGING HAS AMENDED SUCH FINANCIAL INFORMATION AS A PART OF THE RESTATEMENT OF ITS AMENDMENT NO. 2 TO ITS FORM 10-K/A FOR THE PERIOD ENDED
DECEMBER 31, 2003. THEREFORE WHEN CONSIDERING 2002 OR 2003 FINANCIAL INFORMATION YOU SHOULD RELY ONLY ON APPLIED IMAGINGS AMENDMENT NO. 2 TO ITS FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 2003, AND NOT ITS FORM 10-K FOR THE PERIOD ENDED
DECEMBER 31, 2002 NOR ITS QUARTERLY REPORTS ON FORM 10-Q FOR THE YEARS ENDED DECEMBER 31, 2003 OR 2002.

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##### Table of Contents

APPLIED IMAGING CORP.



INDEX



|                              |  |                                                                                                                         |  |      
|----------------------------- |  | ----------------------------------------------------------------------------------------------------------------------- |  | -----
|                              |  |                                                                                                                         |  | Page 
|PART I. FINANCIAL INFORMATION |  |                                                                                                                        
|                              |  |                                                                                                                        
|Item 1.                       |  | Financial Statements (Unaudited)                                                                                        |  |      
|                              |  |                                                                                                                        
|                              |  | Condensed Consolidated Balance Sheets (as Restated) as of June 30, 2004 and December 31, 2003                           |  | 3    
|                              |  |                                                                                                                        
|                              |  | Condensed Consolidated Statements of Operations (as Restated) for the three and six months ended June 30, 2004 and 2003 |  | 4    
|                              |  |                                                                                                                        
|                              |  | Condensed Consolidated Statements of Cash Flows (as Restated) for the six months ended June 30, 2004 and 2003           |  | 5    
|                              |  |                                                                                                                        
|                              |  | Notes to Condensed Consolidated Financial Statements (as Restated)                                                      |  | 6-14 
|                              |  |                                                                                                                        
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                   |  | 15-23
|                              |  |                                                                                                                        
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments                        |  | 24   
|                              |  |                                                                                                                        
|Item 4.                       |  | Disclosure Controls and Procedures                                                                                      |  | 24   
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                                        
|                              |  |                                                                                                                        
|Item 5:                       |  | Submission of Matters to a Vote of Security Holders                                                                     |  | 25   
|                              |  |                                                                                                                        
|Item 6.                       |  | Exhibits and Reports on Form 8-K                                                                                        |  | 26   
|                              |  |                                                                                                                        
|                              |  | Signatures                                                                                                              |  | 27   



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Balance Sheets

(Unaudited, in thousands)



|                                           |  |                      |         |   |                          |   |         |  
|------------------------------------------ |  | -------------------- | ------- | - | ------------------------ | - | ------- | -
|                                           |  | June 30,2004Restated |         |   | December 31,2003Restated |  
|ASSETS                                     |  |                      |         |   |                          |   |         |  
|                                           |  |                     
|Current assets:                            |  |                      |         |   |                          |   |         |  
|Cash and cash equivalents                  |  | $                    | 4,882   |   |                          | $ | 2,047   |  
|Restricted cash                            |  |                      | 181     |   |                          |   | 178     |  
|Trade accounts receivable, net             |  |                      | 4,516   |   |                          |   | 6,122   |  
|Inventories                                |  |                      | 1,353   |   |                          |   | 1,190   |  
|Prepaid expenses and other current assets  |  |                      | 1,886   |   |                          |   | 1,024   |  
|                                           |  |                      |         |   |                          |   |         |  
|Total current assets                       |  |                      | 12,818  |   |                          |   | 10,561  |  
|Property and equipment, net                |  |                      | 1,204   |   |                          |   | 812     |  
|Goodwill                                   |  |                      | 2,364   |   |                          |   | 2,364   |  
|Other assets                               |  |                      | 52      |   |                          |   | 151     |  
|                                           |  |                      |         |   |                          |   |         |  
|Total assets                               |  | $                    | 16,438  |   |                          | $ | 13,888  |  
|                                           |  |                      |         |   |                          |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |                      |         |   |                          |   |         |  
|                                           |  |                     
|Current liabilities:                       |  |                      |         |   |                          |   |         |  
|Accounts payable                           |  | $                    | 1,922   |   |                          | $ | 1,491   |  
|Accrued expenses                           |  |                      | 1,672   |   |                          |   | 1,888   |  
|Bank debt                                  |  |                      | 640     |   |                          |   | 1,728   |  
|Deferred revenue, current                  |  |                      | 6,055   |   |                          |   | 5,114   |  
|Deferred rent incentive, current           |  |                      | 149     |   |                          |   |        |  
|                                           |  |                      |         |   |                          |   |         |  
|Total current liabilities                  |  |                      | 10,438  |   |                          |   | 10,221  |  
|                                           |  |                     
|Deferred revenue, non-current              |  |                      | 364     |   |                          |   | 801     |  
|Deferred rent incentive, non-current       |  |                      | 574     |   |                          |   |        |  
|                                           |  |                      |         |   |                          |   |         |  
|Total liabilities                          |  |                      | 11,376  |   |                          |   | 11,022  |  
|                                           |  |                      |         |   |                          |   |         |  
|Stockholders equity:                      |  |                      |         |   |                          |   |         |  
|Common stock                               |  |                      | 19      |   |                          |   | 16      |  
|Additional paid-in capital                 |  |                      | 53,074  |   |                          |   | 49,207  |  
|Accumulated other comprehensive loss       |  |                      | (367    | ) |                          |   | (367    | )
|Accumulated deficit                        |  |                      | (47,664 | ) |                          |   | (45,990 | )
|                                           |  |                      |         |   |                          |   |         |  
|Total stockholders equity                 |  |                      | 5,062   |   |                          |   | 2,866   |  
|                                           |  |                      |         |   |                          |   |         |  
|Total liabilities and stockholders equity |  | $                    | 16,438  |   |                          | $ | 13,888  |  
|                                           |  |                      |         |   |                          |   |         |  



The accompanying notes
are an integral part of these unaudited condensed consolidated financial statements.



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APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Operations

and Comprehensive Income (Loss)

(in thousands, except per share data)

(Unaudited)



|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|----------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ------------ |  | - | ------------ | - |  | - | ------ | -
|                                    |  | Three months ended June 30, |        |   | Six months ended June 30, |  
|                                    |  | 2004Restated                |        |   | 2003Restated              |   |        | 2004Restated |  |   | 2003Restated |  
|Revenues                            |  | $                           | 4,271  |   |                           | $ | 4,648  |              |  | $ | 9,186        |   |  | $ | 9,743  |  
|Cost of revenues                    |  |                             | 1,690  |   |                           |   | 1,947  |              |  |   | 3,568        |   |  |   | 3,941  |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Gross profit                        |  |                             | 2,581  |   |                           |   | 2,701  |              |  |   | 5,618        |   |  |   | 5,802  |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Operating expenses:                 |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Research and development            |  |                             | 844    |   |                           |   | 934    |              |  |   | 1,735        |   |  |   | 1,781  |  
|Sales and marketing                 |  |                             | 1,630  |   |                           |   | 1,790  |              |  |   | 3,337        |   |  |   | 3,645  |  
|General and administrative          |  |                             | 1,093  |   |                           |   | 456    |              |  |   | 2,130        |   |  |   | 1,269  |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Total operating expenses            |  |                             | 3,567  |   |                           |   | 3,180  |              |  |   | 7,202        |   |  |   | 6,695  |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Operating loss                      |  |                             | (986   | ) |                           |   | (479   | )            |  |   | (1,584       | ) |  |   | (893   | )
|                                    |  |                             |        |  
|Other income (expense), net         |  |                             | (45    | ) |                           |   | 35     |              |  |   | (90          | ) |  |   | 31     |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Net loss                            |  | $                           | (1,031 | ) |                           | $ | (444   | )            |  | $ | (1,674       | ) |  | $ | (862   | )
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Net loss per share                  |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|- basic and diluted                 |  | $                           | (0.06  | ) |                           | $ | (0.03  | )            |  | $ | (0.10        | ) |  | $ | (0.05  | )
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|Weighted average shares outstanding |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  
|- basic and diluted                 |  |                             | 18,622 |   |                           |   | 15,940 |              |  |   | 17,292       |   |  |   | 15,927 |  
|                                    |  |                             |        |   |                           |   |        |              |  |   |              |   |  |   |        |  



The accompanying notes
are an integral part of these unaudited condensed consolidated financial statements.



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APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)



|                                                                                |  |                           |        |   |              |   |        |  
|------------------------------------------------------------------------------- |  | ------------------------- | ------ | - | ------------ | - | ------ | -
|                                                                                |  | Six months ended June 30, |       
|                                                                                |  | 2004Restated              |        |   | 2003Restated |  
|Cash flows from operating activities:                                           |  |                           |        |   |              |   |        |  
|Net loss                                                                        |  | $                         | (1,674 | ) |              | $ | (862   | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                           |        |   |              |   |        |  
|Depreciation and amortization                                                   |  |                           | 293    |   |              |   | 321    |  
|Provision for doubtful accounts                                                 |  |                           |       |   |              |   | (100   | )
|Loss on sale of property and equipment                                          |  |                           |       |   |              |   | 2      |  
|Changes in operating assets and liabilities:                                    |  |                           |        |   |              |   |        |  
|Trade accounts receivable                                                       |  |                           | 1,606  |   |              |   | 1,767  |  
|Inventories                                                                     |  |                           | (163   | ) |              |   | 266    |  
|Prepaid expenses and other current assets                                       |  |                           | (862   | ) |              |   | (357   | )
|Other assets                                                                    |  |                           | 99     |   |              |   | (96    | )
|Accounts payable                                                                |  |                           | 431    |   |              |   | (300   | )
|Accrued expenses                                                                |  |                           | (216   | ) |              |   | 14     |  
|Deferred revenue                                                                |  |                           | 504    |   |              |   | 408    |  
|Deferred rent incentive                                                         |  |                           | 723    |   |              |   |       |  
|                                                                                |  |                           |        |   |              |   |        |  
|Net cash provided by operating activities:                                      |  |                           | 741    |   |              |   | 1,063  |  
|                                                                                |  |                           |        |   |              |   |        |  
|Cash flows from investing activities:                                           |  |                           |        |   |              |   |        |  
|Purchases of property and equipment                                             |  |                           | (685   | ) |              |   | (173   | )
|                                                                                |  |                           |        |   |              |   |        |  
|Net cash used in investing activities:                                          |  |                           | (685   | ) |              |   | (173   | )
|                                                                                |  |                           |        |   |              |   |        |  
|Cash flows from financing activities:                                           |  |                           |        |   |              |   |        |  
|Net proceeds from issuance of common stock                                      |  |                           | 3,870  |   |              |   | 55     |  
|Bank loan proceeds                                                              |  |                           | 5,675  |   |              |   | 6,511  |  
|Bank loan payments                                                              |  |                           | (6,763 | ) |              |   | (7,237 | )
|Restricted cash                                                                 |  |                           | (3     | ) |              |   | (9     | )
|                                                                                |  |                           |        |   |              |   |        |  
|Net cash provided by (used in) financing activities:                            |  |                           | 2,779  |   |              |   | (680   | )
|                                                                                |  |                           |        |   |              |   |        |  
|Net increase in cash and cash equivalents                                       |  |                           | 2,835  |   |              |   | 210    |  
|                                                                                |  |                          
|Cash and cash equivalents at beginning of period                                |  |                           | 2,047  |   |              |   | 2,897  |  
|                                                                                |  |                           |        |   |              |   |        |  
|Cash and cash equivalents at end of period                                      |  | $                         | 4,882  |   |              | $ | 3,107  |  
|                                                                                |  |                           |        |   |              |   |        |  



The accompanying notes
are an integral part of these unaudited condensed consolidated financial statements.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



Throughout these notes to the condensed consolidated financial statements all referenced
amounts reflect the balances and amounts on a restated basis.



NOTE 1
 Restatement of Previously Issued Financial Statements



On November 15, 2004, the Company announced its intent to restate the financial results for the fiscal year ended December 31, 2003 and the quarterly financial results for the first and second quarters of the fiscal year ending December 31,
2004. During the third quarter of 2004, a transaction which was recorded in June, 2004 was identified where revenue was recognized in a manner inconsistent with the Companys policies and procedures then in effect. Following the identification
of this transaction, the Audit Committee commenced an investigation. During the course of its investigation, the Audit Committee identified several revenue transactions principally recorded in fiscal 2003 involving its Cytovision and Ariol systems
in which commitments were made for the future delivery of software applications then under development. Statement of Position (SOP) 97-2 Software Revenue Recognition requires that vendor specific objective evidence (VSOE) of the price
attributable to the fair value of such future deliverables be established in order to recognize a portion of revenue in the reporting period in which the sale was originally made. The Company did not have VSOE established for these
future deliverables at the time revenue was initially recognized. During the investigation, there were certain other transactions identified where the Company recognized revenue (a) upon the shipment of a product to a customer but had
not met all the customer acceptance criteria necessary to recognize revenue; (b) upon shipment of product to customer, but had not met all the revenue recognition criteria as it was a sale with participation by a third party financing company.
Additionally, during the investigation, certain transactions were identified where revenue on extended warranty/post customer support (software maintenance and service) arrangements were inappropriately recognized resulting in incorrect revenue
being recognized and/or deferred at the time of product shipment. As a result, the Company subsequently decided to restate its 2002 financial results as well.



Consequently, the condensed consolidated financial statements for the quarter and six months ended June 30, 2004 are restated in this Amendment No. 1
to Form 10-Q. These restated condensed consolidated financial statements reflect adjustments relating to the recording of revenue previously deferred and the deferral of revenue and cost of goods sold related to the premature recognition of revenue.



The following table presents amounts from operations as
previously reported and as restated (in thousands, except per share data):



|                                               |  |                                         |        |   |                                       |   |        |                       |  |   |             |   |  |   |        |  
|---------------------------------------------- |  | --------------------------------------- | ------ | - | ------------------------------------- | - | ------ | --------------------- |  | - | ----------- | - |  | - | ------ | -
|                                               |  | For the three months endedJune 30, 2004 |        |   | For the six months endedJune 30, 2004 |  
|Condensed Consolidated Statement of Operations |  | As PreviouslyReported                   |        |   | As Restated                           |   |        | As PreviouslyReported |  |   | As Restated |  
|Revenues (1)                                   |  | $                                       | 4,130  |   |                                       | $ | 4,271  |                       |  | $ | 8,979       |   |  | $ | 9,186  |  
|Cost of revenue (1)                            |  |                                         | 1,702  |   |                                       |   | 1,690  |                       |  |   | 3,542       |   |  |   | 3,568  |  
|Gross profit (2)                               |  |                                         | 2,428  |   |                                       |   | 2,581  |                       |  |   | 5,437       |   |  |   | 5,618  |  
|Operating loss (2)                             |  |                                         | (1,139 | ) |                                       |   | (986   | )                     |  |   | (1,765      | ) |  |   | (1,584 | )
|Net loss (2)                                   |  |                                         | (1,184 | ) |                                       |   | (1,031 | )                     |  |   | (1,855      | ) |  |   | (1,674 | )
|Net loss per share, basic and diluted (2)      |  | $                                       | (0.06  | ) |                                       | $ | (0.06  | )                     |  | $ | (0.11       | ) |  | $ | (0.10  | )



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



|                                               |  |                                         |       |   |                                        |   |       |                       |  |   |             |   |  |   |       |  
|---------------------------------------------- |  | --------------------------------------- | ----- | - | -------------------------------------- | - | ----- | --------------------- |  | - | ----------- | - |  | - | ----- | -
|                                               |  | For the three months endedJune 30, 2003 |       |   | For the six months ended June 30, 2003 |  
|Condensed Consolidated Statement of Operations |  | As PreviouslyReported                   |       |   | As Restated                            |   |       | As PreviouslyReported |  |   | As Restated |  
|Revenues (1)                                   |  | $                                       | 4,815 |   |                                        | $ | 4,648 |                       |  | $ | 10,230      |   |  | $ | 9,743 |  
|Cost of revenue (1)                            |  |                                         | 2,001 |   |                                        |   | 1,947 |                       |  |   | 4,165       |   |  |   | 3,941 |  
|Gross profit (2)                               |  |                                         | 2,814 |   |                                        |   | 2,701 |                       |  |   | 6,065       |   |  |   | 5,802 |  
|Operating loss (2)                             |  |                                         | (366  | ) |                                        |   | (479  | )                     |  |   | (630        | ) |  |   | (893  | )
|Net loss (2)                                   |  |                                         | (331  | ) |                                        |   | (444  | )                     |  |   | (599        | ) |  |   | (862  | )
|Net loss per share, basic and diluted (2)      |  | $                                       | (0.02 | ) |                                        | $ | (0.03 | )                     |  | $ | (0.04       | ) |  | $ | (0.05 | )



|                                               |  |                       |         |   |             |   |         |  
|---------------------------------------------- |  | --------------------- | ------- | - | ----------- | - | ------- | -
|                                               |  | June 30, 2004         |        
|Condensed Consolidated Balance Sheet           |  | As PreviouslyReported |         |   | As Restated |  
|Accounts receivable, net (3)                   |  | $                     | 4,516   |   |             | $ | 4,516   |  
|Inventories (3)                                |  |                       | 1,353   |   |             |   | 1,353   |  
|Prepaid expenses and other current assets (3)  |  |                       | 1,196   |   |             |   | 1,886   |  
|Total current assets (6)                       |  |                       | 12,128  |   |             |   | 12,818  |  
|Total assets (6)                               |  |                       | 15,748  |   |             |   | 16,438  |  
|Accrued expenses (4)                           |  |                       | 1,794   |   |             |   | 1,672   |  
|Deferred revenue, current (5)                  |  |                       | 3,995   |   |             |   | 6,055   |  
|Deferred rent incentive, current (5)           |  |                       | 723     |   |             |   | 149     |  
|Deferred revenue, non-current (5)              |  |                       | 361     |   |             |   | 364     |  
|Deferred rent incentive, non-current (5)       |  |                       |        |   |             |   | 574     |  
|Total liabilities (6)                          |  |                       | 9,435   |   |             |   | 11,376  |  
|Accumulated deficit (6)                        |  |                       | (46,413 | ) |             |   | (47,664 | )
|Total liabilities and stockholders equity (6) |  |                       | 15,748  |   |             |   | 16,438  |  



|                                               |  |                                        |        |   |                                        |   |        |                       |  |   |             |   |  |   |       |  
|---------------------------------------------- |  | -------------------------------------- | ------ | - | -------------------------------------- | - | ------ | --------------------- |  | - | ----------- | - |  | - | ----- | -
|                                               |  | For the six months ended June 30, 2004 |        |   | For the six months ended June 30, 2003 |  
|Condensed Consolidated Statement of Cash Flows |  | As PreviouslyReported                  |        |   | As Restated                            |   |        | As PreviouslyReported |  |   | As Restated |  
|Net loss (2)                                   |  | $                                      | (1,855 | ) |                                        | $ | (1,674 | )                     |  | $ | (599        | ) |  | $ | (862  | )
|                                               |  |                                        |        |  
|Changes in assets and liabilities:             |  |                                        |        |   |                                        |   |        |                       |  |   |             |   |  |   |       |  
|Accounts receivable                            |  |                                        | 1,849  |   |                                        |   | 1,606  |                       |  |   | 1,830       |   |  |   | 1,767 |  
|Inventories, net                               |  |                                        | (259   | ) |                                        |   | (163   | )                     |  |   | 257         |   |  |   | 266   |  
|Prepaid expenses and other current assets      |  |                                        | (659   | ) |                                        |   | (862   | )                     |  |   | (219        | ) |  |   | (357  | )
|Other Assets                                   |  |                                        | (34    | ) |                                        |   | 99     |                       |  |   |            |   |  |   | (96   | )
|Deferred revenue                               |  |                                        | 346    |   |                                        |   | 504    |                       |  |   | (143        | ) |  |   | 408   |  
|Net cash used in operating activities          |  |                                        | 775    |   |                                        |   | 741    |                       |  |   | 1,063       |   |  |   | 1,063 |  

---

|(1) | Restated revenues include a net increase of $141,000 and $207,000 for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six
months ended June 30, 2004 and $167,000 and $487,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 due to adjustments relating to the recording of revenue
previously deferred and the deferral of revenue related to (a) $12,000 and $222,000 net decrease for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $355,000
net decrease for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 related to certain Cytovision and Ariol system sales which included the future delivery of
software applications for which VSOE was not established at the time of sale; (b) $22,000 and $12,000 net increase for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30,
2004 and $115,000 and $212,000 for the quarter and six months ended June 30, 2003
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



7



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



| | over the amount previously reported for the quarter and six months ended June 30, 2003 of sales with participation of third party financing companies; (c) $33,000 and $201,000 net
increase for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $276,000 and $55,000 net increase for the quarter and six months ended June 30, 2003 over the
amount previously reported for the quarter and six months ended June 30, 2003 related to certain transactions that required customer acceptance; and (d) $98,000 and $216,000 net increase for the quarter and six months ended June 30, 2004 over the
amount previously reported for the quarter and six months ended June 30, 2004 and $27,000 and $25,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 related
to extended warranty/post customer support arrangements;
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | The restatement of revenues resulted in a corresponding adjustment to cost of revenues. Cost of revenues decreased by $12,000 for the quarter and increased by $26,000 for the six
months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and decreased by $54,000 and $224,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the
quarter and six months ended June 30, 2003 and;
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The adjustments related to the recording of revenue previously deferred and deferral of revenues and cost of revenue resulted in a net increase to gross profit and a corresponding
net decrease in net loss available to stockholders of $153,000 and $181,000 for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $113,000 and $263,000 for the
quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003. Net loss per share decreased $.01 for the six months ended June 30, 2004 and increased $.01 for the quarter and six
months ended June 30, 2003;
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | As a result of the recording of revenue previously deferred and deferral of revenues primarily related to Cytovision and Ariol, deferred costs (included in prepaid expenses and
current assets) increased $690,000 over the amount previously reported for the six months ended June 30, 2004 due to the cumulative effect of current and prior period adjustments to corresponding reductions of cost of revenues;
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Accrued expenses decreased $122,000 due to a reclassification of a previously misclassified deferred revenue transaction;
|--- | -------------------------------------------------------------------------------------------------------------------------



|(5) | Deferred revenue, current increased $2.1 million and deferred revenue non-current increased $3,000 for the six months ended June 30, 2004 over the amount previously reported for the
six months ended June 30, 2004 due to the cumulative effect of the deferral of revenues related to certain Ariol system transactions which included the future delivery of software applications under development for which VSOE was not available and
the deferral of revenues related to extended warranty/post customer support arrangements warranty commitments. Deferred rent incentive, current decreased $574,000 and deferred rent incentive non-current increased $574,000 due to a reclassification
of the previously misclassified non-current rent incentive;
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | Total current assets, total assets, total liabilities and stockholders equity includes an increase of $690,000 due to the cumulative effect of current and prior period
adjustments. As a result of the adjustments noted in (1) through (5) above accumulated deficit increased $1.3 million over amounts previously recorded as of June 30, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



8



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



As reflected on the restated consolidated financial statements, the Company has recorded certain
other adjustments, the net effect of which is presented above. None of these entries is significant individually or in its aggregate.



NOTE 2 - Basis of Presentation



The accompanying condensed consolidated financial statements include the accounts of Applied Imaging Corp. and subsidiaries (the Company,
we, us, our) for the three and six months ended June 30, 2004 and 2003. These financial statements are unaudited and reflect all adjustments, consisting only of normal recurring adjustments, which are, in the
opinion of management, necessary for a fair presentation of our financial position, operating results and cash flows for those interim periods presented. The results of operations for the three and six months ended June 30, 2004 are not necessarily
indicative of results to be expected for the fiscal year ending December 31, 2004. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, for the year ended
December 31, 2003, contained in our Amendment No. 2 to Form 10-K.



Liquidity



The Company expects negative cash flow from operations
through at least 2004, as the Company continues research and development of new applications for its OncoPath systems, conduct clinical trials required for the U.S. Food and Drug Administration (FDA) clearance of new products, litigate against ChromaVision, expands the Companys
marketing, sales and customer support capabilities, expands its program to detect circulating tumor cells in peripheral blood and add additional infrastructure. The Company currently estimates that its capital resources will enable it to meet its
capital needs for at least the next twelve months.



However,
expenditures required to achieve growth and profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, the Companys long-term capital needs may require the
Company to try to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. The Company has expended and will continue to expend substantial amounts of money
for research and development, litigation, preclinical testing, conducting clinical trials for FDA clearance of new products, capital expenditures, working capital needs and manufacturing and marketing of its products. The Companys future
research and development efforts, in particular, are expected to include development of additional applications of its current cytogenetic products, additional applications for the OncoPath systems and an expanded program to detect circulating tumor cells in peripheral blood,
which may require additional funds.



There can be no assurance
that the Company will be able to obtain additional debt or equity financing if needed and on terms acceptable to the Company. If adequate and acceptable funding is not available, the Company could be required to delay development or
commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that we would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other
resources devoted to product development. Accordingly, the Companys failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on the Companys ability to achieve its long-term business
objectives.



On April 13, 2004, the Company completed the
private placement of 3.1 million shares of common stock and warrants to purchase 620,000 additional shares of common stock for an



9



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



aggregate purchase price of $4.25 million. The Company received approximately $3.9 million net after expenses
associated with the placement. Each warrant is exercisable for one share of common stock at an exercise price of $1.70 per share, from six months following the closing date of April 13, 2004 until October 13, 2009.



The Company established a loan agreement with Silicon Valley Bank (SVB) on
September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million
based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to
increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for the Company to maintain a minimum level of tangible net worth. On September 3, 2003, the loan
agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to establish the minimum level of net tangible worth that we had to maintain through the end of the loan agreement. The Company was not in
compliance with the covenant requiring it to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and the Company obtained a waiver for this covenant violation and potential non-compliance with the minimum net tangible worth
covenant in January and February 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March 31, 2005 and to establish the minimum level of net tangible worth that the Company had to maintain through the end
of the loan agreement. The Company was in compliance with the loan covenant at June 30, 2004.



At June 30, 2004, the Company had used $640,000 of the facility with $1.3 million available but not used. The interest rate on the facility was 6.0% at June 30, 2004, computed as the SVB prime rate plus 2.0 percent.
The loan is collateralized by substantially all of the assets of the U.S. corporation and requires maintenance of a minimum level of tangible net worth. Other loan covenants include the need to maintain insurance on our property, monthly reporting
to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. corporations ability to transfer more than $600,000 to a subsidiary.



The Company collateralizes various credit card and bank guarantees (used for customs clearance purposes) with cash deposits
at an international bank in the United Kingdom. This amounted to £100,000 ($181,000) at June 30, 2004.



NOTE 3  Inventories (in thousands)



|                |  |                       |       |                           |   |      
|--------------- |  | --------------------- | ----- | ------------------------- | - | -----
|Balance as of:  |  | June 30, 2004Restated |       | December 31, 2003Restated
|Raw materials   |  | $                     | 1,107 |                           | $ | 994  
|Work in process |  |                       | 157   |                           |   | 25   
|Finished goods  |  |                       | 89    |                           |   | 171  
|                |  |                       |       |                           |   |      
|Total           |  | $                     | 1,353 |                           | $ | 1,190
|                |  |                       |       |                           |   |      



NOTE 4  Net income (loss)
per share



The computation
of basic and diluted net loss per share (EPS) for the three and six months ended June 30, 2004 and June 30, 2003 is determined by dividing net loss as reported



10



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



as the numerator by the number of shares included in the denominator as shown in the following table (in thousands):



|                                              |  |                             |  |                           |  |        |  |       
|--------------------------------------------- |  | --------------------------- |  | ------------------------- |  | ------ |  | ------
|                                              |  | Three months ended June 30, |  | Six months ended June 30,
|                                              |  | 2004                        |  | 2003                      |  | 2004   |  | 2003  
|Weighted average shares outstanding - basic   |  | 18,622                      |  | 15,940                    |  | 17,292 |  | 15,927
|Dilutive shares - stock options               |  |                            |  |                          |  |       |  |      
|Dilutive shares - warrants                    |  |                            |  |                          |  |       |  |      
|                                              |  |                             |  |                           |  |        |  |       
|Weighted average shares outstanding - diluted |  | 18,622                      |  | 15,940                    |  | 17,292 |  | 15,927
|                                              |  |                             |  |                           |  |        |  |       



Securities excluded
from the computation of EPS because their effect on EPS was antidilutive, but could dilute basic EPS in future periods are as follows (in thousands):



|         |  |                             |  |      
|-------- |  | --------------------------- |  | -----
|         |  | Three months ended June 30,
|         |  | 2004                        |  | 2003 
|Options  |  | 3,296                       |  | 3,113
|Warrants |  | 1,420                       |  | 1,222
|         |  |                             |  |      
|Total    |  | 4,716                       |  | 4,335
|         |  |                             |  |      



NOTE 5  Stock Based
Compensation



The Company accounts for stock-based
employee compensation arrangements in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Under APB No. 25, compensation expense is based on the
difference, if any, between the fair value of the Company stock and the exercise price on the date of the grant.



The Company has adopted the pro forma disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 148 Accounting for
Stock-Based Compensation - Transition and Disclosure  An amendment of FASB No. 123 for the 1998 Stock Plan and Employee Stock Purchase Plan. The fair value of the stock options granted to employees is calculated using the Black-Scholes
option pricing model as of the date of grant. Had compensation cost for our stock-based compensation plans been determined in a manner consistent with the fair value approach described in SFAS No. 123, The Companys net loss and net loss per
share as reported would have been changed to the pro forma amounts indicated below (in thousands, except per share data):



|                                                                             |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|---------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ----- | ------------ |  | - | ------------ | - |  | - | ------ | -
|                                                                             |  | Three months ended June 30, |        |   | Six months ended June 30, |  
|                                                                             |  | 2004Restated                |        |   | 2003Restated              |   |       | 2004Restated |  |   | 2003Restated |  
|Net loss:                                                                    |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|As reported                                                                  |  | $                           | (1,031 | ) |                           | $ | (444  | )            |  | $ | (1,674       | ) |  | $ | (862   | )
|Stock-based employee compensation expense determined under fair-value method |  |                             | (179   | ) |                           |   | (193  | )            |  |   | (368         | ) |  |   | (360   | )
|                                                                             |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|Pro forma                                                                    |  | $                           | (1,210 | ) |                           | $ | (637  | )            |  | $ | (2,042       | ) |  | $ | (1,222 | )
|                                                                             |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|Net loss per share:                                                          |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|As reported - basic and diluted                                              |  | $                           | (0.06  | ) |                           | $ | (0.03 | )            |  | $ | (0.10        | ) |  | $ | (0.05  | )
|                                                                             |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  
|Pro forma - basic and diluted                                                |  | $                           | (0.06  | ) |                           | $ | (0.04 | )            |  | $ | (0.12        | ) |  | $ | (0.08  | )
|                                                                             |  |                             |        |   |                           |   |       |              |  |   |              |   |  |   |        |  



11



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



The fair value of each option is estimated on the date of grant using the fair value method with the
following weighted-average assumptions:



|                                    |  |                            |   |  |                          |   |  |      |   |  |      |  
|----------------------------------- |  | -------------------------- | - |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                                    |  | Three months endedJune 30, |   |  | Six months endedJune 30, |  
|                                    |  | 2004                       |   |  | 2003                     |   |  | 2004 |   |  | 2003 |  
|Risk-free interest rate             |  | 3.00                       | % |  | 1.78                     | % |  | 2.51 | % |  | 2.01 | %
|Expected life (in years) (restated) |  | 5                          |   |  | 5                        |   |  | 5    |   |  | 5    |  
|Dividend yield                      |  |                           | % |  |                         | % |  |     | % |  |     | %
|Expected volatility                 |  | 74                         | % |  | 79                       | % |  | 75   | % |  | 85   | %



All of the above
assumptions were used for the Employee Stock Purchase Plan except that the expected life is six months.



The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 Accounting for Stock-based
Compensation and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods and Services.



NOTE 6  Product Warranty



The Company generally warrants its products against defects for a period of
one year and records a liability for such product warranty obligations at the time of sale based upon historical experience. The Company sells separately priced service contracts to provide additional service coverage on the systems when the
warranty period expires. The related revenue on the service contracts is recognized on a straight-line basis over the life of the service contract, which is generally one year. Costs associated with services performed under the service contract
obligation are expensed as incurred.



Changes in product
warranty obligations for the six months ended June 30, 2004 and June 30, 2003 are as follows (in thousands):



|                                            |  |      |     |   |      |   |     |  
|------------------------------------------- |  | ---- | --- | - | ---- | - | --- | -
|                                            |  | 2004 |     |   | 2003 |  
|Balance as of beginning of year             |  | $    | 102 |   |      | $ | 127 |  
|                                            |  |     
|Add accruals for warranties issued          |  |      | 33  |   |      |   | 16  |  
|                                            |  |     
|Less costs incurred under warranties issued |  |      | (42 | ) |      |   | (32 | )
|                                            |  |      |     |   |      |   |     |  
|Balance as of end of quarter                |  | $    | 93  |   |      | $ | 111 |  
|                                            |  |      |     |   |      |   |     |  



12



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



NOTE 7  Other Income (Expense)



The details of other income (expense) are shown below (in thousands):



|                             |  |                            |     |   |                          |   |     |      |  |   |      |   |  |   |     |  
|---------------------------- |  | -------------------------- | --- | - | ------------------------ | - | --- | ---- |  | - | ---- | - |  | - | --- | -
|                             |  | Three months endedJune 30, |     |   | Six months endedJune 30, |  
|                             |  | 2004                       |     |   | 2003                     |   |     | 2004 |  |   | 2003 |  
|Interest income              |  | $                          | 7   |   |                          | $ | 8   |      |  | $ | 11   |   |  | $ | 14  |  
|Interest expense             |  |                            | (20 | ) |                          |   | (22 | )    |  |   | (42  | ) |  |   | (54 | )
|Foreign exchange gain (loss) |  |                            | (30 | ) |                          |   | 56  |      |  |   | (56  | ) |  |   | 74  |  
|Income taxes                 |  |                            | (1  | ) |                          |   | (10 | )    |  |   | (5   | ) |  |   | (13 | )
|Miscellaneous                |  |                            | (1  | ) |                          |   | 3   |      |  |   | 2    |   |  |   | 10  |  
|                             |  |                            |     |   |                          |   |     |      |  |   |      |   |  |   |     |  
|Total                        |  | $                          | (45 | ) |                          | $ | 35  |      |  | $ | (90  | ) |  | $ | 31  |  
|                             |  |                            |     |   |                          |   |     |      |  |   |      |   |  |   |     |  



NOTE 8  Recent Accounting
Pronouncements



In March 2004, the Emerging Issues
Task Force (EITF) issued EITF 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128. This statement provides additional guidance on the calculation and disclosure requirements for earnings per
share. The FASB concluded in EITF 03-6 that companies with multiple classes of common stock or participating securities, as defined by SFAS No. 128, calculate and disclose earnings per share based on the two-class method. EITF 03-06 was effective
for the fiscal quarter ended June 30, 2004. The adoption of this standard did not have any effect on our financial position or results of operations.



NOTE 9  Commitments and Contingencies



On February 24, 2004 the Company received notice of a lawsuit alleging patent infringement filed against the Company by ChromaVision Medical Systems, Inc.
The lawsuit, as subsequently amended, claims that our Ariol® system infringes on four ChromaVision patents. ChromaVision is seeking unspecified damages, as well as an injunction barring the Company from, among other things, making, using, or selling any device in the United
States that incorporates ChromaVisions patented technology.



On April 20, 2004, the Company responded to ChromaVisions complaint by denying ChromaVisions infringement allegations and by asserting the invalidity of ChromaVisions alleged patents, trademarks and copyrights. In
addition, the Company is countersuing ChromaVision for infringing our valid US Patent 6,633,662. The Company is seeking an injunction against ChromaVisions continued manufacture, sale and use of the Automated Cellular Imaging System (ACIS®) in the United States and enhanced economic damages for
ChromaVisions willful infringement. The Company has also asserted claims against ChromaVision for intentionally interfering with our relationships with our customers, unfair competition and false advertising under the Lanham Act, as well as
misappropriation of trade secrets.



The companies met in a
settlement conference in US District Court on August 2, 2004. Discussions are continuing between the companies and will be reviewed periodically by the US Magistrate Judge supervising the case.



Because of the inherent complexity and unpredictable nature of patent
litigation the Company is not able to make any predictions regarding the outcome of this litigation. As a result, the Company has not made any provisions for either a favorable or unfavorable outcome to this litigation.



13



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##### Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(continued)

(Unaudited)



NOTE 10 - Issuance of Common Stock and Warrants



On April 13, 2004, the Company raised approximately $4.25 million in gross
proceeds from the private placement of common stock and warrants to several institutional investors. Net proceeds to the Company after estimated offering costs and expenses were approximately $3.9 million. The transaction involved the sale of
3,100,000 newly issued shares of the Companys common stock at a price of $1.37 per share and warrants to purchase an aggregate of 620,000 shares of common stock an exercise price of $1.70 per share. The common stock warrants have a five-year
term and become exercisable on or after October 13, 2004. The aggregate value of the common stock warrants was determined to be a part of the purchase price and has been classified within additional paid-in capital. The Company deposited the
proceeds in its money market account at Silicon Valley Bank.



Note 11 -
Relocation



The Company relocated from its facilities
in Santa Clara to San Jose. As part of the relocation, the Company incurred expenses amounting to $222,000 for overlapping rent of the two facilities, moving and legal expenses and $501,000 for leasehold improvements and furniture/fixtures at its
new facilities. The leasehold improvements are being amortized over the occupancy period and the furniture/fixtures over their useful life. The Company has received these amounts totaling $723,000 as incentive at the new facilities and this is being
amortized to income over the occupancy period. The Company has minimum lease payments for the San Jose office as follows:



|                         |  |   |      
|------------------------ |  | - | -----
|Years Ended December 31, |  |  
|2004                     |  |   | 159  
|2005                     |  |   | 325  
|2006                     |  |   | 340  
|2007                     |  |   | 354  
|2008                     |  |   | 369  
|2009                     |  |   | 188  
|                         |  |   |      
|                         |  | $ | 1,735
|                         |  |   |      



NOTE 12  Subsequent
Events



On July 8, 2004, the Company incorporated a
wholly-owned subsidiary, Circulating Tumor Cells, Inc., in Delaware. This company was formed to conduct research and development, clinical trials and commercial activities in the area of circulating tumor cells. Also in July, the Company renewed the
exclusive supply agreement with StemCell Technologies Inc. for the use of StemCells RosetteSep® reagent technology in the isolation of circulating tumor cells in the blood of cancer patients. The Company believes that the isolation and analysis of circulating tumor cells,
frequently associated with metastatic cancer, may have clinical value in determining prognosis, response to therapy or the most appropriate monitoring strategies for certain cancers.



On July 29, 2004, the Company received notice from the Nasdaq Stock Market that its stock price had closed below $1.00 per
share for 30 consecutive business days. As a result, under certain circumstances, the Companys stock could be delisted from the Nasdaq SmallCap Market if the Company does not regain compliance prior to January 25, 2005 by having the bid price
on the stock close above $1.00 per share for a minimum of 10 consecutive business days.





14



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##### Table of Contents

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



The following discussion should be read in conjunction with the attached unaudited condensed consolidated financial statements and notes, and with our
audited financial statements and notes for the fiscal year ended December 31, 2003.



This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could differ materially from those predicted in the
forward-looking statements as a result of risks and uncertainties including, but not limited to, those discussed in this quarterly report and those discussed under Item 1  Business, Additional Factors That Might Affect Future
Results, and under Item 7  Managements Discussion And Analysis of Financial Condition And Results of Operations commencing on pages 12 and 24 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003. You
should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no obligation to revise or update any forward-looking statements.



Restatement



On November 15, 2004, we announced our intent to restate our financial
results for the fiscal year ended December 31, 2003 and our quarterly financial results for the first and second quarters of the fiscal year ending December 31, 2004. During the third quarter of 2004, a transaction was identified where revenue was
recognized in a manner inconsistent with our policies and procedures then in effect. Following the identification of this transaction, the Audit Committee commenced an investigation. During the course of its investigation, the Audit Committee
identified several revenue transactions generally involving its Cytovision and Ariol systems in which commitments were made for the future delivery of software applications then under development. Statement of Position (SOP) 97-2 Software
Revenue Recognition requires that vendor specific objective evidence (VSOE) of the price attributable to the fair value of such future deliverables be established in order to recognize a portion of revenue in the reporting period
in which the sale was originally made. We did not have VSOE established for these future deliverables at the time revenue was recognized. During the investigation, there were certain transactions identified where we recognized revenue
(a) upon the shipment of product to a customer but had not met all the customer acceptance criteria necessary to recognize revenue; (b) upon shipment of product to customer, but had not met all the revenue recognition criteria as it was a sale with
participation by a third party financing company. Additionally, during the investigation, certain transactions were identified where revenue on extended warranty/post customer support (software maintenance and service) arrangements were
inappropriately recognized resulting in incorrect revenue being recognized and/or deferred at the time of product shipment. As a result, the Company subsequently decided to restate its 2002 financial results as well.



Consequently, the condensed consolidated financial statements for the quarter
and six months ended June 30, 2004 are restated in this Form 10-Q/A amendment No. 1. These restated condensed consolidated financial statements reflect adjustments relating to the recording of revenue previously deferred and the deferral
of revenue and cost of goods sold related to the premature recognition of revenue.



15



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##### Table of Contents

The principal effects of these adjustments on the accompanying condensed consolidated financial
statements are as follows (in thousands, except per share data):



|                                               |  |                                         |        |   |                                       |   |        |                       |  |   |             |   |  |   |        |  
|---------------------------------------------- |  | --------------------------------------- | ------ | - | ------------------------------------- | - | ------ | --------------------- |  | - | ----------- | - |  | - | ------ | -
|                                               |  | For the three months endedJune 30, 2004 |        |   | For the six months endedJune 30, 2004 |  
|Condensed Consolidated Statement of Operations |  | As PreviouslyReported                   |        |   | As Restated                           |   |        | As PreviouslyReported |  |   | As Restated |  
|Revenues (1)                                   |  | $                                       | 4,130  |   |                                       | $ | 4,271  |                       |  | $ | 8,979       |   |  | $ | 9,186  |  
|Cost of revenue (1)                            |  |                                         | 1,702  |   |                                       |   | 1,690  |                       |  |   | 3,542       |   |  |   | 3,568  |  
|Gross profit (2)                               |  |                                         | 2,428  |   |                                       |   | 2,581  |                       |  |   | 5,437       |   |  |   | 5,618  |  
|Operating loss (2)                             |  |                                         | (1,139 | ) |                                       |   | (986   | )                     |  |   | (1,765      | ) |  |   | (1,584 | )
|Net loss (2)                                   |  |                                         | (1,184 | ) |                                       |   | (1,031 | )                     |  |   | (1,855      | ) |  |   | (1,674 | )
|Net loss per share, basic and diluted (2)      |  | $                                       | (0.06  | ) |                                       | $ | (0.06  | )                     |  | $ | (0.11       | ) |  | $ | (0.10  | )



|                                               |  |                                         |       |   |                                       |   |       |                       |  |   |             |   |  |   |       |  
|---------------------------------------------- |  | --------------------------------------- | ----- | - | ------------------------------------- | - | ----- | --------------------- |  | - | ----------- | - |  | - | ----- | -
|                                               |  | For the three months endedJune 30, 2003 |       |   | For the six months endedJune 30, 2003 |  
|Condensed Consolidated Statement of Operations |  | As PreviouslyReported                   |       |   | As Restated                           |   |       | As PreviouslyReported |  |   | As Restated |  
|Revenues (1)                                   |  | $                                       | 4,815 |   |                                       | $ | 4,648 |                       |  | $ | 10,230      |   |  | $ | 9,743 |  
|Cost of revenue (1)                            |  |                                         | 2,001 |   |                                       |   | 1,947 |                       |  |   | 4,165       |   |  |   | 3,941 |  
|Gross profit (2)                               |  |                                         | 2,814 |   |                                       |   | 2,701 |                       |  |   | 6,065       |   |  |   | 5,802 |  
|Operating loss (2)                             |  |                                         | (366  | ) |                                       |   | (479  | )                     |  |   | (630        | ) |  |   | (893  | )
|Net loss (2)                                   |  |                                         | (331  | ) |                                       |   | (444  | )                     |  |   | (599        | ) |  |   | (862  | )
|Net loss per share, basic and diluted (2)      |  | $                                       | (0.02 | ) |                                       | $ | (0.03 | )                     |  | $ | (0.04       | ) |  | $ | (0.05 | )



|                                               |  |                       |         |   |             |   |         |  
|---------------------------------------------- |  | --------------------- | ------- | - | ----------- | - | ------- | -
|                                               |  | June 30, 2004         |        
|Condensed Consolidated Balance Sheet           |  | As PreviouslyReported |         |   | As Restated |  
|Accounts receivable, net (3)                   |  | $                     | 4,516   |   |             | $ | 4,516   |  
|Inventories (3)                                |  |                       | 1,353   |   |             |   | 1,353   |  
|Prepaid expenses and other current assets (3)  |  |                       | 1,196   |   |             |   | 1,886   |  
|Total current assets (6)                       |  |                       | 12,128  |   |             |   | 12,818  |  
|Total assets (6)                               |  |                       | 15,748  |   |             |   | 16,438  |  
|Accrued expenses (4)                           |  |                       | 1,794   |   |             |   | 1,672   |  
|Deferred revenue, current (5)                  |  |                       | 3,995   |   |             |   | 6,055   |  
|Deferred rent incentive, current (5)           |  |                       | 723     |   |             |   | 149     |  
|Deferred revenue, non-current (5)              |  |                       | 361     |   |             |   | 364     |  
|Deferred rent incentive, non-current (5)       |  |                       |        |   |             |   | 574     |  
|Total liabilities (6)                          |  |                       | 9,435   |   |             |   | 11,376  |  
|Accumulated deficit (6)                        |  |                       | (46,413 | ) |             |   | (47,664 | )
|Total liabilities and stockholders equity (6) |  |                       | 15,748  |   |             |   | 16,438  |  



|                                               |  |                                        |        |   |                                        |   |        |                       |  |   |             |   |  |   |       |  
|---------------------------------------------- |  | -------------------------------------- | ------ | - | -------------------------------------- | - | ------ | --------------------- |  | - | ----------- | - |  | - | ----- | -
|                                               |  | For the six months ended June 30, 2004 |        |   | For the six months ended June 30, 2003 |  
|Condensed Consolidated Statement of Cash Flows |  | As PreviouslyReported                  |        |   | As Restated                            |   |        | As PreviouslyReported |  |   | As Restated |  
|Net loss (2)                                   |  | $                                      | (1,855 | ) |                                        | $ | (1,674 | )                     |  | $ | (599        | ) |  | $ | (862  | )
|                                               |  |                                        |        |  
|Changes in assets and liabilities:             |  |                                        |        |   |                                        |   |        |                       |  |   |             |   |  |   |       |  
|Accounts receivable                            |  |                                        | 1,849  |   |                                        |   | 1,606  |                       |  |   | 1,830       |   |  |   | 1,767 |  
|Inventories, net                               |  |                                        | (259   | ) |                                        |   | (163   | )                     |  |   | 257         |   |  |   | 266   |  
|Prepaid expenses and other current assets      |  |                                        | (659   | ) |                                        |   | (862   | )                     |  |   | (219        | ) |  |   | (357  | )
|Other assets                                   |  |                                        | (34    | ) |                                        |   | 99     |                       |  |   |            |   |  |   | (96   | )
|Deferred revenue                               |  |                                        | 346    |   |                                        |   | 504    |                       |  |   | (143        | ) |  |   | 408   |  
|Net cash used in operating activities          |  |                                        | 775    |   |                                        |   | 741    |                       |  |   | 1,063       |   |  |   | 1,063 |  

---

|(1) | Restated revenues include a net increase of $141,000 and $207,000 for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six
months ended June 30, 2004 and $167,000 and $487,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 due to adjustments relating to the recording of revenue
previously deferred and the deferral of revenue related to (a) $12,000
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | and $222,000 net decrease for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $355,000 net
decrease for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 related to certain Cytovision and Ariol system sales which included the future delivery of software
applications for which VSOE was not established at the time of sale; (b) $22,000 and $12,000 net increase for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and
$115,000 and $212,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 of sales with participation of third party financing companies; (c) $33,000 and $201,000
net increase for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $276,000 and $55,000 net increase for the quarter and six months ended June 30, 2003 over the
amount previously reported for the quarter and six months ended June 30, 2003 related to certain transactions that required customer acceptance; and (d) $98,000 and $216,000 net increase for the quarter and six months ended June 30, 2004 over the
amount previously reported for the quarter and six months ended June 30, 2004 and $27,000 and $25,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003 related
to extended warranty/post customer support arrangements;
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | The restatement of revenues resulted in a corresponding adjustment to cost of revenues. Cost of revenues decreased by $12,000 for the quarter and increased by $26,000 for the six
months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and decreased by $54,000 and $224,000 for the quarter and six months ended June 30, 2003 over the amount previously reported for the
quarter and six months ended June 30, 2003 and;
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The adjustments related to the recording of revenue previously deferred and deferral of revenues and cost of revenue resulted in a net increase to gross profit and a corresponding
net decrease in net loss available to stockholders of $153,000 and $181,000 for the quarter and six months ended June 30, 2004 over the amount previously reported for the quarter and six months ended June 30, 2004 and $113,000 and $263,000 for the
quarter and six months ended June 30, 2003 over the amount previously reported for the quarter and six months ended June 30, 2003. Net loss per share decreased $.01 for the six months ended June 30, 2004 and increased $.01 for the quarter and six
months ended June 30, 2003;
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | As a result of the recording of revenue previously deferred and deferral of revenues primarily related to Cytovision and Ariol, deferred costs (included in prepaid expenses and
current assets) increased $690,000 over the amount previously reported for the six months ended June 30, 2004 due to the cumulative effect of current and prior period adjustments to corresponding reductions of cost of revenues;
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Accrued expenses decreased $122,000 due to a reclassification of a previously misclassified deferred revenue transaction;
|--- | -------------------------------------------------------------------------------------------------------------------------



|(5) | Deferred revenue, current increased $2.1 million and deferred revenue non-current increased $3,000 for the six months ended June 30, 2004 over the amount previously reported for the
six months ended June 30, 2004 due to the cumulative effect of the deferral of revenues related to certain Ariol system transactions which included the future delivery of software applications under development for which VSOE was not
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | available and the deferral of revenues related to extended warranty/post customer support arrangements warranty commitments. Deferred rent incentive, current decreased $574,000 and
deferred rent incentive non-current increased $574,000 due to a reclassification of the previously misclassified non-current rent incentive;
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | Total current assets, total assets, total liabilities and stockholders equity includes an increase of $690,000 due to the cumulative effect of current and prior period
adjustments. As a result of the adjustments noted in (1) through (5) above accumulated deficit increased $1.3 million over amounts previously recorded as of June 30, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As reflected on the restated consolidated financial statements, the Company has recorded certain other adjustments, the net
effect of which is presented above. None of these entries is significant individually or in its aggregate.



Results of Operations, as restated



Revenues. Our revenues are derived primarily from the sale of systems, service contracts, software maintenance and grant revenues. Revenues for the restated three and six months ended 2004 were $4.3 million and $9.2 million,
respectively, compared to $4.6 million and $9.7 million for the corresponding restated periods in 2003. The decreases in revenues in the second quarter and first half were due primarily to increased competitive pressures for CytoVision product
sales.



Sales of systems were $2.9 million and $6.5 million as
restated in the three and six months ended June 30, 2004, respectively, compared to $3.2 million and $7.0 million for the corresponding restated periods in 2003. The decreases in system revenues in the second quarter and first half were due
primarily to the revenue factor mentioned above.



Service
contract, software maintenance and grant revenues were $1.4 million and $2.7 million, as restated in the three and six months ended June 30, 2004, essentially the same level as in the corresponding periods in 2003.



Cost of revenues. Cost of revenues includes direct material and labor costs,
manufacturing overhead, installation costs, warranty-related expenses and service and application support expenses. Costs of revenues as restated for the three and six months ended June 30, 2004 were $1.7 million and $3.6 million, respectively,
compared to $1.9 million and $3.9 million for the corresponding restated periods in 2003. Cost of revenues, as a percentage of total revenues, for the three and six months ended June 30, 2004 were 40% and 39% respectively, compared to 42% and 40%
for the corresponding prior year periods. The decrease is primarily due to the sale of a number of our Ariol® systems at a lower gross margin percent for market development purposes. The impact of such concessionary sales was less in the first half of 2004 than in the first half of 2003.



Research and development expenses.Research and development expenses
for the three and six months ended June 30, 2004 were $844,000 and $1.7 million, respectively, compared to $934,000 and $1.8 million in the comparative prior year periods. This decrease in the second quarter and first half is due primarily to
$50,000 of incremental spending in support of the Sanger Institute project in the second quarter of 2003, compared to no such spending in the second quarter of 2004, and a $44,000 decline in personnel recruitment fees in the second quarter of 2004
compared to 2003.



Sales and marketing expenses. Sales and marketing
expenses for the three and six months ended June 30, 2004 were $1.6 million and $3.3 million, respectively, compared to $1.8 million



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and $3.6 million in the comparative prior year periods. The decline in both periods was due primarily to decreases in
sales commissions paid to internal sales staff and our distributors outside North America ($100,000 in the second quarter and $273,000 in the first half).



General and administrative expenses. General and administrative expenses for the second quarter and first half of 2004 were $1.1 million and $2.1 million
respectively, compared to $456,000 and $1.3 million in the comparative prior year periods. The increase in general and administrative expenses in both periods were primarily attributable to increases in patent and legal fees ($249,000 in the second
quarter and $334,000 in the first half), one-time expenses associated with the relocation to our new office facilities in San Jose ($222,000) and the favorable impact in the second quarter of 2003 of the receipt of a grant (net effect of $170,000)
in the U.K. that was treated as an offset to rent expense.



Other income
(expense), net.The other expense of $45,000 in the second quarter of 2004 was due primarily to $30,000 of foreign exchange losses incurred in the translation of various balance sheet items from foreign currencies into the U.S. dollar and
interest expense of $20,000 payable on our bank borrowings. Other income of $35,000 in the second quarter of 2003 was primarily comprised of foreign exchange gains incurred in the translation of various balance sheet items from foreign currencies
into the U.S. dollar. Other expense of $90,000 in the first half of 2004 was primarily comprised of $56,000 of foreign exchange losses and $42,000 of interest expense. Other income of $31,000 in the first half of 2003 was primarily comprised of
$40,000 in net interest expense payable on our bank borrowings and $74,000 of foreign currency gains incurred in the translation of various balance sheet items from foreign currencies into the U.S. dollar.



Liquidity and Capital Resources, as restated



At June 30, 2004, we had cash and cash equivalents of $4.9 million and
working capital of $2.4 million, compared to $2.0 million and $340,000, respectively, at December 31, 2003. Restricted cash, which collateralizes various credit card and bank guarantees in the United Kingdom, amounted to $181,000 at June 30, 2004
and $178,000 at December 31, 2003.



Cash provided by operations
for the six months ended June 30, 2004 was $741,000, compared to $1.1 million for the first six months of 2003. Changes in the restated components of cash used in operations included an increase in net loss amounting to $812,000. There were also
increased requirements for inventories of $429,000 (an increase of $163,000 in the first half of 2004 primarily due to the purchase of StemCells RosetteSep® reagent and a decrease of $266,000 in the first half of 2003 reflecting a reduction in the components that had been
built up for new products). Cash provided by operations included an increase in accounts payable of $731,000 (an increase of $431,000 in the first half of 2004 and a decrease of $300,000 in 2003). The increase in the first half of 2004 was due
primarily to one time relocation costs associated with the San Jose office. The decrease in the first half of 2003 was primarily due to a reduction in accounts payable to vendors supplying system components, reflecting lower inventory at the end of
June 2003. There was an increase in deferred rent incentive of $723,000 due to the rent incentive received for our new office facilities in 2004. There was no such incentive in 2003. Deferred revenue increased by $96,000 primarily due to a $504,000
increase in 2004, as a result of the deferral of revenue on certain sales transactions that included future deliverables and contingencies.



Trade accounts receivable as a percent of second quarter restated revenues were 106% at June 30, 2004, compared to 117% at June 30, 2003 and 119% at
December 31, 2003, reflecting improved collections in the quarter. This strong relationship between quarter-end receivables and that quarters sales is primarily due to the fact that most of our sales occur late



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in the quarter as is typical of a capital equipment business. Although our payment terms are net 30 days, certain
customers, specifically government, university, Asian and European customers, tend to take longer to pay their receivable balances.



Cash used in investing activities was $685,000 in the first six months of 2004, compared to $173,000 in the first half of 2003. In the first six months of
2004 we invested $685,000 for purchases of capital equipment and leasehold improvements related to the San Jose office. compared to $173,000 of capital equipment purchases in the first six months of 2003.



Cash provided by financing activities was $2.8 million in the first six
months of 2004, compared to $680,000 cash used in financing activities for the first six months of 2003. We received $3.9 million net from the issuance of common stock in a private placement in the first half of 2004. Repayments were made on our
bank line with Silicon Valley Bank (SVB) in the first half of 2004 and 2003, of $1.1 million and $726,000 respectively.



On April 13, 2004, we completed the private placement of 3.1 million shares of common stock and warrants to purchase 620,000 additional shares of common
stock for an aggregate purchase price of $4.25 million. We received approximately $3.9 million net after expenses associated with the placement. Each warrant is exercisable for one share of common stock at an exercise price of $1.70 per share, from
six months following the closing date of April 13, 2004 until October 13, 2009.



We established a loan agreement with SVB on September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001.
The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend
the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for us to maintain a
minimum level of tangible net worth. On September 3, 2003, the loan agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to establish the minimum level of net tangible worth that we had to
maintain through the end of the loan agreement. We were not in compliance with the covenant requiring us to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and we obtained a waiver for this covenant violation and potential
non-compliance with the minimum net tangible worth covenant in January and February, 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March 31, 2005 and to establish the minimum level of net tangible
worth that we had to maintain through the end of the loan agreement. We were in compliance with the loan covenant at June 30, 2004.



At June 30, 2004, we had used $640,000 of the facility with $1.3 million available but not used. The interest rate on the facility was 6.0% at June 30,
2004, computed as the SVB prime rate plus 2 percent. The loan is collateralized by substantially all of the assets of the U.S. corporation and requires maintenance of a minimum level of tangible net worth. Other loan covenants include the need to
maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. corporations ability to transfer more than $600,000 to a subsidiary.



We have received from SVB various waivers of our non-compliance with the loan
covenant requiring us to maintain a minimum level of tangible net worth. There is no assurance that SVB will continue to provide such waivers in the future. In the event that we are unable to



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remain in compliance with this covenant, we would have to repay any outstanding balance on the SVB loan, which could
limit our ability to fund our working capital and growth objectives.



We collateralize various credit card and bank guarantees (used for customs clearance purposes) with cash deposits at an international bank in the United Kingdom. This amounted to £100,000 ($181,000) at June 30, 2004.



We expect negative cash flow from operations through at least 2004, as we
continue research and development of new applications for our OncoPath systems, conduct clinical trials required for the U.S. Food and Drug Administration (FDA) clearance of new products, litigate against ChromaVision, expand our marketing, sales and customer support
capabilities, expand our program to detect circulating tumor cells in peripheral blood and add additional infrastructure. We currently estimate that our capital resources will enable us to meet our capital needs for at least the next twelve months.



However, expenditures required to achieve growth and
profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, our long-term capital needs may require us to try to obtain additional funds through equity or debt
financing, collaborative or other arrangements with other companies, bank financing and other sources. We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, conducting clinical
trials for FDA clearance of new products, capital expenditures, working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular, are expected to include development of additional
applications of our current cytogenetic products and additional applications for the OncoPath systems and an expanded program to detect circulating tumor cells in peripheral blood, which may require additional funds.



There can be no assurance that we will be able to obtain additional debt or equity financing if needed and on terms
acceptable to us. If adequate and acceptable funding is not available, we could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that
we would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, our failure to obtain sufficient funds on acceptable terms when needed could have a
material adverse effect on our ability to achieve our long-term business objectives.



We are restating our consolidated financial statements to reflect adjustments to our previously reported financial information. The adjustments arose out of an investigation by our Audit Committee, as reported in our
Form 8-K filed with the SEC on November 15, 2004. As a result of the then active investigation, we were unable to timely file the Form 10-Q for the quarter ended September 30, 2004 or to announce our financial results for that period.



As part of the Audit Committees investigation, the Audit Committee
evaluated the effectiveness of certain internal controls and procedures. The Audit Committee concluded that there existed material weaknesses in a number of areas in our system of internal controls and procedures as of the date of our initial filing
of our December 31 2003 Form 10-K. As a result of the evaluation, the Audit Committee has directed management to implement and management is in the process of implementing measures designed to ensure that information required to be disclosed in our
periodic reports is complete, recorded, processed, summarized accurately and reported timely. These measures include:



| |  |  | adoption of a disclosure policy, which specifically addresses documentation on commitments made to customers;
| | - |  | -------------------------------------------------------------------------------------------------------------



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| |  |  | hiring of a contracts administrator to review all sales contracts and identify all commitments made to customers in each contract;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | moving of the international sales order processing and finance functions from our UK office to our US headquarters office;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | adoption of a policy regarding future software application commitments;
| | - |  | -----------------------------------------------------------------------



| |  |  | priority given to the hiring of a new CFO;
| | - |  | ------------------------------------------



| |  |  | updating of our revenue recognition policy to specifically address the revenue recognition requirements of SOP 97-2 as it relates to our business; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | creation of an education program with our sales force and management team on our new policies and procedures.
| | - |  | -------------------------------------------------------------------------------------------------------------



Once these additional measures have been fully implemented, we believe that
our internal controls and procedures will be effectively designed to ensure that information we are required to disclose in reports that we file with the SEC is recorded, processed, summarized accurately and reported within the time periods
specified in Securities and Exchange Commission rules and forms. However, the effectiveness of our controls ands procedures is still limited by a variety of factors including:



| |  |  | Faulty human judgment and simple error, omissions or mistakes;
| | - |  | --------------------------------------------------------------



| |  |  | Fraudulent action of an individual or collusion of two or more people;
| | - |  | ----------------------------------------------------------------------



| |  |  | Inappropriate management override of procedures; and
| | - |  | ----------------------------------------------------



| |  |  | The possibility that our enhanced controls and procedures may still not be adequate to assure timely and accurate information.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



If we fail to maintain effective internal controls and procedures for
financial reporting in place, we could be unable to provide timely and accurate financial information, be subject to delisting, and to civil and criminal sanctions.



Due to the investigation commenced by our Audit Committee, we were unable to file our September 30, 2004 Form 10-Q on a
timely basis. As a result, the Nasdaq Listing Qualifications Department notified us that we were not in compliance with the requirements of Nasdaq Marketplace Rule 4310(c)(14), affixed an E to the end of our trading symbol, and subjected
us to delisting proceedings. We appealed this delisting determination and participated in a hearing before a Nasdaq panel in December 2004. On July 29, 2004, we received notice from Nasdaq that our stock price had closed below $1.00 per share for 30
consecutive business days. As a result, we had failed to comply with the minimum bid price requirement for continued listing on The Nasdaq SmallCap Market. The Nasdaq staff further notified us that our stock might be subject to delisting from the
Nasdaq SmallCap Market if we fail to regain compliance with the minimum bid price requirement by having the bid price on our stock close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005. Since our stock price
failed to close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005, we requested an additional 180 day period to regain compliance with the minimum bid price requirement to continue our listing on the Nasdaq
SmallCap Market and avoid delisting.



On February 10, 2005, the
Nasdaq notified the Company that it had determined to grant our request for continued listing on the Nasdaq SmallCap Market subject to several conditions, including: 1.) the filing of the Companys Form 10-Q for the quarter ended September 30,
2004 and any required restatements on or before February 25, 2005 2.) the receipt of board approval to implement a reverse stock split sufficient to remedy the bid price deficiency on or before



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March 1, 2005 and the filing of a proxy statement evidencing the Companys intent to seek stockholder approval for
such reverse stock split on or before March 30, 2005 3.) evidence of a closing bid price of $1.00 per share on or before May 20, 2005 and a closing bid price of at least $1.00 per share for a minimum of ten consecutive business days immediately
thereafter, and 4.) the timely filing of all periodic reports for all reporting periods ending on or before December 31, 2005.



While our board of directors has given approval to seek shareholder approval to implement a reverse stock split for up to one share for each existing four
shares, our shareholders may not approve a reverse stock split. Our share price post a reverse stock split may not trade above a $1.00 per share for ten consecutive trading days. While it is our intent to make timely filings of all periodic reports
for all reporting periods ending on or before December 31, 2005, the company may not complete its filings on a timely basis. If any of these events were to occur, our shares would be delisted from the Nasdaq SmallCap Market. Additionally, should our
shareholders approve a reverse stock split, the reverse stock split may adversely impact our stock price.



If de-listed, our stock may be quoted using the Pink Sheets, LLC or other similar market. A de-listing from the Nasdaq SmallCap Market may adversely
impact our stock price, as well as our liquidity and the ability of our stockholders to purchase and sell their shares in an orderly manner, or at all. Furthermore, a delisting of our shares from the Nasdaq SmallCap Market could damage our general
business reputation and impair our ability to raise additional funds. Any of the foregoing events could have a material adverse effect on our business, financial condition and operating results.



Any of the foregoing events could have a material adverse effect on our
business, financial condition and operating results.



We
prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the Securities and Exchange Commission (the SEC) and various
bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. In particular, changes to
FASB guidelines relating to accounting for stock-based compensation will likely increase our compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause
other changes in the way we conduct our business.



Recent Accounting
Pronouncements



In March 2004, the Emerging Issues
Task Force (EITF) issued EITF 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128. This statement provides additional guidance on the calculation and disclosure requirements for earnings per
share. The FASB concluded in EITF 03-6 that companies with multiple classes of common stock or participating securities, as defined by SFAS No. 128, calculate and disclose earnings per share based on the two-class method. EITF 03-06 was effective
for the fiscal quarter ended June 30, 2004. The adoption of this standard did not have any effect on our financial position or results of operations.



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Item 3. Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments.



For the six months ended June 30, 2004, there were no material changes from the disclosures made in our Form 10-K for the year ended December 31, 2003. We
maintain our funds as cash or cash equivalents, primarily in money market investments with a maturity of less than 90 days. We invested these funds at an average interest rate of 0.87% during the second quarter of 2004. These investments are not
subject to interest rate risk.



Item 4. Disclosure Controls and Procedures.



(a) Evaluation of disclosure controls and procedures. Based on an evaluation as of the end of the period covered by this report, our chief executive officer and principal accounting officer has concluded that
our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act) were not effective to ensure that information required to be disclosed by us in reports that
we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.



We have restated our financial results for the years ended December 31, 2003 and 2002 and for the quarters ended June 30,
2004 and March 31, 2004 to reflect adjustments to our previously reported financial results. The restatements arose out of an investigation by the Audit Committee.



As a result of the investigation, the Audit Committee determined that the Company had incorrectly recorded revenue on sales
contracts that included commitments for as yet undeveloped software upgrade applications for which vendor specific objective evidence (VSOE) for the fair value had not yet been established. The Audit Committee further determined that the
Company had incorrectly recorded revenue on certain sales contracts upon shipment rather than recording revenue when customer acceptance criteria had been met; and on certain other transactions where the Company had recorded revenue upon shipment of
sales with participation by a third party financing company, but had not met all the revenue recognition criteria necessary to recognize revenue. In addition, the Audit Committee determined that the Company had incorrectly recorded revenue on
certain transactions where additional revenue on extended warranty/post customer support (software maintenance and service) arrangements were inappropriately recognized resulting in incorrect revenue being recognized and/or deferred at the time of
product shipment.



As a result, the Audit Committee concluded
that the Company had material weaknesses in its system of internal controls as follows:



| |  |  | The Company does not have a policy for mandatory disclosures in sales contracts including disclosures for commitments for as yet developed software applications and has not properly
trained its sales personnel and management on sales contract disclosure or on SOP 97-2 (Statement of Position 97-2, Software Revenue Recognition);
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Personnel reviewing sales contracts are not qualified or properly trained to review sales contracts particularly as it relates to SOP 97-2 and customer acceptance criteria.
Furthermore, this review is not a formalized process.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Audit Committee has therefore directed management to implement a number of additional measures designed to further ensure that the Companys financial results are reported accurately. These measures include:



| |  |  | The adoption of a disclosure policy to insure that all commitments to customers in a sales contract are fully disclosed so the Company can correctly account for the sales contract;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The hiring of a contracts administrator who will review all sales contracts and identify all commitments to customers to insure that sales contracts are properly accounted for;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The adoption of a future software commitment policy so the Companys sales personnel have guidelines regarding future software application commitments to customers;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The adoption of an updated revenue recognition policy which specifically addresses SOP 97-2 as it relates to the Companys business;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The prioritization of hiring a new Chief Financial Officer ;
| | - |  | ------------------------------------------------------------



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| |  |  | The planned realignment of the international sales order processing and finance function to move these functions from the Companys UK affiliate to the Companys US head
quarters;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The education of the Companys management and sales force on these new policies and procedures.
| | - |  | -----------------------------------------------------------------------------------------------



These changes either have been, or are in the process of being implemented. We believe the planned and implemented changes
to our system of internal controls and our disclosure controls and procedures will be adequate to provide reasonable assurance that the information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported
within the time periods specified in the SECs rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Principal Accounting Officer, as appropriate, to allow timely
decisions regarding required disclosure based closely on the definition of disclosure controls and procedures in Rule 13-a-14(c). However, because of the inherent limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or
mistake.



(b) Changes in internal control over financial
reporting. There were no changes in our internal control over financial reporting or in other factors during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over
financial reporting.



PART II - OTHER INFORMATION



Item 5: Submission of Matters to a Vote of Security Holders



The Company solicited proxies for an annual meeting of stockholders on May 26, 2004 to all of the Companys stockholders.



The election of directors was conducted and the following nominees were elected: John F. Blakemore and G. Kirk Raab. The vote with respect to each
nominee was as follows:



|                       |  |            |  |         
|---------------------- |  | ---------- |  | --------
|                       |  | Votes     
|Name                   |  | For        |  | Withheld
|John F. Blakemore, Jr. |  | 13,814,582 |  | 513,177 
|G. Kirk Raab           |  | 13,840,532 |  | 487,227 



Continuing directors
whose terms of office extended beyond the Annual Meeting were: Jack Goldstein, Carl W. Hull, Andre F. Marion, and Pablo Valenzuela.



PricewaterhouseCoopers LLP was ratified as the independent auditors of the Company for the fiscal year ending December 31, 2004 with 14,281,460 votes in
favor, 45,299 votes against and 1,000 abstentions. There were no broker non-votes.



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An amendment of the Companys 1998 Incentive Stock Plan (the Plan) was approved to
increase the number of shares available for issuance under the Plan by 950,000 shares. The amendment was approved with 4,830,035 votes in favor, 690,801 votes against and 6,180 abstentions. There were 8,800,743 broker non-votes.



Item 6. Exhibits and Reports on Form 8-K.



(a) Exhibits.



|            |  |                                                                                                                                                                                
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                    
|            | 
|31.1        |  | Chief Executive Officer and Principal Financial Officers Certification Pursuant to 15 U.S.C. Section 7241                                                                     
|            | 
|32.1        |  | Certificate of Chief Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002



(b) Reports on Form
8-K



On April 14, 2004, we filed a Current Report on Form 8-K
which contained as an exhibit a copy of our press release announcing that we had completed the private placement of 3,100,000 shares of our common stock at $1.37 per share shares and warrants to purchase additional shares of common stock.



On May 17, 2004, we filed a Current Report on Form 8-K which
contained as an exhibit a copy of our press release announcing earnings for the first quarter of fiscal 2004.



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APPLIED IMAGING CORP.



SIGNATURES



Pursuant to the requirements of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized.



|                        |  |  |  |     |  |                                                        
|----------------------- |  |  |  | --- |  | -------------------------------------------------------
|                        |  |  |  |     |  | APPLIED IMAGING CORP.                                  
|                        |  |  |  |     |  | (Registrant)                                           
|                        |  |  | 
|Date: February 25, 2005 |  |  |  | By: |  | /s/ ROBIN STRACEY                                      
|                        |  |  |  |     |  | Robin Stracey                                          
|                        |  |  |  |     |  | Chief Executive Officer and Principal Financial Officer



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