# UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, DC 20549

# FORM 10-QSB

# QUARTERLY REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

Commission File Number: 1-11140

OPHTHALMIC IMAGING SYSTEMS

|California                      |  | 94-3035367                       
|------------------------------- |  | ---------------------------------
|(State or other jurisdiction of |  | (IRS Employer Identification No.)
|incorporation or organization)  |  |                                  

(916) 646-2020(Issuers telephone number)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d)
of the Exchange Act during the past 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 
  No

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):  Yes 
No

As of November 13, 2006, 16,120,829 shares of common stock,
no par value, were outstanding.

Transitional Small Business
Disclosure Format:  Yes     No



---

OPHTHALMIC IMAGING
SYSTEMS

FORM 10-QSB

FOR THE QUARTER ENDED
September 30, 2006

|PART I  | FINANCIAL INFORMATION                                                                                        | Page
|------- | ------------------------------------------------------------------------------------------------------------ | ----
|       
|Item 1. | Financial Statements (unaudited)                                                                             | 1   
|       
|        | Condensed Balance Sheet as of September 30, 2006                                                             | 2   
|       
|        | Condensed Statements of Income for the Three and Nine Months ended September 30, 2006 and September 30, 2005 | 3   
|       
|        | Condensed Statements of Cash Flows for the Nine Months ended September 30, 2006 and September 30, 2005       | 4   
|       
|        | Notes to Condensed Financial Statements                                                                      | 5   
|       
|Item 2. | Management's Discussion and Analysis or Plan of Operation                                                    | 13  
|       
|Item 3. | Controls and Procedures                                                                                      | 21  
|       
|22     
|       
|Item 6. | Exhibits                                                                                                     | 22  

i



---

PART I      FINANCIAL
INFORMATION

|ITEM 1. |  | FINANCIAL
STATEMENTS
|------- |  | --------------------

1



---

Ophthalmic Imaging
Systems

Condensed Balance Sheet

September 30, 2006

(Unaudited)

|                                                          | 
|--------------------------------------------------------- | 
|Assets                                                    | 
|Current assets:                                           | 
|Cash and cash equivalents                                 | 
|Accounts receivable, net                                  | 
|Receivable from related party                             | 
|Inventories, net                                          | 
|Prepaid expenses and other current assets                 | 
|Deferred tax asset                                        | 
|                                                          | 
|Total current assets                                      | 
|                                                          | 
|Furniture and equipment, net of accumulated               | 
|depreciation and amortization of $373,747                 | 
|Restricted cash                                           | 
|Licensing agreement                                       | 
|Prepaid products                                          | 
|Other assets                                              | 
|                                                          | 
|Total assets                                              | 
|                                                          | 
|Liabilities and Stockholders' Equity                      | 
|Current liabilities:                                      | 
|Accounts payable                                          | 
|Accrued liabilities                                       | 
|Deferred extended warranty revenue                        | 
|Customer deposits                                         | 
|Lease payable- current portion                            | 
|                                                          | 
|Total current liabilities                                 | 
|                                                          | 
|Noncurrent liabilities:                                   | 
|Line of credit                                            | 
|Lease payable, less current portion                       | 
|                                                          | 
|Total liabilities                                         | 
|                                                          | 
|Stockholders' equity:                                     | 
|Common stock, no par value, 35,000,000 shares authorized; | 
|16,104,162 issued and outstanding                         | 
|Accumulated deficit                                       | 
|                                                          | 
|Total stockholders' equity                                | 
|                                                          | 
|Total liabilities and stockholders' equity                | 
|                                                          | 

The accompanying notes
are an integral part of these unaudited condensed financial statements.

2



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Ophthalmic Imaging
Systems

Condensed Statements of
Income

(Unaudited)

|                                          | Three months ended September 30, |  | Nine months ended September 30, |           
|----------------------------------------- | -------------------------------- |  | ------------------------------- | ----------
|                                          | 2006                             |  | 2005                            |           
|Net revenues                              |                                  |  | $                               | 3,927,257 
|Cost of sales                             |                                  |  |                                 | 1,709,611 
|                                          |                                  |  |                                 |           
|Gross profit                              |                                  |  |                                 | 2,217,646 
|                                          |                                  | 
|Operating expenses:                       |                                  | 
|Sales and marketing                       |                                  |  |                                 | 825,023   
|General and administrative                |                                  |  |                                 | 425,448   
|Research and development                  |                                  |  |                                 | 413,302   
|                                          |                                  |  |                                 |           
|Total operating expenses                  |                                  |  |                                 | 1,663,773 
|                                          |                                  |  |                                 |           
|Income from operations                    |                                  |  |                                 | 553,873   
|Interest and other income (expense), net  |                                  |  |                                 | 39,328    
|                                          |                                  |  |                                 |           
|Net income before income taxes            |                                  |  |                                 | 593,201   
|Income tax benefit (expense)              |                                  |  |                                 | 13,632    
|                                          |                                  |  |                                 |           
|Net income                                |                                  |  | $                               | 606,833   
|                                          |                                  |  |                                 |           
|Shares used in the calculation of basic   |                                  | 
|net income per share                      |                                  |  |                                 | 16,104,162
|                                          |                                  | 
|Basic net income per share                |                                  |  | $                               | 0.04      
|                                          |                                  |  |                                 |           
|Shares used in the calculation of diluted |                                  | 
|net income per share                      |                                  |  |                                 | 17,862,301
|                                          |                                  | 
|Diluted net income per share              |                                  |  | $                               | 0.03      
|                                          |                                  |  |                                 |           

The accompanying notes
are an integral part of these unaudited condensed financial statements.

3



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Ophthalmic Imaging
Systems

Condensed Statements of
Cash Flows

(Unaudited)

|                                                       | Nine months ended September 30,
|------------------------------------------------------ | -------------------------------
|
|Operating activities:                                  |                                
|Net income                                             |                                
|Adjustments to reconcile net income to net cash        |                                
|provided by operating activities                       |                                
|Depreciation and amortization                          |                                
|Compensation expense related to FAS123R                |                                
|Non-cash interest charge                               |                                
|Net increase (decrease) in current assets other        |                                
|than cash and cash equivalents                         |                                
|Net (increase) decrease in other assets                |                                
|Net increase  in current liabilities other             |                                
|than short-term borrowings                             |                                
|                                                       |                                
|Net cash provided by operating activities              |                                
|                                                       |                                
|Investing activities:                                  |                                
|Acquisition of furniture and equipment                 |                                
|                                                       |                                
|Financing activities:                                  |                                
|Principal payments on notes payable                    |                                
|Proceeds from note receivable from related parties     |                                
|Proceeds from sale of stock                            |                                
|Proceeds from line of credit, net                      |                                
|                                                       |                                
|Net cash provided by financing activities              |                                
|Net increase in cash and equivalents                   |                                
|Cash and equivalents, beginning of the period          |                                
|                                                       |                                
|Cash and equivalents, end of  the period               |                                
|                                                       |                                
|Supplemental schedule of noncash financing activities: |                                
|Conversion of notes payable with common stock          |                                
|Conversion of interest with common stock               |                                
|Reduction in receivable from                           |                                
|Related party in exchange for inventory and            |                                
|other noncash transactions, net                        |                                
|                                                       |                                
|Supplemental schedule of cash flow information:        |                                
|Cash paid for interest                                 |                                
|Cash paid for taxes                                    |                                

The accompanying notes
are an integral part of these unaudited condensed financial statements.

4



---

Ophthalmic Imaging
Systems

Notes to Condensed Financial
Statements

Three and Nine Month
Periods ended September 30, 2006 and 2005

(Unaudited)

|Note 1. | Basis of Presentation
|------- | ---------------------

| | The
accompanying unaudited condensed balance sheet as of September 30, 2006, condensed statements
of income for the three and nine month periods ended September 30, 2006 and 2005 and the
condensed statements of cash flows for the nine month periods ended September 30, 2006 and 2005
have been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-QSB and Item 310(b) of
Regulation S-B. Accordingly, they do not include all of the information and footnote
disclosures required by generally accepted accounting principles for complete financial
statements. It is suggested that these condensed financial statements should be read in
conjunction with the audited financial statements and notes thereto included in
Ophthalmic Imaging Systems (the Companys) Annual Report for the
year ended December 31, 2005 on Form 10-KSB. In the opinion of management, the
accompanying condensed financial statements include all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the Companys
financial position and results of operations for the periods presented. The results of
operations for the period ended September 30, 2006 are not necessarily indicative of the
operating results for the full year.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 2. | Net Income Per Share
|------- | --------------------

| | Basic
earnings per share (EPS), which excludes dilution, is computed by dividing
income available to common shareholders by the weighted-average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that could occur
if securities or other contracts to issue common stock, such as stock options, result in
the issuance of common stock, which shares in the earnings of the Company. The treasury
stock method is applied to determine the dilutive effect of stock options in computing
diluted EPS.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

5



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|                                                   | Unaudited
Three Months Ended
September 30, | Unaudited
Nine Months Ended
September 30, |  
|-------------------------------------------------- | ------------------------------------------ | ----------------------------------------- | -
|
|Numerator for basic and diluted                    |                                            |                                           |  
|net income per share                               |                                            |                                           | $
|                                                   |                                            |                                           |  
|Denominator for basic net income per share:        |                                            |                                          
|Weighted average shares                            |                                            |                                           |  
|                                                   |                                            |                                          
|                                                   |                                            |                                          
|Effect of dilutive employee/director stock options |                                            |                                           |  
|                                                   |                                            |                                          
|                                                   |                                            |                                           |  
|Dilutive potential common shares                   |                                            |                                           |  
|                                                   |                                            |                                           |  
|Denominator for diluted net income  per share      |                                            |                                           |  
|                                                   |                                            |                                           |  
|Basic net income per share                         |                                            |                                           | $
|                                                   |                                            |                                           |  
|Diluted net income per share                       |                                            |                                           | $
|                                                   |                                            |                                           |  

| | As
of September 30,  2006 and September 30, 2005 there were  21,500 and  744,500  options and
 warrants,                 respectively  whose  exercise  price  exceeded the average
 market price of the stock and have                 been excluded from this computation.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 3. | Related Parties Transactions
|------- | ----------------------------

| | On March 2, 2005, we entered into a
Loan and Security Agreement and Promissory Note with MediVision (the Loan
Agreement) whereby we agreed to loan MediVision up to $2,000,000. Under the terms of
the agreement, interest is 7.25% per annum and is payable on February 28, 2006 along with
all outstanding principal due at that date. The note was secured by 2,409,000 shares of
our common stock owned by MediVision. The number of shares was based on the average
closing price of shares of our stock during the period covering the last ten (10) business
days of February, 2005, which average closing price was $1.11, discounted by 25%. In the
event that MediVision were to sell any shares of our stock it owns during the period of
the agreement, a minimum of 50% of the proceeds from such sales would be required to be
paid to us to reduce the outstanding amount owed. On July 28, 2005, we and MediVision
entered into an amendment to the Loan Agreement whereby MediVision repaid $1,000,000 to
us, decreasing the agreed upon loan of $2,000,000 to $1,000,000 and the amount of shares
securing the loan was decreased by 1,204,500 shares.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On July 20, 2005, our Board of
Directors, at MediVisions request, authorized us to guarantee and/or provide
security interests in our assets for certain of MediVisions loans with United
Mizrahi Bank Ltd. We entered into a Secured Debenture (the Debenture) in favor
of United Mizrahi Bank Ltd., in an amount of up to $2,000,000 (plus interest, commissions
and all expenses).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

6



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| | Under the terms of the Debenture, we
guarantee the payment of all of the debts and liabilities of MediVision to United Mizrahi
Bank. The Debenture is secured by a first lien on all of our assets. MediVision pledged
2,345,500 shares of our common stock it owns to us in order to secure the Debenture.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The amount owed to the financial
institutions by MediVision and secured by us as of September 30, 2006 was approximately
$1,750,000.
| | ------------------------------------------------------------------------------------------------------------------------------------

| | On July 28, 2005, pursuant to the
aforementioned Debenture signed by us, MediVision executed the amended Loan Agreement and
paid back $1,000,000 of the loan from us; reducing the amount MediVision owed us on the
promissory note to $955,558. On September 20, 2005, pursuant to a Common Stock Purchase
Agreement, dated as of September 16, 2005, between MediVision and Meadowbrook Opportunity
Fund LLC, MediVision sold 400,000 shares of our common stock to Meadowbrook Opportunity
Fund LLC at a price of $1.20 per share. MediVision used $240,000 of the proceeds from this
sale to repay part of the aforementioned loan to us, reducing the amount MediVision owes
us on the promissory note to $715,556, plus accrued interest under the loan. On December
8, 2005, MediVision sold 310,000 shares to the clients of an institutional investor at the
price per share of $1.45. MediVision used $225,000 of the proceeds from this sale to repay
part of the aforementioned loan to us, reducing the amount MediVision owes us on the
promissory note to $492,556, plus accrued interest under the loan. On February 14, 2006,
MediVision sold 1 million shares of our common stock to Wasatch Advisors, Inc. at the
market price of $1.80 per share. MediVision used $492,556 of the proceeds from this sale
to repay the remaining principal balance of the aforementioned loan to us.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As a result of the foregoing
transactions, as of September 30, 2006, MediVision owns approximately 59% of our
outstanding common stock.
| | ---------------------------------------------------------------------------------------------------------------------------------------

| | On June 28, 2006, we and MediVision
entered a License and Distribution Agreement whereby MediVision appointed us to be its
exclusive distributor of a new digital imaging system in the Americas and the Pacific Rim
(excluding China and India), for a term of ten years. In return, we paid $273,808,
consisting of a cash payment of $200,000, and recognition of $73, 808 of research and
development advances made in previous periods. Additionally, we are obligated to pay
advances totaling $460,000 based on the completion of certain phases of development of the
new digital imaging system and the completion of certain documents, and granted MediVision
a license to use our OIS WinStation software and any other applicable OIS system and the
accompanying intellectual property rights therein. On September 21, 2006, we paid $160,000
based on the completion of the first milestone in the agreement. The advanced funds will
be recovered as we purchase new digital imaging systems in accordance with the specified
quotas. The quota mandates that we purchase a minimum amount of the new digital imaging
systems each year. If we fail to satisfy our quota obligation, then we may pay MediVision
the gross profit on the shortfall units to maintain exclusivity in the agreed upon
territory. If no such shortfall payment is made, such failure to meet the quota will
constitute a material breach and MediVision may terminate the exclusivity provision or the
entire agreement. The quotas for 2007, 2008, 2009, and 2010 are 50, 70, 80, and 90 units,
respectively, and will be at least 95 units for each year thereafter. The initial term of
the agreement is for ten years, which will be automatically renewed in one year periods.
Either party may terminate the agreement with at least 6 months prior written notice,
provided that, we meet the purchase quota. Cash payments made under this agreement for
exclusive distribution rights have been capitalized and will be amortized over the term of
the agreement.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

7



---

| | At September 30, 2006 we had recorded
a net amount due from MediVision of approximately $94,000 for products.
| | -------------------------------------------------------------------------------------------------------------

| | Sales to MediVision during the three
and nine months ended September 30, 2006 totaled approximately $64,000 and $211,000. Sales
to MediVision during the three and nine months ended September 30, 2005 totaled
approximately $178,200 and $584,200, respectively.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During the three and nine-month
periods ended September 30, 2006, we paid approximately $285,000 and $761,000,
respectively, to MediVision for research and development performed by MediVision on our
behalf. During the three and nine-month periods ended September 30, 2005, we paid
approximately $134,000 and $504,000, respectively, to MediVision for research and
development performed by MediVision on our behalf.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | At September 30, 2006 we had recorded
a net amount due from CCS Pawlowski, a subsidiary of MediVision, of approximately $103,000
for products and services. Sales to CCS Pawlowski during the three and nine months ended
September 30, 2006 totaled approximately $63,000 and $275,000, respectively. Sales to CCS
Pawlowski during the three and nine months ended September 30, 2005 totaled approximately
$67,000 and $127,000, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

8



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|Note 4. | Stock Based Compensation
|------- | ------------------------

| | At September 30, 2006, we had six
stock-based compensation plans (the Plans). On January 1, 2006, the
Company adopted Statement of Financial Accounting Standards (SFAS)
No. 123R, Share-Based Payments, which addresses the accounting for
stock-based payment transactions whereby an entity receives employee services in exchange
for equity instruments, including stock options. SFAS No. 123R eliminates the ability
to account for stock-based compensation transactions using the intrinsic value method
under Accounting Principles Board Opinion (APB) No. 25, Accounting
for Stock Issued to Employees, and instead generally requires that such transactions
be accounted for using a fair-value based method. The Company has elected the modified
prospective transition method as permitted under SFAS No. 123R, and accordingly prior
periods have not been restated to reflect the impact of SFAS No. 123R. The modified
prospective transition method requires that stock-based compensation expense be recorded
for all new and unvested stock options that are ultimately expected to vest as the
requisite service is rendered beginning on January 1, 2006. Stock-based compensation
for awards granted prior to January 1, 2006 is based upon the grant-date fair value
of such compensation as determined under the pro forma provisions of SFAS No. 123,
Accounting for Stock-Based Compensation. The Company issues new shares of
common stock upon the exercise of stock options.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The Company uses a Black-Scholes
option valuation model to determine the fair value of stock-based compensation under SFAS
No. 123R, consistent with that used for pro forma disclosures under SFAS
No. 123. The Black-Scholes model incorporates various assumptions including the
expected term of awards, volatility of stock price, risk-free rates of return and dividend
yield. The expected term of an award is generally no less than the option vesting period
and is based on the Companys historical experience. Expected volatility is based
upon the historical volatility of the Companys stock price. The risk-free interest
rate is approximated using rates available on U.S. Treasury securities with a remaining
term equal to the options expected life. The Company uses a dividend yield of zero
in the Black-Scholes option valuation model as it does not anticipate paying cash
dividends in the foreseeable future.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Stock Options
| | -------------

| | In
calculating compensation related to stock option grants, the fair value of each stock
option is estimated on the date of grant using the Black  Scholes option pricing
model and the following weighted average assumptions:
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                        | Three Months EndedSeptember
30, 2006 | Nine Months Ended
September 30, 2006
|----------------------- | ------------------------------------ | ------------------------------------
|Dividend Yield          | None                                 | None                                
|                       
|Expected volatility     | 71.40 %                              | 71.40%                              
|                       
|Risk-free interest rate | 4.27                                 | 4.27                                
|                       
|Expected term (years)   | 10                                   | 10                                  

9

---

| | The Company recorded an incremental
$4,000 and $17,000 of stock-based compensation expense during the three and nine months
ended September 30, 2006, respectively, as a result of the adoption of SFAS No. 123R.
The following table presents the impact of the adoption of SFAS No. 123R on selected
statement of operations line items for the three and nine months ended September 30, 2006:
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                         | For the Three Months Ended | For the Nine Months Ended |                
|------------------------ | -------------------------- | ------------------------- | ---------------
|
|
|
|                         |                            |                           |                
|Net Income               | $          607             | $          611            | $             4
|                         |                            |                           |                
|Basic Income Per Share   | $         0.04             | $         0.04            | $         ---- 
|Diluted Income Per Share | $         0.03             | $         0.03            | $         ---- 

| | A
summary of the changes in stock options outstanding under our equity-based compensation
plans during the nine months ended September 30, 2006 is presented below:
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                  | Shares |           | Weighted
Average
Exercise Price |       | Weighted Average
Remaining
Contractual Term
(Years) |      | Aggregate
Intrinsic Value |          
|--------------------------------- | ------ | --------- | ------------------------------- | ----- | --------------------------------------------------- | ---- | ------------------------- | ---------
|                                 
|Outstanding at January 1, 2006    |        | 2,107,543 |                                 | $0.55 |                                                     | 7.45 |                           | 2,845,183
|                                 
|Granted                           |        | 190,000   |                                 | $1.84 |                                                     | 9.95 |                           | 11,400   
|                                 
|Exercised                         |        | 18,510    |                                 | $0.67 |                                                     | -    |                           | -        
|                                 
|Forfeited/Expired                 |        | 19,500    |                                 | $0.96 |                                                     | -    |                           | -        
|                                 
|Outstanding at September 30, 2006 |        | 2,259,533 |                                 | $0.65 |                                                     | 7.28 |                           | 3,208,537
|                                 
|Exercisable at September 30, 2006 |        | 1,734,991 |                                 | $0.51 |                                                     | 6.92 |                           | 2,706,586

10



---

| | The incremental stock-based compensation expense resulting from the adoption of SFAS No.123R
represents expense related to stock options granted prior to, but not yet vested as of,
January 1, 2006. As of September 30, 2006, the Company had $35,594 of total
unrecognized expense related to non-vested stock-based compensation, which is expected to
be recognized through 2009. The total fair value of options vested during the three 
and nine-month periods ended September 30, 2006 was $4,105 and $16,958, respectively. Cash
received from stock option exercises for the three- month and nine-month periods ended
September 30, 2006 was $6,129 and $12,445, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | There were 0 and 190,000 options
granted for the three and nine-month period ended September 30, 2006, respectively, all of
which were qualified options, granted to non-executive employees. The exercise price of
the 170,000 options granted is $1.83. The exercise price of the remaining 20,000 options
granted is $1.96. The total intrinsic value of options exercised during the three- and
nine-month periods ended September 30, 2006 was $11,170 and $14,943, respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Prior to the adoption of SFAS
No. 123R, the Company accounted for its stock-based awards to employees and directors
using the intrinsic value method of accounting in accordance with APB No. 25. Under the
intrinsic value method, compensation cost is generally the excess, if any, of the quoted
market price of the stock at the grant or other measurement date over the exercise
price.     The Company recorded no compensation expense under APB
No. 25 and FIN No. 44 for the three and nine months ended September 30, 2005.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Had compensation expense related to
the Companys stock option awards to employees and directors been determined under
the fair value method prescribed under SFAS No. 123, the Companys net income and
income per share would have been the pro forma amounts set forth in the table below:
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                   | For the Three Months Ended September 30, 2005 | For the Nine Months Ended September 30, 2005
|------------------------------------------------------------------ | --------------------------------------------- | --------------------------------------------
|Net income as reported                                             | $         516,380                             | $         1,256,491                         
|Stock-based employee compensation included in net loss as reported | ---                                           | ---                                         
|                                                                  
|Stock-based employee compensation expense                         
|determined under fair value method, net of tax                     | $           (7,449)                           | $             (17,509)                      
|Net income                                                         | $         508,931                             | $         1,238,982                         
|Basic Income Per Share                                             | $               0.03                          | $                  0.08                     

11



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|Note 5. | Warranty Obligations
|------- | --------------------

| | We generally offer a one-year
warranty to our customers. Our warranty requires us to repair or replace defective
products during the warranty period. At the time product revenue is recognized, we record
a liability for estimated costs that may be incurred under our warranties. The costs are
estimated based on historical experience and any specific warranty issues that have been
identified. The amount of warranty liability accrued reflects our best estimate of the
expected future cost of honoring our obligations under the warranty plans. We periodically
assess the adequacy of our recorded warranty liability and adjust the balance as
necessary.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following provides a reconciliation of changes in our warranty reserve.
| | ---------------------------------------------------------------------------

|                                        | Unaudited
Three Months Ended
September 30, | Unaudited
Nine Months Ended
September 30,
|--------------------------------------- | ------------------------------------------ | -----------------------------------------
|
|                                        |                                            |                                          
|                                       
|Warranty balance at beginning of period | $ 502,100                                  | $ 410,013                                
|Net provision for current period        | 7,725                                      | 173,650                                  
|Warranty costs incurred                 | (87,188)                                   | (57,813)                                 
|                                        |                                            |                                          
|Warranty balance at end of period       | $ 422,637                                  | $ 525,850                                
|                                        |                                            |                                          

12



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ITEM 2.          MANAGEMENT'S DISCUSSION
AND ANALYSIS OR PLAN OF OPERATION

We
make forward-looking statements in this report, in other materials we file with the
Securities and Exchange Commission (the SEC) or otherwise release to the
public, and on our website. In addition, our senior management might make forward-looking
statements orally to analysts, investors, the media, and others. Statements concerning our
future operations, prospects, strategies, financial condition, future economic performance
(including growth and earnings) and demand for our products and services, and other
statements of our plans, beliefs, or expectations, including the statements contained in
this Item 2, Managements Discussion and Analysis or Plan of Operation,
regarding our future plans, strategies, and expectations are forward-looking statements.
In some cases these statements are identifiable through the use of words such as
anticipate, believe, estimate, expect,
intend, plan, project, target,
can, could, may, should, will,
would, and similar expressions. We intend such forward-looking statements to
be covered by the safe harbor provisions contained in Section 27A of the Securities Act of
1933, as amended, and in Section 21E of the Securities Exchange Act of 1934, as amended
(the Exchange Act). You are cautioned not to place undue reliance on these
forward-looking statements because these forward-looking statements we make are not
guarantees of future performance and are subject to various assumptions, risks, and other
factors that could cause actual results to differ materially from those suggested by these
forward-looking statements. Thus, our ability to predict results or the actual effect of
our future plans or strategies is inherently uncertain. Factors which could have a
material adverse effect on our operations and future prospects include, but are not
limited to, changes in: economic conditions generally and the medical instruments market
specifically, legislative or regulatory changes that affect us, including changes in
healthcare regulation, the availability of working capital, and the introduction of
competing products. These risks and uncertainties, together with the other risks described
from time to time in reports and documents that we file with the SEC should be considered
in evaluating forward-looking statements and undue reliance should not be placed on such
statements. (There also are other factors that we do not describe because currently, we do
not perceive that such factors will cause actual results to differ materially from our
expectations.) Indeed, it is likely that some of our assumptions will prove to be
incorrect. Our actual results and financial position will vary from those projected or
implied in the forward-looking statements and the variances may be material. We expressly
disclaim any obligation to update or revise any forward-looking statements, whether as a
result of new information, future events, or otherwise, except as required by law.

Overview

To
date, we have designed, developed, manufactured, and marketed ophthalmic digital imaging
systems and informatics solutions and have derived substantially all of our revenues from
the sale of such products. The primary target market for our digital angiography systems
and related products has traditionally been retinal specialists. In 2003, we made a
strategic decision to expand our product offering to include the ophthalmic informatics
field. In 2004, we introduced our Ophthalmology Office line composed of Electronic Medical
Records (EMR) and Enterprise Practice Management (EPM) software
products by NextGen Healthcare Information Systems, Inc. and our Ophthalmic Picture
Archiving and Communication System (Ophthalmic PACS). This decision enabled us
to offer a wider variety of products and comprehensive solutions to our customer base of
ophthalmology departments and practices.

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At
September 30, 2006, we had stockholders equity of $6,970,664 and our current assets
exceeded our current liabilities by $6,239,088.

The
following discussion should be read in conjunction with the unaudited interim financial
statements and the notes thereto which are set forth in Item 1, Financial Statements
(unaudited). In the opinion of management, the unaudited interim period financial
statements include all adjustments, which are of a normal recurring nature, that are
necessary for a fair presentation of the results of the periods. There can be no assurance
that we will be able to achieve or sustain significant positive cash flows, revenues, or
profitability in the future.

Critical Accounting
Policies

Our
financial statements are prepared in accordance with United States generally accepted
accounting principles (GAAP). The financial information contained in the
financial statements is, to a significant extent, financial information based on
transactions and events that have already occurred. A variety of factors could affect the
ultimate value obtained when earning income, recognizing an expense, recovering an asset,
or relieving a liability. Our revenue recognition policies are in compliance with
applicable accounting rules and regulations, including Staff Accounting Bulletin No. 104
(SAB 104), Revenue Recognition in Financial Statements, American Institute of
Certified Public accountants (AICPA), Statement of Position (SOP)
97-2, Software Revenue Recognition, SOP 98-9, Modification of SOP 97-2, with Respect to
Certain Transactions and Emerging Issues Task Force Issue 00-21, Revenue
Arrangements with Multiple Deliverables. As such, revenue is recorded when there is
evidence of an arrangement, delivery has occurred, the price is fixed and determinable and
collectability is reasonably assured. Revenue from installation and training services are
recognized when such services are performed. Revenue generated from service contracts are
recognized ratably over the term of the contracts. Estimates are used relative to the
expected useful lives of depreciable assets.

We
calculate a tax provision quarterly and assess how much deferred tax asset is more likely
than not to be used in the future. According to IRS rule 382, our net operating losses
prior to August of 2000 are capped at $389,000 per year as of fiscal year 2000 for 20
years. We use the following analysis to assess whether we will more likely than not
realize the deferred tax asset. We assume that we will be able to use all of our unlimited
NOL amounts. We then assess the amount of our future capped net operating losses we will
more likely than not be able to use.

We
were not profitable for seventeen consecutive years between 1984 and 2000. We turned a
profit in 2001 and have been profitable for the last five years. There is significant
uncertainty projecting future profitability due to the history of our business, and the
volatility of the market that we are in. We calculate our tax provision quarterly and
assess how much deferred tax asset is more likely than not to be used in the future.

In
the fourth quarter of every fiscal year, we participate in the industrys largest
tradeshow of the year, which contributes approximately 25% of our revenue generated in the
last month of the fiscal year. This tradeshow substantially influences the outcome of our
profitability for that year, as well as gives us an indication of the years to come.
Significant expenses, resources, and risk are put into the tradeshow every year in hopes
of generating revenue. We can also see how the market responds to our new products, as
well as our competitors products. With this tradeshow behind us in the fourth
quarter of every fiscal year, we are in a better position to assess how we are doing, will
be doing in the years to come, and determine whether it is more likely than not that we
will be able to realize our deferred tax assets.

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We
have two types of warranty reserves. A general product reserve on a per product basis, and
specific reserves created as we become aware of issues. The product reserve is calculated
based on a fixed dollar amount per system shipped each quarter. The unanticipated reserves
usually arise from the introduction of new products at our largest tradeshow of the year
in October/November of every year. When a new product is introduced, we reserve for
specific problems arising from potential issues during the implementation phase. As time
passes, and the issues are resolved, we reduce the specific reserve. These types of issues
can cause our warranty reserve to fluctuate outside of sales fluctuations.

Management
is also required to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenues and expenses during the reporting period. Actual
results could differ from those estimates. In addition, GAAP itself may change from one
previously acceptable method to another method. Although the economics of our transactions
would be the same, the timing of the recognition of such events that would impact
transactions could change.

On
November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB
Staff Position No. FAS 123R-3, Transition Election Related to Accounting for Tax Effects
of Share-Based Payment Awards (FSP 123R-3). The alternative transition method
includes simplified methods to establish the beginning balance of the additional paid-in
capital pool (APIC pool) related to the tax effects of employee share-based
compensation, and to determine the subsequent impact on the APIC pool and consolidated
statements of cash flows of the tax effects of employee share-based compensation awards
that are outstanding upon adoption of Statement of Financial Accounting Standards No. 123
(revised 2004), Share Based Payment, (SFAS 123R). We are currently evaluating
the available transition alternatives of FSP 123R-3.  We do not believe the adoption
of FSP 123R-3 will have a material impact on our financial position, results of operations
or cash flows.

On
September 13, 2006, the SEC published Staff Accounting Bulleting No. 108 Considering the
Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements.  The interpretations in this Staff Accounting Bulleting are
being issued to address diversity in practice in quantifying financial statement
misstatements and the potential under current practice to build up improper amounts on the
balance sheet.  This guidance will apply to the first fiscal year ending after
November 15, 2006 and early application in interim periods is encouraged.  We do not
believe the adoption of SAB 108 will have a material impact on our financial position,
results of operations or cash flows.

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Results of Operations

Revenues

On
December 31, 2005, due to a continued increase in installation activity, we elected to
classify installation income within our revenues, versus a net effect within sales and
marketing expenses. We reclassified the respective 2005 amounts of $143,344 and $472,515
for the three and nine-month periods ending September 30, 2005 for comparative purposes.

Our
revenues for the third quarter ended September 30, 2006 were $3,927,257, ($3,643,135
excluding installation revenue), representing a 16% increase from revenues of $3,389,560
($3,246,216 excluding installation revenue) for the third quarter ended September 30,
2005. The increase in revenues of $537,697 is due to higher revenues generated from
product sales of $426,400 and service sales for these products of $111,297.

Revenues
for the first nine months of fiscal 2006 were $11,395,147 ($10,699,964 excluding
installation revenue), representing a 20% increase from revenues of $9,508,335 ($9,035,820
excluding installation revenue), for the comparable nine months of fiscal 2005. The
increase in revenues of $1,886,811 is due to higher revenues generated from product sales
of $1,566,541 and service sales for these products of $320,270. Products accounted
for approximately 85% and 86% of our revenue
for the third quarters of 2006 and 2005, respectively, and 85% and 86% of our revenue for
the nine months ended September 30, 2006 and 2005, respectively.

Service
revenues for these products accounted for approximately 15% and 14% of our revenue for the
third quarters of 2006 and 2005, respectively, and approximately 15% and 14% of our
revenue for the nine months ended September 30, 2006 and 2005, respectively. The increase
in service revenue is mainly derived from increases in our extended service contract
revenue. The volume of extended service contracts sold continues to increase relative to
total sales as we continue to educate our customers about the benefits of the contracts.
This education process has been ongoing for the last five years and the service revenue
increases as more customers buy extended service contracts. The other components of
service revenue have stayed relatively constant. Total service revenue during the third
quarter and nine months ended September 30, 2006 was comprised mostly of service contract
revenue and the rest consists of non warranty repairs and parts, and technical support
phone billings for customers not under warranty.

Revenues
from sales of our products to related parties were approximately $127,000 and $486,000
during the three and nine month periods ended September 30, 2006 and $245,000 and $711,000
for the comparable three and nine month periods ending September 30, 2005, respectively.

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In
the fourth quarter of the fiscal year, we participate in the industrys largest trade
show of the year. Based on our prior experience, substantial income is generated from the
trade show, which comprises approximately 25% of our annual revenue recognized in December
of each year. The trade show substantially determines our profitability for the current
year and provides an indication of the years to come. Significant expenses, resources, and
risk are put into the tradeshow every year in hopes of generating revenue.

Gross Margins

Gross
margins were approximately 57% (60% before installation change) during the three month
period ended September 30, 2006 as compared to 59% (61% before installation change) for
the three month period ended September 30, 2005. Gross margins were approximately 56% (58%
before installation change) during the nine-month period ended September 30, 2006 as
compared to 58% (60% before installation change) for the nine month period ended September
30, 2005. The changed presentation in connection with presenting installation income
within our revenues, versus a net effect within sales and marketing expenses, resulted in
a 3% and 2% decrease in gross margins for the three and nine month period ended September
30, 2006, respectively, and a 2% decrease in gross margins for the three and nine month
periods ended September 30, 2005. We anticipate that our gross margins will decrease, as
our sales of the Ophthalmology Office software products become more significant, because
gross margins associated with the sales of these products are lower than the majority of
the products that we currently sell.

Sales and Marketing
Expenses

The
changed presentation of installation income within our revenues, versus a net effect
within sales and marketing expenses, resulted in a change in sales and marketing expenses.
We reclassified the respective 2005 amounts for comparative purposes.

Sales
and marketing expenses accounted for approximately 21% of total revenues during the third
quarter of fiscal 2006 as compared to approximately 23% during the third quarter of fiscal
2005. Actual expenses increased to $825,023 ($805,034 before the installation change)
during the third quarter of 2006 versus $779,482 ($781,521 before the installation change)
during the third quarter of 2005. For the first nine months of fiscal 2006 and 2005 such
expenses accounted for approximately 22% and 24% of total revenues for the respective
nine-month periods. Actual expenses increased to $2,476,196 ($2,456,207 before the
installation change) during the first nine months of fiscal 2006 versus $2,258,363
($2,195,917 before the installation change) during the first nine months of fiscal 2005.
The primary contributing factor to the increased expenses were new hires to the sales
force.

General and
Administrative Expenses

General
and administrative expenses were $425,448 in the third quarter of fiscal 2006 and $360,291
in the third quarter of fiscal 2005. Such expenses accounted for approximately 11% of
revenues during the third quarters of 2006 and 2005. Expenses increased to $1,194,348 from
$998,922 during the nine month periods ended September 30, 2006 and 2005, respectively.
For the first nine months ended September 30, 2006 and 2005, such expenses accounted for
approximately 11% of total revenues. The % increase in general and administrative expenses
of 19.6%, was consistent with the increase in sales of 19.8%.

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Research and Development
Expenses

Research
and development expenses were $413,302 in the third quarter of fiscal 2006 and $327,501 in
the third quarter of fiscal 2005. Such expenses accounted for approximately 11% and 10% of
revenues during the third quarter of 2006 and 2005, respectively. For the first nine
months of fiscal 2006, such expenses were $1,175,550 and accounted for approximately 10%
of total revenues, as compared to expenses of $835,313 that accounted for approximately 9%
during the first nine months of 2005. We have been and will continue to focus our research
and development efforts on new digital image capture products. Outside consultants and
MediVision currently conduct most of our research and development.

Interest and Other
Expense, net

Interest
and other expenses were ($39,328) during the third quarter of fiscal 2006 versus ($6,378)
during the third quarter of fiscal 2005. These amounts were comprised principally of interest income
of $68,248, and financing facilitations provided to certain of our customers in connection with
sales of our products of $18,817.  For the nine months ended September 30, 2006 and
2005, interest and other expenses were ($29,163) and $97,240, respectively. These amounts
were comprised principally of interest income of $174,763 and financing facilitations provided to certain of
our customers in connection with sales of our products of $95,775. Pursuant
to paragraph 16 of SFAS 140, we participate in tri-party arrangements with our
customers and an intermediary lender. Specifically, the lender accepts an IOU from the
customer and then presents a separate IOU to us. The agreement with the lender allows the
customer to pay over time interest-free. With the IOU, we may require that the lender make
accelerated payment(s) at an appropriately discounted amount. In substance these
transactions allow the customer to obtain financing from an lender to pay amounts due to
us. The customers original liability to us is extinguished when the lenderremits cash or a lender IOU to us. We incur these financing costs to expedite payment
and lessen the necessary collection efforts.

Income Taxes

Income
tax benefit (expense) was $13,632 during the third quarter of fiscal 2006 versus ($17,200)
during the third quarter of fiscal 2005. For the nine months ended September 30, 2006 and
2005, income tax benefit (expense) was $13,632 and ($26,224), respectively.

We
calculate a tax provision quarterly and assess how much deferred tax asset is more likely
than not to be used in the future. We use the following analysis to assess whether we will
more likely than not realize the deferred tax asset. We assume that we will be able to use
all of our unlimited NOL amounts. We then assess the amount of our future capped net
operating losses we will more likely than not be able to use.

Net Income

We
recorded net income of $606,833, or $0.04 and $0.03 per share basic and diluted earnings,
respectively, for the third quarter ended September 30, 2006 as compared to net income of
$516,380 or $0.03 per share basic and diluted earnings for the third quarter ended
September 30, 2005. For the nine months ended September 30, 2006 and 2005, we recorded net
income of $1,627,003 or $0.10 and $0.09 per share basic earnings and diluted earnings,
respectively, as compared to $1,256,491, or $0.08 per share basic and diluted earnings,
respectively.

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Balance Sheet

Our
assets increased by $2,321,955 as of September 30, 2006 as compared to the September 30,
2005. There was a substantial increase in cash and equivalents of $2,706,132, generated
primarily from our profitable operations from the previous 12 months of $2,125,765 and
receipt of $717,556 in repayments from MediVision. Our inventory increased primarily in
finished goods as several orders were substantially completed, but did not meet all of the
applicable criteria for sales recognition. We did not recognize $382,663 in revenue
because these sales failed to meet our revenue recognition policies. Certain of these
revenues did not meet the acceptance rights specified in the contract and for others we
were uncertain about the collectability of the sale, even though the inventory was
physically shipped. The amount of inventory related to this revenue was $73,710.

We
have entered a long term distribution and license agreement for a new digital imaging
system, which required a cash payment of $200,000 and an amount previously paid for
research and development of $73,808 being applied and shown as a licensing agreement. We
have exclusive distributing rights to a new digital imaging system in the Americas and the
Pacific Rim (not including China and India) and the indicated capitalized fee will be
amortized over the term of the agreement. We also prepaid $160,000 for products related to
this new digital imaging system. Our liabilities decreased by $720,455 mainly due to the
repayment and conversion of our notes to Laurus Master Fund. Our stockholders equity
increased by $3,042,410 primarily due to net income from the previous 12 months of
$2,125,765, and the conversion of a portion of our notes payable to Laurus Master Fund
into common stock of $882,661.

During the quarter ended September 30, 2006, our
assets  increased  by $644,010  as compared to the quarter ended June 30,  2006.
This increase is primarily  due to an increase  in our prepaid  expenses  of
 $193,375  related to our largest  tradeshow  of the year taking place in November
 2006, an increase in our fixed assets of $123,043,  an increase in our accounts
receivable of $198,697,  and a prepayment of products of $160,000  related to our new
digital  imaging  system.  During the quarter ended September 30, 2006,
our liabilities increased  by
 $147,393, as compared to the quarter ended June 30, 2006,
primarily  due to an  increase  in  accounts  payable  due to timing
differences between when we cut our checks and when we sent them out.

Liquidity and Capital
Resources

Our
operating activities generated cash of $1,639,229 during the nine months ended September
30, 2006 as compared to cash generated of $1,137,491 in the nine months ended September
30, 2005. The cash generated from operations during the first nine months of 2006 was
principally from net income for the period of $1,627,002. There were no significant
changes in working capital for the period. The cash generated from operations during the
first nine months of 2005 was principally from net income of $1,256,491 for the period and
an increase in customer deposits of $616,104, increase in trade payables of $164,494,
partially offset by increased receivables of $978,011.

Cash
used in investing activities was $189,533 during the first nine months of 2006 as compared
to $24,745 during the first nine months of 2005. Our investing activities consisted of
purchases of software, equipment, telephone and security system, and furniture. We
anticipate continued capital expenditures in connection with our ongoing efforts
to upgrade our existing management information and corporate communication systems. We
anticipate that related expenditures, if any, will be financed from our cash flow from
operations or other financing arrangements available to us, if any.

We
generated cash in financing activities of $496,986 during the first nine months of fiscal
2006 as compared to cash generated of $78,200 during the first nine months of fiscal 2005.
The cash generated in financing activities during the first nine months of 2006 was
principally from proceeds on the note receivable from MediVision of $486,803, draw on our
line of credit of $150,000, offset by repayments of the debt to Laurus of $144,579. The
cash generated in financing activities during the first nine months of 2005 was primarily
due to a payment from MediVision of an intercompany receivable of $285,406, offset by
monthly payments of the debt instrument to Laurus of $247,005.

19

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On
September 30, 2006 our cash and cash equivalents were $5,887,388. Management anticipates
that additional sources of capital beyond those currently available to us may be required
to continue funding for research and development of new products and selling and marketing
related expenses for existing products.

We
will continue to evaluate alternative sources of capital to meet our growth requirements,
including other asset or debt financing, issuing equity securities and entering into other
financing arrangements. There can be no assurance, however, that any of the contemplated
financing arrangements described herein will be available and, if available, can be
obtained on terms favorable to us.

On
October 18, 2006, the investment agreement we entered into with Dutchess Private Equities
Fund II, LP (Dutchess) on December 28, 2004, providing for an equity line of
credit was terminated. Pursuant to the original investment agreement, Dutchess agreed to
provide us with up to $9,000,000 of funding. We had not requested any drawdowns under the
investment agreement on or before the time of termination.

Material Agreement

On
June 28, 2006, we and MediVision entered into a License and Distribution Agreement whereby
MediVision appointed us to be its exclusive distributor of a new digital imaging system in
the Americas and the Pacific Rim (excluding China and India), for a term of ten years. In
return, we paid $273,808, consisting of a cash payment of $200,000, and recognition of
$73,808 of research and development advances made in previous periods. Additionally, we
are obligated to pay an advance totaling $460,000 based on the completion of certain
phases of development of the new digital imaging system and the completion of certain
documents. On September 21, 2006, we paid $160,000 based on the completion of the first
milestone in the agreement. We also granted MediVision a license to use our OIS WinStation
software and any other applicable OIS system and the accompanying intellectual property
rights therein and a license to use our patents to develop the new digital imaging system
and fulfill its obligations under this Agreement. Our foregoing appointment as an
exclusive distributor is conditional upon the payment of the advance and MediVisions
successful completion of the engineering, mass manufacture, and supply of the new digital
imaging system, which has specifically dedicated features for the retinal market, in
accordance with the technical specifications contained in the agreement.

The
advanced funds will be recovered as we purchase new digital imaging systems in accordance
with specified quotas. The quotas mandate that we purchase a minimum amount of the new
digital imaging system each year. The quotas for 2007, 2008, 2009, and 2010 are 50, 70,
80, and 90 units, respectively, and will be at least 95 units for each year thereafter. If
we fail to satisfy our quota obligation, then we may pay MediVision the gross profit on
the shortfall units to maintain exclusivity in the agreed upon territory. If no such
shortfall payment is made, such failure to meet the quota will constitute a material
breach and MediVision may terminate the exclusivity provision or the entire distribution
agreement.

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Under
this Agreement, we may not deal in the new digital imaging system outside the agreed upon
territory. Moreover, excluding our current products or products derived from our current
products, we may not deal in products that compete directly with the new digital imaging
system or represent or provide services to a company which has a product or products that
compete with the new digital imaging system. We also agreed to, among other things, as
confined to the agreed upon territory, (1) use commercially reasonable efforts in
promoting, marketing and selling the new digital imaging system, (2) service customers who
purchased the new digital imaging system in the agreed upon territory, (3) diligently
advertise the new digital imaging system in the agreed upon territory in relevant journals
and by direct mail, (4) cooperate with MediVision in dealing with customer complaints
concerning the new digital imaging system, and (5) provide MediVision with a 12 month
forecast of our intended purchases during such year, including, at least 30 days prior to
the beginning of each quota year, providing MediVision with an annual purchase order that
includes a breakdown of our purchases by quarter; at least 70% of the applicable annual
quota must be ordered in this annual purchase order.

Under
this Agreement, excluding intellectual property rights, neither party is entitled to
damages as a result of loss of use, sales or profits, or any special, indirect,
incidental, or consequential loss or damage. Moreover, MediVision will not be liable to
OIS in connection with any patent infringement claim in certain instances whereby (1) the
new digital imaging system is combined with another device not manufactured by MediVision,
(2) the new digital imaging system is used in a way other than for which it was designed,
and (3) the new digital imaging system is modified by OIS or a third party.

The
initial term of this agreement is for ten years, which will be automatically renewed in
one year periods. Cash payments made under this agreement for exclusive distribution
rights have been capitalized, and will be amortized over the term of the agreement. Either
party may terminate the agreement with at least 6 months prior written notice of the
intent to terminate, provided that, we meet the purchase quota.

# ITEM 3.          CONTROLS AND
PROCEDURES

As
of the end of the period covered by this Report, our management, with the participation of
our Chief Executive Officer (principal executive officer) and our Chief Financial Officer
(principal financial officer), evaluated the effectiveness of our disclosure
controls and procedures, as defined in Rule 13a-15(e) under the Exchange Act. Based
on that evaluation, these officers concluded that, as of September 30, 2006, our
disclosure controls and procedures were effective.

During
the quarter ended September 30, 2006, there were no changes in our internal control over
financial reporting that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.

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|PART II | OTHER INFORMATION
|------- | -----------------

|ITEM 6. | EXHIBITS AND REPORTS
|------- | --------------------

|          |                                                                       
|--------- | ----------------------------------------------------------------------
|
|31.1     | Certification Required Under Section 302 of Sarbanes-Oxley Act of 2002
|31.2     | Certification Required Under Section 302 of Sarbanes-Oxley Act of 2002
|32       | Certification Required Under Section 906 of Sarbanes-Oxley Act of 2002

|* |  | Filed
herewith.
|- |  | ---------------

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SIGNATURES

In
accordance with the requirements of the Exchange Act, the registrant caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized.

|                         |                           
|------------------------ | --------------------------
|
|                         | OPHTHALMIC IMAGING SYSTEMS
|Date:  November 13, 2006 |                           

| |        |                        
| | ------ | -----------------------
|
| | By:    | /s/ Gil Allon          
| |        |                        
| | Name:  | Gil Allon,             
| | Title: | Chief Executive Officer
| | By:    | /s/ Ariel Shenhar      
| |        |                        
| | Name:  | Ariel Shenhar,         
| | Title: | Chief Financial Officer

23