The following discussion of the financial condition and results of operations of Imaging Diagnostic Systems, Inc. should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations; the Condensed Financial Statements; the Notes to the Financial Statements; the Risk Factors included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006,2007, which are incorporated herein by reference; and all our other filings, including Current Reports on Form 8-K, filed with the SEC through the date of this report.  This quarterly report on Form 10-Q contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “projects”, “potential,” or “continue,” or the negative or other comparable terminology regarding beliefs, plans, expectations, or intentions regarding the future.  These forward-looking statements involve substantial risks and uncertainties, and actual results could differ materially from those discussed and anticipated in such statements.  Factors that could cause actual results to materially differ include, without limitation, the timely and successful completion of our U.S. Food and Drug Administration (“FDA”) pre-market approval (“PMA”) clinical trials; the timely and successful submission of our PMA application to the FDA; manufacturing risks relating to the CTLM®, including our reliance on a single or limited source or sources of supply for some key components of our products as well as the need to comply with especially high standards for those components and in the manufacture of optical imaging products in general; uncertainties inherent in the development of new products and the enhancement of our existing CTLM® product, including technical and regulatory risks, cost overruns and delays; our ability to accurately predict the demand for our CTLM® product as well as future products and to develop strategies to address our markets successfully; the early stage of market development for medical optical imaging products and our ability to gain market acceptance of our CTLM® product by the medical community; our ability to expand our international distributor network for both the near and longer-term to effectively implement our globalization strategy; our dependence on senior management and key personnel and our ability to attract and retain additional qualified personnel; risks relating to financing utilizing our Private Equity Credit Agreement or other working capital financing arrangements; technical innovations that could render the CTLM® or other products marketed or under development by us obsolete; competition; risks and uncertainties relating to intellectual property, including claims of infringement and patent litigation; risks relating to future acquisitions and strategic investments and alliances; and reimbursement policies for the use of our CTLM® product and any products we may introduce in the future. These risks and uncertainties include, but are not limited to, those described above or elsewhere in this quarterly report.  All forward-looking statements and risk factors included in this document or incorporated by reference from our Annual Report on Form 10-K for the fiscal year ended June 30, 2006,2007, are made as of the date of this report based on information available to us as of the date of this report, and we assume no obligation to update any forward-looking statements or risk factors.  You are cautioned not to place undue reliance on these forward-looking statements.

Imaging Diagnostic Systems, Inc. (“IDSI”) is a development stage medical technology company.  Since its inception in December 1993, we have been engaged in the development and testing of a computed tomography laser breast imaging systemComputed Tomography Laser Breast Imaging System for detecting breast cancer (CT Laser Mammography or, "CTLM®").  We are currently in the process of commercializing the CTLM® in certain international markets.markets where approvals to market have been secured although CTLM® is not yet approved for sale in the U.S.  CTLM® is a Class III medical device and we are continuing efforts to secure the Food and Drug Administration’s PreMarket Approval based upon clinical studies.  CTLM® has been declared a Non-Significant risk (NSR) device when used for our intended use.

Although theThe CTLM® system is a CT-like scanner, but its energy source for imaging is a laser beam and not ionizing radiationx-radiation such as is foundused in conventional x-ray mammography or CT scanners.  The advantageadvantages of imaging without ionizing radiation may be significant in our markets.  X-ray mammography is a well-established method of imaging the structures within the breast. Ultrasound is often used as an adjunct to mammography to help differentiate tumors and cysts. The CTLM® is being marketed as an adjunct to mammography and will not compete directly with X-ray mammography. CTLM® is, however, an emerging new imaging modality offering the potential of molecular functional imaging, which can visualize the process of angiogenesis which may be used to distinguish between benign and malignant tissue.  X-ray mammography is a well-established method of imaging the breast but has

limitations especially in dense breast cases.  Ultrasound is often used as an adjunct to mammography to help differentiate tumors from cysts or to localize a biopsy site.  The CTLM® is being marketed as an adjunct to mammography not a replacement for it, to provide the radiologist with additional information to manage the clinical case. We believe that the adjunctive use of CT laserLaser Mammography may help diagnose breast imaging will improve early diagnosis,cancer earlier, reduce diagnostic uncertainty especially in mammographically dense breast cases, and may help decrease the number of biopsies performed on benign lesions.  The CTLM® technology is unique and patented.  IDSI intendsWe intend to develop its technologiesour technology into a family of related products.  We believe these technologies and clinical benefits constitute substantial markets for our products well into the future.

 

 

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including those related to customer programs and incentives, inventories, and intangible assets.  We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are defined as those involving significant judgments and uncertainties which could potentially result in materially different results under different assumptions and conditions.  Application of these policies is particularly important to the portrayal of the financial condition and results of operations.  We believe the accounting policy described below meets these characteristics.  All significant accounting policies are more fully described in the notes to the financial statements included in our annual report on Form 10-K for the fiscal year ended June 30, 2006.2007.

Our inventories consist of raw materials, work-in-process and finished goods, and are stated at the lower of cost (first-in, first-out) or market.  As a designer and manufacturer of high technology medical imaging equipment, we may be exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage.  These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices and reliability, replacement and availability of key components from our suppliers.  We evaluate on a quarterly basis, using the guidance of ARB 43, Chapter 4, Statement 5, our ability to realize the value of our inventory based on a combination of factors including the following: how long a system has been used for demonstration or clinical collaboration purposes; the utility of the goods as compared to their cost; physical obsolescence; historical usage rates; forecasted sales or usage; product end of life dates; estimated current and future market values; and new product introductions.  Assumptions used in determining our estimates of future product demand may prove to be incorrect, in which case excess and obsolete inventory would have to be adjusted in the future.  If we determined that inventory was overvalued, we would be required to make an inventory valuation adjustment at the time of such determination.  Although every effort is made to ensure the accuracy of our forecasts

of future product demand, significant unanticipated changes in demand could have a significant negative impact on the value of our inventory and our reported operating results. Additionally, purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure.

The computation of the expense associated with stock-based compensation requires the use of a valuation model.  SFAS 123(R) is a relatively new and very complex accounting standard, the application of which requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility, expected option lives, and expected option forfeiture rates, to value equity-based compensation.  We currently use a Black-Scholes option pricing model to calculate the fair value of our stock options.  We primarily use historical data to determine the assumptions to be used in the Black-Scholes model and have no reason to believe that future data is likely to differ materially from historical data.  However, changes in the assumptions to reflect future stock price volatility and future stock award exercise experience could result in a change in the assumptions used to value awards in the future and may result in a material change to the fair value calculation of stock-based awards.  SFAS 123(R) requires the recognition of the fair value of stock compensation in net income.  Although every effort is made to ensure the accuracy of our estimates and assumptions, significant unanticipated changes in those estimates, interpretations and assumptions may result in recording stock option expense that may materially impact our financial statements for each respective reporting period.

We are continuing to develop our international markets through our global commercialization program.  In the quarter ended March 31,September 30, 2007, we recorded revenues andof $27,543 representing an increase of $7,681 or 39% from $19,862 during the quarter ended September 30, 2006.  The Cost of Sales of $25,236 and $6,526 respectively,during the quarter ended September 30, 2007, were $13,716 representing an increase in revenues of $25,236 and an increase in Cost of Sales of $6,526$8,532 or 165% from $5,184 during the corresponding period inquarter ended September 30, 2006.  No new CTLM® systemsSystems were sold in the quarter ended March 31, 2007 and 2006.September 30, 2007.  See Item 5.  Other Information -– “Other Recent Events”

General and administrative expenses during the three months and nine months ended March 31,September 30, 2007, were $722,823 and $2,309,329, respectively,$713,271, representing decreasesan increase of $202,521$9,852 or 22%1%, and $594,441 or 20% from $703,419 in the corresponding periodsperiod in fiscal 2006.  Of the $722,823 and $2,309,329,$713,271, compensation and related benefits comprised $547,799 (76%) and $1,566,100 (68%$464,545 (65%), compared to $694,085 (75%) and $1,981,957 (68%$489,372 (70%) during the three and nine months ended March 31,September 30, 2006.  Of the $547,799$464,545 and $1,566,100$489,372 compensation and related benefits, for fiscal 2007, $95,436$48,403 (10%) and $263,536,$83,612 (17%), respectively, were due to non-cash compensation associated withrelated to expensing stock options. Of the $694,085 and $1,981,957 compensation and related benefits for fiscal 2006, $242,985 and $674,106, respectively, were due to non-cash compensation associated with expensing stock options.

The three-month decreaseincrease of $202,521$9,852 is primarily due to decreases of $146,286 in compensation and related benefits primarily due to reduced stock option expense and $28,400a net result.  The relevant increases were $17,200 in consulting expenses as a result of less reliance on outside consultants and no placement fees paid for new hires.

We do not expect a material increase in our general and administrative expenses until we realize a significant increase in revenue from the sale of our product.

Research and development expenses during the three months and nine months ended March 31,September 30, 2007, were $541,216 and $1,595,740, respectively,$468,328, representing a decrease of $5,486$85,445 or 1%15%, and an increase of $93,335 or 6% from $553,773 in the corresponding periodsperiod in fiscal 2006.  Of the $541,216 and $1,595,740,$468,328, compensation and related benefits comprised $380,848 (70%) and $1,124,050 (70%$299,955 (64%), compared to $384,410 (70%) and $1,125,521 (75%$379,286 (68%) during the three and nine months ended March 31,September 30, 2006.  Of the $380,847$299,955 and $1,124,050$379,286 compensation and related benefits, for fiscal 2007, $9,943$2,413 (1%) and $30,729,$10,393 (3%), respectively, were due to non-cash compensation associated with expensing stock options. Of the $384,410 and $1,125,521 compensation and related benefits for fiscal 2006, $45,300 and $131,681, respectively, were due to non-cash compensation associated with expensing stock options.

The three-month decrease of $5,486$85,445 is a net result.  The relevant decreases were $37,100 in Legal - FDA Counsel, $3,562$79,331 in compensation and related benefits primarily due toas a result of a reduction in staff; $38,179 in legal patent expenses as a result of a reduced stock option expense,number of new patent filings; and $10,431 in consulting expenses because of decreased use of consultants in the field of scientific and clinical disciplines.  The decreases were partially offset by an increase of $45,309 in clinical expenses associated with our PMA clinical trials.

We expect a significant increase in research and development expenses in the fourth quarter of fiscal 20072008 due to the cost of conducting our PMA clinical trials in the United States.  We also expect consulting expenses and professional fees to increase due to the costs associated with our PMA activities.  See Item 5. Other Information - “Recent Developments, Regulatory Matters”.

Sales and marketing expenses during the three months and nine months ended March 31,September 30, 2007, were $304,148 and $1,065,155, respectively,$251,681, representing a decrease of $11,930$51,256 or 4%, and an increase of $110,373 or 12%17% from $302,937in the corresponding periodsperiod in fiscal 2006.  Of the $304,148 and $1,065,155,$251,681, compensation and related benefits comprised $105,167 (35%) and $312,197 (29%$46,844 (19%), compared to $107,085 (34%) and $327,484$103,572 (34%) during the three and nine months ended March 31,September 30, 2006.  Of the $105,167$46,844 and $312,197$103,572 compensation and related benefits, for fiscal 2007,$776 (2%) and $6,487 and $19,460,(6%), respectively, were due to non-cash compensation associated withrelated to expensing stock options. Of the $107,085 and $327,484 compensation and related benefits for fiscal 2006, $8,122 and $24,240, respectively, were due to non-cash compensation associated with expensing stock options.

The three-month decrease of $11,930$51,256 is a net result.  The relevant decrease was $60,203 in regulatory expenses as a result of the Chinese SFDA Registration Fee recorded in the prior fiscal year. The decrease was partially offset by an increase of $48,298 in representative office expense as a result of opening our representative office in Beijing, China (See - “CEO’s Letter to Shareholders”).

We expect commissions, trade show expenses, advertising and promotion and travel and subsistence costs to increase as we continue to implement our global commercialization program.

In comparing our total operating expenses (general and administrative, research and development, sales and marketing, inventory valuation adjustments and depreciation and amortization) in the three and nine months ended March 31,September 30, 2007 with the levels for the corresponding periods in fiscaland 2006, which were $1,495,387 and $1,634,993, we had decreasesa decrease of $244,492$139,606 or 13% and $443,987 or 8%, respectively.9%.

The decrease of $244,492$139,606 in the three-month comparative period was primarily due primarily to general and administrative expenses decreasing by $202,521, $5,486decreases in research and development expenses of $85,445 and $11,930 in sales and marketing expenses.

We expect a significant increase in research and development expenses inthroughout the fourth quarterbalance of fiscal 20072008 due to the cost of conducting PMA clinical trials in the United States.  We also expect consulting expenses and professional fees to increase due to the costs associated with our PMA activities.

Inventory Valuation Adjustments during the three months and nine months ended March 31,September 30, 2007, were $18,935 and $68,506, respectively,$14,774, representing decreasesa decrease of $22,780$16,427, or 55% and $51,891 or 43%53%, from the corresponding periodsperiod in fiscal 2006.  The decrease is a result ofdue to the reduction in write-downs of obsolete components that are no longer used in the manufacture of the CTLM®.

Total non-cash compensation for stock options recordedCompensation and related benefits during the three months and nine monthsquarter ended March 31,September 30, 2007, were $111,865 and $313,725, respectively,$811,344, representing decreasesa decrease of $184,543$160,886 or 62% and $516,302 or 62%,17% from the corresponding periods in fiscal 2006. The primary reason for the decrease was a result of a change in assumptions regarding unvested options as of the date of adoption of SFAS 123(R) and recorded$972,230 during the nine months ending March 31, 2006. The excess amount that was expensed for the prior fiscal quarters was adjusted during the fourth quarter ended JuneSeptember 30, 2006.  Of the $111,865 expensed for$811,344 and $972,230 compensation and related benefits, $51,592 (6%) and $100,492 (10%), respectively, were due to non-cash compensation associated with expensing stock options.  The net decrease of $160,886 was due to a $48,900 decrease in the third quarter, $21,159 was attributedrecording of non-cash compensation related to options granted since July 1, 2006 and $90,706 was attributed to options which remained unvested as of July 1, 2006. Additional disclosures regarding the expensing of stock options are more fully set forth in Note 5 - Recent Accounting Pronouncements and Note 6 - Stock-Based Compensation.

Interest expense during the three months and nine months ended March 31,September 30, 2007, was $126,635 and $279,142, respectively,$19,447, representing decreasesa decrease of $73,689$19,811, or 37% and $118,126 or 30%50%, from the corresponding periodsperiod in fiscal 2006.  The interest expense is primarily a resultcomprised of the imputed interest associated with our equity credit line with Charlton Avenue, LLC (“Charlton”) as per the terms and conditions of our private equity credit agreement.  Our utilization of the credit line fluctuates during the year and therefore causes increases and decreases in interest expense from quarter to quarter.  See Item 5.  Other Information -– “Financing/Equity Line of Credit”.

Our combined cash and cash equivalents totaled $598,923$1,304,040 as of March 31,September 30, 2007.  This is a decreasean increase of $868,764$826,228 from $1,467,687$477,812 as of June 30, 2006.2007.  During the quarter ending March 31,September 30, 2007, we received a net of $1,430,000$225,000 from the sale of common stock through our private equity agreement with Charlton.  See -– “Financing/Equity Line of Credit.”Credit”

We do not expect to generate a positive internal cash flow for at least the next 12 months due to an anticipated increase in marketing and manufacturing expenses associated with the international commercialization of the CTLM®, expenses associated with our FDA PMA process, the costs associated with product development activities and the time required for homologations from certain countries.

Property and Equipment was valued at $1,945,669$1,993,400 net as of March 31,September 30, 2007.  The overall decrease of $89,514$37,395 from June 30, 20062007 is due primarily to depreciation recorded for the first second and third quarters.quarter.

We are currently a development stage company, and our continued existence is dependent upon our ability to resolve our liquidity problems, principally by obtaining additional debt and/or equity financing.  We have yet to generate a positive internal cash flow, and until significant sales of our product occur, we are mostly dependent upon debt and equity funding from outside investors.  In the event that we are unable to obtain debt or equity financing or are unable to obtain such financing on terms and conditions acceptable to us, we may have to cease or severely curtail our operations.  This would materially impact our ability to continue as a going concern.

Since inception we have financed our operating and research and product development activities through several Regulation S and Regulation D private placement transactions and with loans from unaffiliated third parties.  Net cash used for operating and product development expenses during the ninethree months ending March 31,September 30, 2007, was $4,032,264$1,347,378 primarily due to the costs of wages and related benefits, legal and consulting expenses, research and development expenses, clinical expenses, and travel expenses associated with clinical and sales and marketing activities.  On June 27, 2007, we borrowed the sum of $250,000 from Charlton Avenue LLC, and we repaid the loan plus a $20,000 premium on August 2, 2007.  At March 31,September 30, 2007, we had working capital of $2,042,187($15,916) compared to working capital of $2,844,663$2,282,621 at March 31,September 30, 2006, and $3,309,145$1,137,115 at June 30, 2006.2007.

During the thirdfirst quarter ending March 31,September 30, 2007, we raised a total of $1,430,000$225,000 after expenses through the sale of 19,529,4126,667,325 shares of common stock to Charlton.  We do not expect to generate a positive internal cash flow for at least the next 12 months due to limited expected sales and the expected costs of commercializing our initial product, the CTLM®, in the international market and the expense of continuing our ongoing product development program.  We will require additional funds for operating expenses, FDA regulatory processes, manufacturing and marketing programs and to continue our product development program.  Accordingly, we intend towill continue to use proceeds from the sale of our building for continuing operations and our Fifth Private Equity Credit Agreement with Charlton to raise theany additional funds required through the end of fiscal year 2007 and thereafter in order to continue operations.  In the event that we are unable to utilize the Fifth Private Equity Credit Agreement or any successor agreement(s) on comparable terms, we would have to raise the additional funds required by either equity or debt financing, including entering into a transaction(s) to privately place equity, either common or preferred stock, or debt securities, or combinations of both; or by placing equity into the public market through an underwritten secondary offering.  If additional funds are raised by issuing equity securities, whether to Charlton or other investors, dilution to existing stockholders will result, and future investors may be granted rights superior to

Capital expenditures for the ninethree months ending March 31,September 30, 2007, were $16,500$1,394 as compared to $13,500$5,972 for the ninethree months ending March 31,September 30, 2006.  These expenditures were a direct result of purchases of computer and miscellaneous equipment.  We anticipate that the balance of our capital needs for the fiscal year ending June 30, 20072008 will be approximately $10,000.$25,000.

There were no other changes in our existing debt agreements other than extensions, and we had no outstanding bank loans as of March 31,September 30, 2007.  Our fixed commitments, including salaries and fees for current employees and consultants, rent, payments under license agreements and other contractual commitments are substantial and are likely to increase as additional agreements are entered into and additional personnel are retained.  We will require substantial additional funds for our product development programs, operating expenses, regulatory processes, and manufacturing and marketing programs.  Our future capital requirements will depend on many factors, including the following:

We do not expect to generate a positive internal cash flow for at least 12 months as substantial costs and expenses continue due principally to the international commercialization of the CTLM®, activities related to our FDA PMA process, and advanced product development activities.  We intend to use the Fifth Private Equity Credit Agreement with Charlton as our principal sources of additional capital.  There can be no assurance that this financing will continue to be available on acceptable terms.  We plan to continue our policy of investing excess funds, if any, in a High Performance Money Market account at Wachovia Bank N.A.

We have issued through 2003 and may in the future issue stock for services performed and to be performed by consultants.  Since we have generated no substantial revenues to date, our ability to obtain and retain consultants may be dependent on our ability to issue stock for services.  From July 1, 1996 to February 21, 2003 we issued an aggregate of 2,306,500 shares of common stock to consultants, which were registered on Registration Statements on Form S-8.  The aggregate fair market value of the shares was $2,437,151.  The issuance of large amounts of common stock for services rendered or to be rendered and the subsequent sale of such shares may depress the price of the common stock.  In addition, since each new issuance of common stock dilutes existing shareholders, the issuance of substantial additional shares may effectuate a change in our control.  No shares have been issued for services from February 21, 2003 to the date of this report.

As of the date of this report, we believe that we do not have any material quantitative and qualitative market risks.

We maintain disclosure controls and procedures that are designed to ensure that the information required to be disclosed in the reports that we file under the Securities Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.  In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

In order to market and sell the CTLM® in the United States, we must obtain marketing clearance from the Food and Drug Administration.  A Pre-Market Approval (PMA) application must be supported by extensive data, including pre-clinical and clinical trial data, as well as evidence to prove the safety and effectiveness of the device.  Under the Food, Drug, and Cosmetic Act, the FDA has 180 days to review a submitted PMA application, although in certain cases the FDA may increase that time period through requests for additional information or clarification of existing information.

In our initial PMA application we followed the guidelines of the “Standardized Shell for Modular Submission” for the FDA approval process.  We filed four modules from September 2000 to May 2001, which were accepted, and then filed our PMA application in April 2003.  In June 2003 we received notification from FDA that an initial review of our PMA had been conducted and was sufficiently complete to permit a substantive review and was, therefore, suitable for filing.  An in-depth evaluation of the safety and effectiveness of the device was conducted as part of the PMA application process.

On November 14, 2003 we announced that we received notification from the Medical Device Bureau of Health Canada that our application for a “New Medical Device” license was approved.  The license was issued in accordance with the Medical Device Regulations, Section 36.  Furthermore, we possess the CAN/CSA ISO 13485-2003 certification, which is an additional regulatory requirement that is evidence of compliance to the quality system of the medical device.

In August 2003, we received a letter from the FDA citing some deficiencies in the PMA application.  The FDA identified measures to make the PMA approvable, and we worked with our FDA counsel and consultants to prepare an appropriate amendment.

In March 2004, we received an extension of time to respond with an amendment to the FDA’s August, 2003 letter regarding our pre-market approval application.

In September 2004, we announced that our CT Laser Mammography System, CTLM®, had received Chinese State Food and Drug Administration (SFDA) marketing approval.  The People’s Republic of China SFDA issued the registration “Certificate for Medical Device”.  The medical device registration number is 20043241646.

These are complex matters, but after conferring with the FDA and our outside consultants, I recently made the decision to simply withdraw our current PMA application and resubmit the entire package in a simpler and more clinically and technically robust filing.  Consequently, IDSI will submit a new PMA application with a rephrased intended use statement better supported by our data, the inclusion of new clinical cases to improve the biometrics, and with a new clinical protocol to fully support the adjunctive use of CTLM® in clinical mammography settings.

The key factor in my decision was the belief that re-filing should not additionally delay our previous schedule.  The schedule should remain unchanged because the FDA indicated that Modules 1 through 4 would be ‘grandfathered’ so to speak, and because our clinical case read program will continue in its current form.  We are not starting over in any sense of the word.  We will, however, submit a fresh and concise PMA application without amendments or extensions.  Of course, this approach requires another filing fee but we believe it yields a higher confidence scenario.  So, to be very clear, we will submit a new PMA application and there should be no additional delays in our overall schedule.  You have all waited patiently for CTLM® to become a US market reality, and I would appreciate your continuing support through this next important phase.  I am very satisfied with this new approach.”

In November 2004, we received a letter from the FDA stating that it had determined that the CTLM® proposed clinical investigation was a non-significant risk (NSR) device study because it did not meet the definition of a significant risk (SR) device under section 812.3(m) of the investigational device exemptions (IDE) regulation 21 CFR 812.  We view this new classification as helpful in securing new research and development collaborative agreements.

In January 2005 we issued a press release of a shareholder letter written by Tim Hansen, CEO.  The letter contained a brief status update of the three top priorities stated in Mr. Hansen’s initial letter to shareholders released in October 2004.  Specific to our PMA activities, the letter stated, “…we are altering course.  The clinical study we had analyzed and which we intended to submit to the FDA did not, in our opinion, adequately reflect the capabilities of

CTLM® as an adjunctive mammography tool.  Our clinical cases were collected on CTLM® systems dating back to 2001.  Since that time IDSI has developed significant improvements in the scanning subsystems, image reconstruction and image display software.  We have also improved quality assurance routines to ensure better operator and physician training, and improved image quality control.  These enhancements were routinely implemented as they became validated on our international CTLM® shipments, but the same changes were not made to the 2001 units in order to maintain our PMA modules in their original forms.  We now intend to collect data using our latest systems because we believe the results will yield a stronger study to support our PMA application.

Consequently, we will install updated CTLM® systems in the U.S. and upgrade several international units to collect data under a new protocol.  Our plan will extend the time to actual PMA submission from what we were anticipating in October, but we believe this approach will better support the application.”

We reported in our December 14, 2005 S-1 filing that “We have experienced further delays because of difficulties in designing a revised clinical protocol and in enlisting hospitals and imaging centers to participate in acquiring new clinical cases.”  In spite of the delays we have experienced in obtaining the necessary approvals from the hospitals and their respective Institutional Review Boards (“IRB”), we have made good progress in advancing PMA activities.  Several sites have been installed and we have begun collecting clinical data.  We intend to install 8-10 sites depending on patient volume.  Following data collection we plan to submit the PMA application in its entirety.

In our S-1 Registration Statement filed on March 23, 2006, we reported that changes would be incorporated to bring the CTLM® system to its most current design level.  Those changes have been substantially made and will, we believe, improve the device’s image quality and reliability.  Upgraded CTLM® systems have been installed at several U.S. clinical sites and data collection is proceeding in accordance with our clinical protocol.  We are continuing to research and develop CTLM® technologies to advance the state-of-art of this new imaging modality.

Summarizing the key initiatives, Mr. Hansen explained the issues which slowed our progress in establishing the U.S. clinical sites.  When the FDA determined that CTLM® trials under our intended use would constitute a Non-Significant Risk device study, we assumed such a reclassification would have enabled us to more quickly engage U.S. clinical “partners.”  We also learned that the processes through Investigational Review Boards and legal departments had become much more complex and lengthy in recent years.  We also experienced delays because many of our preferred sites were simply too busy to participate in our study due to serious understaffing and workload issues, a recurring theme in the larger departments we contacted.  We are working diligently towards finalizing the remaining sites and are continuing to contact others as back-ups.  Our practice is to limit public identification of the sites so that the study members may participate without publicity or distraction.  There remain uncertainties about the time it may take to accrue the total number of cases needed for final PMA submission because each site has a unique workload and patient volunteer recruitment process.  All of the U.S clinical sites are using the latest CTLM configurations.  Because the CTLM imaging technique is completely new to doctors and technologists and training could affect results, we improved our certified training programs and added computerized calibration and QA software to the systems.  These improvements take full advantage of the experience we have gained through more than 9,000 international breast exams and our service histories.

In the Asia-Pacific Region, we previously announced that we contracted with BAC, Inc. to manage our existing distributors and develop new areas.  BAC is now managing our China distributor activities and has led IDSI in establishing a representative office in Beijing.  We have a full-time manager (BAC contract) and a marketing specialist, and we plan to add a lead service supervisor: three dedicated Chinese nationals in Beijing.  Reimbursement for CTLM exams was approved for the Beijing region.  Recently, weWe had also previously announced that we had changed our exclusive distribution agreement with our Distributor to non-exclusive, thus paving the way for IDSI to add more distributors to cover the large China market.

Elsewhere in the Asia-Pacific region, BAC is pursuing business connections in Australia, Singapore, Malaysia, New Zealand, Hong Kong, Macao, Taiwan, and the Philippines to enhance our existing representation in South Korea and China.  We have signed an exclusive distributor in Malaysia, where interest in breast cancer detection and treatment is surging due to publicity surrounding their First Lady, who succumbed to the disease.  We are pleased with BAC’s efforts, and we are gaining momentum through their experience and connections.  In September, we announced the installation of a CTLM® system at the Univeriti Putra Malaysia (UPM) in Kuala Lumpur, Malaysia.  The CTLM® was installed at UPM’s academic facility within the jurisdiction of the Ministry of Education and will be evaluated by specialists from UPM in conjunction with specialists from Serdang Hospital in Kuala Lumpur.

Activities in Europe and the Middle East are top marketing priorities for our International Sales VP. We held ourIDSI.  Our previously announced first IDSI Users Meeting, which was held in Berlin in April 2006, in Berlin. Ouryielded the sharing of clinical work by our international users.  These users have been doing excellent clinical work and have contributedmade a meaningful contribution to our Image Interpretation Manual and User Training Program.  In 2006, we receivedannounced the receipt of an order for six CTLM systems from our Polish distributor.  The first of those systems shipped in June 2006, giving us three systems in Poland, all serving major oncology centers.  The remaining CTLM units on the order have not yet been scheduled for shipment.  Among our global users, we have three systems in Poland, four in Italy, two each in the Czech Republic, and the United Arab Emirates, and China as well as systems in Germany and Austria.Malaysia.

 

CTLM® Systems have been installed and patients are being scanned under clinical collaboration agreements as follows:

We are in discussions with other hospitals and clinics wishing to participate in our clinical collaboration program. We have been commercializing the CTLM® in many global markets and we previously announced our plans to set up this network to foster research and to promote the technology in local markets.  We will continue to support

similar programs in other global regions.  These investments may accelerate CTLM® market acceptance while providing valuable clinical experiences.

In January 2007, we announced that the Company entered into a three-year employment agreement and an accompanying stock option agreement with Timothy B. Hansen, our Chief Executive Officer. Mr. Hansen’s new employment contract was an early renewal of his initial three-year contract due to expire in July 2007. His new contract will expire in January 2010. See “Form 8-K filed on January 23, 2007.”

Our Laser Imager for Lab Animals “LILA™” program has developed an optical helical micro-CT scanner in a third-generation configuration.  The system was designed to image numerous compounds, especially green fluorescent protein, derived from the DNA of jellyfish.  The LILA scanner is targeted at pharmaceutical developers and researchers who monitor cancer growth and who use multimodality small animal imaging in their clinical research.

IDSI’s strategic thrust for the LILA project changed in 2006.  As we previously announced, IDSI is focusing on women’s health business markets with a family of CTLM® systems and related devices and services.  The animal imager does not fit our business model although the fundamental technology is related to the human breast imager.

Consequently, we sought to align the project with a company already in the animal imaging market that might complete the LILA and commercialize it.

On August 30, 2006 we announced an exclusive license agreement under which Bioscan, Inc. would integrate LILA technology into their animal imaging portfolio.  Under the agreement we would transfer technology to Bioscan by December 2006 upon receipt of a $250,000 technology transfer fee.  We have received full payment of the technology transfer fee and plans are in place for Bioscan to begin the project during the fourth quarter of fiscal 2007. The agreement also provides for royalties on any future sales of LILA products. We have received full payment of the technology transfer fee, and Bioscan commenced the project during the second quarter of fiscal 2008  On May 9, 2007 we announced that a new patent for our optical CT scanner for small laboratory animals was issued on May 1, 2007 as U.S. Patent 7,212,848.  This second patent adds the concept of a second laser which will provide a geographic reference for the fluorescence image.  Our first patent covered the basic CT fluorescent imaging of small laboratory animals.

AustralianIn November, we announced the issuance of Chinese patent 775069,ZL 99 8 16608.1, issued July 2004; European patent EP01181511, issued June 2005; Hong Kong patent HK1043480, issued January 2006; and German patent DE69925869 issued May 2006; all11, 2007, entitled “Laser Imaging Apparatus Using Biomedicalusing Biochemical Markers Thatthat Bind to Cancer Cells.”  These 4 patents, along withThe patent is granted for a previously issued Canadianperiod 20 years from date of filing, until April 1, 2019.  This patent, are equivalents ofequivalent to US patent 5,952,644 and protect5,952,664, protects the concept of imaging and activating a photodynamic therapy agent in an optical CT scanner, a combined diagnosticscanner.  “We are very pleased to have been issued this patent in China and therapeutic system.

We will require substantial additional funds for working capital, including operating expenses, clinical testing, regulatory processes and manufacturing and marketing programs and our continuing product development programs.  Our capital requirements will depend on numerous factors, including the progress of our product development programs, results of pre-clinical and clinical testing, the time and cost involved in obtaining regulatory approvals, the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights, competing technological and market developments and changes in our existing research, licensing and other relationships and the terms of any new collaborative, licensing and other arrangements that we may establish.  Moreover, our fixed commitments, including salaries and fees for current employees and consultants, and other contractual agreements are likely to increase as additional agreements are entered into and additional personnel are retained.

SinceFrom July 17, 2000 until August 2007, when we entered into the sale/lease-back of our headquarters facility, Charlton Avenue LLC (“Charlton”) has provided all of our necessary funding through the private placement sale of convertible preferred stock with a 9% dividend and common stock through various private

From November 2000 to April 2001, Charlton converted 445 shares of Series K convertible preferred stock into 5,600,071 common shares and we redeemed 50 Series K shares for $550,000 using proceeds from the Charlton private equity line.  Spinneret converted 5 Series K shares for $63,996.  All Series K convertible preferred stock has been converted or redeemed and there are no convertible preferred shares outstanding.

From August 2000 to February 2004, we obtained funding through three Private Equity Agreements with Charlton.  Each equity agreement provided that the timing and amounts of the purchase by the investor were at our sole discretion.  The purchase price of the shares of common stock was set at 91% of the market price.  The market price, as defined in each agreement, was the average of the three lowest closing bid prices of the common stock over the ten day trading period beginning on the put date and ending on the trading day prior to the relevant closing date of the particular tranche.  The only fee associated with the private equity financing was a 5% consulting fee payable to Spinneret.  In September 2001 Spinneret proposed to lower the consulting fee to 4% provided that we pay their

consulting fees in advance.  We reached an agreement to pay Spinneret in advance as requested and paid them $250,000 out of proceeds from a put.

From the date of our first put notice, January 25, 2001 to our last put notice, February 11, 2004, under our Third Private Equity Credit Agreement, we drew a total of $20,506,000 and issued 49,311,898 shares to Charlton.  As each of the obligations under these prior agreements was satisfied, the agreements were terminated.  The Third Private

Equity Agreement was terminated on March 4, 2004 upon the effectiveness of our first Registration Statement for the Fourth Private Equity Credit Agreement.

On January 9, 2004, we and Charlton entered into a new “Fourth Private Equity Credit Agreement” which replaced our prior private equity agreements.  The terms of the Fourth Private Equity Credit Agreement were more favorable to us than the terms of the prior Third Private Equity Credit Agreement.  The new, more favorable terms were: (i) The put option price was 93% of the three lowest closing bid prices in the ten day trading period beginning on the put date and ending on the trading day prior to the relevant closing date of the particular tranche, while the prior Third Private Equity Credit Agreement provided for 91%, (ii) the commitment period was two years from the effective date of a registration statement covering the Fourth Private Equity Credit Agreement shares, while the prior Third Private Equity Credit Agreement was for three years, (iii) the maximum commitment was $15,000,000, (iv) the minimum amount we were required to draw through the end of the commitment period was $1,000,000, while the prior Third Private Equity Credit Agreement minimum amount was $2,500,000, (v) the minimum stock price requirement was controlled by us as we had the option of setting a floor price for each put transaction (the previous minimum stock price in the Third Private Equity Credit Agreement was fixed at $.10), (vi) there were no fees associated with the Fourth Private Equity Credit Agreement; the prior private equity agreements required the payment of a 5% consulting fee to Spinneret, which was subsequently lowered to 4% by mutual agreement in September 2001, and (vii) the elimination of the requirement of a minimum average daily trading volume in dollars.  The previous requirement in the Third Private Equity Credit Agreement was $20,000.

We made sales under the Fourth Private Equity Credit Agreement from time to time in order to raise working capital on an “as needed” basis.  Under the Fourth Private Equity Credit Agreement we drew down $14,198,541 and issued 66,658,342 shares of common stock.  We terminated use of the Fourth Private Equity Credit Agreement and instead began to rely on the Fifth Private Equity Credit Agreement (described below) upon the April 26, 2006, effectiveness of our S-1 Registration Statement filed March 23, 2006.

On March 21, 2006, we and Charlton entered into a new “Fifth Private Equity Credit Agreement” which has replaced our prior Fourth Private Equity Credit Agreement.  The terms of the Fifth Private Equity Credit Agreement are similar to the terms of the prior Fourth Private Equity Credit Agreement.  The new credit line’s terms are (i) The put option price is 93% of the three lowest closing bid prices in the ten day trading period beginning on the put date and ending on the trading day prior to the relevant closing date of the particular tranche (the “Valuation Period”), (ii) the commitment period is two years from the effective date of a registration statement covering the Fifth Private Equity Credit Agreement shares, (iii) the maximum commitment is $15,000,000, (iv) the minimum amount we must draw through the end of the commitment period is $1,000,000,  (v)  the minimum stock price, also known as the floor price is computed as follows:  In the event that, during a Valuation Period, the Bid Price on any Trading Day falls more than 18% below the closing trade price on the trading day immediately prior to the date of the Company’s Put Notice (a “Low Bid Price”), for each such Trading Day the parties shall have no right and shall be under no obligation to purchase and sell one tenth of the Investment Amount specified in the Put Notice, and the Investment Amount shall accordingly be deemed reduced by such amount.  In the event that during a Valuation Period there exists a Low Bid Price for any three Trading Days—not necessarily consecutive—then the balance of each party’s right and obligation to purchase and sell the Investment Amount under such Put Notice shall terminate on such third Trading Day (“Termination Day”), and the Investment Amount shall be adjusted to include only one-tenth of the initial Investment Amount for each Trading Day during the Valuation Period prior to the Termination Day that the Bid Price equals or exceeds the Low Bid Price and (vi) there are no fees associated with the Fifth Private Equity Credit Agreement.  The conditions to our ability to draw under this private equity line, as described above, may

materially limit the draws available to us.  We intend to seek an extension from Charlton of our Fifth Private Equity Credit Agreement which expires on March 21, 2008.  There can be no assurance that this extension will be granted.

We have made sales under the Fifth Private Equity Credit Agreement from time to time in order to raise working capital on an “as needed” basis.  Beginning in August 2007, we used and will use the proceeds from the sale of our building for continuing operations and then utilize our Fifth Private Equity Credit Agreement to raise any additional funds required to continue operations.  As of the date of this report, under the Fifth Private Equity Credit Agreement we have drawn down $5,280,000$5,917,717 and issued 64,028,51281,646,450 shares of common stock and have an available balance to draw of $9,720,000. We intend to continue raising funds through draws under the Fifth Private Equity Credit Agreement.$9,082,283.

As of the date of this report, since January 2001, we have drawn an aggregate of $39,984,541$40,622,258 in gross proceeds from our equity credit lines with Charlton and have issued 179,998,752197,616,690 shares as a result of those draws.

There can be no assurance that adequate financing will be available when needed, or if available, will be available on acceptable terms. Insufficient funds may prevent us from implementing our business plan or may require us to delay, scale back, or eliminate certain of our research and product development programs or to license to third parties rights to commercialize products or technologies that we would otherwise seek to develop ourselves.  To the extent that we utilize our Private Equity Credit Agreements, or additional funds are raised by issuing equity securities, especially convertible preferred stock and convertible debentures, dilution to existing shareholders will result and future investors may be granted rights superior to those of existing shareholders.  Moreover, substantial dilution may result in a change in our control.