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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the Quarterly Period ended September 30, 2005



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)



---



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



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



As of October 24, 2005 there were 4,784,012 shares
of the Registrants Common Stock outstanding.



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##### Table of Contents

APPLIED IMAGING CORP.

INDEX



|        |  |                                                                                                                                        |  |      
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------- |  | -----
|        |  | PART I. FINANCIAL INFORMATION                                                                                                          |  |      
|Item 1. |  | Financial Statements (Unaudited)                                                                                                       |  |      
|        |  |                                                                                                                                       
|        |  | Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                                                   |  | 4    
|        |  |                                                                                                                                       
|        |  | Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2005 and 2004 |  | 5    
|        |  |                                                                                                                                       
|        |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004                                  |  | 6    
|        |  |                                                                                                                                       
|        |  | Notes to Condensed Consolidated Financial Statements                                                                                   |  | 7-11 
|        |  |                                                                                                                                       
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                  |  | 12-15
|        |  |                                                                                                                                       
|Item 3. |  | Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments                                       |  | 15   
|        |  |                                                                                                                                       
|Item 4. |  | Disclosure Controls and Procedures                                                                                                     |  | 15-16
|        |  |                                                                                                                                       
|        |  | PART II. OTHER INFORMATION                                                                                                             |  |      
|        |  |                                                                                                                                       
|Item 1. |  | Legal Proceedings                                                                                                                      |  | 16   
|        |  |                                                                                                                                       
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                                                                    |  | 16   
|        |  |                                                                                                                                       
|Item 6. |  | Exhibits                                                                                                                               |  | 16   
|        |  |                                                                                                                                       
|        |  | Signatures                                                                                                                             |  | 16   



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



Unless the context otherwise indicates, all share and per share common stock information in this Quarterly Report reflects a 1-for-4 reverse stock split of the common stock effected May 20, 2005.



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##### Table of Contents

APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands)

(Unaudited)



|                                           |  |                   |         |   |                  |   |         |  
|------------------------------------------ |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                           |  | September 30,2005 |         |   | December 31,2004 |  
|ASSETS                                     |  |                   |         |   |                  |   |         |  
|                                           |  |                  
|Current assets:                            |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                  |  | $                 | 3,157   |   |                  | $ | 3,927   |  
|Restricted cash                            |  |                   | 176     |   |                  |   | 193     |  
|Trade accounts receivable, net             |  |                   | 4,090   |   |                  |   | 4,083   |  
|Inventories                                |  |                   | 602     |   |                  |   | 1,428   |  
|Prepaid expenses and other current assets  |  |                   | 315     |   |                  |   | 483     |  
|                                           |  |                   |         |   |                  |   |         |  
|Total current assets                       |  |                   | 8,340   |   |                  |   | 10,114  |  
|                                           |  |                  
|Property and equipment, net                |  |                   | 1,173   |   |                  |   | 1,503   |  
|Goodwill                                   |  |                   | 2,364   |   |                  |   | 2,364   |  
|Other assets                               |  |                   | 52      |   |                  |   | 51      |  
|                                           |  |                   |         |   |                  |   |         |  
|Total assets                               |  | $                 | 11,929  |   |                  | $ | 14,032  |  
|                                           |  |                   |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |                   |         |   |                  |   |         |  
|                                           |  |                  
|Current liabilities:                       |  |                   |         |   |                  |   |         |  
|Accounts payable                           |  | $                 | 1,082   |   |                  | $ | 1,453   |  
|Accrued expenses and other                 |  |                   | 2,436   |   |                  |   | 2,860   |  
|Bank debt                                  |  |                   | 1,975   |   |                  |   | 1,531   |  
|Deferred rent, current                     |  |                   | 160     |   |                  |   | 160     |  
|Deferred revenue, current                  |  |                   | 3,378   |   |                  |   | 3,507   |  
|                                           |  |                   |         |   |                  |   |         |  
|Total current liabilities                  |  |                   | 9,031   |   |                  |   | 9,511   |  
|                                           |  |                  
|Deferred rent, non-current                 |  |                   | 401     |   |                  |   | 513     |  
|Deferred revenue, non-current              |  |                   | 457     |   |                  |   | 572     |  
|                                           |  |                   |         |   |                  |   |         |  
|Total liabilities                          |  |                   | 9,889   |   |                  |   | 10,596  |  
|                                           |  |                   |         |   |                  |   |         |  
|Commitment and Contingencies (Note 7)      |  |                   |         |   |                  |   |         |  
|                                           |  |                  
|Stockholders equity:                      |  |                   |         |   |                  |   |         |  
|Common stock                               |  |                   | 19      |   |                  |   | 19      |  
|Additional paid-in capital                 |  |                   | 52,990  |   |                  |   | 53,077  |  
|Accumulated deficit                        |  |                   | (50,602 | ) |                  |   | (49,293 | )
|Accumulated other comprehensive loss       |  |                   | (367    | ) |                  |   | (367    | )
|                                           |  |                   |         |   |                  |   |         |  
|Total stockholders equity                 |  |                   | 2,040   |   |                  |   | 3,436   |  
|                                           |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity |  | $                 | 11,929  |   |                  | $ | 14,032  |  
|                                           |  |                   |         |   |                  |   |         |  



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 Loss

(in
thousands, except per share data)

(Unaudited)



|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|------------------------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                        |  | Three months endedSeptember 30, |       |   | Nine months endedSeptember 30, |  
|                                                        |  | 2005                            |       |   | 2004                           |   |       | 2005 |  |   | 2004   |  
|Revenues                                                |  | $                               | 4,933 |   |                                | $ | 5,709 |      |  | $ | 14,735 |   |  | $ | 14,895 |  
|Cost of revenues                                        |  |                                 | 1,746 |   |                                |   | 2,535 |      |  |   | 5,785  |   |  |   | 6,103  |  
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Gross profit                                            |  |                                 | 3,187 |   |                                |   | 3,174 |      |  |   | 8,950  |   |  |   | 8,792  |  
|Operating expenses                                      |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Research and development                                |  |                                 | 800   |   |                                |   | 887   |      |  |   | 2,555  |   |  |   | 2,622  |  
|Sales and marketing                                     |  |                                 | 1,393 |   |                                |   | 1,619 |      |  |   | 4,115  |   |  |   | 4,956  |  
|General and administrative                              |  |                                 | 1,065 |   |                                |   | 910   |      |  |   | 3,130  |   |  |   | 3,040  |  
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Total operating expenses                                |  |                                 | 3,258 |   |                                |   | 3,416 |      |  |   | 9,800  |   |  |   | 10,618 |  
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Operating loss                                          |  |                                 | (71   | ) |                                |   | (242  | )    |  |   | (850   | ) |  |   | (1,826 | )
|                                                        |  |                                 |       |  
|Other income/(expense), net                             |  |                                 | (128  | ) |                                |   | 5     |      |  |   | (296   | ) |  |   | (85    | )
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Net loss before income taxes                            |  |                                 | (199  | ) |                                |   | (237  | )    |  |   | (1,146 | ) |  |   | (1,911 | )
|                                                        |  |                                 |       |  
|Provision for income taxes                              |  |                                 | (163  | ) |                                |   |      |      |  |   | (163   | ) |  |   |       |  
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Net loss                                                |  | $                               | (362  | ) |                                | $ | (237  | )    |  | $ | (1,309 | ) |  | $ | (1,911 | )
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Net loss per share - basic and diluted                  |  | $                               | (0.08 | ) |                                | $ | (0.05 | )    |  | $ | (0.27  | ) |  | $ | (0.43  | )
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  
|Weighted average shares outstanding - basic and diluted |  |                                 | 4,784 |   |                                |   | 4,768 |      |  |   | 4,779  |   |  |   | 4,471  |  
|                                                        |  |                                 |       |   |                                |   |       |      |  |   |        |   |  |   |        |  



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)



|                                                                            |  |                                |        |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                            |  | Nine months endedSeptember 30, |       
|                                                                            |  | 2005                           |        |   | 2004 |  
|Cash flows from operating activities:                                       |  |                                |        |   |      |   |        |  
|Net loss                                                                    |  | $                              | (1,309 | ) |      | $ | (1,911 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                |        |   |      |   |        |  
|Depreciation and amortization                                               |  |                                | 548    |   |      |   | 429    |  
|Provision for doubtful accounts                                             |  |                                | 32     |   |      |   |       |  
|Provision for excess and obsolete inventory                                 |  |                                | 28     |   |      |   |       |  
|Stock-based compensation                                                    |  |                                | 20     |   |      |   |       |  
|Changes in operating assets and liabilities:                                |  |                                |        |   |      |   |        |  
|Trade accounts receivable                                                   |  |                                | (193   | ) |      |   | 1,398  |  
|Inventories                                                                 |  |                                | 793    |   |      |   | (412   | )
|Prepaid expenses and other current assets                                   |  |                                | 150    |   |      |   | (31    | )
|Other assets                                                                |  |                                | (2     | ) |      |   | 99     |  
|Accounts payable                                                            |  |                                | (342   | ) |      |   | 16     |  
|Accrued expenses and other                                                  |  |                                | (343   | ) |      |   | 280    |  
|Deferred revenue                                                            |  |                                | (243   | ) |      |   | (962   | )
|Deferred rent                                                               |  |                                | (113   | ) |      |   | 695    |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash used in operating activities                                       |  |                                | (974   | ) |      |   | (399   | )
|                                                                            |  |                                |        |   |      |   |        |  
|Cash flows from investing activities:                                       |  |                                |        |   |      |   |        |  
|Purchases of property and equipment                                         |  |                                | (220   | ) |      |   | (884   | )
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash used in investing activities                                       |  |                                | (220   | ) |      |   | (884   | )
|                                                                            |  |                                |        |   |      |   |        |  
|Cash flows from financing activities:                                       |  |                                |        |   |      |   |        |  
|                                                                            |  |                               
|Net proceeds from issuance of common stock                                  |  |                                | (107   | ) |      |   | 3,867  |  
|Bank and other loan proceeds                                                |  |                                | 9,210  |   |      |   | 8,521  |  
|Bank and other loan payments                                                |  |                                | (8,762 | ) |      |   | (9,120 | )
|Restricted cash                                                             |  |                                | 17     |   |      |   | (2     | )
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash provided by financing activities                                   |  |                                | 358    |   |      |   | 3,266  |  
|                                                                            |  |                                |        |   |      |   |        |  
|Effect of exchange rate changes on cash and cash equivalents                |  |                                | 66     |   |      |   | (77    | )
|                                                                            |  |                               
|Net (decrease) increase in cash and cash equivalents                        |  |                                | (770   | ) |      |   | 1,906  |  
|                                                                            |  |                               
|Cash and cash equivalents at beginning of year                              |  |                                | 3,927  |   |      |   | 2,047  |  
|                                                                            |  |                                |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                  |  | $                              | 3,157  |   |      | $ | 3,953  |  
|                                                                            |  |                                |        |   |      |   |        |  
|Supplemental disclosure of cash flow information:                           |  |                                |        |   |      |   |        |  
|Cash paid for interest during the period                                    |  | $                              | 66     |   |      | $ | 60     |  
|                                                                            |  |                                |        |   |      |   |        |  
|Inventory transfers to property and equipment                               |  | $                              | 149    |   |      | $ | 35     |  
|                                                                            |  |                                |        |   |      |   |        |  



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



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APPLIED IMAGING CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)



NOTE 1  Reclassifications



Reclassifications



Certain prior year amounts have been reclassified to conform to the current year presentation. The reclassifications pertain to cash flow and had no
effect on the total assets or net loss.



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 nine months ended September 30,
2005 and 2004. These condensed consolidated 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.



Unless the context otherwise indicates, all share and per share common stock information in this Quarterly Report reflects a 1-for-4 reverse stock split of the common stock effected May 20, 2005.



The results of operations for the three and nine months ended
September 30, 2005 are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2005. These condensed consolidated financial statements should be read in conjunction with the consolidated financial
statements and notes thereto, for the year ended December 31, 2004, contained in our Form 10-K filed with the Securities and Exchange Commission on April 27, 2005.



Going Concern



The accompanying condensed consolidated financial statements of the Company were prepared on a going concern basis, which contemplates the realization of
assets and the satisfaction of liabilities in the normal course of business. The realization of assets and the satisfaction of liabilities in the normal course of business are dependent on, among other things, the Companys ability to operate
profitably, to generate cash flows from operations, collections of receivables to fund its obligations, as well as the Companys ability to maintain credit facilities adequate to conduct its business. In the course of its operations, the
Company has sustained operating losses and negative cash flows from operations and expects such losses to continue in the foreseeable future. As of September 30, 2005, the Company had cash and cash equivalents on hand of $3.2 million, working
capital deficit of $691,000, and an accumulated deficit of $50.6 million. The Company intends to finance its operations primarily through its cash and cash equivalents, future financing and future revenues.



Expenditures required to achieve the Companys growth or the cash flow
used in operations may be greater than projected. As a result, the Companys capital needs may require the Company to seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies,
bank financing and other sources. There can be no assurance that the Company will be able to obtain additional debt or equity financing on terms acceptable to the Company, or at all. If adequate funds are 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 the Company would otherwise seek to commercialize internally, or to reduce the marketing,
customer support, or other resources devoted to product development. Accordingly, the failure of the Company to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on the Companys ability to achieve its
longer term business objectives.



In 2004, we incurred $1.3
million in legal and accounting expenses in conjunction with patent litigation and the restatement of our prior financial statements. Additionally, we had increased the size of our workforce in anticipation of revenue growth that did not
materialize. In the first quarter of 2005 we settled our patent litigation, completed the restatement of our prior financial results and reduced the size of our workforce. We believe these actions will reduce losses and cash used in operations in
2005 as compared to 2004. In addition to the actions we have taken to reduce expenses and cash outlay, we are seeking equity financing to improve both our cash and working capital position as well as to provide funds for additional investment in our
circulating tumor cell initiative. However, there are no assurances that adequate financing will be available on terms acceptable to us.



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The Companys inability to operate profitably and to consistently generate cash flows from
operations, its reliance therefore on external funding either from loans or equity raises substantial doubt about the Companys ability to continue as a going concern.



The Company has a loan agreement with Silicon Valley Bank, SVB, which provides for borrowing of up to $3.5 million based on
the level of certain of its North American accounts receivable. In February 2005, the loan agreement was amended to extend the term of the loan for two years through March 2007. In April 2005, the loan agreement was amended to revise the minimum net
worth covenant commencing April 2005 to $1,000 at the end of each month plus 70% of all consideration received from and after March 2005 for equity securities and subordinated debt and 50% of any quarterly profits in the current quarter. As part of
the April 2005 amendment to the loan agreement, the minimum tangible net worth requirement for March 2005 was waived by SVB. On September 17, 2005, SVB waived the minimum tangible net worth requirement for July and August. On November 3,
2005 SVB waived the minimum tangible net worth requirement for September through December 2005.



At September 30, 2005, the Company had used $2.0 million of the SVB facility with $4,000 available for borrowing. The interest rate on the facility
was 8.75% at September 30, 2005, 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 its 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 at September 30, 2005 ($176,000).



NOTE 3  Inventories



Inventories are stated at the lower of cost (determined on a first in, first
out) or market. The Company records provisions to write down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and its estimated market value based upon assumptions about future
market demand and market conditions. If future demand or market conditions are less favorable than currently expected, additional inventory provision may be required. Inventories consisted of the following (in thousands):



|                     |  |                   |     |                  |   |      
|-------------------- |  | ----------------- | --- | ---------------- | - | -----
|                     |  | September 30,2005 |     | December 31,2004
|Raw materials        |  | $                 | 491 |                  | $ | 966  
|Work in process      |  |                   | 82  |                  |   | 162  
|Finished goods       |  |                   | 29  |                  |   | 300  
|                     |  |                   |     |                  |   |      
|Total inventory, net |  | $                 | 602 |                  | $ | 1,428
|                     |  |                   |     |                  |   |      



NOTE 4  Net Loss Per Share



The
computation of basic and diluted net loss per share (EPS) for the three and nine months ended September 30, 2005 and September 30, 2004 is determined by dividing net loss as reported as the numerator by the number of shares
included in the denominator as shown in the following table (in thousands):



|                                               |  |                                 |  |                                |  |       |  |      
|---------------------------------------------- |  | ------------------------------- |  | ------------------------------ |  | ----- |  | -----
|                                               |  | Three months endedSeptember 30, |  | Nine months endedSeptember 30,
|                                               |  | 2005                            |  | 2004                           |  | 2005  |  | 2004 
|Weighted average shares outstanding - basic    |  | 4,784                           |  | 4,768                          |  | 4,779 |  | 4,471
|                                               |  |                                 |  |                               
|Dilutive shares - stock options                |  |                                |  |                               |  |      |  |     
|Dilutive shares - warrants                     |  |                                |  |                               |  |      |  |     
|                                               |  |                                 |  |                                |  |       |  |      
|Weighted average shares outstanding - dilutive |  | 4,784                           |  | 4,768                          |  | 4,779 |  | 4,471
|                                               |  |                                 |  |                                |  |       |  |      



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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):



|         |  |                   |  |                  
|-------- |  | ----------------- |  | -----------------
|         |  | September 30,2005 |  | September 30,2004
|Options  |  | 887,978           |  | 824,108          
|Warrants |  | 368,645           |  | 393,644          
|         |  |                   |  |                  
|Total    |  | 1,256,623         |  | 1,217,752        
|         |  |                   |  |                  



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 our 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, our 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 endedSeptember 30, |      |   | Nine months endedSeptember 30, |  
|                                                                                   |  | 2005                            |      |   | 2004                           |   |      | 2005 |  |   | 2004   |  
|Net loss as reported                                                               |  | $                               | (362 | ) |                                | $ | (237 | )    |  | $ | (1,309 | ) |  | $ | (1,911 | )
|Less: Stock-based employee compensation expense determined under fair-value method |  |                                 | (85  | ) |                                |   | (156 | )    |  |   | (242   | ) |  |   | (524   | )
|                                                                                   |  |                                 |      |   |                                |   |      |      |  |   |        |   |  |   |        |  
|Pro forma net loss                                                                 |  | $                               | (447 | ) |                                | $ | (393 | )    |  | $ | (1,551 | ) |  | $ | (2,435 | )
|                                                                                   |  |                                 |      |   |                                |   |      |      |  |   |        |   |  |   |        |  



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 endedSeptember 30, |   |  | Nine months endedSeptember 30, |  
|                         |  | 2005                            |   |  | 2004                           |   |  | 2005 |   |  | 2004 |  
|Risk-free interest rate  |  | 3.40                            | % |  | 2.92                           | % |  | 3.40 | % |  | 2.65 | %
|Expected life (in years) |  | 5                               |   |  | 5                              |   |  | 5    |   |  | 5    |  
|Dividend yield           |  |                                | % |  |                               | % |  |     | % |  |     | %
|Expected volatility      |  | 84                              | % |  | 70                             | % |  | 84   | % |  | 73   | %



The above assumptions
for the Employee Stock Purchase Plan were six months expected life, volatility of 86% and interest rate of 3.88%.



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.



9



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##### Table of Contents

NOTE 6  Product Warranty



The Company generally offers warranties on 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 our historical experience of warrantee claims made. The Company sells separately priced service contracts to provide additional service
coverage on its 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 nine months ended are as follows (in thousands):



|                                             |  |                   |      |   |                   |   |     |  
|-------------------------------------------- |  | ----------------- | ---- | - | ----------------- | - | --- | -
|                                             |  | September 30,2005 |      |   | September 30,2004 |  
|Balances as of the beginning of the year     |  | $                 | 101  |   |                   | $ | 102 |  
|Add: accruals for warranties issued          |  |                   | 171  |   |                   |   | 80  |  
|Less: costs incurred under warranties issued |  |                   | (114 | ) |                   |   | (64 | )
|                                             |  |                   |      |   |                   |   |     |  
|Balances as of the end of the quarter        |  | $                 | 158  |   |                   | $ | 118 |  
|                                             |  |                   |      |   |                   |   |     |  



NOTE 7  Commitments and Contingencies



On July 8, 2004, the Company renewed its exclusive supply agreement with StemCell Technologies Inc. for the use of StemCells RosetteSep®reagent technology for the isolation of circulating tumor cells in the blood of cancer patients. The Companys minimum purchase
commitment for 2005 is $108,000. This amount was charged to expense in the first quarter of fiscal year 2005.



Contractual Obligations. The following table presents certain payments due under contractual obligations with minimum firm commitments as of
September 30, 2005, excluding open orders for purchases to support normal operations:



|                               |  |                                |       |             |   |             |  |             |     |             |   |             |  |                            |     |  |   |     |  |   |  
|------------------------------ |  | ------------------------------ | ----- | ----------- | - | ----------- |  | ----------- | --- | ----------- | - | ----------- |  | -------------------------- | --- |  | - | --- |  | - | -
|                               |  | Payments due by period (ooos)
|                               |  | Total                          |       | Due in 2005 |   | Due in 2006 |  | Due in 2007 |     | Due in 2008 |   | Due in 2009 |  | Due in 2010 and thereafter
|Bank loan(1)                   |  | $                              | 1,975 |             | $ | 1,975       |  | $           |    |             | $ |            |  | $                          |    |  | $ |    |  | $ | 
|Operating lease commitments(2) |  |                                | 2,940 |             |   | 766         |  |             | 766 |             |   | 697         |  |                            | 522 |  |   | 188 |  |   | 
|Vendor commitments(3)          |  |                                | 145   |             |   | 37          |  |             | 108 |             |   |            |  |                            |    |  |   |    |  |   | 
|                               |  |                                |       |             |   |             |  |             |     |             |   |             |  |                            |     |  |   |     |  |   |  
|Total contractual obligations  |  | $                              | 5,060 |             | $ | 2,778       |  | $           | 874 |             | $ | 697         |  | $                          | 522 |  | $ | 188 |  | $ | 
|                               |  |                                |       |             |   |             |  |             |     |             |   |             |  |                            |     |  |   |     |  |   |  

---

|(1) | As of December 31, 2004, the Companys bank loan was due on March 25, 2005. On March 25, 2005, the Companys loan agreement with SVB was
amended to extend the term of the loan through March 29, 2007. Refer to Note 2 for further information.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Company has various non-cancelable operating leases for equipment, vehicles and facilities expiring through 2009. The facility leases generally contain renewal
options for periods ranging from two to five years and require the Company to pay all executory costs such as maintenance, property taxes, and insurance. Rent expense under operating leases was $569,000 for the nine months ending September 30,
2005. Rent expense under operating leases aggregated $902,000, $888,000, and $829,000 during 2004, 2003, and 2002 respectively. The Companys primary lease commitment is for its facility in San Jose, California. The lease is for 24,095 square
feet of office space. The lease on the San Jose facility is effective July 1, 2004 through June 30, 2009 with increasing annual rent commencing at $318,000, excluding operating expenses. However, rent expense is recognized on a
straight-line basis. Also, the Company leases a 4,422 square foot service office in League,Texas for $7,739 per month until the end of the lease in October 2006. In addition, the Company leases facilities in the United Kingdom, which aggregate
approximately £165,000 ($303,000) excluding expenses per year through 2008.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | The Company has obtained an exclusive agreement from StemCell Technologies, Inc. (STI) for a technology that may allow for the depletion of white and red
blood cells in peripheral blood samples. The Company is obligated to make minimum payments under a supply agreement for RosetteSept for Non-hematopoietic Tumor enrichment from blood. As of September 30, 2005 there were no open purchase orders
as the Company has sufficient supplies for its immediate needs. The minimum payments due represent monies due in the event no additional product is ordered.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

In September 2004, the Inland Revenue, the UK taxing authority, notified the Company that it disputed the
valuation the Company applied to its Cytogenetics technology that the Company transferred from its UK subsidiary to its US parent entity a transaction which occurred in 2000, claiming that such valuation understated the fair value of the transferred
assets. The Company originally valued the assets at £1.8 million ($3.5 million). The Inland Revenue indicated that it believed the value of the assets should have been £4.0 million ($7.7 million), which would have resulted in the Company
owing tax of approximately £585,000 ($1.1 million). The Company in further discussions with the Inland Revenue reached a settlement and recorded for the period ending September 30, 2005, an estimated tax of $163,000 and interest expense
of approximately of $48,000. As part of the settlement the UK taxing authority is treating approximately £500,000 of the total sale as a capital gain to the Companys subsidiary which reduces the amount of net loss for the year ending
December 2000 but provides approximately £500,000 of net loss carryforwards for use in subsequent tax years.



NOTE 8  Segment and Foreign Operations



The Company operates in one segment. The Companys chief operating decision maker is considered to be the
Companys Chief Executive Officer (CEO). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. The consolidated financial information
is identical to the information presented in the accompanying consolidated statements of operations.



The following table presents net revenues by geographic region (in thousands):



|                                 |  |                                 |       |                                |   |       |  |      |        |  |   |       
|-------------------------------- |  | ------------------------------- | ----- | ------------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|                                 |  | Three months endedSeptember 30, |       | Nine months endedSeptember 30,
|                                 |  | 2005                            |       | 2004                           |   | 2005  |  | 2004
|Revenues                         |  |                                 |       |                                |   |       |  |      |        |  |   |       
|North America                    |  | $                               | 3,373 |                                | $ | 3,699 |  | $    | 9,676  |  | $ | 8,541 
|International-Principally Europe |  |                                 | 1,560 |                                |   | 2,010 |  |      | 5,059  |  |   | 6,354 
|                                 |  |                                 |       |                                |   |       |  |      |        |  |   |       
|Total Revenues                   |  | $                               | 4,933 |                                | $ | 5,709 |  | $    | 14,735 |  | $ | 14,895
|                                 |  |                                 |       |                                |   |       |  |      |        |  |   |       



NOTE 9  Subsequent Events



On October 19, 2005 the Company provided six
months notice per the terms of the supply agreement with StemCell Technologies that the Company was terminating the agreement effective April 20, 2006.



Recently Issued Accounting Pronouncements



In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment, which replaces SFAS No. 123, Accounting for
Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires compensation costs related to share-based payment transactions to be recognized in the
financial statements. With limited exceptions, the amount of compensation cost will be measured based on fair value on the grant date of the equity or liability instruments issued. Compensation cost will be recognized over the period that an
employee provides service for that award. This new standard will be effective for the Company beginning January 1, 2006. The Company is evaluating the effect the adoption of this interpretation will have on its financial position, cash flows
and results of operations.



In May 2005, SFAS No. 154,
Accounting Changes and Error Corrections, was issued. This statement applies to all voluntary changes in accounting principle and requires retrospective application to prior periods financial statements of changes in accounting
principle, unless this would be impracticable. This statement also makes a distinction between retrospective application of an accounting principle and the restatement of financial statements to reflect the correction of an
error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company is evaluating the effect the adoption of this interpretation will have on its financial
position, cash flows and results of operations.



11



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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, 2004.



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 11 and 24 in our Annual Report on Form 10-K for the fiscal year ended December 31,
2004. 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.



Results of Operations



Revenues. Our revenues are derived primarily from the sale of systems, service contracts, software maintenance and grant revenues.
Revenues for the three and nine months ended September 30, 2005 were $4.9 million and $14.7 million, respectively, compared to $5.7 million and $14.9 million for the corresponding periods in 2004.



Sales of systems were $3.5 million and $10.5 million for the three and nine
months ended September 30, 2005, respectively, compared to $4.2 million and $10.7 for the corresponding periods in 2004. In the quarter ending September 2004, Ariol 2.0 was released allowing system sale deferrals of approximately $0.8 million
from prior periods to be recognized. Without revenue from system sale deferrals related to the release of Ariol 2.0, revenue for the quarter ended September 2004, would have been $4.9 million.



Service contract, software maintenance and grant revenues were $1.4 million
and $4.3 million for the three and nine months ended September 30, 2005, respectively, compared to $1.5 million and $4.2 million for the corresponding periods in 2004. Lower service revenues were related to grant revenues which were $0 and $0.1
million in the quarters ending September 2005 and 2004.



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 for the three and nine months ended
September 30, 2005 were $1.7 million and $5.8 million, respectively, compared to $2.5 million and $6.1 million for the corresponding periods in 2004. Cost of revenues, as a percentage of total revenues, for the three months and nine months
ended September 30, 2005 were 35% and 39%, respectively, compared to 2004 were 44% and 41% for the corresponding periods in 2004. The decreased cost of revenues for the three month and nine month periods ending September 2005 as compared to
2004 was attributed to less product cost, less material usage, reduced salary expense and a decrease in facility expense.



Research and development expenses.Research and development expenses for the three and nine months ended September 30, 2005 were $800,000 and $2.6
million, respectively, compared to $887,000 and $2.6 million for the corresponding periods in 2004. Expenses in the first, second and third quarters of 2005 included increased costs for our circulating tumor cell development initiative and
lower costs for our developed Ariol and CytoVision systems. For the quarter ending September 30, 2005, expenses for the circulated tumor cell initiative were $294,000.



Sales and marketing expenses. Sales and marketing expenses for the three and nine months ended September 30, 2005 were $1.4
million and $4.1 million, respectively, compared to $1.6 million and $5.0 million for the corresponding periods in 2004. Expenses were lower in the first, second and third quarters of 2005 as compared to 2004 due to reduced headcount in sales and
marketing and lower overall marketing costs as a result of management actions taken in January 2005 to streamline our operations. For the quarter ending September 30, 2005, expenses for the circulated tumor cell initiative were $222,000.



General and administrative expenses. General and administrative expenses for the
three and nine months ended September 30, 2005 were $1.1 million and $3.1 million, respectively, compared to $900,000 and $3.0 million for the corresponding periods in 2004. Expenses for the quarter ended September 30, 2005 included $0.2
million for professional fees related to the maintenance of our patent portfolio as well as fees associated with the settlement of our dispute with the Inland Revenue.



Other income (expense), net.Other expense of $128,000 in the third quarter of 2005 was due primarily to foreign exchange losses of
$64,000 incurred in the translation of various balance sheet items and transaction loss from foreign currencies into the U.S. dollar and interest expense of $72,000 owed primarily on interest due related to the settlement of our tax dispute with the
Inland Revenue and our bank borrowings. Other income, net of $5,000 in the third quarter of 2004 was primarily comprised of $20,000 in foreign exchange gains incurred in the translation of various balance sheet items from foreign currencies into the
U.S. dollar and $17,000 of interest expense related to our bank borrowings.



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For the nine month periods ending September 30, 2005 and 2004, foreign currency translation and exchange losses and
interest expense primarily caused the net other expense. The foreign exchange loss for the period ending September 30, 2005 relates to the weakening of the U.S. dollar against the British Pound Sterling. For the nine months ending September
2004 foreign exchange losses and interest expense primarily caused the net other expense.



|                                |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |     |  
|------------------------------- |  | ------------------------------- | ---- | - | ------------------------------ | - | --- | ---- |  | - | ---- | - |  | - | --- | -
|                                |  | Three months endedSeptember 30, |      |   | Nine months endedSeptember 30, |  
|                                |  | 2005                            |      |   | 2004                           |   |     | 2005 |  |   | 2004 |  
|Interest income                 |  | $                               | 18   |   |                                | $ | 9   |      |  | $ | 46   |   |  | $ | 20  |  
|Interest expense                |  |                                 | (72  | ) |                                |   | (17 | )    |  |   | (115 | ) |  |   | (60 | )
|Foreign exchange gains (losses) |  |                                 | (64  | ) |                                |   | 20  |      |  |   | (221 | ) |  |   | (34 | )
|Miscellaneous                   |  |                                 | (10  | ) |                                |   | (7  | )    |  |   | (6   | ) |  |   | (11 | )
|                                |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |     |  
|Total                           |  | $                               | (128 | ) |                                | $ | 5   |      |  | $ | (296 | ) |  | $ | (85 | )
|                                |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |     |  



Income tax.Income tax of
$163,000 in the third quarter of 2005 was due to the settlement with the UK Inland Revenue for taxable year 2000.



Liquidity and Capital Resources



At September 30, 2005, we had cash and cash equivalents of $3.2 million and a working capital deficit of $691,000, compared to $3.9 million in cash
and cash equivalents and a $603,000 working capital surplus at December 31, 2004. Restricted cash, which collateralizes various credit card and bank guarantees in the United Kingdom, amounted to $176,000 at September 30, 2005 and $193,000
at December 31, 2004.



Cash used in operations for the
nine months ended September 30, 2005 and 2004, respectively was $974,000 and $399,000.



Cash used by operations for the nine months ended September 30, 2005 included a net loss of $1.3 million. Reduced inventories through improved supply chain management provided cash of $793,000. Depreciation
provided cash of $548,000. Other assets primarily related to UK prepaid rent and other provided cash of $150,000. Payments on accounts payable and accrued expenses related to accounting and legal fees related to the restatement of our prior
financial statements, as well as expenses related to settled patent litigation with Clarient used cash of $685,000. A decrease in deferred revenue largely due to the recognition of deferred revenue used cash of $243,000. Deferred rent used cash of
$113,000.



Cash used by operations for the nine months ended
September 30, 2004 included a net loss $1.9 million. Reduced accounts receivable and an increase in deferred rent incentive received for the San Jose facilities provided cash of $2.1 million. Deferred rent provided approximately $695,000 in
cash as a result of the leasehold improvements incentives provided by the landlord to move into our San Jose facility. Depreciation provided cash of $429,000. Increase in inventory purchases used cash of $412,000. Deferred revenue related to the
restatement used cash of $962,000.



Accounts receivable as a
percent of third quarter revenues were 83% at September 30, 2005, compared to 84% at September 30, 2004 and 71% for the quarter ending December 31, 2004. 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 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 for the nine months ended September 30, 2005 was comprised of approximately $220,000 for property, plant and equipment compared to $884,000 for the same period ending 2004. In the period ending
September 30, 2004, approximately $884,000 was spent on capital equipment and leasehold improvements for our San Jose headquarters which we moved into in 2004.



Cash provided by financing activities for the nine months ended September 30, 2005 was $358,000 compared to cash
provided of $3.3 million for the period ending September 30, 2004. Our net bank borrowings for the period ending



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##### Table of Contents

September 30, 2005 was approximately $448,000 compared to net repayment of $599,000 for the period ending
September 30, 2004. In the first half of fiscal 2004, we received $3.9 million net from the issuance of common stock in a private placement transaction.



We have a loan agreement with SVB which provides for borrowing of up to $3.5 million based on the level of certain of our North American accounts
receivable. In February 2005, the loan agreement was amended to extend the term of the loan for two years through March 2007. In April 2005, the loan agreement was amended to revise the minimum net worth covenant commencing April 2005 to $1,000 at
the end of each month plus 70% of all consideration received from and after March 2005 for equity securities and subordinated debt and 50% of any quarterly profits in the current quarter. As part of the April 2005 amendment to the loan agreement,
the minimum tangible net worth requirement for March 2005 was waived by SVB. On September 17, 2005, SVB waived the minimum tangible net worth requirement for July and August 2005. On November 3, 2005 SVB waived the minimum tangible net
worth requirement for September through December 2005.



At
September 30, 2005, we had used $2.0 million of the facility with $4,000 available but not used. The interest rate on the facility was 8.75% at September 30, 2005, computed as the SVB prime rate plus 2 percent. The loan is collateralized
by substantially all of the assets of our 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 our U.S. corporations ability to transfer more than $600,000 to a subsidiary.



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 $176,000 at September 30, 2005.



We believe that our current cash balances may not be sufficient to fund planned expenditures. This raises substantial doubt about our ability to continue as a going concern. We intend to raise additional funds through the issuance of equity
or debt securities, or a combination thereof, in the public or private markets in order to continue operations, or sell the Company. Additional financing and merger opportunities may not be available, or if available, may not be on favorable terms.
The availability of financing or merger opportunities will depend, in part, on market conditions, and the outlook for us. Any future equity financing would result in substantial dilution to our stockholders. If we raise additional funds by issuing
debt, we may be subject to limitations on our operations, through debt covenants or other restrictions. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products or
license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing, customer support or other resources devoted to our products. Any of these
options could reduce our sales growth and result in continued net losses.



In 2004, we incurred $1.3 million in legal and accounting expenses in conjunction with patent litigation and the restatement of our prior financial statements. Additionally, we had increased the size of our workforce
in anticipation of revenue growth that did not materialize. In the first quarter of 2005 we settled our patent litigation, completed the restatement of our prior financial results and reduced the size of our workforce. We believe these actions will
reduce losses and cash used in operations in 2005 as compared to 2004. In addition to the actions we have taken to reduce expenses and cash outlay, we are seeking equity financing to improve both our cash and working capital position as well as to
provide funds for additional investment in our circulating tumor cell initiative. However, there are no assurances that adequate financing will be available on terms acceptable to us.



Our stockholders equity has dropped below the threshold required for continued listing on the Nasdaq SmallCap Market.
If Nasdaqs listing department notifies us that it determines us to be deficient, we will need to disclose that fact publicly, and then we will be permitted an opportunity to regain compliance. Nasdaq has conditioned our continued listing on
our ability to timely file all our periodic reports for all reporting periods through December 31, 2005. While it is our intent to make timely filings of all periodic reports for all reporting periods ending on or before December 31, 2005,
we may not complete our filings on a timely basis. If we are not able to comply with the conditions specified by the Nasdaq, our shares could be delisted from the Nasdaq SmallCap Market. If delisted, our stock may be quoted using the Pink Sheets,
OTC or other similar market. A delisting 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.



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.



14



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Critical Accounting Policies



There have been no material changes to the critical accounting policies discussed in our Annual Report on Form 10-K for the
year ended December 31, 2004. For a discussion of our critical accounting policies refer to Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting in our
Annual Report on Form 10-K for the year ended December 31, 2004. Below is an update description for clarification purposes:



Revenue Recognition



The Company recognizes revenue on sales contracts upon the transfer of title of the product from the Company to the customer. In the vast majority of the
Companys sales contracts, the transfer of title occurs upon shipment of the product from the Companys facility. However, in certain sales contracts, transfer of title may occur upon receipt or upon acceptance by the customer.
Additionally, should there be a third party financing company involved in a sales contract and there is incremental risk in the sales contract (lease agreement) as compared to a sales contract where there is no third party leasing company involved
in the transaction, the Company recognizes revenue over the life of the lease.



Property and Equipment



The Company records depreciation expense on its demonstration equipment to sales and marketing expense as the Company uses demonstration equipment as a marketing tool and does not hold demonstration equipment for resale.



Recently Issued Accounting Pronouncements



In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires
compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on fair value on the grant date of the equity or liability
instruments issued. Compensation cost will be recognized over the period that an employee provides service for that award. This new standard will be effective for us beginning January 1, 2006. The Company is evaluating the effect the adoption
of this interpretation will have on its financial position, cash flows and results of operations.



In May 2005, SFAS No. 154, Accounting Changes and Error Corrections, was issued. This statement applies to all voluntary changes in
accounting principle and requires retrospective application to prior periods financial statements of changes in accounting principle, unless this would be impracticable. This statement also makes a distinction between retrospective
application of an accounting principle and the restatement of financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. The Company is evaluating the effect the adoption of this interpretation will have on its financial position, cash flows and results of operations.



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



For the nine months ended September 30, 2005, there were no material changes from the disclosures made in our Form 10-K for the year ended
December 31, 2004. 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 3.16% for the third quarter of 2005. These
investments are not subject to interest rate risk.



Item 4. Disclosure Controls and Procedures.



(a)Evaluation of disclosure controls and procedures.



We maintain disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934 (the Exchange Act), that are designed 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, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to



15



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##### Table of Contents

allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures,
management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in
designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and
procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.



Our management, with the participation of our Chief Executive Officer and
Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive
Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective.



(b)Changes in internal control over financial reporting.



There were no changes in our internal control over financial reporting during the quarter ended September 30, 2005,
that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



PART II - OTHER INFORMATION



Item 1. Legal Proceedings



We are not a party to any material legal proceedings.



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



None.



Item 6. Exhibits.



(a)
Exhibits.



|            |  |                                                                                                                                                
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                    
|31.1        |  | Chief Executive Officers Certification Pursuant to 15 U.S.C. Section 7241                                                                     
|            | 
|31.2        |  | Chief Financial Officers Certification Pursuant to 15 U.S.C. Section 7241                                                                     
|            | 
|32.1        |  | Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|            | 
|32.2        |  | Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



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: November 14, 2005 |  | By:                                |  | /s/ ROBIN STRACEY      
|                        |  |                                    |  | Robin Stracey          
|                        |  |                                    |  | Chief Executive Officer



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