**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, 2008




**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 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, 2008, there were
      23,502,352 shares of the registrant’s common stock, $0.001 par value,
      outstanding.








TABLE
      OF
      CONTENTS





Page NumbersPART
                I
            FINANCIAL
                INFORMATIONITEM
                1: Financial StatementsCondensed
                Consolidated Balance Sheets as of September 30, 2008 (unaudited)
                and
                December 31, 2007
            1Unaudited
                Condensed Consolidated Statements of Operations for the three andnine
                months ended September 30, 2008 and 2007
            2Unaudited
                Condensed Consolidated Statements of Cash Flows for the nine months
                ended
                September 30, 2008 and 2007
            3Notes
                to Unaudited Condensed Consolidated Financial Statements
            4-10ITEM
                2: Management's Discussion and Analysis ofFinancial
                Condition and Results of Operations
            11-18ITEM
                4T: Controls and Procedures
            18-19PART
                II
            OTHER
                INFORMATIONITEM
                1: Legal Proceedings
            20ITEM
                2: Unregistered Sales of Equity Securities and Use of Proceeds
            20ITEM
                3: Defaults Upon Senior Securities
            20ITEM
                4: Submission of Matters to a Vote of Security Holders
            20ITEM
                5: Other Information
            20ITEM
                6: Exhibits
            20-21




i




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


September
                30,
            
            December
                31,2008
            
            2007*(Unaudited)***Assets**Current
                assetsCash
                and cash equivalents
            
            $
            3,058,561
            
            $
            3,955,835Restricted
                cash
            
            
            102,429
            
            
            455,583Accounts
                receivable
            
            
            831,376
            
            
            648,300Prepaid
                expenses and other current assets
            
            
            292,477
            
            
            306,301Total
                current assets
            
            
            4,284,843
            
            
            5,366,019Restricted
                cash
            
            
            -
            
            
            43,216Patents,
                net
            
            
            1,920,666
            
            
            1,948,785Property
                and equipment, net
            
            
            402,660
            
            
            542,679Other
                assets
            
            
            187,670
            
            
            280,317Total
                assets
            
            $
            6,795,839
            
            $
            8,181,016**Liabilities
                and Stockholders' Equity**Current
                liabilitiesAccounts
                payable and accrued expenses
            
            $
            584,153
            
            $
            626,693Accrued
                payroll
            
            
            390,756
            
            
            221,013Unearned
                revenue
            
            
            297,272
            
            
            279,275Total
                current liabilities
            
            
            1,272,181
            
            
            1,126,981Commitments
                and Contingencies
            
            
            -
            
            
            -Stockholders'
                EquityConvertible
                preferred stock, $0.001 par value; 15,000,000 shares
                authorized;8,400
                shares designated Series A; issued and outstanding, 3,976 shares
                at
                September 30, 2008 and 4,001 shares at December 31, 2007; liquidation
                preference $1,000 per share
            
            
            4
            
            
            46,000
                shares designated Series B; issued and outstanding, 4,226 shares
                at
                September 30, 2008 and 4,230 shares at December 31, 2007; liquidation
                preference $1,000 per share
            
            
            4
            
            
            4Common
                stock, $0.001 par value; 85,000,000 shares authorized;issued
                and outstanding, 23,459,852 shares at September 30, 2008 and 23,225,664
                shares at December 31, 2007
            
            
            23,460
            
            
            23,226Additional
                paid-in capital
            
            
            16,409,721
            
            
            15,616,124Accumulated
                deficit
            
            
            (10,909,531
            )
            
            (8,585,323
            )Total
                stockholders' equity
            
            
            5,523,658
            
            
            7,054,035Total
                liabilities and stockholders' equity
            
            $
            6,795,839
            
            $
            8,181,016





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
                30,2008
            
            2007
            
            2008
            
            2007Revenues
            
            $
            1,815,616
            
            $
            1,370,021
            
            $
            5,183,017
            
            $
            4,184,713Cost
                of services
            
            
            1,005,700
            
            
            963,076
            
            
            3,057,220
            
            
            2,731,434Gross
                profit
            
            
            809,916
            
            
            406,945
            
            
            2,125,797
            
            
            1,453,279Operating
                expensesResearch
                and development
            
            
            232,986
            
            
            336,687
            
            
            697,640
            
            
            1,124,606Sales
                and marketing
            
            
            263,917
            
            
            150,504
            
            
            937,028
            
            
            555,783General
                and administrative
            
            
            750,747
            
            
            778,519
            
            
            2,512,914
            
            
            2,729,634Depreciation
                and amortization
            
            
            116,234
            
            
            126,673
            
            
            350,565
            
            
            362,878Total
                operating expenses
            
            
            1,363,884
            
            
            1,392,383
            
            
            4,498,147
            
            
            4,772,901Operating
                loss
            
            
            (553,968
            )
            
            (985,438
            )
            
            (2,372,350
            )
            
            (3,319,622
            )Other
                income (expense)Interest
                income
            
            
            13,952
            
            
            22,108
            
            
            59,679
            
            
            114,644Other
                expense
            
            
            (8,569
            )
            
            (5,699
            )
            
            (11,537
            )
            
            (8,930
            )Total
                other income
            
            
            5,383
            
            
            16,409
            
            
            48,142
            
            
            105,714Net
                loss
            
            
            (548,585
            )
            
            (969,029
            )
            
            (2,324,208
            )
            
            (3,213,908
            )Series
              B preferred stock dividend
            
            
            84,547
            
            
            -
            
            
            254,307
            
            
            -Net
                loss attributable to common stockholders
            
            $
            (633,132
            )
            $
            (969,029
            )
            $
            (2,578,515
            )
            $
            (3,213,908
            )Basic
                and diluted net loss per common share
            
            $
            (0.03
            )
            $
            (0.04
            )
            $
            (0.11
            )
            $
            (0.14
            )Weighted
                average number of common sharesoutstanding –
                basic and diluted
            
            
            23,459,853
            
            
            23,111,021
            
            
            23,355,232
            
            
            23,028,715





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
                30,2008
            
            2007**Cash
                flows from operating activities**Net
                loss
            
            $
            (2,324,208
            )
            $
            (3,213,908
            )Adjustments
                to reconcile net lossto
                net cash used in operating activities:Depreciation
                and amortization
            
            
            350,565
            
            
            362,878Stock
                option compensation expense
            
            
            923,891
            
            
            1,041,546Issuance
                of equity instruments for rent
            
            
            170,000
            
            
            -Issuance
                of equity instruments to non-employees for services
            
            
            -
            
            
            1,818Accrual
                for future issuance of equity instruments for rent
            
            
            153,000
            
            
            -Changes
                in operating assets and liabilitiesAccounts
                receivable
            
            
            (183,076
            )
            
            (169,272
            )Prepaid
                expenses and other current assets
            
            
            13,824
            
            
            (41,581
            )Accounts
                payable and accrued expenses
            
            
            (242,170
            )
            
            38,399Accrued
                payroll
            
            
            169,743
            
            
            (105,191
            )Unearned
                revenue
            
            
            17,997
            
            
            (267,728
            )Total
                adjustments
            
            
            1,373,774
            
            
            860,779Net
                cash used in operating activities
            
            
            (950,434
            )
            
            (2,353,129
            )**Cash
                flows from investing activities**Purchase
                of equipment
            
            
            (21,773
            )
            
            (190,519
            )Acquisition
                of patents
            
            
            (68,006
            )
            
            (115,910
            )Net
                cash used in investing activities
            
            
            (89,779
            )
            
            (306,429
            )**Cash
                flows from financing activities**Repayments
                of notes payable - related parties
            
            
            -
            
            
            (59,902
            )Proceeds
                from the exercise of warrants
            
            
            876
            
            
            -Restricted
                cash
            
            
            396,370
            
            
            (417,500
            )Net
                proceeds from the issuance of Series B preferred stock and
                warrants
            
            
            -
            
            
            1,889,798Cash
                dividends on series B preferred stock
            
            
            (254,307
            )
            
            -Net
                proceeds from exercise of stock options
            
            
            -
            
            
            18,375Net
                cash provided by financing activities
            
            
            142,939
            
            
            1,430,771Net
                decrease in cash and cash equivalents
            
            
            (897,274
            )
            
            (1,228,787
            )Cash
                  and cash equivalents at beginning of period
            
            
            3,955,835
            
            
            3,901,153end
                of period
            
            $
            3,058,561
            
            $
            2,672,366**Supplemental
                disclosure of cash flow information**Cash
                paid during the periods for:Interest
            
            $
            -
            
            $
            2,616Non-cash
                financing activity:Dividend
                on Series B preferred stock
            
            $
            -
            
            $
            12,567Issuance
                of common stock for partial payment of rent in equity
            
            $
            170,000
            
            $
            -





See
      notes
      to condensed consolidated financial statements


3


**VirtualScopics,
        Inc. and Subsidiary**
 **Notes
        to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      1 - Organization
      and Basis of Presentation





Nature
      of Business


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





Basis
      of Presentation


The
      accompanying unaudited condensed consolidated financial statements of Company
      have been condensed in certain respects and should, therefore, be read in
      conjunction with the audited consolidated financial statements and notes related
      thereto contained in the Company’s Annual Report on Form 10-KSB as of and for
      the year ended December 31, 2007. In the opinion of the management, these
      unaudited condensed consolidated 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 three and nine
      months ended September 30, 2008 are not necessarily indicative of the results
      to
      be expected for the full year ending December 31, 2008.





In
      February 2008, the Company received a written notice from the Nasdaq Stock
      Market (“Nasdaq”) indicating that its common stock was not in compliance with
      minimum bid price required for continued listing on Nasdaq. The notice stated
      that in accordance with section 4310(c)(8) of the Nasdaq Marketplace Rules,
      the
      Company had until August 6, 2008 to regain compliance by maintaining a bid
      price
      of common stock at a close of $1.00 or higher for a minimum of 10 consecutive
      business days, or such longer period as Nasdaq may determine to show the ability
      to maintain long-term compliance. On August 7, 2008 the Company received a
      Staff
      Determination Letter from Nasdaq stating that it had not regained compliance
      with the $1.00 minimum bid price requirement and that its securities are subject
      to delisting. On September 18, 2008, the Company attended a hearing before
      the
      Nasdaq Listing Qualifications Panel and presented its plan for compliance and
      requested a further stay of delisting until February 2009. On October 8, 2008,
      the Company received word from Nasdaq that they have granted the Company’s
      request to stay delisting until February 3, 2009, and as such, have until that
      time to meet the minimum listing requirements. Further, on October 21, 2008
      the
      Company received notice from Nasdaq stating that due to the current market
      conditions, Nasdaq had suspended the continued listing requirements for the
      minimum bid price until January 16, 2009, for all of its listed companies.
      The
      Company has been informed by Nasdaq that it now has until May 11, 2009 to meet
      the minimum bid requirements.





The
      Company’s stockholders have authorized the Board of Directors to implement a
      reverse stock split of the Company’s outstanding common stock in a ratio from
      1:2 to 1:4 as part of its efforts to regain compliance. If the Company has
      not
      met the minimum bid requirements by the end of the first quarter of 2009, the
      Company plans to do a reverse stock split. **** If
      implemented, the Company expects that a reverse stock split will help it regain
      compliance with Nasdaq Capital Market listing standards, although there can
      be
      no assurance that it will be successful in doing so or that it will be able
      to
      maintain compliance with other continued listing standards.


4


**VirtualScopics,
        Inc. and Subsidiary**
 **Notes
        to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      2 - Summary
      of Certain Significant Accounting Policies





Principles
      of Consolidation


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




Revenue
      Recognition


The
      Company applies the revenue recognition principles set forth under the
      Securities and Exchange Commission Staff Accounting Bulletin No. 104, “Revenue
      Recognition,” with respect to its revenues from image analysis, consulting and
      project/data management services, and recognizes revenue when it is realized
      or
      realizable and earned. The Company considers revenue realized or realizable
      and
      earned when an agreement exists, services and products are provided to the
      customer, prices are fixed or determinable, and collectibility is reasonably
      assured. Revenues are reduced for estimated discounts and other allowances,
      if
      any.





The
      Company provides advanced medical image analysis on a per image 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
      method for projects of short term nature and a percentage of completion method
      for projects of long term nature in accordance with the American Institute
      of
      Certified Public Accountants Statement of Position 81-1, “Accounting for
      Performance of Construction-Type and Certain Production-Type Contracts.” The
      Company does not sell software licenses, upgrades or enhancements, or
      post-contract customer services.





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





Research
      and Development


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





Recent
      Accounting Pronouncements


In
      March 2008, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 161, “Disclosures about
      Derivative Instruments and Hedging Activities—an amendment of FASB Statement
      No. 133” (“ SFAS No.
      161”). SFAS No.
      161
      changes the disclosure requirements for derivative instruments and hedging
      activities. Entities are required to provide enhanced disclosures about
      (a) how and why an entity uses derivative instruments, (b) how
      derivative instruments and related hedged items are accounted for under SFAS
      No.
      133 and its related interpretations, and (c) how derivative instruments and
      related hedged items affect an entity’s financial position, financial
      performance and cash flows.  The guidance in SFAS No.
      161
      is effective for financial statements issued for fiscal years and interim
      periods beginning after November 15, 2008, with early application
      encouraged. This Statement encourages, but does not require, comparative
      disclosures for earlier periods at initial adoption.  At this time,
      management is evaluating the impact of the adoption of SFAS No.
      161
      on the Company’s consolidated financial statements.




5


**VirtualScopics,
          Inc. and Subsidiary**
 **Notes
          to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      2 - Summary
      of Certain Significant Accounting Policies ,
      continued





In
      April
      2008, the FASB issued FASB Staff Position SFAS 142-3, *Determination
      of the Useful Life of Intangible Assets*(“FSP
      SFAS 142-3”). FSP SFAS 142-3 amends the factors that should be considered in
      developing renewal or extension assumptions used to determine the useful life
      of
      arecognized intangible asset under FASB Statement No. 142, Goodwill and
      Other Intangible Assets. The objective of this FSP is to improve the consistency
      between the useful life of a recognized intangible asset under Statement 142
      and
      the period of expected cash flows used to measure the fair value of the asset
      under SFAS 141R, Business Combinations, and other U.S. GAAP principles. FSP
      SFAS
      142-3 is effective for fiscal years beginning after December 15, 2008. The
      adoption of FSP SFAS 142-3 is effective January 1, 2009 and is not expected
      to
      have a material impact on the Company’s consolidated financial statements.





In
      October 2008, the FASB issued FSP 157-3 “Determining Fair Value of a Financial
      Asset in a Market That Is Not Active” (FSP 157-3). FSP 157-3 clarified the
      application of SFAS No. 157 in an inactive market. It demonstrated how the
      fair
      value of a financial asset is determined when the market for that financial
      asset is inactive. FSP 157-3 was effective upon issuance, including prior
      periods for which financial statements had not been issued. The implementation
      of this standard did not have a material impact on our consolidated financial
      statements.





Adoption
      of Statement of Financial Accounting Standards No. 159 and 157


In
      February, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
      provides companies with an option to report selected financial assets and
      liabilities at fair value. SFAS No. 159's objective is to reduce both complexity
      in accounting for financial instruments and the volatility in earnings caused
      by
      measuring related assets and liabilities differently. SFAS No. 159 also
      establishes presentation and disclosure requirements designed to facilitate
      comparisons between Companies that choose different measurement attributes
      for
      similar types of assets and liabilities. SFAS No. 159 requires Companies to
      provide additional information that will help investors and other users of
      financial statements to more easily understand the effect of the Company's
      choice to use fair value on its earnings. It also requires entities to display
      the fair value of those assets and liabilities for which the Company has chosen
      to use fair value on the face of the balance sheet. We adopted SFAS No. 159
      as
      of January 1, 2008. The adoption of SFAS No. 159 did not have a material effect
      on the Company’s consolidated financial statements.





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
      No. 157”). This Statement defines fair value, establishes a framework for
      measuring fair value and expands disclosure of fair value measurements. SFAS
      No.
      157 applies under other accounting pronouncements that require or permit fair
      value measurements and accordingly, does not require any new fair value
      measurements. We adopted SFAS No. 157 as of January 1, 2008. In February 2008,
      the FASB issued FASB Staff Position No. FAS 157-2, "Effective Date of FASB
      Statement No. 157", which provides a one year deferral of the effective date
      of
      SFAS No.157 for non-financial assets and non-financial liabilities, except
      those
      that are recognized or disclosed in the financial statements at fair value
      at
      least annually. Therefore, the Company has adopted the provisions of SFAS No.
      157 with respect to its financial assets and liabilities only. The adoption
      of
      SFAS No. 157 did not have a material effect on the Company’s consolidated
      financial statements.





NOTE
      3 - Stock-Based
      Compensation





On
      January 1, 2006, the Company adopted the fair value recognition provisions
      of
      Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based
      Payment,” using the modified prospective method. Consequently, for the nine
      months ended September 30, 2008 and 2007, 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 $923,891
      and $1,041,456, respectively.


6


**VirtualScopics,
        Inc. and Subsidiary**
 **Notes
        to Condensed Consolidated Financial Statements**
 ***(unaudited)***





NOTE
      3 - Stock-Based
      Compensation ,
      continued





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





The
      fair
      value of stock options granted was determined on the grant date using
      assumptions for risk free interest rate, the expected term, expected volatility,
      and expected dividend yield. The risk free interest rate is based on U.S.
      Treasury zero-coupon yield curve over the expected term of the option.





The
      expected term assumption is primarily based on the Company’s historical data
      related to exercise and post-vesting cancellation information, which is expected
      to be similar to future results. Since the Company has limited historical
      volatility information, it bases its expected volatility on the historical
      volatility of similar entities whose share prices are publicly available. In
      making its determination as to similarity, the Company considered the industry,
      stage of life cycle, size, and financial leverage of such other entities. The
      Company’s model includes a zero dividend yield assumption, as the Company has
      not historically paid nor does it anticipate paying dividends on its common
      stock. The


Company’s
      model does not include a discount for post-vesting restrictions, as the Company
      has not issued awards with such restrictions. The periodic expense is then
      determined based on the valuation of the options, and at that time an estimated
      forfeiture rate is used to reduce the expense recorded. The Company’s estimate
      of pre-vesting forfeitures is primarily based on the Company’s historical
      experience and is adjusted to reflect actual forfeitures as the options vest.
      The following assumptions were used to estimate the fair value of options
      granted for the nine months ended September 30, 2008 and 2007 using the
      Black-Scholes option-pricing model:





September
                30,2008
            
            2007Risk
                free interest rate
            
            
            3.85
            %
            
            4.71
            %Expected
                term (years)
            
            
            9.7
            
            
            9.0Expected
                volatility
            
            
            89.7
            %
            
            98.5
            %Expected
                dividend yield
            
            
            -
            
            
            -





A
      summary
      of the option activity for the nine months ended September 30, 2008 is as
      follows:





Number
              of
                Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted-
              Average
              Remaining
              Contractual TermOptions
                outstanding at January 1, 2008
            
            
            3,790,731
            
            
            2.12Granted
            
            
            1,064,432
            
            
            .97Cancelled
            
            
            (94,987
            )
            
            (1.37
            )Exercised
            
            
            -
            
            
            -Options
                outstanding at September 30, 2008
            
            
            4,760,176
            
            
            1.67
            
            
            6.77Options
                exercisable at September 30, 2008
            
            
            2,897,924
            
            
            2.00
            
            
            5.45





The
      weighted-average grant-date fair value of options granted during the nine months
      ended September 30, 2008 and 2007 was $1,036,631 and $185,440, respectively.
      There have been no options exercised during the nine months ended September
      30,
      2008.




7


**VirtualScopics,
        Inc. and Subsidiary**
 **Notes
        to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      4 - Stockholders’
      Equity





During
      the nine months ended September 30, 2008, 25 shares of the Company’s series A
      convertible preferred stock and 4 shares of the Company’s series B convertible
      preferred stock were converted into 20,759 and 3,321 shares of the Company’s
      common stock, respectively. Also, the Company received cash proceeds of $876
      for
      the exercise of Company warrants resulting in the issuance of 87,601 shares
      of
      common stock.





The
      Company leases approximately 19,500 square feet of office space at its corporate
      headquarters in Rochester, New York. The rent is paid in two portions: a cash
      portion of $156,000 annually, paid in equal monthly installments, increasing
      3%
      every July, and the stock portion equating up to $204,000 annually, paid in
      equal monthly installments, increasing 3% every July. The stock portion is
      payable in common stock, par value $.001 per share. During the nine months
      ended
      September 30, 2008, the Company issued 122,507 shares of the Company’s common
      stock for payment of the equity portion of the rent. The common stock was issued
      at prices ranging from $1.20 - $2.50 per share for a total cost of $170,000.
      As
      of September 30, 2008, the Company had $85,000 in accrued expenses pertaining
      to
      the equity portion of the rent.




Under
      the
      terms of the Company’s Series B Preferred Stock and related warrants, the
      Company is required to meet specific milestone financial performance for the
      2008 fiscal year. These milestone events, which are detailed in the Company’s
      Certificate of Designation for the Series B Preferred Stock and in the related
      warrants, include generating $7.0 million in revenue for the 12 month period
      ending on December 31, 2008. If the Company fails to meet or exceed any of
      the
      milestone events, then the Series B Preferred Stock conversion price will be
      reduced to a lower market price measured on the last trading day of the
      Company’s fiscal year, or the market price five trading days after the Company
      files their next Form 10-K, whichever is lower. If the Company makes a major
      announcement around this time, the measurement date can be changed to a date
      one
      trading day prior to the announcement or 10 trading days after the announcement,
      whichever is lower.





An
      adjustment to the conversion price of the Company’s Series B Preferred Stock and
      related warrants for failure to meet the applicable milestone goals would also
      trigger a downward adjustment to the conversion price of the Company’s Series A
      Preferred Stock and the exercise price of the related warrants issued in
      connection with the Series A Preferred Stock. These price adjustments would
      give
      the holders of those securities the ability to acquire additional shares of
      the
      Company’s common stock upon conversion or exercise, and cause dilution to the
      holders of the Company’s common stock. At this point, we fully anticipate that
      the Company will meet the milestone goals and that a price adjustment will
      not
      be necessary, however, there can be no assurance that the Company will meet
      these goals. Additionally, there are no required financial performance criteria
      under the terms of the Series B Preferred Stock and related warrants after
      2008.





NOTE
      5 - Net
      Loss Per Share





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





8


**VirtualScopics,
          Inc. and Subsidiary**
 **Notes
          to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      5 - Net
      Loss Per Share, continued





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





2008
            
            2007Series
                A convertible preferred stock
            
            
            3,301,098
            
            
            3,322,262Series
                B convertible preferred stock
              Warrants
                to purchase common stock
            
            
            3,509,092
              4,309,055
            
            
            -
              2,161,892Options
                to purchase common stock
            
            
            4,901,866
            
            
            3,350,395Total
            
            
            16,021,111
            
            
            8,834,549





NOTE
      6 - Income
      Taxes





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





The
      Company has concluded that there are no significant uncertain tax positions
      requiring recognition in its financial statements. As of September 30, 2008,
      all
      of the Company’s deferred tax assets were fully reserved by a valuation
      allowance equal to 100% of the net deferred tax assets. The Company has never
      been profitable and has not paid any income taxes.





The
      Company has significant net operating losses 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 encountered ownership changes which
      could
      significantly limit the possible utilization of such carryovers. 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.
      However, it is not anticipated that limitations, if any, would have a material
      impact on the condensed consolidated balance sheet as a result of offsetting
      changes in the deferred tax valuation allowance.





The
      Company will recognize interest and penalties accrued related to unrecognized
      tax benefits as components of its income tax provision. The Company did not
      have
      any interest and penalties accrued upon the adoption of FIN No. 48 and as of
      September 30, 2008, the Company does not have any interest and penalties accrued
      related to unrecognized tax benefits.




9


**VirtualScopics,
          Inc. and Subsidiary**
 **Notes
          to Condensed Consolidated Financial Statements**
 ***(unaudited)***


NOTE
      7 - Business
      Concentrations and Credit Risk





The
      Company’s top three customers accounted for approximately 16%, 13% and 13% of
      its total revenue for the nine months ended September 30, 2008 as compared
      to
      27%, 12% and 11% for the nine months ended September 30, 2007. As of September
      30, 2008, accounts receivable due from the top three customers amounted to
      $193,914, $113,249, and $ 106,942, respectively.




Financial
      instruments that subject the Company to concentrations of credit risk consist
      primarily of cash, cash equivalents, restricted cash and accounts receivable.
      The Company maintains all of its cash, cash equivalents, and restricted cash
      in
      two financial institutions, although substantially all of the balance is within
      one institution.  The Company performs periodic evaluations of the relative
      credit standing of the two institutions.  The cash balances are insured by
      either the FDIC, up to $250,000 per depositor, or the U.S. Department of
      Treasury’s Temporary Guarantee Program for Money Market Funds.  The Company
      has cash balances on deposit with two financial institutions at September 30,
      2008 that exceed the insured limit by the amount of $2.9 million.  The
      Company’s customers are primarily concentrated in the United States. The Company
      performs ongoing credit evaluations, generally does not require collateral,
      and
      establishes an allowance for doubtful accounts based upon factors surrounding
      the credit risk of customers, historical trends and other information. To date,
      actual losses have been within management’s expectations.


10


**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, 2008 and December
      31,
      2007 and the related condensed consolidated statements of operations and cash
      flows for the periods ended September 30, 2008 and 2007, included elsewhere
      in
      this report. This discussion contains forward-looking statements, the accuracy
      of which involve 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
      was established in December 2000 in Rochester, New York. We are a leading
      provider of quantitative imaging for pharmaceutical and medical device
      development. Our imaging technology evolved from research initially begun in
      1990 at the University of Rochester’s Medical Center and School of Engineering
      and Applied Sciences. These early efforts were directed primarily toward the
      accurate and reproducible measurement of advanced image-based biomarkers.





We
      have
      an extensive intellectual property portfolio of 15 patents and patents pending,
      covering methods, systems, and biomarkers. Many of these techniques are imbedded
      in the analysis tools used in our clinical trial services today. We utilize
      the
      patented suite of image analysis algorithms to detect, measure and analyze
      specific biological structures from medical image data, such as those provided
      by computed tomography (CT), magnetic resonance imaging (MRI), positron emission
      tomography (PET), and ultrasound. We believe our technology enables faster
      and
      more reliable detection of disease progression or therapeutic benefit, which
      can
      then accelerate the clinical trial process. The societal benefits include the
      ability to get the right drugs to market faster and ultimately save lives.
      Additionally, terminating an ineffective drug early in the development cycle
      can
      save a pharmaceutical company millions of dollars. We have developed successful
      collaborative relationships with companies such as Pfizer, Inc., who is an
      investor in the company as with GE Healthcare and are currently working with
      12
      of the leading 15 pharmaceutical, biotechnology and medical device companies
      in
      the world.





Our
      services support all aspects of imaging in clinical trials, from design to
      FDA
      submission. Our semi-automated systems measure and monitor disease progression
      and changes in biological processes over time. This process provides highly
      reproducible results, enabling us to measure minute changes in various
      biological structures and functions, both rapidly and with a high degree of
      confidence. Other current image analysis techniques can be time-consuming,
      inaccurate and highly variable. Even when the exact same data is being
      repetitively measured, results in these other techniques can vary from
      measurement to measurement, from technician to technician and from radiologist
      to radiologist. We believe our semi-automated methodology provides several
      significant benefits:




**·**
            Level
                of reproducibility that was previously
                unattainable




**·**
            Less
                dependence on a single reader




**·**
            Greater
                precision




**·**
            Higher
                throughput




**·**
            Smaller
                sample sizes




**·**
            Shorter
                analysis times




**·**
            Shorter
                trial times




11




**·**
            Significantly
                reduced costs




We
      have
      found that our customers value our extensive imaging knowledge and experience
      coupled with the ability to better understand the efficacy profile of their
      compounds. Throughout 2008, we have had over 80 active projects with another
      7
      that have been awarded to us. There can be no assurance that we will secure
      contracts from these awards or that any such contracts or any of our existing
      contracts will not be cancelled on 30 days’ advance notice by a customer.
      Additionally, once we enter into a new contract for participation in a drug
      trial, there are several factors that can effect whether we will realize the
      full benefits under the contract, and the time over which we will realize that
      revenue. Customers may not continue our services due to performance reasons
      with
      their compounds in development. Furthermore, the contracts may contemplate
      performance over multiple years, therefore, revenue may not be realized in
      the
      fiscal year in which the contract is signed or awarded or to the total value
      of
      the contract or award. Recognition of revenue under the contract may also be
      affected by the timing and ability of our customers to recruit patients and
      image site identification and training.




***Results
      of Operations***





***Results
      of Operations for Quarter Ended September 30, 2008 Compared to Quarter Ended
      September 30, 2007***





*Revenue*





We
      had
      revenues of $1,816,000 for the quarter ended September 30, 2008 compared to
      $1,370,000 for the comparable period in 2007, representing a $446,000, or 33%,
      increase. During the quarter, we performed work for 66 different projects,
      in
      connection with our pharmaceutical drug trials in the fields of oncology,
      arthritis and neurology. This compares to 58 projects during the same period
      in
      2007. The increase in revenues for the quarter is attributable to the broadening
      of our customer base as well as increasing demand for our services from our
      current customers. We
      continue to see an increase in the demand for our services relating to new
      imaging techniques within the industry. We believe that the demand we have
      seen
      aligns well to our business model and growth plan. As
      of
      September 30, 2008, we had active projects with 12 of the top 15 pharmaceutical
      companies. The majority of the pharmaceutical trial projects for which we have
      performed work to date are in pre-clinical, Phase I or Phase II studies. We
      are
      experiencing increased demand for our services in Phase II/III trials, and
      we
      expect that a majority of our work on pharmaceutical trial projects will be
      focused in Phase I, II and III studies throughout the rest of 2008.





*Gross
      Profit*





We
      had a
      gross profit of $810,000 for the third fiscal quarter of 2008 compared to
      $407,000 for the comparable period in 2007. Our gross profit margin improved
      to
      45%, from 30%, and gross profit increased $403,000, or 99%, in the third quarter
      of 2008 compared to the same period in 2007 due to efficiencies made in our
      processes throughout the past year along with reductions in our headcount made
      at the end of 2007. Also
      impacting the improvement in gross margin is the inherent efficiency obtained
      in
      performing work in later stage clinical trials. Our stated objective is to
      expand our technology and services into later stage (Phase II/III) trials.
      During the third quarter of 2008, 70% of our revenues were generated from Phase
      I/II/III trials as compared to 61% during the same quarter a year ago. We
      anticipate this trend to continue throughout the rest of 2008.





*Research
      and Development*





Research
      and development costs decreased in the quarter ended September 30, 2008 by
      $104,000, or 31%, to $233,000, when compared to the quarter ended September
      30,
      2007. The decrease was a result of the realignment of our resources at the
      end
      of 2007 to better reflect the demand in the market for our services and the
      direction of our self-funded research and development initiatives. We plan
      to
      continue to centralize the majority of our research and development efforts
      around the development and commercialization of image-based biomarkers which
      have early indications of correlation to disease progression, with a focus
      in
      Oncology, Musculoskeletal, Cardiovascular and Central Nervous System disease
      areas. Additionally, we will continue efforts to refine our processes through
      the use of our software platform in order to gain efficiencies which we believe
      will enhance our operating margins and standardize our processes. As of
      September 30, 2008, there were 10 employees in our research and development
      group, which includes the algorithm development and software development
      groups.


12





*Sales
      and Marketing*





Sales
      and
      marketing costs increased in the quarter ended September 30, 2008 by $113,000,
      or 75%, to $264,000, when compared to the quarter ended September 30, 2007.
      The
      increase was a result of the doubling of our sales force, including the hiring
      of a European Sales Director, over the past year. The hiring within our sales
      group was a result of the need to broaden our reach within the pharmaceutical,
      medical device and biotechnology industry. We have been successful in
      broadening our awareness within the industry as demonstrated in the 115%
      increase in our contracted and awarded backlog, bringing the total backlog
      to over $20 million as of July 2008. As of September 30, 2008, we had four
      individuals in our sales department.





*General
      and Administrative*





General
      and administrative expenses for the quarter ended September 30, 2008 were
      $751,000, a decrease of $28,000 or 4%, when compared to the quarter ended
      September 30, 2007. The decrease was largely due to the reduction in stock
      compensation expense for vested stock options during the third quarter of 2008
      compared to the third quarter of 2007. We do not anticipate significant
      increases in our general and administrative costs for the remainder of
      2008.





*Depreciation
      and Amortization*





Depreciation
      and amortization charges were $116,000 for the quarter ended September 30,
      2008,
      compared to $127,000 for the quarter ended September 30, 2007. The reduction
      represents the timing and obsolescence period of certain IT equipment. The
      company does not anticipate significant expenditures on IT related equipment
      during the rest of 2008.





*Other
      Income (Expense)*





Interest
      income for the quarter ended September 30, 2008 was $14,000, representing
      interest derived on our operating and savings accounts, compared to interest
      income of $22,000 in the three months ended September 30, 2007. The interest
      income was lower due to the lower rates of return on our savings accounts in
      the
      third quarter of 2008 compared to the third quarter of 2007. Other expense
      for
      the quarters ended September 30, 2008 and 2007 was $8,600 and $5,700,
      respectively, which largely represents state franchise taxes.





*Net
      Loss*





Net
      loss
      for the quarter ended September 30, 2008 was $549,000 compared to a net loss
      of
      $969,000 for the quarter ended September 30, 2007. The significant decrease
      in
      our net loss over the prior period was primarily related to the increase in
      revenues and improvement in gross margin, as outlined above.


13




***Results
      of Operations for the Nine Months Ended September 30, 2008 Compared to the
      Nine
      Months Ended September 30, 2007***





*Revenues*





Our
      revenues for the nine months ended September 30, 2008 were $5,183,000, an
      increase of $998,000 or 24% over the first nine months of 2007. The increase
      in
      sales is a reflection of the broadening of our customer base, the broader
      penetration of our services in the industry and the shift to later stage
      clinical trials which are inherently larger contracts. Additionally, we continue
      to see an increase in the demand for our services relating to new imaging
      techniques within the industry. We believe that the demand we have seen aligns
      well to our business model and growth plan. We performed services for a total
      of
      82 projects in the first three quarters of 2008, as compared to 68 in the
      comparable period of 2007. We are experiencing increased demand for our services
      in Phase II/III trials, and we expect that a majority of our work on
      pharmaceutical trial projects will be focused in Phase I, II and III studies
      throughout the rest of 2008.





*Gross
      Profit*





We
      had a
      gross profit of $2,126,000 for the nine months ended September 30, 2008 compared
      to $1,453,000 for the comparable period in 2007. Our gross profit margin
      improved six percentage points to 41% for the first three quarters combined
      in
      2008 compared to 35% in the first three quarters combined in 2007. Gross profit
      increased $673,000, or 46%, in the first nine months of 2008 compared to the
      first nine months of 2007. The improvements in gross profit and gross margin
      are
      a result of higher revenues coupled with better operating efficiencies and
      cost
      reductions that were made at the end of 2007 to better align our cost structure
      with the nature of the demand for our services in the market. Also impacting
      the
      improvement in gross margin is the inherent efficiency obtained in performing
      work in later stage clinical trials. During the first nine months of 2008,
      70%
      of our revenues were generated from Phase I/II/III trials as compared to 56%
      during the same quarter a year ago.





*Research
      and Development*





Total
      research and development expenditures were $698,000 in the first nine months
      of
      2008 compared to $1,125,000 for the comparable period in 2007, a decrease of
      38%. The decrease was largely attributed to the realignment of our resources,
      as
      previously stated, at the end of 2007 to better reflect market demand. The
      realignment resulted in a reduction in our resources within self-funded
      biomarker research. We plan to continue our research and development efforts
      to
      support new imaging techniques in the industry as well as to improve our
      internal software platform to optimize our operating efficiency. We currently
      have 10 individuals in our research and development group, including software
      development.





*Sales
      and Marketing*





Sales
      and
      marketing costs for the nine months ended September 30, 2008 increased to
      $937,000, an increase of $381,000 or 69% over the first nine months of 2007.
      The
      increase was a result of the doubling of our sales force over the past year
      as
      well as a new marketing strategy to better align our marketing materials with
      our value proposition and service offering in the industry. We incurred the
      majority of our marketing expenses for 2008 in the first and second quarters.
      We
      anticipate continued investment in our marketing initiatives throughout the
      remainder of 2008 and into 2009 to more broadly address the market.





*General
      and Administrative*





General
      and administrative expenses for the nine months ended September 30, 2008 were
      $2,513,000, a decrease of $217,000 or 8%, over the first nine months of 2007.
      The decrease is mainly due to a reduction in stock compensation expense for
      vested stock options and the settling of a legal matter with a former executive
      during the second quarter of 2007.


14





*Depreciation
      and Amortization*





Depreciation
      and amortization charges remained relatively consistent in the nine months
      ended
      September 30, 2008 and 2007. We do not anticipate significant capital
      expenditures for the remainder of 2008.





*Other
      Income (Expense)*





Interest
      income for the nine months ended September 30, 2008 was $60,000 and composed
      of
      interest derived on the Company’s operating and savings accounts, compared to
      interest income of $115,000 in the same period in 2007. The decrease in interest
      income was a reflection of the lower average rates of return on our savings
      accounts in 2008 compared to 2007. Other expense for the nine month period
      ended
      September 30, 2008 and 2007 were $12,000 and $9,000, respectively, representing
      interest due to loans from certain stockholders of the Company and bank and
      other fees.





*Net
      Loss*





Our
      net
      loss for the nine months ended September 30, 2008 was $2,324,000 compared to
      a
      net loss of $3,214,000 for the same period in 2007. The significant improvement
      in our net loss over the prior period was primarily related to higher revenues
      and gross profit, as outlined above.





**Liquidity
      and Capital Resources**





Our
      working capital as of September 30, 2008 was approximately $3,013,000 compared
      to $4,239,000 as of December 31, 2007. The decrease in working capital was
      a
      result of investments in sales and marketing, operations along with information
      technology purchases and patent costs.





Net
      cash
      used in operating activities totaled $950,000 in the nine months ended September
      30, 2008 compared to $2,353,000 in the comparable 2007 period. This significant
      decrease in usage was a result of increases in revenues and gross profit along
      with a reduction in spending in research and development and general and
      administrative expenses. Also impacting operating cash flow was the timing
      of
      receivables and advance payments from customers as well as timing on the payment
      of payroll.





We
      invested $90,000 in the purchase of equipment and the acquisition of patents
      in
      the first nine months of 2008, compared to $306,000 for the investment of these
      items in the first three quarters of 2007. The decrease represents investments
      for furniture and leasehold improvements related to the move to a new location
      during the first half of 2007.





Cash
      provided by our financing activities in the nine months ended September 30,
      2008
      was $143,000, compared to cash provided of $1,431,000 in the nine months ended
      September 30, 2007. A significant portion of the decrease represents the
      proceeds received from our convertible series B preferred stock issuance in
      2007.





We
      plan
      to continue to utilize the net proceeds from our 2007 private placement to
      support our operations, including research and development plans as well as
      our
      sales and marketing efforts, until we achieve cash flow breakeven. We also
      plan
      to continue to expand our sales efforts with presentations to pharmaceutical,
      biotechnology and medical device companies and participation in relevant medical
      conferences.





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.


15





In
      February 2008, we received a written notice from the Nasdaq Stock Market
      (“Nasdaq”) indicating that our common stock was not in compliance with minimum
      bid price required for continued listing on Nasdaq. The notice stated that
      in
      accordance with section 4310(c)(8) of the Nasdaq Marketplace Rules, the Company
      has until August 6, 2008 to regain compliance by maintaining a bid price of
      common stock at a close of $1.00 or higher for a minimum of 10 consecutive
      business days, or such longer period as Nasdaq may determine to show the ability
      to maintain long-term compliance. On August 7, 2008 the Company received a
      Staff
      Determination Letter from Nasdaq stating that it had not regained compliance
      with the $1.00 minimum bid price requirement and that its securities are subject
      to delisting. On September 18, 2008, the Company attended a hearing before
      the
      Nasdaq Listing Qualifications Panel and presented its plan for compliance and
      requested a further stay of delisting until February 2009. On October 8, 2008,
      the Company received word from Nasdaq that it had granted the Company’s request
      to stay delisting until February 3, 2009, and as such, have until that time
      to
      meet the minimum listing requirements. Further, on October 21, 2008, the Company
      received notice from Nasdaq stating that due to the current market conditions,
      Nasdaq had suspended the continued listing requirements for the minimum bid
      price until January 16, 2009, for all of its listed companies. The Company
      has
      been informed by Nasdaq that it now has until May 11, 2009 to meet the minimum
      bid requirements.





Our
      stockholders have authorized the Board of Directors to implement a reverse
      stock
      split of our outstanding common stock in a ratio from 1:2 to 1:4 as part of
      our
      efforts to regain compliance. If we have not met the minimum bid requirements
      by
      the end of the first quarter of 2009, we plan to effect a reverse stock split.
      If implemented, the Company expects that a reverse stock split will help it
      regain compliance with Nasdaq Capital Market listing standards, although there
      can be no assurance that it will be successful in doing so or that it will
      be
      able to maintain compliance with other continued listing standards.





Under
      the
      terms of our Series B Preferred Stock and related warrants, we are required
      to
      meet specific milestone financial performance for the 2008 fiscal year. These
      milestone events, which are detailed in our Certificate of Designation for
      our
      Series B Preferred Stock and in the related warrants, include generating $7.0
      million in revenue for the 12 month period ending on December 31, 2008. If
      we
      fail to meet or exceed any of the milestone events, then the Series B Preferred
      Stock conversion price will be reduced to a lower market price measured on
      the
      last trading day of our fiscal year, or the market price five trading days
      after
      we file our next Form 10-K, whichever is lower. If we make a major announcement
      around this time, the measurement date can be changed to a date one trading
      day
      prior to the announcement or 10 trading days after the announcement, whichever
      is lower.





An
      adjustment to the conversion price of our Series B Preferred Stock and related
      warrants for failure to meet the applicable milestone goals would also trigger
      a
      downward adjustment to the conversion price of our Series A Preferred Stock
      and
      the exercise price of the related warrants issued in connection with the Series
      A Preferred Stock. These price adjustments would give the holders of those
      securities the ability to acquire additional shares of our common stock upon
      conversion or exercise, and cause dilution to the holders of our common stock.
      At this point, we fully anticipate that we will meet the milestone goals and
      that a price adjustment will not be necessary, however, there can be no
      assurance that we meet these goals. Additionally, there are no required
      financial performance criteria under the terms of the Series B Preferred Stock
      and related warrants after 2008.





**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.





**Recent
      Accounting Pronouncements**





In
      March 2008, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 161, “Disclosures about
      Derivative Instruments and Hedging Activities—an amendment of FASB Statement
      No. 133” (“SFAS No. 161”). SFAS No. 161 changes the disclosure requirements
      for derivative instruments and hedging activities. Entities are required to
      provide enhanced disclosures about (a) how and why an entity uses
      derivative instruments, (b) how derivative instruments and related hedged
      items are accounted for under SFAS No. 133 and its related interpretations,
      and
      (c) how derivative instruments and related hedged items affect an entity’s
      financial position, financial performance and cash flows.  The guidance in
      SFAS No. 161 is effective for financial statements issued for fiscal years
      and
      interim periods beginning after November 15, 2008, with early application
      encouraged. This Statement encourages, but does not require, comparative
      disclosures for earlier periods at initial adoption.  At this time,
      management is evaluating the impact of the adoption of SFAS No. 161 on the
      Company’s consolidated financial statements.


16





In
      April
      2008, the FASB issued FASB Staff Position SFAS 142-3, *Determination
      of the Useful Life of Intangible Assets* (“FSP
      SFAS 142-3”). FSP SFAS 142-3 amends the factors that should be considered in
      developing renewal or extension assumptions used to determine the useful life
      of
      a recognized intangible asset under FASB Statement No. 142, Goodwill and Other
      Intangible Assets. The objective of this FSP is to improve the consistency
      between the useful life of a recognized intangible asset under Statement 142
      and
      the period of expected cash flows used to measure the fair value of the asset
      under SFAS 141R, Business Combinations, and other U.S. GAAP principles. FSP
      SFAS
      142-3 is effective for fiscal years beginning after December 15, 2008. The
      adoption of FSP SFAS 142-3 is effective January 1, 2009 and is not expected
      to
      have a material impact on the Company’s consolidated financial statements.





In
      October 2008, the FASB issued FSP 157-3 “Determining Fair Value of a Financial
      Asset in a Market That Is Not Active” (FSP 157-3). FSP 157-3 clarified the
      application of SFAS No. 157 in an inactive market. It demonstrated how the
      fair
      value of a financial asset is determined when the market for that financial
      asset is inactive. FSP 157-3 was effective upon issuance, including prior
      periods for which financial statements had not been issued. The implementation
      of this standard did not have a material impact on our consolidated financial
      statements.





Adoption
      of Statement of Financial Accounting Standards No. 159 and 157


In
      February, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
      provides companies with an option to report selected financial assets and
      liabilities at fair value. SFAS No. 159's objective is to reduce both complexity
      in accounting for financial instruments and the volatility in earnings caused
      by
      measuring related assets and liabilities differently. SFAS No. 159 also
      establishes presentation and disclosure requirements designed to facilitate
      comparisons between Companies that choose different measurement attributes
      for
      similar types of assets and liabilities. SFAS No. 159 requires Companies to
      provide additional information that will help investors and other users of
      financial statements to more easily understand the effect of the Company's
      choice to use fair value on its earnings. It also requires entities to display
      the fair value of those assets and liabilities for which the Company has chosen
      to use fair value on the face of the balance sheet. We adopted SFAS No. 159
      as
      of January 1, 2008. The adoption of SFAS No. 159 did not have a material effect
      on the Company’s consolidated financial statements.





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
      No. 157”). This Statement defines fair value, establishes a framework for
      measuring fair value and expands disclosure of fair value measurements. SFAS
      No.
      157 applies under other accounting pronouncements that require or permit fair
      value measurements and accordingly, does not require any new fair value
      measurements. We adopted SFAS No. 157 as of January 1, 2008. In February 2008,
      the FASB issued FASB Staff Position No. FAS 157-2, "Effective Date of FASB
      Statement No. 157", which provides a one year deferral of the effective date
      of
      SFAS No.157 for non-financial assets and non-financial liabilities, except
      those
      that are recognized or disclosed in the financial statements at fair value
      at
      least annually. Therefore, the Company has adopted the provisions of SFAS No.
      157 with respect to its financial assets and liabilities only. The adoption
      of
      SFAS No. 157 did not have a material effect on the Company’s consolidated
      financial statements.


17





**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;


·
            cancellation
                of a significant number of our customer
                contracts;


·
            significant
                delays in customer signature for awarded
                projects;


·
            significant
                delays in starting and recruiting patients by our
                customers;


·
            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;


·
            dilution
                to holders of our common stock if we fail to meet the revenue and
                EBITDA
                milestones on our Series B Preferred Stock and related warrants for
                the
                2008 fiscal year;


·
            possible
                delisting of our common stock from the Nasdaq Capital Market; 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-KSB for the
      fiscal year ended December 31, 2007 filed with the Securities and Exchange
      Commission (“SEC”) and elsewhere in this report. These risk factors qualify all
      forward-looking statements attributable to us or persons acting on our behalf.





**ITEM
      4T. Controls and Procedures**




**Evaluation
      of Disclosure Controls and Procedures**




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


18





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





**Changes
      in Internal Controls Over Financial Reporting**





An
      evaluation was performed under the supervision of the Company’s management,
      including the CEO and CFO, as required under Exchange Act Rule 13a-15(d) and
      15d-15(d) of whether any change in the Company’s internal control over financial
      reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) occurred
      during the fiscal quarter ended September 30, 2008. 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, 2008 that has materially affected or is
      reasonably likely to materially affect, the Company’s internal control over
      financial reporting.


19




**PART
      II. OTHER INFORMATION**





**Item
      1. Legal Proceedings**





None





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





On
      October 22, 2008, the Company issued a total of 42,500 shares of common stock
      to
      500 Linden Oaks Associates LLC, as partial payment for the lease of the
      Company’s corporate headquarters, pursuant to the terms of its lease dated May
      14, 2007. The shares were issued at $1.20 per share for a total consideration
      of
      $51,000. The shares were issued in transactions not involving a public offering
      and exempt from registration pursuant under Section 4(2) of the Securities
      Act
      of 1933, or Securities Act. The purchaser is an accredited investor under the
      Securities Act, was knowledgeable about the Company's operations and financial
      condition and had access to such information. The sales did not involve any
      form
      of general solicitation. The shares were purchased for investment purposes
      only
      and contain restrictions on transfer with certificates containing a legend
      setting forth such the restrictions.





**Item
      3. Defaults upon Senior Securities**





Not
      applicable.





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





None




**Item
      5. Other Information**





None





**Item
      6. Exhibits**





Exhibit
      10.1 Employment Agreement dated August 27, 2008, by and between Jeffrey Markin
      and VirtualScopics, Inc. (as previously described in Item 5.02 of the Current
      Report on Form 8-K dated August 28, 2008)





Exhibit
      10.2 Employment Agreement dated August 27, 2008, by and between Molly Henderson
      and VirtualScopics, Inc. (as previously described in Item 5.02 of the Current
      Report on Form 8-K dated August 28, 2008)





Exhibit
      31.1 Certification of Chief Executive Officer as required by Rule 13a-14 or
      15d-14 of the Securities Exchange Act of 1934, as adopted Pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002.





Exhibit
      31.2 Certification of Chief Financial Officer as required by Rule 13a-14 or
      15d-14 of the Securities Exchange Act of 1934, as adopted Pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002.





Exhibit
      32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act 0f of
      2002.





Exhibit
      32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act 0f of
      2002.


20


**SIGNATURES**





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





Dated:
                November 14, 2008
            VIRTUALSCOPICS,
                INC./s/
                Jeffrey MarkinJeffrey
                MarkinPresident
                and Chief Executive Officer/s/
                Molly HendersonMolly
                HendersonChief
                Business and Financial Officer


21


**Exhibit
      Index**





Exhibit
      10.1 Employment Agreement dated August 27, 2008, by and between Jeffrey Markin
      and VirtualScopics, Inc.





Exhibit
      10.2 Employment Agreement dated August 27, 2008, by and between Molly Henderson
      and VirtualScopics, Inc.





Exhibit
      31.1 Certification of Chief Executive Officer as required by Rule 13a-14 or
      15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002





Exhibit
      31.2 Certification of Chief Financial Officer as required by Rule 13a-14 or
      15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002





Exhibit
      32.1 Certification pursuant to 18 U.S.C. Section 1350 by the Chief Executive
      Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002





Exhibit
      32.2 Certification pursuant to 18 U.S.C. Section 1350 by the Chief Financial
      Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002





22