UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C.  20549




FORM
10-K




(Mark
One)




(X)
            Annual
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934


For
      the fiscal year ended June 30, 2008


or


( )
            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: 0-10832





AFP
Imaging Corporation


(Exact
Name of Registrant as Specified in Its Charter)





New
      York
            13-2956272(State
      or Other Jurisdiction of Incorporation or Organization)
            (I.R.S.
      Employer Identification No.)250 Clearbrook Road, Elmsford,
      NY
            10523(Address
      of Principal Executive Offices)
            (Zip
      Code)





Registrant’s
Telephone Number, Including Area Code:  (914) 592-6100





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





Securities
registered pursuant to Section 12 (g) of the Act:





Common Stock, par value $.01
per share


(Title of
Class)





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. YES (  )    NO
(X).





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  YES
(  )    NO (X).





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.


YES
(X)    NO (  ).





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405) is not contained herein, and will not be contained,
to the best of registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. (X)





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. (Check one):





Large
Accelerated Filer (  )    Accelerated Filer
(  )    Non-Accelerated Filer
(  )    Smaller reporting company (X)


(Do not
check if a smaller reporting company)





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


YES
(  )    NO (X).





The
aggregate market value of the registrant’s common stock held by non-affiliates
of the registrant as of December 31, 2007 was approximately
$9,397,316.  On such date, the average closing bid and asked price of
the Registrant’s Common Stock, as reported by the OTC Bulletin Board, was $
..65.










The
registrant had 17,928,800 shares of Common Stock outstanding as of October 10,
2008.





The
information required by Part III of Form 10-K is incorporated by reference to
the registrant’s Proxy Statement for the 2008 Annual Meeting of
Shareholders.







2




AFP
IMAGING CORPORATION


2008
FORM 10-K




TABLE
OF CONTENTS




PagePART IItem 1.
            
            Business.
            
            5Item 1A.
            
            Risk Factors.
            
            10Item 1B.
            
            Unresolved Staff Comments.
            
            10Item 2.
            
            Properties.
            
            10Item 3.
            
            Legal Proceedings.
            
            10Item 4.
            
            Submission of Matters to a Vote of Security
      Holders.
            
            11PART IIItem 5.
            
            Market for Registrant’s Common Equity, Related Stockholder
      Matters, and Issuer Purchases of Equity Securities.
            
            12Item 6.
            
            Selected Financial Data.
            
            14Item 7.
            
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations.
            
            14Item 7A.
            
            Quantitative and Qualitative Disclosures about Market
      Risk.
            
            22Item 8.
            
            Financial Statements and Supplementary
    Data.
            
            22Item 9.
            
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure.
            
            23Item 9A (T).
            
            Controls and Procedures.
            
            23Item 9B.
            
            Other Information.
            
            25PART IIIItem 10.
            
            Directors, Executive Officers and Corporate
      Governance.
            
            25Item 11.
            
            Executive Compensation.
            
            25Item 12.
            
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters.
            
            25Item 13.
            
            Certain Relationships and Related Transactions, and
      Director Independence.
            
            25Item 14.
            
            Principal Accountant Fees and Services.
            
            25PART IVItem 15.
            
            Exhibits and Financial Statement
    Schedules.Signatures
            
            26-27




3




Introductory
Note – Forward - Looking Statements




This
Annual Report on Form 10-K contains certain forward-looking statements, within
the meaning of Section 27A of the Securities Act of 1933, as amended (the
“Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as
amended (the “Exchange Act”).  Forward-looking statements involve
known and unknown risks, uncertainties and other factors that could cause actual
results of AFP Imaging Corporation (collectively with its subsidiaries, “We”,
“Our”, “Us” or, the “Company”) or achievements expressed or implied by such
forward-looking statements to not occur, not be realized or differ materially
from that stated in such forward-looking statements.  Forward-looking
statements may be identified by terminology such as “may,”  “will,”
project,” “plan,” “expect,”  “believe,” “would,”
“could,”  “estimate,”  “anticipate,”  “intend,”
“continue,”  “potential,”  “opportunity” or similar terms,
variations of such terms, or the negative of such terms or
variations.  Potential risks, uncertainties and factors include, but
are not limited to:


·
            adverse
      changes in general economic
conditions;


·
            the
      Company’s ability to repay its debts when
due;


·
            changes
      in the markets for the Company’s products and
  services;


·
            the
      ability of the Company to successfully design, develop, manufacture and
      sell new products;


·
            the
      Company’s ability to successfully market its existing and new
      products;


·
            adverse
      business conditions;


·
            changing
      industry and competitive
conditions;


·
            the
      effect of technological advancements on the marketability of the Company’s
      products;


·
            the
      Company’s ability to protect its intellectual property rights and/or where
      its intellectual property rights may infringe on the intellectual property
      rights of others;


·
            maintaining
      operating efficiencies;


·
            pricing
      pressures;


·
            risk
      associated with foreign sales;


·
            risk
      associated with the loss of services of the key executive
      officers;


·
            the
      Company’s ability to attract, train and retain key
    personnel;


·
            difficulties
      in maintaining adequate short and long-term financing to meet the
      Company’s obligations, and fund the Company’s working capital
      operations;


·
            changes
      in the nature or enforcement of laws and regulations concerning the
      Company’s products, services, suppliers, or the Company’s
      customers;


·
            determinations
      in various outstanding legal
matters;


·
            the
      success of the Company’s strategy to increase its market share in the
      industries in which it competes;


·
            the
      Company’s ability to successfully integrate the operations of any entity
      acquired by the Company with the Company’s
  operations;


·
            changes
      or fluctuations in currency exchange rates and regulations;
      and


·
            other
      factors set forth in this Form 10-K and from time to time in the Company’s
      other filings with the Securities and Exchange Commission
      (“SEC”).





Readers
are urged to carefully review and consider the various disclosures made by the
Company in this Annual Report on Form 10-K for the year ended June 30, 2008, and
the Company’s other filings with the SEC.  These reports attempt to
advise interested parties of the risks and factors that may affect the Company’s
business, financial condition and results of operations and
prospects.  The forward - looking statements made in this Annual
Report on Form 10-K speak only as of the date hereof and the Company disclaims
any obligation to provide updates, revisions or amendments to any
forward-looking statements to reflect changes in the Company’s expectations or
future events.






4





PART
I





Item
1.  Business.





a)
General Development of Business





AFP
Imaging Corporation was organized on September 20, 1978 under the laws of the
State of New York.  Since then, the Company has been engaged in the
business of designing, developing, manufacturing and distributing equipment for
generating and/or capturing medical and dental diagnostic images.  The
products utilize electronic and radiographic technologies, as well as the
chemical processing of photosensitive materials.  The Company is ISO
9001/2000 certified.  Medical, dental, veterinary and industrial
professionals also use the Company’s imaging products.  The Company
distributes in world-wide markets, under various brand names and trademarks,
through a network of independent and unaffiliated dealers.  Certain
digital imaging products are also sold and distributed by the Company directly
to dental and veterinary professional end users.  The Company has one
business segment; the manufacture and distribution of medical and dental x-ray
imaging equipment and accessories.





The
Company’s primary objective is to be a leading provider of cost effective,
diagnostic radiographic products for applications in the medical, dental,
veterinary and industrial imaging fields.  The Company is
concentrating on:


·
            continually
      broadening its product offerings in the transition from x-ray film to
      electronic imaging,


·
            enhancing
      both its domestic and international distribution channels,
    and


·
            expanding
      its world-wide market presence in the diagnostic, dental and veterinary
      imaging fields.





On April
19, 2007, the Company completed the acquisition of Quantitative Radiology srl,
an Italian corporation (“QR”), by acquiring all of the outstanding share capital
of QR from the shareholders.  QR is a global supplier of
state-of-the-art, in-office three-dimensional dental computed tomography
(CT).  QR uses an imaging technology that features a cone shaped beam
of x-rays (a CBCT scanner).  The Company, prior to April 19, 2007, had
acted as QR’s exclusive distributor in North and South America, excluding
Brazil.  Funding for the acquisition was principally derived from two
sources; the first was the proceeds raised from a private offering of the
Company’s common stock to equity investors and the second was a portion of a new
senior secured loan facility.  In connection with the acquisition, the
Company entered into employment agreements with each of the former shareholders
of QR.  Each agreement contains a non-compete clause which prohibits
the employee from engaging in activities competitive with the business of QR for
a period of five years from the date of termination of employment.





On April
12, 2007, the Company completed the sale of an aggregate of 5,500,000 shares of
its common stock to certain accredited investors for an aggregate consideration
of $8,140,000 pursuant to previously executed subscription
agreements.  The common stock was issued and sold pursuant to the
exemption from registration afforded by Regulation D of the Securities
Act.  In connection with the transaction, the Company paid the
placement agent for the offering $407,000, or five percent of the gross proceeds
of the offering.  The proceeds were used for the purchase of
QR.  The Company granted the investors certain registration rights
with respect to the resale of the shares acquired and has registered these
shares of common stock for resale.





On April
13, 2007, the Company entered into a new senior secured facility (“Revolving
Credit and Term Loan“) with ComVest Capital LLC (“Senior Secured Lender”)
whereby the Senior Secured Lender agreed to lend the Company an aggregate of up
to $8 million in the form of a $5 million term loan and a $3 million revolving
loan facility.  The term loan bears interest at a rate of ten percent
(10%) per annum and provides for repayment over five years commencing in
November 2007; and the revolving loans bear interest at a rate per annum of two
percent (2%) plus the prime rate and is payable in full on April 30,
2012.  The Company and each of its wholly-owned subsidiaries executed
a Collateral Agreement pursuant to which each such party agreed to grant a
security interest in all of its respective assets to ComVest as collateral
security for repayment of the loans.  This new senior secured
Revolving Credit and Term Loan Agreement replaced the Company’s previous $2.5
million senior secured credit facility, which was due to expire on September 21,
2007.  As part of the transaction, the Company granted to the Senior
Secured Lender an aggregate of 800,000 warrants to purchase shares of the
Company’s common stock at exercise prices per share equal to $1.85 with respect
to 266,666 warrants, $2.02 with respect to an additional 266,666 warrants, and
$2.19 with respect to the remaining 266,668 warrants.  The Company
registered the shares of common stock issuable upon exercise of the warrants and
conversion of the term note and must use its best efforts to keep the
registration statement effective during the applicable registration
period.  The Company is presently negotiating with its Senior Secured
Lender to modify certain applicable provisions of the Revolving Credit and Term
Loan Agreement.





In
accordance with the consent of the Senior Secured Lender, since November 2007,
the Company has been making principal and interest payments under the term loan
and interest payments under the revolver by borrowing additional amounts under
the revolver.  As a direct result of the additional borrowings under the
revolver to pay the August and September 2008 term loan and revolver charges,
the Company’s aggregate outstanding advances under the revolver presently exceed
the maximum revolving credit commitment permissible under the Revolving Credit
and Term Loan Agreement.  The Company is presently in technical default
under the Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum borrowings.  The Company has not received any formal notice of
default from the Senior Secured Lender, and is in the process of negotiating
with the Senior Secured Lender to modify certain applicable provisions of the
Revolving Credit and Term Loan Agreement.


5




In
December 2006, the Company completed the acquisition of a domestic distribution
channel for a portion of its digital, dental product line.  This
channel will provide the Company with an additional sales and support function
and will focus on direct sales to the actual professional end user. The Company
will also maintain its historic dealer sales, where
applicable.  Digital dental products sold through this channel will
also utilize the Company’s various brands.  Evolving market trends,
distributor consolidations and competition requires that the Company develop
this capability for direct, domestic sales representation.





b)
Financial Information about Industry Segments





The
Company is engaged in one industry segment; the manufacture and distribution of
medical and dental x-ray imaging equipment and accessories.  Prior to
July 2001, when the Company sold the assets related to its graphic arts
subsidiary, the Company had been engaged in two industry segments, the
manufacture and distribution of medical/dental x-ray equipment and accessories,
and the manufacture and distribution of graphic arts and film processing
equipment.  The Company has agreed not to compete in this same
business line of graphic arts film processing equipment for ten years, to expire
in July 2011.  The Company’s business segments, until July 2001, were
based on significant differences in the nature of the Company’s operations,
including distribution channels and customers.  The composition of the
current industry segment is consistent with that used by the Company’s
management in making strategic decisions.  See Notes to the
Consolidated Financial Statements for further discussion of industry
segments.





c)
Narrative Description of Business





The global
medical/dental market has been and continues to be impacted by technological
improvements which allow a clinician to increase productivity and offer higher
quality treatment to patients.  The Company believes that the
high-tech end of this market is growing at a faster pace than the overall
medical/dental market and that this trend will continue over
time.  Recent technological advancements include three-dimensional
radiography and digital radiography.  The Company offers several
products in each of these high-tech sub-markets.





Principal
Products and Services





Cone Beam CT Scanners –
Three Dimensional Imaging


The
Company, through QR, its Italian subsidiary, designs, manufactures and
distributes a dental CT scanner capable of generating and reconstructing
three-dimensional images of the teeth, jaws and surrounding dental
anatomy.  For many clinical procedures, it is an important diagnostic
improvement over historical two-dimensional film images.  The system
utilizes a conical shaped x-ray cone beam (“CBCT”) that rotates around the skull
and passes through the teeth, at many angles, thus creating unique,
radiographic, dental information that is captured digitally.  A
three-dimensional image is then reconstructed from the data.  QR has
been providing this technology to world-wide markets for over ten
years.  The primary users are dentists, implant specialists, oral
surgeons and orthodontists, as well as Ear, Nose and Throat medical
specialists.  Three-dimensional imaging offers clinicians vast
diagnostic and treatment options which can be seamlessly integrated into routine
practices.





The
configurations include a horizontal patient table support system that assists
positioning for complex cases involving the elderly, the infirmed or small
children, a vertical, standing CBCT model where a patient can be seated or
standing upright during the examination, and a mobile vertical CBCT model which
is used in customized vans to provide a mobile imaging center. The vertical
model also provides user flexibility for smaller examination
rooms.  The Company completed the acquisition of QR on April 19,
2007.





Digital Dental and Large
Body Digital Imaging Systems – Two Dimensional Imaging


The
Company manufactures, distributes and services film-less, digital radiography
sensors in various image format sizes, utilizing x-rays and electronic imaging
applications. The equipment generates and captures two dimensional, dental x-ray
images with these sensors, in place of film, and then displays the image in
digital format.  The Company markets the film-less digital radiography
sensors under the trademark “EVA” and has dental and veterinary applications.
Digital radiographic systems, referred to as DR Systems (direct radiography),
have practical applications in both human and companion animal
diagnostics.  Veterinary dentistry has become an important discipline
and treatment procedure.





6




DR systems
can be either “postage stamp size,” larger for equine applications or in the
largest format to be installed in x-ray tables for companion animal (pets) whole
body examinations.  The primary benefit for the professional is the
improved display of diagnostic information, clinical efficiency and the
flexibility of electronic radiographs for referrals and storage.





Dental X-Ray
Systems


The
Company distributes digital and analog dental x-ray machines, manufactured by
others.  The Company has the exclusive distribution rights in the
North American markets for a well established, European-designed, intraoral
dental x-ray and a panoramic/cephalometric dental x-ray unit. The latter
provides, all in one view, a full format image for the diagnosis of the entire
upper and lower dental arches and jaws.  These dental products are
supplied to the market with a digital, filmless x-ray sensor that is compatible
with various software applications.  Panoramic units are typically
used by dentists, orthodontists, oral surgeons, and endodontists for specific
patient treatment plans where three dimensional imaging is not
required.  Installed equipment utilizes analog x-ray film that can be
developed in the Company’s well established line of processors.





Veterinary Imaging and
Radiographic Table Systems


The
Company manufactures and distributes a line of x-ray tables and related
equipment specifically designed for the veterinary marketplace.  They
include x-ray systems for film or digital dental radiography, a portable digital
imaging system for the diagnosis of equine extremities and a large size
filmless, x-ray sensor used in conjunction with general radiographic equipment.
The Company distributes general-purpose x-ray systems and related imaging
components specifically designed for veterinary applications.  They
are marketed under the Company’s trademark “VetTek.”  These systems
are designed to offer the user either digital or film based image capture
systems and allows the veterinarian to perform either dental or general
radiography.





X-Ray Processors &
Accessories


The
Company manufactures and distributes a line of medical, dental and industrial
x-ray film processors.  These are commonly referred to as analog
film-based systems.  The machines automatically process or develop
x-ray films.  The exposed film is inserted into the equipment and
returned to the operator developed, fixed, washed and dried.  The
equipment can be located either in a dark room site or adapted to a daylight
loading system.  These analog units are used for diagnostic x-ray
imaging and industrial, non-destructive testing applications.  These
products are distributed worldwide through an unaffiliated dealer network to
doctors, dentists, veterinarians, hospitals, medical clinics, and the U.S.
government.




Patents
and Trademarks





The
Company presently holds or has licensed a number of domestic and foreign utility
patents, which the Company believes are material to the technology used in its
products.  The Company’s intellectual property includes several
patents obtained in connection with prior acquisitions.  The Company
is not aware of any patents or other intellectual property held by others that
conflict with the Company’s current product designs.  However, there
can be no assurance that infringement claims will not be asserted against the
Company in the future.  Patent applications have been filed where
appropriate.  The Company owns several domestic and foreign
trademarks, which it uses in connection with the marketing of its products,
including:  AFP Imaging, DENT-X, ENDOS, EVA, NewTom, VetTek and
DIGI-VET, among others.  The Company believes that these utility
patents and trademarks are important to its operations and the loss or
infringement by others of or to its rights to such patents and trademarks could
have a material adverse effect on the Company.  Even with the patent
rights for the Company’s products, the Company’s technology may not preclude or
inhibit competitors from producing products that have substantially similar
performance specifications as the Company’s products.





The
Company has agreed to pay a nominal royalty on the domestic sales of its digital
dental systems to a third party under a license for the use of the third party’s
software format for the computer display of such images.  The Company
also has agreed to pay a royalty to a third party on the worldwide sales of its
digital dental sensors, under a license to use certain technology developed and
owned by the third party and utilized in the sensor’s internal
operations.  The Company is dependant to some degree on this
third-party license, and the loss or inability to replace this license could
result in increased costs as well as substantial delays or reductions in product
shipments.  This license agreement was recently renewed with similar
terms and conditions. The principal technology applied to the construction of
the Company’s other products may be considered proprietary.


7





Research
and Development





The
amounts spent by the Company during each of the Company’s last two fiscal years
on primary research activities relating to the development of new equipment and
the improvement of existing products, all of which was Company sponsored, are as
follows:





Year
Ended June 30,


2008
            2007$1,968,478
            $1,021,766





The
Company conducts research and development activities internally in its Elmsford,
New York facility as well as in its Verona, Italy facility, and contracts out
certain projects to qualified vendors and external consultants, as
needed.  The Company’s research and development efforts and
technologies were significantly enhanced by the acquisition of QR on April 19,
2007.  The Company’s main focus is to continue to develop products
that offer diagnostic treatment options that offer user comfort and are
competitively priced.  The Company has integrated its research and
development between both locations.





Raw
Materials





The
Company manufactures and assembles its products at its facilities in Elmsford,
New York and Verona, Italy, both of which are ISO 9001/2000 (International
Standards Organization) certified.  The Company’s products are
manufactured from parts and components obtained from numerous unaffiliated
suppliers and/or fabricated internally.  In most cases, the Company
does not utilize any unique processes, nor does it traditionally have
difficulties in obtaining raw materials in the manufacture of its
products.  The Company owns proprietary designs and tooling to produce
the digital x-ray sensors and other components that are in the physical
possession of vendors.  Although the Company anticipates that an
adequate commercial supply of necessary raw materials and components will remain
available from various sources, the loss of the Company’s relationship with a
particular supplier could result in productions delays due to the time required
to reproduce the proprietary component or designs elsewhere. Such losses could
materially adversely affect the Company’s long term business.





Warranties





The
Company generally warrants each of its products against defects in materials and
workmanship for a period of one to two years, depending upon the product, from
the date of shipment plus any extended warranty period purchased by the
customer.  The Company offers a three year warranty for the digital,
dental sensors.  The need to fulfill warranty claims by the Company’s
customers or dealers could potentially have an adverse effect on the Company by
requiring additional expenditures for replacements, materials and/or
labor.





Sales,
Marketing and Distribution





The
Company’s manufactured and outsourced products are distributed both domestically
and internationally to end users and independent medical and dental dealers or
distributors.  Regional managers oversee worldwide sales
professionals. The Company has spent significant time and resources to emphasize
AFP Imaging’s leading role in the high-tech three-dimensional diagnostic imaging
market.





The
Company conducts worldwide marketing and regional sales efforts through trade
show attendance and promotion, which are important forums for raising brand and
name awareness, as well as new product introduction.  The Company
advertises in domestic and international trade journals, business publications,
and professional organizations, provides sales support and literature, prepares
technical manuals and conducts customer education and training programs in order
to promote its products.  In addition, the Company participates in
domestic and international technical support for its products.  The
Company maintains a web site (www.afpimaging.com),which provides an
easy-to-navigate, on-line information resource that includes Company
information, product descriptions and extensive technical specifications and
information.





Government
Regulation





The
Company’s medical and dental products are subject to government regulation in
the United States and certain other countries.  The United States Food
and Drug Administration (“FDA”) regulates the distribution of all equipment used
as medical devices.  The Company must comply with the procedures and
standards established by the FDA and comparable foreign regulatory
agencies.  The Company believes it has registered all of its
applicable medical and dental products with the FDA, and that all of its
products and




8




procedures
satisfy all the criteria necessary to comply with FDA
regulations.  The FDA has the right to disapprove the marketing of any
medical device that fails to comply with FDA regulations.  The
Company’s manufacturing facilities are ISO 9001/2000 certified.  Where
applicable, the Company’s products are Conformite’ Europeenne (“CE”) certified
for sales within the European Union.  Any future changes in existing
regulations, or adoption of additional regulations, domestically or
internationally, which govern devices such as the Company’s medical and dental
products have the potential to have a material adverse effect on the Company’s
ability to market its existing products or to market new products. The Company
engages specialized, expert consultants for the preparation of FDA
applications.





The
Company is also subject to other international, federal, state, and local laws,
regulations and recommendations relating to safe working conditions and
manufacturing processes.  The Company believes it is in compliance
with all such rules.





International
sales of our products are subject to the regulatory agency product registration
requirements of each country in which the Company’s products are
sold.  The regulatory review process varies from country to
country.  The Company typically relies on its distributors in foreign
countries to obtain the required regulatory approvals.





Product
Liability Exposure





The
Company’s business involves the inherent risk of product liability
claims.  The Company currently maintains general product liability
insurance as well as an umbrella liability policy, which the Company believes
are sufficient to protect the Company from any potential risks to which it may
be subject.  However, there can be no assurances that product
liability insurance coverage will continue to be available or, if available,
that it can be obtained in sufficient amounts or at a reasonable
cost.  See Item 3. Legal Proceedings, for further discussion of
outstanding product liability claims.





Customers





In the
Company’s fiscal years ended June 30, 2008 (“Fiscal Year 2008”), 2007 (“Fiscal
Year 2007”) and 2006 (“Fiscal Year 2006”), there were no sales to any one
customer which accounted for 10% or more of the Company’s total consolidated
sales.  Management believes that the loss of any one customer would
not have a materially adverse effect on the Company’s consolidated
business.





Competition





The
Company is subject to both foreign and domestic
competition.  Competitors have made significant investments in
research and development of new technologies, products and
services.  Some competitors are well established in similar
manufacturing and distribution businesses and may have greater financial,
manufacturing and distribution resources than the Company.  With
respect to all of its products, the Company competes on the basis of function,
features, product specifications, price per application, promptness of delivery
and customer service.  The Company purchases certain products from
others for resale on a non-exclusive basis, which may be subject to competition
from the suppliers or other independent distributors.





The
Company also competes in the dental imaging market on the basis of its
proprietary and patented technologies.  Certain competitors have
significantly greater resources and revenues in electronic digital imaging
technologies and more expertise in software development utilized in dental
imaging products.





The market
for technology professional services is intensely competitive, rapidly evolving
and subject to rapid technological change.  The Company expects
competition not only to persist, but also to increase.  Competition
may result in price reductions, reduced margins and loss of market
share.  The market for the Company’s goods and services is rapidly
evolving and is subject to continuous technological change.  As a
result, the Company’s competitors may be better positioned to address these
developments or may react more favorably to these changes.





While the
Company believes its products are competitive in terms of capabilities, quality
and price, increased competition in the marketplace could have an adverse effect
on the Company’s business and, recent business mergers and acquisitions may
potentially adversely affect the Company’s business.  Many of the
Company’s competitors are much larger with significantly greater financial
capitalization, sales, marketing and other resources than those of the
Company.  There can be no assurance that these competitors are not
currently developing or will attempt to develop new products that are more
effective than those of the Company or that might render the Company’s products
noncompetitive or obsolete.  No assurances can be given that the
Company will be able to compete successfully with such competitors in the
future.





9




Environmental





The
Company believes it is in compliance with the current laws and regulations, in
the United States and Italy, governing the protection of the environment and
that continued compliance would not have a material adverse effect on the
Company or require any material capital expenditures.  Compliance with
local codes for the installation and operation of the Company’s products is the
responsibility of the end user, or the dealer who independently provides
installation services.  See Item 3, Legal Proceedings, for further
discussion of an environmental claim in which the Company is
involved.








Employees





As of June
30, 2008, the Company employed 122 people on a full-time basis,
world-wide.  The Company has no collective bargaining agreements and
considers its relationship with its employees to be satisfactory.  The
Company’s Italian subsidiary conforms to their statutory, Italian labor
regulations, which includes a mandatory severance indemnity.  All
Italian employees are entitled to an indemnity upon termination of their
employment relationship for any reason.  The respective benefit
accrues to each employee on a pro-rata basis during their employment period and
is based upon their respective salary.  The vested benefit payable
accrues interest.





Item
1A.  Risk Factors.





Not
Applicable.





Item
1B.  Unresolved Staff Comments.





None.





Item
2.  Properties.





Our
executive office and United States manufacturing facility is located in
Elmsford, New York.  This facility, which comprises approximately
47,735 square feet, is subject to a lease, which was renewed in June 2008 and
expires on December 31, 2019. The current rental is $525,085 per year,
increasing through the lease term to $644,423, plus increases for real estate
taxes, utility costs and common area charges.  We believe our facility
is well maintained, in good operating condition and sufficient to meet our
present and anticipated needs.  We have a manufacturing facility
located in Verona, Italy.  This facility, which comprises
approximately 11,000 square feet, is subject to a lease expiring on November 14,
2015, with a current rental of approximately Euro 122,000 plus VAT per
year.  We believe our facility is well maintained, and in good
operating condition.  We also maintain a small technology facility in
Verona, Italy, with a current rental of Euro 39,000 plus VAT per
year.  This facility is subject to a lease which expires in September
2013.  We also maintain a small sales and marketing facility in
Roswell, Georgia, which is subject to a lease expiring on April 30,
2009.





Item
3.  Legal Proceedings.





The
Company is a defendant in an environmental claim relating to a property in New
Jersey owned by the Company between August 1984 and June 1985.  This
claim relates to the offsite commercial disposition of trash and waste in a
landfill in New Jersey.  The Company maintains that its waste
materials were of a general commercial nature. This claim was originally filed
in 1998 by the federal government in United States District Court for the
District of New Jersey, Newark Vicinage, citing several hundred other
third-party defendants.  The Company (through its former subsidiary,
Kenro Corporation) was added, along with many other defendants, to the
suit.  The Company's claimed liability was potentially assessed by the
plaintiff at $150,000.  The Company has joined, along with other
involved defendants in an alternative dispute resolution (ADR) process for
smaller claims.  On May 7, 2008, a tentative mediated settlement was
reached by all parties, and the Consent Decree memorializing the settlement is
being negotiated by the governments and each group’s liaison counsel and is
presently scheduled to be finalized by December 2008.  The Company’s
share is $82,880 of which the Company’s insurance carrier has agreed to pay 50%
of the settlement offer.  The Company cannot, at this time, assess the
amount of liability that could result if this settlement is not
finalized.  The Company’s insurance carrier has agreed to equally
share with the Company the defense costs incurred in this environmental
claim.





10




On May 5,
2008, the Company and Dent-X International, Inc. commenced litigation in the
United States District Court, Southern District of New York, against Genexa
Medical, Inc. (“Genexa”) to recover $394,609 for goods sold and delivered to
Genexa during the period from December 11, 2007 through March 13, 2008, after
Genexa failed and refused to pay the amount due.  On June 27, 2008,
Genexa filed an Answer and Counterclaims alleging several causes of action which
are potentially material.  Although the Company intends to vigorously
defend all such counterclaims, a determination as to the likelihood of Genexa
prevailing on the merits with respect to such counterclaims is premature as of
the date hereof.  The case was scheduled for an initial conference
before Judge Charles L. Brieant on July 25, 2008, but Judge Brieant recently
passed away and the case will be reassigned.




The
Company has received notification of a customer complaint filed in the Superior
Court of California, County of Placer, on December 19, 2007.  The
Complaint seeks damages in excess of $25,000.  The Company has not
been formally served with this Complaint.  The Company, through its
attorneys, has repeatedly agreed to a settlement, but has not received any
further communication.




The
Company is involved in two product liability insurance claims, however, to date,
no lawsuits have been filed.  The Company maintains that its equipment
was not the cause of the respective incidents or the resultant
damage.  The Company’s insurance carriers, and their attorneys, are
assisting in the Company’s defense in these matters.  The Company does
not believe that the final outcome of either of these matters will have a
material adverse effect on the Company.





From time
to time, the Company may be party to other claims and litigation arising in the
ordinary course of business.  The Company does not believe that any
adverse final outcome of any of these matters, whether covered by insurance or
otherwise, would have a material adverse effect on the Company.








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





None.




11




PART
II








Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities.





Market
Information





The
Company’s Common Stock, par value $.01 per share (the “Common Stock”), is the
only class of the Company’s common equity securities outstanding and is quoted
on the OTC Bulletin Board under the trading symbol “AFPC.OB.”





The market
for the Common Stock is highly volatile. We cannot assure you that there will be
a market in the future for our common stock. OTC Bulletin Board securities are
not listed and traded on the floor of an organized national or regional stock
exchange. Instead, OTC Bulletin Board securities transactions are conducted
through a telephone and computer network connecting dealers in stocks. OTC
Bulletin Board stocks are traditionally smaller companies that do not meet the
financial and other listing requirements of a regional or national stock
exchange.





The
following table shows the range of the closing high and low bid information for
the Common Stock for each quarterly period during the Company’s last two fiscal
years.  These prices reflect inter-dealer prices and do not include
retail mark-ups, markdowns or commissions, and may not represent actual
transactions.





Fiscal
      2008
            
            
            Fiscal
      2007High
            
            
            Low
            
            
            High
            
            
            LowFirst
      Quarter
            
            $
            1.72
            
            
            $
            1.20
            
            
            $
            2.44
            
            
            $
            1.60Second
      Quarter
            
            
            1.62
            
            
            
            .62
            
            
            
            1.87
            
            
            
            1.30Third
      Quarter
            
            
            .81
            
            
            
            .37
            
            
            
            1.80
            
            
            
            1.32Fourth
      Quarter
            
            
            .57
            
            
            
            .22
            
            
            
            2.15
            
            
            
            1.63








Holders





As of
October 10, 2008, we had approximately 295 shareholders of record (which number
does not include the number of stockholders whose shares are held by a brokerage
house or clearing agency).





Dividends





No cash
dividends have been declared on the Common Stock to date and the Company does
not anticipate the payment of dividends for the foreseeable
future.  The Board of Directors will have the sole discretion in
determining whether to declare or pay dividends in the future.  The
declaration of dividends will depend on the profitability, financial condition,
cash requirements, future prospects and other factors deemed relevant by the
Board of Directors.  In addition, provisions contained in the existing
credit facility and financing arrangements places certain restrictions on the
Company’s ability to declare and make any cash dividends.  The Company
currently does not have a set policy with respect to payment of
dividends.





Securities
Authorized for Issuance Under Equity Compensation Plans





The
following table sets forth as of June 30, 2008:


§
            the
      number of shares of the Common Stock issuable upon exercise of outstanding
      options, warrants and rights, separately identified by those granted under
      equity incentive plans approved by the Company’s shareholders and those
      granted under plans, including individual compensation contracts, not
      approved by the Company’s shareholders (column
  A),


§
            the
      weighted average exercise price of such options, warrants and rights, also
      as separately identified (column B),
and


§
            the
      number of shares remaining available for future issuance under such plans,
      other than those shares issuable upon exercise of outstanding options,
      warrants and rights (column C).








12





Plan
      Category
            
            Number
      of securities to
              be
      issued upon exercise of outstanding options, warrants and
      rights
            
            
            Weighted
      average exercise price of outstanding options, warrants and
      rights
            
            
            Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))(a)
            
            
            (b)
            
            
            (c)Equity
      compensation plans
              approved
      by security holders (1)
            
            
            865,900
            
            
            $
            .91
            
            
            
            500,500Warrants
      issued to a financial advisor  (2)
            
            
            50,000
            
            
            $
            1.98
            
            
            
            N/AWarrants
      issued to ComVest
              Capital,
      LLC (3)
            
            
            800,000
            
            
            $
            2.02
            
            
            
            N/AEquity
      compensation plans not approved by security holders
            
            
            0
            
            
            
            0
            
            
            
            0Total
            
            
            1,715,900
            
            
            $
            1.46
            
            
            
            500,500





1.
            The
      equity compensation plans approved by the security holders are the
      Company’s 2004 Equity Incentive Plan and the 1999 Stock Option
      Plan.


2.
            These
      warrants were issued to our investment banker in March 2006 in connection
      with advisory services rendered to the
Company.


3.
            These
      warrants were issued to our senior secured lender in April 2007 in
      connection with the Revolving Credit and Term Loan
    Agreement.








13




Item
6.  Selected Financial Data.
 
 Not
Applicable.
 
 Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations.
  The
following should be read in conjunction with the Company’s Consolidated
Financial Statements and notes thereto included elsewhere in this Annual Report
on Form 10-K.  This discussion may contain certain forward-looking
statements based on current expectations that involve risks and
uncertainties.  Actual results and timing of certain events may differ
significantly from those projected in such forward-looking statements due to a
number of factors, including those set forth elsewhere in this
report.  Except as otherwise indicated, all amounts are reported in
U.S. dollars ($).
 
 Capital Resources and
Liquidity
  The
Company’s working capital at June 30, 2008 decreased by approximately $10.99
million from June 30, 2007.  This decrease is principally due to the
loss from operations in Fiscal Year 2008 and an increase in current debt of
approximately $8.0 million.  The Company believes that current
worldwide economic conditions have significantly delayed the purchasing
decisions for high end, high tech products, and therefore sales did not reach
the originally forecasted levels.  The Company had to rely on
short-term borrowing lines of credit to continue to fund working capital
operations and maintain brand and name awareness in the medical/dental
market.  The Company also reclassified debt from the Senior Secured
Lender as a current liability as of June 30, 2008 as described in Note 4 of the
consolidated financial statements.
 Operating
cash flows were much lower in the 12 months ended June 2008 compared to June
2007 principally due to the loss from operations, which is mainly attributable
to increased marketing, sales and administrative costs related to the support
and distribution of the Company’s high-tech products, the strong Euro in
relation to the U.S. dollar, and increased amortization costs related to the
intangibles associated with the acquisition of QR in April 2007, and increased
fuel costs.  These expenses related to new and existing products and
the development of various new distribution channels to continue to advance
sales growth.  These factors caused the Company to utilize its cash
resources, resulting in increased borrowings on the revolver portion of the
domestic credit facility and the foreign lines of credit.  The Company
requires advance deposits from its customers on the new-high dollar valued
equipment prior to shipment.  The Company has neither changed its
payment policies to its vendors nor revised its payment terms with its
customers.
  The
decrease in current assets is mainly due to: (1) the Company’s increase in its
valuation allowance on the U.S. portion of its deferred tax asset and (2) an
increase in the allowance for doubtful accounts (approximately $790,000), which
included a Canadian distributor in arrears and foreign accounts receivable
acquired in April 2007 as part of the acquisition of QR, which have now been
deemed uncollectable. The significant increase in current liabilities is mainly
due to (1) an increase in current borrowings both in the U.S. and Italy to fund
working capital operations, including a reclassification of long-term debt to
current liabilities as discussed above, (2) an increase in accounts payable and
accrued expenses, based on scheduled deliveries of inventory, and (3) the
recording of deferred revenue related to specific contractual arrangements for
certain equipment in accordance with Generally Accepted Accounting Principles as
applied in the U.S.
  On April
12, 2007, the Company completed the sale of an aggregate of 5,500,000 shares of
its common stock to certain accredited investors for an aggregate consideration
of $8,140,000.  The Company has registered these shares for
resale.  The common stock was issued and sold pursuant to the
exemption from registration pursuant to Regulation D of the Securities
Act.  In connection with the transaction, the Company paid the
placement agent a five percent fee.  The net proceeds were used to
fund a portion of the purchase price of QR, which was completed on April 19,
2007.
  On April
13, 2007, the Company entered into a Revolving Credit and Term Loan Agreement
with the Senior Secured Lender, whereby the Senior Secured Lender agreed to lend
the Company an aggregate of up to $8 million in the form of a $5 million term
loan and a $3 million revolving loan facility.  The term loan bears
interest at a rate of ten percent (10%) per annum and provides for repayment
over five years commencing in November 2007 in 53 equal monthly installments of
$92,592.60 with a final balloon payment of all remaining amounts due there under
on April 30, 2012.  The term loan is further subject to mandatory
prepayment to the extent of 50% of proceeds received by the Company in
connection with the sale of its capital stock unless such proceeds are utilized
to acquire another business.  The revolving loans bear interest at a
rate per annum of two percent (2%) plus the prime rate and is payable in full on
April 30, 2012, has a specific formula to calculate available funds based on
eligible accounts receivable and inventory, is subject to maximum “borrowing
base” limitations, and hascertain
reporting requirements.  This senior secured Revolving Credit and Term
Loan Agreement replaced the Company’s previous $2.5 million senior secured
credit facility, which was due to expire on September 21, 2007.  The
proceeds were used to fund a portion of the purchase price of QR srl, and for
ongoing working capital requirements.
  14
  In
accordance with the consent of the Senior Secured Lender, since November 2007,
the Company has been making principal and interest payments under the term loan
and interest payments under the revolver by borrowing additional amounts under
the revolver.  As a direct result of the additional borrowings under the
revolver to pay the August and September 2008 term loan and revolver charges,
the Company’s aggregate outstanding advances under the revolver presently exceed
the maximum revolving credit commitment permissible under the Revolving Credit
and Term Loan Agreement.  The Company is presently in technical default
under the Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum borrowings.  The Company has not received any formal notice of
default from the Senior Secured Lender, and is in the process of negotiating
with the Senior Secured Lender to modify certain applicable provisions of the
Revolving Credit and Term Loan Agreement.
  Both loans
are subject to mandatory prepayment in full in the event of certain events
deemed to be a “sale”, including but not limited to merger, sale of assets or
change in control.  The term loan is convertible by the Senior Secured
Lender at any time into shares of Common Stock at a conversion price of $2.37
per share.  The term loan is convertible at the Company’s option upon
the satisfaction of certain conditions, including a reported trading price equal
to 175% of the conversion price, the common stock being traded on NASDAQ, and a
certain minimum trading volume, among others.  In addition, the
Company and each of its wholly-owned subsidiaries executed a Collateral
Agreement pursuant to which each such party agreed to grant a security interest
in all of its respective assets to the Senior Secured Lender as collateral
security for repayment of the loans.  Further, each subsidiary agreed
to guaranty performance of all of the Company’s obligations to the Senior
Secured Lender.
  As part of
the transaction, the Company granted to the Senior Secured Lender an aggregate
of 800,000 warrants to purchase shares of Common Stock at exercise prices per
share equal to $1.85 with respect to 266,666 warrants, $2.02 with respect to an
additional 266,666 warrants, and $2.19 with respect to the remaining 266,668
warrants.  The Company registered the shares of common stock issuable
upon the exercise of the warrants and conversion of the term note and must use
its best efforts to keep the registration statement effective during the
applicable registration period.
  The
Company’s foreign subsidiary maintains various lines of credit with two separate
financial institutions.  In April 2008, these lines were increased
from 1,750,000 Euros to 2,000,000 Euros.  The borrowings under most of
these lines of credit are guaranteed by specific foreign accounts receivable and
inventory.  These lines of credit were granted in August 2007 and
there are no restrictive covenants, subordination clauses or corporate
guarantees.  As of June 30, 2008, there was 1,652,712 Euros
outstanding in connection therewith.  The Company’s foreign subsidiary
has failed to make payment with respect to certain invoices payable to one of
these financial institutions pursuant to a line of credit
agreement.  The lender has notified QR that such invoices are past
due, but has taken no further action at the present time in respect
thereof.
  Capital
expenditures for Fiscal Year 2008 were approximately $201,800, consisting mainly
of tooling expenditures related to the redesign, development and production of
new imaging equipment, and leasehold improvements related to a new engineering
office in Italy.  The Company purchased a new telephone system for its
domestic operations which has been recorded as a capital lease.  The
Company expects to continue to finance any future capital requirements
principally from internally generated funds.  The total amount of
capital expenditures is not limited under the Company’s Revolving Credit and
Term Loan Agreement.
  The
Company is dependent upon its Revolving Credit and Term Loan Agreement with the
Senior Secured Lender, its foreign lines of credit, and continued minimum sales
levels to finance its ongoing operations.  As of June 30, 2008, the
Company had available approximately $430,000 of unused credit under the
Revolving Credit and Term Loan Agreement.  Currently, as described
above, there is no unused credit balance.
  The
Company presently believes that the Revolving Credit and Term Loan Agreement and
foreign lines of credit may not be sufficient to finance the Company’s ongoing
worldwide working capital requirements for the next twelve months. The Company
has instituted cost cutting measures to reduce its cash requirements.  The
Company is also currently in the process of seeking out
additional financing alternatives, including potential private equity sales of
its securities as well as the possibility of increasing or extending its line of
credit with the Senior Secured Lender.  There can be no assurance that the
Company will be able to obtain any such financing upon favorable terms to the
Company, or at all.  In the event that the Company is unable to secure
sufficient financing to maintain its operations, its business and financial
condition could be materially adversely affected.  These factors
raise substantial doubt about the Company’s ability to continue as a going
concern.  The consolidated financial statements do not include any
adjustments regarding this uncertainty.  The Company’s independent
registered public accounting firm has included a going concern explanatory
paragraph in its audit report for the period ended June 30, 2008.
  15
  The
Company is continuing to investigate various strategic alliances to increase its
market share.  Some of these strategies could involve the acquisition
or joint venturing of one or more businesses or product line
distributions.  There are no assurances that the Company will be able
to identify any suitable candidate(s), or, if so identified, be able to enter
into a definitive agreement with such candidates on terms favorable to the
Company.
 
 
 Off-Balance Sheet
Arrangements
 
 The
Company has no off-balance sheet financing arrangements or interests in
so-called special purpose entities.
 
 Results of
Operations
  The
results of operations for the Company have changed significantly as a result of
the acquisition of QR.  QR, located in Verona, Italy is a global
supplier of state-of-the-art, in-office three-dimensional dental computed
tomography (CT).  QR uses an imaging technology that features a cone
shaped beam of x-rays (a CBCT scanner).  The carrying values of QR’s
assets and liabilities were adjusted to their fair values and the difference
between the purchase price and the fair value of the net assets was recorded as
goodwill and other intangibles, and is subject to periodic impairment
testing.  The Company’s results of operations have been and will
continue to be materially affected by the amortization costs associated with
these other intangibles and any impairment charges.
  The U.S.
dollar is the Company’s reporting currency; however, a significant portion of
the consolidated operating results are denominated in Euros.  Since
the acquisition in April 2007, the U.S. dollar/Euro exchange rate has fluctuated
significantly, thereby impacting the Company’s financial
results.  Between April 2007 and June 2008, the U.S. dollar/Euro
exchange rate used to calculate the consolidated financial statements ranged
from as low as $1.35 to as high as $1.57.  The Company does not
usually use foreign exchange contracts to manage foreign currency
exposure.  As of June 30, 2008, there were no outstanding foreign
exchange contracts.
  Based on
the recent losses, the Company has instituted significant cost cutting measures
in Fiscal 2009, which should begin to take effect in the second quarter Fiscal
2009.  These measures include reductions in operating costs and
worldwide marketing and distribution costs, including payroll, employee
benefits, and operating overhead charges.
  The
Company’s operating results have varied in the past and are likely to vary in
the future.  Due to variations that the Company has experienced in
operating results, management does not believe that period-to-period comparisons
of results of operations are necessarily meaningful or reliable as indicators of
future performance.  These variations result from several factors,
many of which many of which are not in the Company’s control, including but not
limited to:
  ·
              Changes
      in technology, specifically imaging
    modalities, ·
                Demand
      for products and
services,
 ·
                The
      level of product, price and service
    competition,
 ·
                Changes
      in product mix, which could affect profit
      margins,
 ·
                Federal,
      state or local government
  regulation,
 ·
                The
      timing of industry trade
shows,
 ·
                Currency
      fluctuations,
 ·
                Capital
      spending budgets of
customers,
 ·
                General
      economic trends and conditions specific to the Company’s
      industry,
 ·
                Changes
      in the prime rate of borrowing in the United
      States,
 ·
                Changes
      in federal and foreign tax
laws,
 ·
                The
      timing of new product introductions by the Company as well as by its
      competitors, and
         ·
                World-wide
      economic events.
 16
  Fiscal 2008 vs. Fiscal
2007
  Sales
increased approximately $5.56 million or 19.4%, between Fiscal Year 2007 and
Fiscal Year 2008, principally due to the acquisition of
QR.  Approximately $9.6 million of this increase can be attributed to
the Company’s worldwide sales of the three-dimensional dental x-ray imaging
systems manufactured by QR in Italy.  Prior to the purchase of QR, the
Company was the exclusive distributor in the United States, Canada and Latin
America (excluding Brazil) for QR’s three-dimensional x-ray imaging
system.  The Company sells this product into both the dental and
medical ENT markets.  The Company’s veterinary products business
decreased approximately 49%, mainly due to lower than anticipated demand for the
very specialized digital equine systems and general purpose veterinary x-ray
systems.  There is a continuing strong demand for the Company’s
two-dimensional filmless digital dental radiography system which has both
veterinary and human applications, and sales remained relatively constant
between the two fiscal years.  The Company’s intra-oral and panoramic
dental x-ray systems showed a decrease in sales of 25% in the current fiscal
year as intra-oral x-rays have become a commodity product and panoramic x-rays
are in direct competition with three-dimensional imaging.  The
Company’s analog film processor business including related parts, accessories
and consumables showed a decrease of approximately $918,000 in the current
fiscal year, due to the transition from analog to digital imaging
processing.  U.S. health-care professionals continue to migrate to
digital imaging equipment which the Company also supplies.  The
Company has continued its efforts to increase worldwide distribution and expand
and develop new international markets for its digital products, resulting in a
19% increase in international sales, generated from the United States, between
the periods.
  Gross
profit, as a percent of sales, increased by 4.5 percentage points between Fiscal
Year 2007 and Fiscal Year 2008.  Most of this increase is due to the
increase in sales of the three-dimensional x-ray systems, both in the US and
worldwide.  The gross margin increase was negatively impacted by
approximately $100,000 increase in freight charges related to worldwide
increases in fuel costs and approximately $200,000 increase in costs in
intra-oral and panoramic x-rays due to variations in the US dollar/Euro rate, as
most of these expenses are denominated in Euros.
  Selling,
general, and administrative costs increased approximately $5.16 million or 49%,
between Fiscal Year 2007 and Fiscal Year 2008.  Approximately $3.68
million of this increase is due to operating costs in Italy associated with the
acquisition of QR.  Included in the Italian operation’s costs is
approximately $400,000 to increase the allowance for doubtful accounts related
to receivables acquired as part of the acquisition. The balance of this increase
is attributable to the U.S. operations, including:
 (1) an
approximate $790,000 increase in general and administrative costs, which
includes:
 (a) costs
associated with the Company’s initial compliance with Section 404 of the
Sarbanes-Oxley Act of  2002,
 (b)
increased professional fees related to the legal and tax consolidation of the
European operations, and
 (c)
approximately $400,000 to increase the US allowance for doubtful accounts due to
a delinquent Canadian distributor;
  (2)
approximately a $388,000 increase in technical support costs related to the new
digital equipment the Company is selling that require a devoted infrastructure
support system including installation and training and related
costs;
 (3) an
increase in marketing and sales costs of approximately $330,000, attributable
to:
 (a) the
Company’s continued aggressive launch into the dental and medical marketplaces
for the new three dimensional x-ray imaging equipment, including attendance at
several large international trade shows, development of new marketing and
advertising materials including a redesigned website, and the related travel
expenses;
 (b) the
worldwide introduction of the Company’s new vertical three-dimensional CBCT
scanner,
 (c) the
pursuit of various sales opportunities in both the domestic and international
markets, with specific emphasis in the growing veterinary markets,
and
 (d) an
increase in general operating expenses based on increased sales
levels.
 
 Included
in Fiscal Year 2007 is the write-off of approximately $75,000 of deferred
financing costs incurred in the previous fiscal year as the Company chose not to
utilize that lender.
  Amortization
of intangible assets increased $1,009,257 between the Fiscal Year 2007 and
Fiscal Year 2008 due to the amortization of the long-lived assets created from
the acquisition of QR in April 2007.  Prior to April 2007, the Company
did not have any such intangibles.  Fiscal Year 2008 represents a full
year of the amortization cost.
  There was
no write-off of In Process Research and Development Costs in Fiscal Year
2008.  The write-off in Fiscal Year 2007 of $3,760,000 was related to
in-process research and development that had been acquired as part of the
purchase of QR.  The capitalization and immediate write-off were
recorded as a result of the allocation of the purchase price of
QR.  These charges will not have a continued impact on the Company’s
future operating results.
  17
 In Fiscal
Year 2008, there was an impairment charge to the long-lived assets. Developed
technologies was impaired approximately $4.0 million and customer relationships
was impaired approximately $1.6 million.  The long-lived asset
impairment charge in Fiscal Year 2008 is primarily due to increased competition
in the market, new developments in three-dimensional imaging technology, and
current economic conditions; all of which have adversely affected sales
levels.
  Research
and development costs increased approximately $946,700, or 92.7%, between Fiscal
Year 2007 and Fiscal Year 2008.  The Company’s research and
development efforts and technologies were significantly enhanced by the
acquisition of QR.  All of this increase was due to research and
development efforts in Italy, where the primary focus is on three-dimensional
imaging systems.  These expenses are denominated in Euros and
therefore are subject to variations in the US dollar/Euro exchange rate
fluctuations.  The Company continues to invest in the design,
development and refinement of its existing digital imaging equipment, as well as
the design and development of new digital imaging equipment for the human dental
and broad veterinary applications.  Research and development costs may
fluctuate between reporting periods, due to changing research and development
consulting agreements, initiation or completion of certain project tasks, and
market demands.  Research and development costs may continue to
increase over the next several years as the Company evaluates its strategy to
develop and market additional high tech digital products.  The Company
has integrated its research and development between both locations.
  There was
a $2,045,918 gain on foreign currency transactions in Fiscal Year 2008 related
to an unrealized non-cash foreign currency gain on the US dollar denominated
intercompany note and recorded by QR in Euros.  This note was subject
to the significant fluctuations in the US dollar/Euro exchange rates in Fiscal
Year 2008.  A deferred tax liability has been recorded in Italy for
this unrealized gain, in accordance with local laws.  There was no
foreign currency gain or loss recorded in Fiscal Year 2007, as the US
dollar/Euro exchange rate did not fluctuate significantly between April 19, 2007
and June 30, 2007.
  In Fiscal
Year 2008, there was no gain or loss attributable to a Euro or any other
currency hedge contract.  In Fiscal Year 2007, the Company recorded
income of $352,966 related to a Euro hedge contract that was purchased in March
2007 to limit the foreign currency exchange risk related to the purchase of QR,
which was in Euros.
  Net
interest expenses increased approximately $820,000 between Fiscal Year 2007 and
Fiscal Year 2008. In Fiscal Year 2007, interest income was approximately
$185,000.  There was minimal interest income in Fiscal Year
2008.  The decrease in interest income is due to the utilization of
all cash raised from the private placements in Fiscal Years 2007 and 2006 for
the acquisition of QR.  There was approximately $967,000 of interest
expense in Fiscal Year 2008, compared to approximately $319,000 in Fiscal Year
2007.  The current fiscal year had approximately $5.8 million more in
average borrowings on the senior secured debt and foreign lines of credit, and
had a slightly higher average interest rate.  The significant increase
in borrowings was used to fund a portion of the purchase price of QR and to
provide continued working capital for the growth of the new digital imaging
product lines.
  The
Company made several small state tax payments in the U.S. in Fiscal Year 2008,
based on the consolidated loss from operations.  It also made the
required national and local tax payments in Italy for calendar years 2006, 2007
and 2008, based on the foreign operations, as required by local law, and paid
the required taxes in Italy for funds repatriated to the US.  The
Company recorded a provision for taxes on QR’s operations at the combined
required statutory tax rate.  The Company has recorded net deferred
tax liabilities of approximately $155,000 at June 30, 2008.  This net
deferred tax liabilities balance is solely attributable to the Company’s foreign
operations, and is comprised of approximately $698,000 deferred tax liabilities
and $543,000 deferred tax assets.  The deferred tax liabilities are
related to the net unrealized exchange gain on the intercompany note denominated
in U.S. dollars, as it will only be taxed when realized and when payment is
made; and the deferred tax assets are mainly related to the temporary
differences on the intangible assets amortization.   The Company
increased its valuation allowance on the U.S. portion of its deferred tax asset
by approximately $4,398,000 in the current Fiscal Year, as it does not believe
that it is more likely than not that it will be able to utilize the net
operating loss carry forwards based on the recent losses and anticipated market
conditions.  The Company has accounted for the recently enacted
Italian Finance Bill of 2008 which reduced the overall tax rate from 37.25% to
31.4%, and accordingly decreased its foreign deferred tax asset by approximately
$34,000 in the current Fiscal Year.  This decrease in the deferred tax
asset as well as the increase in the valuation allowance, have been reflected as
part of the tax provision in the accompanying financial
statements.  The Company had approximately $12 million in federal net
operating loss carry forwards (“NOLs”), and approximately $16.4 million in state
net operating loss carry forwards, as of June 30, 2008.  These NOLs
will begin to expire in 2010.  Past and future changes in ownership of
the Company, as defined by Section 382 of the Internal Revenue Code, may limit
the amount of NOLs available for use in any one year.
  18
 
 Fiscal 2007 vs. Fiscal
2006
  Sales
increased approximately $3,721,400, or 14.9%, between Fiscal Year 2006 and
Fiscal Year 2007.  Approximately $2.0 million of this increase can be
attributed to the sales of the three-dimensional dental x-ray imaging systems
generated by QR, in Italy, in the current period.  In June 2006, the
Company became the exclusive distributor in the United States, Canada and Latin
America (excluding Brazil) for QR’s three-dimensional imaging system and sells
this product into both the dental and the medical ENT market and experienced new
sales growth of approximately $2.1 million.  The Company’s veterinary
products business increased 43%, mainly due to the introduction in mid-Fiscal
Year 2006 of a digital imaging system for equine patients and general purpose
x-ray systems (analog and digital) specifically designed for all veterinary
applications.  In addition, there is continuing demand for the
Company’s filmless digital dental radiography system which showed a 16% increase
in human and veterinary sales in the current period.  The Company’s
analog film processor business including related part, accessories and
consumables showed a decline of approximately 17% in the current period as
health-care professionals continue to migrate to digital imaging equipment, much
of which the Company also supplies.  There was a slight decline in
intra-oral and panoramic x-rays due to specific vendor issues, which have since
been corrected.  The Company has continued its efforts to increase
worldwide distribution and expand and develop new international markets for its
digital products, resulting in a 20.6% increase in international sales between
the periods.
  Gross
profit as a percent of sales increased slightly, by 0.5 percentage points,
between Fiscal Year 2006 and Fiscal Year 2007.  In the United States,
material costs as a percent of sales increased by 3.0 percentage points, as the
Company began selling more of the higher dollar value distributor goods, which
tend to have lower gross margins.  Many of the distributor goods are
imported, and the Company has realized additional costs with the strong Euro to
the U.S. dollar.  The Company also increased its US warranty reserve
to reflect the extended warranty period on several of its digital
products.  These were offset by favorable profit margins in
Italy.
 
 Selling,
general, and administrative costs increased approximately $2.9 million or 38.8%,
between Fiscal Year 2006 and Fiscal Year 2007.  Approximately $600,000
of this increase is due to operating costs, in Italy, associated with the
acquisition of QR in April 2007.  The balance of this increase is due
to several factors, including:
 (1) the
write-off of certain deferred financing costs incurred in the previous fiscal
year as the Company chose not to utilize that lender;
 (2) an
approximate 13% increase in general and administrative costs associated with the
increase in sales and the Company’s expanded presence in various
markets;
 (3) an
approximate $300,000 increase in technical support costs related to the new
digital equipment the Company is selling, that require a devoted infrastructure
support system;
 (4) an
increase in marketing and sales costs of approximately $1.3 million in the
current fiscal year due to:
 (a) the
Company’s aggressive launch into the dental and medical marketplaces for the new
three dimensional x-ray imaging equipment, including attendance at two large
international tradeshows, development of new brochures and advertising
materials, and the related travel and entertainment expenses,
 (b) the
pursuit of various sales opportunities in both the domestic and international
markets, with specific emphasis in the growing veterinary markets,
 (c) the
Company’s attendance and exhibition at two other large international trade shows
in Europe and
 (d) an
increase in general operating expenses, based on increased sales levels;
and
 (5) an
approximate $580,000 related to the acquisition in mid-December 2006 of a new
distinct distribution channel to implement various methods to increase sales
levels.
  The
Company wrote-off approximately $3,760,000 of costs related to in process
research and development that had been acquired as part of the purchase of
QR.  As of June 30, 2007, no alternative future use was identified for
these assets and, accordingly, these assets were written off in Fiscal Year
2007.  The capitalization and immediate write-off were recorded as a
result of the allocation of the purchase price of QR.  These charges
will not have a continued impact on the Company’s future operating
results.
  Amortization
of intangibles increased approximately $225,000, or 100%, and resulted from the
amortization of the other intangibles created from the acquisition of QR and the
purchase price relative to the fair-value of the assets
acquired.  Prior to April 2007, the Company did not have any such
intangibles.
  Research
and development costs increased approximately $325,100, or 46.7%, between Fiscal
Year 2006 and Fiscal Year 2007.  The Company’s research and
development efforts and technologies were significantly enhanced by the
acquisition of QR.  Approximately 58% of this increase was due to
research and development efforts in Italy.  The Company continues to
invest in the design, development and refinement of its existing digital imaging
products, as well as the design and development of new digital imaging products
for the human dental and broad veterinary applications, including hardware and
enhancements.  Research and development costs may fluctuate between
reporting periods, due to changing research and development consulting
agreements, initiation or completion of certain project tasks, and market
demands.  Research and development costs are generally expected to
continue to increase over the next several years as part of the Company’s
strategy to develop and market additional high tech digital
products.  The Company has integrated its research and development
between both locations.
  19
  In Fiscal
Year 2007, the Company recorded income of $352,966 related to a Euro hedge
contract that was purchased in March 2007 to limit the foreign currency exchange
risk related to the purchase of QR, which was in Euros.
  Interest
expense, net increased approximately $99,000 between Fiscal Year 2006 and Fiscal
Year 2007.  There was approximately $185,600 of interest income in
Fiscal Year 2007 compared to approximately $43,100 in Fiscal Year
2006.  The increase in interest income is due to the $5 million
private placement the Company completed in May 2006, whereby all of the proceeds
were invested in a diversified U.S. Treasury Money Market Fund, until they were
used to acquire QR in April 2007.  There was approximately $319,000 of
interest expense in Fiscal Year 2007 compared to approximately $77,500 in Fiscal
Year 2006.  In Fiscal Year 2007, prior to April 2007 and the
acquisition of QR, the Company’s average borrowings were approximately $900,000;
upon completion of the acquisition and the assumption of a term loan and new
revolver, the Company’s average borrowings increased to $6.9
million.  This is compared to Fiscal Year 2006 which had approximately
$400,000 in average borrowings on the senior secured debt.  The
current fiscal year also had a slightly higher average interest
rate.
  The
Company made several small state and federal tax payments in the U.S. in the
twelve months ended June 30, 2007, based on payments previously made during
Fiscal Year 2006.  The Company also made the required tax payments in
Italy for 2007 and 2006.  The Company recorded a provision for taxes
on its Italian operations at the combined required statutory tax
rate.  The Company has recorded net deferred tax assets of
approximately $1,296,000, which primarily related to the U.S. net operating loss
carry forwards and the foreign deferred tax assets acquired in the QR
acquisition in April 2007.   As of June 30, 2007, the Company had
approximately $7.7 million in federal net operating loss carry forwards, and
approximately $12.2 million in state net operating loss carry forwards. These
NOLs will begin to expire in 2010.  Changes in ownership of the
Company, as defined by Section 382 of the Internal Revenue Code, may limit the
amount of NOLs available for use in any one year.
 
 
 Critical Accounting Policies
and Estimates
  The
preparation of financial statements in conformity with United States generally
accepted accounting principles requires management to makes estimates and
assumptions that affect the reported amounts of assets and liabilities and the
reported amounts of revenues and expenses.  These estimates and
assumptions are evaluated on an ongoing basis based on historical internal
operations, industry trends and conditions, market conditions and other
information that management believes to be reasonable or applicable under the
circumstances.  There can be no assurances that actual results of
operations will be consistent with management’s estimates and assumptions, and
that reported results of operations will not be adversely affected by the
requirement to make accounting adjustments to reflect changes in these estimates
from time to time.  The following policies are those that management
believes to be the most sensitive to estimates and judgments:
 
 Revenue
Recognition
  The
Company recognizes revenue net of related discounts and allowances for its
consolidated operations when persuasive evidence of the arrangement exists, the
price is fixed or determinable, collectability is reasonably assured, and
delivery or title and risk of loss has passed to the customer, based on the
specific shipping terms.   The Company includes shipping and
handling costs as a component of cost of sales.  Revenue related to
equipment orders that contain one or more elements to be delivered at a future
date is recognized in accordance with EITF 00-21 “Accounting for Revenue Arrangements
with Multiple Deliverables”.The Company allocates revenue
between the various elements using the relative fair value method, based on
evidence of fair value for the respective elements.    The
revenue allocated to deferred service contracts, installation and training for
the three-dimensional imaging equipment is deferred until service is
provided.  Amounts received from customers in advance of equipment
deliveries are recorded as deferred income until the revenue can be recognized
in accordance with the Company’s revenue recognition policy.
 
 20
 
 Accounts
Receivable
 The
Company reports accounts receivable net of reserves for doubtful
accounts.  Credit is extended to distributors on varying terms,
usually between 30 and 90 days.  Most of the sales to our direct users
are payment in advance.  Letters of Credit or payment in advance is
required for certain foreign sales.  The reserve for doubtful accounts
is management’s best estimate of the amount of probable credit losses in the
Company’s existing accounts receivable and is based upon continual analysis of
the accounts receivable aging including credit risk of specific customers,
historical trends and other related information.  The Company writes
off accounts receivable when they become uncollectible.  There have
been no significant changes in the computation methodology of the reserve for
doubtful accounts in the past three years. The Company has not had significant
bad debt write-offs in the past few years, except for Fiscal Year 2008, when the
company recorded certain write-offs related to the receivables associated with
the acquisition of QR srl and the write-off related to an exclusive Canadian
distributor. The allowance for doubtful accounts is based on the Company’s
analysis of aged accounts receivable.  Management believes that any
potential risk associated with the estimate of reserve for doubtful accounts is
therefore limited.
 
 Inventories
 Inventories,
which include material and a small component of work-in-process labor and
overhead, are stated at the lower of cost (first in, first out) or market (net
realizable value).  The Company has established inventory reserves
based on inventory estimated to be obsolete, slow moving, or unmarketable due to
changing technological and/or market conditions.  If actual market and
technical conditions are less favorable than those anticipated, additional
inventory reserves would be required.  There have been no significant
changes in the computation methodology of the reserves for inventory in the past
three years.
 
 Warranties
 The
Company records a liability for an estimate of costs that it expects to incur
under its limited warranty based on revenues.  Various factors affect
the Company’s warranty liability, including: (1) number of units sold, (2)
historical rates of claims, (3) anticipated rates of claims, and (4) costs per
claim.  The Company periodically assesses the adequacy of its warranty
liability based on changes in these factors.
  In March
2005, the Company began to include an extended warranty with its digital
sensors.  The Company continues to monitor the rate and costs of
claims and review the adequacy of its warranty liability and has made changes in
the warranty reserve, as necessary based upon the number of units sold, the
actual amount of warranty claims processed, and the specific warranty
period.  The increase in the warranty reserve has resulted in
decreased gross profit.
  In Fiscal
2008, the Company’s Italian subsidiary began to separately account for warranty
costs related to its three-dimensional digital imaging equipment and has
recorded a warranty reserve as of June 30, 2008.
 
 Stock-based
Compensation
 Effective
July 1, 2005, the Company began to account for stock based compensation under
Financial Accounting Standards Board Statement No. 123R, Share Based
Payment.  The Company determines the fair value of options
based on the Black-Scholes model, which is based on specific assumptions
including (1) expected life of the option, (2) risk free interest rates, (3)
expected volatility and (4) expected dividend yield.
 
 Deferred Tax Asset and
Income Taxes
 Income
taxes are accounted for under the asset and liability
method.  Deferred income taxes are recorded for temporary differences
between financial statement carrying amounts and the tax basis of assets and
liabilities.  Deferred tax assets and liabilities reflect the tax
rates expected to be in effect in the period in which the differences are
expected to reverse.  Any changes in tax laws which affect the
effective tax rates will affect the deferred tax asset and will be reflected in
the accompanying current tax provision.  The Company records a
valuation allowance to reduce its deferred tax asset when it is more likely than
not that a portion of the amount may not be realized.  The Company
estimates its valuation allowance based on an estimated forecast of its future
profitability.  Any significant changes in future profitability
resulting from variations in future revenues or expenses could affect the
valuation allowance on the deferred tax asset and operating results could be
affected.  In reviewing the valuation allowance, the Company considers
future taxable income and determines whether it is more likely than not that a
portion of the deferred tax asset will be realized.  Changes in these
circumstances, such as an increase or decline in estimated future taxable
income, would result in a re-determination of the valuation
allowance.  In Fiscal Year 2008, the Company increased its valuation
allowance on the U.S. portion of its deferred tax asset by approximately
$4,398,000, as it does not believe that it is more likely than not that it will
be able to utilize the net operating loss carry forwards based on recent losses
and anticipated market conditions.
  21
  The
Company has recorded deferred tax assets and liabilities associated with its
foreign operations.  Certain tax assets were acquired upon the
acquisition of QR in April 2007 and primarily relate to the financial statement
carrying amount of existing assets and liabilities and their respective tax
bases.
  The
Company has recorded NOLs amounting to approximately $12 million in federal NOLs
and $16.4 million in state NOLs at June 30, 2008.  The NOLs are
subject to review by the Internal Revenue Service.  Past and future
changes in ownership of the Company, as defined in Section 382 of the Internal
Revenue Code, may limit the amount of NOLs available for use in any one
year.
  Goodwill and other
intangibles
 Prior to
April 2007, the Company did not have any long-lived assets or
goodwill.  Long-lived assets held for use by the Company will be
reviewed for impairment whenever circumstances provide evidence that suggests
the carrying amount of the asset may not be recoverable, at which time, the
Company will perform an impairment analysis primarily related to technology and
customer relationships.  Determination of whether impairment exists
will be based upon comparison of the fair value of the assets to the carrying
values of the respective assets. This could result in a material charge to
earnings.  The Company considers factors such as operating results,
market trends, technological developments, competition, other economic factors,
and the effects of obsolescence for this assessment.
  Goodwill
is not amortized, but will be tested for impairment on an annual basis each June
30th, or
whenever circumstances or events indicate that the carrying amount may not be
recoverable.  These events include a significant change in the
business climate, operating performance indicators, legal factors, competition
or a significant change in the business entity.  The first step of the
goodwill impairment tests will be based upon a comparison of the fair value of
the reporting unit to the respective carrying value.  If the fair
value of the reporting unit exceeds its carrying amount, no impairment
exists.  If, however, the carrying amount of a reporting unit exceeds
its fair value, the second step of the goodwill impairment test will be
performed to measure the amount of impairment loss, if any.  The
implied fair value requires a fair value process similar to a business
combination, where the individual assets and liabilities are valued at fair
value with the difference between the fair value of the reporting unit being the
implied fair value of goodwill.  If the carrying amount of the
reporting unit exceeds its fair value, the goodwill impairment loss is measured
as the excess of the carrying amount of goodwill over its implied fair
value.  Any identified impairment will result in a charge to reduce
the carrying value of the associated goodwill.  This could result in a
material charge to earnings.
  Litigation and
Contingencies
 The
Company is party to lawsuits arising out of its respective
operations.  The Company records a liability when it is probable and
can be reasonably estimated.  The Company believes it has properly
estimated in the past; however, court decisions and/or other unforeseen events
could cause liabilities to be incurred in excess of estimates.
 
 
 Item
7A.  Quantitative and Qualitative Disclosures About Market
Risk.
 
 Not
Applicable.
 
 Item 8.
Financial Statements and Supplementary Data.
 
 The
information that appears following Item 15 of this Annual Report on Form 10-K is
incorporated herein by reference.
  22
  AFP
IMAGING CORPORATION AND SUBSIDIARIES
 
 
 CONTENTS
 June
30, 2008
 Reports
      of Independent Registered Public Accounting Firms
                F-1,
      F-2Consolidated
      Financial Statements:Balance
      Sheets
                F-3Statements
      of Operations
                F-4Statements
      of Shareholders' Equity
                F-5Statements
      of Cash Flows
                F-6Notes
      to Consolidated Financial Statements
                F-7-
      F-22Supplemental
      Schedule:Schedule
      of Valuation and Qualifying Accounts
                F-23
  
  REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 To the
Board of Directors and Shareholders
 AFP
Imaging Corporation
 
 
 We have
audited the accompanying consolidated balance sheet of AFP Imaging Corporation
and Subsidiaries as of June 30, 2008, and the related consolidated statements of
operations, shareholders' equity, and cash flows for the year then ended. 
Our audit also included the information for 2008 included in the financial
statement schedule of AFP Imaging Corporation listed in Item 15
(a).  These financial statements and schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of AFP Imaging Corporation and
Subsidiaries at June 30, 2008, and the results of their operations and their
cash flows for the year then ended in conformity with U.S. generally accepted
accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the consolidated financial statements
taken as a whole, present fairly in all material respects the information set
forth therein.
 
 We were
not engaged to examine management’s assessment of the effectiveness of AFP
Imaging Corporation’s internal control over financial reporting as of June 30,
2008, included in the accompanying management’s annual report on internal
control over financial reporting and, accordingly, we do not express an opinion
thereon.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1
to the consolidated financial statements, the Company has exceeded the
maximum revolving credit commitment permissible under its existing
borrowing agreements and presently believes that its existing borrowing
agreements may not be sufficient to finance the Company’s ongoing worldwide
working capital requirements for the next twelve months. This raises substantial
doubt about the Company's ability to continue as a going
concern.  Management's plans in regard to these matters are also
described in Note 1.  The consolidated financial statements do not
include any adjustments that might result from the outcome of this
uncertainty.
 
 
 McGladrey
& Pullen, LLP
 New York,
New York
 
 
 
 October
14, 2008
  F-1
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 To
the Board of Directors and Shareholders
 AFP
Imaging Corporation
   We
have audited the accompanying consolidated balance sheet of AFP Imaging
Corporation and Subsidiaries (the "Company") as of June 30, 2007, and the
related consolidated statements of operations, shareholders' equity and cash
flows for the year then ended.  Our audit also included the financial
statement schedule as of June 30, 2007 listed in the Index at Item
15.  These consolidated financial statements and the schedule are the
responsibility of the Company's management.  Our responsibility is to
express an opinion on these consolidated financial statements and the schedule
based on our audit.
  We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audit provides a reasonable basis
for our opinion.
  In
our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of AFP
Imaging Corporation and Subsidiaries as of June 30, 2007 and the results of
their operations and their cash flows for the year then ended, in conformity
with United States generally accepted accounting principles.  Also, in
our opinion, the related financial statement schedule as of June 30, 2007, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
      Goldstein
Golub Kessler LLP
 New
York, New York
  October
11, 2007
  F-2
  AFP
IMAGING CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEET
 June
      30,
                
                2008
                
                
                2007ASSETSCurrent
      Assets:Cash
      and cash equivalents
                
                $
                819,444
                
                
                $
                921,632Accounts
      receivable, less allowance for doubtful accountsof
      $919,483 and $130,000, respectively
                
                
                4,281,796
                
                
                
                5,030,579Inventories
                
                
                6,950,129
                
                
                
                6,395,052Prepaid
      expenses and other current assets
                
                
                557,947
                
                
                
                179,771Deferred
      income taxes
                
                
                76,921
                
                
                
                926,603Total
      current assets
                
                
                12,686,237
                
                
                
                13,453,637Property
      and Equipment, net of accumulated depreciationof
      $1,778,510 and $1,602,121 respectively
                
                
                473,589
                
                
                
                539,002Deferred
      income taxes
                
                
                466,022
                
                
                
                369,115Other
      assets
                
                
                323,813
                
                
                
                381,905Goodwill
                
                
                4,453,627
                
                
                
                3,846,405Other
      intangibles, net
                
                
                2,997,551
                
                
                
                8,580,762Total
      Assets
                
                $
                21,400,839
                
                
                $
                27,170,826LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      Liabilities:Current
      portion of long-term debt
                
                $
                8,578,056
                
                
                $
                536,727Accounts
      payable
                
                
                3,557,357
                
                
                
                2,834,875Accrued
      expenses
                
                
                3,525,308
                
                
                
                2,887,584Deferred
      revenue
                
                
                822,000
                
                
                
                ---Total
      current liabilities
                
                
                16,482,721
                
                
                
                6,259,186Deferred
      liabilities
                
                
                718,358
                
                
                
                213,860Long-term
      debt
                
                
                22,957
                
                
                
                5,822,347Total
      liabilities
                
                
                17,224,036
                
                
                
                12,295,393Commitments
      and Contingencies (Note 9)Shareholders'
      Equity:Preferred
      stock - $.01 par value;
      authorized 5,000,000 shares, none issued
                
                
                ---
                
                
                
                ---Common stock -$.01 par value; authorized 30,000,000 shares, issued
      andoutstanding
      17,928,800 shares at June 30, 2008 and June 30, 2007
                
                
                179,288
                
                
                
                179,288Common
      stock warrants
                
                
                91,131
                
                
                
                91,131Paid-in
      capital
                
                
                25,444,176
                
                
                
                25,404,045Accumulated
      deficit
                
                
                (21,809,709
                )
                
                
                (10,760,543
                )Cumulative
      translation adjustment
                
                
                271,917
                
                
                
                (38,488
                )Total
      shareholders' equity
                
                
                4,176,803
                
                
                
                14,875,433Total
      Liabilities and Shareholders' Equity
                
                $
                21,400,839
                
                
                $
                27,170,826
  See Notes
to Consolidated Financial Statements
  F-3
  AFP
IMAGING CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENT OF OPERATIONS
 Years
      ended June 30,
                
                2008
                
                
                2007Net
      sales
                
                $
                34,279,807
                
                
                $
                28,719,693Cost
      of sales
                
                
                19,786,180
                
                
                
                17,864,218Gross
      profit
                
                
                14,493,627
                
                
                
                10,855,475Selling,
      general and administrative expenses
                
                
                15,698,796
                
                
                
                10,541,576Amortization
      of intangibles
                
                
                1,234,311
                
                
                
                225,054Write-off
      of in process research and development
                
                
                ---
                
                
                
                3,760,000Impairment
      of long-lived assets
                
                
                5,615,880
                
                
                
                ---Research
      and development expenses
                
                
                1,968,478
                
                
                
                1,021,766Operating
      loss
                
                
                (10,023,838
                )
                
                
                (4,692,921
                )Foreign
      currency gain on intercompany note
                
                
                (2,045,918
                )
                
                
                ---Gain
      realized on Euro hedge contract
                
                
                ---
                
                
                
                (352,966
                )Interest
      expense
                
                
                967,011
                
                
                
                318,979Interest
      income
                
                
                (13,474
                )
                
                
                (185,561
                )Loss
      before provisionfor
      income taxes
                
                
                (8,931,457
                )
                
                
                (4,473,373
                )Income
      taxes
                
                
                2,117,709
                
                
                
                199,451Net
      loss
                
                $
                (11,049,166
                )
                
                $
                (4,672,824
                )Net
      loss per common share:Basic
                
                $
                (.62
                )
                
                $
                (.34
                )Diluted
                
                $
                (.62
                )
                
                $
                (.34
                )
  See Notes
to Consolidated Financial Statements
  F-4
  AFP
IMAGING CORPORATION AND SUBSIDIARIES


CONSOLIDATED
STATEMENT OF SHAREHOLDERS' EQUITY


Years
ended June 30, 2007 and 2008


Comprehensive
      Loss
              
              
              Common
      Stock
              
              
              Common
                Stock
                Warrants
              
              
              Paid-in
                Capital
              
              
              Accumulated
      Deficit
              
              
              Foreign
                Currency
      Translation Adjustment
              
              
              TotalBalance
      June 30, 2006
              
              
              --
              
              
              $
              95,682
              
              
              $
              110,931
              
              
              $
              11,805,852
              
              
              $
              (6,087,719
              )
              
              
              --
              
              
              $
              5,924,746Issuance
      of 82,000 shares of common stock in connection with the exercise of common
      stock warrants
              
              
              --
              
              
              
              828
              
              
              
              (19,800
              )
              
              
              18,972
              
              
              
              --
              
              
              
              --
              
              
              
              --Adjustment
      to reclassify common stock subject to registration rights from temporary
      equity
              
              
              --
              
              
              
              27,778
              
              
              
              --
              
              
              
              4,716,545
              
              
              
              --
              
              
              
              --
              
              
              
              4,744,323Issuance
      of 5,500,000 shares of common stock
              
              
              --
              
              
              
              55,000
              
              
              
              --
              
              
              
              8,085,000
              
              
              
              --
              
              
              
              --
              
              
              
              8,140,000Stock-based
      compensation expense
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              82,461
              
              
              
              --
              
              
              
              --
              
              
              
              82,461Fees
      associated with issuance of common stock
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              (419,569
              )
              
              
              --
              
              
              
              --
              
              
              
              (419,569
              )Issuance
      of 800,000 warrants in connection with the issuance of
debt
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              1,114,784
              
              
              
              --
              
              
              
              --
              
              
              
              1,114,784Foreign
      currency translation loss
              
              $
              (38,488
              )
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              (38,488
              )
              
              
              (38,488
              )Net
      loss
              
              
              (4,672,824
              )
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              (4,672,824
              )
              
              
              --
              
              
              
              (4,672,824
              )Comprehensive
      loss
              
              $
              (4,711,312
              )
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              -
              
              
              
              --
              
              
              
              -Balance
      June 30, 2007
              
              
              --
              
              
              $
              179,288
              
              
              $
              91,131
              
              
              $
              25,404,045
              
              
              $
              (10,760,543
              )
              
              $
              (38,488
              )
              
              $
              14,875,433Stock-based
      compensation expense
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              40,131
              
              
              
              --
              
              
              
              --
              
              
              
              40,131Foreign
      currency translation gain
              
              
              310,405
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              310,405
              
              
              
              310,405Net
      loss
              
              
              (11,049,166
              )
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              (11,049,166
              )
              
              
              --
              
              
              
              (11,049,166
              )Comprehensive
      loss
              
              $
              (10,738,761
              )
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              -Balance
      June 30, 2008
              
              
              
              
              
              $
              179,288
              
              
              $
              91,131
              
              
              $
              25,444,176
              
              
              $
              (21,809,709
              )
              
              $
              271,917
              
              
              $
              4,176,803




See Notes
to Consolidated Financial Statements




F-5




AFP
IMAGING CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2008


CONSOLIDATED
STATEMENT OF CASH FLOWS





Years
      ended June 30,
              
              2008
              
              
              2007Cash
      flows from operating activities:Net
      loss
              
              $
              (11,049,166
              )
              
              $
              (
      4,672,824
              )Adjustments
      to reconcile net loss to netcash
      used in operating activities:Write-off
      of in process research and development
              
              
              --
              
              
              
              3,760,000Impairment
      of long lived assets
              
              
              5,615,880
              
              
              
              --Amortization
      of discount on term loan
              
              
              204,014
              
              
              
              49,144Depreciation
      and amortization
              
              
              1,591,875
              
              
              
              500,257Realized
      gain on Euro hedge contract
              
              
              --
              
              
              
              (352,966
              )Provision
      for losses on accounts receivable
              
              
              761,401
              
              
              
              --Write-off
      of deferred financing costs
              
              
              --
              
              
              
              75,000Exchange
      rate effect on intercompany note
              
              
              (2,045,918
              )
              
              
              --Deferred
      income taxes
              
              
              1,495,406
              
              
              
              23,707Non-cash
      compensation expense
              
              
              40,131
              
              
              
              82,461Change
      in assets and liabilities, net of acquisition:Decrease/(Increase)
      in accounts receivable
              
              
              275,562
              
              
              
              (927,095
              )(Increase)
      in inventories
              
              
              (270,257
              )
              
              
              (382,044
              )Increase)
      in prepaid expenses and other current
      assets
              
              
              (337,281
              )
              
              
              (44,736
              )(Increase)
      in other assets
              
              
              27,623
              
              
              
              (155,905
              )Increase
      in accounts payable
              
              
              309,290
              
              
              
              351,003Increase
      in accrued expenses
              
              
              396,266
              
              
              
              8,205Increase
      in deferred revenue
              
              
              822,000
              
              
              
              --(Decrease)/increase
      in deferred liabilities
              
              
              (132,594
              )
              
              
              142,656Net
      cash used in operating activities
              
              
              (2,295,768
              )
              
              
              (1,543,137
              )Cash
      flows from investing activities:Acquisition
      of QR, net of cash acquired (1)
              
              
              --
              
              
              
              (17,360,931
              )Purchases
      of property and equipment
              
              
              (201,801
              )
              
              
              (251,206
              )Net cash used in investing
      activities
              
              
              (201,801
              )
              
              
              (17,612,137
              )Cash
      flows from financing activities:Issuance
      of common stock
              
              
              --
              
              
              
              8,140,000Payment
      of fees associated with issuance of common stock
              
              
              --
              
              
              
              (419,569
              )Repayments
      of debt
              
              
              (745,710
              )
              
              
              (749,004
              )Borrowing
      of debt
              
              
              2,577,038
              
              
              
              8,173,178Deferred
      financing fees associated with new debt issuance
              
              
              --
              
              
              
              (242,500
              )Net cash provided by financing
      activities
              
              
              1,831,328
              
              
              
              14,902,105Exchange rate effect on cash
      and cash equivalents
              
              
              564,053
              
              
              
              (38,488
              )Net
      decrease in cash and cash equivalents
              
              
              (102,188
              )
              
              
              (4,291,657
              )Cash
      and cash equivalents at beginning of year
              
              
              921,632
              
              
              
              5,213,289Cash
      and cash equivalents at end of
      year
              
              $
              819,444
              
              
              $
              921,632Supplemental
      disclosures of cash flow information:Cash
      paid during the year for:Interest
              
              $
              1,422,944
              
              
              $
              268,899Income
      taxes, net of refunds
              
              $
              183,486
              
              
              $
              1,234,633Supplemental schedule of Non
      Cash ActivityCashless
      exercise of common stock warrants
              
              $
              --
              
              
              $
              19,800Issuance
      of 800,000 warrants in connection withthe
      new debt issuance
              
              $
              --
              
              
              $
              1,114,784Equipment
      under capital lease
              
              $
              35,872
              
              
              
              ---(1)See Note 11 for
      further discussion regarding the acquisition of
  QR.




See Notes
to Consolidated Financial Statements




F-6




AFP
IMAGING CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2008








1.   NATURE OF
BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES:
  AFP
Imaging Corporation, together with its subsidiaries (the "Company"), was
organized on September 20, 1978 under the laws of the State of New
York.  The Company is engaged in the business of designing,
developing, manufacturing and distributing equipment for generating, capturing
and/or producing dental, veterinary and medical diagnostic images through
digital imaging technologies as well as the chemical processing of
photosensitive materials.  These products are used by medical, dental,
veterinary and industrial professionals.  The Company's products are
sold and distributed to worldwide markets, under various brand names, through a
network of independent and unaffiliated dealers and independent sales
representatives.
 
 On April
19, 2007, the Company completed the acquisition of Quantitative Radiology srl,
an Italian corporation (“QR”), by acquiring all of the outstanding share capital
of QR from the shareholders.  QR is a global supplier of
state-of-the-art, in-office three-dimensional dental computed tomography
(CT).  QR uses an imaging technology that features a cone shaped beam
of x-rays (a CBCT scanner).  The Company, prior to April 19, 2007, had
acted as QR’s exclusive distributor in North and South America, excluding
Brazil.  Funding for the acquisition was principally derived from two
sources; the first was the proceeds raised from a private offering of the
Company’s common stock to equity investors and the second was a portion of a new
senior secured loan facility.  In connection with the acquisition, the
Company, entered into employment agreements with each of the former shareholders
of QR.  Each agreement contains a non-compete clause which prohibits
the employee from engaging in activities competitive with the business of QR for
a period of five years from the date of termination of employment.
 
 On April
12, 2007, the Company completed the sale of an aggregate of 5,500,000 shares of
its common stock to certain accredited investors for an aggregate consideration
of $8,140,000 pursuant to previously executed subscription
agreements.  The common stock was issued and sold pursuant to the
exemption from registration afforded by regulation D of the Securities
Act.  In connection with the transaction, the Company paid the
placement agent for the offering $407,000, or five percent of the gross proceeds
of the offering.  The proceeds were used for the purchase of
QR.  The Company has granted the investors certain registration rights
with respect to the resale of the shares acquired and has registered these
shares of common stock for resale.
 
 On April
13, 2007, the Company entered into a new senior facility (“Revolving Credit and
Term Loan”) with a new lender (“Senior Secured Lender”) whereby the Senior
Secured Lender agreed to lend the Company an aggregate of up to $8 million in
the form of a $5 million term loan and a $3 million revolving loan
facility.  The term loan bears interest at a rate of ten percent (10%)
per annum and provides for repayment over five years commencing in November
2007; and the revolving loans bear interest at a rate per annum of two percent
(2%) plus the prime rate and are payable in full on April 30,
2012.  The Company and each of its wholly-owned subsidiaries executed
a Collateral Agreement pursuant to which each such party agreed to grant a
security interest in all of its respective assets to the Senior Secured Lender
as collateral security for repayment of the loans.  This new senior
secured Revolving Credit and Term Loan Agreement replaced the Company’s previous
$2.5 million senior secured credit facility, which was due to expire on
September 21, 2007.  As part of the transaction, the Company granted
to the Senior Secured Lender an aggregate of 800,000 warrants to purchase shares
of the Company’s common stock at exercise prices per share equal to $1.85 with
respect to 266,666 warrants, $2.02 with respect to an additional 266,666
warrants, and $2.19 with respect to the remaining 266,668
warrants.  The Company registered the shares of common stock issuable
upon exercise of the warrants and conversion of the term note and must use its
best efforts to keep the registration statement effective during the applicable
registration period.
 
 The
Company presently believes that the Revolving Credit and Term Loan Agreement and
foreign lines of credit may not be sufficient to finance the Company’s ongoing
worldwide working capital requirements for the next twelve months. In accordance
with the consent of the Senior Secured Lender, since November 2007, the Company
has been making principal and interest payments under the term loan and interest
payments under the revolver by borrowing additional amounts under the
revolver.  As a direct result of the additional borrowings under the
revolver to pay the August and September 2008 term loan and revolver charges,
the Company’s aggregate outstanding advances under the revolver presently exceed
the maximum revolving credit commitment permissible under the Revolving Credit
and Term Loan Agreement.  The Company is presently in technical default
under the Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum.  The Company has not received any formal notice of default from
the Senior Secured Lender, and is in the process of negotiating with the Senior
Secured Lender to modify certain applicable provisions of the Revolving Credit
and Term Loan Agreement.Additionally, the Company’s foreign subsidiary, QR, has failed to make
payment with respect to certain invoices payable to one of its financial
institutions pursuant to a line of credit agreement.  The lender has
notified QR that such invoices are past due, but has taken no further action at
the present time in respect thereof.As discussed in Note 4,
all such debt has been classified as a current liability in the accompanying
consolidated financial statements.  The Company has instituted cost cutting
measures to reduce its cash requirements.  The Company is also currently in
the process of seeking out additional financing alternatives, including
potential private equity sales of its securities as well as the possibility of
increasing or extending its line of credit with the Senior Secured Lender. 
There can be no assurance that the Company will be able to obtain any such
financing upon favorable terms to the Company, or at all.  In the event
that the Company is unable to secure sufficient financing to maintain its
operations, its business and financial condition could be materially adversely
affected.  These factors raise substantial doubt about the Company’s
ability to continue as a going concern.  The consolidated financial
statements do not include any adjustments regarding this
uncertainty.
  F-7
 The
consolidated financial statements include AFP Imaging Corporation and its wholly
owned subsidiaries.  All significant intercompany transactions have
been eliminated in consolidation.
 
 The
Company translates the assets and liabilities of its foreign subsidiaries into
US dollars at the closing balance sheet rate of exchange.  Income and
cash flow statements are translated at the average rates of exchange for the
period.  Gains and losses from translating the financial statements of
the foreign operations where the functional currency is not the US dollar is
included in Foreign Currency Translation Adjustment within Shareholders’
Equity.  The functional currency for the Company’s foreign
subsidiaries is the local currency.  The Company did not have any
foreign operations for the fiscal year ended June 2006.  Any exchange
rate differences arising at the time of collection of accounts receivables or
settlement of accounts payable are included in net income.
 
 In
addition to net loss, comprehensive loss includes other charges or credits to
equity other than those resulting from transactions with
shareholders.  Comprehensive loss relates to foreign currency
translation adjustments related to the Company’s foreign
subsidiaries.
 
 The
preparation of financial statements in conformity with United States generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
reported amounts of revenues and expenses during the reporting
period.  Actual results could differ from those
estimates.  Some of the more significant estimates include allowances
for doubtful accounts, inventory reserves, depreciable lives of assets,
amortization periods, impairment of long-lived assets, deferred tax asset
valuation allowance and warranty reserves.
 
 The Company recognizes revenue net of
related discounts and allowances for its consolidated operations when persuasive
evidence of the arrangement exists, the price is fixed or determinable,
collectability is reasonably assured, and delivery or title and risk of loss has
passed to the customer, based on the specific shipping
terms.   The Company includes shipping and handling costs as a
component of cost of sales.  Revenue related to equipment orders that
contain one or more elements to be delivered at a future date is recognized in
accordance with EITF 00-21 “Accounting for
Revenue Arrangements with Multiple Deliverables”.The Company allocates revenue between
the various elements using the relative fair value method, based on evidence of
fair value for the respective elements.  The revenue allocated to
deferred service contracts, installation and training is deferred until service
is provided.  Amounts received from customers in advance of equipment
deliveries are recorded as deferred income until the revenue can be recognized
in accordance with the Company’s revenue recognition policy.
 
 Cash and
cash equivalents include deposits with original maturities of three months or
less.
 
 The
Company maintains cash in bank deposit accounts which, at times, exceed
federally insured limits.  The Company has not experienced any losses
on these accounts.
 
 Inventories,
which include material, labor and manufacturing overhead, are stated at the
lower of cost (first-in, first-out) or market (net realizable
value).  Inventory reserves are provided for risks relating to slow
moving items.  Demonstration equipment which is on consignment with
customers is valued at cost, reduced for reductions in value due to technical
obsolescence and/or wear and tear over periods of up to five years.
 
 Machinery
and equipment are depreciated using the straight-line method over their
estimated useful lives, ranging from three to ten years.  Leasehold
improvements are depreciated on a straight-line basis over the shorter of their
estimated useful lives or the term of the lease.  Additions and
improvements which extend the life of an asset are
capitalized.  Maintenance and repair costs are expensed as
incurred.  When assets are retired or disposed of, the asset and
related accumulation depreciation and amortization are removed from the balance
sheet and the resulting gain or loss (if any) is reflected in current operating
income.
  F-8
  Research
and development costs are charged to expense as incurred.  These costs
are incurred in connection with the design and development of the Company's new
or enhanced products, and primarily relate to internal costs for salaries,
direct overhead costs and outside vendors.
 
 The
Company offers warranty on its products for periods between one and three
years.  Estimated future warranty obligations related to product sales
are charged to operations in the period in which the related revenue is
recognized and is based on historical warranty experience and other relevant
information the Company is aware of.  Estimated warranty expenses are
recorded as an accrued liability and cost of sales.  Warranty expense
for the year ended June 30, 2008, includes the establishment of a warranty
reserve by the Company’s Italian subsidiary.
 
 Advertising
costs, included in selling, general and administrative costs, are charged to
expense as incurred and were approximately $895,174, and $322,500 for the fiscal
years ended June 30, 2008 and 2007, respectively.
 
 The
Company records sales tax related to sales to its end users on a net basis,
which amounts are not material to the consolidated financial
statements.
 
 Under the
provisions of Statement of Financial Accounting Standards No. 123 (Revised
2004), Share Based
Payment (“SFAS No. 123R”), the Company recognizes share based payment
expense in an amount equal to the fair value of share-based payments (including
stock option awards) on their date of grant, over the vesting period of the
awards.  Under SFAS No. 123R, the Company must recognize compensation
expense for (1) all share-based payments granted on or after July 1, 2005 and
(2) any partially vested options as of July 1, 2005.  Prior to the
adoption of SFAS No. 123R, the Company accounted for these plans pursuant to
Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to
Employees.  Therefore, compensation expense related to stock
option awards was not reflected in operating expenses in any period prior to
July 2005 (first quarter of Fiscal Year 2006), and prior period results have not
been restated.  For the twelve months ended June 30, 2008 and June 30,
2007, non-cash stock based compensation expense related to stock option awards
(“Stock Option Expense”) was $40,131 and $82,461, respectively, and have been
included in selling, general and administrative expenses.  The
compensation expense did not result in a tax benefit as a result of the
valuation allowance applied to the related deferred tax asset.
 
 Accounts
receivable are recorded at the invoiced amount and do not bear
interest.  The allowance for doubtful accounts is the Company's best
estimate of the amount of probable credit losses in the Company's existing
accounts receivable.  The Company establishes an allowance for
doubtful accounts based upon management’s review of certain factors surrounding
the credit risk of specific customers, including historical trends, compliance
with credit terms and other information.  The allowance for doubtful
accounts is adjusted based on such evaluation, with any corresponding provision
included in selling, general and administrative expense.  Receivable
balances are periodically reviewed and account balances are charged off against
the allowance after all means of collection have been exhausted and the
potential for recovery is doubtful.
 
 There were
no derivative financial instruments outstanding as of June 30, 2008 and
2007.  The Company purchased a Euro hedge contract in March 2007 to
limit the Company’s foreign currency exchange risk associated with the purchase
of QR on April 19, 2007, as the purchase price was in Euro.  The
Company realized a gain of $352,966 which is included in the accompanying
consolidated statement of operations in Fiscal Year 2007.  In
accordance with FASB Statement No. 133 (“SFAS 133”), Accounting for Derivative
Instruments and Hedging Activities, the offsetting gain has been recorded
as part of the transaction costs associated with the purchase of
QR.
 
 Prior to
April 2007, the Company did not have any long-lived assets or
goodwill.  Long-lived assets held for use by the Company are reviewed
for impairment whenever circumstances provide evidence that suggests the
carrying amount of the asset may not be recoverable.  The Company
performs ongoing impairment analysis on intangible assets related to technology
and customer relationships.  Determination of whether impairment
exists is based upon comparison of the fair value of the assets to the carrying
values of the respective assets.  This could result in a material
charge to earnings.  The Company considers factors such as operating
results, market trends, technological developments, competition, other economic
factors, and the effects of obsolescence for this assessment.
 
 Goodwill
is not amortized, but is tested for impairment on an annual basis each June
30th, or
whenever circumstances or events indicate that the carrying amount may not be
recoverable.  The first step of the goodwill impairment tests are
based upon a comparison of the fair value of the reporting unit to its
respective carrying amount.  If the fair value of the reporting unit
exceeds its carrying amount, no impairment exists.  If, however, the
carrying amount of the reporting unit exceeds its fair value, the second step of
the goodwill impairment test will be performed to measure the amount of
impairment loss, if any.  The implied fair value requires a fair value
process similar to a business combination, where the individual assets and
liabilities are valued at fair value with the difference between the fair value
of the reporting unit being the implied fair value of goodwill.  If
the carrying amount of the reporting unit exceeds its fair value, the goodwill
impairment loss is measured as the excess of the carrying amount of goodwill
over its implied fair value.  Any identified impairment will result in
a charge to reduce the carrying value of the associated
goodwill.  This could result in a material charge to
earnings
  F-9
  Income
taxes are accounted for under the asset and liability
method.  Deferred tax assets and liabilities are recognized for the
estimated 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 carry
forwards.  Deferred tax assets and liabilities are measured using
enacted tax rates in effect for the year in which those temporary differences
are expected to be recovered or settled.  The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.  The Company records a
valuation allowance to reduce its deferred tax asset to an amount that is more
likely than not to be realized.
 
 Other
non-current assets and prepaid expenses are mainly comprised of prepaid
insurance, prepaid VAT taxes, rent deposits, and capitalized debt issuance costs
related to the debt financing in April 2007.
 
 Deferred
liabilities are mainly comprised of long-term deferred tax liabilities and
deferred service revenue.
 
 The
Company’s basic net income per common share is based upon the weighted-average
number of common shares outstanding during the period.  Diluted net
income per share is based upon the weighted average number of common shares and
common share equivalents outstanding when conversion would cause
dilution.  Common share equivalents include (1) outstanding stock
options and (2) outstanding warrants.
 
 Basic and
diluted income per common share for the fiscal years ended 2008, 2007 and 2006
is presented below:




June
      30,
              
              2008
              
              
              2007Net
      loss
              
              $
              (11,049,166
              )
              
              $
              (4,672,824
              )Weighted-average
      common shares outstanding - Basic
              
              
              17,928,800
              
              
              
              13,635,688Basic
      loss per share
              
              $
              (.62
              )
              
              $
              (.34
              )Weighted-average
      common shares outstanding - DilutedBasic
      shares
              
              
              17,928,800
              
              
              
              13,635,688Dilutive
      effect of stock options
              
              
              ---
              
              
              
              ---Dilutive
      effect of warrants
              
              
              ---
              
              
              
              ---Weighted-average
      common sharesoutstanding
      - diluted
              
              
              17,928,800
              
              
              
              13,635,688Diluted
      loss per share
              
              $
              (.62
              )
              
              $
              (.34
              )




The
diluted loss per common share computation reflects the effect of common shares
contingently issuable upon the exercise of warrants and options in periods in
which conversion would cause dilution.  The diluted weighted-average
number of shares outstanding for the years ended June 30, 2008 and 2007, does
not include the potential exercise of the following stock options and warrants
as such amounts were anti-dilutive.




June
      30
              
              2008
              
              
              2007Options
              
              
              865,900
              
              
              
              893,900Warrants
              
              
              850,000
              
              
              
              850,000Total
              
              
              1,715,900
              
              
              
              1,743,900




On May 2,
2006, the Company issued 2,777,777 shares of its common stock in a private
placement to selected institutional and other accredited
investors.  The Company filed a registration statement which was
declared effective on July 14, 2006, and was required to keep this registration
statement effective for 24 months from the closing date.  In
accordance with the provisions of FSP EITF 00-19-2, the Company has reclassified
this private placement from temporary equity to shareholders’ equity on the
accompanying balance sheet as of June 30, 2007.  At June 30, 2006, the
net proceeds had been classified as temporary equity in accordance with the
provisions of EITF Topic D-98.  The Company has maintained the
effectiveness of this registration statement.
  F-10
  In
September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 157, Fair Value
Measurements(“SFAS No. 157”).  SFAS No. 157 establishes a
framework for measuring fair value in generally accepted accounting principles
and expands disclosures about fair value measurements.  SFAS No. 157
emphasizes that fair value is a market-based measurement, not an entity-specific
measurement.  SFAS No. 157 also expands disclosures about the use of
fair value to measure assets and liabilities in interim and annual periods
subsequent to initial recognition.  The Company has not adopted SFAS
No. 157, as applicable, as of June 30,  2008.  The Company
does not believe that there will be any material effect on the Company’s
financial statements.
 
 In February 2007, the FASB issued SFAS
No. 159,The Fair Value
Option for Financial Assets and Financial Liabilities – Including an Amendment
of FASB Statement No. 115(“SFAS No. 159”).SFAS No. 159 permits entities to choose
to measure many financial instruments and certain other items at fair value, so
as to improve financial reporting by providing entities with the opportunity to
alleviate volatility in reported earnings.  This Statement should
expand the use of fair value measurement and permits all entities to choose to
measure eligible items at fair value at specified election dates.  The
resulting unrealized gains or losses on items which the fair value option has
been elected are to be reported in earnings.  The Company has not
adopted SFAS No. 159, as applicable, as of June 30, 2008.  The Company
does not believe that there will be any material effect on the Company’s
financial statements.
 
 In
December 2007, the FASB issued SFAS No. 141R, Business Combinations(“SFAS
No. 141R”) to replace SFAS No. 141 Business
Combinations.  The objective of this statement is to improve
the relevance, representation and comparability of financial information
provided about a business combination and its effects and establishes principles
and requirements for (1) recognizing and measuring the assets and liabilities
assumed, (2) recognizing and measuring the goodwill or bargain purchase, and (3)
determining the information required to be disclosed in the financial
reports.    This statement applies to business combinations
where the acquisition date is on or after December 15, 2008.  The
Company will adopt SFAS 141R for any business combinations completed on or after
December 15, 2008.
 
 In
December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Statements-an Amendment of ARB No. 51 (“SFAS No.
160”).  The objective of SFAS No. 160 is to improve financial
information related to entities that have an outstanding non-controlling
interest in one or more subsidiaries.  The non-controlling interest in
the subsidiary is an ownership interest in the consolidated entity that should
be reported as equity in the consolidated financial statements and consolidated
net income should include (and separately disclose) the amounts of the parent
and the non-controlling interest on the income statement.  This
statement requires additional financial statement disclosures related to the
parent and the non-controlling owners of the subsidiary.  Earnings per
share amounts will be based on the amounts attributable to the
parent.  The Company is required to adopt SFAS No. 160 beginning in
July 2009.  The Company is evaluating the effect of SFAS No. 160, but
does not believe that there will be any material effect on the Company’s
financial statements.
 
 In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities-an Amendment of FASB Statement No. 133
(“SFAS No. 161”).  The objective of
SFAS No. 161 is to improve financial reporting on derivative instruments and
hedging activities with enhanced disclosures.  This statement requires
disclosure of the fair values of derivative instruments and their gains and
losses in a tabular format, and provides more information about an entity’s
liquidity by requiring disclosure of derivative features that are credit–risk
related. The Company is required to adopt SFAS No. 161 beginning in January
2009.  The Company is evaluating the effect of SFAS No. 161, but does
not believe that there will be any material effect on the Company’s financial
statements.
 
 Management
does not believe that any other recently issued, but not yet effective,
accounting standards if currently adopted would have a material effect on the
accompanying consolidated financial statements.
 
 Certain
prior year amounts have been reclassified to conform to the current-period
presentation.
 
 2.
              INVENTORIES:
  Inventories, net of reserves, consist of
the following:
  June
      30
              
              2008
              
              
              2007Raw
      materials and subcomponent parts
              
              $
              3,675,763
              
              
              $
              2,856,813Work-in-process
      and finished goods
              
              
              3,274,367
              
              
              
              3,538,239$
              6,950,129
              
              
              $
              6,395,052
 
 Provision
has been made for any potential losses on obsolete or slow-moving inventory
items.
  F-11
 
 3.
              PROPERTY AND
      EQUIPMENT:
  Property
and equipment, at cost, consists of the following:
  June
      30,
              
              2008
              
              
              2007Leasehold
      improvements
              
              $
              291,820
              
              
              $
              255,071Machinery
      and equipment
              
              
              1,960,279
              
              
              
              1,886,0522,252,099
              
              
              
              2,141,123Less
      accumulated depreciation and amortization
              
              
              (1,778,510
              )
              
              
              (1,602,121
              )Property
      and equipment, net
              
              $
              473,589
              
              
              $
              539,002
  Equipment
under capital lease relating to the telephone system amounted to $35,872 at June
30, 2008 and the related accumulated amortization amounted to
$4,783.  There were no assets under capital lease at June 30,
2007.
  Depreciation
and amortization was $452,404 and $253,402 for the years ended June 30, 2008 and
2007, respectively.  Depreciation expense includes the amortization of
the capital lease.  The Company uses the straight-line method with
estimated useful lives ranging from three to ten years.
  The
Company retired $136,950 and $101,763 of assets during fiscal years 2008 and
2007, respectively.
 
 4.
              DEBT:
  On April
13, 2007, the Company entered into a new senior secured credit facility
(“Revolving Credit and Term Loan”) with a new lender (“Senior Secured Lender”)
that replaced the Company’s existing $2.5 million revolving line of credit that
was due to expire on September 21, 2007.  The Revolving Credit and
Term Loan consists of a $5 million convertible term note and a $3 million
revolving loan facility.  The convertible term note bears interest at
a rate of ten percent per annum and provides for repayment over five years
commencing in November 2007 with a final balloon payment of all remaining
amounts due there-under on April 30, 2012.  The revolving loan bears
interest at a rate of two percent plus prime rate per annum, equal to 7% at June
30, 2008, has a specific formula to calculate available funds based on eligible
accounts receivable and inventory, is subject to certain maximum borrowing base
requirements, has certain reporting requirements to the lender, and is payable
in full on April 12, 2012.  The convertible term note, in addition to
being convertible by the Company upon the satisfaction of certain conditions,
including a trading price equal to 175% of the conversion price and the
Company’s common stock being traded on Nasdaq, is convertible by the lender at
any time into shares of common stock at a conversion price of $2.37 per share,
or 2,109,705 shares based on the initial principal amount of the convertible
term note.
 
 The
Company and each of its wholly-owned subsidiaries executed a Collateral
Agreement pursuant to which each such party agreed to grant a security interest
in all of its respective assets to the Senior Secured Lender as collateral
security for repayment of the loans.  The Revolving Credit and Term
Loan is secured by all of our and our wholly-owned subsidiaries inventory,
accounts receivable, equipment, officer life insurance policies and proceeds
thereof, trademarks, licenses, patents and general intangibles.  The
Revolving Credit and Term Loan Agreement has a specific formula to calculate
available funds based on eligible accounts receivable and inventory, is subject
to maximum borrowing base limitations, and has certain reporting
requirements.
 
 As part of
the transaction, the Company granted to the Senior Secured Lender an aggregate
of 800,000, five-year warrants to purchase shares of the Company’s common stock
at exercise prices per share equal to $1.85 with respect to 266,666 warrants,
$2.02 with respect to an additional 266,666 warrants, and $2.19 with respect to
the remaining 266,668 warrants. The Company has assessed whether the warrants
granted to the Senior Secured Lender should be classified as either a liability
or equity in accordance with EITF 00-19, “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in a Company’s Own Stock”
and concluded that these warrants should be classified as equity.  The
Black-Scholes Method was used to value these detachable warrants, and have been
recorded in the accompanying Consolidated Balance Sheets at
$1,114,784.  The Company entered into a Registration Rights Agreement
pursuant to which it has registered the shares of common stock issuable upon
exercise of the warrants and conversion of the term note.
 
 In
accordance with Accounting Principles Board Opinion No. 14, “Accounting for Convertible Debt and
Debt Issued with Stock Purchase warrants”, proceeds received from the
sale of debt with detachable stock purchase warrants are allocated to both the
debt and the warrants.  The portion allocable to warrants is accounted
for as additional paid in capital, and the remaining portion is classified as
debt.  The fair value of the warrants issued to the Senior Secured
Lender is being treated as debt discount, which will be accreted as interest
expense utilizing the interest method over the 60-month term of the Term
Loan.  The assumptions used for the Black-Scholes option pricing model
were as follows:  risk-free interest rate of 4.66%, expected
volatility of 123%, an expected life of five years, and no expected
dividends.  A summary of such follows:
  F-12
 
 June
      30, 2008
              
              
              June
      30, 2007Term
      Loan
              
              $
              5,000,000
              
              
              $
              5,000,000Fair
      value of warrants (recorded as capital in excess of par)
              
              
              (1,114,784
              )
              
              
              (1,114,784
              )Accretion
      of debt discount (recorded as interest expense)
              
              
              253,158
              
              
              
              49,144Principal
      Payments
              
              
              (740,741
              )
              
              
              ---Recorded
      value of Term Loan
              
              $
              3,397,633
              
              
              $
              3,934,360
 
 In
accordance with the consent of the Senior Secured Lender, since November 2007,
the Company has been making principal and interest payments under the term loan
and interest payments under the revolver by borrowing additional amounts under
the revolver.  As a direct result of the additional borrowings under the
revolver to pay the August and September 2008 term loan and revolver charges,
the Company’s aggregate outstanding advances under the revolver presently exceed
the maximum revolving credit commitment permissible under the Revolving Credit
and Term Loan Agreement.  The Company is presently in technical default
under the Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum borrowings.  The Company has not received any formal notice of
default from the Senior Secured Lender, and is in the process of negotiating
with the Senior Secured Lender to modify certain applicable provisions of the
Revolving Credit and Term Loan Agreement.  As described in Note 1,
factors exist that result in doubt as to the Company’s ability to continue as a
going concern.  The Company’s Revolving Credit and Term Loan Agreement
contains a subjective acceleration clause and accordingly, all such debt has
been classified as a current liability as of June 30, 2008 in accordance with
FASB Technical Bulletin No. 79-3 “Subjective Acceleration Clauses in Long-Term
Debt Agreements”.  The Company was in compliance with all other terms and
conditions of the Revolving Credit and Term Loan Agreements as of June 30,
2008.
 
 QR has the
ability to borrow up to 2,000,000 Euros under various lines of credit with two
different financial institutions, and are classified as short term
debt.  Most of these lines are guaranteed by its accounts receivables
and inventory.  These lines of credit were granted in August 2007 and
increased from 1,750,000 Euros to 2,000,000 Euros in April 2008.  As
of June 30, 2008, 1,652,712 Euros were outstanding and no Euros were outstanding
as of June 30, 2007.  The funds borrowed in Italy are guaranteed by
specific outstanding accounts receivable and inventory, and the current rate of
borrowing is a function of Euribor plus .75% to 1.5%.  QR has failed
to make payment with respect to certain invoices payable to one of its financial
institutions pursuant to one of its line of credit agreements.  The
lender has notified QR that such invoices are past due, but has taken no further
action at the present time in respect thereof.
 
 In
November 2007, the Company purchased a new telephone system to integrate its US
locations.  This equipment was leased with a bargain purchase option,
and accounted for as a capital lease.  The value of this equipment has
been recorded as capital equipment and the resulting liability
recorded.
 
 As of June
30, 2008 and 2007, debt consisted of the following:
  June
      30, 2008
              
              
              June
      30, 2007Term
      Loan, net of debt discount
              
              $
              3,397,633
              
              
              $
              3,934,360$3.0
      Million Revolving Senior Credit Facility
              
              
              2,569,952
              
              
              
              2,424,714Capitalized
      lease
              
              
              30,903
              
              
              
              ---Foreign
      line of credit borrowings
              
              
              2,602,525
              
              
              
              ---8,601,013
              
              
              
              6,359,074Less
      current portion
              
              
              8,578,056
              
              
              
              536,727Total
      long-term debt
              
              $
              22,957
              
              
              $
              5,822,347
  
 Contractual
maturities of all debt, including the Term loan, net of debt discount, are as
follows:
 
 Year ending June
      30,
              
              Payments
      Due
              
              
              Debt
      Discount
              
              
              Total2009
              
              
              3,721,582
              
              
              
              213,991
              
              
              
              3,507,5912010
              
              
              1,120,128
              
              
              
              225,057
              
              
              
              895,0712011
              
              
              1,121,343
              
              
              
              236,694
              
              
              
              884,6492012
              
              
              3,499,586
              
              
              
              185,884
              
              
              
              3,313,702$
              9,462,639
              
              
              $
              861,626
              
              
              $
              8,601,013
   F-13
  At June
30, 2008, the Company had available $430,048 of unused lines of credit under the
Revolving Senior Credit Facility. Currently, there is no unused line of credit
balance.
 
 Due to the
short-term nature of all of the debt as well as borrowing rates currently
available to the Company, the fair market value of all of the Company's debt
approximated its carrying value.
 
 5.
              ACCRUED
      EXPENSES:
  As of June 30, 2008 and 2007, accrued
expenses consisted of the following:
  June
      30
              
              2008
              
              
              2007Accrued
      environmental claim (see Note 9)
              
              $
              41,334
              
              
              $
              11,550Accrued
      payroll expenses
              
              
              1,060,627
              
              
              
              933,043Warranty
      accrual
              
              
              681,991
              
              
              
              200,000Accrued
      amounts due vendors for in-transit inventory
              
              
              163,887
              
              
              
              446,032Current
      income, sales and VAT taxes payable
              
              
              465,997
              
              
              
              684,967Accrued
      expenses – other (none in excess of 5% of  current
      liabilities)
              
              
              1,111,472
              
              
              
              611,992$
              3,525,308
              
              
              $
              2,887,584
 
 Included
in accrued payroll expenses above at June 30, 2008, and 2007 respectively, is
approximately $358,000 and $273,000 of severance indemnity costs mandated under
Italian labor laws.  All employees are entitled to an indemnity upon
termination of their employment relationship for any reason.  The
respective benefit accrues to each employee on a pro-rata basis during their
employment period and is based upon their respective salary.  The
vested benefit payable accrues interest.  The amounts reflected in the
consolidated balance sheets reflect the respective total amount of the
indemnities that each employee would be entitled to receive if termination were
to occur as of June 30.
 
 6.
              COMMON
      STOCK OPTIONS:
  The
Company has two employee incentive stock option plans under which approximately
1,100,000 shares of Company common stock were originally authorized and
available for issuance.  Most options that are granted under the plans
are fully vested when granted.  Under the terms of these plans,
options to purchase common stock of the Company may be granted at not less than
85% of the fair market value of the stock on the date of grant, 100% of the fair
market value in the case of incentive stock options qualifying under Section
422A of the Internal Revenue Code (“ISOs”), or 110% of the fair market value of
ISOs granted to persons owning more than 10% of the outstanding stock of the
Company.  As of June 30, 2008, all of the outstanding stock options
issued by the Company were fully vested.
 
 As
described in Note 1, effective July 1, 2005, the Company adopted the fair value
based method of accounting for stock-based employee compensation under the
provisions of Statement of Financial Accounting Standards No. 123 (Revised
2004), Share Based Payment (“SFAS No.
123R”), using the modified prospective method without restatement of the periods
prior to the adoption date.  As a result, the Company has begun
recognizing expense in an amount equal to the fair value of share-based payments
(including stock option awards) on their date of grant, over the vesting period
of the awards.  Under SFAS No. 123R, the Company must recognize
compensation expense for (1) all share-based payments granted on or after July
1, 2005 and (2) any partially vested options as of July 1,
2005.  Prior to the adoption of SFAS No. 123R, the Company accounted
for these plans pursuant to Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to
Employees.  Therefore, compensation expense related to stock
option awards was not reflected in operating expenses in any period prior to
July 2005 (first quarter of Fiscal Year 2006), and prior period results have not
been restated.
 
 No
incentive stock options were granted in the twelve months ended June 30,
2008.  The fair value of each option granted under the Company’s
incentive stock plans during the twelve months ended June 30, 2007 was estimated
on the date of grant using the Black-Scholes option pricing
method.  Using this model, fair value is calculated based on
assumptions with respect to (a) expected volatility of the market price of
Company common stock, (b) the periods of time over which employees, directors
and other option holders are expected to hold their options prior to exercise
(expected lives), (c) expected dividend yield on Company common stock and (d)
risk free interest rates which are based on quoted US Treasury rates for
securities with maturities approximating the options’ expected
lives.  Expected volatility has been estimated based on actual
movements in the Company’s stock price over the most recent historical period’s
equivalent to the options’ expected lives.  Expected lives are
principally based on the Company’s limited historical exercise experience with
option grants with similar prices.  The expected dividend yield is
zero as the Company has never paid dividends and does not currently anticipate
paying any dividends in the foreseeable future.  The following table
summarizes the weighted average values of the assumptions used in computing the
fair value of option grants during the twelve months ended June 30,
2007.
  F-14
 
 2007Expected
      volatility
              
              
              148%
      - 151
              %Expected
      lives from grant date
              
              10
      yearsExpected
      dividend yield
              
              
              0
              %Risk-free
      interest rate
              
              
              4.76%
      - 5.13
              %
 
 Stock
options to purchase an aggregate 20,000 shares of Company common stock were
granted to the Company’s outside Board of Director members in the three-month
period ended September 30, 2006.  These stock options were issued with
a ten year life.  The outside Board of Director members elected to
forgo the issuance of additional shares of common stock, to which they were
entitled, in accordance with the Company’s policy for non-employee director
compensation.Stock options to
purchase an aggregate of 50,000 shares of the Company common stock were granted
to an employee in April 2007, half of these options vested immediately and the
remainder vested in April 2008.  These stock options were issued with
a ten year life.  Compensation expense amounting to $40,131 was
recognized in Fiscal Year 2008, upon the vesting of these options.
   Transactions
      under the plans for fiscal 2008 and 2007 are as follows:Year
      ended June 30
              
              2008
              
              
              2007Options
              
              
              Weighted
                Average
                Price
              
              
              Options
              
              
              Weighted
                Average
                PriceOutstanding,
      beginning of  fiscal year
              
              
              893,900
              
              
              $
              .94
              
              
              
              827,900
              
              
              $
              .87Exercised
              
              
              0
              
              
              
              --
              
              
              
              0
              
              
              
              --Granted
              
              
              0
              
              
              
              --
              
              
              
              70,000
              
              
              
              1.78Forfeited
              
              
              (4,000
              )
              
              
              1.15
              
              
              
              (4,000
              )
              
              
              1.15Expired
              
              
              (24,000
              )
              
              
              1.97
              
              
              
              0
              
              
              
              --Outstanding,
      end of fiscal year
              
              
              865,900
              
              
              $
              .91
              
              
              
              893,900
              
              
              $
              .94Exercisable
      at June 30
              
              
              865,900
              
              
              
              
              
              
              
              868,900Weighted-average
      fair value of options granted during years ended June 30
              
              
              --
              
              
              
              
              
              
              $
              1.83
 
 The
aggregate intrinsic value of the outstanding options, which are currently
exercisable, amounted to $5,730 at June 30, 2008 and $665,907 at June 30, 2007,
respectively.  No options were exercised during the twelve months
ended June 30, 2008.
 
 At
      June 30, 2008, stock option information is as follows:Options
      Outstanding
                    
                    
                    Options
      ExercisableRange
      ofExercise
      Prices
                    
                    
                    Number
      Outstanding at
                      June
      30, 2008
                    
                    
                    Weighted-Average
      Remaining
                      Contractual
                      Life
      (Years)
                    
                    
                    Weighted-
                      Average
                      Exercise
      Price
                    
                    
                    Number
                      Exercisable
      at
                      June
      30, 2008
                    
                    
                    Weighted-
                      average
                      Exercise
      Price$
                    .11
      - $ .50
                    
                    
                    
                    396,000
                    
                    
                    
                    1.67
                    
                    
                    $
                    .30
                    
                    
                    
                    396,000
                    
                    
                    $
                    .30$
                    .53
      - $ .81
                    
                    
                    
                    25,500
                    
                    
                    
                    1.96
                    
                    
                    
                    .61
                    
                    
                    
                    25,500
                    
                    
                    
                    .61$
                    1.10
      - $1.63
                    
                    
                    
                    384,400
                    
                    
                    
                    7.94
                    
                    
                    
                    1.37
                    
                    
                    
                    384,400
                    
                    
                    
                    1.37$
                    1.85
      - $2.45
                    
                    
                    
                    60,000
                    
                    
                    
                    7.71
                    
                    
                    
                    2.14
                    
                    
                    
                    60,000
                    
                    
                    
                    2.14865,900
                    
                    
                    
                    5.10
                    
                    
                    $
                    .91
                    
                    
                    
                    865,900
                    
                    
                    $
                    .91
 
 The
weighted-average remaining contractual life of the outstanding stock options at
June 30, 2007 was 6.24 years.
 
 7.
              INCOME
      TAXES:
  Income
taxes are accounted for under the asset and liability
method.  Deferred income taxes are recorded for temporary differences
between financial statement carrying amounts and the tax basis of assets and
liabilities.  Deferred tax assets reflect the tax rates expected to be
in effect in the period in which the differences are expected to
reverse.  The Company records a valuation allowance to reduce its
deferred tax asset to an amount that is more likely than not to be
realized.  The Company has recorded net deferred tax liabilities of
approximately $155,000 as of June 30, 2008 and net deferred tax assets of
approximately $1,296,000 as of June 30, 2007.  The June 30, 2008 net
deferred tax liabilities balance is solely attributable to the Company’s foreign
operations, and is comprised of approximately $698,000 deferred tax liabilities
and $543,000 deferred tax assets.  The deferred tax liabilities are
related to the net unrealized exchange gain on the intercompany note denominated
in U.S. dollars, as it will only be taxed when realized and when repayment is
made; and the deferred tax assets are mainly related to the temporary
differences on the intangible assets amortization.  The June 30, 2007
net deferred tax assets balance is primarily related to the U.S. net operating
loss carry forwards and the foreign tax assets acquired in the QR acquisition in
April 2007.  In Fiscal Year 2008, the Company increased its valuation
allowance on the U.S. portion of its deferred tax asset by approximately
$4,398,000 as it does not believe that it is more likely than not that it will
be able to utilize the net operating loss carry forwards based on recent losses
and anticipated market conditions.   However, should
circumstances change and the Company determine that it will be able to utilize
its net operating loss carry forwards, such as the generation of consolidated
future taxable income, the Company will reevaluate its valuation
allowance.  In Fiscal Year 2008, the Company decreased its foreign
deferred tax asset by approximately $34,000 to reflect the newly enacted Italian
Finance Bill of 2008 which reduced the overall tax rate from 37.25% to
31.4%.  This decrease in the deferred tax asset as well as the
increase in the valuation allowance has been reflected as part of the tax
provision in the accompanying financial statements.
  F-15
  Effective
July 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48
(“FIN 48”), Accounting for
Uncertainties in Income Taxes – an interpretation of FASB Statement No.
109.In accordance with FIN 48, the Company classifies
interest as a component of interest expense and penalties as a component of
income tax expense.  The implementation of FIN 48 had no impact on the
Company’s financial statements for fiscal years ended June 30, 2007 and June 30,
2008, and no interest and penalties related to uncertain tax positions were
accrued at June 30, 2007 and 2008.
 
 The net tax expense recorded for the
years ended June 30, 2008 and 2007 respectively includes foreign taxes at the
statutory rates on the Company’s foreign operations, changes to the deferred tax
accounts, and state income and capital taxes generated in the United
States.  Net operating loss carry forwards ("NOLs") amounting to
approximately $12 million in federal NOLs and $15.4 million in state NOLs
at June 30, 2008, will expire beginning in 2010.  The NOLs are subject
to review by the Internal Revenue Service.  Past and future changes in
ownership of the Company, as defined by Section 382 of the Internal Revenue
Code, may limit the amount of NOLs available for use in any one
year.  In assessing the realizability of deferred tax assets,
management considers whether it is more likely than not that some portion of the
deferred tax assets will not be realized.  The ultimate realization of
deferred tax assets is based upon the generation of future taxable income during
future periods.The Company recorded the above valuation
reserve, based on management's conclusion that it is more likely than not that
consolidated future operations will not generate sufficient taxable income to
realize the entire deferred tax assets during the carry forward period for these
tax attributes.
  The loss
before provision for income taxes is comprised of the following:
  June
      30
              
              2008
              
              
              2007United
      States
              
              $
              (4,566,478
              )
              
              $
              (1,195,502
              )Foreign
              
              
              (4,364,979
              )
              
              
              (3,277,871
              )Total
              
              $
              (8,931,457
              )
              
              $
              (4,473,373
              )
 
 The
provision for income taxes is comprised of the following:
 
 June
      30
              
              2008
              
              
              2007CurrentFederal
      (US)
              
              $
              ---
              
              
              $
              ---State
      (US)
              
              
              9,009
              
              
              
              25,147Foreign
              
              
              657,574
              
              
              
              84,873Total
      Current
              
              
              666,583
              
              
              
              110,020DeferredUnited
      States
              
              
              680,000
              
              
              
              ---Foreign
              
              
              771,126
              
              
              
              89,431Total
      Deferred
              
              
              1,451,126
              
              
              
              89,431Total
              
              $
              2,117,709
              
              
              $
              199,451
 
 The
difference between the provision for income taxes at the effective federal
statutory rates and the amounts provided in the consolidated financial
statements is summarized as follows:
  F-16
  June
      30,
              
              2008
              
              
              2007Tax
      provision at federal statutory  rates
              
              $
              (3,036,695
              )
              
              $
              (1,520,947
              )Increase
      (decrease) in tax provision resulting from:State
      income tax provision/(benefit)
              
              
              (254,650
              )
              
              
              16,597Foreign
      tax provision
              
              
              1,428,700
              
              
              
              47,512Foreign
      tax benefit
              
              
              (423,287
              )
              
              
              (7,185
              )Other
      non deductible items
              
              
              5,295
              
              
              
              31,216Increase/(decrease)
      in valuation allowance
              
              
              4,398,346
              
              
              
              1,632,258Provision
      for income taxes
              
              $
              2,117,709
              
              
              $
              199,451
 
 The items that comprise the deferred tax
balance are as follows:
 
 June
      30,
              
              2008
              
              
              2007Depreciation
      and amortization
              
              $
              124,687
              
              
              $
              118,189Amortization
      of acquisition intangibles
              
              
              3,752,732
              
              
              
              1,487,754Accrued
      liabilities and reserves not currently deductible
              
              
              623,506
              
              
              
              287,604Inventory
              
              
              190,648
              
              
              
              156,000Deferred
      tax assets acquired
              
              
              542,943
              
              
              
              615,718Net
      operating loss carry forwards and tax credits
              
              
              5,078,826
              
              
              
              3,184,13910,313,342
              
              
              
              5,849,404Deferred
      tax asset valuation reserve
              
              
              (8,952,032
              )
              
              
              (4,553,686
              )Net
      deferred tax assets
              
              $
              1,361,310
              
              
              $
              1,295,718Unrealized
      foreign exchange gain
              
              
              (1,516,718
              )
              
              
              ---Total
      net deferred tax assets (liabilities)
              
              
              (155,408
              )
              
              
              1,295,718Deferred
      tax asset - Current
              
              
              76,921
              
              
              
              926,603Deferred
      tax asset – Non-current
              
              
              466,022
              
              
              
              369,115Deferred
      tax liabilities - Current
              
              
              (61,259
              )
              
              
              ---Deferred
      tax liabilities – Non-current
              
              
              (637,092
              )
              
              
              ---Deferred
      tax asset (liability) - Total
              
              $
              (155,408
              )
              
              $
              1,295,718
 
  8.
              DEFINED CONTRIBUTION
      PLANS:
  The
Company maintains a defined contribution profit-sharing plan and trust pursuant
to which its United States participants receive certain benefits upon
retirement, death, disability and, to a limited extent, upon termination of
employment for other reasons.  In Fiscal Year 2008, the Company
distributed the cash and short-term marketable securities contained within the
profit sharing plan to each employee’s respective 401(k) account, based on their
respective pro-rata balances.  The profit sharing plan only contains
its existing common stock portfolio and the Company does not intend to make any
further contributions to this plan.The profit sharing plan
requires no minimum contribution by the Company.No contributions were made
to the profit sharing plan for the years ended June 30, 2008 and
2007.
 
 In fiscal
2006, the Company established a Safe Harbor 401(k) defined contribution plan
pursuant to which all eligible participants can make
contributions.  In addition, the Company is required to make either a
specified matching contribution or a 3% contribution to all participants. The
aggregate amount contributed to this plan by the Company each fiscal year is
determined by the board of directors following a review of the profits of such
fiscal year.  For the years ended June 30, 2008 and 2007, the Company
contributed $145,190 and $143,112 respectively towards this
Plan.  Allocation among participants' interests, including officers
and directors who are employees, is in accordance with IRS
regulations.
 
 9.
              COMMITMENTS AND
      CONTINGENCIES:
 The
Company is a defendant in an environmental claim relating to a property in New
Jersey owned by the Company between August 1984 and June 1985.  This
claim relates to the offsite commercial disposition of trash and waste in a
landfill in New Jersey.  The Company maintains that its waste
materials were of a general commercial nature. This claim was originally filed
in 1998 by the federal government in United States District Court for the
District of New Jersey, Newark Vicinage, citing several hundred other
third-party defendants.  The Company (through its former subsidiary,
Kenro Corporation) was added, along with many other defendants, to the
suit.  The Company's claimed liability was potentially assessed by the
plaintiff at $150,000.  The Company has joined, along with other
involved defendants in an alternative dispute resolution (ADR) process for
smaller claims.  On May 7, 2008, a tentative mediated settlement was
reached by all parties, and the Consent Decree memorializing the settlement is
being negotiated by the governments and each group’s liaison counsel and is
presently scheduled to be finalized by December 2008.  The Company’s
share is $82,880 of which the Company’s insurance carrier has agreed to pay 50%
of the settlement offer.  The Company cannot, at this time, assess the
amount of liability that could result if this settlement is not
finalized.  The Company's insurance carrier has agreed to equally
share with the Company the defense costs incurred in this environmental
claim.
  F-17
  On May 5,
2008, the Company and Dent-X International, Inc. commenced litigation in the
United States District Court, Southern District of New York, against Genexa
Medical, Inc. (“Genexa”) to recover $394,610 for goods sold and delivered to
Genexa during the period from December 11, 2007 through March 13, 2008, after
Genexa failed and refused to pay the amount due.  On June 27, 2008,
Genexa filed an Answer and Counterclaims alleging several causes of action which
are potentially material.  Although the Company intends to vigorously
defend all such counterclaims, a determination as to the likelihood of Genexa
prevailing on the merits with respect to such counterclaims is premature as of
the date hereof.  The case was scheduled for an initial conference
before Judge Charles L. Brieant on July 25, 2008, but Judge Brieant recently
passed away and the case will be reassigned.  The Company intends to
vigorously defend all counterclaims, however the Company cannot, at this time,
assess the amount of liability that could result if there is an adverse
decision.
 
 The
Company has received notification of a customer complaint filed in the Superior
Court of California, County of Placer, on December 19, 2007.  The
Complaint seeks damages in excess of $25,000.  The Company has not
been formally served with this Complaint.  The Company, through its
attorneys, has repeatedly agreed to a settlement, but has not received any
further communication.
 
 On October
1, 2007, a settlement was reached in the product liability insurance action
filed in May 2005 in the Superior Court in Hartford, Connecticut and later
transferred to the United States District Court, District of Connecticut, in
which the Company was a defendant (with several other parties).  The
plaintiff, through its insurance company, claimed that the Company’s equipment
caused damages on the plaintiff’s premises in May 2003.  The case was
settled for less than the originally claimed amount and included mutual releases
for all participating parties from any liability arising from the
claim.  The Company’s insurance carrier was responsible for the
settlement, and therefore there was no financial effect on the
Company.
 
 The
Company is involved in two other product liability insurance claims, however, to
date, no lawsuits have been filed.  The Company maintains that its
equipment was not the cause of the respective incidents or the resultant
damage.  The Company’s insurance carriers, and their attorneys, are
assisting in the Company’s defense in these matters.  The Company does
not believe that the final outcome of either of these matters will have a
material adverse effect on the Company.
 
 From time
to time, the Company may be party to other claims and litigation arising in the
ordinary course of business.  The Company does not believe that any
adverse final outcome of any of these matters, whether covered by insurance or
otherwise, would have a material adverse effect on the Company.
 
 The
Company has a non-cancelable operating lease, which was renewed in June 2008,
for office and manufacturing facilities in Elmsford, New York, which expires in
December 2019.  The lease provides for scheduled increases in base
rent.  Rent expense is charged to operations ratably over the term of
the lease resulting in deferred rent payable, which represents cumulative rent
expense charged to operations from inception of this lease in excess of required
lease payments. Rent expense was approximately $508,000 for each of the years
ended June 30, 2008, 2007, and 2006, respectively.
 
 The
Company has a non-cancelable operating lease for office and manufacturing
facilities in Verona, Italy which expires in November 2015, which it assumed in
April 2007 with the acquisition of QR.  Rent expense is approximately
83,160 Euro per year.  In October 2007, the Company signed a
non-cancelable operating lease for additional office facilities in Verona,
Italy.  Rent expense is approximately 39,000 Euro per
year.  This lease expires in September 2013.  The leasing
agent is owned by three of the four former owners of QR.
 
 As part of
the acquisition of QR, the Company granted employment agreements to each of the
four former owners, for a total yearly commitment of 500,000
Euros.  Each agreement is for a period of five years and contains a
non-compete clause.  The Company can terminate each agreement after
the first year of employment, in which event, any employee so terminated is
entitled to one-half of the salary for the remaining term.  Effective
July 2008, two of these employment agreements were modified so that the total
yearly commitment is 420,000 Euros.
  F-18
 
 The
Company has a non-cancelable operating lease for its small sales and marketing
facility in Roswell, Georgia, which expires in April 2009.  The
Company assumed this lease in December 2007, and rent expense was approximately
$168,200 and $95,600, for the years ended June 30, 2008 and 2007,
respectively.  The Company sub-lets a portion of this facility to an
unrelated third-party.
 
 Minimum
annual rental payments under these leases are as follows:
 Year
      ending June 30,2009
              
              $
              848,5012010
              
              
              716,7662011
              
              
              728,6992012
              
              
              728,6992013
      and thereafter
              
              
              5,084,297$
              8,106,963
 
 The rental
payments for the Italian leases were calculated using the average exchange rate
for Fiscal Year 2008.
 
 10.
              SEGMENT
      INFORMATION:
  As of June
30, 2008 and 2007, the Company had one business segment, medical and dental
x-ray imaging.  The medical and dental segment operations are
conducted under the Dent-X, EVA, NewTom and AFP trade names and consist of the
design, development, manufacturing, marketing and distribution of medical and
dental imaging systems and all related accessories.  The amortization
and impairment of the intangibles and the write-off of the in-process research
and development associated with the acquisition of QR has been attributed to the
Italian operations.
 
 Geographical
      financial information for the years ended June 30, 2008 and 2007 is as
      follows:June
      30,
              
              2008
              
              
              2007Sales:United
      States
              
              $
              21,454,851
              
              
              $
              19,781,071Europe
              
              
              7,309,577
              
              
              
              2,071,262Other
              
              
              5,515,379
              
              
              
              6,867,360$
              34,279,807
              
              
              $
              28,719,693Net
      lossUnited
      States
              
              $
              (6,449,049
              )
              
              $
              (1,220,649
              )Europe
              
              
              (4,600,117
              )
              
              
              (3,452,175
              )$
              (11,049,166
              )
              
              $
              (4,672,824
              )Identifiable
      assets:United
      States
              
              $
              8,282,539
              
              
              $
              9,942,023Europe
              
              
              13,118,300
              
              
              
              17,228,803Total
              
              $
              21,400,839
              
              
              $
              27,170,826
 
 During the
years ended June 30, 2008 and 2007, no one customer aggregated over 10% of
consolidated net sales.
 
 11.  GOODWILL
AND OTHER INTANGIBLES
 
 On April
19, 2007 the Company acquired through its wholly-owned subsidiary QR Imaging
srl, QR srl, (“QR”) an Italian corporation, located in Verona,
Italy.  The results of QR’s operations have been combined with those
of the Company since the date of acquisition.  The purchase price was
13 million Euros and was funded through the issuance of stock and assumption of
new debt.  The company incurred approximately $1,558,000 of
transactions costs, for a total purchase price of $18,875,360. The Company
granted employment agreements to each of the four former owners as part of the
transaction.  QR is a global supplier of three-dimensional dental
computed tomography.
 
 The
Company performed the required annual impairment tests as of June 30, 2008, in
accordance with FASB Statements No. 142, Goodwill and Other Intangibles,and No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. The Company
expressly tested the developed technologies and customer relationships for
impairment and determined that there had been impairment in their respective
values.  The impairment was calculated by a comparison of the fair
values of the assets, using discounted cash flows, to the carrying value of the
assets.  Accordingly, there is a charge in the accompanying
Consolidated Statement of Operations in the line item “Impairment of long-lived assets”for $5,615,880.    This impairment is primarily due
to increased competition in the marketplace and new developments in
three-dimensional imaging technology, which have resulted in lower sales than
had been anticipated.  The current economic conditions have also
adversely impacted the Company’s original forecast of world-wide
three-dimensional imaging equipment.  The developed technologies
primarily relate to the Company’s horizontal patient positioning equipment which
have been principally replaced in the market by vertical patient positioning
equipment.  The Company introduced its vertical patient positioning
three-dimensional equipment in the current fiscal year.  The
impairment charge was booked in the fourth quarter of Fiscal Year
2008.
  F-19
  The
Company tested goodwill for impairment by a comparison of the fair value of the
reporting unit to its respective carrying value and determined that there was no
impairment to the carrying value as of June 30, 2008.
 
 The
acquisition was accounted for under the purchase method of accounting in
accordance with FASB Statement No. 141, Business Combinations (“SFAS
141”).  The carrying values of QR’s assets and liabilities were
adjusted to their fair values on April 19, 2007 and the difference between the
purchase price and the fair value of the net assets and liabilities was recorded
as goodwill.  Many factors were considered including expected
worldwide sales in the next several years, the existing customer base based on
QR being a dominant supplier of three-dimensional dental imaging prior to the
acquisition and the value of the in-process development of new products prior to
the acquisition date. The goodwill and intangible amounts are maintained in
Euros on the subsidiary’s books and converted into US dollars at the respective
exchange rate.
 
 The
allocation of the purchase price was as follows:
 
 Current
      assets, (including cash)
              
              $
              3,673,300Property,
      plant and equipment
              
              
              161,200Deferred
      Income taxes
              
              
              393,000In
      process research and development
              
              
              3,760,000Intangible
      assets subject to amortization
              
              
              8,805,000Goodwill
              
              
              3,846,400Total
      assets
              
              
              20,638,900Current
      liabilities
              
              
              1,499,800Severance
      indemnity
              
              
              263,700Total
      liabilities assumed
              
              
              1,763,500Purchase
      Price
              
              $
              18,875,400
 
 The
Company initially believed that the acquisition would strengthen its competitive
position in the technology-driven Imaging Systems marketplace by adding
three-dimensional imaging to its core products as well as greatly expanding its
product development capabilities and its world-wide presence.  The
acquisition is expected to provide certain synergies for both
companies.
 
 A summary
of the identifiable intangible assets acquired is as follows:
 
 Fair
      Value
              
              
              Amortization
      PeriodDeveloped
      technologies
              
              $
              5,320,000
              
              
              7
      yearsIn-process
      research and development
              
              
              3,760,000
              
              
              
              N/ACustomer
      Relationships
              
              
              3,149,000
              
              
              10
      yearsNon-compete
      contracts and other
              
              
              336,000
              
              
              5-10
      yearsGoodwill
              
              
              3,846,405
              
              
              
              N/A
 
 The in
process research and development (“IPR&D”) primarily related to the
development of additional three-dimensional imaging equipment.  As of
June 30, 2007, this equipment was not completely developed, nor certified for
use, and was therefore classified as IPR&D.  No alternative future
use was identified for these assets, and therefore the entire value was charged
to the earnings statement, included in the accompanying Consolidated Statement
of Operations in the line item “Write-off of in process research and
development”.
 
 The useful
lives of the technology assets was determined based on the expected use of the
technology, any legal or contractual provisions that might limit the useful
lives of the technology, and the effects of known advances, obsolescence, demand
and competition required to maintain the future cash flows of the intangible
assets.  Based on these factors, developed technologies were assigned
useful lives of 7 years.  The useful life of customer relationships
was based on the length of existing contractual dealer and customer
relationships as well as the estimated average period of 10 years after which
the customer or dealer would need to be retrained, similar to a new customer or
dealer.  The useful life of the non-compete contracts was based on
contractual provisions of the acquisition agreement.  The goodwill of
$3,846,405 is expected to be deducted for tax purposes over fifteen
years.  These useful lives are considered reasonable when evaluating
the long-lived asset amounts after impairment.
 
 F-20
  The
following is a summary of the intangible assets subject to
amortization:
 
 June
      30, 2008
              
              Gross
      carrying
                amount
              
              
              Accumulated
      amortization
              
              
              Impairment
              
              
              NetDeveloped
      technologies
              
              $
              6,159,856
              
              
              $
              1,053,564
              
              
              $
              4,006,292
              
              
              $
              1,100,000Customer
      relationships
              
              
              3,646,125
              
              
              
              436,537
              
              
              
              1,609,588
              
              
              
              1,600,000Non-compete
      contracts and other
              
              
              389,044
              
              
              
              91,493
              
              
              
              --
              
              
              
              297,551Total
              
              $
              10,195,025
              
              
              $
              1,581,594
              
              
              $
              5,615,880
              
              
              $
              2,997,551
 
 
 June
      30, 2007
              
              Gross
      carrying
                amount
              
              
              Accumulated
      amortization
              
              
              NetDeveloped
      technologies
              
              $
              5,320,000
              
              
              $
              149,918
              
              
              $
              5,170,082Customer
      relationships
              
              
              3,149,000
              
              
              
              62,117
              
              
              
              3,086,883Non-compete
      contracts and other
              
              
              336,000
              
              
              
              12,203
              
              
              
              323,797Total
              
              $
              8,805,000
              
              
              $
              224,238
              
              
              $
              8,580,762
 
 The change
in the value of the other intangibles from the date of acquisition to June 30,
2008 and the change in accumulated amortization include changes in the US
Dollar/Euro exchange rates, which fluctuated during the period.  The
impact excluding the impairment charge was approximately $1,390,025 on the
long-lived intangible assets.
 
 The
changes in the carrying amount of goodwill are as follows:
 
 For
      the year ended June 30,
              
              2008
              
              
              2007Balance
      as of July 1,
              
              $
              3,846,405
              
              
              $
              ---Goodwill
      recognized during the year in QR transaction
              
              
              ---
              
              
              
              3,846,405Foreign
      currency translation difference
              
              
              607,222
              
              
              
              ---Balance
      as of June 30,
              
              $
              4,453,627
              
              
              $
              3,846,405
 
 Amortization
expense, related to intangible assets subject to amortization was $1,234,311 and
$225,054 respectively for 2008 and 2007, excluding the Fiscal Year 2008
impairment charges.
 
 Amortization
expense related to intangible assets subject to amortization for the next five
years assuming a constant Euro/US Dollar exchange rate and straight line
amortization is as follows:
 
 Year
      ending June 30,2009
              
              $
              376,6532010
              
              
              376,6532011
              
              
              376,6532012
              
              
              364,2552013
              
              
              317,143
 
 The
following summary, pro forma unaudited data of the Company reflects the
acquisition of QR as if the acquisition has occurred on July 1,
2006.
 
 F-21
 
 
 Fiscal
      Year Ended June 30, 2007(Dollars
      in thousands, except
                for
      per share amounts)Net
      sales
              
              $
              33,806Net  loss
              
              
              (4,038
              )Basic
      net loss per share
              
              $
              (.23
              )Diluted
      net loss per share
              
              $
              (.23
              )Such
      pro forma data is not necessarily indicative of future results of
      operations.
   12.
              PRODUCT
      WARRANTY
  The
following table provides the changes in the product warranty accrual for the
years ended June 30, 2008 and 2007.
  
  Year
      ended June 30, 2008
              
              
              Year
      ended June 30, 2007Opening
      balance
              
              $
              200,000
              
              
              $
              80,000Accruals
      for warranties issued during the period
              
              
              940,750
              
              
              
              935,000Warranty
      settlements made during the period
              
              
              (715,750
              )
              
              
              (815,000
              )Closing
      balance
              
              $
              425,000
              
              
              $
              200,000




F-22




SCHEDULE
OF VALUATION AND QUALIFYING ACCOUNTS
 
 Years
ended June 30, 2008 and 2007





Description
                
                Balance
      at Beginning
                  of
      Year
                
                
                Charged
      to
                  Costs
      and Expenses
                
                
                Deductions
      (A)
                
                
                Balance
      at
                  End
      of
                  YearJune
      30, 2008Allowance
      for doubtful accounts and salesreturns
                
                $
                130,000
                
                
                $
                894,625
                
                
                $
                $(105,142
                )
                
                $
                919,483June
      30, 2007Allowance
      for doubtful accounts and salesreturns
                
                
                90,000
                
                
                
                40,000
                
                
                
                ---
                
                
                
                130,000(A)
      Deductions
      consist of write-offs of uncollectible
accounts.




F-23




Item
9.  Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.





On January
24, 2008, the Company was notified that the majority of the partners of
Goldstein Golub Kessler LLP (‘‘GGK’’) became partners of McGladrey & Pullen,
LLP in a limited asset purchase agreement and that GGK resigned as the
independent registered public accounting firm for the Company.  On
January 24, 2008, McGladrey & Pullen, LLP was appointed as the
Company’s new independent registered public accounting firm. A copy of the
letter dated January 24, 2008 from GGK to the Company notifying the Company of
the change was filed as an exhibit to a Current Report on Form 8-K filed on
January 24, 2008.





During the
Company's two most recent fiscal years and through the subsequent interim period
on or prior to January 24, 2008, (a) there were no disagreements between the
Company and GGK on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure, which disagreements, if
not resolved to the satisfaction of GGK, would have caused GGK to make reference
to the subject matter of the disagreement in connection with its report; and (b)
no reportable events as set forth in Item 304(a)(1)(v)(A) through (D) of
Regulation S-K have occurred.





Item 9A
(T).  Controls and Procedures.





Management’s Conclusion
Regarding the Effectiveness of Disclosure Controls and
Procedures.





The
Company conducted an evaluation of the effectiveness of the design and operation
of the Company’s disclosure controls and procedures (as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended
(the “Exchange Act”)) as of the end of the period covered by this Form
10-K.  The controls evaluation was conducted under the supervision and
with the participation of our management, including our Co-Chief Executive
Officers and Chief Financial Officer.  Based upon that evaluation, the
Co-Chief Executive Officers and Chief Financial Officer have concluded that, as
a result of the identification of the material weaknesses identified below, as
of the end of the period covered by this report, our disclosure controls and
procedures were not effective.





Management’s Annual Report
on Internal Control Over Financial Reporting.





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting. Internal control over financial reporting is a
process designed under the supervision of our principal executive and principal
financial officers to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of our financial statements for external
reporting purposes in accordance with generally accepted accounting principles
as applied in the United States.  Our internal control over financial
reporting includes policies and procedures that pertain to the maintenance of
records that, in reasonable detail, accurately and fairly reflect transactions
and disposition of assets of the Company; provide reasonable assurances that
transactions are recorded as necessary to permit preparation of financial
statements in accordance with U.S. generally accepted accounting principles and
that receipts and expenditures of the Company are being made only in accordance
with authorizations of management; and provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use or disposition
of our assets that could have a material effect on our consolidated financial
statements.





Under the
supervision and with the participation of our management, including our Co-chief
Executive Officers and our Chief Financial Officer, we conducted an evaluation
of the effectiveness of the design and operational effectiveness of our internal
control over financial reporting as of June 30, 2008, based on the framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(“COSO”) in Internal Control – Integrated Framework.





A material weakness is a deficiency, or
combination of deficiencies, in internal controls over financial reporting, such
that there is a reasonable possibility that a material misstatement of the
Company’s annual or interim financial statements will not be prevented or
detected on a timely basis.





Entity
Level Controls


In its
assessment of the effectiveness of internal control over financial reporting as
of June 30, 2008, management concluded that the Company's internal controls over
financial reporting were not operating effectively.  It was determined
that there werecontrol
deficiencies that when aggregated, may possibly be viewed as a material weakness
in our internal control over financial reporting as of June 30,
2008.  Those deficiencies were as follows:




23




1.
            We
      do not employ an Audit Committee as defined by Section 3(a)(58) of the
      Exchange Act and none of the Company’s directors are
      independent.  While not being legally obligated to have an audit
      committee, it is the Company's view that such a committee, including a
      financial expert, is an utmost important entity level control over the
      Company's financial statements.  Currently, the full Board of
      Directors acts in the capacity of the Audit
  Committee.





2.
            The
      Company does not have an individual who meets the criteria to be defined
      as a financial expert on its Board of Directors.  The financial
      expert could lead the Audit Committee to provide additional oversight of
      the Company’s Chief Financial Officer, as well as provide the Company’s
      financial management with enhanced segregation of duties and controls
      which would minimize the risk of a material
  misstatement.





3.
            There
      are no processes in place for someone to review and determine financial
      impacts of contracts and agreements.  The financial expert could
      assist in this review prior to the legal review and minimize any potential
      financial exposures.





In light
of this identified material weakness, the Company’s Board interacts with
management frequently and management performed (1) significant additional
substantive review of the financial information, (2) performed additional
analyses, including but not limited to a substantive analytical review that
compared changes from the prior period's financial statements and analyzed all
significant amounts that deviated from expectations, and (3) utilized an outside
consultant to provide assistance with technical accounting and reporting
matters.  These enhanced procedures were completed to mitigate the
entity level control deficiencies noted above.





Remediation of Material
Weaknesses


Management
concluded that the above identified material weakness did not result in material
audit adjustments to our 2008 financial statements. However, it is reasonably
possible that, if not remediated, one or more of the identified deficiencies
noted above could result in a material misstatement in our financial statements
in a future annual or interim period.





In an
effort to remediate the identified material weaknesses, the recommendations are
as follows:





1.
Management will begin seeking candidates to expand the Board of Directors in
order to ensure a majority of the Board is independent.





2. Once
the expansion of the Board is completed, the Company’s Board of Directors will
nominate an Audit Committee, which includes a financial expert that has an
understanding of U.S. generally accepted accounting principles and financial
statements; the ability to assess the general application of such principles in
connection with the accounting for estimates, accruals and reserves; experience
in preparing, auditing, analyzing or evaluating financial statements that
present a breadth and level of complexity of accounting issues that are
generally comparable to the breadth and complexity of issues that can reasonably
be expected to be raised by the registrant's financial statements, or experience
actively supervising one or more persons engaged in such activities; an
understanding of internal controls and procedures for financial reporting; and
an understanding of audit committee functions.





This
person will have acquired such attributes through any one or more of the
following:





·
            Education
      and experience as a principal financial officer, principal accounting
      officer, controller, public accountant or auditor or experience in one or
      more positions that involve the performance of similar
      functions;


·
            Experience
      actively supervising a principal financial officer, principal accounting
      officer, controller, public accountant, auditor or person performing
      similar functions;


·
            Experience
      overseeing or assessing the performance of companies or public accountants
      with respect to the preparation, auditing or evaluation of financial
      statements; or


·
            Other
      relevant experience.





Limitations of Effectiveness
of Controls


As of the
date of this filing, the Company is satisfied that actions implemented to date
and those in progress will remediate the material weaknesses and deficiencies in
the internal controls that have been identified.   The Company
notes that, like other companies, any system of internal controls, however well
designed and operated, can provide only reasonable assurance, and not absolute
assurance, that the objectives of the internal control system will be
met.   The design of any control system is based, in part, upon
the benefits of the control system relative to its costs. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within the Company have been detected.  These inherent
limitations include the realities that judgments in decision making can be
faulty, and that controls can be circumvented by the individual acts of some
persons, by collusion of two or more people or by management override of
control. In addition, over time, controls may become inadequate because of
changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate.  In addition, the design of any control
system is based in part upon certain assumptions about the likelihood of future
events. Because of the limitations inherent in a cost-effective control system,
misstatements due to error or fraud may occur and may not be
detected.




24


This
annual report does not include an attestation report of the Company's registered
public accounting firm regarding internal control over financial
reporting.  Management's report was not subject to attestation by our
registered public accounting firm pursuant to the temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management's report in this annual report.





Changes in Internal Control
Over Financial Reporting


Other than
the changes noted above, there have been no changes to the Company’s internal
control over financial reporting  during the fourth
quarter ended June 30, 2008 that have materially affected, or are
reasonably likely to materially affect, the Company’s internal control over
financial reporting.





Item
9B.  Other Information.





Not
applicable.








PART
III





Item 10.
            Directors,
      Executive Officers and Corporate
Governance.




Information
with respect to this item is incorporated by reference from the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed pursuant to Regulation 14A under the Exchange Act no later than 120 days
after the end of Fiscal Year 2008.




Item 11.
            Executive
      Compensation.





Information
with respect to this item is incorporated by reference from the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed pursuant to Regulation 14A under the Exchange Act.





Item 12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.




Information
with respect to this item is incorporated by reference from the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed pursuant to Regulation 14A under the Exchange Act.




Item 13.
            Certain
      Relationships and Related Transactions, and Director
      Independence.





Information
with respect to this item is incorporated by reference from the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed pursuant to Regulation 14A under the Exchange Act.





Item 14.
            Principal
      Accountant Fees and Services.





Information
with respect to this item is incorporated by reference from the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed pursuant to Regulation 14A under the Exchange Act.




25




PART
IV





Item
15.  Exhibits and Financial Statement
Schedules.





(a)


1.  Financial
Statements.





Reference
is made to the Financial Statements filed under Item 8, Part II
hereof.





2.
Financial Statement Schedules.





Reference
is made to the Financial Statements filed under Item 8, Part II
hereof.





3.
Exhibits.


The
following exhibits are filed pursuant to Item 601 of Regulation
S-K.  The numbers set forth below opposite the description of each
exhibit correspond to the Exhibit Table of Item 601 of Regulation
S-K.




Exhibit
                No.
              Description3.1
              Restated
      Certificate of Incorporation of Registrant (1)3.2
              Amended
      and Restated By-Laws of Registrant, as of July 2008 (2)4.1
              Specimen
      Stock Certificate(3)10.1
              Common
      Stock Purchase Warrant issued to designees of an investment banking firm
      in March 2006.   (4)10.2
              Form
      of Subscription Agreement utilized in a private placement of common stock,
      effective May 2006. (5)10.3
              Form
      of Subscription Agreement utilized in a private placement of common stock,
      effective April 12, 2007. (6)10.4
              Common
      Stock Purchase Warrant issued to ComVest Capital LLC, dated April 13,
      2007. (6)10.5
              Lease
      Agreement dated September 1, 1985, for premises at 250 Clearbrook Road,
      Elmsford, NY. and amended June 2008.*10.6
              Profit
      Sharing Plan of the Registrant, as supplemented.(3)10.7
              Registrants’
      1999 Incentive Stock Option Plan. (8)10.8
              Registrant’s
      2004 Equity Incentive Plan.  (9)10.9
              Revolving
      Credit and Term Loan Agreement by and between ComVest Capital, LLC and AFP
      Imaging Corporation, dated April 13,
  2007.  (6)10.10
              Guaranty
      Agreement made by Dent-X International Inc., QR Imaging USA Inc. and
      Visiplex Instruments Corporation in favor of ComVest Capital, LLC, dated
      April 13, 2007.  (6)10.11
              Collateral
      Agreement by and among AFP Imaging Corporation, Dent-X International Inc.,
      QR Imaging USA, Inc., Visiplex Instruments Corporation and ComVest
      Capital, LLC, dated April 13, 2007.  (6)10.12
              Registration
      Rights Agreement by AFP Imaging Corporation, made as of April 13,
      2007.  (6)10.13
              Convertible
      Term Note issued by AFP Imaging Corporation to ComVest Capital, LLC, dated
      April 13, 2007.  (6)10.14
              Revolving
      Credit Note issued by AFP Imaging Corporation to ComVest Capital, LLC,
      dated April 13, 2007.  (6)10.15
              Notice
      of Patent Security Agreement, dated April 13,
      2007.  (6)10.16
              Notice
      of Trademark Security Agreement, dated April 13,
      2007.  (6)10.17
              Cooperation
      Agreement between QR S.r.l. and Gianmaria Tommasi, effective April 19,
      2007.  (6)10.18
              Contract
      among QR S.r.l., Attilio Tacconi and Mozzo Pierluigi, effective April 19,
      2007.  (6)10.19
              Contract
      between QR S.r.l. and Mara Tacconi, effective April 19,
      2007.  (6)14
              Code
      of Ethics(10)21.1
              List
      of Subsidiaries*23.1
              Consent
      of Goldstein Golub Kessler LLP*23.2
              Consent
      of McGladrey & Pullen, LLP*31.1
              Certification
      of Co-Chief Executive Officer pursuant to Rule 13a-14 or 15d-14 of the
      Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
      of 2002.*31.2
              Certification
      of Co-Chief Executive Officer pursuant to Rule 13a-14 or 15d-14 of the
      Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
      of 2002.*




26




32.1
              Certification
      of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.*32.2
              Certification
      of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.*32.3
              Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.*
 *Filed
herewith
  27




(1)
              Incorporated
      by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form
      10-Q for the quarter ended December 31, 2004, filed with the SEC on
      February 11, 2005 (Commission File No. 000-10832).(2)
              Incorporated
      by reference to Exhibit 3.1 of the Registrant’s Current Report on Form
      8-K, filed with the SEC on July 29, 2008 (Commission File No.
      000-10832).(3)
              Incorporated
      by reference to Exhibits filed with the Registrant’s Registration
      Statement on Form S-18, filed with the SEC on August 28, 1990 (Commission
      File No. 2-G8980).(4)
              Incorporated
      by reference to Exhibit 10.1 of the Registrant’s Quarterly Report on Form
      10-Q for the quarter ended March 31, 2006, filed with the SEC on May 15,
      2006 (Commission File No. 000-10832).(5)
              Incorporated
      by reference to Exhibit 10.1 of the Registrant’s Current Report on Form
      8-K, filed with the SEC on May 3, 2006 (Commission File No.
      000-10832).(6)
              Incorporated
      by reference to the Exhibits filed with the Registrant’s Quarterly Report
      on Form 10-Q for the quarter ended March 31, 2007, filed with the SEC on
      May 15, 2007 (Commission File No. 000-10832).(7)
              Incorporated
      by reference to Exhibit 10(f) of the Registrant’s Current Report on Form
      8-K, filed with the SEC on September 25, 1986.(8)
              Incorporated
      by reference to Exhibit 10(h) of the Registrant’s Annual Report on Form
      10-K for the fiscal year ended June 30, 1999, filed with the SEC on
      September 12, 1999 (Commission File No. 000-10832).(9)
              Incorporated
      by reference to Exhibit 10.1 of the Registrant’s Current Report on Form
      8-K, filed with the SEC on October 8, 2004 (Commission File No.
      000-10832).(10)
              Incorporated
      by reference from the Exhibits filed with the Registrant’s Quarterly
      Report on Form 10-Q for the six months ended December 31,
      2003.




28




SIGNATURES
  Pursuant
to the requirements of Section 13 or 15(d) 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.
  AFP
      IMAGING CORPORATIONBy:
                  
                  /s/
      Elise NissenElise
      Nissen, Chief Financial Officer and Executive Vice-President of
      FinanceDate:
                  
                  October
      14, 2008




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
  By:
                
                /s/
      Donald RabinovitchDonald
      Rabinovitch, Presidentand
      Director(Co-Principal
      Executive Officer)Date:
                
                October
      14, 2008




By:
              
              /s/
      David VozickDavid
      Vozick, Chairman of the Board,Secretary
      and Treasurer(Co-Principal
      Executive Officer)Date:
              
              October
      14, 2008By:
              
              /s/
      Robert BlattRobert
      Blatt, DirectorDate:
              
              October
      14, 2008By:
              
              /s/
      Jack BeckerJack
      Becker, DirectorDate:
              
              October
      14, 2008By:
              
              /s/
      Elise NissenElise
      Nissen, Chief Financial Officer(Principal
      Financial and Accounting Officer)Date:
              
              October
      14, 2008




29