UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 WASHINGTON,
D.C. 20549
  FORM
10-Q
 
 (Mark
One)
 x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
  For
the quarterly period ended December 31, 2008
  OR
   ̈
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934
  For
the transition period from  
to
 
 
 Commission
File Number 0-10832
 
 
 AFP
Imaging Corporation
 (Exact
Name of Registrant as Specified in Its Charter)
    New
      York
                    13-2956272(State
      or Other Jurisdiction of
                    (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
____
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one)
   Large accelerated
      filer _____
              Accelerated
      filer ______
              Non-accelerated
      filer _____(Do not check if a smaller reporting company)Smaller reporting
      company _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
registrant had 17,928,800 shares of its common stock outstanding as of February
12, 2009.
 
 
 
 AFP
Imaging Corporation
 
 Table of
Contents
 
 PagePart
      I.
                                              Financial InformationItem
      1.
                                              Financial Statements.Condensed Consolidated Balance Sheets as of
      December 31, 2008 (unaudited) and June 30, 2008
                                              
                                              
                                              4Condensed Consolidated Statements of Operations for the
      three and six  months ended December 31, 2008 and 2007
      (unaudited)
                                              
                                              
                                              5Condensed Consolidated Statements of
      Shareholders’ Equity for the six months ended December 31, 2008 and 2007
      (unaudited)
                                              
                                              
                                              6Condensed Consolidated Statements of Cash Flows for the
      six months ended December 31, 2008 and 2007
(unaudited)
                                              
                                              
                                              7Notes to Consolidated Interim Financial
      Statements
                                              
                                              
                                              8-15Item
      2.
                                              Management’s Discussion and Analysis of Financial Condition
      and Results of Operations.
                                              
                                              
                                              16-24Item
      3.
                                              Quantitative and Qualitative Disclosures About Market
      Risk.
                                              
                                              
                                              24Item
      4T.
                                              Controls and Procedures.
                                              
                                              
                                              24-26Part
      II.
                                              Other
      InformationItem
      1.
                                              Legal Proceedings.
                                              
                                              
                                              27Item
      4.
                                              Submission of Matters to a Vote of Security
      Holders.
                                              
                                              
                                              27Item
      6.
                                              Exhibits.
                                              
                                              
                                              28Signatures
                                              
                                              
                                              29-35
 
  2
  This
Quarterly Report on Form 10-Q contains certain forward-looking statements within
the meaning of the Private Securities Litigation 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 “plan,” “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 cure the default situation with its senior secured
      lender,
 ·
              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,
 ·
              risks
      associated with foreign sales,
 ·
              risks
      associated with the loss of services of the key executive
      officers,
 ·
              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, 2008, 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, 2008, and the Company’s other filings with
the SEC.  These reports attempt to advise interested parties of the
risks and factors that may affect the Company’s business, financial condition
and results of operations and prospects.  The forward-looking
statements made in this 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, 2008.
 
 In the
opinion of the Company, all adjustments necessary to present fairly the
Company’s consolidated financial position as of December 31, 2008, and its
results of operations for the six and three-month periods ended December 31,
2008 and 2007, and its cash flows for the six-month periods ended December 31,
2008 and 2007, 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.
  3
  Item
1:  FINANCIAL
STATEMENTS


AFP
Imaging Corporation and Subsidiaries
 Condensed Consolidated Balance Sheets – December 31, 2008
and June 30, 2008
  Assets
                                                            
                                                            December
      31,
                                                              2008
                                                            
                                                            June
      30,
                                                              2008
                                                            
                                                            
                                                            Liabilities
      and Shareholders' Equity
                                                            
                                                            December
      31,
                                                              2008
                                                            
                                                            June
      30,
                                                              2008(Unaudited)
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            (Unaudited)Current
      Assets:
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            Current
      Liabilities:Cash
      and cash equivalents
                                                            
                                                            $
                                                            1,451,609
                                                            
                                                            
                                                            $
                                                            819,444
                                                            
                                                            
                                                            
                                                            Current
      portion of long-term debt
                                                            
                                                            $
                                                            8,456,857
                                                            
                                                            
                                                            $
                                                            8,578,056Accounts
      receivable, less allowance for doubtful accounts of $918,625 and $919,483,
      respectively
                                                            
                                                            
                                                            2,223,056
                                                            
                                                            
                                                            
                                                            4,281,796
                                                            
                                                            
                                                            
                                                            Accounts
      payable
                                                            
                                                            
                                                            3,358,457
                                                            
                                                            
                                                            
                                                            3,557,357Accrued
      expenses and other current liabilities
                                                            
                                                            
                                                            2,774,227
                                                            
                                                            
                                                            
                                                            3,525,308Deferred
      revenue
                                                            
                                                            
                                                            40,000
                                                            
                                                            
                                                            
                                                            822,000Total
      current liabilities
                                                            
                                                            
                                                            14,629,541
                                                            
                                                            
                                                            
                                                            16,482,721Inventories
                                                            
                                                            
                                                            4,342,232
                                                            
                                                            
                                                            
                                                            6,950,129Prepaid
      expenses and other current assets
                                                            
                                                            
                                                            338,609
                                                            
                                                            
                                                            
                                                            557,947
                                                            
                                                            
                                                            
                                                            Deferred
      liabilities
                                                            
                                                            
                                                            662,100
                                                            
                                                            
                                                            
                                                            718,358Deferred
      income taxes
                                                            
                                                            
                                                            83,351
                                                            
                                                            
                                                            
                                                            76,921
                                                            
                                                            
                                                            
                                                            Long-term
      debt
                                                            
                                                            
                                                            18,592
                                                            
                                                            
                                                            
                                                            22,957Total
      current assets
                                                            
                                                            
                                                            8,438,857
                                                            
                                                            
                                                            
                                                            12,686,237
                                                            
                                                            
                                                            
                                                            Total
      liabilities
                                                            
                                                            
                                                            15,310,233
                                                            
                                                            
                                                            
                                                            17,224,036Commitments
      and Contingencies (Note 9)Property
      and equipment
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            Shareholders’
      Equity:At cost
                                                            
                                                            
                                                            2,279,229
                                                            
                                                            
                                                            
                                                            2,252,099
                                                            
                                                            
                                                            
                                                            Preferred
      stock - $.01 par value; authorizedLess
      accumulated depreciation
                                                            
                                                            
                                                            (1,896,519
                                                            )
                                                            
                                                            
                                                            (1,778,510
                                                            )
                                                            
                                                            
                                                            5,000,000 shares, none issued
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -382,710
                                                            
                                                            
                                                            
                                                            473,589
                                                            
                                                            
                                                            
                                                            Common
      stock, $.01 par value; authorized100,000,000 shares at December 31, 2008and 30,000,000 shares at June 30, 2008;and
      17,928,800 shares outstanding atDecember 31, 2008 and June 30, 2008
                                                            
                                                            
                                                            179,288
                                                            
                                                            
                                                            
                                                            179,288Deferred
      income taxes
                                                            
                                                            
                                                            611,330
                                                            
                                                            
                                                            
                                                            466,022
                                                            
                                                            
                                                            
                                                            Common
      stock warrants
                                                            
                                                            
                                                            91,131
                                                            
                                                            
                                                            
                                                            91,131Other
      assets
                                                            
                                                            
                                                            162,938
                                                            
                                                            
                                                            
                                                            323,813
                                                            
                                                            
                                                            
                                                            Paid-in
      capital
                                                            
                                                            
                                                            25,444,176
                                                            
                                                            
                                                            
                                                            25,444,176Goodwill
                                                            
                                                            
                                                            3,936,627
                                                            
                                                            
                                                            
                                                            4,453,627
                                                            
                                                            
                                                            
                                                            Accumulated
      deficit
                                                            
                                                            
                                                            (26,860,273
                                                            )
                                                            
                                                            
                                                            (21,809,709
                                                            )Other
      intangibles, net
                                                            
                                                            
                                                            2,429,265
                                                            
                                                            
                                                            
                                                            2,997,551
                                                            
                                                            
                                                            
                                                            Cumulative
      translation adjustment
                                                            
                                                            
                                                            1,797,172
                                                            
                                                            
                                                            
                                                            271,917Total
      shareholders’ equity
                                                            
                                                            
                                                            651,494
                                                            
                                                            
                                                            
                                                            4,176,803Total
      Liabilities and Shareholders’Total
      Assets
                                                            
                                                            $
                                                            15,961,727
                                                            
                                                            
                                                            $
                                                            21,400,839
                                                            
                                                            
                                                            
                                                            Equity
                                                            
                                                            $
                                                            15,961,727
                                                            
                                                            
                                                            $
                                                            21,400,839
  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 Operations
 (Unaudited)
 
 Three
      Months Ended
                                                December
      31,
                                              
                                              
                                              Six
      Months Ended
                                                December
      312008
                                              
                                              
                                              2007
                                              
                                              
                                              2008
                                              
                                              
                                              2007Net
      sales
                                              
                                              $
                                              7,281,315
                                              
                                              
                                              $
                                              8,659,383
                                              
                                              
                                              $
                                              13,929,579
                                              
                                              
                                              $
                                              16,107,438Cost
      of sales
                                              
                                              
                                              3,939,310
                                              
                                              
                                              
                                              5,105,677
                                              
                                              
                                              
                                              7,785,742
                                              
                                              
                                              
                                              9,461,093Gross
      profit
                                              
                                              
                                              3,342,005
                                              
                                              
                                              
                                              3,553,706
                                              
                                              
                                              
                                              6,143,837
                                              
                                              
                                              
                                              6,646,345Selling,
      general and administrative expenses
                                              
                                              
                                              3,542,933
                                              
                                              
                                              
                                              3,680,281
                                              
                                              
                                              
                                              7,114,286
                                              
                                              
                                              
                                              6,791,782Amortization
      of intangibles
                                              
                                              
                                              104,300
                                              
                                              
                                              
                                              303,828
                                              
                                              
                                              
                                              223,154
                                              
                                              
                                              
                                              592,282Research
      and development expenses
                                              
                                              
                                              328,786
                                              
                                              
                                              
                                              569,007
                                              
                                              
                                              
                                              809,251
                                              
                                              
                                              
                                              1,003,0043,976,019
                                              
                                              
                                              
                                              4,553,116
                                              
                                              
                                              
                                              8,146,691
                                              
                                              
                                              
                                              8,387,068Operating
      loss
                                              
                                              
                                              (634,014
                                              )
                                              
                                              
                                              (999,410
                                              )
                                              
                                              
                                              (2,002,854
                                              )
                                              
                                              
                                              (1,740,723
                                              )Foreign
      currency (loss)/gain on intercompany note
                                              
                                              
                                              (788,330
                                              )
                                              
                                              
                                              518,223
                                              
                                              
                                              
                                              (2,150,705
                                              )
                                              
                                              
                                              1,095,346Interest
      expense, net
                                              
                                              
                                              222,564
                                              
                                              
                                              
                                              239,805
                                              
                                              
                                              
                                              1,280,201
                                              
                                              
                                              
                                              493,464Loss
      before provision for income taxes
                                              
                                              
                                              (1,644,908
                                              )
                                              
                                              
                                              (720,992
                                              )
                                              
                                              
                                              (5,433,760
                                              )
                                              
                                              
                                              (1,138,841
                                              )Provision/(benefit)
      for income taxes
                                              
                                              
                                              73,229
                                              
                                              
                                              
                                              1,003,716
                                              
                                              
                                              
                                              (383,196
                                              )
                                              
                                              
                                              1,299,378Net
      loss
                                              
                                              $
                                              (1,718,137
                                              )
                                              
                                              $
                                              (1,724,708
                                              )
                                              
                                              $
                                              (5,050,564
                                              )
                                              
                                              $
                                              (2,438,219
                                              )Net
      loss per common share:Basic
                                              
                                              $
                                              (.10
                                              )
                                              
                                              $
                                              (.10
                                              )
                                              
                                              $
                                              (.28
                                              )
                                              
                                              $
                                              (.14
                                              )Diluted
                                              
                                              $
                                              (.10
                                              )
                                              
                                              $
                                              (.10
                                              )
                                              
                                              $
                                              (.28
                                              )
                                              
                                              $
                                              (.14
                                              )Weighted
      average shares outstanding common stock:Basic
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800Diluted
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800
                                              
                                              
                                              
                                              17,928,800
 
 
 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
      Shareholders’ Equity
                        For
      the Six Months Ended December 31, 2008 and 2007
                        (Unaudited)Comprehensive
                        Loss
                      
                      
                      Common
      Stock
                      
                      
                      Common
      Stock
                        Warrants
                      
                      
                      Paid-in-Capital
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Foreign
      Currency
                        Translation
                        Adjustment
                      
                      
                      TotalBalance
      June 30, 2007
                      
                      $
                      --
                      
                      
                      $
                      179,288
                      
                      
                      $
                      91,131
                      
                      
                      $
                      25,404,045
                      
                      
                      $
                      (10,760,543
                      )
                      
                      $
                      (38,488
                      )
                      
                      $
                      14,875,433Foreign
      currency translation gain
                      
                      
                      73,546
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      73,546
                      
                      
                      
                      73,546Net
      loss for six months ended December 31, 2007
                      
                      
                      (2,438,219
                      )
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      (2,438,219
                      )
                      
                      
                      --
                      
                      
                      
                      (2,438,219
                      )Comprehensive
      loss
                      
                      
                      (2,346,673
                      )
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --Balance
      December 31, 2007
                      
                      $
                      --
                      
                      
                      $
                      179,288
                      
                      
                      $
                      91,131
                      
                      
                      $
                      25,404,045
                      
                      
                      $
                      (13,198,762
                      )
                      
                      $
                      35,058
                      
                      
                      $
                      12,510,760Balance
      June 30, 2008
                      
                      $
                      --
                      
                      
                      $
                      179,288
                      
                      
                      $
                      91,131
                      
                      
                      $
                      25,444,176
                      
                      
                      $
                      (21,809,709
                      )
                      
                      $
                      271,917
                      
                      
                      $
                      4,176,803Foreign
      currency translation gain
                      
                      
                      1,525,255
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      1,525,255
                      
                      
                      
                      1,525,255Net
      loss for six months ended December 31, 2008
                      
                      
                      (5,050,564
                      )
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      (5,050,564
                      )
                      
                      
                      --
                      
                      
                      
                      (5,050,564
                      )Comprehensive
      loss
                      
                      
                      (3,525,309
                      )
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --Balance
      December 31, 2008
                      
                      $
                      --
                      
                      
                      $
                      179,288
                      
                      
                      $
                      91,131
                      
                      
                      $
                      25,444,176
                      
                      
                      $
                      (26,860,273
                      )
                      
                      $
                      1,797,172
                      
                      
                      $
                      651,494
   The
accompanying notes to condensed consolidated financial statements are an
integral part of these statements.
  6
  AFP Imaging Corporation and Subsidiaries
 Condensed
Consolidated Statements of Cash Flows
 (Unaudited)
  Six
      Months Ended
                        December
      31,2008
                      
                      
                      2007Cash
      flows from operating activities:Net
      loss
                      
                      $
                      (5,050,564
                      )
                      
                      $
                      (2,438,219
                      )Adjustments
      to reconcile net loss to net cash provided by/(used in)
      operating activities-Depreciation
      and amortization
                      
                      
                      509,998
                      
                      
                      
                      769,562Amortization
      of discount on term loan
                      
                      
                      861,626
                      
                      
                      
                      101,275Contractual
      obligation to previous owners
                      
                      
                      505,014
                      
                      
                      
                      ---Provision
      for losses on accounts receivable
                      
                      
                      20,000
                      
                      
                      
                      ---Exchange
      rate effect on intercompany note
                      
                      
                      2,105,323
                      
                      
                      
                      (893,645
                      )Deferred
      income taxes
                      
                      
                      (604,923
                      )
                      
                      
                      921,074Change
      in assets and liabilities:Decrease
      in accounts receivable
                      
                      
                      1,849,820
                      
                      
                      
                      977,553Decrease
      in inventories
                      
                      
                      2,435,581
                      
                      
                      
                      1,053,813Increase
      in prepaid expenses and other assets
                      
                      
                      (21,296
                      )
                      
                      
                      (76,415
                      )Increase/(decrease)
      in accounts payable
                      
                      
                      53,478
                      
                      
                      
                      (1,397,774
                      )(Decrease)/Increase
      in accrued expenses and other current liabilities
                      
                      
                      (492,473
                      )
                      
                      
                      185,860Decrease
      in deferred liabilities
                      
                      
                      (780,176
                      )
                      
                      
                      (42,292
                      )Total
      adjustments
                      
                      
                      6,441,972
                      
                      
                      
                      1,599,011Net
      cash provided by/(used in) operating activities
                      
                      
                      1,391,408
                      
                      
                      
                      (839,208
                      )Cash
      flows from investing activities:Purchases
      of property and equipment
                      
                      
                      (39,799
                      )
                      
                      
                      (57,880
                      )Net
      cash used in investing activities
                      
                      
                      (39,799
                      )
                      
                      
                      (57,880
                      )Cash
      flows from financing activities:Borrowing
      of debt
                      
                      
                      422,159
                      
                      
                      
                      1,304,730Repayment
      of debt
                      
                      
                      (1,120,138
                      )
                      
                      
                      (185,185
                      )Net
      cash (used in)/provided by financing activities
                      
                      
                      (697,979
                      )
                      
                      
                      1,119,545Exchange
      rate effect on cash and cash equivalents
                      
                      
                      (21,465
                      )
                      
                      
                      73,546Net
      increase in cash and cash equivalents
                      
                      
                      632,165
                      
                      
                      
                      296,003Cash
      and cash equivalents, at beginning of period
                      
                      
                      819,444
                      
                      
                      
                      921,632Cash
      and cash equivalents, at end of period
                      
                      $
                      1,451,609
                      
                      
                      $
                      1,217,635Supplemental
      cash flow disclosures:
                        Cash
      paid during the periods for-Interest
                      
                      $
                      233,147
                      
                      
                      $
                      409,684Income
      taxes, net of refunds
                      
                      $
                      73,432
                      
                      
                      $
                      836,331
 
 The
accompanying notes to condensed consolidated financial statements are an
integral part of these statements.
  7
  AFP Imaging Corporation and Subsidiaries
 Notes to Consolidated Financial Statements
 December 31,
2008
 (Unaudited)
 
 (1)
General:
 
 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 and/or capturing medical and dental diagnostic images.  The
products utilize electronic and radiographic technologies, as well as the
chemical processing of photosensitive materials.  The Company is ISO
9001 certified.  Medical, dental, veterinary and industrial
professionals use these products.  The Company’s products are sold and
distributed to worldwide markets under various brand names and trademarks
through a network of independent and unaffiliated dealers and independent sales
representatives.   The Company has one business segment – medical
and dental x-ray imaging.
 
 The
Company’s primary objective is to be a leading provider of cost effective,
diagnostic radiographic products for applications in the medical, dental,
veterinary and industrial imaging fields.  The Company is
concentrating on:
 ·
              continually
      broadening its product offerings in the transition from x-ray film to
      electronic imaging,
 ·
              enhancing
      both its domestic and international distribution channels,
    and
 ·
              expanding
      its worldwide market presence in the diagnostic dental and medical imaging
      fields.
 
 On April
19, 2007, the Company completed the acquisition of Quantitative Radiology srl,
an Italian corporation (“QR”), by acquiring all of the outstanding share capital
of QR from its shareholders.  QR is a global supplier of
state-of-the-art, in-office three-dimensional dental and medical computed
tomography (CT).  QR uses an imaging technology that features a cone
shaped beam of x-rays (a CBCT scanner).  The Company, prior to April
19, 2007, had acted as QR’s exclusive distributor in North and South America,
excluding Brazil.
  The
Company presently believes that its senior secured credit facility and foreign
lines of credit will not be sufficient to finance its ongoing worldwide working
capital requirements for the next twelve months.  As previously
disclosed, the Senior Secured Lender agreed to lend to the Company an aggregate
of up to $8 million in the form of a $5 million term loan and a $3 million
revolving loan facility (“Revolver”).  The Company’s aggregate
outstanding advances under the Revolver exceed the maximum revolving credit
commitment permissible under the Loan Agreement as a direct result of additional
borrowings made by the Company under the Revolver to pay the term loan principal
and interest charges and revolver interest charges for August through December
2008.  The Company is in default under the Revolving Credit and Term Loan
Agreement with respect to the Company’s obligation to repay the outstanding
advances in excess of the permissible maximum.  The Senior Secured Lender
has not accelerated the Revolver.The Senior
Secured Lender began charging the default rate of interest (an additional four
(4) points) on the Revolving Credit and Term Loan effective December 1,
2008.  As of December 31, 2008, the rate was 14% on the convertible
term note and 9.25% on the revolving loan facility.  The Company’s
Revolving Credit and Term Loan Agreement contains a subjective acceleration
clause and accordingly, all such debt has been classified as a current liability
as of December 31, 2008 and June 30, 2008 in accordance with FASB Technical
Bulletin No. 79-3 “Subjective Acceleration Clauses in Long-Term Debt
Agreements”.
  The Company’s foreign subsidiary, QR,
has failed to make timely payment with respect to certain amounts due to one of
its financial institutions pursuant to one of its line of credit
agreements.  In January 2009, this lender agreed to an extended repayment
through October 2009 and reduced the line of credit borrowings from 2,000,000
Euros to 1,000,000 Euros; and to extend no further borrowings on this line of
credit.
  All of the
Company’s debt, except for the capitalized lease, has been classified as a
current liability in the accompanying consolidated financial
statements.
  The
Company has instituted significant cost cutting measures to reduce its operating
cash requirements.  The Company has reduced overhead and many discretionary
expenditures.  The Company, along with its investment banking
consultants, is also currently in the process of seeking out additional
financing alternatives, including potential private equity sales of its
securities, or seeking out a domestic or foreign strategic and/or financial
partner to negotiate a transaction, including a merger with or acquisition by
another entity, to best serve its long-term goals and needs.  There
can be no assurance that the Company will be able to obtain any such financing
upon favorable terms to it, or at all.  In the event that the Company is
unable to secure sufficient financing or a transaction to maintain its
operations, its business and financial condition would be materially adversely
affected.  These factors raise substantial doubt about the Company’s
ability to continue as a going concern.  The consolidated financial
statements do not include any adjustments regarding this
uncertainty.
 
 8
 The
consolidated financial statements reflect the financial position of the Company
and its wholly-owned subsidiaries.  They do not reflect any
significant intercompany transactions.
 
 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, 2008.  The Condensed
Consolidated Balance Sheet at June 30, 2008 has been derived from the audited
financial statements.
 
 Certain
prior-period amounts have been reclassified to conform to the current-period
presentation.
 
 (2)
Stock Option
Plans:
 
 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
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 began 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 six months ended December 31, 2008 and
December 31, 2007, no incentive stock options were granted, and therefore, there
was no non-cash stock based compensation expense related to stock option
awards.
 
 When
granting incentive stock options, the fair value of each option granted under
the Company’s incentive stock plans is 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 the Company’s common stock (the “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 the Common Stock and (d) risk-free interest rates which are based on
quoted U.S. Treasury rates for securities with maturities approximating the
options’ expected lives.  Expected volatility has been estimated based
on actual movements in the Company’s stock price over the most recent historical
period’s equivalent to the options’ expected lives.  Expected lives
are principally based on the Company’s limited historical exercise experience
with option grants with similar prices.  The expected dividend yield
is zero as the Company has never paid dividends and does not currently
anticipate paying any dividends in the foreseeable future.
 
 In April
2007, the Company granted an aggregate of 50,000 shares of Common Stock to an
employee, at their current market value, half of which vested immediately and
the remainder of which vested in April 2008.  These options were
issued with a ten-year useful life.
 
 (3)Per Share Data and
Significant Capital Transactions:
 
 The
Company’s basic net loss per share amounts are calculated by dividing net loss
by the weighted average number of common shares outstanding during the
period.  Diluted net loss 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 six
months ended December 31, 2008 and 2007:
 
 Three
      months ended December 31,
                              
                              
                              Six
      months ended December 31,2008
                              
                              
                              2007
                              
                              
                              2008
                              
                              
                              2007Basic
      Shares
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800Dilutive:Options
                              
                              
                              ---
                              
                              
                              
                              ---
                              
                              
                              
                              ---
                              
                              
                              
                              ---Warrants
                              
                              
                              ---
                              
                              
                              
                              ---
                              
                              
                              
                              ---
                              
                              
                              
                              ---Diluted
      Shares
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800
                              
                              
                              
                              17,928,800
 
 9
  The
following stock options and warrants have been excluded from the diluted
weighted average number of shares outstanding for the three and six months ended
December 31, 2008 and 2007, since their potential exercise would be
anti-dilutive.
 
 Three
      and six months ended December 31,2008
                      
                      
                      2007Options
                      
                      
                      849,400
                      
                      
                      
                      891,900Warrants
                      
                      
                      850,000
                      
                      
                      
                      850,000Diluted
      Shares
                      
                      
                      1,699,400
                      
                      
                      
                      1,741,900
 
 The
Company’s Certificate of Incorporation was amended, in December 2008, to
increase the number of outstanding authorized shares of common stock from
30,000,000 to 100,000,000, all with a stated par value of $.01 per
share.  No new shares of common stock have been issued.
 
 (4)
Long and Short Term
Debt:
 
 On April
13, 2007, the Company entered into a new senior secured facility (“Revolving
Credit and Term Loan”) with a new lender (“Senior Secured Lender”) that replaced
the Company’s existing $2.5 million revolving line of credit  that was
due to expire on September 21, 2007.  The Revolving Credit and Term
Loan consists of a $5 million convertible term note and a $3 million revolving
loan facility.  The convertible term note bears interest at a rate of
ten percent (10%) per annum and provides for repayment over five years
commencing in November 2007 with a final balloon payment of all remaining
amounts due there-under on April 30, 2012.  The revolving loan bears
interest at a rate of two percent plus prime rate per annum, has a specific
formula to calculate available funds based on eligible accounts receivable and
inventory, is subject to maximum “borrowing base” limitations, and hascertain
reporting requirements to the lender.  The convertible term note, in
addition to being convertible by the Company upon the satisfaction of certain
conditions, is convertible by the lender at any time into shares of Common Stock
at a conversion price of $2.37 per share or 2,109,705 shares based on the
initial principal amount of the convertible term note.
 
 The
Company and each of its wholly-owned  domestic subsidiaries executed a
collateral agreement pursuant to which each such party agreed to grant a
security interest in all of its respective assets to the Senior Secured Lender
as collateral security for repayment of the loans.  The Revolving
Credit and Term Loan is secured by all of the Company’s and its wholly-owned
subsidiaries’ inventory, accounts receivable, equipment, officer life insurance
policies and proceeds thereof, trademarks, licenses, patents and general
intangibles.
 
 The
Company’s aggregate outstanding advances under the Revolver exceed the maximum
revolving credit commitment permissible under the Loan Agreement as a direct
result of additional borrowings made by the Company under the Revolver to pay
the term loan principal and interest charges and revolver interest charges for
August through December 2008.  The Company is in default under the
Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum borrowings. The Senior Secured Lender has not accelerated the
Revolver.  The Senior Secured Lender began charging the default rate
of interest (an additional four (4) points) on the Revolving Credit and Term
Loan effective December 1, 2008.  As of December 31, 2008, the rate
was 14% on the convertible term note and 9.25% on the revolving loan
facility.  As described in Note 1, factors exist that result in doubt
as to the Company’s ability to continue as a going concern.  The Company’s
Revolving Credit and Term Loan Agreement contains a subjective acceleration
clause and accordingly, all such debt has been classified as a current liability
as of December 31, 2008 and June 30, 2008 in accordance with FASB Technical
Bulletin No. 79-3 “Subjective Acceleration Clauses in Long-Term Debt
Agreements”.  In the first quarter of Fiscal Year 2009, the Company
wrote-off the balance of the deferred financing costs related to this debt,
approximately $152,250, which has been recorded as selling, general and
administrative costs in the accompanying consolidated statements of operations,
as the Company has not been able to successfully negotiate a waiver, a
forbearance agreement or renegotiate this debt.  The Company was in
compliance with all other terms and conditions of the Revolving Credit and Term
Loan Agreement as of June 30, 2008.
 
 As part of
the original transaction, the Company granted to the Senior Secured Lender an
aggregate of 800,000 five-year warrants to purchase shares of the Company’s
Common Stock at exercise prices per share equal to $1.85 with respect to 266,666
warrants, $2.02 with respect to an additional 266,666 warrants, and $2.19 with
respect to the remaining 266,668 warrants.The Company classified the
warrants as equity, using the Black-Scholes Method to value these detachable
warrants.  They have been recorded in the accompanying Consolidated
Balance Sheets at $1,114,784.
 
 10
 The fair
value of the warrants issued to the Senior Secured Lender is being treated as
debt discount, and was originally accreted as interest expense utilizing the
interest method over the 60-month term of the Term Loan.  As the
Company has reclassified this debt as a current liability and has not been able
to successfully negotiate a waiver, a forbearance agreement or renegotiate this
debt, the balance of the debt discount, approximately $808,701, was accreted as
interest expense in the quarter ended September 30, 2008, in the accompanying
consolidated statements of operations.  The original assumptions used
for the Black-Scholes option pricing model were as follows:  a
risk-free interest rate of 4.66%, an expected volatility of 123%, an expected
life of five years, and no expected dividends.  A summary of the
balances of the Term Loan are as follows:
  December 31, 2008
                                    
                                    
                                    June 30, 2008Term
      Loan
                                    
                                    $
                                    5,000,000
                                    
                                    
                                    $
                                    5,000,000Fair
      value of warrants (recorded as capital in excess of par)
                                    
                                    
                                    (1,114,784
                                    )
                                    
                                    
                                    (1,114,784
                                    )Principal
      payments
                                    
                                    
                                    (833,334
                                    )
                                    
                                    
                                    (740,741
                                    )Accretion
      of debt discount (recorded as interest expense)
                                    
                                    
                                    1,114,784
                                    
                                    
                                    
                                    253,158Recorded
      value of Term Loan
                                    
                                    $
                                    4,166,666
                                    
                                    
                                    $
                                    3,397,633
  
 QR
currently has the ability to borrow up to 1,000,000 Euros under various lines of
credit with one foreign financial institution and all such borrowings are
classified as short term debt.  Most of these lines are guaranteed by
its accounts receivables and inventory.  These lines of credit were
granted in August 2007 and increased from 1,750,000 to 2,000,000 Euros in April
2008 and decreased to 1,000,000 Euros in January 2009.  There were
926,582 Euros outstanding as of December 31, 2008 and 1,652,712 Euros
outstanding as of June 30, 2008.  The funds borrowed in Italy are
guaranteed by specific outstanding accounts receivable and inventory, and the
current rate of borrowing is a function of Euribor plus .75% to
1.5%.  QR has failed to make timely payment with respect to certain
amounts due to one of its financial institutions pursuant to one of its line of
credit agreements.  In January 2009, this lender agreed to extend
repayment through October 2009 and to extend no further borrowings on this line
of credit.
 
 As of
December 31, 2008 and June 30, 2008, debt consisted of the
following:
  December 31, 2008
                                                    
                                                    
                                                    June 30, 2008Senior
      Secured Lender Term Loan, net of debt discount, where
      applicable
                                                    
                                                    $
                                                    4,166,666
                                                    
                                                    
                                                    $
                                                    3,397,633$3.0
      Million Revolving Senior Credit Facility
                                                    
                                                    
                                                    2,992,111
                                                    
                                                    
                                                    
                                                    2,569,952Capitalized
      lease
                                                    
                                                    
                                                    27,056
                                                    
                                                    
                                                    
                                                    30,903Foreign
      line of credit borrowings
                                                    
                                                    
                                                    1,289,616
                                                    
                                                    
                                                    
                                                    2,602,5258,475,449
                                                    
                                                    
                                                    
                                                    8,601,013Less
      current portion
                                                    
                                                    
                                                    8,456,857
                                                    
                                                    
                                                    
                                                    8,578,056Total
      long-term debt
                                                    
                                                    $
                                                    18,592
                                                    
                                                    
                                                    $
                                                    22,957
   At
December 31, 2008, the Company had no unused lines of credit
available.
 
 Due to the
short-term nature of all of the debt, the fair market value of all of the
Company's debt approximated its carrying value.
 
 (5)
Inventories:
 
 Inventories,
which include material, labor and manufacturing overhead, are stated at the
lower of cost (first-in, first-out) or market (net realizable
value).  Inventory reserves are provided for risks relating to slow
moving items.  Demonstration equipment which is on consignment with
customers is valued at cost, reduced for reductions in value due to technical
obsolescence and/or wear and tear over periods up to five years.  At
December 31, 2008 and June 30, 2008, inventories, consisted of the
following:
 
 December 31, 2008
                        
                        
                        June 30, 2008Raw
      materials and sub-component parts
                        
                        $
                        2,958,900
                        
                        
                        $
                        3,675,763Work-in-process
      and finished goods
                        
                        
                        1,383,332
                        
                        
                        
                        3,274,366$
                        4,342,232
                        
                        
                        $
                        6,950,129
  
 11
 
 (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 December 31, 2008, the Company has recorded net
deferred tax assets of approximately $467,587 and as of June 30, 2008, net
deferred tax liabilities of approximately $155,000.  The December 31,
2008 net deferred tax assets are comprised of approximately $694,681 of deferred
tax assets and $227,094 of deferred tax liabilities.  The June 30,
2008 net deferred tax liabilities are comprised of approximately $698,000 of
deferred tax liabilities and $543,000 of deferred tax assets.  The
deferred tax liabilities are related to the previously recorded net unrealized
exchange gain on the intercompany note denominated in U.S. dollars, as it will
only be taxed when realized and when repayment is made, and to differences
related to the amortization of the acquisition goodwill for tax
purposes.  The deferred tax assets are mainly related to the temporary
differences on the intangible assets amortization.
 
 The net
tax provision and/or benefit respectively recorded for the three and six months
ended December 31, 2008 and the net tax provision for the three and six months
ended December 31, 2007 include foreign taxes at the statutory rates on the
Company’s foreign operations, changes to the deferred tax accounts, and state
income and capital taxes generated in the United States. As of December 31,
2008, the Company established a non-current deferred tax liability of
approximately $166,000 to reflect tax differences related to the amortization of
the acquisition goodwill for tax purposes.  This amount is included in
the tax provision for the three and six months ended December 31,
2008.  As of December 31, 2008, the Company had approximately $12.0
million in federal net operating loss carry forwards, and approximately $16.4
million in state net operating loss carry forwards.  These NOL’s will
begin to expire in 2010 and are subject to review by the Internal Revenue
Service.  Past and future changes in ownership of the Company as
defined in Section 382 of the Internal Revenue Code, may limit the amount of
NOL’s available for use in any one year.
 
 Effective
July 1, 2007, the Company adopted the provisions of the Financial Accounting
Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”), Accounting for Uncertainties in
Income Taxes – an interpretation of FASB Statement No. 109.In
accordance with FIN 48, the Company classifies interest as a component of income
tax expense.  The implementation of FIN 48 had no impact on the
Company’s financial statements, and no interest and penalties related to
uncertain tax positions were accrued at December 31, 2008 and June 30,
2008.
 
 (7)
Intangible Assets and
Goodwill:
 
 On April
19, 2007, the Company acquired QR, an Italian corporation located in Verona,
Italy.  The carrying values of QR’s assets and liabilities were
adjusted to their fair values on April 19, 2007 and the difference between the
purchase price and the fair value of the net assets and liabilities was recorded
as goodwill.  The goodwill and intangible amounts are maintained in
Euros on the subsidiary’s books and converted into U.S. dollars at the
respective exchange rate.
 
 The
Company performed the required annual impairment tests as of June 30, 2008, in
accordance with FASB Statements No. 142, Goodwill and Other Intangibles,and No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. The Company
expressly tested the developed technologies and customer relationships for
impairment and determined that there had been impairment of $5,615,880 in their
respective values.  The impairment was calculated by a comparison of
the fair values of the assets, using discounted cash flows.  The
impairment charge was booked in the fourth quarter of Fiscal Year
2008.
 
 The
Company tested goodwill for impairment by a comparison of the fair value of the
reporting unit to its respective carrying value and determined that there was no
impairment to the carrying value as of June 30, 2008.
  As of
December 31, 2008, the Company does not believe there is any impairment of its
goodwill or of its other intangible assets.  However, the occurrence
of future events or deteriorating conditions, not limited to the Company's
inability to obtain additional financing alternatives (as described in Note 1),
operating or cash flow losses, potential merger with or acquisition by another
entity, potential sale or disposal of assets significantly before the end of
their previous estimated useful lives, may result in a future
impairment.
  The
following is a summary of the intangible assets subject to
amortization:
 
 June 30, 2008
                          
                          Gross
                            carrying
                            amount
                          
                          
                          Impairment
                          
                          
                          Adjusted
                            carrying
                            amount
                          
                          
                          Accumulated
                            amortization
                          
                          
                          NetDeveloped
      technologies
                          
                          $
                          6,159,856
                          
                          
                          $
                          4,006,292
                          
                          
                          $
                          2,153,564
                          
                          
                          $
                          1,053,564
                          
                          
                          $
                          1,100,000Customer
      relationships
                          
                          
                          3,646,125
                          
                          
                          
                          1,609,588
                          
                          
                          
                          2,036,537
                          
                          
                          
                          436,537
                          
                          
                          
                          1,600,000Non-compete
      contracts and other
                          
                          
                          389,044
                          
                          
                          
                          ---
                          
                          
                          
                          389,044
                          
                          
                          
                          91,493
                          
                          
                          
                          297,551Total
                          
                          $
                          10,195,025
                          
                          
                          $
                          5,615,880
                          
                          
                          $
                          4,579,145
                          
                          
                          $
                          1,581,594
                          
                          
                          $
                          2,997,551
 
 
 12
  December 31, 2008
                    
                    Gross
                      carrying
                      amount
                    
                    
                    Accumulated
                      amortization
                    
                    
                    NetDeveloped
      technologies
                    
                    $
                    1,903,566
                    
                    
                    $
                    1,015,000
                    
                    
                    $
                    888,566Customer
      relationships
                    
                    
                    1,800,124
                    
                    
                    
                    488,046
                    
                    
                    
                    1,312,078Non-compete
      contracts and other
                    
                    
                    343,881
                    
                    
                    
                    115,260
                    
                    
                    
                    228,621Total
                    
                    $
                    4,047,571
                    
                    
                    $
                    1,618,306
                    
                    
                    $
                    2,429,265
 
 Amortization
for the three and six months ended December 31, 2008 were $104,300 and $223,154,
respectively.  Amortization for the three and six months ended
December 31, 2007 were $303,828 and $592,282, respectively.
 
 The change
in the value of the other intangibles from the date of acquisition to December
31, 2008, and the change in accumulated amortization include changes in the U.S.
Dollar/Euro exchange rates, which fluctuated during the periods.  For
the six months ended December 31, 2008, the impact was approximately $345,132 on
the long-lived intangibles subject to amortization.
 
 The
changes in the carrying amount of goodwill are as follows:
  For
      the period ended
                        
                        Fiscal
      Year
                          2008
                        
                        
                        Six
      Months ended
                          December
      31, 2008Balance
      as of July 1,
                        
                        $
                        3,846,405
                        
                        
                        $
                        4,453,627Foreign
      currency translation difference
                        
                        
                        607,222
                        
                        
                        
                        (517,000
                        )Balance
      as of December 31, 2008
                        
                        
                        ---
                        
                        
                        $
                        3,936,627Balance
      as of June 30, 2008
                        
                        $
                        4,453,627
                        
                        
                        
                        ---
  (8)
Segment
Information:
 
 As of December 31, 2008 and 2007, and
June 30, 2008, the Company had one business segment, medical and dental x-ray
imaging.  The medical and dental segment operations are conducted
under the Dent-X, EVA, NewTom and Company trade names and consist of the design,
development, manufacturing, marketing and distribution of medical and dental
x-ray imaging systems and all related accessories.  The amortization
and impairment of the intangibles associated with the acquisition of QR has been
attributed to the Italian operations.  Geographical financial
information is as follows:
 
 Three
      months ended December 31,
                                                                                                                      
                                                                                                                      
                                                                                                                      Six
      months ended December 31,2008
                                                                                                                      
                                                                                                                      
                                                                                                                      2007
                                                                                                                      
                                                                                                                      
                                                                                                                      2008
                                                                                                                      
                                                                                                                      
                                                                                                                      2007Net
      sales:United
      States
                                                                                                                      
                                                                                                                      $
                                                                                                                      4,141,376
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      4,631,847
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      7,807,010
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      8,306,631Europe
                                                                                                                      
                                                                                                                      
                                                                                                                      1,235,758
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      1,444,026
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      3,487,042
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      3,265,140Other
                                                                                                                      
                                                                                                                      
                                                                                                                      1,904,181
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      2,583,510
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      2,635,527
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      4,535,667$
                                                                                                                      7,281,315
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      8,659,383
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      13,929,579
                                                                                                                      
                                                                                                                      
                                                                                                                      $
                                                                                                                      16,107,438Net
      (loss)/incomeUnited
      States
                                                                                                                      
                                                                                                                      $
                                                                                                                      (735,927
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (1,723,930
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (2,705,942
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (3,035,132
                                                                                                                      )Europe
                                                                                                                      
                                                                                                                      
                                                                                                                      (982,210
                                                                                                                      )
                                                                                                                      
                                                                                                                      
                                                                                                                      (778
                                                                                                                      )
                                                                                                                      
                                                                                                                      
                                                                                                                      (2,344,622
                                                                                                                      )
                                                                                                                      
                                                                                                                      
                                                                                                                      596,913$
                                                                                                                      (1,718,137
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (1,724,708
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (5,050,564
                                                                                                                      )
                                                                                                                      
                                                                                                                      $
                                                                                                                      (2,438,219
                                                                                                                      )
 December
      31, 2008
                                            
                                            
                                            June
      30, 2008Identifiable
      assets:United
      States
                                            
                                            $
                                            5,401,695
                                            
                                            
                                            $
                                            8,282,539Europe
                                            
                                            
                                            10,560,032
                                            
                                            
                                            
                                            13,118,300Total
                                            
                                            $
                                            15,961,727
                                            
                                            
                                            $
                                            21,400,839
 
 13
 
 (9) Commitments
and Contingencies:
 
 The
Company is a defendant in an environmental claim relating to a property in New
Jersey owned by the Company between August 1984 and June 1985.  This
claim relates to the offsite commercial disposition of trash and waste in a
landfill in New Jersey.  The Company maintains that its waste
materials were of a general commercial nature.  This claim was
originally filed in 1998 by the federal government in United States District
Court for the District of New Jersey, Newark Vicinage, citing several hundred
other third-party defendants.  The Company (through its former
subsidiary, Kenro Corporation) was added, along with many other defendants, to
the suit.  The Company's claimed liability was potentially assessed by
the plaintiff at $150,000.  The Company joined the other involved
defendants in an alternative dispute resolution (ADR) process for smaller
claims.  On May 7, 2008, a tentative mediated settlement was reached
by all parties, and the Consent Decree memorializing the settlement was lodged
with the Court in January 2009.  The Company’s share is $82,880, of
which the Company’s insurance carrier has agreed to pay 50% of the settlement
offer and to continue to equally share the defense costs incurred in this
environmental claim.  In October 2008, the Company and its insurance
carrier each contributed $41,440 to an escrow account to settle this outstanding
environment claim.  There is a ninety day comment period, and the
Court is expected to enter the Consent Decree in April 2009.  The
Company cannot, at this time, assess the amount of liability that could result
if this settlement is not finalized.
 
 On May 5,
2008, the Company and Dent-X International, Inc. commenced litigation in the
United States District Court, Southern District of New York, against Genexa
Medical, Inc. (“Genexa”) to recover $394,610 for goods sold and delivered to
Genexa during the period from December 11, 2007 through March 13, 2008, after
Genexa failed and refused to pay the amount due.  On June 27, 2008,
Genexa filed an Answer and Counterclaims alleging several causes of action which
are potentially material.  In November 2008, both parties were
instructed by the court to meet on January 9, 2009 to attempt to negotiate
through a court appointed mediator; Genexa did not appear.  The next
court date was set for February 5, 2009, and Genexa did not appear
again.  The court has permitted Genexa’s attorneys to withdraw from
the case and no new attorneys have been appointed as of the date of this filing.
Moreover, the shareholders of Genexa recently voted in favor of its
liquidation.  The Company has filed a motion requesting Summary
Judgment and dismissal of the case and is awaiting the judge’s
ruling.
 
 The
Company is a defendant (with several other parties) in a product liability
insurance action, which was filed in January 2009, in the Superior Court of
Justice, Ontario, Canada, under the simplified procedure provided in Rule 76 of
the Rules of Civil Procedure.  The plaintiff, through their insurance
company, claims that the Company’s equipment caused damage to the plaintiff’s
premises in May 2007.  The complaint seeks approximately $50,000 in
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 its consolidated financial
statements.
 
 The
Company is involved in another product liability claim; however, to date, no
lawsuit has been filed.  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 these matters.  The Company does not believe that the final outcome
of this matter will have a material adverse effect on its consolidated financial
statements.
 
 The
Company received notification of a customer complaint filed in the Superior
Court of California, County of Placer, on December 19, 2007.  The
Complaint seeks damages in excess of $25,000.  On February 3, 2009,
this case was settled for $22,000 through a court appointed
mediator.  The Company has fully accrued this liability as of December
31, 2008 in the accompanying consolidated financial statements.
 
 In
December 2008, the Company received notification of a customer complaint filed
on December 11, 2008, in Superior Court of California, County of
Tuolumne.  The complaint alleges breach of warranty and breach of
contract, and seeks damages in excess of $25,000.  The Company has
referred this case to its attorneys who are attempting to settle this
case.
 
 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 its consolidated financial
statements.
 14
 As part of
the acquisition of QR, the Company granted consulting agreements to each of the
four former owners, for a total yearly commitment of 500,000
Euros.  Each agreement is for a period of five years and contains a
non-compete clause.  The Company can terminate each agreement after
the first year (April 2008), in which event, any individual so terminated is
entitled to one-half of the compensation for the remaining
term.  Effective July 2008, two of these consulting agreements were
modified and the commitment was slightly reduced.  In November 2008,
the other two individuals resigned effective January 1, 2009, and per the terms
of their consulting agreements, each of their commitments was reduced to
one-half of the original amount for the remaining contractual
term.  The total revised commitment is for 310,000 Euros per year,
through April 2012.  As of December 31, 2008, the Company has recorded
a contractual liability of approximately 362,800 Euros, which reflects the total
amount due, through April 2012, for the two former owners that have resigned;
the expense has been reflected in the accompanying consolidated financial
statements as selling, general and administrative expenses, the long-term
portion of the liability has been recorded in deferred liabilities and the
current portion has been recorded in accrued expenses.
  (10)
New Accounting
Standards:
 
 In June
2008, the FASB issued EITF Issue 07-5, “Determining Whether an Instrument (or
Embedded Feature) is indexed to an Entity’s Own Stock” (“EITF
07-5”).  EITF 07-5 provides guidance in assessing whether an
equity-linked financial instrument (or embedded feature) is indexed to an
entity’s own stock for purposes of determining whether the appropriate
accounting treatment falls under the scope of SFAS 133, “Accounting for
Derivative Instruments and Hedging Activities”, and/or EITF 00-19, “Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock.”  EITF 07-5 is effective for financial statements
issued for fiscal years beginning after December 15, 2008 and early application
is not permitted.  The Company is evaluating the effect of EITF 07-5,
to assess whether or not there will be a material effect on the Company’s
consolidated financial statements.
 
 Management
does not believe that there were any other recently issued, but not yet
effective, accounting standards, other than mentioned above, if currently
adopted, would have a material effect on the accompanying consolidated financial
statements.
 
 15
 Item 2.  Management's Discussion and Analysis of Financial
Condition and Results of Operations.
 
 The
following should be read in conjunction with the Company’s Consolidated
Financial Statements and notes thereto included elsewhere in this Quarterly
Report on Form 10-Q.  This discussion may contain certain
forward-looking statements based on current expectations that involve risks and
uncertainties.  Actual results and timing of certain events may differ
significantly from those projected in such forward-looking statements due to a
number of factors, including those set forth in elsewhere in this
report.  Except as otherwise disclosed, all amounts are reported in
U.S. dollars ($).
 
 Capital Resources and
Liquidity
 
 The
Company believes that its senior secured credit facility and foreign lines of
credit will not be sufficient to finance its ongoing worldwide working capital
requirements for the next twelve months.  As previously disclosed, the
Senior Secured Lender agreed to lend to the Company an aggregate of up to $8
million in the form of a $5 million term loan and a $3 million revolving loan
facility (“Revolver”).  The Company’s aggregate outstanding advances
under the Revolver exceed the maximum revolving credit commitment permissible
under the Loan Agreement as a direct result of additional borrowings made by the
Company under the Revolver to pay the term loan principal and interest charges
and revolver interest charges for August through December 2008.  The
Company is in default under the Revolving Credit and Term Loan Agreement with
respect to the Company’s obligation to repay the outstanding advances in excess
of the permissible maximum. The Senior
Secured Lender has not accelerated the Revolver.  The Senior Secured
Lender began charging the default rate of interest (additional four (4) points)
on the Revolving Credit and Term Loan effective December 1, 2008. As of
December 31, 2008, the rate was 14% on the convertible term note and 9.25% on
the revolving loan facility.  Additionally, the Company’s foreign
subsidiary, QR, has failed to make payment with respect to certain amounts due
to one of its financial institutions pursuant to a line of credit
agreement.  In January 2009, this lender agreed to an extended repayment
through October 2009, and cancelled the 1,000,000 Euro outstanding line of
credit.All of the
Company’s debt, except for the capitalized lease, has been classified as a
current liability in the accompanying consolidated financial statements. 
The Company has instituted cost cutting measures to reduce its cash
requirements.
 
 The
Company and its advisors are in the process of seeking out additional financing
alternatives, including potential private equity sales of its securities, or
seeking out a domestic or foreign strategic and/or financial partner to
negotiate a transaction, including a merger with or acquisition by another
entity, to best serve the Company’s long-term goals and needs.  There
can be no assurance that the Company will be able to obtain any such financing
or a transaction upon favorable terms to the Company, or at all.  In the
event that the Company is unable to secure sufficient financing to maintain its
operations, its business and financial condition would be materially adversely
affected.  These factors raise substantial doubt about the Company’s
ability to continue as a going concern.  The consolidated financial
statements do not include any adjustments regarding this
uncertainty.
 
 The
Company’s working capital at December 31, 2008 decreased by approximately $2.39
million from June 30, 2008.  This decrease is principally due to
decreases in accounts receivable and inventory, offset by a decrease in accrued
expenses.  Sales were approximately 23% lower in the six months ended
December 31, 2008 compared to the six months ended June 30, 2008, mainly because
of the continuing current worldwide economic liquidity crisis which has, in
turn, delayed the purchasing decisions for the Company’s high technology
products and reduced the ability for potential customers to obtain
financing.  The Company also received several deposits for the high
technology products shipped in December 2008 as opposed to selling with credit
terms.  The decrease in inventory is due to a better correlation of
inventory levels with the decreased sales levels and the Company limiting its
on-hand inventory to better manage the current cash flow
situation.  The net decrease in accrued expenses is mainly due to the
timing of the payment of certain year-end accruals, offset by the establishment
of the contractual liability to two of the previous owners of
QR.   The current portion of the outstanding debt decreased
slightly.  The Company’s foreign subsidiary reduced its line of credit
borrowings from 1.79M to .93M Euros based on collections of pledged accounts
receivable and the Company wrote-off the balance of the imputed debt discount
related to the warrants issued to the Senior Secured Lender, which was
approximately $808,701, as the Company has currently not been able to
successfully negotiate a waiver, a forbearance agreement or renegotiate the
debt.  Accounts payable decreased slightly in the current six-month
period to better match inventory levels with sales. However, the Company is
continuing to work with its vendors so as to maintain production
schedules.  Still, it has had to delay payments to vendors based on
available cash resources and is currently 60 days past due on many
accounts.
 
 Operating
cash flows were positive for the six months ended December 31, 2008 including
the loss from operations.   As mentioned previously, the Company
significantly reduced its inventory levels through a decision to decrease
finished goods inventory.  Accounts receivable collections were
maintained during this period and the Company is continuing to require
significant deposits or prepayment for its high technology products. The
operating loss for the three and six months ended December 31, 2008 includes
approximately $505,000 related to the accrual (non cash) of the contractual
obligation to two of the previous owners of QR.  The operating loss is
mainly attributable to lower sales in this six month period, as the Company
instituted significant measures to reduce costs in October 2008.  The
operating loss for the three-month period ended December 31, 2008 reflects these
cost reductions as it is significantly less than the operating loss for the
three-month period ended September 30, 2008.  The Company has neither
changed its payment policies to its vendors nor revised its payment terms with
its customers.  The Company does not have any access to additional
funds for working capital requirements.  The Company does not have the
capacity to borrow on its senior secured debt in the United States and has
limited borrowing ability on its lines of credit in Europe which were reduced in
January 2009 from 2,000,000 to 1,000,000 Euros.
 
 16
 Capital
expenditures for the first six months of Fiscal Year 2009 were $39,799,
consisting mainly of small tooling expenditures related to the redesign,
development and production of new imaging equipment, and some new computer
equipment.  The Company expects to continue to finance any future
capital requirements principally from internally generated funds.  The
total amount of capital expenditures is not limited under the Company’s
Revolving Credit and Term Loan Agreement; however, the Company has significantly
reduced or delayed its capital purchases in the current period due to its
limited cash flow.
 
 On April
12, 2007, the Company completed the sale of an aggregate of 5,500,000 shares of
its Common Stock to certain accredited investors for an aggregate consideration
of $8,140,000.  The Company has registered these shares for
resale.  The Common Stock was issued and sold pursuant to the
exemption from registration pursuant to Regulation D of the Securities
Act.  In connection with the transaction, the Company paid the
placement agent a five (5%) percent fee.  The net proceeds were used
to fund a portion of the purchase price of QR, which was completed on April 19,
2007.
 
 On April
13, 2007, the Company entered into a new senior secured facility (“Revolving
Credit and Term Loan”) with a new lender (“Senior Secured Lender”) that replaced
the Company’s existing $2.5 million revolving line of credit  that was
due to expire on September 21, 2007.  The Revolving Credit and Term
Loan consists of a $5 million convertible term note and a $3 million revolving
loan facility.  The convertible term note bears interest at a rate of
ten percent (10%) per annum and provides for repayment over five years
commencing in November 2007 with a final balloon payment of all remaining
amounts due there-under on April 30, 2012.  The revolving loan bears
interest at a rate of two percent plus prime rate per annum, has a specific
formula to calculate available funds based on eligible accounts receivable and
inventory, is subject to maximum “borrowing base” limitations, and hascertain
reporting requirements to the lender.  The convertible term note, in
addition to being convertible by the Company upon the satisfaction of certain
conditions, is convertible by the lender at any time into shares of Common Stock
at a conversion price of $2.37 per share or 2,109,705 shares based on the
initial principal amount of the convertible term note.
 
 The
Company’s aggregate outstanding advances under the Revolver exceed the maximum
revolving credit commitment permissible under the Loan Agreement as a direct
result of additional borrowings made by the Company under the Revolver to pay
the term loan principal and interest charges and revolver interest charges for
August through December 2008.  The Company is in default under the
Revolving Credit and Term Loan Agreement with respect to the Company’s
obligation to repay the outstanding advances in excess of the permissible
maximum borrowings. The Senior Secured Lender has not accelerated the
Revolver.  The Senior Secured Lender began charging the default rate
of interest (an additional four (4) points) on the Revolving Credit and Term
Loan effective December 1, 2008.  As of December 31, 2008, the rate
was 14% on the convertible term note and 9.25% on the revolving loan
facility.  As described in Note 1, factors exist that result in doubt
as to the Company’s ability to continue as a going concern.  The Company’s
Revolving Credit and Term Loan Agreement contains a subjective acceleration
clause and accordingly, all such debt has been classified as a current liability
as of December 31, 2008 and June 30, 2008 in accordance with FASB Technical
Bulletin No. 79-3 “Subjective Acceleration Clauses in Long-Term Debt
Agreements”.  In the first quarter of Fiscal Year 2009, the Company
wrote-off the balance of the deferred financing costs related to this debt,
approximately $152,250, which has been recorded as selling, general and
administrative costs in the accompanying consolidated statements of operations,
as the Company has not been able to successfully negotiate a waiver, a
forbearance agreement or renegotiate this debt.  The Company was in
compliance with all other terms and conditions of the Revolving Credit and Term
Loan Agreement as of June 30, 2008.
 
 Both loans
are subject to mandatory prepayment in full in the event of certain events
deemed to be a “sale,” including, but not limited to, a merger, sale of assets
or change in control.  The term loan is convertible by the Senior
Secured Lender at any time into shares of Common Stock at a conversion price of
$2.37 per share.  The term loan is convertible at the Company’s option
upon the satisfaction of certain conditions, including a reported trading price
equal to 175% of the conversion price, the Common Stock being traded on NASDAQ,
and a certain minimum trading volume, among others.  In addition, the
Company and each of its wholly-owned subsidiaries executed a Collateral
Agreement pursuant to which each such party agreed to grant a security interest
in all of its respective assets to the Senior Secured Lender as collateral
security for repayment of the loans.  Further, each domestic
subsidiary agreed to guarantee performance of all of the Company’s obligations
to the Senior Secured Lender.
 
 17
 As part of
the transaction, the Company granted to the Senior Secured Lender an aggregate
of 800,000 warrants to purchase shares of Common Stock at exercise prices per
share equal to $1.85 with respect to 266,666 warrants, $2.02 with respect to an
additional 266,666 warrants, and $2.19 with respect to the remaining 266,668
warrants.  The Company registered the shares of Common Stock issuable
upon the exercise of the warrants and conversion of the term note and must use
its best efforts to keep the registration statement effective during the
applicable registration period.
 
 The
Company’s foreign subsidiary now maintains various lines of credit with one
financial institution. In January 2009, these lines were decreased from
2,000,000 to 1,000,000 Euros; in April 2008, these lines had been increased from
1,750,000 to 2,000,000 Euros.  The borrowings under most of these
lines of credit are guaranteed by specific foreign accounts receivable and
inventory.  These lines of credit were granted in August 2007 and
there are no restrictive covenants, subordination clauses or corporate
guarantees.  As of December 31, 2008, there was 926,582 Euros
outstanding in connection therewith.  The Company’s foreign subsidiary
failed to make payment with respect to certain amounts due to one of these
financial institutions pursuant to a line of credit agreement.  In
January 2009, this lender agreed to extend repayment through October 2009 and
cancelled the 1,000,000 Euro line of credit.  As of December 31, 2008,
the Company owed 392,000 Euros to this financial institution.
 
 The
Company is dependent upon its Revolving Credit and Term Loan Agreement with the
Senior Secured Lender, its foreign lines of credit, and continued minimum sales
levels to finance its ongoing operations.  As of December 31, 2008,
and the current date, the Company did not have any unused credit under the
Revolving Credit and Term Loan Agreement as described above.
 
 The
Company is continuing to investigate various strategic alliances to increase its
market share.  Some of these strategies could involve a merger with or
acquisition by another entity, or joint venturing of one or more businesses or
product line distributions.  There are no assurances that the Company
will be able to identify any suitable candidate(s), or, if so identified, be
able to enter into a definitive agreement with such candidates on terms
favorable to the Company.
 
 Off-Balance Sheet
Arrangements
 
 The
Company has no off-balance sheet financing arrangements or interests in
so-called special purpose entities.
 
 Results of
Operations
 
 Fluctuations in Operating
Results
 
 The
results of operations for the Company have changed significantly as a result of
the acquisition of QR.  QR, located in Verona, Italy is a global
supplier of state-of-the-art, in-office three-dimensional dental computed
tomography (CT).  QR uses an imaging technology that features a cone
shaped beam of x-rays (a CBCT scanner).  The carrying values of QR’s
assets and liabilities were adjusted to their fair values and the difference
between the purchase price and the fair value of the net assets was recorded as
goodwill and other intangibles, and is subject to periodic impairment
testing.  The Company’s results of operations have been and will
continue to be materially affected by the amortization costs associated with
these other intangibles and any impairment charges.
 
 The U.S.
dollar is the Company’s reporting currency; however, a significant portion of
the consolidated operating results are denominated in Euros.  Since
the acquisition in April 2007, the U.S. dollar/Euro exchange rate has fluctuated
significantly, thereby impacting the Company’s financial
results.  Between April 2007 and December 2008, the U.S. dollar/Euro
exchange rate ranged from as low as $1.25 to as high as $1.59.  In the
current six months ended December 31, 2008, the U.S. dollar/Euro exchange rate
varied from $1.59 to $1.25, based on the current worldwide economic conditions
and marketplace uncertainty.  The Company does not usually use foreign
exchange contracts to manage foreign currency exposure.  As of
December 31, 2008, there were no outstanding foreign exchange
contracts.
 
 Based on
the recent losses, the Company instituted significant cost cutting measures in
the first quarter of Fiscal Year 2009, which began to take effect in the second
quarter of Fiscal Year 2009.  These measures include reductions in
operating costs and worldwide sales, marketing and distribution costs, including
payroll, employee benefits and operating overhead charges. The Company has
replaced a portion of its dedicated sales force with industry-knowledgeable,
independent sales representative to augment sales and reduce fixed
costs.  The Company replaced its executive managers at its foreign
operations so as to better serve worldwide customer demand and increase sales
levels.
 
 18
 The
Company’s operating results have varied in the past and are likely to vary in
the future.  Due to variations that the Company has experienced in
operating results, management does not believe that period-to-period comparisons
of results of operations are necessarily meaningful or reliable as indicators of
future performance.  These variations result from several factors,
many of which are not in the Company’s control, including, but not limited
to:
 
  ·
              Changes
      in technology, specifically imaging modalities,·
              Demand
      for products and services,
 ·
              The
      level of product, price and service
competition,
 ·
              Changes
      in product mix, which could affect profit
  margins,
 ·
              Federal,
      state or local government
regulation,
 ·
              The
      timing of industry trade shows,
 ·
              Currency
      fluctuations,
 ·
              Capital
      spending budgets of customers,
 ·
              General
      economic trends and conditions specific to the Company’s
      industry,
 ·
              Changes
      in the prime rate of borrowing in the United
  States,
 ·
              Changes
      in federal and foreign tax laws,
 ·
              The
      timing of new product introductions by the Company as well as by its
      competitors,
 ·
              Worldwide
      economic events which have continued to negatively impact potential
      customers’ purchasing decisions,
and
 ·
              Worldwide
      economic events which have continued to negatively impact the ability of
      customers to obtain financing.
 
 Six Months in Fiscal Year
2009 Versus Six Months in Fiscal Year 2008
 
 Sales
decreased by approximately $2.2 million or 13.5% between the Fiscal Year 2008
and Fiscal Year 2009 six-month comparable periods.  The Company
experienced lower sales in the current six-month period, which can be
attributable to the current worldwide economic liquidity crisis which has
negatively impacted the potential purchasing decisions for all of the Company’s
products and reduced the ability for customers to obtain financing for these
products.  Many customers continue to reconsider their purchases for
the Company’s equipment and many distributors continue to reduce their on-hand
inventory, based on their own economic circumstances and evolving worldwide
market conditions.  There was an increase of approximately $1.65
million related to sales of the three-dimensional dental x-ray imaging systems,
approximately $800,000 which related to the reclassification from deferred
revenue to revenue, based on completion of certain contractual
obligations.  The amount of sales from the Company’s veterinary
products’ business decreased by approximately $545,000 due to reduced market
demand.  The Company’s dental radiographic products decreased $1.49
million due to the loss of the Company’s Canadian distributor and lower
worldwide sales as dentists continue to delay their purchasing decisions,
especially for the more expensive digital radiographic systems.  The
Company’s analog film processor business, including spare parts and chemistry,
showed a decrease of approximately $1.8 million in the current six-month period,
due to the continuing transition from analog to digital imaging processing as
U.S. healthcare professionals continue to migrate to digital imaging equipment,
which the Company also supplies, and the postponement of a large international
order until the fourth quarter of the current year.  The Company
continues to try to increase its worldwide distribution and expand and develop
new international markets for its digital products, however, the global
financial crisis has negatively impacted foreign customers as they too have
reduced their purchases.
 
 Gross
profit as a percent of sales improved slightly between the Fiscal Year 2008 and
Fiscal Year 2009 six-month comparable periods mainly due to the U.S. dollar
improving in relation to the Euro in the second quarter of Fiscal Year 2009,
which reduced the cost of foreign purchased items.
 
 Selling,
general, and administrative costs increased by approximately $322,500 or 4.75%,
between the Fiscal Year 2008 and Fiscal Year 2009 six-month comparable
periods.  There was an increase of approximately $956,000 in operating
costs in Italy, and a decrease of approximately $633,500 in operating costs in
the United States.  The Company increased administrative and sales
personnel in Italy to properly produce, position, market and distribute the
three-dimensional products worldwide.  In order to accomplish this
goal, one Company senior executive relocated from the U.S. to
Italy.  The Company also leased additional research and development
space in Italy in January 2008, to allow for a realignment of factory production
and distribution demands.  The Company sponsored “NewTom” day in July
2008, for its existing dealers and potential new customers to promote awareness
of the Company’s three-dimensional imaging products and product
improvements.  This event is held every other year.  The
Company incurred higher sales commissions in Italy as it used more agents to
increase sales.  The Company recorded a contractual obligation of
approximately $505,000 to two of the former owners who have resigned effective
January 1, 2009.  The decrease in the United States was offset by the
write-off of approximately $152,250 in September 2008, which was related to the
deferred financing costs which had been capitalized in April 2007, as the
Company has not currently been able to successfully negotiate a waiver, a
forbearance agreement or renegotiate its senior secured debt.  There
was a decrease of approximately $785,800 related to the Company’s
administrative, marketing/sales and technical support costs.  The
Company reduced the number of exhibitions it attended in the current six-month
period, reduced its outside consultants and advertising due to the current
restraints on available funding, and reduced overhead costs and payroll and
related benefits.  The Company has continued to maintain its technical
support department infrastructure to assure timely customer
satisfaction.  The three-dimensional imaging systems require a devoted
technical support system, including installation, training and related costs to
assist the end users.
 
 19
 Amortization
of intangibles decreased approximately $369,100 or 62.3% due to the impairment
charge of $5.6 million recorded in Fiscal Year 2008, which lowered the gross
value of the other intangibles being amortized.
 
 Research
and development costs decreased by approximately $193,800, or 19.3%, between the
Fiscal Year 2008 and Fiscal Year 2009 comparable six-month periods. The entire
decrease is due to reductions in the U.S., as the Company has focused its
research and development efforts on its three-dimensional imaging products with
the group in Italy.  The Company continues to invest in the design,
development and refinement of its existing digital imaging products, as well as
the design and development of new digital imaging products for the human dental
and broad veterinary applications.  Research and development costs may
fluctuate between reporting periods, due to changing research and development
consulting agreements, initiation or completion of certain project tasks, and
market demands.  The Company continues to evaluate its strategy to
develop and market additional high-tech digital products.
 
 For the
six-month period ended December 31, 2008, the loss on foreign currency
transactions amounted to $2,150,705 due to the continued decrease in the value
of the Euro in relation to the U.S. dollar during this time period.  A
deferred tax asset has been recorded in Italy for this unrealized loss, in
accordance with local laws.  For the six-month period ended December
31, 2007, the gain on foreign currency transactions amounted to $1,095,346 due
to the increase in the value of the Euro in relation to the U.S. dollar during
this time period.  A deferred tax liability was recorded in Italy for
this unrealized gain.  This is an unrealized non-cash foreign currency
transaction related to the U.S. dollar denominated intercompany note and
recorded by QR in Euros.  On October 31, 2008, the Company reduced
this intercompany note from $14 to $9 million and converted the $5 million to
equity on the Italian subsidiary’s records to comply with local laws which
require companies to maintain certain levels of equity.
 
 For the
six-month period ended December 31, 2008, net interest expense was approximately
$1.28 million.  For the six-month period ended December 31, 2007, net
interest expense was approximately $493,500.  This increase of
approximately $786,700 is mainly attributable to the acceleration and write-off
of the balance of the Term Note imputed debt discount of $808,701, as the
Company has not been able to successfully negotiate a waiver, a forbearance
agreement or renegotiate its senior secured debt.  There was also
approximately $618,000 more in average borrowings during the current six-month
period, all of which being foreign debt at lower interest rates compared to the
interest rates in the comparable period in Fiscal Year 2008. Additionally, the
U.S. average borrowing rate was approximately 2.5 points lower in the current
six-month period.
 
 The net
tax benefit recorded for the six-month period ended December 31, 2008 and net
tax expense for the six-month  period ended December 31, 2007, include
foreign taxes at the statutory rates on the Company’s foreign operations,
changes to the deferred tax accounts, and state income and capital taxes
generated in the United States.  Included in the tax benefit for the
period ended December 31, 2008 is a charge of approximately $166,000 to reflect
tax differences related to the amortization of the acquisition goodwill which is
not deductible for book purposes.  A long-term deferred tax liability
has been established.  As of December 31, 2008, the Company had
approximately $12.0 million in federal net operating loss carry forwards, and
approximately $16.4 million in state net operating loss carry
forwards.  These NOL’s will begin to expire in 2010 and are subject to
review by the Internal Revenue Service.  Past and future changes in
ownership of the Company as defined in Section 382 of the Internal Revenue Code,
may limit the amount of NOL’s available for use in any one year.
 
 As of
December 31, 2008, the Company has recorded net deferred tax assets of
approximately $467,587 and as of June 30, 2008, net deferred tax liabilities of
approximately $155,000.  The December 31, 2008 net deferred tax assets
are comprised of approximately $694,681 of deferred tax assets and $227,094 of
deferred tax liabilities.  The June 30, 2008 net deferred tax
liabilities are comprised of approximately $698,000 of deferred tax liabilities
and $543,000 of deferred tax assets. The deferred tax liabilities are related to
the previously recorded net unrealized exchange gain on the intercompany note
denominated in U.S. dollars, as it will only be taxed when realized and when
repayment is made; and to differences related to the amortization of the
acquisition goodwill for tax purposes.  The deferred tax assets are
mainly related to the temporary differences on the intangible assets
amortization.
  20
 Second Quarter of Fiscal
Year 2009 Versus Second Quarter of Fiscal Year 2008
 
 Sales for
the second quarter of Fiscal Year 2009 were $7.28 million, which represents a
decrease of approximately $1.38 million, or 15.9%, compared to the second
quarter of Fiscal Year 2008, principally due to volume, as the Company continues
to be adversely effected by the current worldwide economic liquidity crisis
which has negatively impacted the potential purchasing decisions for all of the
Company’s products and reduced the ability for customers to obtain financing for
these products.  Many customers continue to reconsider their purchases
for the Company’s equipment and many distributors continue to reduce their
on-hand inventory, based on their own economic circumstances and evolving
worldwide market conditions.  There was an increase of approximately
$1.12 million related to sales of the three-dimensional dental x-ray imaging
systems, approximately $300,000 which related to the reclassification from
deferred revenue to revenue, based on completion of certain contractual
obligations.  The Company’s veterinary products business decreased
approximately $711,800, with the decline across all of the products,
specifically the digital all-purpose x-ray systems, due to reduced market
demand.  The sales from the Company’s dental radiographic products
decreased by $1.1 million due to the loss of the Company’s Canadian distributor
and lower worldwide sales as dentists continued to delay their purchasing
decisions, especially for the more expensive digital radiographic
systems.  The Company’s analog film processor business including spare
parts and chemistry showed a decrease of approximately $678,800 in the current
three-month period, due to the continuing transition from analog to digital
imaging processing as U.S. healthcare professionals continue to migrate to
digital imaging equipment, which the Company also supplies.  The
Company continues to increase its worldwide distribution and expand and develop
new international markets for its digital products, however, the global
financial crisis has negatively impacted foreign customers as they too have
delayed their purchases.
 
 Gross
profit as a percent of sales was approximately 4.9 percentage points higher in
the second quarter of Fiscal Year 2008 as compared to the second quarter of
Fiscal Year 2009 because the U.S. dollar improved in relation to the Euro in the
second quarter of Fiscal Year 2009, which also reduced the cost of foreign
purchased items.  Additionally, there was approximately $315,700 less
in U.S. manufacturing overhead costs in the current three-month period
attributable to the extensive cost cutting procedures the Company recently
implemented.
 
 Selling,
general, and administrative costs decreased by approximately $137,300 or 3.7%,
between the second quarter of Fiscal Year 2008 and the second quarter of Fiscal
Year 2009.  There was an increase in operating costs in Italy of
approximately $576,000. The Company recorded a contractual obligation of
approximately $505,000 to two of the former owners who have resigned effective
January 1, 2009.  The Company had previously increased its own
administrative and sales personnel to properly produce, position, market and
distribute the three-dimensional products worldwide.  The Company also
leased additional research and development space in Italy in January 2008, to
allow for a realignment of factory production and distribution
demands.  The Company incurred higher sales commissions in Italy as it
used more agents to increase sales.  There was a decrease in the US
operations of approximately $700,000 due to the recent restructuring of the U.S.
operations including significant reductions in operating costs and worldwide
sales, marketing and distribution costs, including payroll, employee benefits
and operating overhead charges.   The Company reduced the number
of exhibitions it attended in the current three-month period, reduced its
outside consultants and advertising expenditures, due to the current restraints
on available funding.  The Company has continued to maintain its
technical support department to assure timely customer
satisfaction.  The three-dimensional imaging systems require a devoted
infrastructure support system, including installation, training and related
costs to assist the end users.
 
 Amortization
of intangibles in the second quarter of Fiscal Year 2009 compared to the prior
year decreased $199,500 or 65.7% due to the impairment charge of $5.6 million
recorded in Fiscal Year 2008, which lowered the gross value of the other
intangibles being amortized.
 
 Research
and development costs decreased approximately $240,200, or 42.2%, between the
second quarter of Fiscal Year 2008 and second quarter of Fiscal Year 2009. The
decrease is due to cost reductions in the U.S., as the Company has focused its
research and development efforts on its three-dimensional imaging products with
the group in Italy.  The Company continues to invest in the design,
development and refinement of its existing digital imaging products, as well as
the design and development of new digital imaging products for the human dental
and broad veterinary applications. Research and development costs may fluctuate
between reporting periods, due to changing research and development consulting
agreements, initiation or completion of certain project tasks, and market
demands.  The Company continues to evaluate its strategy to develop
and market additional high-tech digital products.
 
 For the
second quarter of Fiscal Year 2009, the loss on foreign currency transactions
amounted to $788,330 due to the continued decrease in the value of the Euro in
relation to the U.S. dollar during this time period.  A deferred tax
asset has been recorded in Italy for this unrealized loss, in accordance with
local laws.  For the three-month period ended December 31, 2007, the
gain on foreign currency transactions amounted to $518,223 due to the increase
in the value of the Euro in relation to the U.S. dollar during this time
period.  A deferred tax liability was recorded in Italy for this
unrealized gain.  This is an unrealized non-cash foreign currency
transaction related to the U.S. dollar denominated intercompany note and
recorded by QR in Euros.  On October 31, 2008, the Company reduced
this inter-company note from $14 million to $9 million and converted the $5
million to equity on the Italian subsidiary’s records to comply with local laws
which require companies to maintain certain levels of equity.
 
 21
 For the
second quarter of Fiscal Year 2009, net interest expense was approximately
$222,600.  For the second quarter of Fiscal Year 2008, net interest
expense was approximately $239,800.  This decrease of approximately
$17,200 is attributable to approximately $182,700 more in average borrowings
during the current three-month period, all of which being foreign debt at lower
interest rates compared to the interest rates in the comparable period in Fiscal
Year 2008.  Additionally, the U.S. average borrowing rate was 2 points
lower in the current three-month period than in the comparable period in Fiscal
Year 2008.
 
 The
Company made a small state tax payment in the U.S. in the second quarter of
Fiscal Year 2009, based on the consolidated loss from operations and made the
required national and local tax payments in Italy for Fiscal Year 2009, based on
its foreign operations, as required by local law.  There is a charge
of approximately $166,000 included in the provision for the three months ended
December 31, 2008 to reflect tax differences related to the amortization of the
acquisition goodwill which is not deductible for book purposes.  The
Company recorded a provision for taxes on QR’s operations at the combined
required statutory tax rate.  The net tax expense recorded for the
three months ended December 31, 2008 and December 31, 2007, include foreign
taxes at the statutory rates on the Company’s foreign operations, changes to the
deferred tax accounts, and state income and capital taxes generated in the
United States.  As of December 31, 2008, the Company had approximately
$12.0 million in federal net operating loss carry forwards, and approximately
$16.4 million in state net operating loss carry forwards.  These NOL’s
will begin to expire in 2010 and are subject to review by the Internal Revenue
Service.  Past and future changes in ownership of the Company as
defined in Section 382 of the Internal Revenue Code, may limit the amount of
NOL’s available for use in any one year.
  As of
December 31, 2008, the Company has recorded net deferred tax assets of
approximately $467,587 and as of June 30, 2008, net deferred tax liabilities of
approximately $155,000.  The December 31, 2008 net deferred tax assets
are comprised of approximately $694,681 of deferred tax assets and $227,094 of
deferred tax liabilities.  The June 30, 2008 net deferred tax
liabilities are comprised of approximately $698,000 of deferred tax liabilities
and $543,000 of deferred tax assets. The deferred tax liabilities are related to
the previously recorded net unrealized exchange gain on the intercompany note
denominated in U.S. dollars, as it will only be taxed when realized and when
repayment is made; and to differences related to the amortization of the
acquisition goodwill for tax purposes.  The deferred tax assets are
mainly related to the temporary differences on the intangible assets
amortization.
 
 Critical Accounting Policies
and Estimates
 
 The
preparation of financial statements in conformity with United States generally
accepted accounting principles requires management to makes estimates and
assumptions that affect the reported amounts of assets and liabilities and the
reported amounts of revenues and expenses.  These estimates and
assumptions are evaluated on an ongoing basis based on historical internal
operations, industry trends and conditions, market conditions and other
information that management believes to be reasonable or applicable under the
circumstances.  There can be no assurances that actual results of
operations will be consistent with management’s estimates and assumptions, and
that reported results of operations will not be adversely affected by the
requirement to make accounting adjustments to reflect changes in these estimates
from time to time.  The following policies are those that management
believes to be the most sensitive to estimates and judgments.
 
 Revenue
Recognition
 The
Company recognizes revenue net of related discounts and allowances for its
consolidated operations when persuasive evidence of the arrangement exists, the
price is fixed or determinable, collectability is reasonably assured, and
delivery or title and risk of loss has passed to the customer, based on the
specific shipping terms.   The Company includes shipping and
handling costs as a component of cost of sales.  Revenue related to
equipment orders that contain one or more elements to be delivered at a future
date is recognized in accordance with EITF 00-21 “Accounting for Revenue Arrangements
with Multiple Deliverables”.The Company allocates revenue
between the various elements using the relative fair value method, based on
evidence of fair value for the respective elements.    The
revenue allocated to deferred service contracts, installation and training for
the three-dimensional imaging equipment is deferred until service is
provided.  Amounts received from customers in advance of equipment
deliveries are recorded as deferred income until the revenue can be recognized
in accordance with the Company’s revenue recognition policy.
 
 22
 Accounts
Receivable
 The
Company reports accounts receivable net of reserves for doubtful
accounts.  Credit is extended to distributors on varying terms,
usually between 30 and 90 days.  Most of the sales to our direct users
are payment in advance.  Letters of Credit or payment in advance is
required for certain foreign sales.  The reserve for doubtful accounts
is management’s best estimate of the amount of probable credit losses in the
Company’s existing accounts receivable and is based upon continual analysis of
the accounts receivable aging including credit risk of specific customers,
historical trends and other related information.  The Company writes
off accounts receivable when they become uncollectible.  There have
been no significant changes in the computation methodology of the reserve for
doubtful accounts in the past three years. The Company has not had significant
bad debt write-offs in the past few years, except for Fiscal Year 2008, when the
Company recorded certain write-offs related to the receivables associated with
the acquisition of QR srl and the write-off related to an exclusive Canadian
distributor. The allowance for doubtful accounts is based on the Company’s
analysis of aged accounts receivable.  Management believes that any
potential risk associated with the estimate of reserve for doubtful accounts is
therefore limited.
 
 Inventories
 Inventories,
which include material and a small component of work-in-process labor and
overhead, are stated at the lower of cost (first in, first out) or market (net
realizable value).  The Company has established inventory reserves
based on inventory estimated to be obsolete, slow moving, or unmarketable due to
changing technological and/or market conditions.  If actual market and
technical conditions are less favorable than those anticipated, additional
inventory reserves would be required.  There have been no significant
changes in the computation methodology of the reserves for inventory in the past
two years.
 
 Warranties
 The
Company records a liability for an estimate of costs that it expects to incur
under its limited warranty based on revenues.  Various factors affect
the Company’s warranty liability, including: (1) number of units sold, (2)
historical rates of claims, (3) anticipated rates of claims, and (4) costs per
claim.  The Company periodically assesses the adequacy of its warranty
liability based on changes in these factors.
 
 In March
2005, the Company began to include an extended warranty with its digital
sensors.  The Company continues to monitor the rate and costs of
claims and review the adequacy of its warranty liability and has made changes in
the warranty reserve, as necessary based upon the number of units sold, the
actual amount of warranty claims processed, and the specific warranty
period.  The increase in the warranty reserve has resulted in
decreased gross profit for the Company.
 
 In Fiscal
Year 2008, the Company’s Italian subsidiary began to separately account for
warranty costs related to its three-dimensional digital imaging equipment and
has recorded a warranty reserve as of June 30, 2008 and December 31,
2008.
 
 Stock-based
Compensation
 Effective
July 1, 2005, the Company began to account for stock based compensation under
Financial Accounting Standards Board Statement No. 123R, Share Based
Payment.  The Company determines the fair value of options
based on the Black-Scholes model, which is based on specific assumptions
including (1) expected life of the option, (2) risk free interest rates, (3)
expected volatility and (4) expected dividend yield.
 
 Deferred Tax Asset and
Income Taxes
 Income
taxes are accounted for under the asset and liability
method.  Deferred income taxes are recorded for temporary differences
between financial statement carrying amounts and the tax basis of assets and
liabilities.  Deferred tax assets and liabilities reflect the tax
rates expected to be in effect in the period in which the differences are
expected to reverse.  Any changes in tax laws which affect the
applicable tax rates will affect the deferred tax asset and will be reflected in
the accompanying current tax provision.  The Company records a
valuation allowance to reduce its deferred tax asset when it is more likely than
not that a portion of the amount may not be realized.  The Company
estimates its valuation allowance based on an estimated forecast of its future
profitability.  Any significant changes in future profitability
resulting from variations in future revenues or expenses could affect the
valuation allowance on the deferred tax asset and operating results could be
affected.  In reviewing the valuation allowance, the Company considers
future taxable income and determines whether it is more likely than not that a
portion of the deferred tax asset will be realized.  Changes in these
circumstances, such as an increase or decline in estimated future taxable
income, would result in a re-determination of the valuation
allowance.  In Fiscal Year 2008, the Company increased its valuation
allowance on the U.S. portion of its deferred tax asset by approximately
$4,398,000, as it does not believe that it is more likely than not that it will
be able to utilize the net operating loss carry forwards based on recent losses
and anticipated market conditions.
 
 The
Company has recorded deferred tax assets and liabilities associated with its
operations.  Certain tax assets were acquired upon the acquisition of
QR in April 2007 and primarily relate to the financial statement carrying amount
of existing assets and liabilities and their respective tax bases.
 
 23
 The
Company has recorded NOLs amounting to approximately $12.0 million in federal
NOLs and $16.4 million in state NOLs at December 31, 2008.  The NOLs
are subject to review by the Internal Revenue Service.  Past and
future changes in ownership of the Company, as defined in Section 382 of the
Internal Revenue Code, may limit the amount of NOLs available for use in any one
year.
 
 Goodwill and other
intangibles
 Prior to
April 2007, the Company did not have any long-lived assets or
goodwill.  Long-lived assets held for use by the Company will be
reviewed for impairment whenever circumstances provide evidence that suggests
the carrying amount of the asset may not be recoverable, at which time, the
Company will perform an impairment analysis primarily related to technology and
customer relationships.  Determination of whether impairment exists
will be based upon comparison of the fair value of the assets to the carrying
values of the respective assets. This could result in a material charge to
earnings.  The Company considers factors such as operating results,
market trends, technological developments, competition, other economic factors,
and the effects of obsolescence for this assessment.
 
 Goodwill
is not amortized, but will be tested for impairment on an annual basis each June
30th, or
whenever circumstances or events indicate that the carrying amount may not be
recoverable.  These events include, without limitation, a significant
change in the business climate, operating performance indicators, legal factors,
competition or a significant change in the business entity.  The first
step of the goodwill impairment tests will be based upon a comparison of the
fair value of the reporting unit to the respective carrying value.  If
the fair value of the reporting unit exceeds its carrying amount, no impairment
exists.  If, however, the carrying amount of a reporting unit exceeds
its fair value, the second step of the goodwill impairment test will be
performed to measure the amount of impairment loss, if any.  The
implied fair value requires a fair value process similar to a business
combination, where the individual assets and liabilities are valued at fair
value with the difference between the fair value of the reporting unit being the
implied fair value of goodwill.  If the carrying amount of the
reporting unit exceeds its fair value, the goodwill impairment loss is measured
as the excess of the carrying amount of goodwill over its implied fair
value.  Any identified impairment will result in a charge to reduce
the carrying value of the associated goodwill.  This could result in a
material charge to earnings.
  As of
December 31, 2008, the Company does not believe there is any impairment of its
goodwill or of its other intangible assets.  However, the occurrence
of future events or deteriorating conditions, not limited to the Company's
inability to obtain additional financing alternatives (as described above),
operating or cash flow losses, potential merger with or acquisition by another
entity, potential sale or disposal of assets significantly before the end of
their previous estimated useful lives, may result in a future
impairment.
 
 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 3.  Quantitative and Qualitative Disclosures About
Market Risk.
 
 Not
Applicable.
 
 Item 4T.  Controls and Procedures.
 
 a) Evaluation of Disclosure
Controls and Procedures
 
 The
Company conducted an evaluation of the effectiveness of the design and operation
of the Company’s disclosure controls and procedures (as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended
(the “Exchange Act”)) as of December 31, 2008.  The controls
evaluation was conducted under the supervision and with the participation of our
management, including our Co-Chief Executive Officers and Chief Financial
Officer.  Based upon that evaluation, the Co-Chief Executive Officers
and Chief Financial Officer have concluded that, as a result of the
identification of the material weaknesses identified below, as of the end of the
period covered by this report, our disclosure controls and procedures were not
effective.
 
 In its
assessment of the effectiveness of internal control over financial reporting as
of December 31, 2008, management concluded that the Company's internal controls
over financial reporting were not operating effectively.  It was
determined that there were control deficiencies that when aggregated, may
possibly be viewed as a material weaknessin our internal control
over financial reporting as of December 31, 2008.  Those deficiencies
were as follows:
 
 1.
              We
      do not employ an Audit Committee as defined by Section 3(a)(58) of the
      Exchange Act and none of the Company’s directors are
      independent.  While not being legally obligated to have an audit
      committee, it is the Company's view thatsuch a committee,
      including a financial expert, is an utmost important entity level control
      over the Company's financial statements.  Currently, the full
      Board of Directors acts in the capacity of the Audit
      Committee.
  24
 2.
              The
      Company does not have an individual who meets the criteria to be defined
      as a financial expert on its Board of Directors.  The financial
      expert could lead the Audit Committee to provide additional oversight of
      the Company’s Chief Financial Officer, as well as provide the Company’s
      financial management with enhanced segregation of duties and controls
      which would minimize the risk of a material
  misstatement.
 
 3.
              There
      are no processes in place for someone to review and determine financial
      impacts of contracts and agreements.  The financial expert could
      assist in this review prior to the legal review and minimize any potential
      financial exposures.
 
 In light
of this identified material weakness, the Company’s Board interacts with
management frequently and management performed (1) significant additional
substantive review of the financial information, (2) performed additional
analyses, including but not limited to a substantive analytical review that
compared changes from the prior period's financial statements and analyzed all
significant amounts that deviated from expectations, and (3) utilized an outside
consultant to provide assistance with technical accounting and reporting
matters.  These enhanced procedures were completed to mitigate the
entity level control deficiencies noted above.
 
 Remediation of Material
Weaknesses
 
 Management
concluded that the above identified material weakness did not result in material
audit adjustments to our 2008 financial statements. However, it is reasonably
possible that, if not remediated, one or more of the identified deficiencies
noted above could result in a material misstatement in our financial statements
that might result in a material misstatement in a future annual or interim
period.
 
 In an
effort to remediate the identified material weaknesses, consideration will be
given to the following:
 
 1.
Management will continue to consider seeking candidates to expand the Board of
Directors in order to ensure a majority of the Board is
independent.
 
 2. Once
the expansion of the Board is completed, the Company’s Board of Directors will
nominate an Audit Committee, which includes a financial expert that has an
understanding of U.S. generally accepted accounting principles and financial
statements; the ability to assess the general application of such principles in
connection with the accounting for estimates, accruals and reserves; experience
in preparing, auditing, analyzing or evaluating financial statements that
present a breadth and level of complexity of accounting issues that are
generally comparable to the breadth and complexity of issues that can reasonably
be expected to be raised by the registrant's financial statements, or experience
actively supervising one or more persons engaged in such activities; an
understanding of internal controls and procedures for financial reporting; and
an understanding of audit committee functions.
 
 This
financial expert will have any one or more of the following
attributes:
 
 ·
              Education
      and experience as a principal financial officer, principal accounting
      officer, controller, public accountant or auditor or experience in one or
      more positions that involve the performance of similar
      functions;
 ·
              Experience
      actively supervising a principal financial officer, principal accounting
      officer, controller, public accountant, auditor or person performing
      similar functions;
 ·
              Experience
      overseeing or assessing the performance of companies or public accountants
      with respect to the preparation, auditing or evaluation of financial
      statements; or
 ·
              Other
      relevant experience.
 
 Limitations of Effectiveness
of Controls
 
 As of the
date of this filing, the Company is satisfied that actions implemented to date
and those under consideration  will remediate the material weaknesses
and deficiencies in the internal controls that have been
identified.   The Company notes that, like other companies, any
system of internal controls, however well designed and operated, can provide
only reasonable assurance, and not absolute assurance, that the objectives of
the internal control system will be met.   The design of any
control system is based, in part, upon the benefits of the control system
relative to its costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within the Company have been
detected.  These inherent limitations include the realities that
judgments in decision making can be faulty, and that controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people or by management override of control. In addition, over time, controls
may become inadequate because of changes in conditions, or the degree of
compliance with the policies or procedures may deteriorate.  In
addition, the design of any control system is based in part upon certain
assumptions about the likelihood of future events. Because of the limitations
inherent in a cost-effective control system, misstatements due to error or fraud
may occur and may not be detected.
 
 25
 (b) Changes in Internal Controls
over Financial Reporting
 
 During the
second quarter ended December 31, 2008, there were no significant changes in the
Company’s internal controls over financial reporting or in other factors that
have materially affected, or are reasonably likely to materially affect, the
Company’s internal control over financial reporting.
  26
  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, 2008, and to the references therein, for a discussion of all
material pending legal proceedings to which the Company and its subsidiaries are
parties.
 
 In October
2008, the Company and its insurance carrier each contributed $41,440 to an
escrow account to settle the outstanding environmental litigation relating to
property owned by the Company in New Jersey between August 1984 and June
1985.  In January 2009, the Consent Decree memorializing the
settlement was lodged with the Court.  There is a ninety day comment
period and the Court is expected to enter the Consent Decree in April
2009.
 
 In
November 2008, the Company and Genexa Medical Inc. (“Genexa”), were instructed
by the court to attempt to negotiate through a court appointed mediator on
January 9, 2009 the outstanding litigation which had been filed on May 5, 2008,
in the United States District Court, Southern District of New
York.  Genexa did not appear and the mediation was rescheduled for
February 5, 2009.  Genexa did not appear again.  The Court
has permitted Genexa’s attorneys to withdraw from the case and no new attorneys
have been appointed as of the date of this filing.  Moreover, the
shareholders of Genexa recently voted in favor of its
liquidation.  The Company has filed a motion requesting Summary
Judgment and dismissal of the case and is awaiting the judge’s
ruling.
 
 On
February 3, 2009, the Company settled, through a court appointed mediator, the
customer complaint which had been filed on December 19, 2007 in the Superior
Court of California, County of Placer.  The complaint was settled for
$22,000 and full releases were obtained.
 
 The
Company is a defendant (with several other parties) in a product liability
insurance action, which was filed in January 2009, in the Superior Court of
Justice, Ontario, Canada, under the simplified procedure provided in Rule 76 of
the Rules of Civil Procedure.  The plaintiff, through their insurance
company, claims that the Company’s equipment caused damage to the plaintiff’s
premises in May 2007.  The complaint seeks approximately $50,000 in
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’s consolidated
financial statements.
 
 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’s consolidated
financial statements.
 
 Item 4.  Submission of Matters to a Vote of Security
Holders.
 
 On
December 10, 2008, the Company held its Annual Meeting of
Shareholders.  At the Annual Meeting, the following actions
occurred:
 
 1. The
following individuals were each re-elected to the Board of Directors for
one-year terms:
 
 For
      Election
                      
                      
                      Against
      ElectionDavid
      Vozick
                      
                      
                      13,014,518
                      
                      
                      
                      1,327,535Donald
      Rabinovitch
                      
                      
                      13,017,568
                      
                      
                      
                      1,324,485Jack
      Becker
                      
                      
                      13,011,568
                      
                      
                      
                      1,330,485Robert
      Blatt
                      
                      
                      13,021,518
                      
                      
                      
                      1,320,535
 
 2. A
proposal to approve an amendment to the Company’s Certificate of Incorporation
to increase the number of authorized shares of Common Stock from 30,000,000 to
100,000,000 was ratified by the following votes:
 
 For the Proposal
                        
                        
                        Against the Proposal
                        
                        
                        AbstainProposal
      No. 2
                        
                        
                        11,683,722
                        
                        
                        
                        2,391,001
                        
                        
                        
                        267,329
 
 
 27
  Item 6.  Exhibits.
  31.1
      -
                Certification
      of Co-Chief Executive Officer pursuant to Exchange Act Rule 13a – 14 (a)
      or Rule 15d-14(a).*31.2
      -
                Certification
      of Co-Chief Executive Officer pursuant to Exchange Act Rule 13a – 14 (a)
      or Rule 15d-14(a).*31.3
      -
                Certification
      of Chief Financial Officer pursuant to Exchange Act Rule 13a – 14 (a) or
      Rule 15d-14(a).*32.1
      -
                Certification
      of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the
      Sarbanes – Oxley Act of 2002.*32.2
      -
                Certification
      of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the
      Sarbanes – Oxley Act of 2002.*32.3
      -
                Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the
      Sarbanes – Oxley Act of
2002.*
  *Filed
herewith.
  28
  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(Registrant)By:/s/David
      VozickDavid
      VozickChairman
      of the Board,(Co-Chief
      Executive Officer)Secretary,
      TreasurerDate:  February
      23, 2009By:/s/Donald
      RabinovitchDonald
      RabinovitchPresident(Co-Chief
      Executive Officer)Date:  February
      23, 2009By:/s/Elise
      NissenElise
      NissenChief
      Financial Officer(Principal
      Financial and Accounting Officer)Date:  February
      23, 2009


29


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