**United
      States**




**Securities
      and Exchange Commission**


Washington,
      D.C. 20549




**Form
      10-K**


(X)
              Annual
                  Report Pursuant to Section 13 or 15 (d) of the
                  SecuritiesExchange
                  Act of 1934For
                  the fiscal year ended June 30, 2006or(
                  )
              Transition
                  Report Pursuant to Section 13 or 15 (d) of the
                  SecuritiesExchange
                  Act of 1934For
                  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 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 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 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 if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K 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.


YES
      ( ) NO
      ( X).





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


Large
                  Accelerated Filer ( )
              
              Accelerated
                  Filer ( )
              
              Non-Accelerated
                  Filer ( X )




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


YES
      ( ) NO
      ( X).










The
      aggregate market value of the registrant’s common stock held by non-affiliates
      of the registrant as of December 30, 2005 was approximately $10,386,619. On
      such
      date, the average of the closing bid and asked prices of the Registrant’s Common
      Stock, as reported by the OTC Bulletin Board, was $1.73.





The
      registrant had 12,401,732 shares of Common Stock outstanding as of September
      12,
      2006.





The
      information required by Part III of Form 10-K is incorporated by reference
      to
      the registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders
      tentatively scheduled for December 11, 2006 to be filed with the Securities
      and
      Exchange Commission on or prior to October 28, 2006.




2


**Introductory
      Note - Forward - Looking Statements**





This
      Annual Report on Form 10-K contains certain forward-looking statements, within
      the meaning of the Private Securities Reform Act of 1995. 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, 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,” “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 long-term financing to meet the Company’s
                obligations, and fund the Company’s
                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
                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.





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, 2006,
      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.




3


**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 such date, the Company has been engaged in the business
      of designing, developing, manufacturing and distributing equipment for
      generating, capturing and/or producing medical and dental diagnostic images
      through electronic technologies, as well as the chemical processing of
      photosensitive materials. Medical, dental, veterinary and industrial
      professionals use these products. The Company’s products are distributed to
      worldwide markets, under various brand names, through a network of independent
      and unaffiliated dealers. The Company has been ISO 9001 certified since
      1996.





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


·
            continually
                broadening is product offerings,


·
            enhancing
                both its domestic and international distribution channels, and


·
            expanding
                its market presence in the diagnostic veterinary and dental imaging
                fields.





In
      May
      2006, the Company completed a private offering of its common stock to selected
      institutional and other accredited investors. The offering was priced at $1.80
      per share and 2,777,777 shares of common stock were sold. Proceeds from the
      private placement are anticipated to be used for general corporate purposes,
      including working capital, new product development, and possibly, for strategic
      acquisitions.





In
      February 2005, the Company settled an outstanding environmental litigation
      claim
      which had been filed in 2001 as a civil complaint by the current owners of
      property, which the Company had owned between August 1984 and June 1985. The
      Company paid $325,000, which represented its entire liability under the
      settlement offer. See Item 3, Legal proceedings for a further discussion of
      this
      matter.





**b)
      Financial Information about Industry Segments**





The
      Company is engaged in one industry segment, the manufacture and distribution
      of
      medical/dental x-ray 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 graphic arts processing
      equipment. The Company has agreed not to compete in this same business line
      of
      graphic arts film and plate 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 Note 10 to the Consolidated Financial Statements for
      further discussion of the Company’s industry segments.





**c)
      Narrative Description of Business**





All
      of the
      Company’s products are distributed worldwide through an unaffiliated dealer
      network to doctors, dentists, veterinarians, hospitals, medical clinics, the
      U.S. military and others.





**Principal
      Products and Services**





Digital
      Dental and Large Body DR and CR Imaging Systems


§
            The
                Company manufactures, distributes and services a filmless, digital
                dental
                radiography system, utilizing x-rays and electronic imaging technology.
                Such equipment generates and captures a patient’s dental x-ray images with
                an intraoral sensor and then displays the image on a computer screen
                that
                operates in a Windows-based, software environment. These filmless,
                digital
                dental radiographic systems, referred to as DR Systems, have practical
                applications in both human and companion animal dentistry. The Company
                has
                developed proprietary application software for use with the sensor.


§
            In
                February 2006, the Company began to manufacture and distribute a
                portable,
                field ready real-time digital imaging system for the diagnosis of
                equine
                patients. This system uses an amorphous silicon digital x-ray sensor,
                which operates in a wide variety of temperature settings, and provides
                high quality images for improved medical care at the patient’s site. The
                primary application is to radiograph horses’
                legs.


§
            In
                February 2006, the Company began to distribute a value-priced high
                quality
                digital panoramic x-ray machine. This machine is manufactured in
                Italy,
                and provides a more complete analysis and diagnosis, without the
                use of
                x-ray film, and is commonly used by dentists, oral surgeons, and
                endodontists for more advanced patient treatment.


§
            In
                May 2006, the Company became the exclusive distributor in the United
                States, Canada, and Latin America (excluding Brazil) for a three
                dimensional dental x-ray imaging equipment manufactured by Quantitative
                Radiology, in Italy. This imaging equipment produces computer generated,
                three dimensional x-ray images which are a dynamic improvement over
                historical two dimensional film images and provide more diagnostic
                information to implantologists, othodontists, and oral
                surgeons.


§
            The
                Company also distributes a computed radiology system, referred to
                as CR
                Systems, that utilizes a reusable phosphorus plate and laser scanner
                in
                place of x-ray film. The plate can be erased and then re-exposed
                to
                capture another image. The CR System is applicable to larger body
                x-ray
                examinations.




4


Medical,
      Dental and Industrial X-Ray Processors & Accessories


The
      Company manufactures and distributes a line of freestanding and table top
      medical, dental and industrial x-ray film processors, commonly referred to
      as
      analog systems. These machines are capable of processing or developing films
      of
      various sizes. The exposed film is inserted into the Company’s 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 units are used for diagnostic x-ray imaging and industrial,
      non-destructive testing applications.





X-Ray
      Systems


The
      Company has the exclusive distribution rights in the North American and Mexican
      markets for a well established, European-designed intraoral dental x-ray machine
      and a panoramic/cephalometric dental x-ray machine. The Company also has the
      North American distribution rights to a Japanese-developed panoramic/
      cephalometric dental x-ray machine. The x-ray film exposed by all of these
      units
      can be developed in the Company’s film processors. Alternatively, these x-ray
      products can be sourced and distributed with a digital, filmless sensor that
      is
      compatible with the Company’s other digital x-ray products and
      software.




Veterinary
      Imaging and Radiographic Systems


The
      Company manufactures and distributes a line of x-ray and related equipment
      specifically designed for the veterinary marketplace. These include intraoral
      x-ray systems, a filmless digital dental radiography system, film processors,
      dental veterinary film, a digital imaging system for the diagnosis of equine
      patients and a large body CR filmless scanner used in conjunction with general
      radiographic equipment. In July 2005, the Company was appointed the exclusive
      distributor of general-purpose x-ray systems and components specifically
      designed for all veterinary applications, known in the market under trade names
      “Universal” and “VetTek.” These systems are designed to be either digital or
      film based and allows the veterinarian to perform either dental or general
      radiography on companion animals.





**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 acquisitions completed in 1997. 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, EVA, ImageVet, Digi-Vet Equine,
      and DIGIVET, 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 in the Company’s
      products, the Company’s technology may not preclude or inhibit competitors from
      producing products that have identical performance 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. This royalty will
      cease
      in early FY 2007, when the Company introduces a modified version of its software
      which does not use the third party’s software format for the computer display of
      the 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
      operations. The Company is dependant to some degree on this third-party license,
      and the loss or inability to replace these license could result in increased
      costs as well as initial delays or reductions in product shipments. The
      principal technology applied to the construction of the Company’s other products
      may be considered proprietary.





5




**Research
      and Development**





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


**Year
      Ended June 30** ,


2006
            
            2005
            
            2004$696,700
            
            $435,813
            
            $397,444





The
      Company conducts research and development activities internally at its Elmsford,
      New York facility and contracts out certain projects to qualified vendors and
      external consultants. The Company’s research and development efforts and
      technologies have been enhanced by business acquisitions completed prior to
      2001.





**Raw
      Materials**





The
      Company manufactures, assembles, and services its products at its ISO 9001/2000
      (International Standards Organization) certified facility in Elmsford, New
      York.
      The Company’s products are manufactured from parts, components and subassemblies
      obtained from several unaffiliated suppliers and/or fabricated internally at
      its
      manufacturing facility. In most cases, the Company does not utilize any unique
      procedures, nor does it traditionally have difficulties in obtaining raw
      materials or processes, in the design and manufacture of its products. The
      Company does own proprietary designs and tooling to produce the digital x-ray
      sensors, which are in the physical possession of a Company vendor. Although
      the
      Company anticipates that an adequate commercial supply of most raw material
      parts and components will remain available from multiple sources, the loss
      of
      the Company’s relationship with a particular supplier could result in some
      productions delays; however, such a loss is not expected to materially adversely
      affect the Company’s business, as the proprietary design is
      reproducible.





**Warranties**





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





**Sales,
      Marketing and Distribution**





The
      Company’s manufactured products are produced domestically and distributed both
      domestically and internationally to independent dealers and distributors. The
      Company’s products are marketed under the Company’s own trade names and are
      distributed through an extensive network of independent medical, dental, and
      veterinary dealers. These dealers install and service such products. Other
      products are imported from foreign suppliers and sold in North
      America.





The
      Company conducts worldwide marketing and regional sales management efforts
      to
      promote all of its products and brand names. The Company advertises in domestic
      and international trade journals, 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 trade and clinical shows. The Company also maintains
      two separate web sites, which provide an easy-to-navigate, on-line information
      environment, including Company information, product description 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 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 facility is 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.





6




The
      Company is also subject to other federal, state, and local laws, regulations
      and
      recommendations relating to safe working conditions and manufacturing
      processes.





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
      any outstanding product liability claims.





**Seasonal
      Nature**





Historically,
      the Company’s fourth quarter revenues of any fiscal year have been higher than
      the subsequent first quarter’s revenues. This is due to aggressive fourth
      quarter marketing, followed by lower customer demand in the first fiscal quarter
      attributed to summer holidays and traditional foreign business closings during
      July and August. The Company expects net sales and operating results to continue
      to reflect this seasonality.





**Working
      Capital Practices**





The
      Company believes its practices regarding inventories, receivables or other
      items
      of working capital to be typical for the industry involved. On September 21,
      2004, the Company renewed its senior secured credit facility (the “Renewed
      Revolving Credit Loan”), with its existing senior secured lender, for an
      additional three-year period. The maximum borrowing permitted under the Renewed
      Revolving Credit Loan is lower than that under the prior credit facility, based
      on the Company’s current requirements. However, the Renewed Revolving Credit
      Loan has more favorable terms, including a lower interest rate and less
      stringent reporting requirements, than that under the prior credit facility
      and
      gives the Company the ability to borrow on a specific amount of foreign accounts
      receivable. The Renewed Revolving Credit Loan replaced the existing senior
      credit facility (the “Original Revolving Credit Loan”). The Renewed Revolving
      Credit Loan consists of a $2.5 million revolving line of credit, which is
      secured by all of the Company’s inventory, accounts receivable, equipment,
      officer life insurance policies and proceeds thereof, trademarks, licenses,
      patents and general intangibles. It is believed that the Renewed Revolving
      Credit Loan is sufficient to finance the Company’s ongoing working capital
      requirements for the foreseeable future. The Renewed Revolving Credit Loan
      has
      an interest rate of 1.375% over the prime rate, currently at 8.25%, has a
      specific formula to calculate available funds based on eligible accounts
      receivable and inventory, and has certain reporting requirements to the senior
      secured lender. The Renewed Revolving Credit Loan requires that certain
      financial ratios and net worth amounts be maintained. The Renewed Revolving
      Credit Loan provides for increases in the interest rate charged on monies
      outstanding under specific circumstances.





As
      of June
      30, 2006, the Company was in compliance with all the terms and conditions of
      its
      Renewed Revolving Credit Loan, as amended. In connection with the initial
      closing of the Original Revolving Credit Loan, the Company issued a 5-year
      warrant to the lender for the purchase of 100,000 shares of the Company’s common
      stock at $.32 per share, subject to adjustment for all subsequent issuances
      of
      stock. This warrant expires on September 21, 2006. The Black-Scholes Method
      was
      used to value the warrant, and the stock price was based on the stock price
      the
      day prior to closing, plus 10%, as stipulated in the Loan and Security Agreement
      for the Original Revolving Credit Loan. In August 2006, the lender chose to
      exercise a portion of the warrant and converted approximately 66,666 shares
      covered by the warrant into 55,738 shares of common stock in a cashless exercise
      in a manner as specified in the warrant.





7





**Customers**





In
      the
      Company’s fiscal years ended June 30, 2006 and 2005 (“Fiscal Years 2006 and
      2005”) there were no sales to any one customer, which accounted for 10% or more
      of the Company’s total consolidated sales. In the Company’s fiscal year ended
      June 30, 2004 (“Fiscal Year 2004”), sales of dental imaging equipment to Henry
      Schein Inc., accounted for approximately 11% of the Company’s total consolidated
      sales. Management believes that the loss of any one customer would have an
      adverse effect on the Company’s consolidated business for a short period of
      time, as the Company seeks new customers.





**Backlog
      Orders**





As
      of June
      30, 2006, the Company’s backlog of orders for its products was approximately
      $1,066,839 as
      compared to $1,089,500 as of June 30, 2005. All of the orders included in the
      backlog at June 30, 2006 are scheduled for delivery on or before June 30, 2007.
      Spare part sales are not included in the Company’s backlog calculations. In the
      opinion of the Company, fluctuations in the backlog and its size at any given
      time are not necessarily indicative of intermediate or long-term trends in
      the
      Company’s business. Much of the Company’s backlog can be canceled or the
      delivery dates of orders can be accelerated or extended without penalty.
      Delivery of capital equipment is frequently subject to changing budget
      conditions of medical institutions and end user clinical practitioners, which
      can vary significantly between fiscal periods.





**Government
      Contracts**





The
      Company did not fulfill any significant contracts in Fiscal Years 2006 and
      2005
      with the United States Government that were material to the Company’s
      consolidated business. The Company’s policy is to be responsive to all
      governmental Requests for Quotations (RFQ), which can be fulfilled by items
      within the scope of the Company’s product lines.





**Competition**





The
      Company’s products utilize mechanical, as well as analog and digital electronic,
      technologies. The Company is subject to both foreign and domestic competition.
      The competition is characterized by significant investment in research and
      development of new technologies, products and services. Some competitors are
      well established in the film processor manufacturing and distribution businesses
      and may have greater financial, distribution


resources
      and facilities than the Company. With respect to all of its products, the
      Company competes on the basis of price, features, product quality, applications,
      engineering, promptness of delivery and customer service. The Company purchases
      certain products from others for resale on an exclusive or non-exclusive basis,
      which may be subject to competition from other independent
      distributors.





The
      Company also competes in the dental imaging market on the basis of its
      proprietary and patented technologies. Certain competitors have significant
      or
      greater resources and revenues in electronic digital imaging technologies and
      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 have
      potentially adversely affect the Company’s business. Many of the Company’s
      competitors are much larger with significantly greater financial, 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.





8





**Environmental**





The
      Company believes it is in compliance with the current laws and regulations
      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, 2006, the Company employed 83 people on a full-time basis. The Company
      has
      no collective bargaining agreements and considers its relationship with its
      employees to be satisfactory.





**d)
      Financial Information about Foreign and Domestic Operations and Export
      Sales**





Financial
      information related to foreign and domestic operations and export sales for
      the
      last three fiscal years is as follows:


**FY
              2006**
            
            
            
            
            
            **FY
              2005**
            
            
            
            
            
            **FY
              2004**Domestic
                sales
            
            $
            19,305,971
            
            
            77
            %
            $
            18,858,056
            
            
            82
            %
            $
            16,733,360
            
            
            84
            %Export
                and foreign sales
            
            $
            5,692,301
            
            
            23
            %
            $
            4,277,007
            
            
            18
            %
            $
            3,099,550
            
            
            16
            %Domestic
                operating income
            
            $
            1,036,324
            
            
            
            
            $
            1,354,617
            
            
            
            
            $
            1,466,228Foreign
                operating loss
            
            
            -
            
            
            
            
            
            -
            
            
            
            
            
            ($12,600
            )





Assets
      used in the manufacture of export sales are integrated with the other assets
      of
      the Company.


The
      Company liquidated its foreign subsidiary in September 2003.





**Item
      1A. Risk Factors.**





**Business
      Risks**





*We
      will be dependent on key management and advisors* .
      Our
      success is highly dependent on our ability to attract and retain experienced
      management and industry personnel to supplement our present management team.
      The
      loss of the services or advice of any one or more of these persons, whether
      part
      of the present management or new hires, could have a material adverse effect
      on
      our business. We face considerable competition from other entities in the fields
      in which we operate and with other entities for qualified personnel, many of
      which have significantly greater resources than us. We may be unable to offer
      key employees compensation of the type and quantity that our competitors and
      other entities can offer. There can be no assurance that we will be able to
      attract and retain personnel in the future, and the inability to do so could
      have material adverse effects on us.





*We
      are
      significantly dependent upon the continued availability of Donald Rabinovitch,
      our president and co-chief executive officer, David Vozick, our chairman and
      co-chief executive officer, and Roberto Molteni, our executive vice-president
      of
      technology* .
      We
      currently do not have employment agreements with any of these executive
      officers. The loss or unavailability to us of any of Messrs. Rabinovitch, Vozick
      or Molteni for an extended period of time could have a material adverse effect
      on our business operations and prospects. To the extent that their services
      would be unavailable to us for any reason, we would be required to procure
      other
      personnel to manage and operate us. There can be no assurance that we will
      be
      able to locate or employ such qualified personnel on acceptable
      terms.





*We
      are
      dependent on our key personnel and ability to recruit, train and retain
      technology professionals* .
      Our
      current and planned operations will depend in large part on our ability to
      identify, hire, train and retain technology professionals and sales and senior
      management personnel who can provide the technical, strategic, creative,
      marketing and audience development skills required by our clients and for our
      financial success. There is a shortage of qualified personnel in these fields
      and we compete with other companies, both those within the industry in which
      we
      operate and those in other industries, for this limited pool of technology
      professionals and sales and senior management personnel. There is no assurance
      that we will be able to attract, train, or retain such qualified
      personnel.





9




Further,
      additions of new and departures of existing personnel, particularly in key
      positions, can be disruptive, which also could have a material adverse effect
      upon us, the result of which could have a negative impact on our operations
      and
      financial results.





*We
      are
      dependent on a limited number of products and any material decrease in revenues
      from these products could have a adverse impact on our revenue and financial
      position* .
      Our
      revenues primarily are generated from sales of our analog processor products,
      panoramic and intra-oral x-ray machines and, to a lesser extent, other products,
      including digital sensors. We can give no assurance that any of these systems
      and products, or any of the other products which we currently sell, or may
      sell
      in the future, will not be rendered obsolete or inferior as a result of
      technological change, changing customer demands, new product introductions
      or
      other developments. There also can be no assurance that our competitors will
      not
      succeed in developing or marketing technologies, systems and products that
      are
      superior to and/or more commercially attractive than our technologies, systems
      and products. The rendering obsolete or inferior of our technologies, systems
      and products could have a material adverse effect on us.





Further,
      our success will depend in part on our ability to improve and enhance our
      technologies, systems and products timely in comparison to our competitors.
      There can be no assurance that we will be able to do so. Our failure to improve
      and enhance any of our technologies, systems and products in a timely manner
      could have a material adverse effect on us.





*A
      failure to adapt to technological changes within our industry could have an
      adverse effect on our operating results* .
      Our
      success will depend on our ability to keep pace with technological developments
      of new products and services and our ability to fulfill increasingly
      sophisticated customer demands. The medical, dental and veterinary imaging
      equipment and service markets are characterized by rapidly changing technology
      and frequent introductions of new products, services and product and service
      enhancements. There can be no assurance that we will be able to provide the
      products, services and support necessary to remain competitive. If we were
      to
      incur delays in sourcing and developing new products and services or
      enhancements to our current lines of products and services, such delays could
      have a material adverse effect on our operations and financial results.





*We
      are
      subject to substantial competition which could adversely affect our operating
      results* .
      The
      markets in which we operate are highly competitive with respect to performance,
      quality and price. We directly compete with local, regional and national
      manufacturers and distributors of medical, dental and veterinary imaging
      equipment. In the future, we may face further competition from new market
      entrants and possible alliances between existing competitors. Some of our
      competitors have, or may have, greater financial, marketing and other resources
      than us. As a result, competitors may be able to respond more quickly to new
      or
      emerging technologies and changes in customer requirements, benefit from greater
      purchasing economies, offer more aggressive hardware and service pricing to
      customers, or devote greater resources to the promotion of their products and
      services than we are capable of accomplishing. There can be no assurance that
      we
      will be able to successfully compete in the future with such competitors. The
      failure to successfully compete could have an adverse effect on our operating
      results.





*The
      market for technology professional services is intensely competitive, rapidly
      evolving and subject to rapid technological change* .
      We
      expect competition not only to persist, but to increase. Competition may result
      in price reductions, reduced margins and loss of market share. The market for
      our goods and services is rapidly evolving and is subject to continuous
      technological change. As a result, our competitors may be better positioned
      to
      address these developments or may react more favorably to these changes.
      Existing or future competitors may develop or offer strategic services that
      provide significant technological, creative, performance, price or other
      advantages over the services that we offer.





*Our
      growth will depend on our ability to continue to develop our
      brands* .
      We
      believe that strengthening our brands will be critical to achieving widespread
      acceptance of our products and services. Promoting and positioning our brands
      will depend largely on the success of our marketing efforts and ability to
      provide high quality products and services. In order to promote our brands,
      we
      will need to increase our marketing budget and otherwise increase our financial
      commitment to creating and maintaining brand loyalty among our customers. Brand
      promotion activities may not yield increased revenues and, even if they do,
      any
      increased revenues may not offset the expenses that we incur in building our
      brands. If we fail to promote and maintain our brands or incur substantial
      expenses in an unsuccessful attempt to promote and maintain our brands, our
      business would be harmed.





10




*Our
      dependence on third party licenses could have adverse effects* .
      We rely
      on certain software, technology and products that we have licensed from third
      parties, including software, technologies and products that is integrated with
      internally developed software and/or used in our products to perform key
      functions. These third-party licenses may not continue to be available for
      use
      on commercially reasonable terms. Also, the licensed software, technologies
      and
      products may not be appropriately supported, maintained or enhanced by the
      licensors such that the license would not continue to provide the necessary
      commercial benefits to us. In addition, we may not be able to license additional
      software, technologies and products in the future on terms advantageous to
      us.
      The loss of or inability to obtain or replace licenses to, or inability to
      support, maintain and enhance, any of such licensed software, could result
      in
      increased costs, including the expense of internally developing the required
      software, technologies and products, as well as delays or reductions in product
      shipments.





*We
      are
      subject to pricing pressures and variable foreign exchange rates, which could
      result in lower sales revenues and gross profits* .
      We
      believe our prices and payment and delivery terms are competitive. However,
      certain competitors may offer more aggressive pricing and payment terms to
      customers. We have experienced, and expect to continue to experience pricing
      pressure, on our products and services due to competitive factors, including
      industry consolidation. In addition, we have seen a general weakness in the
      U.S.
      economy negatively impacting our operating results as dental, medical and
      veterinary professionals reduced their capital expenditures in response to
      such
      general economic weakness. In an attempt to stimulate sales to existing and
      new
      customers, we believe, that pricing pressures may increase in the future.
      Decreasing prices for our products and services would require us to sell a
      greater number of products and services to achieve the same level of net sales
      and gross profit.





*Seasonality
      can cause fluctuations in our revenues and operating results* .
      We have
      seen seasonal variations in our revenues and operating results. Our fourth
      quarter results for a fiscal year have historically exceeded corresponding
      revenues and operating results for the first quarter of the following fiscal
      year. We expect our net sales and operating results to continue to reflect
      this
      seasonality. The seasonality of our operating results could result in
      fluctuations of the market price of our common stock.





*We
      have had and may continue to have fluctuations in our quarterly operating
      results* .
      Our
      quarterly operating results have and, in the future, may fluctuate
      significantly, depending on a variety of factors, many of which are outside
      of
      our control. Factors that may affect our quarterly results include:


•  the
      demand
      for our products and services;


•  the
      size,
      timing and timely fulfilment of orders for our products and
      services;


•  the
      level
      of product, price and service competition;


•  changes
      in
      average selling prices and product mix, which also could affect our profit
      margins;


•  changes
      in
      our sales incentive strategy, as well as sales personnel changes;


•  the
      mix of
      direct and indirect sales, product returns and rebates;


•  federal,
      state or local government regulation;


•  our
      ability to upgrade and develop our systems and infrastructure to accommodate
      growth;


•  our
      ability to attract and retain qualified personnel;


•  consumer
      trends;


•  the
      success of our brand building and marketing campaigns;


•  capital
      spending budgets of our customers;


•  the
      timing, size and mix of product and service orders and deliveries;
      and


•  general
      economic conditions and economic conditions specific to the industries in which
      we compete.





*Our
      operating expenses and capital expenditures are based in large part on our
      expectations of future revenues* .
      Therefore, if revenue levels are below expectations, operating results are
      likely to be adversely affected. Net income may be disproportionately affected
      by an unanticipated decline in revenue for a particular quarter because a
      relatively small amount of our expenses will vary with our revenue in the short
      term. As a result, we believe that period-to-period comparisons of our results
      of operations are not and will not necessarily be meaningful and should not
      be
      relied upon as any indication of future performance. Due to all of the foregoing
      factors, it is likely that in some future quarter our operating results will
      be
      below expectations.





*We
      are
      dependent on third-party distributors and a loss of any of these distributors
      could adversely affect us* .
      We
      distribute our products through third-party, independent distributors.
      Historically, a limited number of distributors have accounted for a significant
      portion of our overall revenues. In general, these distributors could
      discontinue marketing our products with little or no notice. Certain
      distributors also could market products which compete with our products. The
      loss of or significant reduction in revenues generated through one or more
      of
      our distributors could have a material adverse effect on our operating results
      and financial position.





11




*There
      are a number of uncertainties associated with international sales that could
      adversely affect us* .
      In each
      of our last three fiscal years, sales to customers outside of the United States
      exceeded 16% of our overall sales. We anticipate that international sales will
      continue to account for a similar portion of our overall sales revenue.
      International revenues are subject to a number of uncertainties, including,
      but
      not limited to:


•  contracts
      may be difficult to enforce and receivables difficult to collect;


•  foreign
      customers and distributors may require longer payment cycles,


•  foreign
      governments may impose additional withholding taxes or otherwise tax our foreign
      income, as well as impose tariffs or adopt other restrictions on foreign
      trade;


•  fluctuations
      in exchange rates may affect product demand;


•  United
      States export licenses may be difficult to obtain; and


•  intellectual
      property rights in foreign countries may be difficult or impossible to
      enforce.





Moreover,
      many foreign countries have their own regulatory approval requirements for
      the
      sale of our products. As a result, our introduction of new products into
      international markets could be hindered, costly and/or time-prohibited. There
      can be no assurance that we will be able to obtain the required regulatory
      approvals on a timely basis, if at all.





*We
      are
      subject to the uncertainty of litigation results that could adversely impact
      our
      financial position* .
      We are
      subject to a variety of legal actions relating to our business operations.
      Recent court decisions, legislative activity and regulatory enforcement may
      increase our exposure for claims by third-parties, including environmental
      claims. In some cases, substantial punitive damages may be sought. We currently
      have insurance coverage for some of these potential liabilities. Other potential
      liabilities may not be covered by insurance. In addition, insurers may dispute
      coverage or the amount of insurance may not be sufficient to cover the damages
      awarded. Further, certain types of damages, such as punitive damages, may not
      be
      covered by insurance and insurance coverage for all or certain forms of
      liability may become unavailable or prohibitively expensive in the future.
      An
      adverse outcome from a litigation matter could have a material adverse effect
      on
      us.





*We
      are
      subject to regulatory and legislative risks that could adversely affect our
      operations* .
      We must
      obtain certain approvals and marketing clearances from governmental authorities,
      including the federal Food and Drug Administration (the “FDA”) and similar
      health authorities in foreign countries, to market and sell our products
      domestically and in such foreign countries. The FDA regulates the marketing,
      manufacturing, labeling, packaging, advertising, sale and distribution of
      medical devices, as do various foreign authorities in their respective
      jurisdictions. The FDA also enforces additional regulations regarding the safety
      of equipment utilizing x-rays. Various states impose similar regulations.
      Certain of our manufactured and imported products and product components,
      including our x-ray systems and sensors, are currently regulated by such
      authorities and certain of our future products will require approval or
      marketing clearance from such various governmental authorities, including the
      FDA. In addition, various additional requirements are imposed upon us to make
      us
      eligible to sell products to the federal government.





The
      FDA
      review process typically requires extended proceedings pertaining to the safety
      and efficacy of new products. A Section 510(k) application is required in order
      to market a new or modified medical device. If specifically required by the
      FDA,
      a pre-market approval may be necessary. This procedure, which must be completed
      prior to marketing a new medical device, is potentially expensive and time
      consuming. The procedure may delay or hinder a product’s timely entry into the
      marketplace. Moreover, there can be no assurance that the review or approval
      process for these products by the FDA or any other applicable governmental
      authorities will occur in a timely fashion, if at all, or that additional
      regulations will not be adopted or current regulations amended in such a manner
      as will adversely affect us. In addition, final approval does not assure, in
      any
      manner, the success of the approved product.





We
      also
      are subject to other federal, state and local laws, regulations and
      recommendations relating to safe working conditions and manufacturing
      practices.





*International
      sales of our products are subject to the regulatory agency product registration
      requirements of each country in which our products are sold* .
      The
      regulatory review process varies from country to country and may in some cases
      require the submission of clinical data. We typically rely upon our distributors
      in foreign countries to obtain the required regulatory approvals.





12




The
      extent
      of government regulation that might result from any future legislation or
      administrative action cannot be accurately predicted. Failure to comply with
      regulatory requirements could have a material adverse effect on our operating
      results and financial condition.





In
      addition to legislative and regulatory concerns directly affecting us, our
      customers operate in the health care industry, which is highly regulated. Both
      existing and future governmental regulations directed at our customers could
      adversely impact us indirectly. Further, cost-containment efforts by health
      maintenance organizations may adversely affect the potential market for our
      products.





*We
      have product warranty exposure which could adversely affect our operating
      results and financial condition* .
      We
      generally warrant each of our products against defects in materials and
      workmanship for a period of one year from the date of shipment, plus any
      extended warranty period purchased by the customer and three years for our
      digital sensors. The need for warranty service could have a material adverse
      effect on us by, among other things, requiring additional expenditures for
      parts
      and personnel, as well as damaging our reputation and goodwill.





*There
      is a potential for product recall and product liability claims* .
      Our
      products may be subject to recall for unforeseen reasons. In addition, certain
      applications, including projected applications, of our products entail the
      risk
      of product liability claims. Such risks will exist even with respect to those
      products that have received, or in the future may receive, regulatory approval
      for commercial sale. These claims may be made by our customers, distributors
      or
      others. Although we have maintained insurance coverage related to product
      liability claims, no assurance can be given that product liability insurance
      coverage will continue to be available or, if available, that it can be obtained
      in sufficient amounts or at reasonable cost or that it will be sufficient to
      cover any claims that may arise. We do not maintain any insurance relating
      to
      potential recalls of our products. Costs associated with potential product
      recalls or product liability claims could have a material adverse effect on
      us.





*Our
      inability to protect our intellectual property rights could prevent us from
      selling our products and hinder our financial performance* .
      The
      technology and designs underlying our products may not be fully protected by
      patent rights. Our future success is dependent primarily on non-patented trade
      secrets and on the innovative skills, technological expertise and management
      abilities of our employees. Even with the patent rights in our products, our
      technology may not preclude or inhibit competitors from producing products
      that
      have identical performance as our products. In addition, we cannot guarantee
      that any protected trade secret could ultimately be proven valid if challenged.
      Any such challenge, with or without merit, could be time consuming to defend,
      result in costly litigation, divert the attention and resources of our
      management and, if successful, require us to pay monetary damages.





*Our
      products may infringe the intellectual property rights of others which may
      cause
      us to incur unexpected costs or prevent us from selling our
      products* .
      We
      believe our products do not infringe on the intellectual property rights of
      others. However, there can be no assurance that infringement claims will not
      be
      asserted against us in the future or that, if asserted, any infringement claim
      will be successfully defended. We also may be subject to legal proceedings
      and
      claims from time to time, including claims of alleged infringement of the
      patents, trademarks and other intellectual property rights of third parties.
      Intellectual property litigation is expensive and time-consuming and could
      divert the attention of our management away from running our business and
      seriously harm our business. If we were to discover that our products violated
      the intellectual property rights of others, we would have to obtain licenses
      from these parties in order to continue marketing our products without
      substantial re-engineering. We might not be able to obtain the necessary
      licenses on acceptable terms or at all and, if we could not obtain such
      licenses, we might not be able to re-engineer our products successfully or
      in a
      timely fashion. If we fail to address any infringement issues timely and
      successfully, we would be forced to incur significant costs, including damages
      and potentially satisfying indemnification obligations that we have with our
      customers, and we could be prevented from selling certain of our products.





*Price
      competition could reduce market share or cause us to reduce prices to retain
      or
      recapture market share, which could reduce revenues and margins* .
      Our
      operations generally face intense competition in all markets. The medical,
      dental and veterinary imaging industries have historically experienced price
      competition. This price competition could result in us losing market share
      in
      some markets or force us to reduce prices and thereby our profit margins in
      order to retain or recapture market share. Increased price competition in the
      future could further reduce revenues, profit margins and backlog.





*Increased
      advertising or better marketing by our competitors could cause us to lose market
      share and revenues, or cause us to incur increased costs in order to retain
      or
      recapture market share* .
      Extensive advertising or effective marketing by competitors could cause us
      to
      lose market share and revenues, or cause us to increase our own marketing costs.
      In addition, competitors may change the types or mix of products or services
      offered. These changes may attract customers, causing us to lose market share
      and revenue or to incur costs to vary our own types or mix of products or
      services in response to such competitive factors.





13




If
      we do
      not respond effectively to changing consumer preferences, our market share,
      revenues and profitability could decrease. Our future market share, revenues
      and
      profits will depend in part on our ability to anticipate, identify and respond
      to changing consumer preferences of professionals who utilize medical, dental
      and veterinary imaging equipment. We may not correctly anticipate or identify
      trends in consumer preferences, or we may identify them later than our
      competitors do. In addition, any strategies we may implement to address these
      trends may prove excessively costly, incorrect or ineffective.





Changes
      or
      increases in, or failure to comply with, regulations applicable to our business
      could increase our costs. The industries in which we compete are subject to
      extensive regulation and licensing requirements under federal, state and local
      laws.





**Risks
      Involving Our Common Stock and Corporate Governance**





*Limited
      directors’ liability could prevent our shareholders from holding our directors
      responsible for a lack of care.* Our
      certificate of incorporation provides that our directors will not be held liable
      to us or our shareholders for monetary damages upon breach of a director’s
      fiduciary duty, except to the extent otherwise required by law.





*There
      is significant volatility in our stock prices.* The
      market
      for our common stock is highly volatile. The trading price of our common stock
      could widely fluctuate in response to, among other things:


•  quarterly
      variations in our operating and financial results;


•  announcements
      of technological innovations or new products by us, our vendors or our
      competitors;


•  changes
      in
      prices of our or our competitors’ products and services;


•  changes
      in
      the product and service mix of our sales;


•  changes
      in
      our revenue and revenue growth rates as a whole or for individual geographic
      areas, products, services or product and sales categories;


•  unscheduled
      system interruptions;


•  our
      ability to timely develop, introduce and market new products, as well as
      enhanced versions of our current products;


•  additions
      or departures of key personnel;


•  changes
      in
      financial estimates by securities analysts;


•  conditions
      or trends in the medical imaging industries;


•  changes
      in
      the market valuations of other medical imaging companies;


•  developments
      in governmental regulations of medical imaging products;


•  announcements
      by us or our competitors of significant acquisitions, strategic partnerships,
      joint ventures or capital commitments;


•  sales
      of
      our common stock or other securities in the open market; and


•  other
      events or factors that may be beyond our control.





Statements
      or changes in opinions, ratings, or earnings estimates made by brokerage firms
      or industry analysts relating to the markets in which we conduct our business
      or
      relating to us or our competitors could result in an immediate and adverse
      effect on the market price of our common stock. In addition, the stock market
      has from time to time experienced extreme price and volume fluctuations which
      have particularly affected the market price for the securities of many companies
      which often have been unrelated to the operating performance of these companies.
      These broad market fluctuations may adversely affect the market price of our
      common stock.





*We
      have no history of paying dividends.* We
      have
      never paid any cash dividends on our common stock and we do not anticipate
      paying any dividends in the foreseeable future. In addition, our ability to
      pay
      dividends to the holders of our common stock is limited under our credit
      facility with our bank.





*We
      may
      issue substantial amounts of additional shares of our common stock without
      shareholder approval, which could dilute the equity interests of our
      shareholders.* We
      have
      outstanding an aggregate of 12,401,732 shares of our common stock. We also
      have
      5 million shares of serial preferred stock authorized but unissued, all of
      which
      shares are not reserved for specific purposes, and an additional (a) 1,388,400
      shares of our common stock issuable upon the exercise of stock options granted
      or available for grant under our various stock plans and (b) 83,334 shares
      of
      our common stock issuable upon exercise of warrants we previously granted and
      are currently outstanding (including the 50,0000 warrants held by certain of
      the
      selling securityholders, the underlying shares for which are being offered
      pursuant to a registered resale prospectus). All of such shares may be issued
      without any action or approval by our shareholders. Any shares issued by us
      in
      the future would further dilute the percentage ownership held by our
      shareholders.





14




*Substantial
      sales of our common stock could adversely affect the market price of our common
      stock.* Sales
      of a
      substantial number of shares of our common stock could adversely affect the
      market price of our common stock by introducing a large number of sellers to
      the
      market. This could cause the market price of our common stock to
      decline.





*Our
      acquisition strategy may result in dilution to our shareholders.* Our
      business strategy to increase our market share in the industries in which we
      compete includes the possibility of strategic acquisitions of other businesses,
      technologies and services. We anticipate that future acquisitions will require
      cash and issuances of our capital stock, including our common stock. To the
      extent we are required to pay cash for any acquisition, we anticipate that
      we
      would be required to obtain additional equity and/or debt financing. Equity
      financing would result in dilution for our then current shareholders. Such
      stock
      issuances and financing, if obtained, may not be on terms favorable to us and
      could result in substantial dilution to our shareholders at the time(s) of
      these
      stock issuances and financings.





**Item
      2. Properties**





The
      Company’s sole executive offices and manufacturing facility are located in
      Elmsford, New York. This facility, which comprises approximately 47,735 square
      feet, is subject to a lease expiring on December 31, 2009 with a current rental
      of $525,085 per year, through the lease term, plus increases for real estate
      taxes, utility costs and common area charges. The Company believes its facility
      is well maintained, in good operating condition and sufficient to meet the
      Company’s present and anticipated needs.





**Item
      3. Legal Proceedings**





The
      Company is a defendant in an environmental claim relating to 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 are of a general
      commercial nature. This claim was originally filed in 1998 by the federal
      government in United States District Court and the State of New Jersey, 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
      companies, in an alternative dispute resolution (ADR) process for smaller
      claims. An initial settlement was offered by this group, however, to date,
      no
      settlement has been reached. The potential cost to the Company has been assessed
      at $23,100. The Company has accrued $11,550 in Fiscal year 2006, which
      represents the Company’s estimate of its potential liability, net of the
      Company’s insurance carrier’s agreed upon contribution towards a potential
      settlement. The Company does not expect to receive any further information
      until
      a status conference is held in mid-September 2006. The Company cannot, at this
      time, assess the amount of liability above its accrued amount, if any, that
      could result from any adverse final outcome of this environmental complaint.
      The
      Company’s insurance carrier has agreed to equally share with the Company the
      defense costs incurred in this environmental claim.





On
      February 8, 2005 the Company finalized a settlement relating to a separate
      environmental claim filed in 2001 as a civil complaint by the current owners
      of
      the same property owned by the Company between August 1984 and June 1985. This
      action was filed in the Superior Court of New Jersey, Morris County, and alleged
      that  the
      Company’s discontinued graphic art camera subsidiary had contaminated a portion
      of the site during its manufacturing process prior to 1985. The Settlement
      included a Release and Indemnification as well as a Stipulation of Dismissal
      with Prejudice. The Company paid $325,000 on February 18, 2005, which
      represented the Company’s entire liability under this settlement offer, net of
      the Company’s insurance carrier’s agreed upon contribution towards the total and
      final settlement.





The
      Company is a defendant (with several other parties) in a product liability
      insurance action, which was filed in May 2005 in the Superior Court in Hartford,
      Connecticut and later transferred to the United States District Court, District
      of Connecticut. The plaintiff, through their insurance company, claims that
      the
      Company’s equipment caused damage to the plaintiff’s premises in May 2003. The
      complaint seeks approximately $200,000 in compensatory damages. Two additional
      suits seeking approximately $113,000 in damages were filed in May 2006 in the
      Superior Court in Hartford, Connecticut as subrogation claims relating to the
      same incident. The Company maintains that its equipment was not the cause of
      the
      incident or the resultant damage. The Company’s insurance carriers, and their
      attorneys, are assisting in the Company’s defense in this matter. The Company
      does not believe that the final outcome of this matter will have a material
      adverse effect on the Company.





15




From
      time
      to time, the Company is 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**





There
      were
      no matters submitted to a vote of security holders during the fourth quarter
      of
      Fiscal Year 2006.




16


**Part
      II**





**Item
      5. Market for the Registrant’s Common Equity and Related Stockholder
      Matters**





**Market
      Information**





The
      Company’s Common Stock, par value $.01 per share, is the only class of the
      Company’s common equity securities outstanding and is traded on the OTC Bulletin
      Board (Symbol “AFPC”), maintained by the NASD Inc. The following table, based on
      information supplied by Commodity Systems Inc., shows the range of the closing
      high and low bid information for the Company’s 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.





Quarter
                ended
            
            High
                Bid
            
            Low
                BidSeptember
                30, 2004
            
            
            1.85
            
            
            1.21December
                31, 2004
            
            
            1.51
            
            
            1.11March
                31, 2005
            
            
            1.70
            
            
            1.12June
                30, 2005
            
            
            2.25
            
            
            1.40September
                30, 2005
            
            
            3.10
            
            
            2.00December
                31, 2005
            
            
            2.15
            
            
            1.70March
                31, 2006
            
            
            2.40
            
            
            1.75June
                30, 2006
            
            
            2.75
            
            
            2.00





The
      market
      for the Company’s Common Stock is highly volatile and the trading price of the
      Common Stock could widely fluctuate in response to numerous factors. In
      addition, the stock market has from time to time experienced extreme price
      and
      volume fluctuations, which have particularly affected the market price for
      the
      securities of many companies, which often have been unrelated to the operating
      performance of these companies. These broad market fluctuations may adversely
      affect the market price of the Company’s Common Stock.





**Holders**





As
      of
      September 8, 2006 the closing bid price for the Company’s Common Stock, as
      reported on the OTC Bulletin Board, was $1.85, and there were 317 shareholders
      of record of the Common Stock. The Company estimates, based on surveys conducted
      by its transfer agent in connection with the Company’s 2005 Annual Meeting of
      Shareholders, that there are approximately 1,100 beneficial holders of the
      Common Stock.





**Dividends**





No
      cash
      dividends have been declared on the Company’s Common Stock to date and the
      Company anticipates that any earnings will be retained for use in the Company’s
      business for the foreseeable future. The Company currently is prohibited from
      paying cash dividends on its Common Stock under the terms and conditions of
      its
      Renewed Revolving Credit Loan. The Company currently does not have a set policy
      with respect to payment of dividends. Any future determination to pay cash
      dividends will be at the discretion of the Company’s Board of Directors and will
      be dependent upon the Company’s financial condition, results of operations,
      capital requirements and other relevant factors.





**Securities
      authorized for issuance under equity compensation plans**





The
      following table sets forth as of June 30, 2006:


o
            the
                number of shares of the Company’s 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),


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


o
            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).





17




(a)
            
            (b)
            
            (c)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
                incolumn
                (a))Equity
                compensation plans approved by security holders (1)
            
            
            827,900
            
            $
            .87
            
            
            560,500Equity
                compensation plan not approved by security holders
            
            
            0
            
            
            0
            
            
            0Total
            
            
            827,900
            
            $
            .87
            
            
            560,500





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





18


**Item
      6. Selected Financial Data**





**As
                of and for the Years Ended June 30,**2006
            
            2005
            
            2004
            
            2003
            
            2002NET
                SALES
            
            $
            24,998,272
            
            $
            23,135,063
            
            $
            19,832,910
            
            $
            18,043,668
            
            $
            20,086,888OPERATING
                INCOME (LOSS)
            
            
            1,036,324
            
            
            1,354,617
            
            $
            1,453,628
            
            $
            (545
            )
            $
            391,408INCOME
                (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
                PRINCIPLE
            
            
            1,005.348
            
            
            1,899,930
            
            $
            1,345,467
            
            $
            (218,338
            )
            $
            84,002CUMULATIVE
                EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE (a)
            
            $
            --
            
            $
            --
            
            $
            --
            
            $
            (1,297,069
            )
            $
            --NET
                INCOME (LOSS)
            
            
            1,005,348
            
            
            1,899,930
            
            $
            1,345,467
            
            $
            (1,515,407
            )
            $
            84,002EARNINGS
                (LOSS) PER SHARE BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
                PRINCIPLEBASIC
            
            $
            .10
            
            $
            .20
            
            $
            .15
            
            $
            (.02
            )
            $
            .01DILUTED
            
            $
            .10
            
            $
            .19
            
            $
            .14
            
            $
            (.02
            )
            $
            .01NET
                EARNINGS (LOSS) PER SHAREBASIC
            
            $
            .10
            
            $
            .20
            
            $
            .15
            
            $
            (.16
            )
            $
            .01DILUTED
            
            $
            .10
            
            $
            .19
            
            $
            .14
            
            $
            (.16
            )
            $
            .01TOTAL
                ASSETS
            
            $
            14,340,564
            
            $
            8,153,396
            
            $
            6,244,895
            
            $
            6,043,855
            
            $
            7,849,510LONG-TERM
                DEBT
            
            $
            --
            
            $
            --
            
            $
            222,223
            
            $
            630,556
            
            $
            1,180,556SHAREHOLDERS’
                EQUITY
            
            $
            5,924,746(b
            )
            $
            4,662,631
            
            $
            2,665,396
            
            $
            1,319,929
            
            $
            2,822,717SHAREHOLDERS’
                EQUITY PER COMMON SHARE
            
            $
            .62(b
            )
            $
            .50
            
            $
            .29
            
            $
            .14
            
            $
            .30COMMON
                SHARES OUTSTANDING, at end of period
            
            
            12,345,994
            
            
            9,407,717
            
            
            9,270,617
            
            
            9,270,617
            
            
            9,270,617CASH
                DIVIDENDS PER COMMON SHARE
            
            
            none
            
            
            none
            
            
            none
            
            
            none
            
            
            none




(a)
            Upon
                adoption of SFAS 142 in the first quarter of Fiscal Year 2003, the
                Company
                recorded a one-time, non-cash charge of approximately $1,297,069,
                to
                reduce the carrying value of its goodwill. Such charge is non-operational
                in nature and is reflected as a cumulative effect of an accounting
                change.
                See Note 1 to the Consolidated Financial Statements for further discussion
                and required disclosures.




(b)
            The
                amounts for fiscal year 2006 do not include the private placement
                the
                Company completed in May 2006. The Company sold a total of 2,777,777shares
                of its common stock at $1.80 per share to a group of selected investors.
                The Company filed a registration statement which was declared effective
                on
                July 14, 2006. However, if the registration statement is subsequently
                suspended for a specified period of time, the Company could be required
                to
                pay a penalty of 1% of the financing per month to the investors.
                Additionally, the Company is required to file amendments to the
                registration statement as necessary to keep the registration effective
                for
                24 months from the closing date. Accordingly, these proceeds have
                been
                classified as temporary equity on the accompanying June 30, 2006
                balance
                sheet, and will be reclassified to shareholder’s equity upon the
                termination of the 24 month period.




19




**Item
      7. Management’s Discussion and Analysis of Financial Condition and Results of
      Operation**





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.





**Capital
      Resources and Liquidity**





The
      Company’s working capital increased by approximately $5,631,600 between Fiscal
      Year 2006 and Fiscal Year 2005. This increase is principally due to the private
      placement the Company completed in May 2006, whereby the Company sold 2,777,777
      shares of stock and raised $4.83 million, net of fees and expenses. Working
      capital also increased this year from internally generated funds, increases
      in
      inventory, with corresponding reductions in the revolver debt, and offset by
      increases in accounts payable and accrued expenses, and scheduled payments
      on
      the subordinated debt. The Company used the current availability from the
      revolving line of credit to make the required principal payments and, in April
      2006, repaid the final subordinated note. In January 2006, the Company
      completely repaid its borrowings on its revolver debt and did not borrow any
      additional funds through June 2006.





Operating
      cash flows were slightly lower in the twelve months ended June 2006 compared
      to
      June 2005 due to a lower operating income and the increase in other assets.
      In
      the current twelve-month period, the Company repaid approximately $675,000
      in
      subordinated debt and revolver payments and had no outstanding debt as of June
      30, 2006.





The
      Company’s higher sales in Fiscal Year 2006 increased cash collections, and was
      used to reduce debt whenever possible. A slight increase in customers using
      national credit cards and wire transfers has expedited the collection process.
      The Company is continuing to increase its finished goods inventory levels,
      so as
      to better satisfy worldwide customer demand. The Company has not changed its
      payment policies available to its significant vendors, nor revised its payment
      terms to its customers.





On
      May 2,
      2006, the Company completed a private placement of its common stock to a group
      of selected institutional and other accredited investors. The Company sold
      a
      total of 2,777,777 shares of its common stock at $1.80 per share. The Company
      has granted the investors certain registration rights with respect to the resale
      of the shares acquired. The Company intends to use the net proceeds for working
      capital, new product development, general corporate purposes and, possibly,
      for
      strategic acquisitions in the medical, dental and/or veterinary imaging
      equipment markets. There currently are no material commitments or arrangements
      with respect to any of the net proceeds of the private placement.





With
      respect to the above described financing, the Company filed a registration
      statement which was declared effective on July 14, 2006. If this registration
      statement is subsequently suspended for a specified period of time, the Company
      could be required to pay a penalty of 1% of the financing per month to the
      investors. Additionally, the Company is required to file amendments to the
      registration statement as necessary to keep the registration effective for
      24
      months from the closing date. In accordance with the provisions of EITF Topic
      D-98, the net proceeds from the private placement are classified as temporary
      equity on the accompanying June 30, 2006 balance sheet. The financing amount
      will be reclassified to shareholder’s equity upon the termination of the 24
      month period.





Effective
      March 28, 2006, the Company issued an aggregate of 50,000 warrants to a total
      of
      seven designees of an investment banking firm in connection with the Company’s
      retention of such firm to provide advisory services to the Company as part
      of
      the Company’s strategy to increase its market share in the industries in which
      the Company competes. Each of such warrants entitles its holder to purchase
      one
      share of Company common stock at a purchase price of $1.98 per share. The
      warrants expire on March 27, 2011. The Black-Scholes option pricing method
      was
      used to value the warrant.





On
      September 21, 2004, the Company renewed its senior secured credit facility
      (the
“Renewed Revolving Credit Loan”) with its existing senior secured lender for an
      additional three-year period. The Renewed Revolving Credit Loan replaced the
      existing senior credit facility (the “Original Revolving Credit Loan”).The
      maximum borrowing permitted under the Renewed Revolving Credit Loan is lower
      than that under the prior credit facility, based on the Company’s current
      requirements. However, the Renewed Revolving Credit Loan has more favorable
      terms, including a lower interest rate and less stringent reporting
      requirements, than that under the Original Revolving Credit Loan and gives
      the
      Company the ability to borrow on a specific amount of foreign accounts
      receivable The Renewed Revolving Credit Loan consists of a $2.5 million
      revolving line of credit, which is secured by all of the Company’s inventory,
      accounts receivable, equipment, officer life insurance policies and proceeds
      thereof, trademarks, licenses, patents and general intangibles. The Company
      believes that the Renewed Revolving Credit Loan is sufficient to finance the
      Company’s ongoing working capital requirements for the foreseeable future. The
      Renewed Revolving Credit Loan has an interest rate of 1.375% over the prime
      rate, currently at 8.25%, has a specific formula to calculate available funds
      based on eligible accounts receivable and inventory, and has certain reporting
      requirements to the senior secured lender. The Renewed Revolving Credit Loan
      also requires that certain financial ratios and net worth amounts be maintained
      by the Company. The Renewed Revolving Credit Loan provides for increases in
      the
      interest rate charged on monies outstanding under specific circumstances. As
      of
      June 30, 2006, there were no amounts outstanding under the Renewed Revolving
      Credit Loan.




20




As
      of June
      30, 2006, the Company was in compliance with all the terms and conditions of
      the
      Renewed Revolving Credit Loan, as amended.





In
      connection with the Original Revolving Credit Loan, the Company issued a 5-year
      warrant to the lender for the purchase of 100,000 shares of the Company’s common
      stock at $.32 per share, subject to adjustment for all subsequent issuances
      of
      stock. This warrant expires on September 21, 2006. The Black-Scholes option
      pricing method was used to value the warrant, and the stock price was based
      on
      the stock price the day prior to closing, plus 10%, as stipulated in the Loan
      and Security Agreement for the Original Revolving Credit Loan. In August 2006,
      the lender chose to exercise a portion of the warrant, and converted
      approximately 66,666 shares covered by the warrant into 55,738 shares of common
      stock in a cashless exercise in a manner as specified in the
      warrant.





A
      subordinated promissory note related to a prior dental company acquisition
      was
      repaid in full in April 2006.





The
      Company’s historical operating cash flows have been positive; however, the
      Company is dependent upon the Renewed Revolving Credit Loan to finance its
      ongoing operations. The Company expects its working capital requirements will
      continue to be financed by operations and from borrowings on the Renewed
      Revolving Credit Loan. It is believed that the Renewed Revolving Credit Loan
      is
      sufficient to finance the Company’s ongoing working capital requirements for the
      foreseeable future. The Company currently believes that there are no significant
      trends, demands, commitments or contingencies, other than an unexpected material
      adverse conclusion to the ongoing environmental litigation case, which are
      reasonably likely to result in a significant increase or decrease in its
      liquidity or capital resources within the foreseeable future. As of June 30,
      2006, the Company had available $1,845,862 of unused credit under the Renewed
      Revolving Credit Loan. As of September 8, 2006, the Company had available
      $1,578,063 of unused credit under the Renewed Revolving Credit Loan. No
      assurances can be given that the Company will have sufficient cash flow in
      the
      long term.





Capital
      expenditures for Fiscal Year 2006 were approximately $205,100, consisting mainly
      of several tooling, foundry and test equipment expenditures related to the
      design, development and production of the new imaging products, costs relating
      to improvements to the Company’s network, email and voice-mail servers, new
      computer equipment for the sales personnel, the purchase of a new modular trade
      show booth for national veterinary exhibitions, the purchase and implementation
      of a new customer relationship management software module and related hardware,
      fully integrated within the Company’s ERP computer system, and other appropriate
      replacements in the normal course of operations. The Company expects to continue
      to finance any future capital requirements principally from internally generated
      funds. The total amount of capital expenditures was limited under the Original
      Revolving Credit Loan, and continues to be limited under the Renewed Revolving
      Credit Loan. However, such terms can be waived by the senior secured lender
      when
      needed. The Company was in compliance with this requirement as of June 30,
      2006.
      Where practical, the Company continues to conserve its cash.





The
      Company has made a concerted effort during Fiscal Year 2006 to have sufficient
      quantities of finished goods inventory available so as to be able to quickly
      fulfill customer demands. That, combined with the anticipated increase in sales
      levels in Fiscal Year 2007, has resulted in an increase in inventory levels,
      accounts payable and accrued expenses as at June 30, 2006 compared to the
      inventory levels, accounts payable, and accrued expenses at June 30, 2005.
      The
      Company also prepared for the extended European summer holiday, when foreign
      vendors usually limit their shipments.





The
      Company is investigating various strategies to increase its market share and
      some of these strategies involve the acquisition of one or more businesses
      in
      the industry and that, if, the Company was to acquire any other business, such
      acquisition would likely involve equity and/or debt financing, possibly also
      utilizing the net proceeds of the above-mentioned private placement. There
      are
      no assurances that the Company will be able to identify the appropriate
      acquisition candidate(s), that the Company will be able to enter into definitive
      agreements with such candidates on terms favorable to the Company, or that
      any
      acquisition would result in increased market share or profits.





21





**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
      Company’s quarterly operating results may fluctuate depending on a variety of
      factors, many of which are not in the Company’s control, including but not
      limited to:


·
            Demand
                for products and services,


·
            The
                level of product, price and service competition,


·
            Changes
                in product mix, which could effect profit
                margins,


·
            Federal,
                state or local government
                regulation,


·
            Consumer
                trends,


·
            Capital
                spending budgets of customers,


·
            General
                economic conditions specific to the Company’s
                industry.





**Fiscal
      2006 vs. Fiscal 2005**





Sales
      increased approximately $1,863,200 or 8.1%, between Fiscal Year 2005 and Fiscal
      Year 2006. A significant portion of this increase is attributable to the
      continued growth of the Company’s digital imaging systems in both the domestic
      and international dental and veterinarian marketplaces. In the third quarter
      FY
      2006, the Company introduced a mobile digital imaging system specifically
      designed for the equine marketplace, which accounted for a considerable portion
      of the increase in sales. Sales of the digital sensor (veterinary and human
      dental applications) showed a 48% increase in the current twelve-month period.
      The balance of the increase in sales is mainly attributable to sales of the
      general-purpose veterinary x-ray systems, introduced in the current fiscal
      year.
      There was a 16% decline in intra-oral and panoramic x-ray systems, as intra-oral
      x-rays are becoming more price-sensitive due to competitive factors.
      Additionally, there was an 8% decrease in analog processor sales due to the
      global transition in diagnostic image recording from analog to digital. The
      Company has continued its efforts to increase worldwide distribution and expand
      and develop new international markets for analog and digital products, resulting
      in a 33% increase in international sales between the two fiscal
      years.





Gross
      profit as a percent of sales decreased slightly (1.4 percentage points) between
      Fiscal Year 2005 and Fiscal Year 2006. Material costs as a percent of sales
      increased .8 percentage points, mainly due a slight change in the product mix,
      with the sale of more distributor goods, which tend to have lower gross margins,
      offset by processing improvements in some of the manufactured products. Due
      to
      the higher sales volumes in the current twelve-month period, labor and overhead
      costs increased approximately $380,200, including related employee benefits,
      shipping and transportation costs and other operating costs.





Selling,
      general, and administrative costs increased approximately $439,300 or 6.1%,
      between Fiscal Year 2005 and Fiscal Year 2006. This increase is due to several
      factors, including: (1) the Company began to expense stock options issued,
      in
      accordance with SFAS No. 123R, (2) marketing and sales costs increased
      approximately $437,000 in the current period, due to the Company aggressively
      pursuing various sales opportunities in both the domestic and international
      markets, with specific emphasis in the growing veterinary markets (these costs
      included increased travel costs, attendance at several national and regional
      clinical exhibitions, additional advertising, and increased operating costs),
      (3) costs associated with the purchase and implementation of a new customer
      relationship management software program (CRM), (4) the Company began accruing
      and funding an employee 401K retirement plan, and (5) an increase in general
      operating expenses, based on increases sales levels. This increase in costs
      was
      partially offset by approximately $300,000 of costs associated with two separate
      environmental lawsuits and accrued in the prior year’s second
      quarter.





Research
      and development costs increased approximately $260,900 or 60%, between Fiscal
      Year 2005 and Fiscal Year 2006. In June 2005, the Company recruited an Executive
      Vice-President of Technology in order to implement the Company’s strategic plans
      for all engineering development focusing on new products in the digital imaging
      field. 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 both hardware and software enhancements. The Company
      also continues to invest in sustaining engineering and related costs for its
      existing products. Research and development costs may fluctuate between
      reporting periods, due to changing research and development consulting
      requirements, 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 digital products.





22




Interest
      expense, net decreased approximately $90,900 or 73%, between Fiscal Year 2005
      and Fiscal Year 2006. In January 2006, the Company repaid the outstanding
      balance on the Renewed Revolving Credit Loan. A subordinated note was repaid
      as
      of December 2004 and another subordinated note was repaid as of April 2006.
      Interest expense only decreased approximately $52,200 due to significantly
      less
      borrowings in Fiscal Year 2006, offset in part by an approximately 2% higher
      interest rate, which was due to an increase in the prime rate, which is the
      basis for establishing the interest rate under the Renewed Revolving Credit
      Loan. The Company recorded approximately $38,700 more in interest income in
      Fiscal Year 2006 due to the private placement equity raise of $4.8 million,
      which has been invested in a U.S. Treasury money market fund.





The
      Company made small federal and state tax payments in March and June 2006 for
      the
      twelve months ended June 30, 2006, based on current earnings and over-payments
      made during Fiscal Year 2005. The small tax benefit recorded as of June 30,
      2006
      includes federal and state income and capital taxes, and related refunds and
      credits received. As of June 30, 2006, the Company had a deferred tax asset
      of
      $680,000, which primarily relates to losses recorded in prior years; the Company
      believes it is likely that it will utilize a portion of these prior year net
      operating loss carry forwards. As of June 30, 2006, the Company had
      approximately $8.2 million in federal net operating loss carryforwards, and
      approximately $13.0 million in state net operating loss
      carryforwards.





**Fiscal
      2005 vs. Fiscal 2004**





Sales
      increased approximately $3,302,200 or 16.6%, between Fiscal Year 2004 and Fiscal
      Year 2005. Approximately 57% of this increase is attributable to the continued
      sales growth of the Company’s digital products in both the domestic and
      international marketplaces. X-ray sales increased approximately 28% in the
      current fiscal year, due to the introduction of new products or product
      enhancements. The balance of the increase in sales is mainly attributable to
      x-ray processor sales, chemistry and the introduction into the veterinary market
      of a CR filmless scanner used in conjunction with general radiographic
      equipment. The Company’s international sales increased 38%, mostly in the dental
      sector, due to sales of the new products.





Gross
      profit as a percent of sales stayed relatively constant between Fiscal Year
      2004
      and Fiscal Year 2005; however, the detail between material costs and labor
      and
      overhead costs showed differences. Material costs, as a percent of sales,
      increased 1.0 percentage points, mainly due to the strength of the Euro related
      to the dollar, which was offset by production improvements in other new products
      and price increases implemented in the third quarter for some of the imported
      products. Labor and overhead costs increased $213,000 due to the significantly
      higher sales volumes in the current fiscal year. However, the relative
      percentage points for labor and overhead costs decreased 1.1 percentage points
      due to the higher sales base.





Selling,
      general, and administrative costs increased approximately $1,351,800 or 23.3%,
      between Fiscal Year 2004 and Fiscal Year 2005. This increase is due to several
      different factors: (1) as of December 31, 2004, the Company had recorded a
      total
      of $305,000 of G&A costs which included associated legal and settlement fees
      related to two separate environmental lawsuits (one of which was settled in
      February 2005), (2) marketing and sales costs increased by approximately
      $843,000 in the current fiscal year due to the Company aggressively pursuing
      various sales opportunities in both the domestic and international markets,
      including increased travel costs, attendance at several national and regional
      clinical exhibitions, additional advertising, and increased operating costs,
      (3)
      consulting costs related to exploring various acquisition opportunities
      increased in the current fiscal year, and (4) increased variable general
      operating costs associated with the 16% increase in sales. The Company
      anticipates continuing to evaluate acquisition opportunities and therefore
      may
      continue to incur related consulting costs in the future. Such costs relating
      to
      acquisition opportunities may vary significantly between fiscal periods
      depending on the extent of acquisition activities.





Research
      and development costs increased slightly, by approximately $38,400 or 9.7%,
      between Fiscal Year 2004 and Fiscal Year 2005. The Company continues to invest
      in the design, development and refinement of new digital imaging products,
      as
      well as to invest in sustaining engineering and related costs for existing
      products. Research and development costs may fluctuate between fiscal periods,
      due to changing research and development consulting requirements, initiation
      or
      completion of certain project tasks, and market demands.





Interest
      expense, net decreased by approximately $31,700 or 20.2% between Fiscal Year
      2004 and Fiscal Year 2005. A subordinated note was repaid as of December 2004,
      and the other subordinated note had a lower principal amount and slightly lower
      interest rate (based on the LIBOR rate of borrowing) in the current fiscal
      year.
      The average revolving credit loan balance in Fiscal Year 2005 was approximately
      $26,000 less than the average in Fiscal Year 2004; however, the prime rate
      of
      borrowing, upon which interest rates for the revolving credit loan is based,
      was
      slightly higher.




23




A
      deferred
      income tax benefit of approximately $680,000 resulted from a decrease in the
      Company’s valuation allowance against its deferred tax asset and was recorded in
      the third and fourth quarters of Fiscal Year 2005. The deferred tax asset
      primarily relates to losses reported in prior years. The Company believes it
      is
      likely that it will utilize a portion of these prior year net operating loss
      carry forwards, based on the Company’s recent strong earnings history. As a
      result, net income for Fiscal Year 2005 was $680,000 ($.07 per diluted share)
      higher than would have been reported if such tax benefit had not been recorded.
      The remaining balance of the tax benefit recorded for Fiscal Year 2005, includes
      federal and state income and capital taxes, and related refunds and credits
      received. The Company’s income tax benefit for Fiscal Year 2004 primarily
      reflect certain state capital taxes and Federal alternative tax. The Fiscal
      Year
      2004 tax benefit also reflects the realization of net operating losses
      previously subject to valuation allowances, which offset federal and state
      income tax provisions.





**Aggregate
      Contractual Obligations**





The
      Company’s aggregate contractual obligations are as follows:





As
      of June
      30, 2006, the Company did not have any long or short term debt obligations
      outstanding. The Company does not have any capital lease obligations, purchase
      obligations, or any other long-term liabilities. The Company’s only material
      operating lease obligation is a noncancelable lease for office and manufacturing
      facilities which expires in December 2009. The annual rental payments under
      the
      terms of this lease are $525,085 until the end of the lease term.





**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 for both its domestic and international sales when
      products are shipped and title passes to the customer. The Company includes
      shipping and handling costs as a component of cost of sales.





Accounts
      Receivable


The
      Company reports accounts receivable net of reserves for doubtful accounts.
      Credit is extended to distributors on varying terms between 30 and 90 days.
      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 and the Company has not had
      significant bad debt write-offs in the past few years. 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 uses a standard cost accounting system in
      conjunction with an actual perpetual system to properly account for, control
      and
      maintain the movement of all inventory components. 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, as well as (4) costs per
      claim. The Company periodically assesses the adequacy of its warranty liability
      based on changes in these factors.





24




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 will make any changes as
      necessary. If the Company experiences significant increased warranty claims
      or
      activity, the warranty reserve will be increased, resulting in decreased gross
      profit.





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.





Approximately
      $48,000 of stock-based employee compensation cost is included in net income
      for
      Fiscal Year 2005, as certain options were granted at an exercise below market
      value on the date of grant.





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 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 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 its deferred tax asset and operating
      results could be effected, accordingly, deferred income tax benefits aggregating
      approximately $680,000 resulting from a decrease in the Company’s valuation
      allowance against its deferred tax asset were recorded in the third and fourth
      quarters of Fiscal 2005. Based upon this forecast of future profitability,
      the
      Company has maintained this deferred tax asset at $680,000 as of June 30, 2006.
      The deferred tax asset primarily relates to losses reported in prior years.
      The
      Company believes it is likely that they will utilize a portion of these prior
      year net operating loss carry forwards, based on the Company’s current strong
      earnings history. In reviewing the valuation allowance, the Company has
      considered future taxable income and has determined that 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-valuation of the valuation allowance.





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**





The
      Company’s earnings and cash flows are subject to changes in interest rates
      (short-term prime based interest rates and was subject to the 12-month LIBOR
      rate) primarily from its borrowings under its senior and subordinate debt.
      The
      Company does not believe that it is materially exposed to changes in interest
      rates; as at June 30, 2006 there was no debt outstanding. The Company does
      not
      currently use interest rate derivative instruments to manage exposure to
      interest rate changes.





The
      Company’s earnings and cash flows are subject to changes in interest rates
      associated with U.S. Treasury Notes and U.S. Treasury Bills, primarily from
      its
      investments of excess cash. The Company invests this cash in an open-end,
      diversified U.S. Treasury Money Market Fund, whose investment objective is
      high
      current income consistent with the preservation of principal and liquidity.
      All
      investments are exclusively in U.S. Treasury obligations which have remaining
      maturities of 397 days or less and repurchase agreements collateralized by
      U.S.
      Treasury obligations. The Company does not believe that they are materially
      exposed to market rate volatility.





The
      Company’s earnings and cash flows are subject to foreign currency exchange rate
      risk, specifically the Euro/Dollar and the Yen/Dollar. The Company does not
      believe that it is materially exposed to foreign currency exchange rate risk
      due
      to the volume of purchases in foreign currency relative to purchases in US
      dollars; however, the relative strength of the Dollar to the Euro or to the
      Yen
      does affect the Company’s gross profit. The Company continuously monitors all
      changes in foreign currency and may adjust its pricing to customers to reflect
      these changes .




25




**Item
      8. Financial Statements and Supplementary Data**





The
      information that appears following Item 15 of this Annual Report on Form 10-K
      and is incorporated herein by reference.




26


**AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
 
 
 **CONTENTS**
 **June
        30, 2006**
  **Report
                  of Independent Registered Public Accounting Firm**
              
              F-1**Consolidated
                  Financial Statements:**Balance
                  Sheet
              
              F-2Statement
                  of Operations
              
              F-3Statement
                  of Shareholders' Equity
              
              F-4Statement
                  of Cash Flows
              
              F-5Notes
                  to Consolidated Financial Statements
              
              F-6
                  - F-14**Supplemental
                  Schedule:**Schedule
                  of Valuation and Qualifying Accounts
              
              F-15
  
 
 **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 To
        the
        Board of Directors
 AFP
        Imaging Corporation
 
 We
        have
        audited the accompanying consolidated balance sheets of AFP Imaging Corporation
        and Subsidiaries (the "Company") as of June 30, 2006 and 2005, and the related
        consolidated statements of operations, shareholders' equity and cash flows
        for
        each of the three years in the period ended June 30, 2006. Our audits also
        included the financial statement schedule 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
        audits.
 
 We
        conducted our audits 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 audits provide 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, 2006 and 2005 and the results
        of
        their operations and their cash flows for each of the three years in the
        period
        ended June 30, 2006, in conformity with United States generally accepted
        accounting principles. Also, in our opinion, the related financial statement
        schedule, 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.
 
 As
        disclosed in Note 1, the Company changed its method of accounting for
        stock-based compensation effective July 1, 2005.
 
 **GOLDSTEIN
        GOLUB KESSLER LLP**
 New
        York,
        New York
 
 August
        11,
        2006




F-1




**AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
  **CONSOLIDATED
        BALANCE SHEET**
 **June
                  30,**
              
              **2006**
              
              **2005****ASSETS**Current
                  Assets:Cash
                  and cash equivalents
              
              $
              5,213,289
              
              $
              331,009Accounts
                  receivable, less allowance for doubtful accountsof
                  $90,000 and $90,000, respectively
              
              
              2,757,114
              
              
              2,704,136Inventories
              
              
              4,834,510
              
              
              3,921,383Prepaid
                  expenses and other current assets
              
              
              97,189
              
              
              89,069Deferred
                  income taxes
              
              
              680,000
              
              
              680,000**Total
                  current assets**
              
              
              13,582,102
              
              
              7,725,597Property
                  and Equipment, net of accumulated depreciationof
                  $1,450,484 and $1,234,305, respectively
              
              
              377,665
              
              
              388,738Other
                  Assets
              
              
              380,797
              
              
              39,061**Total
                  Assets**
              
              $
              14,340,564
              
              $
              8,153,396**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Current
                  Liabilities:Current
                  portion of long-term debt
              
              $
              -
              
              $
              674,585Accounts
                  payable
              
              
              2,035,117
              
              
              1,339,251Accrued
                  expenses
              
              
              1,565,174
              
              
              1,361,514**Total
                  current liabilities**
              
              
              3,600,291
              
              
              3,375,350Deferred
                  Rent
              
              
              71,204
              
              
              115,415**Total
                  liabilities**
              
              
              3,671,495
              
              
              3,490,765Commitments
                  and ContingenciesCommon
                  Stock subject to registration rights
              
              
              4,744,323
              
              
              -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
                  12,345,994 shares at June 30, 2006 (including 2,777,777 sharessubject
                  to registration rights) and 9,407,717 shares at June 30, 2005
              
              
              95,682
              
              
              94,077Common
                  stock warrants
              
              
              110,931
              
              
              19,800Paid-in
                  capital
              
              
              11,805,852
              
              
              11,641,821Accumulated
                  deficit
              
              
              (6,087,719
              )
              
              (7,093,067
              )**Total
                  shareholders' equity**
              
              
              5,924,746
              
              
              4,662,631**Total
                  Liabilities and Shareholders' Equity**
              
              $
              14,340,564
              
              $
              8,153,396
  See
        Notes
        to Consolidated Financial Statements
  F-2
  **AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
  **CONSOLIDATED
        STATEMENT OF OPERATIONS**


**Years
                  ended June 30,**
              
              **2006**
              
              **2005**
              
              **2004**Net
                  sales
              
              $
              24,998,272
              
              $
              23,135,063
              
              $
              19,832,910Cost
                  of sales
              
              
              15,670,428
              
              
              14,189,096
              
              
              12,178,072Gross
                  profit
              
              
              9,327,844
              
              
              8,945,967
              
              
              7,654,838Selling,
                  general and administrative expenses
              
              
              7,594,820
              
              
              7,155,537
              
              
              5,803,766Research
                  and development expenses
              
              
              696,700
              
              
              435,813
              
              
              397,444Operating
                  income
              
              
              1,036,324
              
              
              1,354,617
              
              
              1,453,628Interest
                  expense, net of interest income
              
              
              34,457
              
              
              125,358
              
              
              157,015Income
                  before benefit forincome
                  taxes
              
              
              1,001,867
              
              
              1,229,259
              
              
              1,296,613Benefit
                  for income taxes
              
              
              (3,481
              )
              
              (670,671
              )
              
              (48,854
              )Net
                  income
              
              $
              1,005,348
              
              $
              1,899,930
              
              $
              1,345,467Net
                  income per common share:Basic
              
              $
              .10
              
              $
              .20
              
              $
              .15Diluted
              
              $
              .10
              
              $
              .19
              
              $
              .14


See
        Notes
        to Consolidated Financial Statements
  F-3


**AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED
          STATEMENT OF SHAREHOLDERS' EQUITY**
 **Years
                    ended June 30, 2004, 2005 and 2006****Common****Common**
                
                **Stock**
                
                **Paid-in**
                
                **Accumulated****Stock**
                
                **Warrants**
                
                **Capital**
                
                **Deficit**
                
                **Total**Balance
                    June 30, 2003
                
                $
                92,710
                
                $
                19,800
                
                $
                11,545,883
                
                $
                (10,338,464
                )
                $
                1,319,929Net
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                1,345,467
                
                
                1,345,467Balance
                    June 30, 2004
                
                
                92,710
                
                
                19,800
                
                
                11,545,883
                
                
                (8,992,997
                )
                
                2,665,396Issuance
                    of 137,100 shares of common stock
                
                
                1,367
                
                
                -
                
                
                47,938
                
                
                -
                
                
                49,305in
                    connection with the exercise of stock optionsIssuance
                    of 100,000 stock options below
                
                
                -
                
                
                -
                
                
                48,000
                
                
                -
                
                
                48,000market
                    priceNet
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                1,899,930
                
                
                1,899,930Balance
                    June 30, 2005
                
                
                94,077
                
                
                19,800
                
                
                11,641,821
                
                
                (7,093,067
                )
                
                4,662,631Issuance
                    of 2,777,777 shares of common stock
                
                
                27,778
                
                
                -
                
                
                4,972,222
                
                
                -
                
                
                5,000,000Fees
                    associated with the issuance of common stock
                
                
                -
                
                
                -
                
                
                (255,677
                )
                
                -
                
                
                (255,677
                )Reclassification
                    of common stock subject toregistration
                    rights
                
                
                (27,778
                )
                
                -
                
                
                (4,716,545
                )
                
                -
                
                
                (4,744,323
                )Issuance
                    of 160,500 shares of common stockin
                    connection with the exercise of stock options
                
                
                1,605
                
                
                -
                
                
                81,633
                
                
                -
                
                
                83,238Issuance
                    of common stock warrants
                
                
                -
                
                
                91,131
                
                
                -
                
                
                -
                
                
                91,131Stock
                    based compensation expense
                
                
                -
                
                
                -
                
                
                82,398
                
                
                -
                
                
                82,398Net
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                1,005,348
                
                
                1,005,348Balance
                    June 30, 2006
                
                $
                95,682
                
                $
                110,931
                
                $
                11,805,852
                
                $
                (6,087,719
                )
                $
                5,924,746




See
        Notes
        to Consolidated Financial Statements
  F-4


**AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED
          STATEMENT OF CASH FLOWS**


**Years
                  ended June 30,**
              
              **2006**
              
              **2005**
              
              **2004**Cash
                  flows from operating activities:Net
                  income
              
              $
              1,005,348
              
              $
              1,899,930
              
              $
              1,345,467Adjustments
                  to reconcile net income to netcash
                  provided by operating activities:Issuance
                  of stock options below market price
              
              
              -
              
              
              48,000
              
              
              -Depreciation
                  and amortization
              
              
              224,939
              
              
              218,682
              
              
              159,823Loss
                  on disposal of property and equipment
              
              
              -
              
              
              -
              
              
              11,685Provision
                  for losses on accounts receivable
              
              
              16,245
              
              
              38,454
              
              
              5,989Deferred
                  income taxes
              
              
              -
              
              
              (680,000
              )
              
              -Non-cash
                  compensation expense
              
              
              82,398
              
              
              -
              
              
              -Change
                  in assets and liabilities:(Increase)
                  in accounts receivable
              
              
              (69,223
              )
              
              (238,830
              )
              
              (260,268
              )(Increase)
                  in inventories
              
              
              (913,127
              )
              
              (1,217,374
              )
              
              (222,005
              )(Increase)
                  decrease in prepaid expenses and othercurrent
                  assets
              
              
              (8,120
              )
              
              178,311
              
              
              (168,288
              )(Increase)
                  decrease in other assets
              
              
              (259,365
              )
              
              (31,747
              )
              
              53,391Increase
                  in accounts payable
              
              
              695,866
              
              
              416,752
              
              
              6,171Increase
                  (decrease) in accrued expenses
              
              
              203,660
              
              
              513,591
              
              
              (78,819
              )(Decrease)
                  Increase in deferred rent
              
              
              (44,211
              )
              
              (20,345
              )
              
              27,389**Net
                  cash provided by operating activities**
              
              
              934,410
              
              
              1,125,424
              
              
              880,535Cash
                  flows from investing activities:Purchases
                  of property and equipment
              
              
              (205,106
              )
              
              (176,981
              )
              
              (107,512
              )Cash
                  flows from financing activities:Issuance
                  of common stock
              
              
              5,000,000
              
              
              -
              
              
              -Payment
                  of fees associated with issuance of common stock
              
              
              (255,677
              )
              
              -
              
              
              -Repayments
                  of debt
              
              
              (674,585
              )
              
              (998,732
              )
              
              (1,099,168
              )Exercise
                  of common stock options
              
              
              83,238
              
              
              49,305
              
              
              -**Net
                  cash provided by (used in) financing activities**
              
              
              4,152,976
              
              
              (949,427
              )
              
              (1,099,168
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              4,882,280
              
              
              (984
              )
              
              (326,145
              )Cash
                  and cash equivalents at beginning of year
              
              
              331,009
              
              
              331,993
              
              
              658,138Cash
                  and cash equivalents at end of year
              
              $
              5,213,289
              
              $
              331,009
              
              $
              331,993**Supplemental
                  disclosures of cash flow information:**Cash
                  paid during the year for:Interest
              
              $
              81,468
              
              $
              132,441
              
              $
              161,266Income
                  taxes
              
              $
              10,329
              
              $
              24,701
              
              $
              13,528


See
        Notes
        to Consolidated Financial Statements
  F-5




**AFP
        IMAGING CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **June
        30, 2006**


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 distributed to worldwide markets, under various brand names,
        through a network of independent and unaffiliated dealers.
  The
        consolidated financial statements include AFP Imaging Corporation and its
        wholly
        owned subsidiaries. All significant intercompany transactions have been
        eliminated in consolidation.
  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.
  Revenue
        is
        recognized by the Company when products are shipped and title passes to the
        customer. The Company includes shipping and handling costs as a component
        of
        cost of sales.
  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).
  Machinery
        and equipment are depreciated using straight-line and accelerated methods
        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.
  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
        products.
  Advertising
        costs, included in selling, general and administrative costs, are charged
        to
        expense as incurred and were approximately $287,600, $185,300 and $102,600
        for
        the fiscal years ended June 30, 2006, 2005 and 2004, respectively.
  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 described in SFAS 123R . The
        share
        based compensation cost will be measured based on the fair value of the equity
        or liability instruments issued. SFAS No. 123R also requires the benefits
        of tax
        deductions in excess of recognized compensation cost to be reported as a
        financing cash flow rather than as an operating cash flow as required under
        prior literature.
  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 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 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, 2006, non-cash stock based compensation expense related
        to
        stock option awards (“Stock Option Expense”) was $82,398, and has 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. For the twelve months ended June 30, 2005,
        and
        June 30, 2004, had the Company adopted the fair value based method of accounting
        for stock-based compensation under the provisions of SFAS 123R, Stock Option
        Expense would have been $151,884 and $231,815, respectively, and the effect
        on
        the Company’s net income and net income per share would approximate the pro
        forma amounts shown in the following table:




F-6


**June
                  30,**
              
              **2005**
              
              **2004**Net
                  income as reported
              
              $
              1,899,930
              
              $
              1,345,467Deduct:Stock
                  compensation expensedetermined
                  under fair-value-basedmethod
                  for all awards
              
              
              (151,884
              )
              
              (231,815
              )Pro
                  forma net income (loss)
              
              $
              1,748,046
              
              $
              1,113,652Basic
                  net income per share, as reported
              
              $
              .20
              
              $
              .15Basic
                  net income per share, pro forma
              
              $
              .19
              
              $
              .13Diluted
                  net income per share, as reported
              
              $
              .18
              
              $
              .14Diluted
                  net income per share, pro forma
              
              $
              .18
              
              $
              .12


The
        Company did not have any foreign operations for the fiscal years ended June
        2006, 2005 and 2004. Any transaction gains or losses resulting from payments
        to
        foreign vendors are included in net income.
  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 factors
        surrounding the credit risk of specific customers, historical trends and
        other
        information. Receivable balances are reviewed on an aged basis and account
        balances are charged off against the allowance after all means of collection
        have been exhausted and the potential for recovery is doubtful.
  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 carryforwards. 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.
  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 2006, 2005 and
        2004
        is presented below:


**June
                  30,**
              
              **2006**
              
              **2005**
              
              **2004**Net
                  income
              
              $
              1,005,348
              
              $
              1,899,930
              
              $
              1,345,467Weighted-average
                  common shares outstanding - Basic
              
              
              10,009,958
              
              
              9,380,855
              
              
              9,270,617Basic
                  Net income per share
              
              $
              .10
              
              $
              .20
              
              $
              .15Weighted-average
                  common shares outstanding - DilutedBasic
                  shares
              
              
              10,009,958
              
              
              9,380,855
              
              
              9,270,617Dilutive
                  effect of stock options
              
              
              416,417
              
              
              426,758
              
              
              318,732Dilutive
                  effect of warrants
              
              
              86,864
              
              
              78,049
              
              
              42,839Weighted-average
                  common sharesoutstanding
                  - diluted
              
              
              10,513,239
              
              
              9,885,662
              
              
              9,632,188Diluted
                  Net income per share
              
              $
              .10
              
              $
              .19
              
              $
              .14




The
        diluted income 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, 2006, 2005 and 2004 does
        not
        include the potential exercise of 10,000, 18,000 and 81,000 stock options,
        respectively, as such amounts were antidilutive.
  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 offering
        price was at $1.80 per share. In conjunction with the private placement,
        the
        Company has granted the investors certain registration rights with respect
        to
        the resale of the shares acquired. No warrants were issued to the investors
        in
        this private placement. The Company incurred fees of approximately $256,000
        including all placement fees and related legal and accounting expenses. The
        Company intends to use the net proceeds for working capital, new product
        development, general corporate purposes, and possibly for strategic acquisitions
        in the medical, dental and/or veterinary equipment markets. There is no
        material, definitive commitments or arrangements with respect to any of the
        net
        proceeds of the private placement.
  F-7
 With
          respect to the above described financing, the Company filed a registration
          statement which was declared effective on July 14, 2006. If this registration
          statement is subsequently suspended for a specified period of time, the
          Company
          could be required to pay a penalty of 1% of the financing per month to
          the
          investors. Additionally, the Company is required to file amendments to
          the
          registration statement as necessary to keep the registration effective
          for 24
          months from the closing date. In accordance with the provisions of EITF
          Topic
          D-98, the net proceeds from the private placement are classified as temporary
          equity on the accompanying June 30, 2006 balance sheet. The financing amount
          will be reclassified to shareholder’s equity upon the termination of the 24
          month period.
  On
          March
          28, 2006, the Company issued an aggregate of 50,000 warrants to designees
          of an
          investment banking firm. Each warrant entitles the holder to purchase one
          share
          of common stock at a purchase price of $1.98, the closing stock price on
          March
          28, 2006. The warrants are for five years and the Black-Scholes method
          was used
          to value these warrants.
  In
          May
          2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, *Accounting
          Changes and Error Corrections* (“SFAS
          No. 154”). SFAS No. 154 replaces APB Opinion No. 20, *Accounting
          Changes* ,
          and SFAS
          No. 3, *Reporting
          Accounting Changes in Interim Financial Statements* ,
          and
          requires retrospective application to prior-period financial statements
          of
          changes in accounting principle, unless it is impracticable to determine
          either
          the period-specific effects or the cumulative effect of the change. Previously,
          most changes in accounting principle were recognized by including in net
          income
          of the period of the change, the cumulative effect of the change. SFAS
          No. 154
          also redefines “restatement” as the revising of previously issued financial
          statements to reflect the correction of an error. The Company will adopt
          SFAS
          No. 154, beginning July 1, 2006, if applicable.
  In
          February 2006, the FASB issued SFAS No. 155, *Accounting
          for Certain Hybrid Financial Instruments - an amendment of FASB Statements
          No.
          133 and 140* (“SFAS
          No. 155”). This statement improves financial reporting by allowing fair value
          measurement for hybrid financial instruments that contain an embedded derivative
          as well as clarifying certain points of SFAS No. 133 and SFAS No. 140.
          SFAS No.
          155 is effective for all financial instruments acquired or issued in fiscal
          years beginning after September 15, 2006. In March 2006, the FASB issued
          SFAS
          No. 156, *Accounting
          for Servicing of Financial Assets - an amendment of FASB Statement No.
          140* (“SFAS
          No. 156”). This statement requires that all separately recognized servicing
          assets and liabilities be initially measured at fair value if practicable
          and
          clarifies certain points of SFAS140. SFAS No. 156 is effective for fiscal
          years
          that begin after September 15, 2006. The Company does not believe that
          SFAS Nos.
          155 and 156 will have any material effect on the Company’s financial statements
          or results of operations..
  In
          July
          2006, the FASB issued FASB Interpretation No. 48, *Accounting
          for Uncertainty in Income Taxes, an interpretation of FASB No. 109* (“FIN
          48”), which provides criteria for the recognition, measurement, presentation
          and
          disclosure of uncertain tax positions. A tax benefit from an uncertain
          position
          may be recognized only if it is “more likely than not” that the position is
          sustainable based on its technical merits. The provisions of FIN 48 are
          effective for fiscal years beginning after December 15, 2006. We do not
          expect
          FIN 48 will have a 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.
 
 **2.**
                **INVENTORIES****:**
  Inventories,
          net of reserves, consist of the following :
  **June
                    30**
                
                **2006**
                
                **2005**Raw
                    materials and subcomponent parts
                
                $
                1,984,979
                
                $
                1,721,165Work-in-process
                    and finished goods
                
                
                2,849,531
                
                
                2,200,218$
                4,834,510
                
                $
                3,921,383
  Inventories,
          which include material and a small component of labor and manufacturing
          overhead, are stated at the lower of cost (first-in, first-out) or market
          (net
          realizable value). The Company uses a standard cost accounting system in
          conjunction with an actual perpetual inventory system to properly account
          for,
          control and maintain the movement of all inventory components.
 
 **3.**
                **PROPERTY
                    AND EQUIPMENT****:**
  Property
          and equipment, at cost, consists of the following :
  F-8


**June
                  30,**
              
              **2006**
              
              **2005**Leasehold
                  improvements
              
              $
              239,277
              
              $
              237,396Machinery
                  and equipment
              
              
              1,588,872
              
              
              1,385,6471,828,149
              
              
              1,623,043Less
                  accumulated depreciation and amortization
              
              
              (1,450,484
              )
              
              (1,234,305
              )**Property
                  and equipment, net**
              
              $
              377,665
              
              $
              388,738
  Depreciation
        and amortization was $216,179, $176,514 and $159,823 for the years ended
        June
        30, 2006, 2005 and 2004, respectively.
  The
        Company retired $56,749 and $639,665 of assets during fiscal years 2005 and
        2004, respectively, and did not retire any assets during fiscal year
        2006.
  **4.**
              **DEBT:**
  On
        September 21, 2004, the Company renewed its senior secured credit facility
        (the
        "Renewed Revolving Credit Loan") for an additional three-year period. The
        Renewed Revolving Credit Loan replaced the existing senior credit facility
        (the
“Original Revolving Credit Loan”). The maximum borrowing permitted under the
        Renewed Revolving Credit Loan is lower than that under the prior credit
        facility, based on the Company’s current requirements. However, the Renewed
        Revolving Credit Loan has more favorable terms, including a lower interest
        rate,
        and less stringent reporting requirements, than that under the Original
        Revolving Credit Loan, and gives the Company the ability to borrow on specific
        amounts of foreign accounts receivable. The Renewed Revolving Credit Loan
        consists of a $2,500,000 revolving line of credit, which is secured by all
        of
        the Company's inventory, accounts receivable, equipment, officer life insurance
        policies and proceeds thereof, trademarks, licenses, patents and general
        intangibles. The Renewed Revolving Credit Loan has an interest rate of prime
        plus 1.375%, (8.25% at June 30, 2006), a specific formula to calculate available
        funds based on eligible accounts receivable and inventory, and certain reporting
        requirements to the senior secured lender. The Renewed Revolving Credit Loan
        requires that certain financial ratios and net worth amounts be maintained
        by
        the Company, and prohibits the paying of dividends . The
        Renewed Revolving Credit Loan provides for increases in the interest rate
        charged on monies outstanding under specific circumstances.
  As
        of June
        30, 2006, the Company was in compliance with all terms and conditions of
        the
        Renewed Revolving Credit Loan.
  In
        connection with the original facility, the Company issued a five-year warrant
        to
        the lender for the purchase of 100,000 shares of the Company's common stock
        at
        $0.32 per share, subject to an adjustment for all subsequent issuances of
        stock.
        The Black-Scholes option pricing model was used to value the warrant, and
        the
        stock purchase price was based on the stock price the day prior to closing,
        plus
        10%, as stipulated in the Loan and Security Agreement for the Original Revolving
        Credit Loan. In August 2006, the lender chose to exercise a portion of the
        warrant, and converted approximately 66,666 shares covered by the warrant
        into
        55,738 shares of common stock in a cashless exercise in a manner as specified
        in
        the warrant.
  As
        of June
        30, 2006 and 2005, debt consisted of the following:
  **June
                  30**
              
              **2006**
              
              **2005**Renewed
                  Revolving Credit Loan
              
              $
              -
              
              $
              452,363Nystrom
                  subordinated note payable(a)
              
              
              -
              
              
              222,222-
              
              
              674,585Less
                  current portion
              
              
              -
              
              
              (674,585
              )**Total
                  long-term debt**
              
              $
              -
              
              $
              -
  (a)
            This
                note payable consisted of an $800,000 promissory note to ACG
                Nystromgruppen AB ("Nystrom"), the former parent of a Swedish dental
                company. Under the terms of this note, as amended, interest only
                was paid
                quarterly for the first three years, followed by 36 equal monthly
                installments of $22,222 plus interest on the unpaid balance, which
                began
                in May 2003. The Nystrom promissory note had an interest rate reset
                annually based on the LIBOR plus 2%. This note was repaid in full
                as of
                April 2006.  At
        June
        30, 2006, the Company had available $1,845,862 of unused lines of credit
        under
        the Renewed Revolving Credit Loan.
  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, 2006 and 2005, accrued expenses consisted of the following :




F-9


**June
                  30**
              
              **2006**
              
              **2005**Accrued
                  environmental claim (see Note 9)
              
              $
              11,550
              
              $
              75,000Accrued
                  payroll expenses
              
              
              545,487
              
              
              585,094Accrued
                  amounts due vendors for in-transit inventory
              
              
              433,639
              
              
              405,951Customer
                  deposits
              
              
              175,687
              
              
              -Accrued
                  expenses - other (none in excess of 5% of current
                  liabilities)
              
              
              398,811
              
              
              295,469$
              1,565,174
              
              $
              1,361,514




**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, 2006, 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 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
        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. See Note 1,
        for the
        effect on the Company’s net income and net income per share amount for the years
        ended June 30, 2005 and 2004, had Stock Option Expense been determined in
        accordance with FAS 123.
  The
        fair
        value of each option granted under the Company’s incentive stock plans during
        the twelve months ended June 30, 2006, 2005 and 2004 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 periods 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, does not currently anticipate paying any dividends in the foreseeable
        future and is restricted from paying dividends under the terms of its senior
        secured debt. 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, 2006, 2005 and 2004.
  2006
              
              2005
              
              2004Expected
                  volatility
              
              
              151%
                  - 155
              %
              
              80
              %
              
              79
              %Expected
                  lives from grant date
              
              
              10
                  years
              
              
              10
                  years
              
              
              5
                  - 10 yearsExpected
                  dividend yield
              
              
              0
              %
              
              0
              %
              
              0
              %Risk-free
                  interest rate
              
              
              4.19%
                  - 5.07
              %
              
              3.09%
                  - 4.29
              %
              
              4.17%
                  - 4.79
              %
 
 Stock
        options to purchase an aggregate 10,000 shares of Company common stock were
        granted to the Company’s outside Board of Director members in each of the
        three-month periods ended September 30, 2005, December 31, 2005, March 31,
        2006,
        and June 30, 2006, in accordance with the Company’s policy for non-employee
        director compensation .




F-10




Transactions
        under the plans for fiscal 2006, 2005 and 2004 are as
        follows:


**Year
                  ended June 30**
              
              **2006**
              
              **2005**
              
              **2004**Options
              
              Weighted
                Average
                Price
              
              Options
              
              Weighted
                Average
                Price
              
              Options
              
              Weighted
                Average
                PriceOutstanding,
                  beginning of fiscal year
              
              
              948,400
              
              $
              .76
              
              
              1,008,500
              
              $
              .57
              
              
              945,000
              
              $
              .42Exercised
              
              
              (160,500
              )
              
              .52
              
              
              (137,100
              )
              
              .36
              
              
              0
              
              
              -Granted
              
              
              40,000
              
              
              2.14
              
              
              140,000
              
              
              1.53
              
              
              259,500
              
              
              1.13Forfeited
              
              
              0
              
              
              -
              
              
              (6,000
              )
              
              .96
              
              
              (155,000
              )
              
              .49Expired
              
              
              0
              
              
              -
              
              
              (57,000
              )
              
              .31
              
              
              (41,000
              )
              
              1.00Outstanding,
                  end of fiscal year
              
              
              827,900
              
              $
              .87
              
              
              948,400
              
              $
              .76
              
              
              1,008,500
              
              $
              .57Exercisable
                  at June 30
              
              
              827,900
              
              
              -
              
              
              948,400
              
              
              -
              
              
              708,500
              
              
              -Weighted-average
                  fair value of options granted during years ended June 30
              
              $
              2.11
              
              
              -
              
              $
              1.09
              
              
              -
              
              $
              .89
              
              
              -




The
        aggregate intrinsic value of the outstanding options, which are all currently
        exercisable, amounted to $1,183,812 at June 30, 2006. The intrinsic value
        of
        options exercised during the twelve months ended June 30, 2006 amounted to
        $282,738.
  At
        June
        30, 2006, stock option information is as follows:
  Options
                  Outstanding
              
              Options
                  ExercisableRange
                  of
                Exercise
                  Prices
              
              Number
                Exercisable
                  at
                June
                  30, 2006
              
              Weighted-Average
                  Remaining
                Contractual
                  Life
                (Years)
              
              Weighted-
                Average
                Exercise
                  Price
              
              Number
                Exercisable
                  at
                June
                  30, 2006
              
              Weighted-
                average
                Exercise
                  Price$
                  .11 - $ .50
              
              
              396,000
              
              
              3.67
              
              $
              .30
              
              
              396,000
              
              $
              .30$
                  .53 - $ .81
              
              
              25,500
              
              
              3.94
              
              
              .61
              
              
              25,500
              
              
              .61$1.06
                  - $1.75
              
              
              348,400
              
              
              8.24
              
              
              1.33
              
              
              348,400
              
              
              1.33$2.00
                  - $2.26
              
              
              58,000
              
              
              5.38
              
              
              1.76
              
              
              58,000
              
              
              1.76827,900
              
              
              5.72
              
              $
              .87
              
              
              827,900
              
              $
              .87




**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. As of June 30, 2006, the Company has recorded a deferred tax asset
        of
        $680,000, which primarily relates to losses recorded in prior years, and
        which
        the Company believes it is likely that the Company will utilize these prior
        year
        net operating loss carry forwards. The tax benefit recorded as of June 30,
        2006
        includes state income and capital taxes, and related refunds and credits
        received. Should circumstance change and the Company determine that it will
        not
        be able to utilize its net operating loss carryforward, such as a decline
        in
        future taxable income, the Company will reevaluate its valuation allowance.
  Net
        operating loss carryforwards ("NOLs") amounting to approximately
        $7,389,000 in federal NOLs and $12,134,880 in state NOLs at June 30, 2006,
        will expire beginning in 2010. The NOLs are subject to review by the Internal
        Revenue Service. Future changes in ownership of the Company, as defined by
        Section 382 of the Internal Revenue Code, could limit the amount of NOLs
        available for use in any one year. The Company recorded the above valuation
        reserve, based on management's conclusion that it is more likely than not
        that
        future operations will not generate sufficient taxable income to realize
        the
        entire deferred tax assets during the carryforward period for these tax
        attributes.
 
 The
        income
        before benefit for income taxes is comprised of the following:
  June
                  30
              
              2006
              
              2005
              
              2004United
                  States
              
              $
              1,001,867
              
              $
              1,229,259
              
              $
              1,309,213Foreign
              
              
              -
              
              
              -
              
              
              (12,600
              )Total
              
              $
              1,001,867
              
              $
              1,229,259
              
              $
              1,296,613




F-11


The
        benefit for income taxes is comprised of the following:
 
 June
                  30
              
              2006
              
              2005
              
              2004CurrentFederal
              
              $
              (1,919
              )
              $
              11,775
              
              $
              20,000State
              
              
              (1,562
              )
              
              (2,446
              )
              
              13,530Deferred
              
              
              -
              
              
              (680,000
              )
              
              -Adjustment
                  to income tax liability accounts
              
              
              -
              
              
              -
              
              
              (82,384
              )Total
              
              $
              (3,481
              )
              $
              (670,671
              )
              $
              (48,854
              )
 
 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:
  June
                  30,
              
              2006
              
              2005
              
              2004Tax
                  provision at federal statutory rates
              
              $
              340,635
              
              $
              417,948
              
              $
              440,848Increase
                  (decrease) in tax provision resulting from:State
                  income tax provision (benefit)
              
              
              (1,562
              )
              
              (2,446
              )
              
              13,530Adjustment
                  to income tax liability accounts
              
              
              -
              
              
              -
              
              
              (82,384
              )Decrease
                  in valuation allowance
              
              
              -
              
              
              (680,000
              )
              
              -Utilization
                  of federal operating loss carryforwards
              
              
              (342,554
              )
              
              (406,173
              )
              
              (420,848
              )Benefit
                  for income taxes
              
              $
              (3,481
              )
              $
              (670,671
              )
              $
              (48,854
              )
 
 The
        items
        that comprise the deferred tax balance are as follows :
  June
                  30,
              
              2006
              
              2005Depreciation
                  and amortization
              
              $
              22,736
              
              $
              41,352Accrued
                  liabilities and reserves not currently deductible
              
              
              174,292
              
              
              187,725Inventory
              
              
              134,082
              
              
              128,000Net
                  operating loss carryforwards and tax credits
              
              
              3,270,318
              
              
              3,694,9363,601,428
              
              
              4,052,013Deferred
                  tax asset valuation reserve
              
              
              (2,921,428
              )
              
              (3,372,013
              )Tax
                  asset recognized on balance sheet
              
              $
              680,000
              
              $
              680,000
 
 **8.**
              **PROFIT-SHARING
                  PLAN****:**
  The
        Company maintains a defined contribution profit-sharing plan and trust pursuant
        to which participants receive certain benefits upon retirement, death,
        disability and, to a limited extent, upon termination of employment for other
        reasons. 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. Allocation
        among
        participants' interests, including officers and directors who are employees,
        is
        in accordance with IRS regulations for both of these plans.
  The
        aggregate amount contributed to each of these plans 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 year ended June 30, 2006, the Company contributed
        $126,716 towards the Safe Harbor 401(k). The profit sharing plan requires
        no
        minimum contribution by the Company. The Company made a contribution of
        $63,550 and $60,000 for the years ended June 30, 2005 and 2004,
        respectively towards the profit sharing plan.
 
 **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 and the State of New Jersey, 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. An initial settlement amount was offered by this group, however,
        to
        date, no settlement has been reached. The potential cost to the Company based
        on
        this settlement offer has been assessed at $23,100. The Company has accrued
        $11,550 in Fiscal Year 2006, which represents the Company’s estimate of its
        potential liability, net of the Company’s insurance carrier’s agreed-upon
        contribution towards a potential settlement. The Company does not expect
        to
        receive any further information until a status conference is held, which
        is
        scheduled for mid-September 2006. The Company cannot, at this time, assess
        the
        amount of liability that could result from any adverse final outcome of this
        environmental complaint. The Company's insurance carrier has agreed to equally
        share with the Company the defense costs incurred in this environmental
        claim.
  F-12




On
        February 8, 2005, the Company finalized a settlement relating to a separate
        environmental claim filed in 2001 as a civil complaint brought by the current
        owners of the same property owned by the Company between August 1984 and
        June
        1985. This action was filed in the Superior Court of New Jersey, Morris County,
        and alleged that the Company’s discontinued graphic art camera subsidiary had
        contaminated a portion of the site during its manufacturing process prior
        to
        1985. The settlement included a release and indemnification as well as a
        stipulation of dismissal with prejudice. The Company paid $325,000 on February
        18, 2005, which represented the Company’s entire liability under the settlement
        agreement, net of the Company’s insurance carrier’s contribution towards the
        total and final settlement.
  The
        Company is a defendant (with several other parties) in a product liability
        insurance action, which was filed in May 2005 in the Superior Court in Hartford,
        Connecticut and later transferred to the United States District Court, District
        of Connecticut. The plaintiff, through their insurance company, claims that
        the
        Company’s equipment caused a fire on the plaintiff’s premises in May 2003. The
        complaint seeks approximately $200,000 in compensatory damages. Two additional
        suits seeking approximately $113,000 in damages were filed in May
        2006 in the
        Superior Court in Hartford, Connecticut as subrogation claims relating to
        the
        same incident. The Company maintains that its equipment was not the cause
        of the
        incident or the resultant damage. The Company’s insurance carriers, and their
        attorneys, are assisting in the Company’s defense in this matter. The Company
        does not believe that the final outcome of this matter 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 noncancelable operating lease, as amended in March 2004, for
        office and manufacturing facilities expiring in fiscal year 2010. Minimum
        annual
        rental payments under this lease are as follows:
  Year
                  ending June 30,2007
              
              $
              525,0852008
              
              
              525,0852009
              
              
              525,0852010
              
              
              262,543$
              1,837,798
  The
        lease
        provides for rent abatements and 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 $505,000 for each of the years ended June
        30,
        2006, 2005 and 2004, re spectively.
 
 **10.**
              **SEGMENT
                  INFORMATION****:**
  As
        of June
        30, 2006 and 2005, the Company had only one business segment, medical/dental.
        Medical/dental segment operations are conducted under the Dent-X and AFP
        trade
        names and consists of the design, development, manufacturing and marketing
        of
        medical and dental imaging systems and all related
        accessories.




F-13




Geographical
      financial information for the years ended June 30, 2006, 2005 and 2004 is as
      follows:


June
                  30,
              
              2006
              
              2005
              
              2004Sales:United
                  States
              
              $
              19,306,971
              
              $
              18,858,056
              
              $
              16,733,360Domestic
                  export sales
              
              
              5,691,301
              
              
              4,277,007
              
              
              3,099,550$
              24,998,272
              
              $
              23,135,063
              
              $
              19,832,910Net
                  Income (loss)United
                  States
              
              $
              1,005,348
              
              $
              1,899,930
              
              $
              1,358,067Europe
              
              
              -
              
              
              -
              
              
              (12,600
              )$
              1,005,348
              
              $
              1,899,930
              
              $
              1,345,467Identifiable
                  assets:United
                  States
              
              $
              14,340,564
              
              $
              8,153,396
              
              $
              6,244,895Europe
              
              
              -
              
              
              -
              
              
              -Total
              
              $
              14,340,564
              
              $
              8,153,396
              
              $
              6,244,895




During
        the
        years ended June 30, 2006 and 2005, no one customer aggregated over 10% of
        consolidated net sales. During the year ended June 30, 2004, one customer
        aggregated approximately 11% of consolidated net sales.
  **11.**
              **QUARTERLY
                  FINANCIAL DATA (UNAUDITED****):**
  Summarized,
        unaudited quarterly financial data for fiscal 2006 and 2005 are as
        follows:
  June
                  30, 20061st
              
              2nd
              
              3rd
              
              4th
              
              TotalQuarter
              
              Quarter
              
              Quarter
              
              Quarter
              
              YearNet
                  Sales
              
              $
              5,130,114
              
              $
              6,359,879
              
              $
              7,173,942
              
              $
              6,334,337
              
              $
              24,998,272Gross
                  profit
              
              
              1,847,518
              
              
              2,552,390
              
              
              2,692,506
              
              
              2,235,430
              
              
              9,327,844Net
                  Income (loss)
              
              
              (109,896
              )
              
              310,256
              
              
              490,621
              
              
              314,367
              
              
              1,005,348Net
                  income (loss) per common shareBasic
              
              $
              (.01
              )
              $
              .03
              
              $
              .05
              
              $
              .03Diluted
              
              $
              (.01
              )
              $
              .03
              
              $
              .05
              
              $
              .03June
                  30, 20051st
              
              
              2nd
              
              
              3rd
              
              
              4th
              
              
              TotalQuarter
              
              
              Quarter
              
              
              Quarter
              
              
              Quarter
              
              
              YearNet
                  Sales
              
              $
              4,655,471
              
              $
              6,082,235
              
              $
              6,240,931
              
              $
              6,156,426
              
              $
              23,135,063Gross
                  profit
              
              
              1,747,792
              
              
              2,469,926
              
              
              2,475,788
              
              
              2,252,461
              
              
              8,945,967Net
                  Income (loss)
              
              
              (71,612
              )
              
              457,024
              
              
              998,599
              
              
              515,919
              
              
              1,899,930Net
                  income (loss) per common shareBasic
              
              $
              (.01
              )
              $
              .05
              
              $
              .11
              
              $
              .05Diluted
              
              $
              (.01
              )
              $
              .05
              
              $
              .10
              
              $
              .05
  F-14
 **SCHEDULE
          OF VALUATION AND QUALIFYING ACCOUNTS**




**Years
                  ended June 30, 2006, 2005 and 2004****Balance
                  at**
              
              **Charged
                  to**
              
              
              
              **Balance
                  at****Beginning**
              
              **Costs
                  and**
              
              
              
              **End
                  of****Description**
              
              **of
                  Year**
              
              **Expenses**
              
              **Deductions
                  (A)**
              
              **Year**June
                  30, 2006Allowance
                  for doubtful accounts and salesreturns
              
              $
              90,000
              
              $
              20,245
              
              $
              (20,245
              )
              $
              90,000June
                  30, 2005Allowance
                  for doubtful accounts and salesreturns
              
              
              95,000
              
              
              38,454
              
              
              (43,454
              )
              
              90,000June
                  30, 2004Allowance
                  for doubtful accounts and salesreturns
              
              
              95,200
              
              
              5,989
              
              
              (6,189
              )
              
              95,000




(A)
        Deductions consist of write-offs of uncollectible accounts.




F-15




**Item
      9. Changes in and Disagreements with Accountants and Financial
      Disclosure**





None





**Item
      9A. Controls and Procedures**





An
      evaluation was performed as of June 30, 2006, under the supervision and with
      the
      participation of the Company’s management, including its co-chief executive
      officers and chief financial officer, of the effectiveness of the design and
      operation of the Company’s disclosure controls and procedures. Based on such
      evaluation, the Company’s management has concluded that the Company’s disclosure
      controls and procedures were effective as of June 30, 2006. There have been
      no
      significant changes in our internal controls or in other factors that could
      significantly affect our internal control subsequent to June 30,
      2006.





**Item
      9B. Other Information**





Not
      applicable.





**Part
      III**





The
      information required in items 10, 11,12, 13, and 14 are hereby incorporated
      by
      reference from the Company’s definitive Proxy Statement for the 2006 Annual
      Meeting of Shareholders, tentatively scheduled for December 11, 2006, to be
      filed with the SEC on or prior to October 28, 2006.




27


**Part
      IV**





**Item
      15. Exhibits and Financial Statement Schedules**




(a)
                  Financial Statements.The
                  financial statements and schedules listed in Item 8 are filed as
                  a part of
                  this Annual Report on Form 10K.(b)
                  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.2.
              (a)
                  -- Stock Purchase Agreement between ACG Nystromgruppen AB and AFP
                  Imaging
                  Corporation, dated April 17, 1997. (6)(b)
                  -- Asset Purchase Agreement between AFP Imaging and ProDen Systems,
                  Inc.,
                  dated December 24, 1997. (7).(c)
                  --Promissory Note between ProDen Systems, Inc. and AFP Imaging
                  Corporation, dated August 10, 1999. (8)(d)
                  -- Amended Promissory Note between ACG Nystromgruppen AB and AFP
                  Imaging
                  Corporation, dated August 11, 1999. (8)3.
              (a)
                  -- Certificate of Incorporation of Registrant, as amended.
                  (1)(b)
                  -- Restated Certificate of Incorporation of Registrant.
                  (15)(c)
                  -- Certificate of Amendment to Certificate of Incorporation of
                  Registrant.
                  (4)(d)
                  -- Certificate of Amendment of the Certificate of Incorporation
                  of the
                  Company filed with the Secretary of the State of New York on October
                  12,
                  1995. (5)(e)
                  - Revised By-Laws of Registrant, issued December 2004.
                  (14)4.
              (a)
                  -- Specimen of Common Stock Certificates. (1)(b)
                  -- Common Stock Purchase Warrant issued to Keltic Financial Partners
                  LP.
                  (9)(c)
                  -- Common Stock Purchase Warrant issued to designees of an investment
                  banking firm in March 2006. (18), (20)(d)
                  - Form of Subscription Agreement utilized in a private placement
                  of common
                  stock, effective May 2006. (19), (20)10.
              (a)
                  -- Health and Medical Reimbursement Plan. (1)(b)
                  -- Lease Agreement dated September 1, 1985, for premises at 250
                  Clearbrook
                  Road, Elmsford, NY. (3)(c)
                  -- Profit Sharing Plan of the Registrant, as supplemented.
                  (1)(d)
                  -- Registrants’ 1999 Incentive Stock Option Plan. (8),
                  (16)(e)
                  -- Registrant’s 2004 Equity Incentive Plan. (13), (17)(f)
                  -- Mediation Resolution Agreement dated August 10, 1999.
                  (8)(g)
                  -- Keltic Financial Partners LP Loan and Security Agreement.
                  (9)(h)
                  -- Keltic Financial Partners LP Revolving Note. (9)(i)
                  -- Keltic Financial Partners LP Fifth Amendment to Loan and Security
                  Agreement. (12)(j)
                  -- Keltic Financial Partners LP Restated Revolving Note
                  (12)(k)
                  -- Contract for Sale of Business Assets between AFP Imaging and
                  Amergraph
                  Corporation, dated July 30, 2001.
                  (9)




11.--
      Statement re computation per share earnings. (2)




14.
      - Code
      of Ethics. (11)





16
      (a) --
      Change in Certifying Accountant (October 3, 2003). (10)





21.--
      Subsidiaries of the Registrant.





23.1
      --
      Consent of Goldstein Golub Kessler LLP





31.1,
      31.2, 31.3 - Certifications pursuant to Exchange Act Rule 13a-14 (a).





32.1,
      32.2, 32.3 - Certifications pursuant to Section 1350 of the Sarbanes - Oxley
      Act
      of 2002.




28


(1)
      Incorporated by reference from the exhibits filed with Registration Statement
      file #2-G8980 of the Company, as amended, on file with the Securities and
      Exchange Commission.





(2)
      See
      Note 1 to “Notes to Financial Statements”.





(3)
      Incorporated by reference from the Exhibits filed with Registrant’s Current
      Report on Form 8-K, dated July 31, 1995.





(4)
      Incorporated by reference from the Exhibits filed with Registrant’s Annual
      Report on Form 10-K for the fiscal year ended June 30, 1994.





(5)
      Incorporated by reference from the Exhibits filed with Registrant’s Current
      report on Form 8-K, dated October 12, 1995.





(6)
      Incorporated by reference from the Exhibits filed with the Registrant’s Current
      Report on Form 8-K, dated May 1, 1997.





(7)
      Incorporated by reference from the Exhibits filed with Registrant’s Current
      Report on Form 8-K, dated January 8, 1998.





(8)
      Incorporated by reference from the Exhibits filed with the Registrant’s Annual
      Report on Form 10-K for the fiscal year ended June 30, 1999.





(9)
      Incorporated by reference from the Exhibits filed with the Registrant’s Annual
      Report on Form 10K for the fiscal year ended June 30, 2001.





(10)
      Incorporated by reference from the Exhibits filed with the Registrant’s Current
      Report on Form 8-K, dated October 3, 2003.





(11)
      Incorporated by reference from the Exhibits filed with the Registrant’s
      Quarterly Report on Form 10Q for the six months ended December 31,
      2003




(12)
      Incorporated by reference from the Exhibits filed with the Registrant’s Annual
      Report on Form 10K for the fiscal year ended June 30, 2004.




(13)
      Incorporated by reference from the Exhibits filed with the Registrant’s Current
      Report on Form 8-K, dated October 8, 2004.





(14)
      Incorporated by reference from the Exhibits filed with the Registrant’s Current
      Report on Form 8-K, dated December 10, 2004.





(15)
      Incorporated by reference from the Exhibits filed with the Registrant’s
      Quarterly Report on Form 10Q for the six months ended December 31,
      2004.





(16)
      Incorporated by reference from the Form S-8, Registration Statement Under the
      Securities Act of 1933, filed October 12, 2005.





(17)
      Incorporated by reference from the Form S-8, Registration Statement Under the
      Securities Act of 1933, filed November 17, 2005.





(18)
      Incorporated by reference from the Exhibits filed with the Registrant’s
      Quarterly Report on Form 10Q for the nine months ended March 31,
      2006.





(19)
      Incorporated by reference from the Exhibits filed with the Registrant’s Current
      Report on Form 8-K, dated May 2, 2006





(20)
      Incorporated by reference from the Form S-1, Registration Statement Under the
      Securities Act of 1933, filed June 26, 2006.




29


**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 CORPORATION




By:
                  __________/s/_________________Elise
                  Nissen, Chief Financial OfficerDate:
                  September 15, 2006
  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
                Rabinovitch, President &
                Director(Principal
                Executive Officer)Date:
                September 15, 2006By:
                ____________/s/_____________David
                Vozick, Chairman of the Board,Secretary
                and TreasurerDate:
                September 15, 2006By:
                __________/s/_______________Robert
                Blatt, DirectorDate:
                September 15, 2006By:
                _________ /s/________________Jack
                Becker, DirectorDate:
                September 15, 2006By:
                _________ /s/________________Elise
                Nissen, Chief Financial Officer(Principal
                Financial and Accounting Officer)Date:
                September 15, 2006




30