**UNITED
      STATES**




**Securities
      and Exchange Commission**


Washington,
      D.C. 20549





**Form
      10-Q**





**Quarterly
      Report Pursuant to Section 13 or 15 (d)**


**of
      the Securities Exchange Act of 1934**





For
      Quarterly Period Ended March 31, 2006





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
            (I.R.S.
                Employer Identification No.)Incorporation
                or Organization)





250
                Clearbrook Road, Elmsford, New York
            10523(Address
                of Principal Executive Offices)
            (Zip
                Code)





914-592-6100


(Registrant's
      Telephone Number, Including Area Code)





Indicate
                by check mark whether the registrant: (1) has filed all reports required
                to be filed by Section 13 or 15 (d) of the Securities Exchange Act
                of 1934
                during the preceding 12 months (or for such shorter period that the
                registrant was required to file such reports), and (2) has been subject
                to
                such filing requirements for the past 90 days.
            Yes x
            No
                x




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer.





Large
                accelerated filer o
            Accelerated
                filer o
            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 
                o
            No x




The
      registrant had 12,345,994 shares of its common stock outstanding as of May
      12,
      2006.




1





This
      Quarterly Report on Form 10-Q contains certain forward-looking statements within
      the meaning of the Private Securities Reform Act of 1995. Forward-looking
      statements involve known and unknown risks and uncertainties and other factors
      that could cause the 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,” “could,”
“would,” “project,” “expect,” “believe,” “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,


·
            maintaining
                operating efficiencies,


·
            pricing
                pressures,


·
            risks
                associated with foreign sales,


·
            the
                Company’s ability to attract 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
                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 Quarterly Report on Form 10-Q, and the
                Company’s
                Annual Report on Form 10-K for the year ended June 30, 2005, 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 Quarterly Report on Form 10-Q, the Company’s Annual Report on
      Form 10-K for the year ended June 30, 2005, 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 Form
      10-Q 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.





**PART
      I. Financial Information**





The
      consolidated financial statements included herein have been prepared by the
      Company without audit, pursuant to the rules and regulations of the Securities
      and Exchange Commission. While certain information and footnote disclosures
      normally included in financial statements prepared in accordance with generally
      accepted accounting principles in the United States have been condensed or
      omitted pursuant to such rules and regulations, the Company believes that the
      disclosures made herein are adequate to make the information presented not
      misleading. It is recommended that these consolidated financial statements
      be
      read in conjunction with the Company’s consolidated financial statements and
      notes thereto included in the Company's Annual Report on Form 10-K for the
      fiscal year ended June 30, 2005.





In
      the
      opinion of the Company, all adjustments necessary to present fairly the
      Company’s consolidated financial position as of March 31, 2006, and its results
      of operations for the three and nine-month periods ended March 31, 2006 and
      2005, and its cash flows for the nine-months period ended March 31, 2006 and
      2005, consisting of normal recurring adjustments, have been included. The
      accompanying unaudited interim consolidated financial statements include all
      adjustments (consisting only of those of a normal recurring nature) necessary
      for a fair statement of the results of the interim periods.





2




**Item
        1: FINANCIAL STATEMENTS**
 **AFP
        Imaging Corporation and Subsidiaries**
 **Condensed
        Consolidated Balance Sheets - March 31, 2006 and June 30,
        2005**
 **Assets**
                    
                    **March
                        31,**
                    
                    **June
                        30,****2006**
                    
                    **2005**(Unaudited)Current
                        Assets:Cash
                        and cash equivalents
                    
                    $
                    696,755
                    
                    $
                    331,009Accounts
                        receivable,less
                        allowance fordoubtful
                        accounts of $90,000 and $90,000, respectively
                    
                    
                    3,023,978
                    
                    
                    2,704,136Inventories
                    
                    
                    3,782,118
                    
                    
                    3,921,383Prepaid
                        expenses and other current assets
                    
                    
                    65,067
                    
                    
                    89,069Deferred
                        income taxes
                    
                    
                    680,000
                    
                    
                    680,000**Total
                        current assets**
                    
                    
                    8,247,918
                    
                    
                    7,725,597Property
                      and EquipmentAt
                        cost
                    
                    
                    1,815,106
                    
                    
                    1,623,043Less
                        accumulated depreciation
                    
                    
                    (1,398,905
                    )
                    
                    (1,234,305
                    )416,201
                    
                    
                    388,738Other
                        Assets
                    
                    
                    179,362
                    
                    
                    39,061**Total
                        Assets**
                    
                    **$**
                    **8,843,481**
                    
                    **$**
                    **8,153,396**
 **Liabilities
                    and Shareholders' Equity**
                
                **March
                    31, 2006**
                
                **June
                    30,**
                  **2005**(Unaudited)Current
                    Liabilities:Current
                    portion of long-term debt
                
                $
                22,222
                
                $
                674,585Accounts
                    payable
                
                
                1,838,247
                
                
                1,339,251Accrued
                    expenses
                
                
                1,312,585
                
                
                1,361,514**Total
                    current liabilities**
                
                
                3,173,054
                
                
                3,375,350Deferred
                    Rent
                
                
                82,250
                
                
                115,415**Total
                    liabilities**
                
                
                3,255,304
                
                
                3,490,765Shareholders’
                    Equity:
                  Preferred
                    stock -$.01
                    par value; authorized 5,000,000 shares, none issued
                
                
                –
                
                
                –Common
                    stock,$.01
                    par value; authorized 30,000,000 shares, issued and outstanding
                    9,568,217 and 9,407,717 shares at March 31, 2006, and June 30, 2005,
                    respectively
                
                
                95,682
                
                
                94,077Common
                    stock warrants
                
                
                110,931
                
                
                19,800Paid-in
                    capital in excess of par
                
                
                11,783,650
                
                
                11,641,821Accumulated
                    deficit
                
                
                (6,402,086
                )
                
                (7,093,067)7
                )**Total
                    shareholders’ equity**
                
                
                5,588,177
                
                
                4,662,631**Total
                    Liabilities and Shareholders’****Equity**
                
                **$**
                **8,843,481**
                
                **$**
                **8,153,396**
 The
        accompanying notes to condensed consolidated financial statements are an
        integral part of these statements.


3


**AFP
        Imaging Corporation and Subsidiaries**
 **Condensed
          Consolidated Statements of Operations**
 (Unaudited)
  **Three
                    Months Ended**
                  **March
                    31,**
                
                **Nine
                    Months Ended**
                  **March
                    31,****2006**
                
                **2005**
                
                **2006**
                
                **2005****Net
                    sales**
                
                **$**
                **7,173,942**
                
                **$**
                **6,240,931**
                
                **$**
                **18,663,935**
                
                **$**
                **16,978,637**Cost
                    of sales
                
                
                4,481,436
                
                
                3,765,143
                
                
                11,571,521
                
                
                10,285,131Gross
                    profit
                
                
                2,692,506
                
                
                2,475,788
                
                
                7,092,414
                
                
                6,693,506Selling,
                    general and administrative expenses
                
                
                2,011,530
                
                
                1,715,313
                
                
                5,811,177
                
                
                5,270,786Research
                    and development expenses
                
                
                183,014
                
                
                97,106
                
                
                527,593
                
                
                275,6912,194,544
                
                
                1,812,419
                
                
                6,338,770
                
                
                5,546,477Operating
                    income
                
                
                497,962
                
                
                663,369
                
                
                753,644
                
                
                1,147,029Interest
                    expense, net
                
                
                8,851
                
                
                22,235
                
                
                64,173
                
                
                104,543Income
                    before provision for income taxes
                
                
                489,111
                
                
                641,134
                
                
                689,471
                
                
                1,042,486Provision
                    (benefit) for income taxes
                
                
                (1,510
                )
                
                (357,465
                )
                
                (1,510
                )
                
                (341,525
                )**Net
                    income**
                
                **$**
                **490,621**
                
                **$**
                **998,599**
                
                **$**
                **690,981**
                
                **$**
                **1,384,011**Net
                    income per common share:Basic
                
                $
                .05
                
                $
                .11
                
                $
                .07
                
                $
                .15Diluted
                
                $
                .05
                
                $
                .10
                
                $
                .07
                
                $
                .14Weighted
                    average outstanding common stock:Basic
                
                
                9,568,217
                
                
                9,399,717
                
                
                9,558,533
                
                
                9,373,386Diluted
                
                
                10,050,532
                
                
                9,869,712
                
                
                10,053,422
                
                
                9,863,416
 
 The
          accompanying notes to condensed consolidated financial statements are an
          integral part of these statements.
  4
 **AFP
          Imaging Corporation and Subsidiaries**
 **Condensed
          Consolidated Statements of Shareholders’ Equity**
 **For
          the Nine Months Ended March 31, 2006 and 2005**
 (Unaudited)
 
 **CommonStock**
                
                **CommonStockWarrants**
                
                **Paid-in
                    Capital InExcess of Par**
                
                **AccumulatedDeficit**
                
                **Total****Balance
                    June 30, 2004**
                
                **$****92,710**
                
                **$****19,800**
                
                **$****11,545,883**
                
                **$**(8,992,997)
                
                **$****2,665,396**Issuance
                    of 129,000 shares of common stockin connection with the exercise of
                    stock options
                
                
                1,287
                
                
                –
                
                
                38,818
                
                
                –
                
                
                40,105Net
                      income for nine months  ended March 31, 2005
                
                
                –
                
                
                –
                
                
                –
                
                
                1,384,011
                
                
                1,384,011**Balance
                    March 31, 2005**
                
                **$**
                **93,997**
                
                **$**
                **19,800**
                
                **$**
                **11,584,701**
                
                **$**
                (7,608,986
                )
                **$**
                **4,089,512****Balance
                    June 30, 2005**
                
                **$**
                **94,077**
                
                **$**
                **19,800**
                
                **$**
                **11,641,821**
                
                **$**
                (7,093,067
                )
                **$**
                **4,662,631**Issuance
                    of 160,500 shares of common stock in connection with the exercise of
                    stock options
                
                
                1,605
                
                
                –
                
                
                81,633
                
                
                –
                
                
                83,238Stock-based
                    compensation expense
                
                
                –
                
                
                –
                
                
                60,196
                
                
                –
                
                
                60,196Issuance
                    of common stock warrants
                
                
                –
                
                
                91,131
                
                
                –
                
                
                –
                
                
                91,131Net
                            income for nine months ended March 31,
                            2006
                
                
                –
                
                
                –
                
                
                –
                
                
                690,981
                
                
                690,981**Balance
                    March 31, 2006**
                
                **$**
                **95,682**
                
                **$**
                **110,931**
                
                **$**
                **11,783,650**
                
                **$**
                (6,402,086
                )
                **$**
                **5,588,177**
  The
          accompanying notes to condensed consolidated financial statements are an
          integral part of these statements.
  5
 **AFP
            Imaging Corporation and Subsidiaries**
 **Condensed
            Consolidated Statements of Cash Flows**
 (Unaudited)
 
 **Nine
                      months ended**
                    **March
                      31,******
                  
                  **2006**
                  
                  **2005**Cash
                      flows from operating activities:Net
                      income
                  
                  $690,981
                  
                  $1,384,011Adjustments
                      to reconcile net income to net cash provided by operating
                      activities-Depreciation
                      and amortization
                  
                  
                  171,170
                  
                  
                  172,600Deferred
                      income tax benefit
                  
                  
                  –
                  
                  
                  (340,000
                  )Non-cash
                      compensation expense
                  
                  
                  60,196
                  
                  
                  –Change
                      in assets and liabilities:(Increase)
                      in accounts receivable
                  
                  
                  (319,842
                  )
                  
                  (123,953
                  )Decrease
                      (increase) in inventories
                  
                  
                  139,265
                  
                  
                  (412,766
                  )(Increase)
                      decrease in prepaid expenses and other assets
                  
                  
                  (31,738
                  )
                  
                  120,800Increase
                      in accounts payable
                  
                  
                  498,996
                  
                  
                  466,153(Decrease)
                      in accrued expenses
                  
                  
                  (48,929
                  )
                  
                  (50,675
                  )(Decrease)
                      in deferred rent
                  
                  
                  (33,165
                  )
                  
                  (15,264
                  )Total
                      adjustments
                  
                  
                  435,953
                  
                  
                  (183,105
                  )**Net
                      cash provided by operating activities**
                  
                  
                  1,126,934
                  
                  
                  1,200,906Cash
                      flows from investing activities:Purchases
                      of property and equipment
                  
                  
                  (192,063
                  )
                  
                  (137,436
                  )**Net
                      cash used in investing activities**
                  
                  
                  (192,063
                  )
                  
                  (137,436
                  )Cash
                      flow from financing activities:Repayment
                      of debt
                  
                  
                  (652,363
                  )
                  
                  (1,000,038
                  )Proceeds
                      from exercise of common stock options
                  
                  
                  83,238
                  
                  
                  40,105**Net
                      cash used in financing activities**
                  
                  
                  (569,125
                  )
                  
                  (959,933
                  )Net
                      increase in cash and cash equivalents
                  
                  
                  365,746
                  
                  
                  103,537Cash
                      and cash equivalents, at beginning of period
                  
                  
                  331,009
                  
                  
                  331,993Cash
                      and cash equivalents, at end of period
                  
                  $
                  696,755
                  
                  $
                  435,530**Supplemental
                      cash flow disclosures:**
                    Cash
                      paid during the periods for-Interest
                  
                  $
                  74,057
                  
                  $
                  109,294Income
                      taxes, net of refunds
                  
                  $
                  4,563
                  
                  $
                  35,940
 
 The
              accompanying notes to condensed consolidated financial statements are
              an
              integral part of these statements.
  6
 **AFP
              Imaging Corporation and
              Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**March 31,
      2006**


(Unaudited)





**(1)** **Genera** **l:**


AFP
      Imaging Corporation (together with its subsidiaries, the “Company”) 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,
      producing and recording medical, veterinary and dental images through digital
      technology, 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
      only one business segment, medical/dental.





The
      accounting policies followed during the interim periods reported on herein
      are
      in conformity with accounting principles generally accepted in the United States
      and are consistent with those applied for annual periods, as described in the
      Company's consolidated financial statements included in the Company's Annual
      Report on Form 10-K for the year ended June 30, 2005. The Condensed Consolidated
      Balance Sheet at June 30, 2005 has been derived from the audited financial
      statements.





**(2)** **Stock
      Option Plans:**


The
      Company currently has in effect two employee incentive stock plans, under which
      approximately 1,100,000 shares of Company common stock were originally
      authorized and available for issuance. Options that are granted under the plans
      generally 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% in the case of
      incentive stock options qualifying under Section 422A of the Internal Revenue
      Code (“ISOs”) or 110% in the case of ISOs granted to persons owning more than
      10% of the outstanding stock of the Company). As of March 31, 2005, all of
      the
      outstanding stock options issued by the Company were fully vested.





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
      interim periods prior to the adoption date, as described in SFAS 123R. 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 three
      and
      nine months ended March 31, 2006, non-cash stock based compensation expense
      related to stock option awards (“Stock Option Expense”) was $23,688 and $60,196,
      respectively, and has been included in operating expenses. For the three and
      nine months ended March 31, 2005, 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 $7,240 and $23,041, respectively,
      and
      the effect on the Company’s net income and net income per share would have been
      as follows:





Three
                months ended
              March
                31, 2005
            
            Nine
                months ended
              March
                31, 2005Net
                income, as reported
            
            $
            998,599
            
            $
            1,384,011Deduct:
                Stock-based compensation expense determined underfair
                value based method for all awards
            
            
            (7,240
            )
            
            (23,041
            )Pro
                forma net income
            
            $
            991,359
            
            $
            1,360,970Basic
                net income per share amounts:As
                reported
            
            $
            .11
            
            $
            .15Pro
                forma
            
            $
            .10
            
            $
            .14Diluted
                net income per share amounts:As
                reported
            
            $
            .11
            
            $
            .15Pro
                forma
            
            $
            .10
            
            $
            .14




7


The
      fair
      value of each option granted under the Company’s incentive stock plans during
      the three and nine months ended March 31, 2006 and 2005 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 weighted-average of the fair value of the options granted
      during the three and nine months ended March 31, 2006 was $2.40 and $2.10 per
      option, respectively; and the weighted-average of the fair value of the options
      granted during the three and nine months ended March 31, 2005 was $1.15 and
      $1.22 per option, respectively. The following table summarizes the weighted
      average values of the assumptions used in computing the fair value of the option
      grants.





Three
                months ended March 31
            Nine
                months ended March 312006
            2005
            2006
            2005Expected
                volatility
            152%
            47%
            152%
                - 155%%
            47%Expected
                lives from grant date
            10
                years
            10
                years
            10
                years
            10
                yearsExpected
                dividend yield
            0%
            0%
            0%
            0%Risk-free
                interest rate
            4.58%
            4.10%
            4.19%
                - 4.58%
            4.04%
                - 4.16%




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, and March
      31,
      2006 in accordance with the Company’s policy for non-employee director
      compensation.





Transactions
      under the plans for the nine months ended March 31, 2006 and 2005 are as
      follows:





Nine
                months ended March 31,
            2006
            2005Options
            Weighted
              average
              price
            Options
            Weighted
              average
              priceOutstanding,
                beginning of fiscal year
            948,400
            $.76
            1,008,500
            $.57Exercised
            (160,500)
            .52
            (129,100)
            .31Granted
            30,000
            2.10
            30,000
            1.22Forfeited
            0
            0
            (5,000)
            .98Expired
            0
            0
            (57,000)
            .31Outstanding,
                end of period
            817,900
            $.85
            847,400
            $.65Exercisable
                at March 31,
            817,900
            
            847,400Weighted
                average fair value of
              options
                granted
            $2.08
            
            
            $.77







The
      aggregate intrinsic value of the outstanding options, which are all currently
      exercisable, amounted to $934,922 at March 31, 2006. The total intrinsic value
      of options exercised during the nine months ended March 31, 2006, amounted
      to
      $282,738.







At
      March
      31, 2006, the range of exercise prices is as follows:




Options
                Outstanding
            Options
                ExercisableRange
                of Exercise Prices
            Number
                Exercisable
              at
                March 31, 2006
            Weighted-averageRemaining
              Contractual
                Life (Years)
            Weighted-average
                Exercise Price
            Number
                Exercisable
              March
                31, 2006
            Weighted-averageExercise
                Price$.11
                - $.50
            396,000
            3.92
            $.30
            396,000
            $.30$.53
                - $.81
            25,500
            4.19
            .61
            25,500
            .61$1.06
                - $1.75
            348,400
            8.49
            1.33
            348,400
            1.33$1.90
                - $2.26
            48,000
            6.75
            2.12
            48,000
            2.12817,900
            6.04
            $.85
            817,900
            $.85








8


**(** **3)
      Per Share Data** **:**


The
      Company’s basic net income per share amounts are calculated by dividing net
      income by 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 dilutive. Common
      stock equivalents include (1) outstanding stock options and (2) outstanding
      warrants. The following is a reconciliation from basic to diluted shares for
      the
      three and nine months ended March 31, 2006 and 2005:





Three
                months ended March 31,
            Nine
                months ended March 31,2006
            2005
            2006
            2005Basic
                Shares
            9,568,217
            9,399,717
            9,558,533
            9,373,386Dilutive:Options
            398,235
            393,353
            410,176
            413,203Warrants
            84,080
            76,642
            84,713
            76,827Diluted
                Shares
            10,050,532
            9,869,712
            10,053,422
            9,863,416





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 Company 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.




**(4)
      Long and Short Term Debt** **:**


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 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
      Renewed Revolving Credit Loan has an interest rate of 1.375% over the prime
      rate, 7.75% as of March 31, 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
      also 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 March 31,
      2006, there was no amount outstanding under the Renewed Revolving Credit Loan
      and the Company was in compliance with all the terms and conditions of the
      Renewed Revolving Credit Loan.





Included
      in debt is a subordinated promissory note related to a prior acquisition. This
      note had a principal outstanding amount of $22,222 at March 31, 2006, of which
      the entire amount has been classified as a current liability; the final payment
      was made in April 2006.





**(5)** **Inventory** **:**


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). Production materials represent a small component of inventory
      at month-end due to the manufacturing cycle. 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. All standard costs are reviewed periodically and updated accordingly
      to verify that the standard costs approximate the actual costs. At March 31,
      2006 and June 30, 2005, inventories, net of reserves, consist of the
      following:





March
                31, 2006
            June
                30, 2005(Unaudited)Raw
                materials and sub-component parts
            $1,938,795
            $1,721,165Work-in-process
                and finished goods
            1,843,323
            2,200,218$3,782,118
            $3,921,383




**(6)** **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 March 31, 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. Should circumstance change and the Company
      determine that it will not be able to utilize its net operating loss
      carryforward, such as a continuous decline in future taxable income, the Company
      will reevaluate its valuation allowance. As of March 31, 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.





9


The
      Company made small federal and state tax payments in March 2006 for the
      nine-months ended March 31, 2006, based on current earnings and over-payments
      made during its fiscal year ended June 30, 2005.





**(7)**  **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 was
      originally filed in 1998 by the federal government in United States District
      Court (New Jersey), citing several hundred other third-party defendants. 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. 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 certain other defendants, in an
      alternative dispute resolution (ADR) process for smaller claims. The Company's
      insurance carrier has agreed to equally share, with the Company, the defense
      costs incurred in this environmental claim. No definitive potential cost to
      the
      Company has been assessed on this claim; however, the Company has accrued
      $75,000, 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 draft allocation report was issued in March 2006
      and
      the Company has been advised that a settlement offer for the de minimis claims
      (which includes the Company) will be issued shortly. 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 is a defendant (with several other parties) in a product liability
      subrogation claim, 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 damages to the plaintiff’s premises in May
      2003. The complaint seeks unspecified compensatory damages. 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.





**(8)** **** **New
      Accounting Standards:**


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. SFAS No. 154 is effective
      for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. The Company is required to adopt SFAS No. 154, as
      applicable, beginning July 1, 2006. The Company is evaluating the effect of
      SFAS
      No. 154, but does not believe that there will be any material effect on the
      Company’s historical financial statements.





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.





10


**(9)
      Subsequent Event**


On
      May 2,
      2006, the Company consummated a private placement of shares of Company common
      stock to a group of selected institutional and other accredited investors.
      The
      Company sold 2,777,777 shares of Company common stock at $1.80 per share in
      this
      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
      $168,000, including all placement fees and 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 currently are no material, definitive
      commitments or arrangements with respect to any of the net proceeds of the
      private placement.




11


**Item
      2: Management's Discussion and Analysis of Financial Condition and Results
      of
      Operation**





**Capital
      Resources and Liquidity**





The
      Company’s working capital at March 31, 2006 increased by approximately $724,600
      from June 30, 2005. This increase is principally is due to the income from
      operations, reductions in inventory and current debt, offset by an increase
      in
      accounts payable.





Operating
      cash flows were slightly lower in the current nine-month period due to a lower
      operating income, offset by improved utilization of the available inventory
      and
      inventory production planning and scheduling. In the current nine-month period,
      the Company’s senior secured debt borrowings decreased approximately $452,000
      and the subordinated note was reduced by $200,000. In the current quarter,
      the
      Company repaid in full its senior secured debt and has had no amounts
      outstanding since January 2006. The Company has not changed its payment policies
      to its vendors, nor revised its payment terms with its customers.





Effective
      as of March 28, 2006, the Company issued an aggregate 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 financial 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 entitle 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.





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 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
      Renewed Revolving Credit Loan has an interest rate of 1.375% over the prime
      rate, 7.75% as of March 31, 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
      also 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 March 31,
      2006, there was no amount outstanding under the Renewed Revolving Credit Loan
      and the Company was in compliance with all the terms and conditions of the
      Renewed Revolving Credit Loan .





Included
      in debt is a subordinated promissory note related to a prior acquisition. This
      note had a principal outstanding amount of $22,222 at March 31, 2006, of which
      the entire amount has been classified as a current liability; and was repaid
      in
      full in April 2006.





The
      Company’s historical operating cash flows generally have been positive; however,
      the Company is dependent upon operations and the Renewed Revolving Credit Loan
      to finance its ongoing operations. It is believed that the Renewed Revolving
      Credit Loan is sufficient to finance the Company’s ongoing working capital
      requirements for the foreseeable future at the current rate of operations.
      The
      Company expects its customary operating working capital requirements will
      continue to be financed by operations and from borrowings, including borrowings
      under the Renewed Revolving Credit Loan. The Company currently believes that
      there are no significant trends, demands, commitments or contingencies, other
      than previously discussed, which are reasonably likely to result in a material
      increase or decrease in its liquidity or capital resources in the foreseeable
      near-term future. As of May 5, 2006, the Company had available approximately
      $2.5 million of unused credit under the terms of the Renewed Revolving Credit
      Loan .





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.





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.





12


The
      terms
      of the Renewed Revolving Credit Loan limit the amount of capital expenditures.
      Capital expenditures for the first nine months of Fiscal 2006 were approximately
      $192,000, consisting of the purchase of a new 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, tooling, foundry and test equipment
      expenditures related to the design, development and production of the new
      imaging products, and an upgrade to the Company’s voice-mail system. Where
      practical, the Company continues to conserve its cash. The Company expects
      to
      continue to finance any future capital requirements principally from internally
      generated funds.








**Results
      of Operations - Nine Months Fiscal 2006 Versus Nine Months Fiscal
      2005**





Sales
      increased approximately $1,685,300 or 10.0%, between the Fiscal 2005 and Fiscal
      2006 nine-month periods. 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 marketplaces. The Company signed an OEM agreement
      with a subsidiary of Henry Schein, Inc. for the production and supply of its
      intraoral digital dental x-ray sensors. In the third quarter FY 2006, the
      Company introduced a mobile digital imaging system specifically designed for
      the
      equine marketplace, which accounted for a significant portion of the increase
      in
      sales. Sales of the digital sensor (veterinary and human dental applications)
      showed a 49% increase in the current nine-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 14%
      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 a 6% 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 40%
      increase in international sales between the periods.





Gross
      profit as a percent of sales decreased slightly (1.4 percentage points) between
      the Fiscal 2005 and Fiscal 2006 nine-month comparable periods. Material costs
      as
      a percent of sales increased .9 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 nine-month
      period, labor and overhead costs increased approximately $324,600, including
      related employee benefits, transportation costs and other operating
      costs.





Selling,
      general, and administrative costs increased approximately $540,400 or 10.3%,
      between the Fiscal 2005 and Fiscal 2006 nine-month comparable periods. 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 $477,000 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 $251,900 or 91%, between the
      Fiscal 2005 and Fiscal 2006 nine-month comparable periods. 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.





Interest
      expense, net decreased approximately $40,400 or 38.6%, between the Fiscal 2005
      and Fiscal 2006 nine-month comparable periods. In January 2006, the Company
      repaid the outstanding balance on the Renewed Revolving Credit Loan. A
      subordinated note was repaid as of December 2004, which reduced interest for
      the
      period by approximately $17,600. The balance of the decrease is due to
      approximately $344,900 less in the average monthly revolving credit borrowings
      for the current nine-month period, 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.





13


The
      Company made small federal and state tax payments in March 2006 for the
      nine-months ended March 31, 2006, based on current earnings and over-payments
      made during Fiscal Year 2005. As of March 31, 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 it will utilize
      these prior year net operating loss carry forwards. As of March 31, 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.





**Results
      of Operations - Third Quarter Fiscal 2006 Versus Third Quarter Fiscal
      2005**





Sales
      increased approximately $933,000 or 14.9%, between the third quarter Fiscal
      2005
      and the third quarter Fiscal 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 marketplaces. The Company signed an OEM
      agreement with a subsidiary of Henry Schein, Inc., for the production and supply
      of its intraoral digital dental x-ray sensors. In the third quarter FY 2006,
      the
      Company introduced a mobile digital imaging system specifically designed for
      the
      equine marketplace, which accounted for a significant portion of the increase
      in
      sales. 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 17% decline in intra-oral and panoramic x-ray systems between
      the comparable periods, as intra-oral x-rays are becoming more price-sensitive
      due to competitive factors. There was a 16% decline in the Company’s analog
      processor sales, mainly due to the gaining recognition and acceptance of the
      Company’s digital imaging systems. The Company has continued its efforts to
      increase worldwide distribution and expand and develop new international
      markets, resulting in a 34% increase in international sales between the
      periods.





Gross
      profit as a percent of sales decreased 2.2 percentage points between the third
      quarter Fiscal 2005 and the third quarter Fiscal 2006. Material costs, as a
      percent of sales, increased 1.6 percentage points between the two comparable
      periods. There was a small change in the product mix, with the sale of more
      distributor goods, which tend to have a lower gross margin, as well as material
      cost increases from vendors which were not passed onto our customers; offset
      by
      processing improvements in some of the manufactured products. Due to the higher
      sales volumes in the current three-month period, labor and overhead costs
      increased approximately $153,400, including employee benefit, transportation
      costs and other operating costs.





Selling,
      general, and administrative costs increased approximately $296,200 or 17.3%,
      between the third quarter Fiscal 2005 and third quarter Fiscal 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 $173,000 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), and (3) a slight increase in general operating expenses.





Research
      and development costs increased approximately $85,900 or 88.5%, between the
      third quarter Fiscal 2005 and third quarter Fiscal 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.





Interest
      expense, net decreased approximately $13,400 or 60.2%, between the third quarter
      Fiscal 2005 and third quarter Fiscal 2006. In January 2006, the Company repaid
      the outstanding balance on the Renewed Revolving Credit Loan. The decrease
      is
      due to approximately $476,900 less in the average monthly revolving credit
      borrowings for the current three-month period, offset in part by an
      approximately 2.1% 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 made small federal and state tax payments in March 2006, based on
      current earnings and over-payments made during Fiscal Year 2005. As of March
      31,
      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 it will utilize these prior year net operating loss carry forwards.
      As of March 31, 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.





14


**Critical
      Accounting Policies and Estimates**





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. These estimates and assumptions
      are
      evaluated on an ongoing basis focusing 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 worldwide distributors on varying terms between 30 and
      90
      days. 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 are determined
      by management to be 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 the Company’s limited warranties issued to its customers. Various factors
      affect the Company’s warranty liability, including the (1) number of units sold,
      (2) historical rates of claims, (3) anticipated rates of claims, and (4) costs
      per claim. The Company periodically assesses the adequacy of its warranty
      liability based on changes in these factors. Management believes that the
      current warranty provisions are sufficient based on the warranty information
      available to the Company.





In
      March
      2005, the Company began to issue extended warranties in connection with sales
      of
      its digital sensors. The Company is continuing to monitor the rate and costs
      of
      claims and review the adequacy of its warranty liability and make any changes
      as, and if, necessary. If the Company experiences significant increased warranty
      claims or activity, or the warranty claims exceed the currently reserved amount,
      the warranty reserve will be increased, resulting in decreased gross profit
      during the period(s) in which the warranty reserve is increased.




Stock-based
      Compensation


Stock
      based compensation is accounted for in accordance with SFAS No. 123R. The
      Company determines the fair value of options based on the Black-Scholes model,
      which is based on specific assumptions including (1) the expected life of the
      option, (2) risk free interest rates, (3) expected volatility and (4) expected
      dividend yield.




15


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 affected. In reviewing the valuation allowance, the Company
      considers future taxable income and determines whether it is more likely than
      not that a portion of the deferred tax asset will be realized. Changes in these
      circumstances, such as an increase or decline in estimated future taxable
      income, would result in a re-determination of the valuation allowance.





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 its potential litigation
      liability in the past; however, court decisions and/or other unforeseen events
      could cause liabilities to be incurred in excess of estimates.





**Item
      3: 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 the 12-month LIBOR rate), primarily
      from its borrowings under its senior and subordinated debt. The Company does
      not
      believe that it is materially exposed to changes in interest rates; as at March
      31, 2006, there was approximately $22,222 in total debt outstanding. The Company
      repaid its subordinated note as of April 2006 and repaid its outstanding balance
      on the Renewed Revolving Credit Loan in January 2006. The Company currently
      does
      not use interest rate derivative instruments to manage exposure to interest
      rate
      changes.





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/weakness
      of the Dollar to the Euro or to the Yen does affect the Company’s gross profit.
      The Company regularly monitors all changes in foreign currency and may adjust
      its pricing to customers to reflect these changes.





**Item
      4: Controls and Procedures.**





a) Evaluation
      of disclosure controls and procedures





Our
      co-principal executive officers and chief financial officer have reviewed and
      evaluated the effectiveness of the Company’s disclosure controls and procedures
      (as defined in Rule 13a - 15 (e) of the Securities Exchange Act of 1934 (the
      “Act”)). Based on their review and evaluation, the co-chief executive officers
      and chief financial officer have concluded that, as of March 31, 2006, the
      Company’s disclosure controls and procedures were adequate and effective to
      ensure that information required to be disclosed by the Company in the reports
      that it files or submits under the Act is recorded, processed, summarized and
      reported, within the time periods specified in the rules and forms of the
      Securities and Exchange Commission.





(b) Changes
      in internal controls





During
      the
      quarter ended March 31, 2006, there were no significant changes in the Company’s
      internal controls over financial reporting or in other factors that could
      materially affect, or is reasonably likely to materially affect, these internal
      controls, nor were there any significant deficiencies or material weaknesses
      in
      these internal controls requiring corrective actions. As a result, no corrective
      actions were necessary.





16


**Part
      II Other Information**





**Item
      1: Legal Proceedings** **.**





Reference
      is made to Item 3 in the Company’s Annual Report on Form 10-K for the fiscal
      year ended June 30, 2005, and to the references therein, for a discussion of
      all
      material pending legal proceedings to which the Company and its subsidiaries
      are
      parties.





The
      status
      conference relating to the environmental claim involving a property in New
      Jersey owned by the Company between August 1984 and June 1985 was held in
      December 2005. The draft allocation report was issued in March 2006 and a
      revised settlement offer for the de minimis claims (which includes the Company)
      is expected to be issued shortly.





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





**Item
      2: Unregistered Sales in Equity Securities and Uses of
      Proceeds** **.**





Effective
      as of March 28, 2006, the Company issued an aggregate 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 financial 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 entitle 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 Company has granted
      certain registration rights with respect to the registration under the
      Securities Act of 1933, as amended, of the shares issuable upon exercise of
      the
      warrants for resale by the warrant holders. The Company believes that the
      issuance of the warrants was exempt from the registration requirements of the
      Securities Act pursuant to the provisions of Section 4(2) of the Securities
      Act.




**Item
      3: Defaults Upon Senior Securities** **.**





None





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





None





**Item
      5: Other Information** **.**





None





**Item
      6:**  **Exhibits** **.**





(a)
            Exhibits:


(1)
            31.1,
                31.2, 31.3 - Certifications pursuant to Exchange Act Rule 13a - 14
                (a).





(2)
            32.1,
                32.2, 32.3 - Certifications pursuant to 18 U.S.C. Section 1350 of
                the
                Sarbanes - Oxley Act of 2002.




(4.1)
              Form
                  of Subscription Agreement utilized by the Company in its private
                  placement
                  consummated on May 2, 2006, containing registration rights granted
                  to the
                  purchasers in the private placement. (Incorporated by reference
                  from the
                  Exhibits filed with the Registrant’s Current Report on Form 8-K, dated May
                  2, 2006.)(10.1)
              Form
                  of Warrant certificate evidencing warrants granted to designees
                  of an
                  investment banking firm retained by the Company, effective March
                  28, 2006,
                  to provide certain financial advisory services to the Company.


17





**Signatures**




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











**AFP
      IMAGING CORPORATION**











/s/
      David Vozick


**David
      Vozick**


Chairman
      of the Board,


(Co-Principal
      Executive Officer)


Secretary,
      Treasurer


Date:
      May
      15, 2006











/s/
      Donald Rabinovitch


**Donald
      Rabinovitch**


President


(Co-Principal
      Executive Officer)


Date:
      May
      15, 2006








/s/
      Elise Nissen


**Elise
      Nissen**


Chief
      Financial Officer


(Principal
      Financial and Accounting Officer)


Date:
      May
      15, 2006





18