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    June 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)











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.





xYes ̈ 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).□Yes    ̈No





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
July 31, 2009, there were 23,758,632 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 June 30, 2009 (unaudited) and December
      31, 2008
                          1Unaudited
      Condensed Consolidated Statements of Operations for the three and sixmonthsended
      June 30, 2009 and 2008
                          2Unaudited
      Condensed Consolidated Statements of Cash Flows for the six monthsended
      June 30, 2009 and 2008
                          3Notes
      to Unaudited Condensed Consolidated Financial Statements
                          4-12ITEM
      2: Management's Discussion and Analysis of  Financial Condition
      and Results of
      Operations
                          13-20ITEM
      4T: Controls and Procedures
                          20PART
      II
                          OTHER
      INFORMATIONITEM
      1: Legal Proceedings
                          21ITEM
      2: Unregistered Sales of Equity Securities and Use of
    Proceeds
                          21ITEM
      3: Defaults Upon Senior Securities
                          21ITEM
      4: Submission of Matters to a Vote of Security Holders
                          21ITEM
      5: Other Information
                          22ITEM
      6: Exhibits
                          22


i





PART
1:  FINANCIAL INFORMATION





ITEM
1.  Financial Statements





VirtualScopics,
Inc. and Subsidiary


Condensed
Consolidated Balance Sheets




June
      30,
                    
                    
                    December
      31,2009
                    
                    
                    2008(Unaudited)AssetsCurrent
      assetsCash
                    
                    $
                    3,157,927
                    
                    
                    $
                    3,143,904Accounts
      receivable
                    
                    
                    1,395,565
                    
                    
                    
                    1,021,110Prepaid
      expenses and other current assets
                    
                    
                    355,104
                    
                    
                    
                    263,297Total
      current assets
                    
                    
                    4,908,596
                    
                    
                    
                    4,428,311Patents,
      net
                    
                    
                    1,877,522
                    
                    
                    
                    1,920,446Property
      and equipment, net
                    
                    
                    428,960
                    
                    
                    
                    355,479Other
      assets
                    
                    
                    95,023
                    
                    
                    
                    156,788Total
      assets
                    
                    $
                    7,310,101
                    
                    
                    $
                    6,861,024Liabilities
      and Stockholders' EquityCurrent
      liabilitiesAccounts
      payable and accrued expenses
                    
                    $
                    984,035
                    
                    
                    $
                    659,009Accrued
      payroll
                    
                    
                    452,081
                    
                    
                    
                    554,425Unearned
      revenue
                    
                    
                    609,493
                    
                    
                    
                    291,594Derivative
      liability
                    
                    
                    1,026,231
                    
                    
                    
                    -Total
      current liabilities
                    
                    
                    3,071,840
                    
                    
                    
                    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, 3,773 shares at June
      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, 4,226 shares at June
      30, 2009 and at December 31, 2008; liquidation preference $1,000 per
      share
                    
                    
                    4
                    
                    
                    
                    4Common
      stock, $0.001 par value; 85,000,000 shares authorized;issued
      and outstanding, 23,758,632 shares at June 30, 2009 and 23,502,352 shares
      at December 31, 2008
                    
                    
                    23,759
                    
                    
                    
                    23,503Additional
      paid-in capital
                    
                    
                    13,881,704
                    
                    
                    
                    16,546,550Accumulated
      deficit
                    
                    
                    (9,667,210
                    )
                    
                    
                    (11,214,065
                    )Total
      stockholders' equity
                    
                    
                    4,238,261
                    
                    
                    
                    5,355,996Total
      liabilities and stockholders' equity
                    
                    $
                    7,310,101
                    
                    
                    $
                    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
                  June 30,
                
                
                For the Six Months Ended
                  June 30,2009
                
                
                2008
                
                
                2009
                
                
                2008Revenues
                
                $
                2,541,316
                
                
                $
                1,733,299
                
                
                $
                4,675,685
                
                
                $
                3,367,402Cost
      of services
                
                
                1,147,980
                
                
                
                1,021,536
                
                
                
                2,162,564
                
                
                
                2,051,520Gross
      profit
                
                
                1,393,336
                
                
                
                711,763
                
                
                
                2,513,121
                
                
                
                1,315,882Operating
      expensesResearch
      and development
                
                
                258,180
                
                
                
                212,825
                
                
                
                493,735
                
                
                
                464,654Sales
      and marketing
                
                
                357,222
                
                
                
                384,237
                
                
                
                639,676
                
                
                
                673,111General
      and administrative
                
                
                859,512
                
                
                
                864,663
                
                
                
                1,704,191
                
                
                
                1,762,167Depreciation
      and amortization
                
                
                119,126
                
                
                
                116,765
                
                
                
                236,636
                
                
                
                234,332Total
      operating expenses
                
                
                1,594,040
                
                
                
                1,578,490
                
                
                
                3,074,238
                
                
                
                3,134,264Operating
      loss
                
                
                (200,704
                )
                
                
                (866,727
                )
                
                
                (561,117
                )
                
                
                (1,818,382
                )Other
      income (expense)Interest
      income
                
                
                87
                
                
                
                17,002
                
                
                
                3,280
                
                
                
                45,727Other
      expense
                
                
                (6,592
                )
                
                
                (1,385
                )
                
                
                (8,076
                )
                
                
                (2,968
                )Loss
      on derivative financial instrument
                
                
                (205,914
                )
                
                
                -
                
                
                
                (603,323
                )
                
                
                -Total
      other income (expense)
                
                
                (212,419
                )
                
                
                15,617
                
                
                
                (608,119
                )
                
                
                42,759Net
      loss
                
                
                (413,123
                )
                
                
                (851,110
                )
                
                
                (1,169,236
                )
                
                
                (1,775,623
                )Series
      B preferred stock dividend
                
                
                84,520
                
                
                
                84,520
                
                
                
                169,040
                
                
                
                169,760Net
      loss attributable to common  stockholders
                
                $
                (497,643
                )
                
                $
                (935,630
                )
                
                $
                (1,338,276
                )
                
                $
                (1,945,383
                )Basic
      and diluted net loss per common share
                
                $
                (0.02
                )
                
                $
                (0.04
                )
                
                $
                (0.06
                )
                
                $
                (0.08
                )Weighted
      average number of common shares outstanding – basic and
      diluted
                
                
                23,738,855
                
                
                
                23,358,625
                
                
                
                23,636,886
                
                
                
                23,302,346





See notes
to condensed consolidated financial statements.


2





VirtualScopics,
Inc. and Subsidiary


Condensed
Consolidated Statements of Cash Flows


(unaudited)





For the Six Months Ended June
      30,2009
                        
                        
                        2008Cash
      flows from operating activitiesNet
      loss
                        
                        $
                        (1,169,236
                        )
                        
                        $
                        (1,775,623
                        )Adjustments
      to reconcile net loss  to net cash provided by (used in)
      operating activities:Depreciation
      and amortization
                        
                        
                        236,636
                        
                        
                        
                        234,332Loss
      on disposal of asset
                        
                        
                        2,904
                        
                        
                        
                        -Stock-based
      compensation expense
                        
                        
                        554,348
                        
                        
                        
                        687,291Issuance
      of equity instruments for rent
                        
                        
                        105,570
                        
                        
                        
                        170,000Accrual
      for future issuance of equity instruments for services
                        
                        
                        -
                        
                        
                        
                        102,000Fair
      value adjustment of derivative liability
                        
                        
                        603,323
                        
                        
                        
                        -Changes
      in operating assets and liabilitiesAccounts
      receivable
                        
                        
                        (374,455
                        )
                        
                        
                        (270,063
                        )Prepaid
      expenses and other assets
                        
                        
                        (91,807
                        )
                        
                        
                        24,274Accounts
      payable and accrued expenses
                        
                        
                        308,557
                        
                        
                        
                        (37,573
                        )Accrued
      payroll
                        
                        
                        (102,344
                        )
                        
                        
                        163,096Unearned
      revenue
                        
                        
                        317,899
                        
                        
                        
                        (66,336
                        )Total
      adjustments
                        
                        
                        1,560,631
                        
                        
                        
                        1,007,021Net
      cash provided by (used in) operating activities
                        
                        
                        391,395
                        
                        
                        
                        (768,602
                        )Cash
      flows from investing activitiesPurchase
      of equipment
                        
                        
                        (185,287
                        )
                        
                        
                        (21,773
                        )Acquisition
      of patents
                        
                        
                        (23,045
                        )
                        
                        
                        (56,479
                        )Net
      cash used in investing activities
                        
                        
                        (208,332
                        )
                        
                        
                        (78,252
                        )Cash
      flows from financing activitiesRestricted
      cash
                        
                        
                        -
                        
                        
                        
                        298,723Proceeds
      from the exercise of warrants
                        
                        
                        -
                        
                        
                        
                        876Cash
      dividends on series B preferred stock
                        
                        
                        (169,040
                        )
                        
                        
                        (169,760
                        )Net
      cash (used in) provided by financing activities
                        
                        
                        (169,040
                        )
                        
                        
                        129,839Net
      increase (decrease) in cash and cash equivalents
                        
                        
                        14,023
                        
                        
                        
                        (717,015
                        )Cash
      and cash equivalentsBeginning
      of period
                        
                        
                        3,143,904
                        
                        
                        
                        3,955,835End
      of period
                        
                        $
                        3,157,927
                        
                        
                        $
                        3,238,820Supplemental
      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 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 the 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 six months ended June
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. As of May 19, 2009, the
Company regained compliance.





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
Securities and Exchange Commission Staff Accounting Bulletin No. 104, “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 the American Institute
of Certified Public




4


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Accountants
Statement of Position 81-1, “Accounting for Performance of Construction-Type and
Certain Production-Type Contracts.”  The Company does not sell
software licenses, upgrades or enhancements, or post-contract customer
services.





Reimbursements
received for out-of-pocket expenses incurred are reported as revenue in the
financial statements in accordance with Emerging Issues Task Force No. 01-14,
“Income Statement Characterization of Reimbursements received for
‘Out-of-Pocket’ Expenses Incurred.”





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 August 12,
2009, the date the financial statements were issued.





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


In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standard No. 157, “Fair Value Measurements,”
(“SFAS 157”) which is effective for fiscal years beginning after November 15,
2007 and for interim periods within those years. This statement defines fair
value, establishes a framework for measuring fair value and expands the related
disclosure requirements. This statement applies under other accounting
pronouncements that require or permit fair value measurements.  The
statement indicates, among other matters, that a fair value measurement assumes
that the transaction to sell an asset or transfer a liability occurs in the
principal market for the asset or liability or, in the absence of a principal
market, the most advantageous market for the asset or liability.  FAS
157 defines fair value based upon an exit price model.  Relative to
FAS 157, the FASB issued FASB Staff Positions (“FSP”) 157-1, FSP 157-2, and
proposed FSP 157-c.  FSP 157-1 amends FAS 157 to exclude SFAS No. 13,
“Accounting for Leases,” (“FAS 13”), and its related interpretive accounting
pronouncements that address leasing transactions, while FSP 157-2 delays the
effective date of FAS 157 for all nonfinancial assets and nonfinancial
liabilities, except those that are recognized or disclosed at fair value in the
financial statements on a recurring basis.  FSP 157-c clarifies the
principles in FAS 157 on the fair value measurement of
liabilities.  The Company adopted FAS 157 as of January 1, 2008. Refer
to Note 5 for additional discussion on fair value measurements.




5


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





In
December 2007, the FASB issued SFAS No. 141(R), "Business Combinations," (“FAS
141(R)”) which replaces SFAS No. 141, “Business Combinations.”  FAS
141(R) establishes principles and requirements for determining how an enterprise
recognizes and measures the fair value of certain assets and liabilities
acquired in a business combination, including noncontrolling interests,
contingent consideration and certain acquired contingencies. FAS 141 ( R ) also
requires that acquisition-related transaction expenses and restructuring costs
be expensed as incurred rather than capitalized as a component of the business
combination.   FAS 141(R)   became   effective   on  
January 1, 2009.





In
December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51," (“FAS 160”). FAS
160 establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary (previously referred to as minority interests). FAS 160
also requires that a retained noncontrolling interest upon the deconsolidation
of a subsidiary be initially measured at its fair value. Under FAS 160,
noncontrolling interests are reported as a separate component of consolidated
stockholders’ equity. In addition, net income allocable to noncontrolling
interests and net income attributable to stockholders of the Company
are reported separately in the consolidated statements of  operations. FAS 160
became effective beginning January 1, 2009. FAS 160 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.




In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities,” (“FAS 161”).  The new standard amends SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (“FAS
133”) and enhances disclosures about how and why a company uses derivatives; how
derivative instruments are accounted for under FAS 133 (and the interpretations
of that standard); and how derivatives affect a company’s financial position,
financial performance and cash flows.  FAS 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008.  The Company has adopted this standard as of
January 1, 2009.  Additional disclosures have been included in the
Company’s condensed consolidated financial statements in accordance with FAS
161.





In
April 2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3,
“Determination of the Useful Life of Intangible Assets,” (“FSP 142-3”). FSP
142-3 amends the factors that should be considered in developing renewal or
extension assumptions used to determine the useful life of a recognized
intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets,”
(“FAS 142”) .  The objective of FSP 142-3 is to improve the
consistency between the useful life of a recognized intangible asset under FAS
142 and the period of expected cash flows used to measure the fair value of the
asset under FAS 141(R) and other United States GAAP principles .  FSP
142-3 is effective prospectively for intangible assets acquired or received
after January 1, 2009.  The Company does not expect FSP 142-3 to have
a material impact on its accounting for future acquisitions or renewals of
intangible assets.





Effective
January 1, 2009, the Company adopted the provisions of Emerging Issues Task
Force (‘‘EITF’’) EITF 07-05, Determining Whether an Instrument
(or Embedded Feature) is Indexed to an Entity’s Own Stock, (‘‘EITF
07-05’’). EITF 07-05 applies to any freestanding financial instruments or
embedded features that have the characteristics of a derivative, as defined by
SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, and to any freestanding
financial instruments that are potentially settled in an entity’s own common
stock. The adoption of EITF 07-05 had a material impact on our consolidated
financial position, results of operations and cash flows as the Company has
financial instruments with characteristics which meet the definition of a
derivative instrument in accordance with the provisions of this
pronouncement.  Refer to Note 5 for additional disclosure regarding the
adoption of EITF 07-05.




6


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





In April
2009, the FASB issued FSP SFAS 157-4, “Determining Whether a Market Is Not
Active and a Transaction Is Not Distressed,” (“FSP FAS 157-4”) which provides
guidelines for making fair value measurements more consistent with the
principles presented in SFAS 157.  FSP FAS 157-4 provides additional
authoritative guidance in determining whether a market is active or inactive and
whether a transaction is distressed, is applicable to all assets and liabilities
(i.e. financial and nonfinancial) and will require enhanced
disclosures.  This standard is effective for periods ending after June
15, 2009.  The Company is evaluating the impact that this standard
will have on the Company’s financial position and results of
operations.





In April
2009, the FASB issued FSP SFAS 107-1 and APB 28-1, “Interim Disclosures about
Fair Value of Financial Instruments,” (“FSP FAS 107-1 and APB
28-1”).  FSP FAS 107-1 and APB 28-1 amends SFAS No. 107, “Disclosures
about Fair Value of Financial Instruments,” to require disclosures about fair
value of financial instruments in interim as well as in annual financial
statements.  FSP FAS 107-1 and APB 28-1 amends APB Opinion No. 28,
“Interim Financial Reporting,” to require those disclosures in all interim
financial statements. This standard is effective for periods ending after June
15, 2009.  The adoption of this standard did not have any impact on
the Company’s financial position and results of operations.





In
May 2009, the FASB issued SFAS 165, Subsequent Events (“SFAS 165”), which
provides guidance on events that occur after the balance sheet date but prior to
the issuance of the financial statements. SFAS 165 distinguishes events
requiring recognition in the financial statements and those that may require
disclosure in the financial statements. Furthermore, SFAS 165 requires
disclosure of the date through which subsequent events were evaluated. SFAS 165
is effective for interim and annual periods after June 15, 2009.
  The adoption of SFAS 165 is did not have any impact on the condensed
consolidated financial statements.





In July
2009, the FASB issued Statement of Financial Accounting Standards No. 168, “The
FASB Accounting Codification and the Hierarchy of Generally Accepted Accounting
Principles” (“SFAS. 168"). Statement No. 168 supersedes Statement No. 162 issued
in May 2008. Statement No. 168 will become the source of authoritative U.S.
generally accepted accounting principles (GAAP) recognized by the FASB to be
applied by nongovernmental entities. 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. On the
effective date of this Statement, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other
nongrandfathered non-SEC accounting literature not included in the Codification
will become nonauthoritative.   This Statement is effective for our
quarterly reporting period ending September 30, 2009.  The adoption of
Statement No. 168 is not expected to have any impact the Company’s consolidated
financial position or results of operations.





NOTE 3 -
Stock-Based
Compensation





The
Company uses the fair value recognition provisions of Statement of Financial
Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” using the
modified prospective method.  Consequently, for the six months ended
June 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 $554,348 and $687,291,
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.




7


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





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 six
months ended June 30, 2009 and 2008 using the Black-Scholes option-pricing
model:





June
      30,2009
                  
                  
                  2008Risk
      free interest rate
                  
                  
                  2.96
                  %
                  
                  
                  3.85
                  %Expected
      term (years)
                  
                  
                  10.0
                  
                  
                  
                  9.7Expected
      volatility
                  
                  
                  85.73
                  
                  
                  
                  89.7
                  %Expected
      dividend yield
                  
                  
                  -
                  
                  
                  
                  -





A summary
of the option activity for the six months ended June 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
                  
                  
                  743,058
                  
                  
                  
                  0.73Cancelled
                  
                  
                  (6,000
                  )
                  
                  
                  (1.20
                  )Exercised
                  
                  
                  -
                  
                  
                  
                  -Options
      outstanding at June 30, 2009
                  
                  
                  5,413,926
                  
                  
                  
                  1.42
                  
                  
                  
                  6.54Options
      exercisable at June 30, 2009
                  
                  
                  3,374,849
                  
                  
                  
                  1.99
                  
                  
                  
                  5.69





The
weighted-average grant-date fair value of options granted during the six months
ended June 30, 2009 and 2008 was $545,525 and $1,031,981,
respectively.  There have been no options exercised during the six
months ended June 30, 2009.





NOTE 4 -
Stockholders’
Equity





During
the first two quarters ended June 30, 2009, 202.5 shares of the Company’s series
A convertible preferred stock were converted into 168,148 shares of the
Company’s common stock and no shares of series B convertible preferred stock
were converted.


8





VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





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.
The shares were issued in transactions not involving a public offering and
exempt from registration pursuant to Section 4(2) of the Securities Act of 1933,
or Securities Act. The purchaser is an accredited investor under the Securities
Act, was knowledgeable about the Company's operations and financial condition
and had access to such information. The sales did not involve any form of
general solicitation. The shares were purchased for investment purposes only and
contain restrictions on transfer with certificates containing a legend setting
forth such restrictions.




NOTE 5
- Derivative
Liability





In June
2008, the FASB finalized Emerging Issues Task Force (“EITF”) 07-05, “Determining
Whether an Instrument (or Embedded Feature) is indexed to an Entity’s Own
Stock.”  Under EITF 07-05, 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 EITF 07-05, the warrants were recognized as a derivative instrument and
have been re-characterized as derivative liabilities. SFAS No. 133, “Accounting
for Derivative Instruments and Hedging Activities” (“FAS 133”) 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.





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





June 30, 2009
                    
                    
                    January 1,
                      2009
                    
                    
                    November 5,
                      2005Series
      A warrants:Risk-free
      interest rate
                    
                    
                    .19
                    %
                    
                    
                    2.24
                    %
                    
                    
                    4.66
                    %Expected
      volatility
                    
                    
                    69.4
                    %
                    
                    
                    72.9
                    %
                    
                    
                    59.6
                    %Expected
      life (in years)
                    
                    
                    .42
                    
                    
                    
                    .92
                    
                    
                    
                    4Expected
      dividend yield
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Number
      of warrants
                    
                    
                    1,400,000
                    
                    
                    
                    1,400,000
                    
                    
                    
                    1,400,000Fair
      value
                    
                    $
                    23,380
                    
                    
                    $
                    14,840
                    
                    
                    $
                    1,299,900





June 30, 2009
                    
                    
                    January 1,
                      2009
                    
                    
                    September 7,
                      2007Series
      B warrants:Risk-free
      interest rate
                    
                    
                    2.54
                    %
                    
                    
                    2.24
                    %
                    
                    
                    4.37
                    %Expected
      volatility
                    
                    
                    59.5
                    %
                    
                    
                    57.8
                    %
                    
                    
                    70.0
                    %Expected
      life (in years)
                    
                    
                    5.16
                    
                    
                    
                    5.67
                    
                    
                    
                    7Expected
      dividend yield
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Number
      of warrants
                    
                    
                    2,234,764
                    
                    
                    
                    2,234,764
                    
                    
                    
                    2,234,764Fair
      value
                    
                    $
                    1,002,851
                    
                    
                    $
                    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, and
does not expect to pay dividends in the future.




9


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





EITF
07-05 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.





The fair
value of these warrant liabilities was $1,026,231 at June 30, 2009. The $603,323
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


FAS 157
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 June 30, 2009:





Fair Value Measurements at June 30, 2009Total Carrying
                    Value at June
                    30, 2009
                  
                  
                  Quoted prices
                    in active
                    markets
                    (Level 1)
                  
                  
                  Significant
                    other
                    observable
                    inputs
                    (Level 2)
                  
                  
                  Significant
                    unobservable
                    inputs (Level 3)Derivative
      liabilities
                  
                  $
                  1,026,231
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,026,231





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 six months ended June 30, 2009.




10


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





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 June 30:





2009
                  
                  
                  2008Series
      A convertible preferred stock
                  
                  
                  3,132,950
                  
                  
                  
                  3,301,098Series
      B convertible preferred stock
                    Series
      A warrants to purchase common stock
                  
                  
                  3,509,092
      1,629,402
                  
                  
                  
                  3,509,092
      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
                  
                  
                  5,555,616
                  
                  
                  
                  4,972,366Total
                  
                  
                  16,506,712
                  
                  
                  
                  16,091,610





NOTE 7 -
Income
Taxes





Effective
January 1, 2007, the Company adopted the provisions of FASB Interpretation No.
48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB
Statement No. 109” (“FIN No. 48”).  FIN No. 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise’s
financial statements in accordance with FASB Statement 109, “Accounting for
Income Taxes,” and prescribes a recognition threshold and measurement process
for financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return.





Upon
adoption, the Company has concluded that there were no significant uncertain tax
positions requiring recognition in its financial statements.  As of
June 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 to
have 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.  The Company
did not have any interest and penalties accrued upon the adoption of FIN No. 48
and as of June 30, 2009, the Company does not have any interest and penalties
accrued related to unrecognized tax benefits.


11


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





NOTE 8 -
Concentration of
Credit Risk





The
Company’s top customer accounted for approximately 30% of its total revenue and
27% of its accounts receivable for the six months ended June 30, 2009. For the
six months ended June 30, 2008, its then top three customers accounted for 15%,
13% and 12% of its total revenue.




12


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 June 30, 2009 and December 31, 2008
and the related condensed consolidated statements of operations and cash flows
for the quarters ended June 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




We are a
provider of imaging solutions to accelerate drug and medical device development.
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.





Since
VirtualScopics’ inception, VirtualScopics’ principal activities have consisted
of:





·
            research
      and development;





·
            hiring
      technical, sales and other
personnel;





·
            providing
      imaging services and consultancy to pharmaceutical and medical device
      companies;





·
            business
      development of customer and strategic relationships;
  and





·
            raising
      capital.





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.  We expect that the concentration of
our revenue will continue in these services and in these areas throughout
2009.  Revenues are recognized as the services are performed and as
images processed are quantified and delivered to our customers.




13


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.





Additionally,
once we enter into a new contract for participation in a drug trial, there are
several factors that can effect 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.





Results
of Operations





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





Revenues





We had
revenues of $2,541,000 for the quarter ended June 30, 2009 compared to
$1,733,000 for the comparable period in 2008.  This $808,000, or 47%,
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 82 different projects, in connection with our
pharmaceutical drug trials in the fields of oncology, osteoarthritis and various
other projects.  This compares to 64 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 second quarter of 2009, 70% of our business was in
oncology services, 21% in musculoskeletal, the remaining 9% was work performed
for the Department of Defense and in other therapeutic areas. This compares to
55%, 27% and 18%, respectively, in 2008. During the second three months of 2009,
59% of the revenues were derived from Phase II and III studies compared to 44%
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 $1,393,000 for the second quarter of 2009 compared to $712,000
for the comparable period in 2008, an increase of 681,000, or
96%.  Our gross profit margin was 55% during the period ended June 30,
2009 compared to 41% in the first six months 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.


14


Research
and Development





Research
and development costs increased in the quarter ended June 30, 2009 by $45,000,
or 21%, to $258,000, when compared to the quarter ended June 30,
2008.  The increase was a result of relocation costs for one of our
scientific staff. 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 June 30, 2009, there were 9
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 June 30, 2009 by $27,000, or 7%,
to $357,000, when compared to the quarter ended June 30, 2008.  The
decrease was a result of the costs incurred rebranding our marketing materials
in the first and second quarter of 2008. The resulting marketing materials now
display a consistent and representative reflection of the services we provide
and the value it generates for our customers. The decrease in the outside
marketing costs during the second quarter of 2009 were offset by higher costs
associated with the attendance at various trade shows and company sponsored
seminars in 2009.





General
and Administrative





General
and administrative expenses for the quarter ended June 30, 2009 were $859,000, a
decrease of $5,000 or 1%, when compared to the quarter ended June 30,
2008.  The slight decrease was mainly due to the valuation changes
within our stock compensation expense. In May 2009, the stockholders approved a
stock option exchange program whereby certain option holders are eligible to
receive 1 option at the closing market price on the date of the exchange for 2
of their current options. Based on the amount of option holders electing to
participate, the non-cash stock compensation expense may increase at the time of
the exchange. The specific timing of the exchange is not yet determined however,
it is estimated to occur prior to year end.





Depreciation
and Amortization





Depreciation
and amortization charges remained constant at $119,000 for the quarter ended
June 30, 2009 when compared to the quarter ended June 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. We anticipate higher IT costs in 2009 as we
seek efficiencies through acquired software applications and computers necessary
to support the existing employees and the planned increase in our
headcount.





Other
Income (Expense)





Interest
income for the quarter ended June 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 $206,000 related to the loss in fair value of certain derivative
financial instruments as a result of the implementation of EITF 07-05 during the
first quarter of 2009 (see Financial Statement Note 5).  Under the
guidelines of EITF 07-05, and because implementation was required beginning in
2009, there was no adjustment required in 2008.





Net
Loss





Net loss
for the quarter ended June 30, 2009 was $413,000 compared to a net loss of
$851,000 for the quarter ended June 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.


15


Results
of Operations for the Six Months Ended June 30, 2009 Compared to the Six Months
Ended June 30, 2008





Revenues





Our
revenues for the six months ended June 30, 2009 were $4,676,000, an increase of
$1,309,000 or 39% over the first half 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 92
projects in the first half of 2009, as compared to 70 in the first half 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 $2,513,000 for the six months ended June 30, 2009 compared to
$1,316,000 for the comparable period in 2008. Our gross profit improved
$1,197,000 or 91% for the first two quarters combined in 2009 compared to the
first two 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
half of 2009, 57% of our revenues were generated from Phase II/III trials as
compared to 36% during the same period a year ago.





Research
and Development





Total
research and development expenditures were $494,000 in the first half of 2009
compared to $465,000 for the comparable period in 2008, an increase of 6%. The
slight increase was due to relocation costs incurred in 2009 related to one of
our scientific staff. 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 June 30, 2009, there were 9
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 six months ended June 30, 2009 decreased to $640,000, a
decrease of $33,000 or 5% over the first half 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 six months ended June 30, 2009 were
$1,704,000, a decrease of $58,000 or 3%, over the first half 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.


16


Depreciation
and Amortization





Depreciation
and amortization charges remained consistent in the six months ended June 30,
2009 and 2008.





Other
Income (Expense)





Interest
income for the six months ended June 30, 2009 was $3,000 and composed of
interest derived on the Company’s operating and savings accounts, compared to
interest income of $46,000 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 $603,000 related to the loss in fair value of certain
derivative financial instruments as a result of the implementation of EITF 07-05
in 2009 (see Financial Statement Note 5).  Under the guidelines of
EITF 07-05, and because implementation was required beginning in 2009, there was
no adjustment required in 2008.





Net
Loss





Our net
loss for the six months ended June 30, 2009 was $1,169,000 compared to a net
loss of $1,776,000 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 June 30, 2009 was approximately $1,837,000 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 EITF 07-05
which became effective during 2009 and therefore, no similar adjustment was
required in 2008.





Net cash
provided by operating activities totaled $391,000 in the six months ended June
30, 2009 compared to net cash used of $769,000 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 $208,000 in the purchase of equipment and the acquisition of patents in
the first half of 2009, compared to $78,000 for the investment in these items in
the first half of 2008. The increase represents investments in our IT
infrastructure to support the growing demand for our services.





Cash used
in our financing activities in the six months ended June 30, 2009 was $169,000,
compared to $130,000 provided by financing activities in the six months ended
June 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.


17


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.





Recently
Issued and Adopted Accounting Pronouncements





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standard No. 157, “Fair Value Measurements,”
(“SFAS 157”) which is effective for fiscal years beginning after November 15,
2007 and for interim periods within those years. This statement defines fair
value, establishes a framework for measuring fair value and expands the related
disclosure requirements. This statement applies under other accounting
pronouncements that require or permit fair value measurements.  The
statement indicates, among other matters, that a fair value measurement assumes
that the transaction to sell an asset or transfer a liability occurs in the
principal market for the asset or liability or, in the absence of a principal
market, the most advantageous market for the asset or liability.  FAS
157 defines fair value based upon an exit price model.  Relative to
FAS 157, the FASB issued FASB Staff Positions (“FSP”) 157-1, FSP 157-2, and
proposed FSP 157-c.  FSP 157-1 amends FAS 157 to exclude SFAS No. 13,
“Accounting for Leases,” (“FAS 13”), and its related interpretive accounting
pronouncements that address leasing transactions, while FSP 157-2 delays the
effective date of FAS 157 for all nonfinancial assets and nonfinancial
liabilities, except those that are recognized or disclosed at fair value in the
financial statements on a recurring basis.  FSP 157-c clarifies the
principles in FAS 157 on the fair value measurement of
liabilities.  The Company adopted FAS 157 as of January 1, 2008. Refer
to Note 5 for additional discussion on fair value measurements.





In
December 2007, the FASB issued SFAS No. 141(R), "Business Combinations," (“FAS
141(R)”) which replaces SFAS No. 141, “Business Combinations.”  FAS
141(R) establishes principles and requirements for determining how an enterprise
recognizes and measures the fair value of certain assets and liabilities
acquired in a business combination, including noncontrolling interests,
contingent consideration and certain acquired contingencies. FAS 141 ( R ) also
requires that acquisition-related transaction expenses and restructuring costs
be expensed as incurred rather than capitalized as a component of the business
combination.   FAS 141 ( R )   became   effective   on
  January 1, 2009.





In
December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51," (“FAS 160”). FAS
160 establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary (previously referred to as minority interests). FAS 160
also requires that a retained noncontrolling interest upon the deconsolidation
of a subsidiary be initially measured at its fair value. Under FAS 160,
noncontrolling interests are reported as a separate component of consolidated
stockholders’ equity. In addition, net income allocable to noncontrolling
interests and net income attributable to stockholders of the Company
are  reported separately in the   consolidated statements of
 operations. FAS
160 became effective beginning January 1, 2009.  FAS 160 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.




In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities,” (“FAS 161”).  The new standard amends SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (“FAS
133”) and enhances disclosures about how and why a company uses derivatives; how
derivative instruments are accounted for under FAS 133 (and the interpretations
of that standard); and how derivatives affect a company’s financial position,
financial performance and cash flows.  FAS 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008.  The Company has adopted this standard as of
January 1, 2009.  Additional disclosures have been included in the
Company’s condensed consolidated financial statements in accordance with FAS
161.


18


In
April 2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3,
“Determination of the Useful Life of Intangible Assets ,” (“FSP 142-3”). FSP
142-3 amends the factors that should be considered in developing renewal or
extension assumptions used to determine the useful life of a recognized
intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets,”
(“FAS 142”) .  The objective of FSP 142-3 is to improve the
consistency between the useful life of a recognized intangible asset under FAS
142 and the period of expected cash flows used to measure the fair value of the
asset under FAS 141 ( R ) and other United States GAAP principles
..  FSP 142-3 is effective prospectively for intangible assets acquired
or received after January 1, 2009.  The Company does not expect FSP
142-3 to have a material impact on its accounting for future acquisitions or
renewals of intangible assets.





Effective
January 1, 2009, the Company adopted the provisions of Emerging Issues Task
Force (‘‘EITF’’) EITF 07-05, Determining Whether an Instrument
(or Embedded Feature) is Indexed to an Entity’s Own Stock, (‘‘EITF
07-05’’). EITF 07-05 applies to any freestanding financial instruments or
embedded features that have the characteristics of a derivative, as defined by
SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, and to any freestanding
financial instruments that are potentially settled in an entity’s own common
stock. The adoption of EITF 07-05 had a material impact on our consolidated
financial position, results of operations and cash flows as the Company has
financial instruments with characteristics which meet the definition of a
derivative instrument in accordance with the provisions of this
pronouncement.  Refer to Note 5 for additional disclosure regarding the
adoption of EITF 07-05.





In April
2009, the FASB issued FSP SFAS 157-4, “Determining Whether a Market Is Not
Active and a Transaction Is Not Distressed,” (“FSP FAS 157-4”) which provides
guidelines for making fair value measurements more consistent with the
principles presented in SFAS 157.  FSP FAS 157-4 provides additional
authoritative guidance in determining whether a market is active or inactive and
whether a transaction is distressed, is applicable to all assets and liabilities
(i.e. financial and nonfinancial) and will require enhanced
disclosures.  This standard is effective for periods ending after June
15, 2009.  The Company is evaluating the impact that this standard
will have on the Company’s financial position and results of
operations.





In April
2009, the FASB issued FSP SFAS 107-1 and APB 28-1, “Interim Disclosures about
Fair Value of Financial Instruments,” (“FSP FAS 107-1 and APB
28-1”).  FSP FAS 107-1 and APB 28-1 amends SFAS No. 107, “Disclosures
about Fair Value of Financial Instruments,” to require disclosures about fair
value of financial instruments in interim as well as in annual financial
statements.  FSP FAS 107-1 and APB 28-1 amends APB Opinion No. 28,
“Interim Financial Reporting,” to require those disclosures in all interim
financial statements. This standard is effective for periods ending after June
15, 2009.  The adoption of this standard did not have an impact on the
Company’s financial position and results of operations.





In
May 2009, the FASB issued SFAS 165, Subsequent Events (“SFAS 165”), which
provides guidance on events that occur after the balance sheet date but prior to
the issuance of the financial statements. SFAS 165 distinguishes events
requiring recognition in the financial statements and those that may require
disclosure in the financial statements. Furthermore, SFAS 165 requires
disclosure of the date through which subsequent events were evaluated. SFAS 165
is effective for interim and annual periods after June 15, 2009.
  The adoption of SFAS 165 is did not have any impact on the condensed
consolidated financial statements.





In July
2009, the FASB issued Statement of Financial Accounting Standards No. 168, “The
FASB Accounting Codification and the Hierarchy of Generally Accepted Accounting
Principles” (“SFAS. 168"). Statement No. 168 supersedes Statement No. 162 issued
in May 2008. Statement No. 168 will become the source of authoritative U.S.
generally accepted accounting principles (GAAP) recognized by the FASB to be
applied by nongovernmental entities. 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. On the
effective date of this Statement, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other
nongrandfathered non-SEC accounting literature not included in the Codification
will become nonauthoritative.   This Statement is effective for our
quarterly reporting period ending September 30, 2009.  The adoption of
Statement No. 168 is not expected to have any impact the Company’s consolidated
financial position or results of operations.


19


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;





·
            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.


20


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.





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 June 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 June 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 June 30, 2009, approximately 42.5 shares the Company’s series
A convertible preferred stock were converted into 35,290 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 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





a)  The
Company held its Annual Meeting of Stockholders on May 28, 2009.





c)  The
stockholders voted for the election of eight nominees to serve as directors for
a one-year term expiring in 2010 and until their successors are elected. The
vote was as follows:





Name of Candidate
                        
                        For
                        
                        WithheldMostafa
      Analoui
                        
                        23,039,444
                        
                        370,792Dan
      Kerpelman
                        
                        22,961,600
                        
                        448,636Robert
      Klimasewski
                        
                        23,032,785
                        
                        377,451Sidney
      Knafel
                        
                        21,897,646
                        
                        1,512,590Jeffrey
      Markin
                        
                        23,028,908
                        
                        381,328Norman
      Mintz
                        
                        22,937,787
                        
                        472,449Charles
      Phelps
                        
                        22,942,535
                        
                        467,701Terence
      Walts
                        
                        23,035,537
                        
                        374,699




21


There
were no abstentions and no broker non-votes.





The
stockholders voted to approve an amendment to our Certificate of Incorporation
to effect a reverse stock split of our outstanding common stock in the range of
1:2 to 1:4, to be determined by our Board of Directors at any time between May
28, 2009 and May 28, 2010, without the requirement of further approval by our
stockholders. The vote was 22,763,640for, 626,716against and there were
19,880abstentions.
There were no broker non-votes.





The
stockholders voted to approve our Amended and Restated 2006 Long-Term Incentive
Plan (the “Plan”)  (i) to increase the number of shares authorized for
issuance under the Plan from 2,500,000 to 6,900,000, (ii) to permit conditional
awards under the amended Plan and future amendments thereto, and (iii) to
increase the limitation on the number of shares available for stock awards with
no vesting restrictions from 5% to 20% under the Plan. The vote was
10,140,872for,
7,404,064against
and there were 13,850abstentions. There were
no broker non-votes.





The
stockholders voted to approve a one-time stock option exchange program under
which our eligible employees (including our executive officers) and directors
would be able to elect to exchange outstanding stock options issued under our
equity incentive plans for new lower-priced options. The vote was
11,140,944for,
6,399,895against
and there were 17,947abstentions. There were
no broker non-votes.





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.


22





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:  August
      12, 2009
                  VIRTUALSCOPICS,
      INC./s/  Jeffrey
    MarkinJeffrey
      MarkinPresident
      and Chief Executive Officer/s/  Molly
    HendersonMolly
      HendersonChief
      Business and Financial Officer and SeniorVice
  President




23


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


24