UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549


FORM
10-Q




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





For
      the quarterly period ended
            September 30,
  2010





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





For
      the transition period from
                
                to





Commission
      File Number:
            000-52018





VirtualScopics, Inc.(Exact
      name of registrant as specified in its charter)Delaware
                                
                                04-3007151(State
      or other jurisdiction of incorporation or organization)
                                
                                (I.R.S.
      Employer Identification No.)500 Linden Oaks, Rochester, New
      York
                                
                                14625(Address
      of principal executive offices)
                                
                                (Zip
      Code)(585)249-6231(Registrant’s
      telephone number, including area code)(Former
      name, former address and former fiscal year, if changed since last
      report)





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





x
Yes    ̈
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 companyx





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


Yes  ̈ No
x




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




As of
October 31, 2010, there were 26,313,937 shares of the registrant’s common stock,
$0.001 par value, outstanding.





VIRTUALSCOPICS,
INC.


TABLE OF
CONTENTS




Page
      NumbersPART
      I
                FINANCIAL
      INFORMATIONITEM
      1: Financial StatementsCondensed
      Consolidated Balance Sheets as of September 30, 2010(unaudited)
      and December 31, 2009
                
                1Condensed
      Consolidated Statements of Operations for the three and nine months ended
      September 30, 2010 and 2009 (unaudited)
                
                2Condensed
      Consolidated Statements of Cash Flows for the nine months ended September
      30, 2010 and 2009 (unaudited)
                
                3Notes
      to Condensed Consolidated Financial
      Statements  (unaudited)
                
                4-14ITEM
      2: Management's Discussion and Analysis of Financial Condition and Results
      of Operations
                
                15-24ITEM
      4: Controls and Procedures
                
                24-25PART
      II
                OTHER
      INFORMATIONITEM
      1: Legal Proceedings
                
                25ITEM
      2: Unregistered Sales of Equity Securities and Use of
    Proceeds
                
                25ITEM
      3: Defaults Upon Senior Securities
                
                25ITEM
      5: Other Information
                
                25ITEM
      6: Exhibits
                
                25-26


i





PART
1:  FINANCIAL INFORMATION




ITEM
1.  Financial Statements




VirtualScopics,
Inc. and Subsidiary


Condensed
Consolidated Balance Sheets





September
      30,
                    
                    
                    December
      31,2010
                    
                    
                    2009(Unaudited)AssetsCurrent
      assetsCash
                    
                    $
                    4,009,477
                    
                    
                    $
                    4,327,410Accounts
      receivable, net
                    
                    
                    2,558,323
                    
                    
                    
                    1,481,381Prepaid
      expenses and other current assets
                    
                    
                    358,376
                    
                    
                    
                    387,247Total
      current assets
                    
                    
                    6,926,176
                    
                    
                    
                    6,196,038Patents,
      net
                    
                    
                    1,739,667
                    
                    
                    
                    1,832,560Property
      and equipment, net
                    
                    
                    428,833
                    
                    
                    
                    456,169Other
      assets
                    
                    
                    -
                    
                    
                    
                    33,258Total
      assets
                    
                    $
                    9,094,676
                    
                    
                    $
                    8,518,025Liabilities
      and Stockholders’ EquityCurrent
      liabilitiesAccounts
      payable and accrued expenses
                    
                    $
                    930,687
                    
                    
                    $
                    658,430Accrued
      payroll
                    
                    
                    654,455
                    
                    
                    
                    837,177Unearned
      revenue
                    
                    
                    276,973
                    
                    
                    
                    1,011,498Derivative
      liability
                    
                    
                    780,096
                    
                    
                    
                    1,139,953Total
      current liabilities
                    
                    
                    2,642,211
                    
                    
                    
                    3,647,058Commitments
      and ContingenciesStockholders'
      EquityConvertible
      preferred stock, $0.001 par value; 15,000,000 shares
      authorized;Series
      A 8,400 shares authorized; issued and outstanding, 3,188 and 3,438 shares
      at September 30, 2010 and December 31, 2009, respectively; liquidation
      preference $1,000 per share
                    
                    
                    3
                    
                    
                    
                    3Series
      B 6,000 shares authorized; issued and outstanding, 2,026 and 2,910 at
      September 30, 2010 and December 31, 2009, respectively; liquidation
      preference $1,000 per share
                    
                    
                    2
                    
                    
                    
                    3Common
      stock, $0.001 par value; 85,000,000 shares authorized;issued
      and outstanding, 26,313,937 and 25,233,255 shares at September 30, 2010
      and December 31, 2009, respectively
                    
                    
                    26,314
                    
                    
                    
                    25,233Additional
      paid-in capital
                    
                    
                    14,957,532
                    
                    
                    
                    14,354,929Accumulated
      deficit
                    
                    
                    (8,531,386
                    )
                    
                    
                    (9,509,201
                    )Total
      stockholders' equity
                    
                    
                    6,452,465
                    
                    
                    
                    4,870,967Total
      liabilities and stockholders' equity
                    
                    $
                    9,094,676
                    
                    
                    $
                    8,518,025





See notes
to condensed consolidated financial statements.


1


VirtualScopics,
Inc. and Subsidiary


Condensed
Consolidated Statements of Operations


(unaudited)





For the Three Months Ended
                      September 30,
                    
                    
                    For the Nine Months Ended
                      September 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Revenues
                    
                    $
                    3,590,591
                    
                    
                    $
                    2,797,680
                    
                    
                    $
                    9,883,190
                    
                    
                    $
                    7,473,366Cost
      of services
                    
                    
                    1,696,279
                    
                    
                    
                    1,201,353
                    
                    
                    
                    4,736,088
                    
                    
                    
                    3,363,916Gross
      profit
                    
                    
                    1,894,312
                    
                    
                    
                    1,596,327
                    
                    
                    
                    5,147,102
                    
                    
                    
                    4,109,450Operating
      expensesResearch
      and development
                    
                    
                    270,280
                    
                    
                    
                    255,755
                    
                    
                    
                    789,517
                    
                    
                    
                    749,490Sales
      and marketing
                    
                    
                    263,198
                    
                    
                    
                    238,112
                    
                    
                    
                    904,522
                    
                    
                    
                    877,788General
      and administrative
                    
                    
                    831,187
                    
                    
                    
                    798,427
                    
                    
                    
                    2,447,495
                    
                    
                    
                    2,502,618Depreciation
      and amortization
                    
                    
                    129,412
                    
                    
                    
                    114,707
                    
                    
                    
                    381,425
                    
                    
                    
                    351,344Total
      operating expenses
                    
                    
                    1,494,077
                    
                    
                    
                    1,407,001
                    
                    
                    
                    4,522,959
                    
                    
                    
                    4,481,240Operating
      income (loss)
                    
                    
                    400,235
                    
                    
                    
                    189,326
                    
                    
                    
                    624,143
                    
                    
                    
                    (371,790
                    )Other
      income (expense)Interest
      income
                    
                    
                    1,058
                    
                    
                    
                    668
                    
                    
                    
                    8,417
                    
                    
                    
                    3,948Other
      expense
                    
                    
                    (9,316
                    )
                    
                    
                    (4,226
                    )
                    
                    
                    (14,602
                    )
                    
                    
                    (12,303
                    )Gain
      (Loss) on derivative financial instrument
                    
                    
                    236,722
                    
                    
                    
                    (401,675
                    )
                    
                    
                    359,857
                    
                    
                    
                    (1,004,998
                    )Total
      other income (expense)
                    
                    
                    228,464
                    
                    
                    
                    (405,233
                    )
                    
                    
                    353,672
                    
                    
                    
                    (1,013,353
                    )Net
      income (loss)
                    
                    
                    628,699
                    
                    
                    
                    (215,907
                    )
                    
                    
                    977,815
                    
                    
                    
                    (1,385,143
                    )Series
      B preferred stock dividend
                    
                    
                    40,520
                    
                    
                    
                    75,476
                    
                    
                    
                    140,577
                    
                    
                    
                    244,516Net
      income (loss) attributable to
    common  stockholders
                    
                    $
                    588,179
                    
                    
                    $
                    (291,383
                    )
                    
                    $
                    837,238
                    
                    
                    $
                    (1,629,659
                    )Weighted
      average basic shares outstanding
                    
                    
                    26,313,937
                    
                    
                    
                    24,129,045
                    
                    
                    
                    25,975,864
                    
                    
                    
                    23,802,742Weighted
      average diluted shares outstanding
                    
                    
                    31,039,284
                    
                    
                    
                    24,129,045
                    
                    
                    
                    30,794,874
                    
                    
                    
                    23,802,742Basic
      earnings (loss) per share
                    
                    $
                    0.02
                    
                    
                    $
                    (0.01
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    (0.07
                    )Diluted
      earnings (loss) per share
                    
                    $
                    0.02
                    
                    
                    $
                    (0.01
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    (0.07
                    )





See notes
to condensed consolidated financial statements.


2


VirtualScopics,
Inc. and Subsidiary


Condensed
Consolidated Statements of Cash Flows


(unaudited)





For
      the Nine Months Ended September 30,2010
                
                
                2009Cash
      flows from operating activitiesNet
      income (loss)
                
                $
                977,815
                
                
                $
                (1,385,143
                )Adjustments
      to reconcile net income (loss) to net cash (used in) provided by operating
      activities:Depreciation
      and amortization
                
                
                381,425
                
                
                
                351,344Loss
      on disposal of asset
                
                
                -
                
                
                
                2,904Stock-based
      compensation
                
                
                621,774
                
                
                
                836,403Derivative
      financial instrument
                
                
                (359,857
                )
                
                
                1,004,998Changes
      in operating assets and liabilitiesAccounts
      receivable
                
                
                (1,076,942
                )
                
                
                (791,517
                )Prepaid
      expenses and other assets
                
                
                (30,518
                )
                
                
                (96,128
                )Accounts
      payable and accrued expenses
                
                
                369,493
                
                
                
                155,847Accrued
      payroll
                
                
                (182,722
                )
                
                
                (6,696
                )Unearned
      revenue
                
                
                (734,525
                )
                
                
                947,012Total
      adjustments
                
                
                (1,011,872
                )
                
                
                2,404,167Net
      cash (used in) provided by operating activities
                
                
                (34,057
                )
                
                
                1,019,024Cash
      flows from investing activitiesPurchase
      of equipment
                
                
                (161,297
                )
                
                
                (222,872
                )Acquisition
      of patents
                
                
                (7,252
                )
                
                
                (43,044
                )Net
      cash used in investing activities
                
                
                (168,549
                )
                
                
                (265,916
                )Cash
      flows from financing activitiesProceeds
      from the exercise of stock options for common stock
                
                
                25,250
                
                
                
                -Cash
      dividends on series B preferred stock
                
                
                (140,577
                )
                
                
                (244,516
                )Net
      cash used in financing activities
                
                
                (115,327
                )
                
                
                (244,516
                )Net
      (decrease) increase in cash and cash equivalents
                
                
                (317,933
                )
                
                
                508,592Cash
      and cash equivalentsBeginning
      of period
                
                
                4,327,410
                
                
                
                3,143,904End
      of period
                
                $
                4,009,477
                
                
                $
                3,652,496Supplemental
      disclosure of cash flow informationNon-cash
      financing activity:Issuance
      of common stock for partial payment of rent in equity
                
                $
                -
                
                
                $
                105,570Issuance
      of restricted stock awards in settlement of accrued
    liability
                
                $
                132,303
                
                
                $
                -





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.  The Company has created a suite of image
analysis software tools and applications which are used in detecting and
measuring specific anatomical structures and metabolic activity using medical
images.  The Company’s developed proprietary software provides
measurement capabilities designed to improve clinical research and
development.





Basis of
Presentation


The
accompanying unaudited condensed consolidated financial statements of the
Company have been condensed in certain respects and should, therefore, be read
in conjunction with the audited consolidated financial statements and notes
related thereto contained in the Company’s Annual Report on Form 10-K as of and
for the year ended December 31, 2009.  In the opinion of management,
these financial statements contain all adjustments necessary for a fair
presentation for the interim period, all of which were normal recurring
adjustments.  The results of operations for the nine months ended
September 30, 2010 are not necessarily indicative of the results to be expected
for the full year ending December 31, 2010.





NOTE 2 -
Summary of Certain
Significant Accounting Policies





Principles of
Consolidation


The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiary, VirtualScopics, LLC.  All
significant intercompany balances and transactions have been eliminated in
consolidation.





Certain
prior period amounts have been reclassified to conform to the current year
presentation.





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 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 (Note 5).


4


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Revenue
Recognition


The
Company 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.  The Company does not sell
software, 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.





Income
Taxes


Income
taxes are accounted for under the asset and liability
method.  Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases, and operating loss and tax credit
carryforwards.  Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or
settled.  The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in operations in the period that includes the
enactment date.  A valuation allowance is provided when it is more
likely than not that some portion or all of a deferred tax asset will not be
realized.  The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income and the reversal of
deferred tax liabilities during the period in which related temporary
differences become deductible. The benefit of tax positions taken or expected to
be taken in the Company’s income tax returns are recognized in the consolidated
financial statements if such positions are more likely than not of being
sustained.





Research and
Development


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


5


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Fair Value of Financial
Instruments


Fair
value of financial instruments is defined as an exit price, which is the price
that would be received upon sale of an asset or paid upon transfer of a
liability in an orderly transaction between market participants at the
measurement date.  The degree of judgment utilized in measuring the
fair value of assets and liabilities generally correlates to the level of
pricing observability.  Financial assets and liabilities with readily
available, actively quoted prices or for which fair value can be measured from
actively quoted prices in active markets generally have more pricing
observability and require less judgment in measuring fair
value.  Conversely, financial assets and liabilities that are rarely
traded or not quoted have less price observability and are generally measured at
fair value using valuation models that require more judgment.  These
valuation techniques involve some level of management estimation and judgment,
the degree of which is dependent on the price transparency of the asset,
liability or market and the nature of the asset or liability.  The
Company has categorized its financial assets and liabilities measured at fair
value into a three-level hierarchy.  See Note 5 – Derivative Liability
for a further discussion regarding the Company’s measurement of financial assets
and liabilities at fair value.





Recently Issued and Adopted
Accounting Pronouncements


In October 2009, the Financial Accounting Standards Board
(“FASB”) issued ASU No. 2009-13, “Multiple-Deliverable Revenue
Arrangements.” This ASU establishes the accounting and reporting guidance for
arrangements including multiple revenue-generating activities. This ASU provides
amendments to the criteria for separating deliverables, measuring and allocating
arrangement consideration to one or more units of accounting. The amendments in
this ASU also establish a selling price hierarchy for determining the selling
price of a deliverable. Significantly enhanced disclosures are also required to
provide information about a vendor’s multiple-deliverable revenue arrangements,
including information about the nature and terms, significant deliverables, and
its performance within arrangements. The amendments also require providing
information about the significant judgments made and changes to those judgments
and about how the application of the relative selling-price method affects the
timing or amount of revenue recognition. The amendments in this ASU are
effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010. Early
application is permitted. The Company is currently evaluating the impact the
adoption of this standard will have on its consolidated financial position and
results of operations.




In
October 2009, the FASB issued ASU No. 2009-14, “Certain Revenue
Arrangements That Include Software Elements.” This ASU changes the accounting
model for revenue arrangements that include both tangible products and software
elements that are “essential to the functionality,” and scopes these products
out of current software revenue guidance. The new guidance will include factors
to help companies determine what software elements are considered “essential to
the functionality.” The amendments will now subject software-enabled products to
other revenue guidance and disclosure requirements, such as guidance surrounding
revenue arrangements with multiple-deliverables. The amendments in this ASU are
effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010. Early
application is permitted. The Company is currently evaluating the impact the
adoption of this standard will have on its consolidated financial position and
results of operations.


6


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





In
January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.
This ASU requires some new disclosures and clarifies some existing disclosure
requirements about fair value measurement as set forth in Codification Subtopic
820-10. ASU 2010-06 amends Codification Subtopic 820-10 and now requires a
reporting entity to use judgment in determining the appropriate classes of
assets and liabilities and to provide disclosures about the valuation techniques
and inputs used to measure fair value for both recurring and nonrecurring fair
value measurements. ASU 2010-06 is effective for interim and annual reporting
periods beginning after December 15, 2009.  As this standard relates
specifically to disclosures, the adoption did not have an impact on the
Company’s consolidated financial position and results of
operations.





In
February 2010, the FASB issued ASU 2010-09, "Subsequent Events (Topic 855) -
Amendments to Certain Recognition and Disclosure Requirements." ASU 2010-09
requires an entity that is an SEC filer to evaluate subsequent events through
the date that the financial statements are issued and removes the requirement
that an SEC filer disclose the date through which subsequent events have been
evaluated. ASC 2010-09 was effective upon issuance. The adoption of this
standard had no effect on our consolidated financial position or results of
operations.





In March
2010, the FASB issued ASU No. 2010-17, Revenue Recognition— Milestone Method
(Topic 605): Milestone Method of Revenue Recognition. This
standard  provides that the milestone method is a valid application of
the proportional performance model for revenue recognition if the milestones are
substantive and there is substantive uncertainty about whether the milestones
will be achieved. Determining whether a milestone is substantive requires
judgment that should be made at the inception of the arrangement. To meet the
definition of a substantive milestone, the consideration earned by achieving the
milestone (1) would have to be commensurate with either the level of effort
required to achieve the milestone or the enhancement in the value of the item
delivered, (2) would have to relate solely to past performance, and
(3) should be reasonable relative to all deliverables and payment terms in
the arrangement. No bifurcation of an individual milestone is allowed and there
can be more than one milestone in an arrangement. The new standard is effective
for interim and annual periods beginning on or after June 15, 2010. Early
adoption is permitted.  The Company is currently evaluating the impact
the adoption of this standard will have on its consolidated financial position
and results of operations.





NOTE 3 -
Stock-Based
Compensation





For the
nine months ended September 30, 2010 and 2009, 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
$586,707 and $809,627, respectively.


7


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





For the
three months ended September 30, 2010 and 2009, 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
$216,611 and $271,748, respectively.





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





The fair
value of stock options granted was determined on the grant date using
assumptions for risk free interest rate, the expected term, expected volatility,
and expected dividend yield.  The risk free interest rate is based on
U.S. Treasury zero-coupon yield curve over the expected term of the
option.  The expected term assumption is determined using the weighted
average midpoint between vest and expiration for all individuals within the
grant. 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 averaged with the Company’s historical
volatility excluding the first ten months due to the discreet and non-recurring
nature of the trading.  In making its determination as to similarity,
the Company considered the industry, stage of life cycle, size, and financial
leverage of such other entities.  The Company’s model includes a zero
dividend yield assumption, as the Company has not historically paid nor does it
anticipate paying dividends on its common stock.  The Company’s model
does not include a discount for post-vesting restrictions, as the Company has
not issued awards with such restrictions.  The periodic expense is
then determined based on the valuation of the options, and at that time an
estimated forfeiture rate is used to reduce the expense recorded. The Company’s
estimate of pre-vesting forfeitures is primarily based on the Company’s
historical experience and is adjusted to reflect actual forfeitures as the
options vest.  The following assumptions were used to estimate the
fair value of options granted for the nine months ended September 30, 2010 and
2009 using the Black-Scholes option-pricing model:





September
      30,2010
                  
                  
                  2009Risk
      free interest rate
                  
                  
                  2.77
                  %
                  
                  
                  2.96
                  %Expected
      term (years)
                  
                  
                  6.2
                  
                  
                  
                  10.0Expected
      volatility
                  
                  
                  57.7
                  %
                  
                  
                  85.7
                  %Expected
      dividend yield
                  
                  
                  -
                  
                  
                  
                  -





8


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





A summary
of the option activity for the nine months ended September 30, 2010 is as
follows:





Number
                      of Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      Price
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      TermOptions
      outstanding at January 1, 2010
                    
                    
                    4,765,802
                    
                    
                    
                    1.28Granted
                    
                    
                    1,557,328
                    
                    
                    
                    1.06Exercised
                    
                    
                    (25,000
                    )
                    
                    
                    (1.01
                    )Cancelled
                    
                    
                    (133,795
                    )
                    
                    
                    (1.64
                    )Options
      outstanding at September 30, 2010
                    
                    
                    6,164,335
                    
                    
                    
                    1.22
                    
                    
                    
                    6.34Options
      exercisable at September 30, 2010
                    
                    
                    2,714,965
                    
                    
                    
                    1.42
                    
                    
                    
                    4.22





The
weighted-average grant-date fair value of options granted during the nine months
ended September 30, 2010 and 2009 was $939,796 and $545,525,
respectively.  There were 25,000 options exercised during the nine
months ended September 30, 2010 resulting in proceeds to the company of
$25,250.





NOTE 4 -
Stockholders’
Equity





During
the nine months ended September 30, 2010, 250 shares of the Company’s series A
convertible preferred stock were converted into 207,590 shares of the Company’s
common stock and 884 shares of series B convertible preferred stock were
converted in 734,038 shares of the Company’s common stock.





Restricted
Stock Awards


A
restricted stock award entitles the recipient to receive shares of unrestricted
common stock upon vesting of the award.  The fair value of each
restricted stock award is determined upon granting of the shares and the related
compensation expense is recognized ratably over the vesting period and charged
to the income statements as non-cash compensation expense.  Restricted
stock awards granted but unvested shares are forfeited upon termination of
employment, unless otherwise agreed.  The fair value of restricted
stock issued under the Plan is determined based on the closing price of the
Company’s common stock on the grant date. During the nine months ended September
30, 2010, the Company issued 114,054 shares of its common stock valued at
$132,303 in settlement of accrued stock awards.


9


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





The
Company incurred $35,067 and $26,776 in compensation expense in the first nine
months of 2010 and 2009, respectively, related to the restricted stock awards
for services by Board members for those respective periods. As of September 30,
2010, accrued expenses includes $51,624 of accrued stock awards representing
43,991 shares of common stock granted but not yet issued to directors for their
services on the board.


NOTE 5
- Derivative
Liability





Effective
January 1, 2009, the Company adopted a new accounting policy requiring it to
change the manner in which it accounts for certain equity instruments. The
warrants issued with the Company’s 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.  Accordingly,
the warrants were recognized as a derivative instrument and have been
re-characterized as derivative liabilities. The change in accounting for
warrants was reported as a cumulative effect of a change in accounting principle
as of January 1, 2009.





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





September 30,
                      2010
                    
                    
                    January 1,
                      2010Series
      B warrants:Risk-free
      interest rate
                    
                    
                    0.94
                    %
                    
                    
                    2.62
                    %Expected
      volatility
                    
                    
                    57.7
                    %
                    
                    
                    67.5
                    %Expected
      life (in years)
                    
                    
                    3.94
                    
                    
                    
                    4.67Expected
      dividend yield
                    
                    
                    -
                    
                    
                    
                    -Number
      of warrants
                    
                    
                    2,234,764
                    
                    
                    
                    2,234,764Fair
      value
                    
                    $
                    780,096
                    
                    
                    $
                    1,139,953





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 averaged with the historical volatility of the Company’s trading
history excluding the first ten months due to the discreet and non-recurring
nature of the trading.  The expected life of the warrants was
determined by the expiration date of the warrants.  The expected
dividend yield was based upon the fact that the Company has not historically
paid dividends on its common stock, and does not expect to pay dividends on its
common stock in the future.





The fair
value of these warrant liabilities was $780,096 at September 30, 2010. The
change in fair value during 2010 of $359,857 is reported in our condensed
consolidated statement of operations as a gain 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.


10


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Fair
Value Measurement





Valuation
Hierarchy


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





The
following table provides the liabilities carried at fair value measured on a
recurring basis as of September 30, 2010:





Fair Value Measurements at September 30, 2010Total Carrying
                    Value at
                    September 30,
                    2010
                  
                  
                  Quoted
                    prices in
                    active
                    markets
                    (Level 1)
                  
                  
                  Significant
                    other
                    observable
                    inputs
                    (Level 2)
                  
                  
                  Significant
                    unobservable
                    inputs (Level 3)Derivative
      liabilities
                  
                  $
                  780,096
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  780,096





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.





The
following table sets forth a summary of the changes in the fair value of our
Level 3 financial liabilities that are measured at fair value on a recurring
basis:





For the three months ended
                  September 30,
                
                
                For the nine months ended
                  September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Beginning
      balance
                
                $
                1,016,818
                
                
                $
                1,026,231
                
                
                $
                1,139,953
                
                
                $
                422,908Net
      unrealized (gain)loss on derivative financial instruments
                
                
                (236,722
                )
                
                
                401,675
                
                
                
                (359,857
                )
                
                
                1,004,998Ending
      balance
                
                $
                780,096
                
                
                $
                1,427,906
                
                
                $
                780,096
                
                
                $
                1,427,906


11


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





NOTE 6 -
Net Income (Loss) Per
Share





Basic net
income per share is computed using the weighted average number of common shares
outstanding during the period. Diluted net income per share is computed using
the weighted average number of common shares and, if dilutive, potential common
shares outstanding during the period. Potential common shares consist of the
incremental common shares issuable upon the exercise of stock options (using the
treasury stock method) and the conversion of the Company’s convertible preferred
stock and warrants (using the if-converted method).





The
following table reconciles the numerator and denominator for the
calculation





For the Three Months Ended
                                                    September 30,
                                                  
                                                  
                                                  For the Nine Months Ended
                                                    September 30,2010
                                                  
                                                  
                                                  2009
                                                  
                                                  
                                                  2010
                                                  
                                                  
                                                  2009Basic
      net income (loss) per shareNumerator:Income
      (loss) from operations
                                                  
                                                  $
                                                  628,699
                                                  
                                                  
                                                  $
                                                  (215,907
                                                  )
                                                  
                                                  $
                                                  977,815
                                                  
                                                  
                                                  $
                                                  (1,385,143
                                                  )Preferred
      stock cash dividends
                                                  
                                                  
                                                  (40,520
                                                  )
                                                  
                                                  
                                                  (75,476
                                                  )
                                                  
                                                  
                                                  (140,577
                                                  )
                                                  
                                                  
                                                  (244,516
                                                  )Numerator
      for basic earningsper
      share:Net
      income (loss) available tocommon
      stockholders
                                                  
                                                  $
                                                  588,179
                                                  
                                                  
                                                  $
                                                  (291,383
                                                  )
                                                  
                                                  $
                                                  837,238
                                                  
                                                  
                                                  $
                                                  (1,629,659
                                                  )Denominator:Weighted
      average basic sharesoutstanding
                                                  
                                                  
                                                  26,313,937
                                                  
                                                  
                                                  
                                                  24,129,045
                                                  
                                                  
                                                  
                                                  25,975,864
                                                  
                                                  
                                                  
                                                  23,802,742Net
      income (loss) per basic share:Income
      (loss) from operations
                                                  
                                                  $
                                                  0.02
                                                  
                                                  
                                                  $
                                                  (0.01
                                                  )
                                                  
                                                  $
                                                  0.04
                                                  
                                                  
                                                  $
                                                  (0.06
                                                  )Preferred
      stock cash dividends
                                                  
                                                  
                                                  0.00
                                                  
                                                  
                                                  
                                                  0.00
                                                  
                                                  
                                                  
                                                  (0.01
                                                  )
                                                  
                                                  
                                                  (0.01
                                                  )Net
      income (loss) available tocommon
      stockholders
                                                  
                                                  $
                                                  0.02
                                                  
                                                  
                                                  $
                                                  (0.01
                                                  )
                                                  
                                                  $
                                                  0.03
                                                  
                                                  
                                                  $
                                                  (0.07
                                                  )Dilutive
      net income (loss) per shareNumerator:Income
      (loss) from operations
                                                  
                                                  $
                                                  628,699
                                                  
                                                  
                                                  $
                                                  (215,907
                                                  )
                                                  
                                                  $
                                                  977,815
                                                  
                                                  
                                                  $
                                                  (1,385,143
                                                  )Preferred
      stock cash dividends
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (75,476
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (244,516
                                                  )Numerator
      for diluted earnings per share:Net
      income (loss) available tocommon
      stockholders
                                                  
                                                  $
                                                  628,699
                                                  
                                                  
                                                  $
                                                  (291,383
                                                  )
                                                  
                                                  $
                                                  977,815
                                                  
                                                  
                                                  $
                                                  (1,629,659
                                                  )Denominator:Weighted
      average basic sharesoutstanding
                                                  
                                                  
                                                  26,313,937
                                                  
                                                  
                                                  
                                                  24,129,045
                                                  
                                                  
                                                  
                                                  25,975,864
                                                  
                                                  
                                                  
                                                  23,802,742Weighted
      average effect of dilutivesecurities:Employee
      stock options
                                                  
                                                  
                                                  287,040
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  352,653
                                                  
                                                  
                                                  
                                                  -Convertible
      preferred stock
                                                  
                                                  
                                                  4,329,496
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  4,329,496
                                                  
                                                  
                                                  
                                                  -Warrants
                                                  
                                                  
                                                  108,811
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  136,861
                                                  
                                                  
                                                  
                                                  -Weighted
      average diluted sharesoutstanding
                                                  
                                                  
                                                  31,039,284
                                                  
                                                  
                                                  
                                                  24,129,045
                                                  
                                                  
                                                  
                                                  30,794,874
                                                  
                                                  
                                                  
                                                  23,802,742Net
      income (loss) per diluted share:Income
      (loss) from operations
                                                  
                                                  $
                                                  0.02
                                                  
                                                  
                                                  $
                                                  (0.01
                                                  )
                                                  
                                                  $
                                                  0.03
                                                  
                                                  
                                                  $
                                                  (0.06
                                                  )Preferred
      stock cash dividends
                                                  
                                                  
                                                  0.00
                                                  
                                                  
                                                  
                                                  0.00
                                                  
                                                  
                                                  
                                                  0.00
                                                  
                                                  
                                                  
                                                  (0.01
                                                  )Net
      income (loss) available tocommon
      stockholders
                                                  
                                                  $
                                                  0.02
                                                  
                                                  
                                                  $
                                                  (0.01
                                                  )
                                                  
                                                  $
                                                  0.03
                                                  
                                                  
                                                  $
                                                  (0.07
                                                  )Securities
      excluded from the weightedaverage
      dilutive common sharesoutstanding
      because their inclusionwould
      have been antidilutive:Preferred
      Stock
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  5,612,399
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  5,612,399Stock
      options
                                                  
                                                  
                                                  5,435,285
                                                  
                                                  
                                                  
                                                  5,558,616
                                                  
                                                  
                                                  
                                                  5,193,461
                                                  
                                                  
                                                  
                                                  5,558,616Warrants
                                                  
                                                  
                                                  2,322,577
                                                  
                                                  
                                                  
                                                  4,309,054
                                                  
                                                  
                                                  
                                                  2,322,577
                                                  
                                                  
                                                  
                                                  4,309,054


12


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





NOTE 7 -
Income
Taxes





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


13


VirtualScopics,
Inc. and Subsidiary


Notes
to Condensed Consolidated Financial Statements


(unaudited)





The
Company will recognize interest and penalties accrued related to unrecognized
tax benefits as components of its income tax provision.  As of
September 30, 2010, the Company does not have any interest and penalties accrued
related to unrecognized tax benefits.





NOTE 8 -
Concentration of
Credit Risk





The
Company’s top customer accounted for approximately 54% of total revenue and 66%
of accounts receivable for the nine months ended September 30, 2010. For the
nine months ended September 30, 2009, the largest customer accounted for 41% of
total revenue and 58% of accounts receivable.





The
Company’s top customer accounted for approximately 60% of total revenue for the
three months ended September 30, 2010. For the three months ended September 30,
2009, the largest customer accounted for 59% of total revenue.





NOTE 9 –
Subsequent
Events





On
October 22, 2010, the Company entered into a Strategic Alliance Agreement with
PPD, Inc. (”Agreement").  The Agreement provides a framework under
which the parties will work to provide integrated clinical and medical imaging
services to biopharmaceutical companies in the therapeutic areas of hematology
and oncology.  Although the initial focus of the alliance will be to
develop integrated service offerings in the areas of hematology and oncology,
the parties intend to work to expand the alliance beyond these therapeutic
areas.





Management
has evaluated subsequent events or transactions occurring through the date the
financial statements were issued.


14


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





The
following discussion should be read in conjunction with VirtualScopics’
condensed consolidated balance sheets as of September 30, 2010 and December 31,
2009 and the related condensed consolidated statements of operations and cash
flows for the quarters ended September 30, 2010 and 2009, included elsewhere in
this report. This discussion contains forward-looking statements, the accuracy
of which involves risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements for many
reasons including, but not limited to, those discussed under the heading
“Forward Looking Statements” below and elsewhere in this report. We disclaim any
obligation to update information contained in any forward-looking
statements.





Overview





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





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





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





·
            reduced
      processing time for image data analysis through
  automation.





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





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





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





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


15


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





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





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





In
October 2010, we entered into a Strategic Alliance Agreement (“Agreement”) with
PPD, Inc., a multi-national CRO based in Wilmington, North
Carolina.  The Agreement provides a framework under which we will work
to provide integrated clinical and medical imaging services to biopharmaceutical
companies in the therapeutic areas of hematology and
oncology.  Although the initial focus of the alliance will be to
develop integrated service offerings in the areas of hematology and oncology,
the parties intend to work to expand the alliance beyond these therapeutic
areas.  We anticipate our alliance with PPD will be an important
channel for VirtualScopics as we look to broaden market awareness of our
company.


16


Results
of Operations





Results
of Operations for Quarter Ended September 30, 2010 Compared to Quarter Ended
September 30, 2009





Revenues





We had
revenues of $3,591,000 for the quarter ended September 30, 2010 compared to
$2,798,000 for the comparable period in 2009.  This $793,000, or 28%,
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 103 different projects, in connection with our
pharmaceutical drug trials in the fields of oncology, osteoarthritis and various
other projects.  This compares to 83 projects during the same period
in 2009. The majority of the demand is seen within our oncology service line;
however, we have recently seen increased interest in our musculoskeletal
applications. During the third quarter of 2010, 83% of our business was in
oncology services, 15% in musculoskeletal, the remaining 2% was in other
therapeutic areas. This compares to 84%, 14% and 2%, respectively, in 2009.
During the third quarter of 2010, 76% of the revenues were derived from Phase II
and III studies compared to 67% during the comparable period in
2009.





Gross
Profit





We had a
gross profit of $1,894,000 for the third quarter of 2010 compared to $1,596,000
for the comparable period in 2009, an increase of 298,000, or
19%.  Our gross profit margin was 53% during the period ended
September 30, 2010 compared to 57% in the third quarter of 2009 due to the
hiring of additional resources within our operation group along with higher
wages for existing employees in 2010 as compared to 2009.  Our margins
are impacted by the nature of the service mix during the reported
quarter.  Site qualification activities tend to result in higher
margins whereas image analysis activities yield a lower margin. Therefore,
depending on the mix of services in a quarter, our margins may vary from quarter
to quarter. Additionally, we continue to invest in our infrastructure to support
efficiencies as we scale the business to support our growth. These investments
and the higher revenue volume allow us to be more effective in the processing of
our services in the future. In order to balance the needs of our customers and
our internal capacity, we anticipate margins around 50% for the remainder of
2010.




Research
and Development





Research
and development costs increased slightly in the quarter ended September 30, 2010
by $15,000, or 6%, to $270,000, when compared to the quarter ended September 30,
2009.  The increase was a result of general wage and benefit cost
increases as well as the addition of two employees within our software
development group in 2009. Our research and development efforts center around
refining our processes through the use of our software platform in order to
allow for greater reporting capabilities by our customers and to gain
efficiencies which we believe will better allow us to standardize our processes
as we scale the business. Additionally, we continue to invest in the
commercialization of new imaging techniques across many modalities and
therapeutic areas to best serve our customers. As of September 30, 2010, there
were ten employees in our research and development group, which includes the
algorithm and software development groups.


17


Sales and
Marketing





Sales and
marketing costs increased in the quarter ended September 30, 2010 by $25,000, or
10%, to $263,000, when compared to the quarter ended September 30,
2009.  The increase was a result of the timing of trade shows and
travel costs during the quarter as compared to the prior year quarter. Our sales
and marketing efforts include conference attendance and presentations,
technically-focused webinars, customer webinars and related travel along with
advertising in key scientific journals and occasional consulting and other costs
associated with market research activities. In addition to these internal
activities we anticipate, our recently signed strategic alliance with PPD will
provide us with an even broader channel opportunity through their strong
customer relationships and global breadth.





General
and Administrative





General
and administrative expenses for the quarter ended September 30, 2010 were
$831,000, an increase of $33,000 or 4%, when compared to the quarter ended
September 30, 2009.  The increase is mainly due to higher consulting
costs associated with our personalized medicine application and salary and
benefit cost increases for 2010 for our employees within the general and
administrative function. These increases were offset by decreases in our
quarterly stock based compensation expense. General and administrative personnel
include finance, information technology, quality, human resources and the CEO
position. Non-payroll related costs included within general and administration
include stock option expense, audit and legal fees, regulatory and compliance
fees, Nasdaq listing fees, board fees, non-capitalizable hardware and software
costs and licenses and non-sales related travel costs.





Depreciation
and Amortization





Depreciation
and amortization charges were $129,000 for the quarter ended September 30, 2010
compared to $115,000 during the quarter ended September 30,
2009.  This $14,000 increase was a result of depreciation charges
related to recent capital purchases, including the purchase and installation
cost of an Enterprise Resource Planning (“ERP”) system. We anticipate that our
depreciation charges will continue to increase as we invest in our IT systems to
support our growth.


18


Other
Income (Expense)





Interest
income for the quarter ended September 30, 2010 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 an unrealized marked to market gain of $237,000 related to the
decrease in fair value of certain warrants that were issued in connection with
our 2007 series B offering (see Financial Statement Note 5) resulting from the
decrease in our stock price, compared to an unrealized marked to market
loss of $402,000 during the third quarter of 2009.





Net
Income (Loss)





Net
Income for the quarter ended September 30, 2010 was $629,000 compared to a net
loss of $216,000 for the quarter ended September 30, 2009.  The
significant improvement in our net income over the prior period was primarily
related to the increase in our revenues, growth in our gross profit along with
recording of an unrealized gain in the non-cash marked to market adjustment for
certain outstanding warrants during the third quarter of 2010 as compared to an
unrealized loss during the third quarter of 2009.





Results
of Operations for the Nine Months Ended September 30, 2010 Compared to the Nine
Months Ended September 30, 2009





Revenues





Our
revenues for the nine months ended September 30, 2010 were $9,883,000, an
increase of $2,410,000 or 32% over the first nine months of
2009.  Excluding non-recurring projects performed for the U.S.
Department of Defense during the first nine months of 2009, revenues from our
clinical trial business increased 39% during the first nine months of 2010
compared to the prior year. The increase in sales within the clinical trial
business is due to 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 116 projects in the first three quarters of
2010, as compared to 96 in the first nine months of 2009.  During the
first nine months of 2010, 73% of our revenues were generated from Phase II/III
projects compared to 61% during the first nine months of 2009. We expect that a
majority of our revenues from pharmaceutical and medical device clinical trials
will be derived from Phase II and III studies throughout the rest of
2010.





Gross
Profit





We had a
gross profit of $5,147,000 for the nine months ended September 30, 2010 compared
to $4,109,000 for the comparable period in 2009. Our gross margin for the nine
months ended September 30, 2010 was 52% compared to 55% for the nine months
ended 2009.  Our gross margin fluctuations are largely a result of the
mix of services performed during a given period. Our site initiation activities
typically yield higher margins than our analysis services. In 2009, a higher
percent of our business came from site initiation activities as we began work on
several Phase III studies.  We anticipate margins to approximate 50%
for the remainder of 2010.


19


Research
and Development





Total
research and development expenditures were $790,000 for the nine months ended
2010 compared to $749,000 for the comparable period in 2009, an increase of
5%.  The slight increase was mainly due to higher consulting costs
associated with our personalized medicine application and wage increases during
2010. Our research and development efforts center around refining our processes
through the use of our software platform in order to gain efficiencies which we
believe will better allow us to standardize our processes as we scale the
business. Additionally, we continue to invest in the commercialization of new
imaging techniques across many modalities and therapeutic areas to best serve
our customers. As of September 30, 2010, there were ten employees in our
research and development group, which includes the algorithm development and
software development groups. For the remainder of 2010, we anticipate increasing
general and administrative costs as we further our investments in regulatory
consultants assisting us with the 510k approval of our personalized medicine
application.





Sales and
Marketing





Sales and
marketing costs for the nine months ended September 30, 2010 increased to
$905,000, an increase of $27,000 or 3% over the first nine months of
2009.  The increase was a result of higher trade show and travel costs
during the first nine months of 2010 as compared to the prior
year.  Our sales and marketing efforts include conference attendance
and presentations, technically-focused webinars, customer webinars and related
travel along with advertising in key scientific journals and occasional
consulting and other costs associated with market research activities. In
addition to these internal activities, we anticipate our recently signed
strategic alliance with PPD will provide us with an even broader channel
opportunity through their strong customer relationships and global
breadth.





General
and Administrative





General
and administrative expenses for the nine months ended September 30, 2010 were
$2,447,000, a decrease of $55,000 over the first three quarters of
2009.  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 offset by higher salary and benefit costs as well as higher
consulting costs associated with our personalized medicine application. We
anticipate that general and administrative costs will continue to increase for
the remainder of 2010 as we further our investments in consultants assisting us
with our personalized medicine application.





Depreciation
and Amortization





Depreciation
and amortization charges were $381,000 for the nine months ended September 30,
2010 compared to $351,000 during the nine months ended September 30,
2009.  This $30,000 increase was a result of depreciation charges
related to recent capital purchases, including the purchase and installation
cost of an ERP system. We anticipate that our depreciation charges will continue
to increase as we invest in our IT systems to support our
growth.


20


Other
Income (Expense)





Interest
income for the nine months ended September 30, 2010 was $8,000 and comprised of
interest earned on the Company’s operating and savings accounts, compared to
interest income of $4,000 in the same period in 2009.  The increase in
interest income was a reflection of the average rates of return on our savings
accounts in 2010 compared to 2009. Additionally, we recognized an unrealized
marked to market gain of $360,000 related to the decrease in fair value of
certain warrants that were issued in connection with our 2007 series B offering
(see Financial Statement Note 5), resulting from the decrease in our stock
price.  During the nine months ended 2009, we recognized an unrealized
marked to market loss of $1,005,000 due to the increase in fair value of those
warrants.





Net
Income (Loss)





Our net
income for the nine months ended September 30, 2010 was $978,000 compared to a
net loss of $1,385,000 for the same period in 2009.  The significant
improvement in our net income over the prior period was primarily related to
higher revenues and gross profit, as outlined above, along with reductions in
the non-cash marked to market adjustment for certain outstanding warrants during
the first nine months of 2010 as compared to 2009.





Liquidity
and Capital Resources





Our
working capital as of September 30, 2010 was $4,284,000 compared to $2,549,000
as of December 31, 2009.  The increase in working capital was a result
of the generation of operating income during the nine months ended 2010, offset
by timing differences and the recording of an unrealized marked to market gain
related to the decrease in fair value of certain warrants in accordance with ASC
815-40.





Net cash
used by operating activities totaled $34,000 in the nine months ended September
30, 2010 compared to net cash provided of $1,019,000 in the comparable 2009
period.  The change in cash provided by operating activities is a
largely a result of the timing of the collection of accounts receivable and
advance payments from customers. Also impacting operating cash flow was the
timing of the payment of accounts payable and payroll.





We
invested $169,000 in the purchase of equipment and the acquisition of patents in
the first three quarters of 2010, compared to $266,000 for the investment in
these items in the first three quarters of 2009. The decrease represents the
timing of investments in our IT infrastructure in support of the growing demand
for our services as well as the costs associated with purchasing an ERP system
in 2009.





Cash used
in our financing activities in the nine months ended September 30, 2010
was  $115,000, compared to $245,000 used by financing activities in
the nine months ended September 30, 2009.  The reduction is a result
of lower dividend payments due to the conversion of series B preferred shares to
common stock over the past year which has reduced the amount of required
dividend payments.


21


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





Off
Balance Sheet Arrangements





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





Recently
Issued and Adopted Accounting Pronouncements




In
October 2009, the Financial Accounting Standards Board (“FASB”) issued ASU
No. 2009-13, “Multiple-Deliverable Revenue Arrangements.” This ASU
establishes the accounting and reporting guidance for arrangements including
multiple revenue-generating activities. This ASU provides amendments to the
criteria for separating deliverables, measuring and allocating arrangement
consideration to one or more units of accounting. The amendments in this ASU
also establish a selling price hierarchy for determining the selling price of a
deliverable. Significantly enhanced disclosures are also required to provide
information about a vendor’s multiple-deliverable revenue arrangements,
including information about the nature and terms, significant deliverables, and
its performance within arrangements. The amendments also require providing
information about the significant judgments made and changes to those judgments
and about how the application of the relative selling-price method affects the
timing or amount of revenue recognition. The amendments in this ASU are
effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010. Early
application is permitted. The Company is currently evaluating the impact the
adoption of this standard will have on its consolidated financial position and
results of operations.




In
October 2009, the FASB issued ASU No. 2009-14, “Certain Revenue
Arrangements That Include Software Elements.” This ASU changes the accounting
model for revenue arrangements that include both tangible products and software
elements that are “essential to the functionality,” and scopes these products
out of current software revenue guidance. The new guidance will include factors
to help companies determine what software elements are considered “essential to
the functionality.” The amendments will now subject software-enabled products to
other revenue guidance and disclosure requirements, such as guidance surrounding
revenue arrangements with multiple-deliverables. The amendments in this ASU are
effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010. Early
application is permitted. The Company is currently evaluating the impact the
adoption of this standard will have on its consolidated financial position and
results of operations.


22


In
January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.
This ASU requires some new disclosures and clarifies some existing disclosure
requirements about fair value measurement as set forth in Codification Subtopic
820-10. ASU 2010-06 amends Codification Subtopic 820-10 and now requires a
reporting entity to use judgment in determining the appropriate classes of
assets and liabilities and to provide disclosures about the valuation techniques
and inputs used to measure fair value for both recurring and nonrecurring fair
value measurements. ASU 2010-06 is effective for interim and annual reporting
periods beginning after December 15, 2009.  As this standard relates
specifically to disclosures, the adoption did not have an impact on the
Company’s consolidated financial position and results of
operations.





In
February 2010, the FASB issued ASU 2010-09, "Subsequent Events (Topic 855) -
Amendments to Certain Recognition and Disclosure Requirements." ASU 2010-09
requires an entity that is an SEC filer to evaluate subsequent events through
the date that the financial statements are issued and removes the requirement
that an SEC filer disclose the date through which subsequent events have been
evaluated. ASC 2010-09 was effective upon issuance. The adoption of this
standard had no effect on our consolidated financial position or results of
operations.





In March
2010, the FASB issued ASU No. 2010-17, Revenue Recognition— Milestone Method
(Topic 605): Milestone Method of Revenue Recognition. This
standard  provides that the milestone method is a valid application of
the proportional performance model for revenue recognition if the milestones are
substantive and there is substantive uncertainty about whether the milestones
will be achieved. Determining whether a milestone is substantive requires
judgment that should be made at the inception of the arrangement. To meet the
definition of a substantive milestone, the consideration earned by achieving the
milestone (1) would have to be commensurate with either the level of effort
required to achieve the milestone or the enhancement in the value of the item
delivered, (2) would have to relate solely to past performance, and
(3) should be reasonable relative to all deliverables and payment terms in
the arrangement. No bifurcation of an individual milestone is allowed and there
can be more than one milestone in an arrangement. The new standard is effective
for interim and annual periods beginning on or after June 15, 2010. Early
adoption is permitted.  The Company is currently evaluating the impact
the adoption of this standard will have on its consolidated financial position
and results of operations.





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;


23


·
            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, 2009 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
4.  Controls and Procedures




Evaluation
of Disclosure Controls and Procedures




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





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


24


Changes
in Internal Controls Over Financial Reporting





An
evaluation was performed under the supervision of the Company’s management,
including the CEO and CFO, as required under Exchange Act Rule 13a-15(d) and
15d-15(d) of whether any change in the Company’s internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) occurred
during the fiscal quarter ended September 30, 2010.  Based on that
evaluation, the Company’s management, including the CEO and CFO, concluded that
no change in the Company’s internal controls over financial reporting occurred
during the fiscal quarter ended September 30, 2010 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 three months ended September 30, 2010, and through the date of this report,
there were no conversions of the Company’s series A convertible preferred stock
and series B convertible preferred stock into shares of the Company’s common
stock.  The Company did not receive any cash or other consideration in
connection with the conversions. Additionally, no commission or other
remuneration was paid by the Company in connection with such
conversions.  The issuance of common stock upon conversions of the
series A and B convertible preferred stock was made in reliance on the exemption
provided in Section 3(a)(9) of the Securities Act of 1933, as
amended.





Item
3.  Defaults upon Senior Securities





Not
applicable.





Item
5.  Other Information





None





Item
6.  Exhibits





Exhibit
10.1      Strategic Alliance Agreement between
VirtualScopics, Inc. and PPD Development, LP, dated October 22, 2010(1)





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.


25


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.





(1)
            Certain
      confidential information contained in the document has been omitted and
      filed separately with the Securities and Exchange Commission under an
      application for confidential treatment pursuant to Rule 24b-2 promulgated
      under the Securities Exchange Act of 1934, as
  amended.





SIGNATURES





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





Dated:  November
      12, 2010
            VIRTUALSCOPICS,
      INC./s/  Jeffrey
    MarkinJeffrey
      MarkinPresident
      and Chief Executive Officer/s/  Molly
    HendersonMolly
      HendersonChief
      Business and Financial Officer, SeniorVice
      President


26


Exhibit Index





Exhibit
10.1     Strategic Alliance Agreement between
VirtualScopics, Inc. and PPD Development, LP, dated October 22,
2010(1)





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





(1)
            Certain
      confidential information contained in the document has been omitted and
      filed separately with the Securities and Exchange Commission under an
      application for confidential treatment pursuant to Rule 24b-2 promulgated
      under the Securities Exchange Act of 1934, as
  amended.


27