U.S.
      SECURITIES AND EXCHANGE COMMISSION


Washington,
      D.C. 20549




FORM
      10-QSB




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


SECURITIES
      EXCHANGE ACT OF 1934





**For
      the quarterly period ended March 31, 2007**


OR


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


SECURITIES
      EXCHANGE ACT OF 1934


**Commission
      file number 000-49636**




**VIKING
      SYSTEMS, INC.**


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





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





4350
      La Jolla Village Drive, Suite 900, San Diego, CA 92122


(Address
      of principal executive offices)





Registrant's
      telephone no., including area code: (858) 431-4010







Former
      name, former address, and former fiscal year, if changed since last
      report.





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





Securities
      registered pursuant to Section 12(g) of the Exchange Act: $.001 Par Value Common
      Stock





Check
      whether the Issuer (1) has filed all reports required to be filed by Section
      13
      or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter
      period that the registrant was required to file such reports), and (2) has
      been
      subject to such filing requirements for the past 90 days.


(1)
YesýNo ̈(2) YesýNo ̈




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




Common
      Stock outstanding on March 31, 2007; 65,864,941 shares of $.001 par value Common
      Stock.




Transitional
      Small Business Disclosure Format (check one) Yes  ̈Noý




DOCUMENTS
      INCORPORATED BY REFERENCE: NONE











**FORM
      10-QSB**





**FINANCIAL
      STATEMENTS AND SCHEDULES**


**VIKING
      SYSTEMS, INC.**





**For
      the Quarter ended March 31, 2007**







**PART
      I - FINANCIAL INFORMATION**


Page
                ofForm
                10-QSBItem
                1.
            Financial
                Statements (unaudited):Balance
                Sheets at March 31, 2007 and December 31, 2006
            3Statements
                of Operations for the Three Months Ended March 31, 2007 and
                2006
            4Statements
                of Cash Flows for the Three Months Ended March 31, 2007 and
                2006
            5-6Notes
                to Financial Statements
            7 -
                14Item
                2.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            15Item
                3.
            Controls
                and Procedures, Evaluation of Disclosure Controls and
                Procedures
            20




**PART
      II - OTHER INFORMATION**




PageItem
                1.
            Legal
                Proceedings
            21Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            21Item
                3.
            Defaults
                Upon Senior Securities
            21Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            21Item
                5.
            Other
                Information
            21Item
                6.
            Exhibits
            21





2


**PART
      I - FINANCIAL INFORMATION**


**ITEM
      1: FINANCIAL STATEMENTS**


**VIKING
      SYSTEMS, INC.**


**Balance
      Sheets - Unaudited**




**Assets**
            
            **March
                31,**
            
            **December
                31,****2007**
            
            **2006**Current
                assets:Cash
                and cash equivalents
            
            $
            2,577,156
            
            $
            440,465Accounts
                receivable
            
            
            1,258,416
            
            
            855,299Inventories
            
            
            1,520,340
            
            
            1,117,929Prepaid
                expenses
            
            
            -
            
            
            34,208Other
                current assets
            
            
            358,718
            
            
            72,535Total
                current assets
            
            
            5,714,630
            
            
            2,520,436Property
                and equipment, net
            
            
            579,654
            
            
            594,402Debt
                issuance costs
            
            
            87,734
            
            
            -Intangible
                assets, net
            
            
            332,500
            
            
            350,000Total
                assets
            
            $
            6,714,518
            
            $
            3,464,838**Liabilities
                and Stockholders' Deficit**Current
                liabilities:Accounts
                payable
            
            $
            878,667
            
            $
            1,037,334Accrued
                expenses
            
            
            1,068,700
            
            
            1,780,302Deferred
                revenue
            
            
            103,737
            
            
            100,181Capital
                lease obligations - current
            
            
            37,080
            
            
            36,649Notes
                payable
            
            
            -
            
            
            350,000Derivative
                liability
            
            
            10,011,392
            
            
            3,373,676Total
                current liabilities
            
            
            12,099,576
            
            
            6,678,142Capital
                lease obligations
            
            
            66,980
            
            
            77,253Convertible
                notes payable, net of debt discount of $5,237,519 at March 31,
                2007
            
            
            139,014
            
            
            -Commitments
                and contingenciesSeries
                B redeemable preferred stock, $0.001 par value; 8,000 shares authorized,
              issued
                and outstanding at March 31, 2007 and December 31, 2006(aggregate
                liquidation preference of $8,552,329 at March 31, 2007 and
                $8,391,014
              at
                December 31, 2006, respectively).
            
            
            8,552,329
            
            
            8,391,014Stockholders'
                deficit:Preferred
                stock, $.001 par value, 25,000,000 shares authorized,no
                shares issued and outstanding
            
            
            -
            
            
            -Common
                stock, $.001 par value, 200,000,000 shares authorized;65,864,941
                and 34,529,052 issued and outstanding at March 31, 2007 and
              December
                31, 2006, respectively
            
            
            65,865
            
            
            61,865Additional
                paid-in capital
            
            
            7,554,293
            
            
            6,804,876Accumulated
                deficit
            
            
            (21,763,539
            )
            
            (18,548,312
            )Total
                stockholders' deficit
            
            
            (14,143,381
            )
            
            (11,681,571
            )Total
                liabilities and stockholders' deficit
            
            $
            6,714,518
            
            $
            3,464,838




See
      accompanying notes to financial statements


3


**VIKING
      SYSTEMS, INC.**


**Statements
      of Operations -Unaudited**




**Three
                Months Ended****March
                31,****2007**
            
            **2006**Sales,
                net
            
            $
            1,925,245
            
            $
            1,254,844Cost
                of sales
            
            
            1,380,215
            
            
            889,877Gross
                profit
            
            
            545,030
            
            
            364,967Operating
                expenses:General
                and administrative
            
            
            632,074
            
            
            529,190Selling
                and marketing
            
            
            1,144,773
            
            
            874,368Research
                and development
            
            
            411,917
            
            
            310,224Total
                operating expenses
            
            
            2,188,764
            
            
            1,713,782Operating
                loss
            
            
            (1,643,734
            )
            
            (1,348,815
            )Other
                income (expense):Interest
                income
            
            
            15,409
            
            
            -Interest
                expense
            
            
            (182,287
            )
            
            (145,365
            )Amortization
                of debt discount and debt issuance costs
            
            
            (143,430
            )
            
            (2,980,924
            )Loss
                on derivative liability
            
            
            (1,261,184
            )
            
            -(1,571,492
            )
            
            (3,126,289
            )Net
                loss
            
            $
            (3,215,226
            )
            $
            (4,475,104
            )Series
                B Preferred Stock dividend
            
            
            (161,315
            )
            
            -Net
                loss applicable to common stockholders
            
            $
            (3,376,541
            )
            $
            (4,475,104
            )Net
                loss per share - basic and diluted
            
            $
            (0.05
            )
            $
            (0.13
            )Weighted
                average shares outstanding - basic and diluted
            
            
            63,420,497
            
            
            34,850,757






See
      accompanying notes to financial statements


4


**VIKING
      SYSTEMS, INC.**


**Statements
      of Cash Flows-Unaudited**










**Three
                Months Ended**
              **March
                31,****2007**
            
            **2006****Cash
                flows from operating activities:**Net
                loss
            
            $
            (3,215,226
            )
            $
            (4,475,104
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            130,303
            
            
            86,444Common
                stock issued for services
            
            
            -
            
            
            21,995Stock
                based compensation expense
            
            
            74,732
            
            
            156,612Amortization
                of debt discount and debt issuance costs
            
            
            143,430
            
            
            2,980,924Loss
                on derivative liability
            
            
            1,261,184
            
            
            -Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (403,117
            )
            
            (195,951
            )Inventories,
                net
            
            
            (496,985
            )
            
            (51,686
            )Prepaid
                expenses
            
            
            34,208
            
            
            48,148Other
                current assets
            
            
            (286,183
            )
            
            (43,576
            )Accounts
                payable
            
            
            (158,667
            )
            
            763,846Accrued
                expenses
            
            
            134,932
            
            
            27,030Deferred
                revenue
            
            
            3,556
            
            
            15,188Net
                cash used in operating activities
            
            
            (2,777,833
            )
            
            (666,130
            )**Cash
                flows from investing activities:**Purchase
                of property and equipment
            
            
            (3,482
            )
            
            (35,266
            )Net
                cash used in investing activities
            
            
            (3,482
            )
            
            (35,266
            )





**Cash
                flows from financing activities:**Net
                change in short-term bank borrowings
            
            
            -
            
            
            158,705Payment
                of debt offering costs
            
            
            (47,152
            )
            
            -Proceeds
                from related party notes
            
            
            300,000
            
            
            200,000Repayment
                of capital lease obligations
            
            
            (9,842
            )Proceeds
                from convertible debt
            
            
            4,675,000
            
            
            -Net
                cash provided by financing activities
            
            
            4,918,006
            
            
            358,705Net
                change in cash and cash equivalents
            
            
            2,136,691
            
            
            (342,691
            )Cash
                and cash equivalents at beginning of period
            
            
            440,465
            
            
            434,503Cash
                and cash equivalents at end of period
            
            $
            2,577,156
            
            $
            91,812**Supplemental
                disclosure of cash flow information:**Cash
                paid during the period for:Interest
            
            $
            11,301
            
            $
            145,367Income
                taxes
            
            $
            -
            
            $
            -






See
      accompanying notes to financial statements


5





**Non-Cash
      Investing and Financing Activity**


*Three
      months ended March 31, 2007:*





During
      the three months ended March 31, 2007, the Company:


**·**
              Converted
                  $350,000 in notes payable and $6,534 in accrued interest into $356,534
                  in
                  convertible notes payable in February 2007**·**
              Converted
                  $300,000 of related party notes payable held by Donald Tucker,
                  a
                  significant shareholder, and the Company’s President and Chief Executive
                  Officer into $300,000, in convertible notes payable in February
                  2007.**·**
              Issued
                  4,000,000 shares of common stock with a fair value of $840,000
                  as for
                  liquidated damages to Series B Preferred stockholders pursuant
                  to the
                  February 2007 convertible debt
                  transaction.





*Three
      months ended March 31, 2006:*





During
      the three months ended March 31, 2006 the Company:


**·**
              During
                  March 2006, 837,000 shares of common stock were issued pursuant
                  to a
                  cashless exercise of 1,000,000 non qualified stock options issued
                  in
                  December 2003.




See
      accompanying notes to financial statements


6


**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**







**1.
      INTERIM FINANCIAL STATEMENTS**





The
      balance sheet of Viking Systems, Inc. (“Viking” or the “Company”) as of March
      31, 2007 and the statements of operations and cash flows for the three months
      ended March 31, 2007 and 2006 are unaudited. However, management, in its
      opinion, has made all adjustments (consisting only of normal recurring accruals)
      necessary to present fairly the financial position, results of operations and
      cash flows for the periods presented. Th7e balance sheet as of December 31,
      2006
      was derived from the company’s audited financial statements. The financial
      statements and notes thereto should be read in conjunction with the financial
      statements and notes for the years ended December 31, 2006, included in
      Viking Systems, Inc’s Form 10-KSB filed on March 27, 2007 with the Securities
      and Exchange Commission. The results of operations and cash flows for the three
      months ended March 31, 2007, are not necessarily indicative of results to be
      expected for the fiscal year ending December 31, 2007.





**2.
      LIQUIDITY AND GOING CONCERN**





The
      accompanying financial statements have been prepared on a going concern basis
      which contemplates the realization of assets and the satisfaction of liabilities
      in the normal course of business. Historically, the Company has incurred
      significant losses, and has not demonstrated the ability to generate sufficient
      cash flows from operations to satisfy its liabilities and sustain operations.
      Our independent registered public accounting firm included a going concern
      uncertainty explanatory paragraph in their report dated March 23, 2007, which
      is
      included in our Form 10-KSB for the year ended December 31, 2006.





The
      Company’s continuation as a going concern is dependent on its ability to
      generate sufficient income and cash flow to meet its obligations on a timely
      basis and/or obtain additional financing as may be required. During the three
      months ended March 31, 2007 the Company generated net proceeds of approximately
      $4.9 million from financing activities. In addition, the Company continues
      to
      examine all aspects of its business for areas of improvement and continues
      to
      focus on increasing revenues and gross margins, reducing its fixed cost base
      and
      improving the Company’s working capital position. However, if anticipated
      improvements in operating results and cash flows from operations do not
      materialize, the Company will need to further reduce expenses. The Company
      also
      may require additional equity or debt financing to meet its working capital
      requirements. The sale of additional equity securities or debt financing could
      result in additional dilution to the Company’s current stockholders. There can
      be no assurance that additional financing, if required, will be available on
      terms satisfactory to the Company.





The
      financial statements included herein do not include any adjustments relating
      to
      the recoverability and classification of recorded assets or the amount or
      classification of liabilities or any other adjustments that might be necessary
      should the Company be unable to continue as a going concern.







**3.
      EARNINGS (LOSS) PER SHARE**





Due
      to the net losses for the three months ended March 31, 2007 and 2006,
      potentially dilutive securities have been excluded in the calculation of diluted
      loss per share because their inclusion would be anti-dilutive. Accordingly,
      basic and diluted loss per share for the three month period ended March 31,
      2007
      presented are the same. For the purposes of this calculation, net loss for
      the
      three months ended March 31,2007 has been adjusted for dividends on preferred
      stock accrued during the period.


7





**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**




**4.
      INVENTORY**




Details
      of our inventory account balances as of March 31, 2007 and December 31, 2006
      are
      as follows:







**March
                31, 2007**
            
            **December
                31, 2006**Inventories:Parts
                and supplies
            
            $
            687,183
            
            $
            558,669Work-in-progress
            
            
            236,802
            
            
            344,483Finished
                goods
            
            
            677,892
            
            
            310,559Valuation
                reserve
            
            
            (81,537
            )
            
            (95,782
            )$
            1,520,340
            
            $
            1,117,929








**5.
      ACCRUED EXPENSES**





Accrued
      expenses consist of the following:





**March
                31, 2007**
            
            **December
                31, 2006**Accrued
                wages and salaries
            
            $
            367,495
            
            $
            352,390Accrued
                liquidated damages
            
            
            -
            
            
            840,000Accrued
                registration delay fees
            
            
            300,300
            
            
            192,300Accrued
                board of director fees
            
            
            172,625
            
            
            151,625Other
                accrued expenses
            
            
            228,280
            
            
            243,987$
            1,068,700
            
            $
            1,780,302





**6.
      INCOME TAXES**





Viking
      Systems accounts for income taxes using the asset and liability method. Under
      the asset and liability method, deferred tax assets and liabilities are
      recognized for the future tax consequences attributable to differences between
      the financial statement carrying amounts of existing assets and liabilities
      and
      their respective tax bases. Deferred tax assets and liabilities are measured
      using enacted tax rates expected to apply to taxable income in the years in
      which those temporary differences are expected to be recovered or settled.
      The
      effect on deferred tax assets and liabilities of a change in tax rates is
      recognized in income in the period that includes the enactment date. A valuation
      allowance is recognized against deferred tax assets when it is more likely
      than
      not that the assets will not be realized.





Effective
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board ("FASB") Interpretation No. 48 ("FIN 48"), "Accounting for
      Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109."
      The
      implementation of FIN 48 had no impact on the Company's financial statements.




The
      Company is primarily subject to U.S. federal and state income tax. Tax years
      ending December 31, 2004 and after remain open to examination by U.S. federal
      and state tax authorities. The Company's policy is to recognize interest and
      penalties related to income tax matters in income tax expense. As of January
      1
      and March 31, 2007, the Company had no accruals for interest or penalties
      related to income tax matters.


8


**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**








**7.
      STOCK-BASED COMPENSATION**




On
      January 1, 2006 the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No.123 (Revised 2004), “Share Based Payment,” (“SFAS 123R”), using the
      modified prospective method. In accordance with SFAS 123R, the Company measures
      the cost of employee services received in exchange for an award of equity
      instruments based on the grant-date fair value of the award. That cost is
      recognized over the period during which an employee is required to provide
      service in exchange for the award - the requisite service period. The Company
      determines the grant-date fair value of employee share options using the
      Black-Scholes option-pricing model.




Under
      the
      modified prospective approach, SFAS 123R applies to new awards and to awards
      that were outstanding on January 1, 2006 that are subsequently modified,
      repurchased or cancelled. Under the modified prospective approach, compensation
      cost recognized for the first quarter of fiscal 2006 includes compensation
      cost
      for all share-based payments granted prior to, but not yet vested on, January
      1,
      2006, based on the grant-date fair value estimated in accordance with the pro
      forma provisions of SFAS 123R, and compensation cost for all share-based
      payments granted subsequent to January 1, 2006, based on the grant-date fair
      value estimated in accordance with the provisions of SFAS 123R. Prior periods
      were not restated to reflect the impact of adopting the new standard. During
      the
      three months ended March 31, 2007 and 2006, the Company recorded $74,732 and
      $156,612 respectively, in non-cash stock-based compensation expense related
      to
      the implementation of SFAS 123R. As of March 31, 2007, there was approximately
      $590,190 of total unrecognized compensation costs related to unvested options,
      which is expected to be recognized over a weighted average period of
      approximately 1.71 years.





The
      fair
      value of stock options at date of grant was estimated using the Black-Scholes
      model with the following assumptions: expected volatility ranging from 76.89%
      to
      112.28%, expected term of 10 years, risk-free interest rate ranging from 4.30%
      to 5.23%, and expected dividend yield of 0%. Expected volatility is based on
      the
      historical volatilities of the Company’s common stock. The expected life of
      employee stock options is determined using historical data of employee exercises
      and represents the period of time that stock options are expected to be
      outstanding. The risk free interest rate is based on U.S. Treasury constant
      maturing for the expected life of the stock option.




The
      following table summarizes the stock option transactions during the three months
      ended March 31, 2007:




**Number
                of**
              **Shares**
            
            **Weighted
                - Average**
              **Exercise
                Price**
            
            **Weighted
                - Average**
              **Contractual
                Life**Options
                outstanding December 31, 2006
            
            
            6,976,000
            
            $
            0.42
            
            
            4.95Granted
            
            
            1,040,000
            
            
            0.20
            
            
            9.98Exercised
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            (30,000
            )
            
            0.50
            
            
            -Options
                outstanding March 31, 2007
            
            
            7,986,000
            
            
            0.40
            
            
            6.75Options
                exercisable at March 31, 2007
            
            
            4,330,000
            
            
            0.43
            
            
            4.66







**8.
      RECENT ACCOUNTING PRONOUNCEMENTS**





In
      June
      2006, the Financial Accounting Standards Board ("FASB") ratified the consensus
      on Emerging Issues Task Force ("EITF") Issue No. 06-3, “How Taxes Collected from
      Customers and Remitted to Governmental Authorities Should Be Presented in the
      Income Statement" ("EITF No. 06-3"). The scope of EITF No. 06-3 includes any
      tax
      assessed by a governmental authority that is directly imposed on a
      revenue-producing transaction between a seller and a customer and may include,
      but is not limited to, sales, use, value added, Universal Service Fund ("USF")
      contributions and some excise taxes. The Task Force affirmed its conclusion
      that
      entities should present these taxes in the income statement on either a gross
      or
      a net basis, based on their accounting policy, which should be disclosed
      pursuant to APB Opinion No. 22, "Disclosure of Accounting Policies." If such
      taxes are significant and are presented on a gross basis, the amounts of those
      taxes should be disclosed. The consensus on EITF No. 06-3 is effective for
      interim and annual reporting periods beginning after December 15, 2006. The
      adoption of EITF Issue No. 06-3 during the 1 st quarter
      of 2007 did not have a significant impact on our financial position, results
      of
      operations or cash flows.


9


**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**




**8.
        RECENT ACCOUNTING PRONOUNCEMENTS (Continued)**





In
      November 2006, the EITF reached a final consensus in EITF Issue 06-06 “Debtor’s
      Accounting for a Modification (or Exchange) of Convertible Debt Instruments”
(“EITF No. 06-6”). EITF No. 06-6 addresses the modification of a convertible
      debt instrument that changes the fair value of an embedded conversion option
      and
      the subsequent recognition of interest expense for the associated debt
      instrument when the modification does not result in a debt extinguishment
      pursuant to EITF No. 96-19, “Debtor’s Accounting or a Modification or Exchange
      of Debt Instruments.” The consensus should be applied to modifications or
      exchanges of debt instruments occurring in interim or annual periods beginning
      after November 29, 2006. We do not expect the adoption of EITF 06-6 during
      the
      first quarter of 2007 did not have a material impact on our consolidated
      financial position, results of operations or cash flows.





In
      November 2006, the FASB ratified EITF Issue No. 06-7, “Issuer’s Accounting for a
      Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
      the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities” (“EITF
      No. 06-7”). At the time of issuance, an embedded conversion option in a
      convertible debt instrument may be required to be bifurcated from the debt
      instrument and accounted for separately by the issuer as a derivative under
      SFAS
      No. 133, based on the application of EITF No. 00-19. Subsequent to the issuance
      of the convertible debt, facts may change and cause the embedded conversion
      option to no longer meet the conditions for separate accounting as a derivative
      instrument, such as when the bifurcated instrument meets the conditions of
      EITF
      No. 00-19 to be classified in stockholders’ equity. Under EITF No. 06-7, when an
      embedded conversion option previously accounted for as a derivative under
      Statement of Financial Accounting Standards (“SFAS”) No. 133 no longer meets the
      bifurcation criteria under that standard, an issuer shall disclose a description
      of the principal changes causing the embedded conversion option to no longer
      require bifurcation under SFAS No. 133 and the amount of the liability for
      the
      conversion option reclassified to stockholders’ equity. EITF No. 06-7 should be
      applied to all previously bifurcated conversion options in convertible debt
      instruments that no longer meet the bifurcation criteria in SFAS No. 133 in
      interim or annual periods beginning after December 15, 2006, regardless of
      whether the debt instrument was entered into prior or subsequent to the
      effective date of EITF No. 06-7. The adoption of EITF 06-7 during the
      1 st quarter
      of 2007 did not have a material impact on our financial position, results of
      operations or cash flows.








**9.
      CONVERTIBLE NOTES PAYABLE**





During
      January 2007, we issued a $300,000 promissory note to our CEO who is also a
      significant shareholder and Director. The promissory note and the $350,000
      Note
      Payable issued by the Company in December 2006 were converted into the February
      2007 debentures described below.




In
      February 2007, Viking Systems **** issued
      a
      total of $5,376,533 of convertible debentures (“Debentures”) to 13 Investors.
      Proceeds from the issuance of the Debentures consisted of $4,726,533 in cash
      and
      conversion of $650,000 of notes payable. The general terms of this financing
      are
      as follows:





Maturity
      Date of Notes


Two
      years
      from the date of issuance and may be accelerated by Investor upon default by
      Viking.





Interest
      Rate


Eight
      percent per annum, payable quarterly and subject to certain conditions, Viking
      may pay interest by issuing the holders of the Debentures shares of Viking
      common stock.




Security


The
      Debentures are secured by all of the assets of Viking.





Optional
      Conversion by Investors





***Conversion.*** The
      Debentures may, at the option of the Investors, be converted into shares of
      Viking common stock at the price of $0.18 per share. In the event Viking does
      not achieve certain operational milestones, as defined, during the first three
      quarters of 2007, the conversion price will be reduced to $0.12 per share.
      The
      conversion price is also subject to downward adjustment, upon certain conditions
      pursuant to the terms of Security Purchase Agreement, the Debentures and other
      Transaction Documents. As of March 31, 2007, if all Debenture holders were
      to
      convert all of the Debentures into common stock at the initial conversion price,
      approximately 29.9 million shares of common stock will be issued in such
      conversion. See footnote 10.


10


**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**





**9.
        CONVERTIBLE NOTES PAYABLE (Continued)**


Optional
      Redemption by Viking


Viking
      may not prepay the Debentures but it may redeem some or all of them if certain
      conditions are met. The Optional Redemption Amount equals 120% of the principal
      amount of the Debentures redeemed if the redemption occurs prior to the first
      anniversary date of the issuance of the Debentures, and 140% of the principal
      amount of the Debentures redeemed if the redemption occurs after the first
      anniversary date of the issuance of the Debentures but prior to the second
      anniversary date of issuance.




Warrants


As
      additional consideration, Viking issued the Investors Warrants to purchase
      shares of Viking common stock at the price of $0.18 per share. In the event
      Viking does not achieve certain operational milestones, as described, during
      the
      first three quarters of 2007, the exercise price will be reduced to $0.12 per
      share. The exercise price is also subject to downward adjustment, upon certain
      conditions pursuant to the terms of Security Purchase Agreement, the Warrant
      and
      other Transaction Documents. The Warrants are exercisable for a period of seven
      years from the date of issuance. The Warrants provide that each Investor is
      issued to purchase that number of shares of common stock of Viking that equals
      50% of the number of shares issuable upon conversion of the Debentures.





Registration
      Rights


Viking
      has agreed to register with the Securities and Exchange Commission, the shares
      of common stock that are issuable upon the conversion of the Debentures and
      the
      shares of common stock that underlie the Warrants. Viking will pay all expenses
      and cost of registration except for commissions. In the event that Viking fails
      to file or if the securities underlying the debentures and warrants are not
      registered by the dates agreed to in the transaction documents, Viking will
      be
      required to pay liquidated damages to the Holders. Such liquidated damages
      amount to 2% per month but will not exceed 18% of the face amount of the
      Debentures. Viking was required to file an initial registration statement by
      April 2, 2007 and has not yet completed this filing.





Additional


Pursuant
      to the securities purchase agreement, the Holders were granted certain rights
      to
      participate in subsequent financings by Viking.




In
      February 2007, we received the consent of our Series B Preferred Shareholders
      to
      consummate the convertible debenture financing and executed a consent and waiver
      agreement as described below.





The
      Debentures were assessed under SFAS No. 133 and management determined that
      the
      conversion option represented an embedded derivative liability. Accordingly,
      the
      Company bifurcated the embedded conversion option and accounted for it as a
      derivative liability. In accordance with SFAS No. 133, the embedded conversion
      option of the Debenture was revalued each period end and the change in fair
      value was reflected as a gain (loss) for the period. The proceeds received
      on
      issuance of the February 2007 Debentures were first allocated to the fair value
      of the bifurcated conversion option and the fair value of the derivative
      liability resulting from the warrants issued in connection with the Debentures.
      The aggregate fair values of the embedded conversion option and the warrant
      derivative liability totaled $6,859,608. Of this total $5,376,533 was recorded
      as a discount to the face amount the February 2007 Debentures, and $1,483,075
      was recorded as a loss on derivative liability. The recorded discount is being
      accreted as interest expense using the effective interest method over the term
      of the Debentures.




The
      carrying value of the debentures will accrete up to the face value over the
      life
      of the Debentures. The Company recorded accretion of $139,014 during the three
      months ended March 31, 2007 related to the February 2007 Debentures. The amount
      recorded on the balance sheet at March 31, 2007 has been calculated as
      follows:





Face
                value of the Debentures at inception
            
            $
            5,376,533Discount
                recorded in connection with derivative liabilities
            
            
            (5,376,533
            )Accretion
                of discount
            
            
            139,014Carrying
                value at March 31, 2007
            
            $
            139,014


11





**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**








**10.
      SERIES B CONVERTIBLE PREFERRED STOCK**





In
      May 2006, our Board of Directors adopted a resolution designating a Series
      B
      preferred stock consisting of 8,000 shares. All 8,000 shares of Series B
      Preferred Stock (“Preferred Stock”) authorized have been issued. Each share of
      Series B Preferred, par value $0.001 per share, with a stated value of
      $1,000 per share (“Stated Value”), is convertible, subject to adjustments,
      into approximately 5,555 shares of common stock and warrants to purchase an
      additional 2,778 shares of common stock at an initial price of $0.35 per share.
      In May, 2006 the Company issued the Series B Preferred for gross proceeds
      of $8,000,000, and incurred approximately $436,143 in issuance costs, which
      are
      recorded as a discount to the carrying value of the Series B Preferred.
      Proceeds from the sale of Series B Preferred consisted of $7,250,000 in cash
      and
      the conversion of $750,000 of convertible notes.





The
      Company applied the proceeds for general corporate purposes. The Company has
      recorded the redeemable convertible preferred stock as mezzanine equity on
      the
      accompanying balance sheet in accordance with the provisions of Emerging Issues
      Task Force (“EITF”) Topic D-98: “Classification and Measurement of Redeemable
      Securities” (“EITF Topic D-98”).





During
      the three months ended March 31, 2007, the Company recorded preferred stock
      dividends of approximately $161,315 as an increase to the net loss available
      to
      common stockholders in the accompanying consolidated statement of operations.
      All dividends accrued to date remain unpaid as of March 31, 2007. The Company
      may request that the preferred B shareholders consent to receive payment of
      dividends in shares of the Company’s stock.





The
      following table summarizes the change in carrying value of the Series B
      Preferred for the three months ended March 31, 2007.




Carrying
                value of convertible preferred stock at December 31, 2006
            
            $
            8,391,014Plus:Accrued
                dividends
            
            
            161,315Carrying
                value of convertible preferred stock at March 31, 2007
            
            $
            8,552,329





Conversion .
      The
      stated value of the shares of Preferred Stock are initially convertible into
      shares of Viking’s common stock at a price of $0.18 per share; however, the
      conversion price is subject to adjustment based upon certain conditions. 
Ay March 31, 2007, if all shares of Preferred Stock are converted into common
      stock at the initial conversion price, of which there can be no assurance,
      approximately 44,444,444 shares of common stock will be issued in such
      conversion.


12





**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**




**11.
      DERIVATIVE LIABILITY**




The
      following table summarizes warrants to purchase common stock outstanding as
      of
      March 31, 2007:





**Shares**
            
            **Range
                of Exercise Prices**
            
            **Weighted
                Average Exercise Prices**
            
            **Weighted
                Average Remaining Contractual Life**Warrants
                outstanding December 31, 2006
            
            
            31,694,444
            
            $
            0.35
                - 0.75
            
            $
            0.37
            
            $
            3.66Granted
            
            
            14,934,807
            
            
            0.18
            
            
            0.18
            
            
            6.91Exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -
            
            
            -
            
            
            -Warrants
                outstanding March 31, 2007
            
            
            46,629,251
            
            $
            0.18
                - 0.75
            
            $
            0.37
            
            $
            4.70








The
      total
      of 14,934,807 warrants granted to purchase common shares during the three months
      ended March 31, 2007 were granted to the purchaser of the
      Debentures.





Evaluation
      of criteria under Emerging Issues Task Force (“EITF”) Issue 00-19, “Accounting
      for Derivative Instruments Indexed to and Potentially Settled in, a Company’s
      own Stock,” resulted in the determination that the fair value of warrants to
      purchase common stock issued in connection with the Preferred Stock, and all
      other issued and outstanding warrants, should be classified as derivative
      liabilities. In accordance with EITF 00-19, warrants classified as
      derivative liabilities are marked to market value each reporting period with
      the
      corresponding non-cash gain or loss reflected in the current period.





As
      discussed in Note 9, the Company recorded the embedded conversion option of
      the
      Debentures as a derivative liability. Approximately 29,869,000 shares of Common
      Stock will be issued if all Debentures are converted. The aggregate fair value
      of the warrant derivative liability and the conversion option derivative
      liability on March 31, 2007 was $10,011,392 and the change in fair value of
      $1,261,183 during the quarter ended March 31, 2007 required an increase in
      the
      derivative liability and a derivative loss in the amount of
      $1,261,184.








**12.
      COMMON STOCK**




In
      January 2007, the majority of shareholders, through written consent, agreed
      to
      amend the Company's Certificate of Incorporation to increase the number of
      authorized number of common shares from 200,000,000 to 400,000,000. In May
      2007,
      we filed the amended Certificate of Incorporation with the State of Delaware.


13




**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**




**13. 
      CONSENT, WAIVER AND AMENTMENT AGREEMENT**




In
      May
      2006, Viking issued shares of its Convertible Series B Preferred Stock and
      Warrants to a limited number of accredited investors (the “Preferred Stock
      Transaction”). Pursuant to the terms and conditions of the Preferred Stock
      Transaction, Viking agreed to register the shares of common stock underlying
      the
      Series B Preferred Stock and Warrants issued in the Preferred Stock Transactions
      (the “Preferred Stock Transaction Shares”). Some of the Preferred Stock
      Transaction Shares were registered but other Preferred Stock Transaction Shares
      were not registered as a result of the Securities and Exchange Commission’s
      interpretation of Rule 415. The failure to register all of the Preferred Stock
      Transaction Shares resulted in a default by Viking of the terms and conditions
      of the Preferred Stock Transaction documents. Viking and the Preferred
      Stockholders have entered into a Consent, Waiver and Amendment Agreement
      pursuant to which:





**·**
            Viking
                agreed to issue the Preferred Stockholders a total of 4,000,000 shares
                of
                Viking common stock;





**·**
            the
                Preferred Stockholders agreed to amend certain provisions of the
                Preferred
                Stock Transaction documents; and





**·**
            the
                Preferred Stockholders agreed to waiver certain breaches of the Preferred
                Stock Transaction documents.


Liquidated
      damages in the amount $840,000 were accrued as of December 31, 2006 based on
      the
      estimated fair value of the four million shares of common stock issued by the
      Company in February 2007 pursuant to this agreement.








**14.
      REGISTRATION DELAY FEES**





During
      2005, Viking issued Convertible Promissory Notes (“Notes”) to certain accredited
      investors. Each of these investors was also issued a warrant to purchase shares
      of Viking common stock. In May 2006, each of the Note holders converted their
      Notes into shares of Viking common stock. In April 2006, Viking agreed to file,
      prior to June 21, 2006, a registration statement covering the shares of common
      stock issued upon the conversion of $4,750,000 of the Notes and shares of common
      stock underlying the warrants of these former Note holders. As a result of
      the
      required terms of the recently completed Series B Preferred Stock transaction,
      we were unable to include the securities of the former Note holders in the
      first
      registration statement. We anticipate a registration statement covering
      the Securities of these investors will be filed during 2007.





We
      have
      agreed to pay all Note purchasers, who elect to receive it, a registration
      delay
      fee of one percent per month of their initial Note principal balance. The delay
      fee began on June 21, 2006 and terminates on the date the Securities and
      Exchange Commission declares effective a registration statement covering the
      securities of the Note purchasers. Based on this agreement, we are accruing
      approximately $34,000 per month and as of March 31, 2007, we have accrued a
      total of $300,300 for such fees.





**15.
      RELATED PARTY TRANSACTIONS**




During
      the three months ended March 31, 2007;





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





During
      the three months ended March 31, 2006:





**·**
            Had
                an unsecured note payable to Donald E. Tucker, a significant shareholder,
                and the Company’s President and CEO, in the amount of $200,000. This note
                was repaid on June 14, 2006.**·**
            On
                January 27, 2005 the Company entered into a Loan and Security Agreement
                with Silicon Valley Bank. The Loan Agreement provided for a maximum
                borrowing of $200,000 and was secured by the assets of Viking Systems.
                The
                loan was also secured by a $200,000 certificate of deposit owned
                by Donald
                E. Tucker, a significant shareholder, and since May 31, 2006, the
                Company’s President and CEO. We terminated the Loan and Security Agreement
                on June 6, 2006.


14





**ITEM
      2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**





In
      this
      report references to "Viking," "we," "us," "our" and the “Company” refer to
      Viking Systems, Inc.


The
        following discussion of our financial condition and results of operations
        should
        be read in conjunction with our Financial Statements and Notes thereto, and
        the
        other financial information included elsewhere in this Form 10-QSB Report.
        This
        Management’s Discussion and Analysis of Financial Condition and Results of
        Operations contains descriptions of our expectations regarding future trends
        affecting our business. These forward-looking statements and other
        forward-looking statements made elsewhere in this document are made in reliance
        upon safe harbor provisions of the Private Securities Litigation Reform Act
        of
        1995. The following discussion sets forth certain factors we believe could
        cause
        actual results to differ materially from those contemplated by the
        forward-looking statements.


**Overview**





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





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





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





**·**
            That
                3-D vision, providing natural depth perception and a clear view of
                a
                patient’s anatomy, is superior in facilitating the performance of complex
                surgical tasks;**·**
            That
                a Head Mounted Display, or HMD is a more ergonomic display solution
                for
                surgeons and interventional physicians than conventional video monitors;
                and**·**
            That
                integrating additional information in a voice controlled,
                picture-in-picture format into the surgeon’s view, in conjunction with the
                anatomical view, can facilitate decision making during
                surgery.





As
      of
      March 31, 2007, we had an installed base of more than eighty-three (83) 3-D
      vision systems worldwide and more than 500 2-D digital cameras with OEM
      partners, including Boston Scientific Corporation and Medtronic, Inc.  The
      list price for products range from $100,000 to $200,000 for EndoSite 3Di Systems
      and from $3,000 to $27,000 for 2-D digital cameras and components.





Effective
      July 25, 2006, we changed our domicile from the State of Nevada to the State
      of
      Delaware by way of a reincorporation merger. Our Certificate of Incorporation
      and Bylaws as a Delaware corporation are similar to the Certificate of
      Incorporation and Bylaws we had as a Nevada Corporation. In May 2007, we amended
      our Articles of Incorporation in Delaware to increase the number of authorized
      common shares from 200,000,000 to 400,000,000 common shares.





**Use
      of Estimates and Critical Accounting Policies**





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





The
      preparation of our financial statements requires management to make estimates
      and assumptions that affect reported amounts of assets and liabilities and
      the
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. On an ongoing basis, management evaluates its estimates and
      assumptions, including those related to inventory, income taxes, long lived
      asset valuation, revenue recognition and stock based compensation and derivative
      liabilities. Management bases its estimates and judgments on historical
      experience of the operations and on various other factors that are believed
      to
      be reasonable under the circumstances, the results of which form the basis
      for
      making judgments about the carrying value of assets and liabilities that are
      not
      readily apparent from other sources. Actual results may differ from these
      estimates under different assumptions or conditions.


15





Management
      believes the following critical accounting policies, among others, will affect
      its more significant judgments and estimates used in the preparation of our
      Financial Statements.





***Inventory.*** Parts
      and
      supplies inventories are stated at the lower of cost or market. Cost is
      determined using the standard cost method. Work-in-process and finished goods
      are stated at the lower of the accumulated manufacturing costs or
      market. ****** Viking
      Systems reduces the stated value of its inventory for obsolescence or impairment
      in an amount equal to the difference between the cost of the inventory and
      the
      estimated market value, based upon assumptions about future demand and market
      conditions. If actual future demand or market conditions are less favorable
      than
      those projected by management, additional reductions in stated value may be
      required.





***Income
      Taxes.*** In
      determining the carrying value of Viking Systems’ net deferred tax assets,
      Viking Systems must assess the likelihood of sufficient future taxable income
      in
      certain tax jurisdictions, based on estimates and assumptions, to realize the
      benefit of these assets. If these estimates and assumptions change in the
      future, Viking Systems may record a reduction in the valuation allowance,
      resulting in an income tax benefit in Viking Systems’ Statements of Operations.
      Management evaluates the realizability of the deferred tax assets and assesses
      the valuation allowance quarterly.





Effective
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board ("FASB") Interpretation No. 48 ("FIN 48"), Accounting for
      Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.
      The
      implementation of FIN 48 had no impact on the Company's financial statements.




The
      Company is primarily subject to U.S. federal and state income tax. Tax years
      subsequent to December 31, 2003 remain open to examination by U.S. federal
      and
      state tax authorities. In addition, the Company's policy is to recognize
      interest and penalties related to income tax matters in income tax expense.
      As
      of January 1 and March 31, 2007, the Company had no accruals for interest or
      penalties related to income tax matters.





***Amortization
      and Impairment of Long Lived Assets.*** Long
      lived assets, such as property, equipment and intangible assets are recorded
      at
      historical cost. We amortize our intangible assets using the straight-line
      method over their estimated useful lives, usually two to five years. We review
      intangible assets subject to amortization periodically to determine if any
      adverse conditions exist or a change in circumstances has occurred that would
      indicate impairment or a change in the remaining useful life. Conditions that
      would indicate impairment and trigger a more frequent impairment assessment
      include, but are not limited to a significant adverse change in the legal
      factors or business climate that could affect the value of an asset, or an
      adverse action or assessment by a regulator. If the carrying amount of an asset
      exceeds its estimated fair value, an impairment charge is recognized for the
      amount by which the carrying amount exceeds the estimated fair value of the
      asset. Assets to be disposed of are reported at the lower of the carrying amount
      or fair value, less the estimated costs to sell. In addition, depreciation
      of
      the asset ceases. During the years ended December 31, 2006 and 2005, no
      impairment of long-lived assets was recorded.





***Revenue
      Recognition*** .
      Our
      revenues are derived from the sale of surgical visualization technology products
      to end users, distributors and original equipment manufacturers. Revenue from
      the sale of products is recognized when a purchase order has been received,
      the
      product has been shipped, the selling price is fixed or determinable, and
      collection is reasonably assured and when both title and risk of loss transfer
      to the customer, provided that no significant obligations remain. If
      installation is included as part of the contract, revenue is not recognized
      until installation has occurred, or until any remaining installation obligation
      is deemed to be perfunctory. Shipping and handling costs are included in cost
      of
      sales.





For
      the
      sale of products and services as part of a multiple-element arrangement, we
      allocate revenue from multiple-element arrangements to the elements based on
      the
      relative fair value of each element. The allocation of fair value for a
      multiple-element arrangement is based on vendor specific objective evidence
      (“VSOE”) or in absence of VSOE for delivered elements, the residual method. In
      the absence of VSOE for undelivered elements, revenue is deferred and
      subsequently recognized over the term of the arrangement. For sales of extended
      warranties with a separate contract price, Viking defers revenue equal to the
      separately stated price. Revenue associated with undelivered elements is
      deferred and recorded when delivery occurs.





***Stock-Based
      Compensation.*** On
      January 1, 2006 the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No.123 (Revised 2004), “ *Share
      Based Payment* ,”
(“SFAS
      123R”), using the modified prospective method. In accordance with SFAS 123R, the
      Company measures the cost of employee services received in exchange for an
      award
      of equity instruments based on the grant-date fair value of the award. That
      cost
      is recognized over the period during which an employee is required to provide
      service in exchange for the award - the requisite service period. The Company
      determines the grant-date fair value of employee share options using the
      Black-Scholes option-pricing model.


16


***Valuation
      of Derivative Liabilities.*** At
      each subsequent balance sheet date, the fair value of all warrants and other
      derivative liabilities are remeasured, and any changes in the fair value are
      recorded as a gain or loss on derivatives in the statement of
      operations.





**Recent
      Accounting Pronouncements**





In
      June
      2006, the FASB ratified the consensus on Emerging Issues Task Force ("EITF")
      Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental
      Authorities Should Be Presented in the Income Statement" ("EITF No. 06-3").
      The
      scope of EITF No. 06-3 includes any tax assessed by a governmental authority
      that is directly imposed on a revenue-producing transaction between a seller
      and
      a customer and may include, but is not limited to, sales, use, value added,
      Universal Service Fund ("USF") contributions and some excise taxes. The Task
      Force affirmed its conclusion that entities should present these taxes in the
      income statement on either a gross or a net basis, based on their accounting
      policy, which should be disclosed pursuant to APB Opinion No. 22, "Disclosure
      of
      Accounting Policies." If such taxes are significant and are presented on a
      gross
      basis, the amounts of those taxes should be disclosed. The consensus on EITF
      No.
      06-3 will be effective for interim and annual reporting periods beginning after
      December 15, 2006. The adoption of EITF 06-3 during the 1 st quarter
      of 2007 did not have a material impact on our financial position, results of
      operations or cash flows.





In
      November 2006, the EITF reached a final consensus in EITF Issue 06-06 “Debtor’s
      Accounting for a Modification (or Exchange) of Convertible Debt Instruments”
(“EITF No. 06-6”). EITF No. 06-6 addresses the modification of a convertible
      debt instrument that changes the fair value of an embedded conversion option
      and
      the subsequent recognition of interest expense for the associated debt
      instrument when the modification does not result in a debt extinguishment
      pursuant to EITF No. 96-19, “Debtor’s Accounting or a Modification or Exchange
      of Debt Instruments.” The consensus should be applied to modifications or
      exchanges of debt instruments occurring in interim or annual periods beginning
      after November 29, 2006. The adoption of EITF 06-6 during the 1 st quarter
      of 2007 did not have a material impact on our financial position, results of
      operations or cash flows.





In
      November 2006, the FASB ratified EITF Issue No. 06-7, “Issuer’s Accounting for a
      Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
      the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities” (“EITF
      No. 06-7”). At the time of issuance, an embedded conversion option in a
      convertible debt instrument may be required to be bifurcated from the debt
      instrument and accounted for separately by the issuer as a derivative under
      SFAS
      No. 133, based on the application of EITF No. 00-19. Subsequent to the issuance
      of the convertible debt, facts may change and cause the embedded conversion
      option to no longer meet the conditions for separate accounting as a derivative
      instrument, such as when the bifurcated instrument meets the conditions of
      EITF
      No. 00-19 to be classified in stockholders’ equity. Under EITF No. 06-7, when an
      embedded conversion option previously accounted for as a derivative under SFAS
      No. 133 no longer meets the bifurcation criteria under that standard, an issuer
      shall disclose a description of the principal changes causing the embedded
      conversion option to no longer require bifurcation under SFAS No. 133 and the
      amount of the liability for the conversion option reclassified to stockholders’
equity. EITF No. 06-7 should be applied to all previously bifurcated conversion
      options in convertible debt instruments that no longer meet the bifurcation
      criteria in SFAS No. 133 in interim or annual periods beginning after December
      15, 2006, regardless of whether the debt instrument was entered into prior
      or
      subsequent to the effective date of EITF No. 06-7. Earlier application of EITF
      No. 06-7 is permitted in periods for which financial statements have not yet
      been issued. The adoption of EITF 06-7 during the 1 st quarter
      of 2007 did not have a material impact on our financial position, results of
      operations or cash flows.


17





**RESULTS
      OF OPERATIONS**





**Three
      Month Period Ended March 31, 2007 Compared to the Three Month Period Ended
      March
      31, 2006**





***Sales.*** ** For
      the
      three months ended March 31, 2007, we had sales $1,925,245 compared to sales
      of
      $1,254,844 for the three months ended March 31, 2007. This represents an
      increase of $670,401 or 53%. Sales to individual customers exceeding 10% or
      more
      of revenues in the three months ended March 31, 2007 were to three customers
      who
      accounted for 20.3%, 17.3%, and 13% of revenues, respectively.





***Gross
      Profit.*** We had
      gross profit of $545,030 or 28% of total revenues for the three months ended
      March 31, 2007 and gross profit of $364,967 or 29% of total revenues for the
      three months ended March 31, 2006, representing an increase of $180,063. The
      increase in gross profit dollars during the first quarter of 2007 was due to
      increased sales compared to the prior quarter.





***Sales
      and Marketing Expenses*** **.** Selling
      and Marketing expenses were $1,144,773 for the three months ended March 31,
      2007
      and $874,368 for the three months ended March 31, 2006. Viking Systems continued
      to add employees in 2006, resulting in nearly a $230,000 increase in sales
      and
      marketing salaries, commissions, deferred compensation and payroll related
      costs
      in the first quarter of 2007 over 2006. Sales and marketing travel,
      entertainment and transportation expense was up approximately $52,000 and
      repairs, maintenance, telephone and facility costs and depreciation of trade
      show and demonstration equipment increased over $46,000 in the first quarter
      of
      2007 over 2006. In addition, tradeshows, sales meeting and other marketing
      efforts increased by approximately $12,000 in 2007 over 2006. Recruitment fees
      decreased by approximately $58,000 in 2007 and operating supplies were lower
      by
      $12,000 in 2007 from 2006.





***Research
      and Development Expenses.*** ** Research
      and Development expenses were $411,917 for the three months ended March 31,
      2007
      and $310,224 for the three months ended March 31, 2006. The year-over-year
      increase is due to the continued development of our 3Di product line as well
      as
      the development of OEM customer product lines for new customers. We expect
      that
      our research and development expenses will increase from current levels as
      we
      continue to develop, maintain and support our current products and introduce
      new
      products.





***General
      and Administrative Expenses.*** ** We had
      General and Administrative expenses of $632,074 for the three months ended
      March
      31, 2007 and $529,190 for the three months ended March 31, 2006. We expect
      that
      our General and Administrative expenses will increase from their current levels
      as we implement and document internal controls in connection with our efforts
      to
      become compliant with requirements of Section 404 of The Sarbanes - Oxley Act
      of
      2002 and expend resources on the implementation of a new ERP system. During
      the
      three months ended March 31, 2007 and 2006 we recorded $74,732 and $156,612,
      respectively, in incremental stock-based compensation expense associated with
      the adoption of Statement of Financial Accounting Standards No. 123(Revised
      2004), *Share-based
      Payment.*





***Other
      Income and Expenses.*** We
      had
      interest income of $15,409 for the three months ended March 31, 2007. We had
      no
      such income in the comparable periods in 2006. Interest income in 2007 resulted
      from the proceeds of our February 2007 convertible debt financing being
      deposited in interest bearing accounts. We had non-cash amortization of debt
      discount expense for the three months ended March 31, 2007 of $139,014 and
      amortization of debt discount expense of $2,980,924 for the three months ended
      March 31, 2006. We also adjusted the fair value of all the Company’s warrants
      and derivative liabilities with the recognition of a non-cash derivative
      liability loss of $1,261,184 for the three months ended March 31,
      2007.





***Net
      Income (Loss).*** We had a
      net loss of $3,215,226 for the three months ended March 31, 2007 and a net
      loss
      of $4,475,104 for the three months ended March 31, 2006. We incurred significant
      costs operating our business, and implementing our sales and marketing plan.





**LIQUIDITY
      AND CAPITAL RESOURCES**





We
      have
      financed our operations principally through private sales of equity securities
      and convertible notes. From January 1, 2004 through March 31, 2007, we have
      raised net proceeds of $8,150,000 through the sale of common and preferred
      stock
      in private placements, and approximately $11,000,000 through the issuance of
      convertible promissory notes. As of March 31, 2007, we had cash, cash
      equivalents and short-term investments of $2,577,156 compared to $440,465 as
      of
      December 31, 2006. We incurred operating losses in 2007 and 2006, and at March
      31, 2007, had an accumulated deficit of approximately
      $21,764,000.


18


Net
      cash
      used in operating activities was $2,777,833 **** and
      $666,130 during the three months ended March 31, 2007 and 2006, respectively.
      The increase in net cash used in operating activities during 2007 compared
      to
      2006 was attributable primarily to the operating loss of $1,643,734, an
      investment in inventories, increase in accounts receivable due to higher sales,
      and the increased operating expenses associated with expanding the Company’s
      business activities.





Net
      cash
      used in investing activities was $3,482 and $35,266 during the three months
      ended March 31, 2007 and 2006, respectively. The higher level of cash used
      in
      investing activities in 2007 was attributable to purchases of demonstration
      equipment of our 3Di product line in support of our sales and marketing
      efforts.





Cash
      flow
      provided by financing activities was $4,918,006 and $358,705 during the three
      months ended March 31, 2007 and 2006, respectively. The cash flows from
      financing activities in the three months ended March 31, 2007 consisted of
      $4,927,848 in net proceeds from related party and convertible notes payable,
      offset by $9,842 in repayments of capital lease obligations. In the three months
      ended March 31, 2006, cash provided by financing activities consisted of
      $158,705 in short term bank borrowings and $200,000 in proceeds from related
      party notes. In the three months ended March 31, 2006, Viking had an agreement
      with a bank through which the bank advanced funds to Viking Systems equal to
      80%
      of receivables resulting from sales by Viking Systems up to a maximum of
      $400,000. Funds advanced accrued interest at prime plus 3.5%. The agreement
      originally expired on September 14, 2006 and was extended until it was cancelled
      by the Company upon the completion of the February 2007 convertible note
      financing.




Additionally,
      we are continuing our efforts to achieve profitability through increased sales
      and profit margins. There can be no assurance that we will be successful in
      our
      efforts to achieve profitable operations. If we are unable to do so we may
      be
      required to reduce operations, reduce or discontinue further research and
      development, and/or reduce or eliminate further acquisition
      activities.





During
      2005, Viking issued Convertible Promissory Notes (“Notes”) to certain accredited
      investors. Each of these investors was also issued a warrant to purchase shares
      of Viking common stock. In May 2006, each of the Note holders converted their
      Notes into shares of Viking common stock. In April 2006, Viking agreed to file,
      prior to June 21, 2006, a registration statement covering the shares of common
      stock issued upon the conversion of the Notes and shares of common stock
      underlying the warrants of these former Note holders. As a result of the
      required terms of the Series B Preferred Stock transaction in 2006, we were
      unable to include the securities of the former Note holders in the first
      registration statement. During August 2006, we agreed to pay a delay fee to
      the
      note purchasers at the rate of one percent per month to those former Note
      holders who elect to receive a fee. The delay fee began on June 21, 2006 and
      terminates on the date the Securities and Exchange Commission declares effective
      a registration statement covering the securities of the Note purchasers. Given
      the former Note holders who have waived the fee to date, we expect the aggregate
      monthly delay fee to be approximately $36,000. We are unable to predict when
      the
      delay fee will terminate. Through March 31, 2007, the cumulative accrued delay
      fee totaled $300,300.





***Off-Balance
      Sheet Arrangements.*** We do
      not have any off balance sheet arrangements that are reasonably likely to have
      a
      current or future effect on our financial condition, revenues, results of
      operation, liquidity or capital expenditures.


This
        Form
        10-QSB contains certain “forward-looking statements” within the meaning of
        Section 27A of the Securities Act and Section 21E of the Exchange Act with
        respect to results of our operations and businesses. All statements, other
        than
        statements of historical facts, included in this Form 10-QSB, including those
        regarding market trends, our financial position, business strategy, projected
        costs, and plans and objectives of management for future operations, are
        forward-looking statements. In general, such statements are identified by
        the
        use of forward- looking words or phrases including, but not limited to,
“intended,” “will,” “should,” “may,” “expects,” “expected,” “anticipates,” and
“anticipated” or the negative thereof or variations thereon or similar
        terminology. These forward-looking statements are based on our current
        expectations. Although we believe that the expectations reflected in such
        forward-looking statements are reasonable, there can be no assurance that
        such
        expectations will prove to be correct. Because forward-looking statements
        involve risks and uncertainties, our actual results could differ materially.
        Important factors that could cause actual results to differ materially from
        our
        expectations are disclosed hereunder and elsewhere in this Form 10-QSB. These
        forward-looking statements represent our judgment as of the date of this
        Form
        10-QSB. All subsequent written and oral forward-looking statements attributable
        to us are expressly qualified in their entirety by the Cautionary Statements.
        We
        disclaim, however, any intent or obligation to update our forward-looking
        statements.


**Forward
      Outlook and Risks**





Except
      as
      set forth below, during the quarter ended March 31, 2007, there were no material
      changes to the quantitative and qualitative disclosures of our Risk Factors
      previously reported in the Annual Report contained in the Company's Form 10-KSB
      for the year ended December 31, 2006. See "Risk Factors" in the Company's in
      the
      Managements Discussion an Analysis Section of  Form 10-KSB for the year
      ended December 31, 2006 for a detailed discussion.





***Issuance
      of Convertible Notes Payable Debebtures*** In
      February 2007, Viking Systems **** issued
      a
      total of $5,376,533 of 8% convertible debentures to 13 Investors and mature
      two
      years from the date of issuance or may be accelerated upon default by Viking.
      Viking may issue additional Debentures. We
      are
      required to pay interest on these Debentures at 8% per annum. The
      Debentures are secured by all of the assets of Viking. The Debentures may,
      at
      the option of the Investors, be converted into shares of Viking common stock
      at
      the price of $0.18 per share. In the event Viking does not achieve certain
      operation milestones (described in the Debentures Warrants) during the first
      three quarters of 2007, the conversion price will be reduced to $0.12 per share.
      The conversion price is also subject to downward adjustment, upon certain
      conditions pursuant to the terms of Security Purchase Agreement, the Debentures
      and other Transaction Documents. The
      other
      terms and conditions of the Debentures are described in footnote 8 to the
      financial statements included in this form 10-QSB.


19





As
      additional consideration for the Investors purchasing the Debentures, Viking
      has
      issued the Investors Warrants to purchase shares of Viking common stock at
      the
      price of $0.18 per share. In the event Viking does not achieve certain operation
      milestones (described in the Warrants and the Debentures) during the first
      three
      quarters of 2007, the exercise price will be reduced to $0.12 per share. The
      exercise price is also subject to downward adjustment, upon certain conditions
      pursuant to the terms of Security Purchase Agreement, the Warrant and other
      Transaction Documents. The Warrants are exercisable for a period of seven years
      from the date of issuance. The Warrants provide that each Investor is issued
      to
      purchase that number of shares of common stock of Viking that equals 50% of
      the
      number of shares issuable upon conversion of the Debentures. Assuming $6,000,000
      of Debentures are sold, and assuming the Debentures are convertible into
      33,333,333 shares of Viking common stock, the warrants will entitle the holders
      to purchase an aggregate of approximately 16,666,667 shares of Viking common
      stock. Assuming $6,000,000 of Debentures are sold, and assuming the Debentures
      are convertible into 50,000,000 shares of Viking common stock, the warrants
      will
      entitle the holders to purchase an aggregate of approximately 25,000,000 shares
      of Viking common stock.




Viking
      has agreed to register with the Securities and Exchange Commission, the shares
      of common stock that are issuable upon the conversion of the Debentures and
      the
      shares of common stock that underlie the Warrants. Viking will pay all expenses
      and cost of registration except for commissions. In the event the securities
      underlying the debentures and warrants are not registered by the dates agreed
      to
      in the transaction documents, Viking will be required to pay liquidated damages
      to the Holders. Such liquidated damages amount to 2% per month but will not
      exceed 18% of the face amount of the Debentures.





***Additional
      Financing Requirements.*** We completed the convertible Debentures transaction in February 2007. We
      anticipate that we will have adequate cash resources to fund our operations
      for
      approximately the next 2 months. We expect to raise additional funds through
      debt or the sale of additional equity securities to maintain sufficient
      operating capital. Thereafter, our liquidity and capital requirements will
      depend upon numerous other factors, including the following:




**·**
            The
                extent to which our products and services gain market
                acceptance;**·**
            The
                progress and scope of product evaluations;**·**
            The
                timing and costs of filing future regulatory
                submissions;**·**
            The
                timing and costs required to receive both domestic and international
                governmental approvals;**·**
            The
                timing and costs of acquisitions and product and services
                introductions;**·**
            The
                extent of our ongoing research and development
                programs;**·**
            The
                costs of sponsorship training of physicians to become proficient
                in the
                use of our products and procedures; and**·**
            The
                costs of developing marketing and distribution
                capabilities.





If,
      in
      the future we are required to seek additional financing in order to fund our
      operations and carry out our business plan, there can be no assurance that
      such
      financing will be available on acceptable terms, or at all, and there can be
      no
      assurance that any such arrangement, if required or otherwise sought, would
      be
      available on terms deemed to be commercially acceptable and in our best
      interests.






**ITEM
      3.  CONTROLS AND PROCEDURES**




**EVALUATION
      OF DISCLOSURE CONTROLS AND PROCEDURES**


We
        maintain disclosure controls and procedures that are designed to ensure that
        information required to be disclosed in our reports under the Securities
        Exchange Act of 1934, as amended, (the “Exchange Act”) is recorded, processed,
        summarized and reported within the time periods specified in the Securities
        and
        Exchange Commission’s 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 allow timely decisions regarding
        required disclosure.
 
 As
        of the
        end of the period covered by this report, we carried our an evalutaion, under
        the supervision and with the participation of our Chief Executive Officer
        and
        Chief Financial Officer, of the effectiveness of our disclosure controls
        and
        procedures pursuant to Rule 13a-15 or 15a-15 of the Exchange Act. Based upon
        that evaluation, our Chief Executive Officer and Chief Financial Officer
        concluded that, as of the end of the period covered by this report, our
        disclosure controls and procedures are effective at the reasonable assurance
        level.
 
 We
        believe that a control system, no matter how well designed and operated,
        can
        only provide reasonable, not absolute, assurance that the objectives of the
        controls system are met. In reaching a reasonable level of assurance, management
        necessarily was required to apply its judgment in evaluating the cost-benefit
        relationship of possible controls and procedures. In addition, the design
        of any
        system of controls also is based in part upon certain assumptions about the
        likelihood of future events, and there can be no assurance that any design
        will
        succeed in achieving its stated goals under all potential future conditions.
        Over time, a control may become inadequate because of changes in conditions,
        or
        the degree of compliance with policies or procedures may deteriorate. No
        evaluation of controls can provide absolute assurance that all control issues
        and instances of fraud, if any, within a company will be
        detected.


20





**PART
      II - OTHER INFORMATION**


Item
        1  Legal
        Proceedings .
        We are
        not a party to any legal proceeding.
 
 Item
        2  Unregistered
        Sales of Equity Securities .
        During
        the quarter ended March 31, 2007, we issued 4,000,000 shares of our common
        stock
        in an unregistered transaction. Such shares were issued in connection with
        the
        Consent, Waiver and Amendment Agreement with our Series B Preferred shareholders
        as payment in lieu of liquidated damages resulting from our failure to effect
        the registration of all the securities underlying the Series B preferred
        shares.
        The shares were issued pursuant to Section 4(2) of the Securities Act of
        1933,
        as amended, (the “Securities Act”) and/or Rule 506 promulgated thereunder. Each
        of the Series B shareholders to which the shares of common stock were issued
        is
        an accredited investor as that term is defined in Regulation D promulgated
        under
        the Securities Act.
 
 Item
        3.  Defaults
        by the Company on its Senior Securities .
        We are
        required to pay dividends under the terms of our Series B Preferred Stock
        transaction documents. We
        have
        failed to pay dividends to date, and are accruing interest on the unpaid
        dividends at 18% per annum per the terms of our agreement. As of the date
        of
        filing this report, the amount of unpaid dividends totals approximately $632,987
        and the arrearage is $552,329.
 
 Item
        4.  Submission
        of Matters to Vote of Security Holders .
        On
        January 31, 2007 the holders of 33,154,483 shares of our common stock out
        of the
        61,864,941 shares of common stock then issued and outstanding consented in
        writing to a proposal to amend our Articles of Incorporation to increase
        the
        number of shares of common stock which we are authorized to issue from
        200,000,000 to 400,000,000. This consent was obtained in lieu of holding
        a
        meeting of shareholders. A Preliminary Information Statement and a Final
        Information Statement on Schedule 14(c) were filed with the Securities and
        Exchange Commission in connection with such written consent and we effected
        the
        amendment to increase our authorized shares. The increase in authorized shares
        was effective as of May 4, 2007.
 
 Item
        5.  Other
        Information .
        None
  Item
        6.
Exhibits
 ExhibitNumber
                Exhibit3
                    (i)
                Articles
                    of Incorporation (1)3
                    (ii)
                Bylaws
                    (2)4
                REGISTRATION
                    RIGHTS AGREEMENT (3)10.1
                SECURITIES
                    PURCHASE AGREEMENT (3)10.3
                SECURED
                    CONVERTIBLE DEBENTURE (3)10.4
                COMMON
                    STOCK PURCHASE WARRANT (3)10.5
                SECURITY
                    AGREEMENT (3)10.6
                WAIVER
                    AND AMENDMENT AGREEMENT (3)10.7
                LiveData
                    OEM License and Reseller Agreement (1)31.1
                Certification
                    of Chief Executive Officer in accordance with 18 U.S.C. Section
                    1350, as
                    adopted by Section 302 of the Sarbanes- Oxley Act of 2002
                    (1)31.2
                Certification
                    of Principal Financial Officer in accordance with 18 U.S.C. Section
                    1350,
                    as adopted by Section 302 of the Sarbanes-Oxley Act of 2002
                    (1)32.1
                Certification
                    of Chief Executive Officer in accordance with 18 U.S.C. Section
                    1350, as
                    adopted by Section 906 of the Sarbanes-Oxley Act of 2002
                    (1)32.2
                Certification
                    of Chief Financial Officer in accordance with 18 U.S.C. Section
                    1350, as
                    adopted by Section 906 of the Sarbanes-Oxley Act of 2002
                    (1)
 _________________
  (1)
                Attached(2)
                Incorporated
                    herein by reference from Registrant’s Form 8-K dated July 25,
                    2006.(3)
                Incorporated
                    herein by reference from Registrant’s Form 8-K dated February 27,
                    2007(4)
                Incorporated
                    herein by reference from Registrant’s Form 8-K dated April 6,
                    2007.


21





SIGNATURE





In
      accordance with the requirements of the Exchange Act, the Company has caused
      this report to be signed on its behalf by the undersigned thereunto duly
      authorized.





Dated:
                May 14, 2007
            VIKING
                SYSTEMS, INC.By: 
                /s/ Donald
                TuckerDonald
                Tucker
              Chief
                Executive Officer, PresidentBy: 
                /s/ John ConatonJohn
                Conaton
              Chief
                Financial Officer




22