UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2005

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from        to        

Commission File Number 0-22229

VITAL IMAGES, INC.

(Exact name of registrant as specified in its charter)

(952) 487-9500

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   ý   No   o

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

Yes   o   No   ý

On November 4, 2005, there were 12,615,304 shares of the Registrant’s common stock, par value $.01 per share, outstanding.

Vital Images, Inc.

Form 10-Q

September 30, 2005

Table of Contents

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Part I. Financial Information

Item 1.  Financial Statements

Vital Images, Inc.
Condensed Consolidated Balance Sheets

(The accompanying notes are an integral part of the condensed consolidated financial statements.)

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Vital Images, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)

(The accompanying notes are an integral part of the condensed consolidated financial statements.)

4

Vital Images, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)

(The accompanying notes are an integral part of the condensed consolidated financial statements.)

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Vital Images, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.      Basis of presentation

The accompanying unaudited consolidated financial statements of Vital Images, Inc. (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America.  In the opinion of management, all adjustments, consisting only of normal recurring adjustments, for a fair statement, have been included. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2005. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

The accompanying unaudited consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, HInnovation, Inc. All significant intercompany accounts and transactions have been eliminated.  The Company operates as a single business segment.  The Company markets its products to healthcare providers and to manufacturers of diagnostic imaging systems and picture archive and communication systems (“PACS”) through a direct sales force in the United States and independent distributors in international markets.

2.      Major customer and geographic data

The following customer accounted for more than 10% of the Company’s total revenue for the periods indicated:

As of September 30, 2005 and December 31, 2004, Toshiba Medical Systems Corporation (“Toshiba”) accounted for 29% and 23% of accounts receivable, respectively. 

In March 2005, the Company and Toshiba renewed their U.S. and international marketing and distribution agreement for two years, through December 31, 2006.  As under the previous agreement, Toshiba will offer the Company’s Vitrea^® 2 software through its subsidiaries and distributors in more than 50 nations in North and South America, Europe, the Middle East, Africa, Australia and Asia, except Japan.  Since 2000, Toshiba has been providing Vitrea software as the advanced visualization and analysis software of choice to customers purchasing Toshiba's Aquilion^™ scanners and other Toshiba CT scanners.

Substantially all of the Company’s export revenue is negotiated, invoiced and paid in U.S. dollars.  Gross export revenue by geographic area based on end user location is summarized as follows:

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3.      Stock-based compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and complies with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, "Accounting for Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of Financial Accounting Standards Board ("FASB") Statement No. 123."  See Note 12 to the consolidated financial statements for discussion on SFAS No. 123 (revised 2004), “Share-Based Payment”.

The Company has adopted the disclosure-only provisions of SFAS No. 123. For purposes of the pro forma disclosures below, the estimated fair value of the options and restricted stock is amortized to expense over the vesting period. Had compensation cost for the Company's stock options and restricted stock awards been recognized based on the fair value at the grant date consistent with the provisions of SFAS No. 123, the Company's net income (loss) would have been adjusted to the pro forma amounts indicated below:

The pro forma effects on the net income (loss) for the three and nine months ended September 30, 2005 and 2004 may not be indicative of the future results for the full fiscal year due to continuing option activity and other factors.

4.      Per share data

Basic earnings (loss) per share is computed using net income and the weighted average number of common shares outstanding. Diluted earnings (loss) per share reflect the weighted average number of common shares outstanding plus

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any potentially dilutive shares outstanding during the period.  Potentially dilutive shares consist of shares issuable upon the exercise of stock options and warrants.  As discussed in Note 10 to the consolidated financial statements, the contingent stock consideration related to the acquisition of HInnovation, Inc. has not been earned to date; accordingly, there was no impact on the Company’s diluted earnings (loss) per share.

The computations for basic and diluted net income (loss) per share for each period are as follows:

Aggregates of 210,200 and 392,130 shares of restricted stock and options to purchase shares of common stock were excluded from the computations of diluted earnings per share for the three and nine month periods ended September 30, 2005, respectively, because they were anti-dilutive.  Aggregates of 556,100 and 2,588,423 options and warrants to purchase shares of common stock were excluded from the computations of diluted earnings per share for the three and nine month periods ended September 30, 2004, respectively, because they were anti-dilutive.

5.      Comprehensive income (loss)

Comprehensive income (loss) as defined by SFAS No. 130, "Reporting Comprehensive Income," includes net income (loss) and items defined as other comprehensive income (loss).  SFAS No. 130 requires that items defined as other comprehensive income (loss), such as unrealized gains and losses on certain marketable securities, be separately classified in the financial statements.  Such items are reported in the consolidated statements of stockholders' equity as comprehensive income (loss).

The components of comprehensive income (loss) were as follows:

Accumulated other comprehensive loss at September 30, 2005 and December 31, 2004 was $32,010 and $47,865,

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respectively.

6.      Pro forma information

The following unaudited pro forma condensed consolidated results of operations have been prepared as if the acquisition of HInnovation, Inc. in February 2004 had occurred as of the beginning of the period presented.  Pro forma adjustments relate to amortization of identified intangible assets, acquired in-process research and development (“IPR&D”) and income taxes.  The unaudited pro forma condensed consolidated results of operations are for comparative purposes only and are not necessarily indicative of results that would have occurred had the acquisition occurred as of the beginning of the period presented, nor are they necessarily indicative of future results.

7.      Other intangible assets and goodwill

Acquired intangible assets subject to amortization were as follows:

Intangible assets subject to amortization are amortized on a straight-line basis over the estimated period of benefit.  Amortization expense related to other intangible assets was $321,000 and $312,000 for the three months ended September 30, 2005 and 2004, respectively.   Amortization expense related to other intangible assets was $963,000 and $802,000 for the nine months ended September 30, 2005 and 2004, respectively.   The estimated future amortization expense for identified intangible assets is as follows:

The preceding expected amortization expense is an estimate.  Actual amortization expense may differ from estimates due to additional intangible asset acquisitions, impairment of intangible assets, accelerated amortization of intangible assets, and other events.

Goodwill

The changes in the carrying amount of goodwill for the nine months ended September 30, 2005 was as follows:

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8.      Deferred revenue

The components of deferred revenue were as follows:

9.      Income taxes

The Company’s quarterly consolidated effective income tax rate is 36.4% for the nine months ended September 30, 2005, which is based on the Company’s estimated effective income tax rate for fiscal 2005, compared to 67.5% for the same period in 2004 and the consolidated effective income tax rate of 66.5% for fiscal 2004.  The 2005 effective income tax rate is anticipated to be lower than the Company’s combined federal and state statutory rates of 38.0% as a result of research and development credits, which are a direct reduction of taxes.  The 2004 effective income tax rate was impacted by a $1.0 million charge for in-process research and development that was incurred following the Company’s acquisition of HInnovation, Inc,, and was not tax deductible. 

The provision for income taxes consists of provisions for federal and state income taxes.  Losses incurred by the Company’s China subsidiary are not recognized as a benefit to the provision for income taxes because such losses are fully reserved, as it has been determined that it is more likely than not that no tax benefit will be realized relating to these losses in the future.  The consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates.

The Company reviews its annual effective income tax rate on a quarterly basis and makes changes as necessary. The estimated annual effective income tax rate may fluctuate due to changes in forecasted annual operating income; changes to the valuation allowance for net deferred tax assets; changes to actual or forecasted permanent book to tax differences; impacts from future tax settlements with state, federal or foreign tax authorities; or impacts from tax law changes. In addition, the Company identifies items which are not normal and recurring in nature and treats these as discrete events.  The tax effect of discrete items is booked entirely in the quarter in which the discrete event occurs. 

Although the Company had cumulative pre-tax income for financial reporting purposes for the three years ended December 31, 2004, the Company did not pay any significant income taxes for that period due to tax deductions from the exercise of stock options as well as its utilization of net operating losses.  In assessing the realizability of its deferred tax assets as of each balance sheet date, the Company considered evidence regarding its ability to generate sufficient future taxable income to realize its deferred tax assets. The primary evidence considered included the cumulative pre-tax income for financial reporting purposes for the past three years; the cumulative tax operating loss for the past three years; the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date; and the estimated future taxable income based on historical operating results.

After giving consideration to these factors, the Company concluded that it was more likely than not that tax loss carryforwards that expire in 2005 and other tax credits that expire within the next four years will not be utilized due to the estimated future tax deductions from the exercise of stock options outstanding as of December 31, 2004.  As a result,

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the Company recorded a valuation allowance of $183,000 for the year ended December 31, 2004.  The Company also recorded a full valuation allowance of $43,000 relating to 2004 foreign net operating losses that are subject to uncertainty regarding utilization.

As of September 30, 2005, the Company updated its December 31, 2004 realization of deferred tax assets analysis to reflect the necessary changes in estimates and determined that no increase in the valuation allowance was necessary related to the net deferred tax assets.

The Company also concluded that it was more likely than not that the net deferred tax assets of $9.1 million as of September 30, 2005 and the estimated future tax deductions from the exercise of stock options outstanding as of September 30, 2005 would be utilized prior to expiring.  Based on this conclusion, the Company would require approximately $48 million in cumulative future taxable income to be generated at various times over the next 20 years to realize the related net deferred tax assets of $9.1 million as of September 30, 2005 as well as the estimated future tax deductions from the exercise of stock options outstanding and in-the-money as of September 30, 2005.

If the Company adjusts its estimates of future taxable income or tax deductions from the exercise of stock options, or the Company’s stock price increases significantly without an increase in taxable income, the Company may need to establish additional valuation allowances, which could materially impact its financial position and results of operations.

10.     Commitments and contingencies

Contingent consideration related to acquisition

The Company has a contingent consideration agreement related to its acquisition of HInnovation, Inc. in February 2004.  The maximum potential contingent consideration was initially $6.0 million.  No contingent consideration has been earned, and, as of September 30, 2005, the potential maximum contingent consideration is $4.5 million, which consists of $3.0 million in common stock and $1.5 million in cash, provided that the number of shares of the Company’s common stock comprising the equity portion of the contingent consideration cannot exceed 300,000 shares.  Therefore, if, at the time of issuance, the aggregate market value of the 300,000 shares is less than $3.0 million, the Company will pay additional cash to compensate for the shortfall.  The number of shares of common stock to be issued under the equity portion of the contingent consideration will be determined by the average closing price of the Company’s common stock during the 10 trading days before completion of the milestone.

The remaining milestones upon which contingent consideration may be earned are (1) porting the Company’s base software to HInnovation’s web-based platform and the commercial launch thereof, upon which $1.5 million in cash consideration may be earned; and (2) within 24 months after the closing date of the acquisition, licensing products based upon patents held by HInnovation, upon which common stock with an aggregate value of $3.0 million may be earned.  A third milestone, based upon achieving certain revenue targets for the HInnovation products by March 2005, was not met and has now expired.

Any contingent payments made by the Company will result in an equivalent increase in goodwill.

Agreement with R2 Technology, Inc.

In April 2005, the Company entered into an agreement with R2 Technology, Inc. (“R2”) to market R2’s lung nodule CAD software product to the Company’s customers.  The April 2005 agreement replaced the Company’s November 2002 agreement with R2.  Under the April 2005 agreement, all previous commitments were cancelled and replaced with a new commitment.  Beginning in the third quarter of 2005, the Company committed to R2 certain minimum quarterly revenues (“Applicable Minimums”) from the sale of certain R2 lung CAD related products and services (“R2 Lung CAD Products”) over a 12-quarter period ending June 30, 2008.  The Company will receive a commission based on sales of R2 Lung CAD Products to the Company’s customers.  This agreement states that to the extent the quarterly Applicable Minimum is not met, the Company will pay R2 the difference between the Applicable Minimum and the actual R2 Lung CAD Product revenue achieved.

The Applicable Minimums for the quarters ending September 30, 2005, December 31, 2005 and March 31, 2006 are $414,000 per quarter.  However, beginning in the quarter ending June 30, 2006 and for each subsequent quarter thereafter, the Applicable Minimum will be reduced to the lowest of: i) the Applicable Minimum in the preceding quarter; ii) the Applicable Minimum of the preceding quarter multiplied by the percent by which the R2 Lung CAD Product revenue in the preceding quarter fell below that quarter’s Applicable Minimum, up to a maximum decline of twenty-three percent; or iii) two times the R2 Lung CAD Product revenue generated by R2 during the preceding quarter

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through all other sales, marketing and distribution channels, excluding R2 Lung CAD Product revenue generated through the agreement with the Company.  If at any time during the remainder of this agreement the Applicable Minimum is less than $414,000 and R2 Lung CAD Product revenue for a quarter exceeds $414,000, the Applicable Minimum for the next quarter will be $414,000.  Thereafter, the Applicable Minimums will be subject to the above adjustment.  Additionally, at the end of every fourth quarter under the April 2005 R2 agreement, if the aggregate revenue generated under the agreement in the previous four quarters exceeded $1,665,000, the remaining Applicable Minimum per quarter shall be reduced by the amount of excess divided by the number of quarters remaining under the agreement. 

As of September 30, 2005, based on current estimates, management believes it is probable that the estimated aggregate Applicable Minimums will be met and that it will not recognize a loss on this agreement.  However, the estimated aggregate Applicable Minimums is a subjective determination, and any changes to estimates and actual results could have an adverse impact on the Company’s financial position and results of operations.  As of September 30, 2005, the remaining aggregate Applicable Minimums ranges from a minimum of approximately $828,000 to a maximum of approximately $4.5 million. 

As of September 30, 2005, the Company deferred approximately $151,000 in commission fees from R2 under this agreement.  The Company determined that commission fees will be deferred to the extent they do not exceed the remaining aggregate Applicable Minimums.

11.     Other items

Loss on operating lease – In March 2004, the Company signed a non-cancelable operating lease for a new office facility in Minnetonka, Minnesota.  The new lease term started in February 2005 and expires in January 2012.  The Company moved into the Minnetonka location and moved out of its Plymouth, Minnesota location in February 2005.  The Company’s lease for the office facility in Plymouth expired on July 31, 2005 with the exception of a small portion of the space that is under lease until May 31, 2006.  Under the terms of the Minnetonka lease, since February 2005, the lessor is to pay the monthly base rent payments and taxes and operating cost rent obligation payments for the Company’s former office in Plymouth.   In the first quarter of 2005, the Company recorded a lease loss of $493,000 related to the abandonment of the Plymouth office.  The estimated lease payments to be made by the Minnetonka landlord to the Plymouth landlord are considered a lease incentive and recorded as an immediate charge and deferred rent, which is amortized as a reduction of rent expense through the term of the lease.

Acquired in-process research and development – Results for the first quarter of 2004 included a $1.0 million write-off of in-process research and development costs related to the HInnovation acquisition.

12.     New accounting pronouncement

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment.” SFAS No. 123R supersedes APB Opinion No. 25, which requires recognition of an expense when goods or services are provided. SFAS No. 123R requires the determination of the fair value of the share-based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. SFAS No. 123R permits a prospective or two modified versions of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by the original SFAS No. 123.  In April 2005, the Securities and Exchange Commission adopted a new rule that amends the compliance dates for SFAS No. 123R.  The Company is required to adopt the provisions of SFAS No. 123R effective January 1, 2006, at which time the Company will begin recognizing an expense for unvested share-based compensation that has been issued or will be issued after that date. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The Company has not yet finalized its decision concerning the transition option it will utilize to adopt SFAS No. 123R.  The Company is currently assessing its stock-based compensation strategy and related tax implications.  Future stock-based compensation may differ from pro forma amounts (see Note 3). The Company expects the impact of the adoption of SFAS No. 123R to be material to its consolidated financial statements.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Vital Images, Inc. (the “Company”) continued to achieve significant growth in the third quarter of 2005.  Total revenue for the third quarter ended September 30, 2005 was $13.2 million, compared with $9.2 million in the third quarter of 2004, a 42 percent increase.  Pretax income for the third quarter increased to $2.6 million, which included amortization costs of $351,000 and equity-based compensation costs of $89,000 related to restricted stock awards.  This compares to pretax income of $1.1 million in the year-ago period, which included amortization costs of $342,000, but no costs for equity-based compensation.  Net income for the 2005 third quarter rose to $1.6 million, or $0.12 per diluted share, compared to year-earlier net income of $670,000, or $0.05 per diluted share.

For the nine months ended September 30, 2005, revenue was $36.4 million and pretax income improved to $5.3 million.  The results for the nine months ended September 2005 include a lease loss of $493,000 that was recorded in the first quarter.  This compares to revenue of $25.0 million and pretax loss of $361,000 for the nine months ended September 30, 2004.  The results for the nine months ended September 2004 include a write-off in the first quarter of in-process research and development costs of $1.0 million related to the acquisition of HInnovation, which closed in February 2004.  Net income for the nine months ended September 30, 2005 was $3.4 million, or $0.26 per diluted share, a marked improvement over a net loss of $604,000, or $0.05 per diluted share, for the same period in 2004.

Throughout the Company’s history, a significant portion of the Company’s revenue has been generated from the U.S. computed tomography (“CT”) market.  Going forward, the Company anticipates a growing contribution from other sources, including an expanding picture archive and communication systems (“PACS”) market, sales of Web-based products and the Company’s installed customer base. 

Overview

The Company develops, markets and supports enterprise-wide advanced visualization solutions for use primarily in clinical diagnosis, disease screening and therapy planning.  The Company’s software applies proprietary computer graphics and image processing technologies to a wide variety of data supplied by CT, magnetic resonance (“MR”) and positron emission tomography (“PET”) scanners.  The Company’s products allow clinicians to create 2D, 3D and 4D views of human anatomy and to non-invasively navigate within these images to better visualize and understand internal structures and pathologies.  The Company believes that its high-speed visualization technology and customized protocols cost-effectively bring 3D visualization and analysis into the routine, day-to-day practice of medicine.  The Company, which operates in a single business segment, markets its products to healthcare providers and to manufacturers of diagnostic imaging systems and PACS through a direct sales force in the United States and independent distributors in international markets.  Vital Images’ common stock is currently traded on The NASDAQ National Market under the symbol “VTAL.”

Critical Accounting Policies and Estimates

The Company has adopted various accounting policies to prepare the condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America.  The most significant accounting policies are disclosed in Note 2 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  The Company continually evaluates its critical accounting policies and estimates. 

The Company believes the critical accounting polices listed below reflect significant judgments, estimates and assumptions used in the preparation of its consolidated financial statements.

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Allowance for doubtful accounts

The Company maintains an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from extending credit to the Company’s customers. In judging the adequacy of the allowance for doubtful accounts, the Company considers multiple factors, including historical bad debt experience, the general economic environment, the need for specific client reserves and the aging of the Company’s receivables.  This provision is included in operating expenses as a general and administrative expense in the consolidated statements of operations.  A considerable amount of judgment is required in assessing these factors. If the factors utilized in determining the allowance do not reflect future performance, then a change in the allowance for doubtful accounts would be necessary in the period such determination has been made, which would impact future results of operations.  As of September 30, 2005, the allowance for doubtful accounts was $608,000 for gross accounts receivable of $13.3 million.

Deferred taxes

Significant judgment is required in determining the realizability of the Company’s deferred tax assets.  The Company must assess the likelihood that its net deferred tax assets will be recovered from future taxable income, and to the extent the Company believes that recovery is not likely, it must establish a valuation allowance.  To the extent the Company establishes a valuation allowance, it must include an expense within the tax provision in the statement of operations.  As of September 30, 2005, the consolidated balance sheet included net deferred tax assets of $9.1 million.

The Company’s methodology for determining the realizability of its deferred tax assets involves estimates of future taxable income from its core business, the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date, and the expiration dates and amounts of net operating loss carryforwards and other tax credits.  These estimates are projected through the life of the related deferred tax assets based on assumptions which management believes to be reasonable and consistent with current operating results.

Although the Company had cumulative pre-tax income for financial reporting purposes for the three years ended December 31, 2004, the Company did not pay any significant income taxes for that period due to tax deductions from the exercise of stock options as well as its utilization of net operating losses.  In assessing the realizability of its deferred tax assets as of each balance sheet date, the Company considered evidence regarding its ability to generate sufficient future taxable income to realize its deferred tax assets. The primary evidence considered included the cumulative pre-tax income for financial reporting purposes for the past three years; the cumulative tax operating loss for the past three years; the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date; and the estimated future taxable income based on historical operating results.

After giving consideration to these factors, the Company concluded that it was more likely than not that tax loss carryforwards that expire in 2005 and other tax credits that expire within the next four years will not be utilized due to the estimated future tax deductions from the exercise of stock options outstanding as of December 31, 2004.  As a result, the Company recorded a valuation allowance of $183,000 for the year ended December 31, 2004.  The Company also recorded a full valuation allowance of $43,000 relating to 2004 foreign net operating losses that are subject to uncertainty regarding utilization.

As of September 30, 2005, the Company updated its December 31, 2004 realization of deferred tax assets analysis to reflect the necessary changes in estimates and determined that no increase in the valuation allowance was necessary related to the net deferred tax assets.

The Company also concluded that it was more likely than not that the net deferred tax assets of $9.1 million as of September 30, 2005 and the estimated future tax deductions from the exercise of stock options outstanding as of September 30, 2005 would be utilized prior to expiring.  Based on this conclusion, the Company would require approximately $48 million in cumulative future taxable income to be generated at various times over the next 20 years to realize the related net deferred tax assets of $9.1 million as of September 30, 2005 as well as the estimated future tax deductions from the exercise of stock options outstanding and in-the-money as of September 30, 2005.

If the Company adjusts its estimates of future taxable income or tax deductions from the exercise of stock options, or the Company’s stock price increases significantly without an increase in taxable income, the Company may need to establish additional valuation allowances, which could materially impact its financial position and results of operations.

Long-lived assets

The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  Events or changes in circumstances that

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indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used, or a significant adverse change in the business climate.  If such events or changes in circumstances are present, the undiscounted cash flows method is used to determine whether the asset is impaired.  Cash flows would include the estimated terminal value of the asset and exclude any interest charges.  To the extent the carrying value of the asset exceeds the undiscounted cash flows over the estimated remaining life of the asset, the impairment is measured using the discounted cash flows.  The discount rate utilized would be based on management’s best estimate of the related risks and return at the time the impairment assessment is made.  

The Company’s long-lived assets consist of property and equipment of $5.0 million, licensed technology of $240,000 and other intangible assets subject to amortization of $4.8 million as of September 30, 2005.

Goodwill and other intangible assets with indefinite lives

The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.”  Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized to expense and must be reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.  The Company operates as one reporting unit and therefore compares the book value to the market value (market capitalization plus a control premium).  If the market value exceeds the book value, goodwill is considered not impaired, thus the second step of the impairment test is not necessary.  If the Company’s book value exceeds the market value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.  The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the goodwill with the book value of the goodwill.  If the carrying value of the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized in an amount equal to the excess.  Any loss recognized cannot exceed the carrying amount of goodwill.  After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis.  Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed.  The Company completed the annual goodwill impairment assessment as of December 31, 2004, upon which no impairment was identified.

Agreement with R2 Technology, Inc.

In April 2005, the Company entered into an agreement with R2 Technology, Inc. (“R2”) to market R2’s lung nodule CAD software product to the Company’s customers.  The April 2005 agreement replaced the Company’s November 2002 agreement with R2.  Under the April 2005 agreement, all previous commitments were cancelled and replaced with a new commitment.  Beginning in the third quarter of 2005, the Company committed to R2 certain minimum quarterly revenues (“Applicable Minimums”) from the sale of certain R2 lung CAD related products and services (“R2 Lung CAD Products”) over a 12-quarter period ending June 30, 2008.  The Company will receive a commission based on sales of R2 Lung CAD Products to the Company’s customers.  This agreement states that to the extent the quarterly Applicable Minimum is not met, the Company will pay R2 the difference between the Applicable Minimum and the actual R2 Lung CAD Product revenue achieved.

The Applicable Minimums for the quarters ending September 30, 2005, December 31, 2005 and March 31, 2006 are $414,000 per quarter.  However, beginning in the quarter ending June 30, 2006 and for each subsequent quarter thereafter, the Applicable Minimum will be reduced to the lowest of: i) the Applicable Minimum in the preceding quarter; ii) the Applicable Minimum of the preceding quarter multiplied by the percent by which the R2 Lung CAD Product revenue in the preceding quarter fell below that quarter’s Applicable Minimum, up to a maximum decline of twenty-three percent; or iii) two times the R2 Lung CAD Product revenue generated by R2 during the preceding quarter through all other sales, marketing and distribution channels, excluding R2 Lung CAD Product revenue generated through the agreement with the Company.  If at any time during the remainder of this agreement the Applicable Minimum is less than $414,000 and R2 Lung CAD Product revenue for a quarter exceeds $414,000, the Applicable Minimum for the next quarter will be $414,000.  Thereafter, the Applicable Minimums will be subject to the above adjustment.  Additionally, at the end of every fourth quarter under the April 2005 R2 agreement, if the aggregate revenue generated under the agreement in the previous four quarters exceeded $1,665,000, the remaining Applicable Minimum per quarter shall be reduced by the amount of excess divided by the number of quarters remaining under the agreement. 

As of September 30, 2005, based on current estimates, management believes it is probable that the estimated aggregate Applicable Minimums will be met and that it will not recognize a loss on this agreement.  However, the estimated aggregate Applicable Minimums is a subjective determination, and any changes to estimates and actual results could

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have an adverse impact on the Company’s financial position and results of operations.  As of September 30, 2005, the remaining aggregate Applicable Minimums ranges from a minimum of approximately $828,000 to a maximum of approximately $4.5 million. 

As of September 30, 2005, the Company deferred approximately $151,000 in commission fees from R2 under this agreement.  The Company determined that commission fees will be deferred to the extent they do not exceed the remaining aggregate Applicable Minimums.

Revenue Recognition

Revenue recognition rules for software companies are complex. The Company follows specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of the Company’s revenue recognition policy.  Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause the Company’s operating results to vary significantly from period to period.

The significant judgments for revenue recognition typically involve whether collectibility can be considered probable and whether fees are fixed or determinable.  In addition, the Company’s transactions often consist of multiple element arrangements, which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized.

The Company licenses its software and sells products and services to end-users and also indirectly through original equipment manufacturers (“OEMs”) and independent distributors (collectively, “Resellers”).  Terms offered by the Company do not generally differ based on whether the customer is an end-user or a Reseller.  The Company offers terms that require payment within 30 to 90 days after product delivery.  The Company does not generally offer rights of return, acceptance clauses or price protection to its customers.  In rare situations where the Company provides rights of return or acceptance clauses, revenue is deferred until the clause expires.

License fees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale of system hardware, including peripheral equipment.  Maintenance and service revenue is derived from software maintenance and from telephone support, installation, training and consulting services.  The Company’s software licenses are always sold as part of an arrangement that includes maintenance and support and often installation and training services.  The Company generally sells hardware as part of a system sale, but it occasionally sells hardware as part of a system upgrade or additional product sale.

The Company recognizes revenue in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the AICPA; and SEC Staff Accounting Bulletin No. 104. The Company recognizes revenue when it is realized or realizable and earned.  The Company considers revenue realized or realizable and earned when it has persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable, and collectability is probable.  Provided all other revenue recognition criteria are met, license revenue from Resellers is recognized on a sell-in or sell-through basis depending on the arrangement with the Reseller.  The Company recognizes revenue from Resellers on a sell-in basis provided the Reseller i) assumes all risk of the purchase, ii) has the ability and obligation to pay regardless of receiving payment from the end user, and iii) has a history of timely payments.

The Company evaluates the credit worthiness of all customers.  In circumstances where the Company does not have experience selling to a customer and lacks adequate credit information to conclude that collection is probable, revenue is deferred until the arrangement fees are collected and all other revenue recognition criteria in the arrangement have been met.

In addition to the aforementioned general policy, the following are the specific revenue recognition policies for services and multiple-element arrangements:

• Software and Hardware – Revenue from license fees and hardware is recognized when shipment of the product has occurred, no significant Company obligations with regard to implementation remain and the Company’s services are not considered essential to the functionality of other elements of the arrangement.  See also “—Multiple Element Arrangements” below for further information.

• Services – Revenue from maintenance and support arrangements is deferred and recognized ratably over the term of the maintenance and support arrangements.  Revenue from training, installation and consulting services

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        is recognized as the services are provided to customers. 

• Multiple-Element Arrangements – The Company enters into arrangements with customers that include a combination of software products, system hardware, specified upgrades, maintenance and support, or installation and training services.  For such arrangements, the Company recognizes revenue using the residual value method.  The Company allocates the total arrangement fee among the various elements of the arrangement based on the relative fair value of each of the undelivered elements determined by vendor-specific objective evidence. The fair value of maintenance and support services is based upon the renewal rate for continued service arrangements.  The fair value of installation and training services is established based upon sold separately pricing for the services. In software arrangements for which the Company does not have vendor-specific objective evidence of fair value for all elements, revenue is deferred until the earlier of when vendor-specific objective evidence is determined for the undelivered elements (residual method) or when all elements for which the Company does not have vendor-specific objective evidence of fair value have been delivered.

The following table sets forth information from the Company’s Statements of Operations, expressed as a percentage of total revenue.