UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


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





For the
quarterly period ended    September 30,
2009_______________________________________





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




For the
transition period from
___________________________________to__________________________________




Commission
File Number:  000-52018________________________________________________________________





VirtualScopics, Inc


(Exact
name of registrant as specified in its charter)





Delaware
              
              04-3007151(State
      or other jurisdiction of incorporation or organization)
              
              (I.R.S.
      Employer Identification No.)








500 Linden Oaks, Rochester, New
      York
              
              14625(Address
      of principal executive offices)
              
              (Zip
      Code)





(585)249-6231


(Registrant’s
telephone number, including area code)









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





Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days.





xYeso
No





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


oYes   oNo





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
      accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈  (Do
      not check if a smaller reporting company)
              Smaller
      reporting company x





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


Yes  ̈ No x


Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.





As of
October 30, 2009, there were 24,897,069 shares of the registrant’s common stock,
$0.001 par value, outstanding.








TABLE OF
CONTENTS





Page
      NumbersPART
      I
                                                      FINANCIAL
      INFORMATIONITEM
      1: Financial StatementsCondensed
      Consolidated Balance Sheets as of September 30, 2009
      (unaudited)and
      December 31, 2008
                                                      
                                                      1Unaudited
      Condensed Consolidated Statements of Operations for the three
      andnine
      monthsended
      September 30, 2009 and 2008
                                                      
                                                      2Unaudited
      Condensed Consolidated Statements of Cash Flows for the nine monthsended
      September 30, 2009 and 2008
                                                      
                                                      3Notes
      to Unaudited Condensed Consolidated Financial Statements
                                                      
                                                      4-11ITEM
      2: Management's Discussion and Analysis of  Financial Condition
      and Results of Operations
                                                      
                                                      12-19ITEM
      4T: Controls and Procedures
                                                      
                                                      19-20PART
      II
                                                      OTHER
      INFORMATIONITEM
      1: Legal Proceedings
                                                      
                                                      20ITEM
      2: Unregistered Sales of Equity Securities and Use of
    Proceeds
                                                      
                                                      20ITEM
      3: Defaults Upon Senior Securities
                                                      
                                                      20ITEM
      4: Submission of Matters to a Vote of Security Holders
                                                      
                                                      20ITEM
      5: Other Information
                                                      
                                                      20ITEM
      6: Exhibits
                                                      
                                                      20


i


PART
1:  FINANCIAL INFORMATION
 
 ITEM
1.  Financial Statements
 
 VirtualScopics,
Inc. and Subsidiary
 Condensed
Consolidated Balance Sheets




September 30,
                  
                  
                  December 31,2009
                  
                  
                  2008(Unaudited)AssetsCurrent
      assetsCash
                  
                  $
                  3,652,496
                  
                  
                  $
                  3,143,904Accounts
      receivable
                  
                  
                  1,812,627
                  
                  
                  
                  1,021,110Prepaid
      expenses and other current assets
                  
                  
                  359,425
                  
                  
                  
                  263,297Total
      current assets
                  
                  
                  5,824,548
                  
                  
                  
                  4,428,311Patents,
      net
                  
                  
                  1,864,284
                  
                  
                  
                  1,920,446Property
      and equipment, net
                  
                  
                  415,957
                  
                  
                  
                  355,479Other
      assets
                  
                  
                  64,140
                  
                  
                  
                  156,788Total
      assets
                  
                  $
                  8,168,929
                  
                  
                  $
                  6,861,024Liabilities
      and Stockholders' EquityCurrent
      liabilitiesAccounts
      payable and accrued expenses
                  
                  $
                  736,062
                  
                  
                  $
                  659,009Accrued
      payroll
                  
                  
                  547,729
                  
                  
                  
                  554,425Unearned
      revenue
                  
                  
                  1,238,606
                  
                  
                  
                  291,594Derivative
      liability
                  
                  
                  1,427,906
                  
                  
                  
                  -Total
      current liabilities
                  
                  
                  3,950,303
                  
                  
                  
                  1,505,028Commitments
      and Contingencies
                  
                  
                  -
                  
                  
                  
                  -Stockholders'
      EquityConvertible
      preferred stock, $0.001 par value; 15,000,000 shares
      authorized;8,400
      shares designated Series A; issued and outstanding, 3,563 shares at
      September 30, 2009 and 3,976 shares at December 31, 2008; liquidation
      preference $1,000 per share
                  
                  
                  4
                  
                  
                  
                  46,000
      shares designated Series B; issued and outstanding, 3,196 shares at
      September 30, 2009 and 4,226 at December 31, 2008; liquidation preference
      $1,000 per share
                  
                  
                  3
                  
                  
                  
                  4Common
      stock, $0.001 par value; 85,000,000 shares authorized;issued
      and outstanding, 24,788,278 shares at September 30, 2009 and 23,502,352
      shares at December 31, 2008
                  
                  
                  24,788
                  
                  
                  
                  23,503Additional
      paid-in capital
                  
                  
                  14,076,948
                  
                  
                  
                  16,546,550Accumulated
      deficit
                  
                  
                  (9,883,117
                  )
                  
                  
                  (11,214,065
                  )Total
      stockholders' equity
                  
                  
                  4,218,626
                  
                  
                  
                  5,355,996Total
      liabilities and stockholders' equity
                  
                  $
                  8,168,929
                  
                  
                  $
                  6,861,024





See notes
to condensed consolidated financial statements.


1


VirtualScopics,
Inc. and Subsidiary
 Condensed
Consolidated Statements of Operations
 (unaudited)





For the Three Months Ended
                    September 30,
                  
                  
                  For the Nine Months Ended
                    September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Revenues
                  
                  $
                  2,797,680
                  
                  
                  $
                  1,815,616
                  
                  
                  $
                  7,473,366
                  
                  
                  $
                  5,183,017Cost
      of services
                  
                  
                  1,201,353
                  
                  
                  
                  1,005,700
                  
                  
                  
                  3,363,916
                  
                  
                  
                  3,057,220Gross
      profit
                  
                  
                  1,596,327
                  
                  
                  
                  809,916
                  
                  
                  
                  4,109,450
                  
                  
                  
                  2,125,797Operating
      expensesResearch
      and development
                  
                  
                  255,755
                  
                  
                  
                  232,986
                  
                  
                  
                  749,490
                  
                  
                  
                  697,640Sales
      and marketing
                  
                  
                  238,112
                  
                  
                  
                  263,917
                  
                  
                  
                  877,788
                  
                  
                  
                  937,028General
      and administrative
                  
                  
                  798,427
                  
                  
                  
                  750,747
                  
                  
                  
                  2,502,618
                  
                  
                  
                  2,512,914Depreciation
      and amortization
                  
                  
                  114,707
                  
                  
                  
                  116,234
                  
                  
                  
                  351,344
                  
                  
                  
                  350,565Total
      operating expenses
                  
                  
                  1,407,001
                  
                  
                  
                  1,363,884
                  
                  
                  
                  4,481,240
                  
                  
                  
                  4,498,147Operating
      income (loss)
                  
                  
                  189,326
                  
                  
                  
                  (553,968
                  )
                  
                  
                  (371,790
                  )
                  
                  
                  (2,372,350
                  )Other
      income (expense)Interest
      income
                  
                  
                  668
                  
                  
                  
                  13,952
                  
                  
                  
                  3,948
                  
                  
                  
                  59,679Other
      expense
                  
                  
                  (4,226
                  )
                  
                  
                  (8,569
                  )
                  
                  
                  (12,303
                  )
                  
                  
                  (11,537
                  )Loss
      on derivative financial instrument
                  
                  
                  (401,675
                  )
                  
                  
                  -
                  
                  
                  
                  (1,004,998
                  )
                  
                  
                  -Total
      other income (expense)
                  
                  
                  (405,233
                  )
                  
                  
                  5,383
                  
                  
                  
                  (1,013,353
                  )
                  
                  
                  48,142Net
      loss
                  
                  
                  (215,907
                  )
                  
                  
                  (548,585
                  )
                  
                  
                  (1,385,143
                  )
                  
                  
                  (2,324,208
                  )Series
      B preferred stock dividend
                  
                  
                  75,476
                  
                  
                  
                  84,547
                  
                  
                  
                  244,516
                  
                  
                  
                  254,307Net
      loss attributable to common  stockholders
                  
                  $
                  (291,383
                  )
                  
                  $
                  (633,132
                  )
                  
                  $
                  (1,629,659
                  )
                  
                  $
                  (2,578,515
                  )Basic
      and diluted net loss per common share
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.03
                  )
                  
                  $
                  (0.07
                  )
                  
                  $
                  (0.11
                  )Weighted
      average number of common shares outstanding – basic and
      diluted
                  
                  
                  24,129,045
                  
                  
                  
                  23,459,853
                  
                  
                  
                  23,802,742
                  
                  
                  
                  23,355,232





See notes
to condensed consolidated financial statements.


2




VirtualScopics,
Inc. and Subsidiary
 Condensed
Consolidated Statements of Cash Flows
 (unaudited)


For the Nine Months Ened September30,2009
                    
                    
                    2008Cash
      flows from operating activitiesNet
      loss
                    
                    $
                    (1,385,143
                    )
                    
                    $
                    (2,324,208
                    )Adjustments
      to reconcile net loss  to net cash provided by (used in)
      operating activities:Depreciation
      and amortization
                    
                    
                    351,344
                    
                    
                    
                    350,565Loss
      on disposal of asset
                    
                    
                    2,904
                    
                    
                    
                    -Stock-based
      compensation expense
                    
                    
                    836,403
                    
                    
                    
                    923,891Issuance
      of equity instruments for rent
                    
                    
                    105,570
                    
                    
                    
                    170,000Accrual
      for future issuance of equity instruments for services
                    
                    
                    -
                    
                    
                    
                    153,000Fair
      value adjustment of derivative liability
                    
                    
                    1,004,998
                    
                    
                    
                    -Changes
      in operating assets and liabilitiesAccounts
      receivable
                    
                    
                    (791,517
                    )
                    
                    
                    (183,076
                    )Prepaid
      expenses and other assets
                    
                    
                    (96,128
                    )
                    
                    
                    13,824Accounts
      payable and accrued expenses
                    
                    
                    50,277
                    
                    
                    
                    (242,170
                    )Accrued
      payroll
                    
                    
                    (6,696
                    )
                    
                    
                    169,743Unearned
      revenue
                    
                    
                    947,012
                    
                    
                    
                    17,997Total
      adjustments
                    
                    
                    2,404,167
                    
                    
                    
                    1,373,774Net
      cash provided by (used in) operating activities
                    
                    
                    1,019,024
                    
                    
                    
                    (950,434
                    )Cash
      flows from investing activitiesPurchase
      of equipment
                    
                    
                    (222,872
                    )
                    
                    
                    (21,773
                    )Acquisition
      of patents
                    
                    
                    (43,044
                    )
                    
                    
                    (68,006
                    )Net
      cash used in investing activities
                    
                    
                    (265,916
                    )
                    
                    
                    (89,779
                    )Cash
      flows from financing activitiesRestricted
      cash
                    
                    
                    -
                    
                    
                    
                    396,370Proceeds
      from the exercise of warrants
                    
                    
                    -
                    
                    
                    
                    876Cash
      dividends on series B preferred stock
                    
                    
                    (244,516
                    )
                    
                    
                    (254,307
                    )Net
      cash (used in) provided by financing activities
                    
                    
                    (244,516
                    )
                    
                    
                    142,939Net
      increase (decrease) in cash and cash equivalents
                    
                    
                    508,592
                    
                    
                    
                    (897,274
                    )Cash
      and cash equivalentsBeginning
      of period
                    
                    
                    3,143,904
                    
                    
                    
                    3,955,835End
      of period
                    
                    $
                    3,652,496
                    
                    
                    $
                    3,058,561Supplemental
      disclosure of cash flow informationNon-cash
      financing activity:Issuance
      of common stock for partial payment of rent in equity
                    
                    $
                    105,570
                    
                    
                    $
                    170,000





See notes
to condensed consolidated financial statements.


3


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





NOTE 1 -
Organization and Basis
of Presentation





Nature of
Business


The
Company’s headquarters are located in Rochester, New York.  The
Company’s business evolved from research first carried out at the University of
Rochester, a related party.  As a result of this research, the Company
has created a suite of image analysis software tools and applications which are
used in detecting and measuring specific anatomical structures and metabolic
activity using medical images.  The Company’s developed proprietary
software provides measurement capabilities designed to improve clinical research
and development.





Basis of
Presentation


The
accompanying unaudited condensed consolidated financial statements of the
Company have been condensed in certain respects and should, therefore, be read
in conjunction with the audited consolidated financial statements and notes
related thereto contained in the Company’s Annual Report on Form 10-K as of and
for the year ended December 31, 2008.  In the opinion
of  management, these financial statements contain all adjustments
necessary for a fair presentation for the interim period, all of which were
normal recurring adjustments.  The results of operations for the nine
months ended September 30, 2009 are not necessarily indicative of the results to
be expected for the full year ending December 31, 2009.





In
February 2008, the Company received a written notice from the Nasdaq Stock
Market indicating that its common stock was not in compliance with minimum bid
price required for continued listing on the Nasdaq Capital
Market.  The Company was granted additional time by Nasdaq to regain
compliance with the continued listing requirements. In its 2009 proxy, the
Company included the proposal for stockholders to vote on the ability for the
board of directors to effectuate a reverse stock split any time prior to May 28,
2010 as a possible mechanism to regain compliance with Nasdaq. The stockholders
approved the proposal, however, on May 19, 2009, the Company regained compliance
and therefore, it does not anticipate effectuating a reverse stock
split.





NOTE 2 -
Summary of Certain
Significant Accounting Policies





Principles of
Consolidation


All
significant intercompany balances and transactions have been eliminated in
consolidation.





Revenue
Recognition


The
Company applies the revenue recognition principles set forth under the
Accounting Standards Codification (“ASC”) 605, “Revenue Recognition,” with
respect to its revenues from image analysis, consulting and project/data
management services, and recognizes revenue when it is realized or realizable
and earned.  The Company considers revenue realized or realizable and
earned when an agreement exists, services and products are provided to the
customer, prices are fixed or determinable, and collectability is reasonably
assured.  Revenues are reduced for estimated discounts and other
allowances, if any.





The
Company provides advanced medical image analysis on a per analysis basis, and
recognizes revenue when the image analysis is completed and delivered to the
customer.  Revenue related to project, data and site management
services is recognized as the services are rendered and in accordance with the
terms of the contract.  Consulting revenue is recognized once the
services are rendered and typically charged as an hourly rate.





Occasionally,
the Company provides software development services to its customers, which may
require significant development, modification, and
customization.  Software development revenue is billed on a fixed
price basis and recognized upon delivery of the software and acceptance by the
customer on a completed contract basis in accordance with ASC 605-35,
“Construction – Type and Production-Type Contracts.”  The Company does
not sell software, software licenses, upgrades or enhancements, or post-contract
customer services.


4


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Reimbursements
received for out-of-pocket expenses incurred are reported as revenue in the
financial statements in accordance with ASC 605-45, “Principal Agent
Considerations.”





Research and
Development


Research
and development expense relates to the development of new products and processes
including improvements to existing products. These costs are expensed as
incurred.





Fair Value of Financial
Instruments


The
Company’s financial instruments are cash, accounts receivable and accounts
payable.  The recorded values of cash, accounts receivable and accounts
payable approximate their fair values based on their short-term
nature.





Subsequent
Events


Management
has evaluated subsequent events or transactions occurring through November 13,
2009, the date the financial statements were issued, to determine if such events
or transactions require adjustment or disclosure in the financial
statements.





Derivative Financial
Instruments


The
Company does not use derivative instruments to hedge exposures to cash flow,
market or foreign currency risks.  The Company evaluates all of its
financial instruments to determine if such instruments are derivatives or
contain features that qualify as embedded derivatives.  For derivative
financial instruments that are accounted for as liabilities, the derivative
instrument is initially recorded at its fair value and is then re-valued at each
reporting date, with changes in the fair value reported in the condensed
consolidated statements of operations.  For stock-based derivative
financial instruments, the Company uses the Black-Scholes option valuation model
to value the derivative instruments at inception and on subsequent valuation
dates.  The classification of derivative instruments, including
whether such instruments should be recorded as liabilities or as equity, is
evaluated at the end of each reporting period.  Derivative instrument
liabilities are classified in the balance sheet as current or non-current based
on whether or not net-cash settlement of the derivative instrument could be
required within 12 months of the balance sheet date.





Recently Issued and Adopted
Accounting Pronouncements




On
September 30, 2009, the Company adopted changes issued by the Financial
Accounting Standards Board (FASB) to the authoritative hierarchy of GAAP. These
changes establish the FASB Accounting Standards Codification TM (Codification)
as the source of authoritative accounting principles recognized by the FASB to
be applied by nongovernmental entities in the preparation of financial
statements in conformity with GAAP. Rules and interpretive releases of the
Securities and Exchange Commission (SEC) under authority of federal securities
laws are also sources of authoritative GAAP for SEC registrants. The FASB will
no longer issue new standards in the form of Statements, FASB Staff Positions,
or Emerging Issues Task Force Abstracts; instead the FASB will issue Accounting
Standards Updates. Accounting Standards Updates will not be authoritative in
their own right as they will only serve to update the Codification. These
changes and the Codification itself do not change GAAP. Other than the manner in
which new accounting standards are referenced, the adoption of these changes had
no impact on the Financial Statements.




Fair
Value




The
Company adopted a new accounting standard included in ASC 820, “Fair Value
Measurements and Disclosures”, which delayed the effective date for disclosing
all non-financial assets and non-financial liabilities, except for items that
are recognized or disclosed at fair value on a recurring basis (at least
annually). This standard did not have a material impact on the Company’s
financial condition and results of operations. See Note 5, “Fair Value
Measurements”.


5


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)




The
Company adopted a new accounting standard related to interim disclosures about
fair value of financial instruments included in ASC 825, “Financial
Instruments,” which requires disclosures about fair value of financial
instruments for interim reporting periods of publicly-traded companies, as well
as in annual financial statements. Our adoption of this standard, effective
April 1, 2009, did not impact our consolidated financial condition or
results of operations.




Business
Combinations




The
Company adopted a new accounting standard included in ASC 805, “Business
Combinations,” which significantly changed the accounting for and reporting of
business combination transactions. This standard was effective for the Company
for business combination transactions for which the acquisition date was on or
after January 1, 2009. The adoption of this standard will have an impact on
the Company’s accounting for any future business combinations.




Consolidation





The
Company adopted a new accounting standard included in ASC 810, “Consolidation,”
which establishes new accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary through the
use of disclosures that clearly identify and distinguish between the interests
of the parent and the interests of the noncontrolling owners. This standard is
effective for fiscal years beginning on or after December 15, 2008 with early
adoption prohibited.   The new standard would have an impact on the
presentation and disclosure of the non-controlling interests of any non
wholly-owned businesses acquired by the Company in the future.




Derivative
Instruments and Hedging Activities




The
Company adopted a new accounting standard included in ASC 815, “Derivatives and
Hedging,” requiring entities to provide greater transparency through additional
disclosures about (a) how and why an entity uses derivative instruments,
(b) how derivative instruments and related hedged items are accounted for
under U.S. GAAP, and (c) how derivative instruments and related hedged
items affect an entity’s financial position, results of operations and cash
flows. Additional disclosures have been included in the Company’s condensed
consolidated financial statements in accordance with this standard.







The
Company adopted a new accounting standard included in, ASC 815-40, “Contracts in
Entity’s Own Equity,”  which requires that the Company apply a
two-step approach in evaluating whether an equity-linked financial instrument
(or embedded feature) is indexed to the Company’s stock, including evaluation of
the instrument’s contingent exercise and settlement provisions.  See
Note 5 for the impact of the adoption of ASC 815-40 on the Company’s
consolidated financial position and results of operations.





Intangibles




The
Company adopted a new accounting standard relating to intangibles and business
combinations included in ASC 350, “Intangibles — Goodwill and Other,” which
amends the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset.
This standard is intended to improve the consistency between the useful life of
a recognized intangible asset and the period of expected cash flows used to
measure the fair value of the asset. This standard is effective prospectively
for intangible assets acquired or received after January 1, 2009.  The
adoption of this standard did not impact our consolidated financial position and
results of operations.


6


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)




Subsequent
Events




The
Company adopted a new accounting standard included in ASC 855, “Subsequent
Events,” which requires an entity to recognize in the financial statements the
effects of all subsequent events that provide additional evidence about
conditions that existed at the date of the balance sheet. For nonrecognized
subsequent events that must be disclosed to keep the financial statements from
being misleading, an entity will be required to disclose the nature of the event
as well as an estimate of its financial effect, or a statement that such an
estimate cannot be made. In addition, this standard requires an entity to
disclose the date through which subsequent events have been
evaluated.




Accounting
Standards Updates




In
August 2009, the FASB issued Accounting Standards Update (“ASU”)
No. 2009-04, “Accounting for Redeemable Equity Instruments — Amendment to
Section 480-10-S99.”  This ASU represents an update to
Section 480-10-S99, Distinguishing Liabilities from Equity, per
Emerging Issues Task Force Topic D-98, “Classification and Measurement of
Redeemable Securities.” The adoption of ASU 2009-04 did not have a material
impact on our condensed consolidated financial statements.




In
August 2009, the FASB issued ASU No. 2009-05, “Fair Value Measurements
and Disclosures (Topic 820) — Measuring Liabilities at Fair Value.”  This
Accounting Standards Update amends Subtopic 820-10, Fair Value Measurements and
Disclosures - Overall, to provide guidance on the fair value measurement of
liabilities. The adoption of ASU 2009-05 did not have a material impact on our
condensed consolidated financial statements.




In
September 2009, the FASB issued ASU No. 2009-08, “Earnings Per Share
Amendments to Section 260-10-S99.” This Codification Update represents
technical corrections to Topic 260-10-S99, Earnings per Share, based on EITF
Topic D-53, Computation of Earnings Per Share for a Period that Includes a
Redemption or an Induced Conversion of a Portion of a Class of Preferred Stock
and EITF Topic D-42, The Effect of the Calculation of Earnings per Share for the
Redemption or Induced Conversion of Preferred Stock. The adoption of ASU 2009-08
did not have material impact on our condensed consolidated financial
statements.





NOTE 3 -
Stock-Based
Compensation





The
Company uses the fair value recognition provisions of ASC 718, “Compensation –
Stock Compensation,” using the modified prospective
method.  Consequently, for the nine months ended September 30, 2009
and 2008, the Company’s condensed consolidated statements of operations reflect
stock-based compensation expense for stock options granted under its long-term
stock incentive plans amounting to $836,403 and $923,891,
respectively.





Stock
options issued under the Company’s long-term incentive plans are granted with an
exercise price equal to no less than the market price of the Company’s stock at
the date of grant and expire up to ten years from the date of
grant.  These options generally vest over a three- or four-year
period.





The fair
value of stock options granted was determined on the grant date using
assumptions for risk free interest rate, the expected term, expected volatility,
and expected dividend yield.  The risk free interest rate is based on
U.S. Treasury zero-coupon yield curve over the expected term of the
option.  The expected term assumption is primarily based on the
Company’s historical data related to exercise and post-vesting cancellation
information, which is expected to be similar to future results.  Since
the Company has limited historical volatility information, it bases its expected
volatility on the historical volatility of similar entities whose share prices
are publicly available.  In making its determination as to similarity,
the Company considered the industry, stage of life cycle, size, and financial
leverage of such other entities.  The Company’s model includes a zero
dividend yield assumption, as the Company has not historically paid nor does it
anticipate paying dividends on its common stock.  The Company’s model
does not include a discount for post-vesting restrictions, as the Company has
not issued awards with such restrictions.  The periodic expense is
then determined based on the valuation of the options, and at that time an
estimated forfeiture rate is used to reduce the expense recorded.  The
Company’s estimate of pre-vesting forfeitures is primarily based on the
Company’s historical experience and is adjusted to reflect actual forfeitures as
the options vest.  The following assumptions were used to estimate the
fair value of options granted for the nine months ended September 30, 2009 and
2008 using the Black-Scholes option-pricing model:


7


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





September 30,2009
                    
                    
                    2008Risk
      free interest rate
                    
                    
                    2.96
                    %
                    
                    
                    3.85
                    %Expected
      term (years)
                    
                    
                    10.0
                    
                    
                    
                    9.7Expected
      volatility
                    
                    
                    85.7
                    %
                    
                    
                    89.7
                    %Expected
      dividend yield
                    
                    
                    -
                    
                    
                    
                    -





A summary
of the option activity for the nine months ended September 30, 2009 is as
follows:





Number
                    of Shares
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Weighted-
                    Average
                    Remaining
                    Contractual TermOptions
      outstanding at January 1, 2009
                  
                  
                  4,676,868
                  
                  
                  
                  1.64Granted
                  
                  
                  747,058
                  
                  
                  
                  0.73Cancelled
                  
                  
                  (7,000
                  )
                  
                  
                  (1.99
                  )Exercised
                  
                  
                  -
                  
                  
                  
                  -Options
      outstanding at September 30, 2009
                  
                  
                  5,416,926
                  
                  
                  
                  1.41
                  
                  
                  
                  6.29Options
      exercisable at September 30, 2009
                  
                  
                  3,415,474
                  
                  
                  
                  2.00
                  
                  
                  
                  5.46





The
weighted-average grant-date fair value of options granted during the nine months
ended September 30, 2009 and 2008 was $545,525 and $1,036,631,
respectively.  There have been no options exercised during the nine
months ended September 30, 2009.





NOTE 4 -
Stockholders’
Equity





During
the first three quarters ended September 30, 2009, 413 shares of the Company’s
series A convertible preferred stock were converted into 342,524 shares of the
Company’s common stock and 1,030 shares of series B convertible preferred stock
were converted in 855,270 shares of the Company’s common stock.





On March
23, 2009, the Company issued a total of 88,132 shares of common stock to 500
Linden Oaks Associates LLC, as partial payment for the lease of the Company's
corporate headquarters, pursuant to the terms of its lease dated May 14, 2007.
The shares were issued at $1.20 per share for a total consideration of
$105,570.


NOTE 5
- Derivative
Liability





Under ASC
815-40, “Contracts in Entity’s Own Equity,” instruments which do not have fixed
settlement provisions are deemed to be derivative instruments. The warrants
issued with the Company’s series A and series B preferred stock, and to the
placement agent in the series B financing, do not have fixed settlement
provisions because their exercise prices may be lowered if the Company issues
securities at lower prices in the future.  The Company was required to
include the reset provisions in order to protect the warrant holders from the
potential dilution associated with future financings.  In accordance
with ASC 815-40, the warrants were recognized as a derivative instrument and
have been re-characterized as derivative liabilities. ASC 815-40 requires that
the fair value of these liabilities be re-measured at the end of every reporting
period with the change in value reported in the statement of
operations.


8


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





The
derivative liabilities were valued using the Black-Scholes option valuation
model and the following assumptions on the following dates:





September 30,
                    2009
                  
                  
                  January 1,
                    2009
                  
                  
                  November 5,
                    2005Series
      A warrants:Risk-free
      interest rate
                  
                  
                  .06
                  %
                  
                  
                  2.24
                  %
                  
                  
                  4.66
                  %Expected
      volatility
                  
                  
                  44.4
                  %
                  
                  
                  72.9
                  %
                  
                  
                  59.6
                  %Expected
      life (in years)
                  
                  
                  .167
                  
                  
                  
                  .92
                  
                  
                  
                  4Expected
      dividend yield
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Number
      of warrants
                  
                  
                  1,400,000
                  
                  
                  
                  1,400,000
                  
                  
                  
                  1,400,000Fair
      value
                  
                  $
                  1,120
                  
                  
                  $
                  14,840
                  
                  
                  $
                  1,299,900





September 30,
                    2009
                  
                  
                  January 1,
                    2009
                  
                  
                  September 7,
                    2007Series
      B warrants:Risk-free
      interest rate
                  
                  
                  2.34
                  %
                  
                  
                  2.24
                  %
                  
                  
                  4.37
                  %Expected
      volatility
                  
                  
                  59.4
                  %
                  
                  
                  57.8
                  %
                  
                  
                  70.0
                  %Expected
      life (in years)
                  
                  
                  4.92
                  
                  
                  
                  5.67
                  
                  
                  
                  7Expected
      dividend yield
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Number
      of warrants
                  
                  
                  2,234,764
                  
                  
                  
                  2,234,764
                  
                  
                  
                  2,234,764Fair
      value
                  
                  $
                  1,426,786
                  
                  
                  $
                  408,068
                  
                  
                  $
                  1,839,099





The
risk-free interest rate was based on rates established by the Federal
Reserve.  The Company’s expected volatility was based on the
historical volatility of similar entities whose share prices are publicly
available.  The expected life of the warrants was determined by the
expiration date of the warrants.  The expected dividend yield was
based upon the fact that the Company has not historically paid dividends on its
common stock, and does not expect to pay dividends on its common stock in the
future.





ASC
815-40 was implemented in the first quarter of 2009 and was reported as a
cumulative effect of a change in accounting principle.  As a result,
the cumulative effect on the accounting for the warrants was as
follows:





Derivative
                    Instrument
                  
                  Decrease in
                    Additional Paid-In-Capital
                  
                  
                  Decrease in
                    Accumulated
                    Deficit
                  
                  
                  Increase in
                    Derivative
                    LiabilityWarrants
                  
                  $
                  3,138,999
                  
                  
                  $
                  2,716,091
                  
                  
                  $
                  422,908





The
warrants were originally recorded at their relative fair value as an increase in
additional paid-in-capital.  Changes in accumulated deficit include
$2,716,091 in gains resulting from the decrease in the fair value of the
derivative liabilities through December 31, 2008.  The derivative
liability amount reflects the fair value of each derivative instrument as of the
January 1, 2009 date of implementation.


9


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





The fair
value of these warrant liabilities was $1,427,906 at September 30, 2009. The
$1,004,998 change in fair value is reported in our condensed consolidated
statement of operations as a loss on derivative financial instruments. The fair
value of these liabilities will be re-measured at the end of every reporting
period and the change in fair value will be reported in our consolidated
statement of operations as a gain or loss on derivative financial
instruments.





Fair
Value Measurement





Valuation
Hierarchy


ASC 820,
“Fair Value Measurements and Disclosures,” establishes a valuation hierarchy for
disclosure of the inputs to valuation used to measure fair value. This hierarchy
prioritizes the inputs into three broad levels as follows.  Level 1
inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities.  Level 2 inputs are quoted prices for similar assets and
liabilities in active markets or inputs that are observable for the asset or
liability, either directly or indirectly through market corroboration, for
substantially the full term of the financial instrument.  Level 3
inputs are unobservable inputs based on the Company’s own assumptions used to
measure assets and liabilities at fair value.  A financial asset or
liability’s classification within the hierarchy is determined based on the
lowest level input that is significant to the fair value
measurement.





The
following table provides the assets and liabilities carried at fair value
measured on a recurring basis as of September 30, 2009:





Fair Value Measurements at September 30, 2009Total Carrying
                    Value at
                    September 30,
                    2009
                  
                  
                  Quoted prices
                    in active
                    markets
                    (Level 1)
                  
                  
                  Significant
                    other
                    observable
                    inputs
                    (Level 2)
                  
                  
                  Significant
                    unobservable
                    inputs (Level 3)Derivative
      liabilities
                  
                  $
                  1,427,906
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,427,906





The
carrying amounts of cash, accounts receivable, accounts payable, and accrued
liabilities approximate their fair value due to their short
maturities.  The derivative liabilities are measured at fair value
using quoted market prices and estimated volatility factors, and are classified
within Level 3 of the valuation hierarchy. There were no changes in the
valuation techniques during the nine months ended September 30,
2009.





NOTE 6 -
Net Loss Per
Share





Basic net
loss per share is computed by dividing the net loss applicable to common shares
by the weighted average number of common shares outstanding during the
period.  Diluted loss attributable to common shares adjusts basic loss
per share for the effects of convertible securities, warrants, stock options and
other potentially dilutive financial instruments, only in the periods in which
such effect is dilutive.  The shares issuable upon the conversion of
preferred stock, the exercise of stock options and warrants are excluded from
the calculation of net loss per share as their effect would be
antidilutive.





Securities
that could potentially dilute earnings per share in the future that were not
included in the computation of diluted loss per share consist of the following
as of September 30:


10


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





2009
                  
                  
                  2008Series
      A convertible preferred stock
                  
                  
                  2,958,575
                  
                  
                  
                  3,301,098Series
      B convertible preferred stock
                  
                  
                  2,653,824
                  
                  
                  
                  3,509,092Series
      A warrants to purchase common stock
                  
                  
                  1,629,402
                  
                  
                  
                  1,629,402Series
      B warrants to purchase common stock
                  
                  
                  2,234,764
                  
                  
                  
                  2,234,764Other
      warrants to purchase common stock
                  
                  
                  444,888
                  
                  
                  
                  444,888Options
      to purchase common stock
                  
                  
                  5,558,616
                  
                  
                  
                  4,972,366Total
                  
                  
                  15,480,069
                  
                  
                  
                  16,091,610





NOTE 7 -
Income
Taxes





The
Company follows ASC 740, “Income Taxes,” for its reporting of taxes. The Company
has concluded that there were no significant uncertain tax positions requiring
recognition in its financial statements.  As of September 30, 2009,
all of the Company’s deferred tax assets were fully reserved by a valuation
allowance equal to 100% of the net deferred tax assets.  The Company
has never been profitable and has not paid any income taxes.





The
Company has significant net operating loss and business credit carryovers which
are subject to a valuation allowance due to the uncertain nature of the
realization of the losses.  The Internal Revenue Code imposes certain
limitations on the utilization of net operating loss carryovers and other tax
attributes after a change in control.  The Company does not believe it
has encountered ownership changes which could significantly limit the possible
utilization of such carryovers.  However, the Company has not
performed a detailed analysis to determine the effect of any such ownership
changes on its ability to use these net operating loss and credit
carryforwards.  It is not anticipated that limitations, if any, would
have a material impact on the condensed consolidated balance sheet as a result
of offsetting changes in the deferred tax valuation allowance.





The
Company will recognize interest and penalties accrued related to unrecognized
tax benefits as components of its income tax provision.  As of
September 30, 2009, the Company does not have any interest and penalties accrued
related to unrecognized tax benefits.





NOTE 8 -
Concentration of
Credit Risk





The
Company’s top customer accounted for approximately 41% of its total revenue and
58% of its accounts receivable for the nine months ended September 30, 2009. For
the nine months ended September 30, 2008, its then top three customers accounted
for 16%, 13% and 13% of its total revenue.  The Company’s top customer
accounted for approximately 59% of its total revenue for the three months ended
September 30, 2009.





NOTE 9 –
Subsequent
Events





On
November 4, 2009, the Company executed a stock option exchange program whereby
eligible employees and directors could elect to receive one stock option at the
closing market price on November 4, 2009 for two previously granted stock
options.  Pursuant to the exchange offer, 1,366,250 eligible options
(representing 40% of the total stock options eligible for exchange) were
exchanged for new stock options with similar terms (including an additional year
vesting period) to purchase 683,125 shares of common stock. The exercise price
of the new options is $1.20 per share, which was the closing price of the
Company’s common stock on November 4, 2009 as reported by the Nasdaq Capital
Market. The exchange did not result in incremental fair value or an additional
charge to the Company’s consolidated statement of operations for the period
ended September 30, 2009.


11


ITEM
2:  Management's Discussion and Analysis of Financial Condition and
Results of Operations





The
following discussion should be read in conjunction with VirtualScopics’
condensed consolidated balance sheets as of September 30, 2009 and December 31,
2008 and the related condensed consolidated statements of operations and cash
flows for the quarters ended September 30, 2009 and 2008, included elsewhere in
this report. This discussion contains forward-looking statements, the accuracy
of which involves risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements for many
reasons including, but not limited to, those discussed under the heading
“Forward Looking Statements” below and elsewhere in this report. We disclaim any
obligation to update information contained in any forward-looking
statements.





Overview





VirtualScopics,
Inc. is a leading provider of imaging solutions to accelerate drug and medical
device development.  We have developed a robust software platform for
analysis and modeling of both structural and functional medical
images.  In combination with our industry-leading experience and
expertise in advanced imaging biomarker measurement, this platform provides a
uniquely clear window into the biological activity of drugs and devices in
clinical trial patients, allowing pharmaceutical, biotechnology and medical
device companies to make better decisions faster. Additionally, our technology
helps to curtail trials that are not likely to be beneficial and to avoid
mistaken termination of compounds that are likely to prove efficacious, as well
as allow our customers to expedite compounds that are demonstrating response.
This is done through:





·
            improved
      precision in the measurement of existing imaging-based biomarkers
      resulting in shorter observation periods, with beneficial cost savings
      within a clinical trial;





·
            new
      imaging biomarkers, which are better correlated with disease states, again
      reducing trial length and therefore costs;
and





·
            reduced
      processing time for image data analysis through
  automation.





In
addition, we believe our technology helps reduce aggregate clinical development
costs through:





·
            improved
      precision for existing biomarkers, thus requiring smaller patient
      populations and lower administrative costs;
and





·
            new
      biomarkers that serve as better correlates, leading to better early
      screening and elimination of weak drug candidates in pre-clinical
      trials.





In July
2000, VirtualScopics was formed after being spun out of the University of
Rochester and in June 2002, VirtualScopics purchased the underlying technology
and patents created by VirtualScopics’ founders from the University of
Rochester. VirtualScopics owns all rights to the patents underlying its
technology.





Revenues
over the past eight years have been derived primarily from image processing
services in connection with pharmaceutical drug trials.  For these
services, we have been concentrating in the areas of oncology and
osteoarthritis.  We have also derived a portion of revenue from
consulting services and pharmaceutical drug trials in the neurology and
cardiovascular therapeutic areas.  Revenues are recognized as the
services are performed and as images processed are quantified and delivered to
our customers.





The
number of customers that we perform services for has increasingly grown over the
past several years, and we continue to submit proposals and bids for new
contracts. However, there can be no assurance that we will secure contracts from
these efforts or that any such contracts or any of our existing contracts will
not be cancelled by a customer.


12





Additionally,
once we enter into a new contract for participation in a drug trial, there are
several factors that can affect whether we will realize the full benefits under
the contract, and the time over which we will realize that
revenue.  Customers may not continue our services due to performance
reasons with their compounds in development.  Furthermore, the
contracts may contemplate performance over multiple years.  Therefore,
revenue may not be realized in the fiscal year in which the contract is signed
or awarded.  Recognition of revenue under the contract may also be
affected by the timing of patient recruitment and image site identification and
training.





We have
also begun pursuing the application of one of our technologies into the
personalized medicine market. Specifically, we believe there could be further
benefit of our blood flow and vascular permeability software tool in assisting
patients and oncologists in determining whether an anti-angiogenic therapy is
having the desired effect. We believe this application will assist oncologists
with treatment planning for patients undergoing anti-angiogenic cancer
therapies. We have begun the regulatory process for obtaining 510k clearance
from the FDA. We will continue to assess the best mechanism for channeling our
application into the market; however, there can be no assurance that approval
will be granted or we will experience significant demand for our
application.





In 2007,
we were awarded an appropriation from the Department of Defense to work on two
projects relating to hyperspectral imagery and image work flow. During the third
quarter of 2009, both of these projects have been satisfactorily completed. At
present, we are not anticipating significant further projects with the
Department of Defense.





Results
of Operations





Results
of Operations for Quarter Ended September 30, 2009 Compared to Quarter Ended
September 30, 2008





Revenues





We had
revenues of $2,798,000 for the quarter ended September 30, 2009 compared to
$1,816,000 for the comparable period in 2008.  This $982,000, or 54%,
increase in revenues was directly related to the expansion of our penetration
within the pharmaceutical and medical device industries. During the current
quarter, we performed work on 83 different projects, in connection with our
pharmaceutical drug trials in the fields of oncology, osteoarthritis and various
other projects.  This compares to 66 projects during the same period
in 2008. The majority of the demand is seen within our oncology service line;
however, we have recently seen increased interest in our musculoskeletal
applications. During the third quarter of 2009, 84% of our business was in
oncology services, 14% in musculoskeletal, the remaining 2% was work performed
for the Department of Defense and in other therapeutic areas. This compares to
54%, 23% and 23%, respectively, in 2008. During the third three months of 2009,
67% of the revenues were derived from Phase II and III studies compared to 48%
during the comparable period in 2008. Our margins in the later stage studies
(Phase II and III) tend to be higher due to the efficiencies gained with the
larger volume of analysis and site coordination.





Gross
Profit





We had a
gross profit of $1,596,000 for the third quarter of 2009 compared to $810,000
for the comparable period in 2008, an increase of 786,000, or
97%.  Our gross profit margin was 57% during the period ended
September 30, 2009 compared to 45% in the third quarter of
2008.   The percentage of our business in Phase II and III trials
has grown over the past twelve months which is reflected in our gross margin.
Phase II and III studies are inherently more efficient for us to process. Also
impacting the improved margin is the increase in overall volume of business
during the quarter. We have made significant improvements in order for us to
effectively scale the business without requiring a significant amount of
additional resources. These improvements and the higher revenue volume allow us
to be more effective in the processing of our services, thereby typically
resulting in higher margins. We have begun hiring within our operations to
support the growing demand for our services and therefore, anticipate margins to
be slightly lower for the remainder of 2009.


13





Research
and Development





Research
and development costs increased in the quarter ended September 30, 2009 by
$23,000, or 10%, to $256,000, when compared to the quarter ended September 30,
2008.  The increase was a result of the addition of a software
engineer in the quarter. The engineer previously worked on our Department of
Defense project which came to an end during the quarter and therefore, the
engineer transferred into our core business to assist with building efficiencies
within our core software platform. Our research and development efforts center
around refining our processes through the use of our software platform in order
to gain efficiencies which we believe will better allow us to standardize our
processes as we scale the business. Additionally, we continue to invest in the
commercialization of new imaging techniques across many modalities and
therapeutic areas to best serve our customers. As of September 30, 2009, there
were 10 employees in our research and development group, which includes the
algorithm development and software development groups.





Sales
and Marketing





Sales and
marketing costs decreased in the quarter ended September 30, 2009 by $26,000, or
10%, to $238,000, when compared to the quarter ended September 30,
2008.  The decrease was a result of the timing of trade shows and
travel costs during the quarter as compared to prior year.





General
and Administrative





General
and administrative expenses for the quarter ended September 30, 2009 were
$798,000, an increase of $47,000 or 6%, when compared to the quarter ended
September 30, 2008.  The increase was due to the valuation changes
within our stock compensation expense which increased stock compensation expense
by $44,000 during the quarter. In May 2009, the stockholders approved a stock
option exchange program whereby certain option holders are eligible to receive
one option at the closing market price on the date of the exchange for two of
their current options. Based on the number of option holders electing to
participate, the non-cash stock compensation expense may increase at the time of
the exchange. On November 4, 2009, the Company executed the exchange. The
Company does not anticipate this transaction to impact its financial statements;
additionally, the exchange reduced the number of stock options outstanding by
approximately 683,000.





Depreciation
and Amortization





Depreciation
and amortization charges were $115,000 for the quarter ended September 30, 2009
compared to $116,000 during the quarter ended September 30,
2008.  This was a result of depreciation charges related to recent
capital purchases being offset by a reduction in depreciation charges for assets
that have been fully depreciated during the past quarter.





Other
Income (Expense)





Interest
income for the quarter ended September 30, 2009 was nominal due to the low
interest rates received from our primary banking institution. We continue to
assess the level of risk and related rates within our current banking
arrangement as well as opportunities with other institutions in order to
leverage our cash balances while minimizing our risk. Additionally, we
recognized a marked to market adjustment of $402,000 related to the
loss in fair value of certain derivative financial instruments (see Financial
Statement Note 5).  No adjustment was required in 2008 in accordance
with ASC 815-40.





Net
Loss





Net loss
for the quarter ended September 30, 2009 was $216,000 compared to a net loss of
$549,000 for the quarter ended September 30, 2008.  The significant
improvement in our net loss over the prior period was primarily related to the
increase in our revenues, growth in our gross profit along with reductions in
our operating expenses offset by a non-cash marked to market adjustment to
reflect the changes in the fair value of certain outstanding warrants during the
second quarter of 2009 as compared to 2008.


14





Results
of Operations for the Nine Months Ended September 30, 2009 Compared to the Nine
Months Ended September 30, 2008





Revenues





Our
revenues for the nine months ended September 30, 2009 were $7,473,000, an
increase of $2,290,000 or 44% over the first nine months of 2008.  The
increase in sales is a reflection of the broadening of our customer base, the
broader penetration of our services in the industry and the shift to later stage
clinical trials which are inherently larger contracts. We performed services for
a total of 96 projects in the first nine months of 2009, as compared to 82 in
the first nine months of 2008.   We are experiencing increased
demand for our services in Phase II/III trials, and as a result, we expect that
a majority of our revenues from pharmaceutical trial projects will be derived
from Phase II and III studies throughout the rest of 2009.





Gross
Profit





We had a
gross profit of $4,109,000 for the nine months ended September 30, 2009 compared
to $2,126,000 for the comparable period in 2008. Our gross profit improved
$1,983,000 or 93% for the first three quarters combined in 2009 compared to the
first three quarters combined in 2008.  The improvement is the result
of operating efficiencies, greater sales volume and the inherent efficiency
obtained in performing work in later stage clinical trials. During the first
nine months of 2009, 61% of our revenues were generated from Phase II/III trials
as compared to 40% during the same period a year ago.





Research
and Development





Total
research and development expenditures were $749,000 in the first three quarters
of 2009 compared to $697,000 for the comparable period in 2008, an increase of
7%. The slight increase was due to relocation costs incurred in 2009 related to
one of our scientific staff as well as the addition of one staff in software
development. Our research and development efforts center around refining our
processes through the use of our software platform in order to gain efficiencies
which we believe will better allow us to standardize our processes as we scale
the business. Additionally, we continue to invest in the commercialization of
new imaging techniques across many modalities and therapeutic areas to best
serve our customers. As of September 30, 2009, there were 10 employees in our
research and development group, which includes the algorithm development and
software development groups.





Sales
and Marketing





Sales and
marketing costs for the nine months ended September 30, 2009 decreased to
$878,000, a decrease of $59,000 or 6% over the first nine months of
2008.  The decrease was a result of a new marketing strategy to better
align our marketing materials with our value proposition and service offering in
the industry in 2008. We incurred the majority of our rebranding expenses in the
first and second quarters of 2008. Offsetting the decrease in 2009 we have
incurred higher costs associated with presenting and attending industry
sponsored conferences and conducting seminars on emerging topics within imaging
for new and existing customers.





General
and Administrative





General
and administrative expenses for the nine months ended September 30, 2009 were
$2,503,000, a decrease of $10,000 over the first three quarters of
2008.  The decrease is mainly due to a reduction in stock compensation
expense for vested stock options related to the timing and vesting schedule of
stock option grants.


15





Depreciation
and Amortization





Depreciation
and amortization charges remained consistent in the nine months ended September
30, 2009 and 2008.





Other
Income (Expense)





Interest
income for the nine months ended September 30, 2009 was $4,000 and comprised of
interest earned on the Company’s operating and savings accounts, compared to
interest income of $60,000 in the same period in 2008.  The decrease
in interest income was a reflection of the lower average rates of return on our
savings accounts in 2009 compared to 2008. Additionally, we recognized a marked
to market adjustment of $1,005,000 related to the loss in fair value of certain
derivative financial instruments (see Financial Statement Note
5).  There was no adjustment required in 2008 in accordance with ASC
815-40.





Net
Loss





Our net
loss for the nine months ended September 30, 2009 was $1,385,000 compared to a
net loss of $2,324,000 for the same period in 2008.  The improvement
in our net loss over the prior period was primarily related to higher revenues
and gross profit, as outlined above, offset by the marked to market adjustment
for the fair value of certain outstanding warrants.





Liquidity
and Capital Resources





Our
working capital as of September 30, 2009 was approximately $1,875,000 compared
to $2,923,000 as of December 31, 2008.  The decrease in working
capital was a result of the recording of a derivative warrant liability related
to the marked to market adjustment of certain warrants in accordance with ASC
815-40.  As discussed above, no similar adjustment was required in
2008.





Net cash
provided by operating activities totaled $1,019,000 in the nine months ended
September 30, 2009 compared to net cash used of $950,000 in the comparable 2008
period.  This significant improvement in the amount of cash provided
by operating activities is a direct result of increases in revenues and gross
profit without increases in spending in research and development and general and
administrative expenses. Also impacting operating cash flow was the timing of
receivables and payment of accounts payable and payroll.





We
invested $266,000 in the purchase of equipment and the acquisition of patents in
the first three quarters of 2009, compared to $90,000 for the investment in
these items in the first three quarters of 2008. The increase represents
investments in our IT infrastructure and the costs associated with implementing
an ERP system in order to support the growing demand for our
services.





Cash used
in our financing activities in the nine months ended September 30, 2009 was
$245,000, compared to $143,000 provided by financing activities in the nine
months ended September 30, 2008 representing the release of restricted cash for
investor relations and dividend payments offset by monthly dividend payments for
the convertible series B preferred stock.





We
currently expect that existing cash and cash equivalents will be sufficient to
fund operations for the next 12 months. If in the next 12 months our plans or
assumptions change or prove to be inaccurate, we may be required to seek
additional capital through public or private debt or equity financings. If we
need to raise additional funds, we may not be able to do so on terms favorable
to us, or at all. If we cannot raise sufficient funds on acceptable terms, we
may have to curtail our level of expenditures and our rate of
expansion.





Off
Balance Sheet Arrangements





We have
no off-balance sheet arrangements (other than the consulting agreements and
operating leases) that have or are reasonably likely to have a current or future
effect on our financial condition, changes in financial condition, revenues or
expenses, results of operations, liquidity, capital resources or capital
expenditures that is material to investors.


16





Recently
Issued and Adopted Accounting Pronouncements




On
September 30, 2009, the Company adopted changes issued by the Financial
Accounting Standards Board (FASB) to the authoritative hierarchy of GAAP. These
changes establish the FASB Accounting Standards Codification TM (Codification)
as the source of authoritative accounting principles recognized by the FASB to
be applied by nongovernmental entities in the preparation of financial
statements in conformity with GAAP. Rules and interpretive releases of the
Securities and Exchange Commission (SEC) under authority of federal securities
laws are also sources of authoritative GAAP for SEC registrants. The FASB will
no longer issue new standards in the form of Statements, FASB Staff Positions,
or Emerging Issues Task Force Abstracts; instead the FASB will issue Accounting
Standards Updates. Accounting Standards Updates will not be authoritative in
their own right as they will only serve to update the Codification. These
changes and the Codification itself do not change GAAP. Other than the manner in
which new accounting standards are referenced, the adoption of these changes had
no impact on the Financial Statements.




Fair
Value




The
Company adopted a new accounting standard included in ASC 820, “Fair Value
Measurements and Disclosures”, which delayed the effective date for disclosing
all non-financial assets and non-financial liabilities, except for items that
are recognized or disclosed at fair value on a recurring basis (at least
annually). This standard did not have a material impact on the Company’s
financial condition and results of operations. See Note 5, “Fair Value
Measurements”.




The
Company adopted a new accounting standard related to interim disclosures about
fair value of financial instruments included in ASC 825, “Financial
Instruments,” which requires disclosures about fair value of financial
instruments for interim reporting periods of publicly-traded companies, as well
as in annual financial statements. Our adoption of this standard, effective
April 1, 2009, did not impact our consolidated financial condition or
results of operations.




Business
Combinations




The
Company adopted a new accounting standard included in ASC 805, “Business
Combinations,” which significantly changed the accounting for and reporting of
business combination transactions. This standard was effective for the Company
for business combination transactions for which the acquisition date was on or
after January 1, 2009. The adoption of this standard will have an impact on
the Company’s accounting for any future business combinations.




Consolidation





The
Company adopted a new accounting standard included in ASC 810, “Consolidation,”
which establishes new accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary through the
use of disclosures that clearly identify and distinguish between the interests
of the parent and the interests of the noncontrolling owners. This standard is
effective for fiscal years beginning on or after December 15, 2008 with early
adoption prohibited.   The new standard would have an impact on the
presentation and disclosure of the non-controlling interests of any non
wholly-owned businesses acquired by the Company in the future.




Derivative
Instruments and Hedging Activities




The
Company adopted a new accounting standard included in ASC 815, “Derivatives and
Hedging,” requiring entities to provide greater transparency through additional
disclosures about (a) how and why an entity uses derivative instruments,
(b) how derivative instruments and related hedged items are accounted for
under U.S. GAAP, and (c) how derivative instruments and related hedged
items affect an entity’s financial position, results of operations and cash
flows. Additional disclosures have been included in the Company’s condensed
consolidated financial statements in accordance with this
standard.


17


The
Company adopted a new accounting standard included in, ASC 815-40, “Contracts in
Entity’s Own Equity,”  which requires that the Company apply a
two-step approach in evaluating whether an equity-linked financial instrument
(or embedded feature) is indexed to the Company’s stock, including evaluation of
the instrument’s contingent exercise and settlement provisions.  See
Note 5 for the impact of the adoption of ASC 815-40 on the Company’s
consolidated financial position and results of operations.





Intangibles




The
Company adopted a new accounting standard relating to intangibles and business
combinations included in ASC 350, “Intangibles — Goodwill and Other,” which
amends the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset.
This standard is intended to improve the consistency between the useful life of
a recognized intangible asset and the period of expected cash flows used to
measure the fair value of the asset. This standard is effective prospectively
for intangible assets acquired or received after January 1, 2009.  The
adoption of this standard did not impact our consolidated financial position and
results of operations.




Subsequent
Events




The
Company adopted a new accounting standard included in ASC 855, “Subsequent
Events,” which requires an entity to recognize in the financial statements the
effects of all subsequent events that provide additional evidence about
conditions that existed at the date of the balance sheet. For nonrecognized
subsequent events that must be disclosed to keep the financial statements from
being misleading, an entity will be required to disclose the nature of the event
as well as an estimate of its financial effect, or a statement that such an
estimate cannot be made. In addition, this standard requires an entity to
disclose the date through which subsequent events have been
evaluated.




Accounting
Standards Updates




In
August 2009, the FASB issued Accounting Standards Update (“ASU”)
No. 2009-04, “Accounting for Redeemable Equity Instruments — Amendment to
Section 480-10-S99.”  This ASU represents an update to
Section 480-10-S99, Distinguishing Liabilities from Equity, per
Emerging Issues Task Force Topic D-98, “Classification and Measurement of
Redeemable Securities.” The adoption of ASU 2009-04 did not have a material
impact on our condensed consolidated financial statements.




In
August 2009, the FASB issued ASU No. 2009-05, “Fair Value Measurements
and Disclosures (Topic 820) — Measuring Liabilities at Fair Value.”  This
Accounting Standards Update amends Subtopic 820-10, Fair Value Measurements and
Disclosures - Overall, to provide guidance on the fair value measurement of
liabilities. The adoption of ASU 2009-05 did not have a material impact on our
condensed consolidated financial statements.




In
September 2009, the FASB issued ASU No. 2009-08, “Earnings Per Share
Amendments to Section 260-10-S99.” This Codification Update represents
technical corrections to Topic 260-10-S99, Earnings per Share, based on EITF
Topic D-53, Computation of Earnings Per Share for a Period that Includes a
Redemption or an Induced Conversion of a Portion of a Class of Preferred Stock
and EITF Topic D-42, The Effect of the Calculation of Earnings per Share for the
Redemption or Induced Conversion of Preferred Stock. The adoption of ASU 2009-08
did not have material impact on our condensed consolidated financial
statements.





Forward
Looking Statements





Certain
statements made in this discussion are “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of
1995.  These forward-looking statements include statements that
address activities, events or developments that we expect, believe or anticipate
may occur in the future, including the following risk factors:





·
            adverse
      economic conditions;


18





·
            inability
      to raise sufficient additional capital to operate our
      business;





·
            unexpected
      costs, lower than expected sales and revenues, and operating
      defects;





·
            adverse
      results of any legal proceedings;





·
            the
      volatility of our operating results and financial
    condition;





·
            inability
      to attract or retain qualified senior management personnel, including
      sales and marketing, and scientific personnel;
  and





·
            other
      specific risks that may be referred to in this
  report.





All
statements, other than statements of historical facts, included in this report
including, without limitation, statements regarding our strategy, future
operations, financial position, estimated revenue or losses, projected costs,
prospects and plans and objectives of management are forward-looking
statements.  When used in this report, the words “may,” “believe,”
“anticipate,” “intend,” “estimate,” “expect,” “project,” “plan,” “could,”
“would” and similar expressions are intended to identify forward-looking
statements, although not all forward-looking statements contain such identifying
words.  All forward-looking statements speak only as of the date of
this report.  We do not undertake any obligation to update any
forward-looking statements or other information contained in this
report.  Existing stockholders and potential investors should not
place undue reliance on these forward-looking statements. Although we believe
that our plans, intentions and expectations reflected in or suggested by the
forward-looking statements in this report are reasonable, we cannot assure our
stockholders or potential investors that these plans, intentions or expectations
will be achieved.  We disclose important factors that could cause our
actual results to differ materially from our expectations under the heading
entitled “Risk Factors” in our annual report on Form 10-K for the fiscal year
ended December 31, 2008 filed with the Securities and Exchange Commission
(“SEC”) and elsewhere in this report.  These risk factors qualify all
forward-looking statements attributable to us or persons acting on our
behalf.





ITEM
4T.  Controls and Procedures




Evaluation
of Disclosure Controls and Procedures




We
maintain a set of disclosure controls and procedures, as defined in Section
13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange
Act”), that are designed to ensure that information required to be disclosed by
us in the reports filed by us 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 SEC’s rules and forms. We carried out
an evaluation, under the supervision and with the participation of our Chief
Executive Officer and our Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures pursuant to Rule
13a-15(b) of the Exchange Act. Based on that evaluation, our Chief Executive
Officer and our Chief Financial Officer concluded that our disclosure controls
and procedures were effective as of the end of the period covered by this
report.





Notwithstanding
the foregoing, there can be no assurance that the Company’s disclosure controls
and procedures will detect or uncover all failures of persons within the Company
to disclose material information otherwise required to be set forth in the
Company’s periodic reports. There are inherent limitations to the effectiveness
of any system of disclosure controls and procedures, including the possibility
of human error and the circumvention or overriding of the controls and
procedures. Accordingly, even effective disclosure controls and procedures can
only provide reasonable, not absolute, assurance of achieving their control
objectives.


19


Changes
in Internal Controls Over Financial Reporting





An
evaluation was performed under the supervision of the Company’s management,
including the CEO and CFO, as required under Exchange Act Rule 13a-15(d) and
15d-15(d) of whether any change in the Company’s internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) occurred
during the fiscal quarter ended September 30, 2009.  Based on that
evaluation, the Company’s management, including the CEO and CFO, concluded that
no change in the Company’s internal controls over financial reporting occurred
during the fiscal quarter ended September 30, 2009 that has materially affected
or is reasonably likely to materially affect, the Company’s internal control
over financial reporting.




PART
II. OTHER INFORMATION





Item
1.  Legal Proceedings





None





Item
2.  Unregistered Sales of Equity Securities and Use of
Proceeds





During
the quarter ended September 30, 2009 and through the date hereof, 370 shares of
the Company’s series A convertible preferred stock were converted into 307,234
shares of the Company’s common stock and 1,030 shares of series B convertible
preferred stock were converted in 855,270 shares of the Company’s common stock.
The Company did not receive any cash or other consideration in connection with
the conversions. Additionally, no commission or other remuneration was paid by
the Company in connection with such conversions.  The issuance of
common stock upon conversions of the series A and B convertible preferred stock
was made in reliance on the exemption provided in Section 3(a)(9) of the
Securities Act of 1933, as amended.





Item
3.  Defaults upon Senior Securities





Not
applicable.





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





None





Item
5.  Other Information





None





Item
6.  Exhibits


Exhibit
31.1         Certification of Chief
Executive Officer as required by Rule 13a-14 or 15d-14 of the Securities
Exchange Act of 1934, as adopted Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
 
 Exhibit
31.2         Certification of Chief
Financial Officer as required by Rule 13a-14 or 15d-14 of the Securities
Exchange Act of 1934, as adopted Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
 
 Exhibit
32.1         Certification of Chief
Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act 0f of 2002.
 
 Exhibit
32.2         Certification of Chief
Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act 0f of 2002.


20




SIGNATURES





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





Dated:  November
      13, 2009
                  VIRTUALSCOPICS,
      INC./s/  Jeffrey
    MarkinJeffrey
      MarkinPresident
      and Chief Executive Officer/s/  Molly
    HendersonMolly
      HendersonChief
      Business and Financial Officer and Senior Vice
  President


21


Exhibit
Index





Exhibit
31.1         Certification of Chief
Executive Officer as required by Rule 13a-14 or 15d-14 of the Securities
Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002
 
 Exhibit  31.2        Certification
of Chief Financial Officer as required by Rule 13a-14 or 15d-14 of the
Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
 
 Exhibit
32.1         Certification pursuant
to 18 U.S.C. Section 1350 by the Chief Executive Officer, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
 
 Exhibit
32.2         Certification pursuant
to 18 U.S.C. Section 1350 by the Chief Financial Officer, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002


22