UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2006

OR

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

For the Transition Period from              to             

Commission file number 0-21371

APPLIED IMAGING CORP.

(Exact name of registrant as specified in its charter)

Delaware	77-0120490
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

120 Baytech Drive San Jose, California	95134-2302
(Address of principal executive offices)	(Zip Code)

(408) 719-6400

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report).

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.    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of ”accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

¨  Large accelerated filer    ¨  Accelerated filer    x  Non-accelerated filer

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

The number of shares of Common Stock, with $0.001 par value, outstanding on August 1, 2006 was 5,588,593.

APPLIED IMAGING CORP.

INDEX

		Page
	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)	3
	Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005	4
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005	5
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005	6
	Notes to Condensed Consolidated Financial Statements	7-14
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15-18
Item 3.	Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments	18
Item 4.	Controls and Procedures	18
	PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	19
Item 1. A	Risk Factors	19-26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3.	Defaults Upon Senior Securities	26
Item 4.	Submission of Matters to a Vote of Security Holders	26
Item 5.	Other Information	27
Item 6.	Exhibits	27
	Signatures	28

2

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Unless the context otherwise indicates, all share and per share common stock information in this Quarterly Report reflects a 1-for-4 reverse stock split of the common stock effective May 20, 2005.

3

APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(unaudited, in thousands, except share par value)

	June 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	3,321		$	3,136
Restricted cash		164			172
Trade accounts receivable, net of allowance for doubtful accounts		4,146			4,806
Inventories		408			434
Prepaid expenses and other current assets		374			354
Total current assets		8,413			8,902
Property and equipment, net		1,131			1,208
Goodwill		2,364			2,364
Other assets		49			54
Total assets	$	11,957		$	12,528
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Bank debt	$	727		$	2,054
Accounts payable		1,237			1,288
Accrued expenses		2,662			2,368
Deferred rent, current		149			149
Deferred revenue, current		3,004			3,537
Total current liabilities		7,779			9,396
Deferred rent, non-current		342			374
Deferred revenue, non-current		464			405
Total liabilities		8,585			10,175
Commitments and contingencies (Note 3)
Stockholders’ equity:
Preferred stock, $0.001 par value; 6,000,000 shares authorized; none issued and outstanding at June 30, 2006 and December 31, 2005		—			—
Common stock, $0.001 par value; 50,000,000 shares authorized; 5,588,593 and 4,814,781 issued and outstanding at June 30, 2006 and December 31, 2005, respectively		19			19
Additional paid-in capital		54,412			53,021
Accumulated deficit		(50,692	)		(50,320	)
Accumulated other comprehensive loss		(367	)		(367	)
Total stockholders’ equity		3,372			2,353
Total liabilities and stockholders’ equity	$	11,957		$	12,528

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

4

APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(unaudited, in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Revenues	$	5,032		$	4,912		$	9,898		$	9,802
Cost of revenues (a)		1,744			2,015			3,637			4,039
Gross profit		3,288			2,897			6,261			5,763
Operating expenses
Research and development (a)		755			870			1,501			1,755
Sales and marketing (a)		1,537			1,323			2,906			2,721
General and administrative (a)		1,364			1,013			2,257			2,066
Total operating expenses		3,656			3,206			6,664			6,542
Operating loss		(368	)		(309	)		(403	)		(779	)
Other income (expense), net		58			(127	)		31			(168	)
Net loss	$	(310	)	$	(436	)	$	(372	)	$	(947	)
Net loss per share - basic and diluted	$	(0.06	)	$	(0.09	)	$	(0.07	)	$	(0.20	)
Weighted shares used to calculate basic and diluted net loss per share		5,589			4,776			5,270			4,780
___________
(a)      SFAS No. 123(R) stock-based compensation expense was allocated as follows:
Cost of Revenues	$	6					$	22
Research and development		30						77
Sales and marketing		21						41
General and administrative		78						155
Total stock compensation expense	$	135					$	295

Cost of revenues and operating expense for the three months and six months ended June 30, 2006 includes share-based compensation expense in accordance with Statement of Financial Accounting Standards No. 123(R), which the Company adopted on January 1, 2006. See Note 5 to the financial statements for additional information.

5

APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

	Six Months Ended June 30,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(372	)	$	(947	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		236			369
Stock-based compensation		295			—
Changes in operating assets and liabilities:
Trade accounts receivable, net		756			155
Inventories		28			520
Prepaid expenses and other current assets		(11	)		(287	)
Other assets		5			(1	)
Accounts payable		(63	)		12
Accrued expenses		247			(443	)
Deferred revenue		(474	)		(119	)
Deferred rent		(32	)		(75	)
Net cash provided by (used in) operating activities		615			(816	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(155	)		(113	)
Net cash used in investing activities		(155	)		(113	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from private placement		1,094			14
Bank and other loan proceeds		5,331			5,933
Bank and other loan payments		(6,658	)		(6,003	)
Restricted cash		8			13
Net cash used in financing activities		(225	)		(43	)
Effect of exchange rate changes		(50	)		—
Net increase (decrease) in cash and cash equivalents		185			(972	)
Cash and cash equivalents at beginning of year		3,136			3,927
Cash and cash equivalents at end of quarter	$	3,321		$	2,955
Supplemental disclosure of cash flow information:
Cash paid for interest	$	48		$	42
Supplemental disclosure of non-cash investing and financing activities:
Inventory transfers to property and equipment	$	24		$	—

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

6

APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1– Basis of Presentation

Basis of Presentation

The accompanying condensed consolidated financial statements include the accounts of Applied Imaging Corp. and subsidiaries (the “Company”, “we”, “us”, “our”) for the three and six months ended June 30, 2006 and 2005. These financial statements are unaudited and reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position, operating results and cash flows for those interim periods presented.

Unless the context otherwise indicates, all share and per share common stock information in this Quarterly Report reflects a 1-for-4 reverse stock split of the common stock effective May 20, 2005.

The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2006. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, for the year ended December 31, 2005, contained in our Form 10-K filed with the Securities and Exchange Commission on March 29, 2006.

Management Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Stock-based Compensation

During the first quarter of fiscal 2006, we adopted the provisions of, and account for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards No. 123—revised 2004 (“SFAS 123R”), “Share-Based Payment” which replaced Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a ratable basis over the requisite service period, which is the vesting period. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated in the prior SFAS 123 pro forma disclosures.

The adoption of SFAS 123R had a material impact on our consolidated financial position, results of operations and cash flows. See Note 5 for further information regarding our stock-based compensation assumptions and expenses, including pro- forma disclosures for prior periods as if we had recorded stock-based compensation expense during these periods.

7

NOTE 2 – Inventories (in thousands)

	June 30, 2006		December 31, 2005
Raw materials	$	343	$	350
Work in progress		34		1
Finished goods		31		83
Total net inventory	$	408	$	434

NOTE 3 – Commitments and Contingencies

In December 2006, the Company’s Board of Directors approved equity and cash incentives to enhance benefits designed to retain employees of the Company as the Board considers strategic alternatives. The cash component is payable upon the earlier of (i) January 1, 2007, (ii) six months after a change of control of the Company, or (iii) involuntary termination of the employee at any time after October 1, 2006 or the earlier entry into a term sheet for a change of control. The Company presently anticipates this cash incentive to involve payment of $810,000. The Company accrued $810,000 as of June 30, 2006.

Contractual Obligations. The following table presents certain payments due under contractual obligations with minimum firm commitments as of June 30, 2006 (in thousands):

	Payments Due By Period
	(ooo’s)
	Total		Due in 2006		Due in 2007		Due in 2008		Due in 2009		Due in 2010		Due in 2011 and thereafter
Bank loan(1)	$	727	$	727	$	—	$	—	$	—	$	—	$	—
Operating lease commitments(2)		1,925		420		755		561		189		—		—
Vendor commitments(3)		363		363		—		—		—		—		—
Retention incentives(4)		810		—		810		—		—		—		—
Total contractual obligations	$	3,825	$	$1,510	$	1,565	$	561	$	189	$	—	$	—

(1) The Company’s loan agreement with SVB terminates in March 29, 2007.

(2) The Company has various non-cancelable operating leases for equipment, vehicles and facilities expiring through 2009. The facility leases generally contain renewal options for periods ranging from two to five years and require the Company to pay all executory costs such as maintenance, property taxes, and insurance. The Company’s primary lease commitment is for its facility in San Jose, California. The lease is for 24,095 square feet of office space. The lease on the San Jose facility is effective July 1, 2004 through June 30, 2009 with increasing annual rent commencing at $318,000, excluding operating expenses. However, rent expense is recognized on a straight-line basis. The 2005 rent expense was $325,000. Also, the Company leases a 4,422 square foot service office in League, Texas for $7,739 per month until the end of the lease in October 2006. In addition, the Company leases facilities in the United Kingdom, which aggregate approximately $302,445, excluding expenses per year through 2008. Total facility expense under operating leases aggregated $755,000, $902,000, and $888,000 during 2005, 2004, and 2003, respectively.

(3) These commitments are generally for inventory, operating supplies/equipment, investor relations and for financing of D&O and employment practice insurance.

(4) The Board and Management have approved equity and cash incentives to enhance benefits designed to retain employees of the Company as the Board considers strategic alternatives.

8

NOTE 4 – Net loss per share

Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share,” requires a dual presentation of basic and diluted earnings per share (“EPS”). Basic EPS excludes dilution and is computed by dividing net income or loss by the weighted average number of shares of common stock outstanding during the period. Diluted EPS reflects the potential dilution that would occur if outstanding securities to issue common stock were exercised or converted to common stock. Diluted net loss per share for the three and six months ended June 30, 2006 and 2005 does not differ from basic net loss per share since potential shares of common stock issuable upon exercise of stock options and warrants are anti-dilutive under the treasury stock method.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Numerator - Basic and Diluted
Net loss	$	(310	)	$	(436	)	$	(372	)	$	(947	)
Denominator - Basic and Diluted
Weighted average shares outstanding basic		5,589			4,776			5,270			4,780
Dilutive shares - stock options		—			—			—			—
Dilutive shares - warrants		—			—			—			—
Weighted average shares outstanding basic		5,589			4,776			5,270			4,780
Basic and Diluted net loss per share	$	(0.06	)	$	(0.09	)	$	(0.07	)	$	(0.20	)

Securities excluded from the computation of EPS because their effect on EPS was antidilutive, but could dilute basic EPS in future periods are as follows (in thousands):

	June 30,
	2006 Shares	2005 Shares
Options	1,048	861
Warrants	608	394
Total	1,656	1,255

NOTE 5 – Stock Based Compensation

Stock Compensation

Beginning with our first quarter of fiscal 2006, we adopted SFAS 123R. See Note 1 for a description of our adoption of SFAS 123R. We use the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

Prior to the adoption of SFAS 123R, we provided disclosures required under FAS No. 123 for stock-based compensation, amended by SFAS NO. 148, “Accounting for Stock-Based Compensation Transition and Disclosures.” The estimated compensation cost is based on the fair value of the Company’s common stock on the date of grant. We will continue to recognize the compensation cost, net of estimated forfeitures, over the vesting term.

9

Prior to the Adoption of SFAS No. 123(R)

The pro-forma information for the three months and six months ended June 30, 2005 was as follows (in thousands, except per share data):

	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Net loss:
As reported	$	(436	)	$	(947	)
Stock-based employee compensation expense determined under fair-value method		(85	)		(157	)
Pro forma	$	(521	)	$	(1,104	)
Net loss per share:
As reported:
Basic and diluted	$	(0.09	)	$	(0.20	)
Pro forma
Basic and diluted	$	(0.11	)	$	(0.23	)

Impact of the Adoption of SFAS No. 123(R)

The Company elected to adopt the modified prospective application method as provided by SFA No. 123 (R). The effect of recording stock-based compensation for the three months and six months ended June 30, 2006 was as follows (in thousands, except per share data):

	Three Months Ended June 30, 2006			Six Months Ended June 30, 2006
Share-based compensation expense impact by type of award:
As reported	$	(310	)	$	(372	)
Stock plans	$	132		$	292
Employee stock purchase plan	$	3		$	3
Effect on loss from continuing operations	$	(175	)	$	(77	)
Effect on loss before income taxes	$	(175	)	$	(77	)
Effect on Net loss	$	(175	)	$	(77	)
Effect on cash flow from operations	$	—		$	—
Effect on basic and diluted net loss per share	$	(0.03	)	$	(0.01	)

The total compensation cost related to nonvested awards not yet recognized as of June 30, 2006 was approximately $863,000. The weighted-average period over which this compensation cost is expected to be recognized is 3.21 years.

There were no stock option exercises for the three or six month period ended June 30, 2006. The company did not receive any cash from option exercises nor pay any cash to settle stock options. In addition, the Company did not realize any tax benefit from stock option exercises for the three or six months ended June 30, 2006.

Valuation Assumptions

The Company estimates the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS No. 123 (R), SEC SAB No. 107 and the Company’s prior period pro forma disclosures of net loss, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model and the ratable attribution approach with the following weighted-average assumptions:

	Three Months				Six Months
	2006		2005		2006		2005
Expected life (in years)	5		5		5		5
Volatility	82.19% - 82.50	%	84.00	%	82.19% - 82.50	%	84.00% - 92.00	%
Risk free interest rate	4.94% -   5.02	%	3.53	%	4.68% -   5.02	%	3.53% -   3.66	%
Dividend yield	—  % -    —	%	—	%	—  % -    —	%	—  % -    —	%

10

The dividend yield is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the combination of historical volatility of the Company’s common stock, the expected moderation in future volatility over the period commensurate with the expected life of options and other factors. The risk free interest rates are taken from the Daily Federal yield Curve Rates as of the grant dates as published by the Federal Reserve and represents the yield on actively traded treasury securities for terms equal to the expected term of the options. The expected term calculation is based on observed historical option exercise behavior, post-vesting employment termination behavior of the Company’s employees and the options’ contractual term.

Equity Incentive Program

As of June 30, 2006, the Company had the following stock plans:

	Reserved for Issuance	Shares Available for Grant	Options Outstanding
1998 Incentive Stock Option Plan	1,160,717	326,242	860,717
1988 Incentive Stock Option Plan	110,108	—	110,108
1994 Director’s Stock Option Plan	27,500	—	27,500
2003 Stand-Alone Option Plan	50,000	—	50,000
Totals	1,348,325	326,242	1,048,325

Under the 1998 Stock Plan, stock options may be granted to Board members, officers, key employees, and consultants at the fair market value of the common stock at the date of the grant, as determined by the Board of Directors, typically the closing share price on the day of grant. Options are exercisable over 10 years from the date of grant, and typically vest ratably over 4 years.

The Company’s 1988 Stock Plan expired in October 1998. No options were granted in this Plan after October 1998.

The Company’s 1994 Directors Option Plan was enacted and designed to encourage participation on the Company’s Board of Directors. The terms of the plan allow the granting of stock options upon initial election to the Board of Directors and for subsequent grants.

The Company’s 2003 Stand-Alone Plan was established in November 2003 designed to offer incentive options to a key new employee.

11

The following table sets forth the summary of option activity under our stock option program for the six months ended June 30, 2006:

	Options Available for Grant		Weighted Average Exercise Price		Weighted Average Contractual Life		Aggregate Intrinsic Value
Beginning at December 31, 2005	1,076,903		$	4.45
Options granted	37,000		$	1.95
Options exercised	—			—
Options cancelled/forfeited/expired	(65,578	)	$	5.41
Outstanding at June 30, 2006	1,048,325		$	4.30	$	7.28	$	247,360
Vested and expected to vest at June 30, 2006 (1)	949,198		$	4.59		0.77	$	204,805
Exercisable at June 30, 2006	439,799		$	7.93		4.60	$	—

(1) The expected to vest options are the result of applying the pre-vesting forfeiture rate assumptions to total outstanding options.

The aggregate intrinsic value in the table above represents the total intrinsic value (the aggregate difference between the closing stock price of the Company’s common stock on June 30, 2006 and the exercise price of in-the-money options) that would have been received by the option holders if all option had been exercised on June 30, 2006.

The weighted average grant date fair value of options granted during the quarter ended June 30, 2006 was $1.60.

Information regarding the stock options outstanding and exercisable at June 30, 2006 is summarized below:

Range of Exercise Prices				Number Outstanding	Weighted Average Remaining Contractual	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$	1.21	$	1.21	419,000	9.48	$	1.21	—	$	—
$	1.70	$	2.28	197,583	8.87	$	2.17	49,473	$	2.21
$	3.04	$	4.88	113,026	5.83	$	3.88	91,772	$	3.92
$	5.44	$	9.60	131,492	5.82	$	7.22	111,330	$	7.49
$	9.75	$	11.00	116,358	1.66	$	9.98	116,358	$	9.98
$	12.00	$	12.00	19,616	4.01	$	12.00	19,616	$	12.00
$	13.75	$	13.75	7,000	4.09	$	13.75	7,000	$	13.75
$	14.50	$	14.50	9,750	4.15	$	14.50	9,750	$	14.50
$	16.00	$	16.00	25,375	3.86	$	16.00	25,375	$	16.00
$	16.12	$	16.12	9,125	4.36	$	16.12	9,125	$	16.12
$	1.21	$	16.12	1,048,325	7.28	$	4.30	439,799	$	7.94

Employee Stock Purchase Plan

In 2005, the Company’s prior Employee Stock Purchase Plan was discontinued. At the Company’s 2006 meeting of stockholders, the stockholders approved, among other things, the adoption of the Company’s 2006 Employee Stock Purchase Plan and a reservation of a total of 175,000 shares of common stock for purchase under the 2006 Purchase Plan. The 2006 Stock Purchase Plan allows eligible employee participants to purchase shares of our common stock at a discount through payroll deductions. The ESPP consist of two six month offering periods. Employees purchase shares in each purchase period at 85% of the market value of our common stock at either the beginning of the offering period or the end of the purchase period, whichever price is lower.

As of June 30, 2006 there were 175,000 shares reserved for issuance.

The estimated fair value of purchase rights under the Company’s Purchase Plan was determined using the Black-Scholes pricing model with the following assumptions for the period ending June 30, 2006:

	Three Months 2006
Expected life (in years)	6 months
Volatility	53.88	%
Risk free interest rate	5.06	%
Dividend yield	—	%

12

NOTE 6 – Product Warranty

The Company generally warrants its products against defects for a period of one year and records a liability for such product warranty obligations at the time of sale based upon historical experience. The Company sells separately priced service contracts to provide additional service coverage on its systems when the warranty period expires. The related revenue on the service contracts is recognized on a straight-line basis over the life of the service contract, which is generally one year. Costs associated with services performed under the service contract obligation are expensed as incurred.

Changes in product warranty obligations are as follows (in thousands):

	June 30, 2006			June 30, 2005
Balances at Beginning of Year	$	183		$	101
Add accruals for warranties issued		73			110
Less cost incurred under warranties issued		(85	)		(78	)
Balance end of quarter	$	171		$	133

NOTE 7 – Segment and Geographic

The Company has historically reported as one segment, namely, the imaging business. In late 2004, the Company formed a subsidiary “CTC” with the intent to develop a commercial system for the detection, quantification and analysis of circulating tumor cells in blood. The Company began very early stage research and development activities on CTC in 2005 and the program was managed as a research and development project within existing management and financial reporting structures.

In the first quarter of 2006, as part of the 2006 planning effort, the Company organized itself in a way to give focus to its CTC effort. The Chief Operating Decision Maker now reviews financial results by two segments, namely, the imaging business and CTC. Management’s determination is that CTC moved from a project to a fully functional research and development program with management, initial funding, management focus, internal financial reporting segmentation and formal resource allocation segmentation during first quarter of 2006.

13

A reconciliation of the totals reported for the operating segments to the applicable line items in the condensed consolidated financial statements for the quarters ended June 30, 2006 and June 30, 2005 is as follows:

	Imaging Business			CTC			Total Consolidated
Period ended June 30, 2006
Revenue	$	5,032		$	—		$	5,032
Operating Expenses		3,209			447			3,656
Net Income (Loss)	$	137		$	(447	)	$	(310	)
Period ended June 30, 2005
Revenue	$	4,912		$	—		$	4,912
Operating Expenses		2,963			243			3,206
Net Income (Loss)	$	(193	)	$	(243	)	$	(436	)

Total operating expenses comprise research and development, sales and marketing and general and administrative except for CTC which does not have general and administrative expenses. For fiscal 2006, operating expense also included stock-based compensation.

A reconciliation of the totals reported for the operating segments to the applicable line items in the condensed consolidated financial statements for the quarters ended June 30, 2006 and December 31, 2005 is as follows in thousands:

Identifiable Assets	June 30, 2006		December 31, 2005
CTC	$	131	$	144
Imaging Business	$	11,826	$	12,384
Total Consolidated	$	11,957	$	12,528

The following table presents net revenues by geographic region in thousands:

	Three Months				Six Months
	2006		2005		2006		2005
North America	$	3,448	$	3,116	$	6,424	$	6,302
International-Principally Europe		1,584		1,796		3,474		3,500
Total revenues	$	5,032	$	4,912	$	9,898	$	9,802

NOTE 8 – Goodwill

The carrying value of goodwill was $2.4 million as of June 30, 2006 and December 31, 2005, respectively, and was allocated to Applied Imaging’s imaging business reporting segment pursuant to SFAS No. 142. In accordance with SFAS No. 142, Applied Imaging completed its annual evaluation of the goodwill by reporting unit during the quarter ended March 31, 2006, and concluded that there was no impairment.

NOTE 9 – Recently Issued Accounting Prouncements

In June 2006, the FASB issued FASB Interpretation No.48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48), which prescribes accounting for and disclosure of uncertainty in tax positions. This interpretation defines the criteria that must be met for the benefits of a tax position to be recognized. The provisions of FIN 48 are effective as of the beginning of the Company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on its financial statements.

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

The following discussion should be read in conjunction with the attached unaudited condensed consolidated financial statements and notes, and with our audited financial statements and notes for the fiscal year ended December 31, 2005.

This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include those statements concerning our progress on our CTC initiative, our expectations on revenue, margins, operating expenses, and expenditures on our CTC initiative. Our actual results could differ materially from those predicted in the forward-looking statements as a result of risks and uncertainties including, but not limited to, those discussed in this quarterly report and those discussed under “Item 1 – Business, Additional Factors That Might Affect Future Results,” and under “Item 7 – Management’s Discussion And Analysis of Financial Condition And Results of Operations” commencing on pages 11 and 22 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. You should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no obligation to revise or update any forward-looking statements.

Results of Operations

Revenues

	Three Months						Percent Change		Six Months						Percent Change
	2006			2005					2006			2005
Product	$	3,481		$	3,506		-0.7	%	$	6,868		$	6,954		-1	%
Percentage of total revenues		69	%		71	%				69	%		71	%
Service and support		1,551			1,407		10	%		3,030			2,848		6	%
Percentage of total revenues		31	%		29	%				31	%		29	%
Total revenues	$	5,032		$	4,912				$	9,898		$	9,802

Our revenues are derived primarily from the sale of systems, service contracts, software maintenance and grant revenues.

System sales were flat in the three and six month periods ending June 30, 2006 compared to the same period in 2005.

Service contract and software maintenance revenues increased during the three and six month periods ending 2006 compared to the same periods in 2005 primarily due to increased consulting revenues.

We expect quarterly revenue to trend upward in the second half of 2006 in anticipation of new software releases.

Cost of revenue

	Three Months						Percent Change		Six Months						Percent Change
	2006			2005					2006			2005
Product	$	1,305		$	1,504		-13	%	$	2,716		$	3,042		-11	%
Percentage of total revenues		75	%		75	%				75	%		75	%
Service and support		439			511		-14	%		921			997		-8	%
Percentage of total revenues		25	%		25	%				25	%		25	%
Total cost of revenues	$	1,744		$	2,015				$	3,637		$	4,039

Cost of revenues includes direct material and labor costs, manufacturing overhead, installation costs, warranty-related expenses and service and application support expenses.

Cost of revenues, as a percentage of total revenues, for the three months and six months ended June 30, 2006 and 2005 were flat. Lower costs in 2006 were primarily due to management’s focus on reducing the material costs of systems. Also, high margin consulting revenues were achieved in the quarter ending June 30, 2006.

We expect our margin percent to remain relatively stable for the remainder of 2006.

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Research and development expenses

	Three Months						Percent Change		Six Months						Percent Change
	2006			2005					2006			2005
Research and development	$	755		$	870		-13	%	$	1,500		$	1,755		-14	%
Percentage of total revenues		15	%		18	%				15	%		18	%

Research and development expenses consist primarily of salary and benefit expenses for software developers, contracted development efforts, related facilities costs and expenses associated with computer equipment used in software development.

Research and development expenses decreased for the period ending June 30, 2006 compared to the same period of 2005 primarily due to lower personnel expenses of $124,000 and reduced consulting expenses of $52,000 which were partially offset by stock compensation expense of $30,000 and retention bonus of $40,000. The retention bonus relates to our board approved equity and cash incentives arrangements designed to retain our employees as our board considers strategic alternatives. The decrease in expenses for the first six months ending June 30, 2006 as compared to the same period in 2005 was primarily due to $207,000 in reduced personnel expenses, $147,000 of reduced research supplies and $63,000 of reduced consulting expenses partially offset by stock-based compensation of $77,000 and retention and project bonuses of $95,000.

We expect quarterly R&D expenses to remain relatively flat for the remainder of 2006.

Sales and marketing expenses

	Three Months						Percent Change		Six Months						Percent Change
	2006			2005					2006			2005
Sales and marketing	$	1,537		$	1,323		16	%	$	2,906		$	2,721		7	%
Percentage of total revenues		31	%		27	%				29	%		28	%

Sales and marketing expenses primarily include salary and benefit expenses, sales commissions, travel expenses and related facilities costs for our sales, marketing, and order management personnel. Sales and marketing expenses also include the costs of programs aimed at increasing revenue, such as, trade shows, public relations and other market development programs.

Sales and marketing expenses increased in the second quarter of 2006 compared to the same period of 2005 primarily due to stock compensation expense of $21,000 and retention bonus of $163,000. The retention bonus relates to our board approved equity and cash incentives arrangements designed to retain our employees as our board considers strategic alternatives. Expenses for the first six months ending June 30, 2006 as compared to the same period in 2005 were higher primarily due to stock-based compensation of $41,000 and retention bonus of $193,000.

We expect quarterly sales and marketing expenses to remain relatively flat for the remainder of 2006.

General and administrative expenses.

	Three Months						Percent Change		Six Months						Percent Change
	2006			2005					2006			2005
General and administrative	$	1,364		$	1,013		35	%	$	2,257		$	2,066		9	%
Percentage of total revenues		27	%		21	%				23	%		21	%

General and administrative expenses consist primarily of compensation and benefit expenses, travel expenses, and related facilities costs for our finance, facilities, human resources, information services and executive personnel. General and administrative expenses also include outside legal and accounting fees, provision for bad debts, expenses associated with computer equipment and software used in the administration of the business, and various forms of insurance.

General and administration expenses increased in the second quarter of 2006 compared the same quarter in 2005 primarily due to stock-based compensation of $77,000 and retention bonus of $487,000 which were partially offset by reduced accounting fees of $116,000 and lower consulting fees of $64,000. The retention relates to our board approved equity and cash incentives arrangements designed to retain our employees as our board considers strategic alternatives. Expenses for the first six months of 2006 were higher as compared to the same period in 2005 due to stock-based compensation of $155,000, retention bonus of $502,000 and increased personnel expense of $100,000 partially offset by reduced legal and auditing fees of $265,000 and reduced consulting of $220,000.

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We expect quarterly general and administration expenses to relatively flat for the remainder of 2006. We expect reduced retention bonus expenses to be offset with Sarbanes-Oxley consulting costs.

Other income (expense), net

	Three Months						Percent Change		Six Months					Percent Change
	2006			2005					2006		2005
Non-Operating income (expense), Net	$	58		$	(127	)	-146	%	$	31	$	(168	)	-119	%
Percentage of total revenues		1	%		-3	%				—		-2	%

Non-operating income (expense) consists primarily of interest income, interest expense, foreign translation and transaction expense.

Non-operating income was higher in the three months and six months ending June 30, 2006 as compared to the same periods in 2005 primarily due to the foreign translation and transaction expense associated with our UK operations.

Liquidity and Capital Resources

	June 30, 2006		December 31, 2005			Percent Change
Cash and cash equivalents	$	3,328	$	3,136		6	%
Working capital	$	634	$	(494	)	-228	%
Stockholders’ equity	$	3,372	$	2,353		43	%

	Six Months Ended
	June 30, 2006			June 30, 2005
Net cash provided (used in) by operating activities	$	615		$	(816	)
Net cash used in investing activities	$	(155	)	$	(113	)
Net cash used in financing activities	$	(225	)	$	(43	)

Our primary source of cash is receipts from revenue. The primary uses of cash are payroll (salaries, bonuses, and benefits), general operating expenses (marketing, travel, office rent) and cost of product revenue. Another potential source of cash is proceeds from private equity financing such as the one which occurred in March 2006.

Working capital

The increase in working capital from December 2005 to June 2006 resulted primarily from the net proceeds of $1.1 million from a March 2006 private placement.

Stockholders’ equity

The increase in stockholders’ equity from December 2005 to June 2006 resulted primarily from stock-based compensation expense and net proceeds of $1.1 million from a March 2006 private placement.

Net cash provided by operating activities

Operating cash flow for the six months ended June 30, 2006 was $615,000 versus cash used of $816,000 in the comparable period in 2005. Net loss of $947,000 was the main use of cash in the six months ended June 30, 2005. Net loss of $372,000 and a reduction of $474,000 of deferred revenue were the main uses of cash while non cash charges of $531,000 and a reduction in accounts receivable of $756,000 were the main sources of cash for the six months ended June 30, 2006. The reduction in deferred revenue was primarily attributable to the recognition of revenue on a consulting contract as well as reduced deferred revenue for service obligations. The reduction in accounts receivable relates to reduced payment terms and improved collections.

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Net cash used by investing activities

Net cash used by investing increased in the six months ended June 30, 2006 as a result of purchases of software and computers equipment for internal and sales demonstration use.

Net cash used by financing activities

Net cash used by financing activities in the six months ended June 30, 2006 was as a result of pay-down of our bank debt which was offset by $1.1 million net cash provided in a March 2006 private placement.

We have a loan agreement with Silicon Valley Bank “SVB” which provides for borrowing of up to $3.5 million based on the level of certain of its North American accounts receivable. We were in compliance with the covenant requiring us to maintain $(1,250,000) in minimum tangible net worth as of June 30, 2006. Our tangible net worth was $1,008,000 at June 30, 2006.

At June 30, 2006, we had used $727,000 of the facility with $923,800 available but not used. The interest rate on the facility was 10.25% at June 30, 2006, computed as the SVB prime rate plus 2 percent. The loan is collateralized by substantially all of the assets of the U.S. Corporation and requires maintenance of a minimum tangible net worth level. Other loan covenants include the need to maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. corporation’s ability to transfer more than $600,000 to a foreign subsidiary.

We collateralize various credit card and bank guarantees (used for customs clearance purposes) with cash deposits at an international bank in the United Kingdom. This amounted to $164,000 at June 30, 2006.

Item 3. Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments

Foreign Currency Fluctuations

In the normal course of business, we are exposed to market risk from the effect of foreign exchange rate fluctuations on the U.S. dollar value from our foreign operations. Our revenues are primarily denominated in U.S. dollars, sterling and euros. In addition, the operating expenses incurred by our foreign subsidiaries are denominated in local currencies. Accordingly, we are subject to exposure from movements in foreign currency exchange rates. To date, the effect of changes in foreign currency exchange rates have impacted our financial position and operating results. We currently do not use financial instruments to hedge foreign currency risks. We intend to assess the use of financial instruments to hedge currency exposures on an ongoing basis.

Interest Rate Risk

For the six months ended June 30, 2006, there were no material changes from the disclosures made in our Form 10-K for the year ended December 31, 2005. We maintain our funds as cash or cash equivalents, primarily in money market investments with a maturity of less than 90 days. We invested these funds at an average interest rate of 4.8% during the second quarter of 2006. These investments are not subject to interest rate risk.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. Based on an evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”) were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in internal control over financial reporting. There has been no change in our internal control over financial reporting during the quarter ended June 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings

We are not a party to any other material legal proceedings.

Item 1A. Risk Factors

The following represent some of the factors that create risk and uncertainty for our business and us. If any of the following factors actually occur, our business, financial condition or results of operations could be materially adversely affected.

We are evaluating our strategic options which could result in the sale of our assets, the sale of some or all of our business or a debt or equity financing, any of which may have a negative impact on our business and our stock price.

We do not have sufficient funds to fully implement our growth strategy. We have consequently engaged an investment bank to work with our management to evaluate our strategic options. Such evaluation could result in the sale of certain of our product lines, the licensing of certain of our intellectual property to third parties, the sale of our entire business, or the sale of our debt or equity securities. The terms of such transactions, if any, may be unfavorable to our stockholders. A sale of less than our entire business may result in a surviving entity that is materially different from what we are today. A sale of our entire business may not provide adequate proceeds to both discharge our liabilities and provide a return to our stockholders. A financing transaction may be highly dilutive to existing stockholders, impose constraints on our operations, or otherwise have a negative impact on our share price. The availability of strategic options will depend, in part, on market conditions, and the outlook for us. If these transactions do not occur, we may have to delay development or commercialization of certain of our products, license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize, reduce our marketing, customer support or other resources devoted to our existing products, or otherwise cease certain or all of our operations.

We have a history of operating losses and may never achieve profitability.

We have not been profitable on a fiscal year basis since our inception in 1986. We incurred net losses of $1.0 million and $3.3 million in 2005 and 2004, respectively. As of June 30, 2006, we had an accumulated deficit of $50.7 million. We will continue to incur significant costs as we continue our efforts to develop and market our current systems and related applications. If we do achieve profitability in any period, we may not be able to sustain or increase our profitability on a quarterly or annual basis.

The detection, quantification and characterization of tumor cells in circulating blood involve complex and unproven technologies. Our CTC initiative may never become commercially successful.

We are developing a system for the detection, quantification and characterization of tumor cells in circulating blood. Some of the technologies involved are complex and unproven. The timing of the system’s development may not meet our expectations. It is possible that we may never be successful in developing a system. Successful development of a system will require us to optimize a protocol for the enrichment of tumor cells. Optimizing a protocol for the enrichment of tumor cells is an effort that entails adapting existing research technology for a clinical setting, a challenging effort that neither we nor our competitors have yet succeeded in accomplishing. We may have to partner with one or more parties in our efforts to develop and optimize the system. We are now assessing, testing and optimizing other cell selection and depletion technologies and methods with other partners. Such partnerships may not be on terms favorable to us. Even if we were successful in developing a system, we may not have sufficient resources to commercialize the system. We may have to engage one or more commercialization partners and such relationships may not result in returns adequate to justify our investment.

Our common stock is currently traded on the over-the-counter market, and the liquidity of our stock may be seriously limited.

We have been delisted from the Nasdaq Capital Market. Our common stock is currently traded on the over-the-counter bulletin board. Trading on the over-the-counter bulletin board may adversely impact our stock price and liquidity, and the ability of our stockholders to purchase and sell our shares in an orderly manner. Furthermore, the delisting of our shares could damage our general business reputation and impair our ability to raise additional funds.

We expect quarterly revenue and operating results to vary significantly in future periods, which could cause our stock price to fluctuate. If our operating results are below expectations, our stock price could drop.

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We have experienced significant fluctuations in our quarterly operating results, and we expect to continue to experience fluctuations in the future. Our customers, who are primarily public and private clinical laboratories, research organizations and hospitals, generally operate on annual budgets. Their budgeting cycles and spending practices affect our revenues. Factors that may have an influence on our operating results in any particular quarter include:

• demand for our products,

• seasonality of our sales,

• accounting, tax, consulting and other professional fees,

• new product introductions by us or our competitors, and the costs and time required for a transition to the new products,

• delays in the timing of introduction of new products, systems or applications due to longer research and development cycles than anticipated,

• changes in the amount of reimbursement to our customers by insurance companies and other third parties for tests conducted on our systems,

• timing of orders and shipments for capital equipment sales,

• our mix of sales between our distributors and our direct sales force,

• competition, including pricing pressures,

• timing and amount of research and development expenses, including clinical and pre-clinical trial-related expenditures,

• foreign currency fluctuations, and

• delays between our incurrence of expenses to develop new products, including expenses related to marketing and service capabilities, and the timing of sales and payments received for the new products.

In addition, because we develop applications for our imaging systems, a delay in the release of a system would result in the delay of applications for the system.

It is possible in the future that our operating results will be below the expectations of public market analysts and investors. If our operating results fall below market expectations, the price of our common stock could drop significantly.

Our operating and capital expenditures are difficult to predict and can depend on a number of factors that are not entirely within our control.

The exact timing and amount of our operating and capital spending cannot be accurately determined and will depend on several factors, including:

• market acceptance and demand for our products,

• competing technological and market developments,

• progress of our research and development efforts and planned clinical investigations, and

• commercialization of products currently under development by us and our competitors.

We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, clinical investigations, working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular, are expected to include development of additional applications for our current cytogenetic and OncoPath^™ systems, as well as a system to detect circulating tumor cells which will likely require additional funds.

Our internal controls and procedures for financial reporting may not ensure that our public filings include timely and reliable financial information.

The effectiveness of our controls and procedures is limited by a variety of factors including:

• faulty human judgment and simple error, omissions or mistakes,

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• fraudulent action of an individual or collusion of two or more people,

• inappropriate management override of procedures, and

• the possibility that our enhanced controls and procedures may still not be adequate to assure timely and accurate information.

If we fail to maintain effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and accurate financial information, be subject to, civil and criminal sanctions. By way of example, in March 2005, as a result of an internal investigation by our Audit Committee, we restated our consolidated financial statements for the years ended December 31, 2003 and 2002 and for the quarters ended March 31, 2004 and June 30, 2004 to reflect adjustments to our previously reported financial information. Also, as a result of the investigation, we were unable to timely file the Form 10-Q for the quarter ended September 30, 2004 or to announce our financial results for that period.

The marketing and sale of our products requires regulatory approval and on-going certifications. Failure to obtain and maintain required regulatory approvals and certifications could prevent or delay our ability to market and sell our products and may subject us to significant regulatory fines or penalties.

The FDA regulates design, testing, manufacturing, labeling, distribution, marketing, sales and service of our products. Our products are marketed in the United States according to premarket notifications to the FDA under Section 510(k) of the Food, Drug and Cosmetic Act.

Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. The FDA’s 510(k) clearance process usually takes from three to twelve months, but may take longer. The premarket approval process generally takes from one to three years from the time FDA files the application, but it can be significantly longer and can be significantly more expensive. Although we have obtained the necessary 510(k) clearance for our products, our 510(k) clearance can be revoked if safety or effectiveness problems develop.

We may need to seek additional regulatory approval for clearances if we modify existing products or intend to market other products under development and cannot be certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. If the FDA requires us to seek 510(k) clearance or premarket approval for any modification to a previously cleared product, we also may be required to cease marketing or recall the modified device until we obtain such clearance or approval. Delays in obtaining clearances or approvals will adversely affect our ability to market and sell our products and may subject us to significant regulatory fines or penalties, which would result in a decline in revenue and profitability. We have in the past received, and may in the future receive, warning letters from the FDA related to improper promotion of an unapproved use of our products. As a result of such warning letters, the FDA could request that we modify our promotional materials or could subject us to regulatory enforcement actions, including injunction, seizure, civil fine and criminal penalty.

Intellectual property litigation, can be costly, lead to payment of substantial damages or royalties and/or prevent us from manufacturing and selling our current and future products.

The medical diagnostic equipment industry, in general, is extremely competitive. Litigation among the participants regarding patent and other intellectual property rights is common. For example, in February 2004, we were sued by Clarient, Inc. The lawsuit claimed that our Ariol system infringed on three Clarient patents. Clarient sought damages, as well as an injunction barring us from, among other things, making, using, or selling any device in the United States that used Clarient’s patents-in-suit. The case settled in March 2005. Whether or not intellectual property infringement claims have merit, they are time consuming and expensive to litigate and divert the attention of technical and management personnel from other work. We may be involved in other litigation to defend against claims of infringement, to enforce our patent rights or to protect our trade secrets. If any other party’s claims are upheld in any litigation or administrative proceeding, we could be prevented from exploiting the subject matter of those claims or forced to obtain licenses from the patent owners or to redesign our products or processes to avoid infringement. In the event of any infringement by us, we cannot assure you that we will be able to successfully redesign our products or processes to avoid infringement. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling our products and could require us to pay substantial damages and/or royalties and/or prevent us from manufacturing and selling our current and future products.

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Our success depends, in part, on our ability to protect our intellectual property rights. We could lose sales and our competitive advantage could be harmed if we are not able to prevent infringement of our intellectual property rights.

We rely primarily on trade secret protection and on our unpatented proprietary know-how in the development and manufacturing of our products. Our trade secrets or proprietary technology could become known or be independently developed by our competitors. In addition, the patents we hold may not be sufficiently broad to protect what we believe to be our proprietary rights. Our issued patents could also be disallowed, challenged or circumvented by our competitors.

We cannot assure you that competitors or other parties have not filed or in the future will not file applications for, or have not received or in the future will not receive, patents or obtain additional proprietary rights relating to products or processes used or proposed to be used by us. In that case, our competitive position could be harmed and we may be required to obtain licenses to patents or proprietary rights of others.

The market for medical diagnostic equipment for cancer, prenatal and other genetic tests is extremely competitive. Our competitors may succeed in developing products and obtaining related regulatory approvals faster than us.

The medical diagnostic equipment industry is highly competitive and competition is likely to intensify. Certain of our competitors have greater financial and technical resources and production and marketing capabilities than us. We cannot assure you that these competitors will not succeed in developing technologies and products that are more effective, easier to use or less expensive than those which are currently offered or being developed by us or that would render our technology and products obsolete and noncompetitive. In addition, some of our competitors have significantly greater experience than we have in conducting clinical investigations of new diagnostic products and in obtaining FDA and other regulatory clearances and approvals of products. Accordingly, our competitors may succeed in developing and obtaining regulatory approvals for such products more rapidly than us.

We operate in a consolidating industry which creates barriers to our market penetration.

The healthcare industry in recent years has been characterized by consolidation. Large hospital chains and groups of affiliated hospitals prefer to negotiate comprehensive supply contracts for all of their supply needs at once. Large suppliers can often equip an entire laboratory and offer these hospital chains and groups “one-stop shopping” for laboratory instruments, supplies and services. Larger suppliers also typically offer annual rebates to their customers based on the customer’s total volume of business with the supplier. The convenience and rebates offered by these larger suppliers are administrative and financial incentives that we do not offer our customers. The success of our future plans will depend in part on our ability to overcome these and any new barriers resulting from continued consolidation in the healthcare industry.

Any disruption or delay in the supply of components or custom subassemblies could require us to redesign our products or otherwise delay our ability to assemble our products, which could cause our sales to decline and result in continued net losses.

We assemble our products from a combination of (i) commodity technology components, such as computers and monitors, (ii) custom subassemblies, such as automated filter wheels, (iii) proprietary hardware for scanning microscopy and (iv) operating systems and proprietary applications software. While we typically use components and subassemblies that are available from alternate sources, any unanticipated interruption of the supply of these components or subassemblies could require us to redesign our products or otherwise delay our ability to assemble our products, which could cause our sales to decline and result in continued net losses.

If we fail to comply with Quality System Regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer.

Our manufacturing processes and those of our suppliers are required to comply with the FDA’s Quality System Regulation, or QSR, which covers the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our products. The FDA enforces the QSR through inspections. We were subject to a QSR inspection in December 2001 and May 2003, as a result of which, the FDA made observations to which we responded. Following our response, the FDA informed us that it did not intend to take further action. We may be inspected in the future and we cannot assure you that we would pass any future inspections. If we fail a QSR inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to a QSR inspection could force a shutdown of our manufacturing operations and a recall of our products, which would cause our product sales and profitability to suffer.

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The marketing and sale of our products outside of the United States is subject to regulations, which vary from those in the United States. Failure to obtain and maintain required regulatory approvals could prevent or delay our ability to market and sell our products in international markets.

The regulatory environment for testing, manufacturing, labeling, distributing, marketing and sale of our products varies from country to country. Currently, some of our products, and modifications to these products, may be subject to pre-market approval in selected countries that are members of the European Union. Our products, and modifications to these products, are also subject to other regulatory requirements in those and other countries. Our failure to comply with applicable regulatory requirements could result in fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

Our products have been classified in Europe as In Vitro diagnostic devices (“IVDs”), which are regulated under a different standard than medical devices. As such, our products are subject to the requirements of the In Vitro Diagnostic Medical Device Directive (IVDD). An IVD is defined as a device which is a reagent, reagent product, kit, instrument, equipment or system, whether used alone or in combination, intended by the manufacturer to be used in vitro for the examination of samples derived from the human body with a view to providing information on a physiological state, state of health or disease, or congenital abnormality. IVDs are specifically excluded from the provisions of the Medical Device Directive (“MDD”), although IVDs are subject to equally stringent but different controls under the IVDD and other directives. If it is determined that our products are marketed as or intended to be issued as equipment that can produce therapeutic effects or alleviate the symptoms of any disability, injury or illness, the equipment may then fall within the scope of the MDD and product registration and appropriate documentation, including possible clinical trials would be required prior to commercialization. That same medical equipment, if also intended and promoted by us for use in the examination of samples derived from the human body with a view to providing information on a physiological state, state of health or disease, or congenital, abnormality, would also be regulated under the IVDD, requiring performance data, including where appropriate, analytical sensitivity, diagnostic sensitivity, analytical specificity, diagnostic specificity, accuracy, repeatability and reproducibility.

Although our products are currently regulated under the IVDD, European regulatory authorities may independently interpret our marketing and promotional claims as falling within the scope of the MDD, and require us to comply with its differing requirements, including substantiating any therapeutic claims. A redefinition could harm our marketing and sales if we were restricted from marketing or selling our products until we are able to comply with the MDD. Moreover, a member state of the EU or any other European country could adopt other laws or regulations that require approval to market and sell our products.

We depend on distributors to sell our products outside of North America. Sales through our distributors may be lower than direct sales efforts.

We rely substantially on independent distributors and sales agents to market and sell our products outside of North America. We cannot assure you that distributors and agents will devote adequate resources to support sales of our products.

Our international sales and operations are a significant portion of our business. Changes in international markets and currency fluctuations could lead to a decline in our revenues or result in continued net losses.

We have significant international operations based in the United Kingdom. As of June 30, 2006, 27 employees, constituting approximately 42% of the total number of our employees, were based outside the United States. We generate a substantial portion of our revenues from outside of the United States. In 2005 and 2004, we derived approximately 35% and 45% of our total revenues, respectively, from our customers and distributors outside of North America. We expect that international sales will continue to account for a significant portion of our revenues.

The international nature of our business subjects us and our representatives, agents and distributors to laws and regulations of the jurisdictions in which we operate and sell our products. Changes in overseas economic conditions, currency exchange rates, foreign tax laws or tariffs or other trade regulations could have an adverse effect on our financial condition or results of operations. For example, most of our international sales are denominated in U.S. dollars, U.K. pounds sterling or Euros. We do not attempt to reduce the risk of currency fluctuations by hedging. Currency fluctuations against the U.S. dollar could substantially reduce our U.S. dollar revenue or increase our costs. Changes in currency exchange rates could also make the products of our competitors less expensive than ours, which could result in our customers purchasing our competitors’ products instead of ours.

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Export controls could prevent us from exporting our products to foreign countries or customers, which could cause our sales to decline and result in continued net losses.

Our research, investigational and clinical products are subject to regulation by U.S. Department of Commerce export controls, primarily as they relate to the associated computers. These controls could prevent us from exporting our products to certain countries or customers, which could cause our sales to decline and result in continued net losses.

Our customers rely substantially on the availability of third-party reimbursement. Our customers’ failure to obtain sufficient reimbursement from third-party payors could cause our sales and the future growth of our business to decline.

Hospitals, physicians and other health care providers in the United States that purchase our products generally rely on third-party payors and other sources for reimbursement of health care costs to reimburse all or part of the cost of the procedures in which our products are used. If hospitals, physicians and other health care providers are unable to obtain adequate reimbursement from third-party payors for the procedures in which our products or products currently under development are intended to be used, our sales and future growth of our business could be adversely affected.

Market acceptance of our products and products under development in countries outside of the United States is also dependent on availability of reimbursement within prevailing health care payment systems in those countries. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance. We cannot assure you that we will be able to obtain international reimbursement approvals in a timely manner, if at all. Failure to receive international reimbursement approvals could harm the market acceptance of our products in the international markets in which such approvals are sought.

We depend on key technical, scientific and management personnel. Any difficulty in retaining our current employees or in hiring new employees could harm our ability to maintain and build our business operations.

Our future success depends in significant part upon the continued service of key scientific, technical and management personnel, and our continuing ability to attract and retain them. Competition for these personnel is intense and we cannot assure you that we can retain our key scientific, technical and managerial personnel or that we can attract or retain other highly qualified scientific, technical and managerial personnel in the future. Our key employees include Robin Stracey, our President and Chief Executive Officer, Terence Griffin, our Chief Financial Officer, and Diane Day, our Corporate Vice President-Regulatory, Quality and Clinical Affairs.

We have taken steps to retain our key employees, including the granting of stock options that vest over time, and we have entered into employment agreements with key employees. The loss of key personnel, especially if without advance notice, or the inability to hire or retain qualified personnel, could harm our ability to maintain and build our business operations. Furthermore, we have no key man life insurance on any of our key employees.

In addition, some companies have adopted a strategy of suing or threatening to sue former employees and their new employers to discourage those employees from leaving. As we hire new employees from our current or potential competitors, we may become a party to one or more lawsuits involving our employees. Any future litigation against us or our employees, regardless of the merit or outcome, may result in substantial costs and expenses to us and may divert management’s attention away from the operation of our business.

Undetected errors or failures in our software could result in loss or delay in the market acceptance for our product, lost sales or costly litigation.

Our existing products and products under development involve one or more software components that facilitate the detection of chromosomal, genetic or protein abnormalities through the interaction of certain imaging algorithms with the sample under examination. This software, including any new versions that may be released, may contain undetected errors or failures. We cannot assure you that, despite testing by us and our customers, all errors will be found in the software components of our products. Errors in our software could result in loss or delay in the market acceptance for our products, lost sales or costly litigation.

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A successful products liability claim brought in excess of our insurance coverage could require us to pay substantial damages and result in harm to our business reputation.

The manufacture and sale of our products involve the risk of product liability claims. We cannot assure you that the coverage limits of our insurance policies will be adequate in the event we are successfully sued. We evaluate our coverage limits on a regular basis and in connection with the introduction of products currently under development. However, liability insurance is expensive and may not be available on commercially reasonably terms, if at all, or in sufficient coverage amounts to cover all eventualities. A successful claim brought against us in excess of our insurance coverage could require us to pay substantial damages and result in harm to our business reputation.

A small number of our stockholders, together with our officers and directors have substantial control over our stock and could delay or prevent a change in corporate control.

Four of our stockholders who are institutions beneficially own over 43% of our outstanding common stock. Officers and directors as a group beneficially own 7% of our stock as of March 14, 2006. These stockholders will, to the extent they act together, have the ability to exert significant influence and control over matters requiring the approval of our stockholders. Their interests may be different from yours. Matters that typically require stockholder approval include: (i) election of directors; (ii) approval of a merger or consolidation; and (iii) approval of a sale of all or substantially all of our assets. Accordingly, you may not be able to influence any action we take or consider taking, even if it requires a stockholder vote.

Our stock price has been volatile. It will likely be volatile in the future. You could lose all or a portion of your investment.

The market prices for securities, generally, and for medical diagnostic instrument companies, in particular, including our common stock, have historically been highly volatile. Investment in our common stock is risky, and you could lose all or part of your investment. Many factors could cause the market price of our stock to fluctuate, perhaps substantially, including the announcement of:

• an Audit Committee investigation,

• our need to seek additional funding in the near future to maintain our operations as planned,

• material weakness in our internal controls or procedures,

• technological innovations or new competitor products,

• developments concerning proprietary rights, including patents and litigation matters,

• publicity regarding actual or potential results with respect to products under development,

• regulatory developments in the United States or other countries,

• changes or potential changes in reimbursement rates to our customers,

• developments in relationships with partners or distributors,

• public concern as to the safety of new technologies, or

• changes in financial estimates by securities analysts or our failure to meet those estimates,

In addition, changes in our operating results may cause the market price of our common stock to fluctuate.

Any future sale of a substantial number of shares eligible for resale could depress the trading price of our stock, lower our value and make it more difficult for us to raise capital.

According to Forms 4, 13D and 13G filed by our stockholders, approximately 2.8 million shares of our common stock, stock options and warrants (representing approximately 43% of the total shares outstanding) are held by affiliates. Should anyone of our affiliates sell any or all of their holdings in our common stock, it may have the effect of depressing the trading price of our common stock. In addition, such sales could lower our value and make it more difficult for us to raise capital.

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Our preferred shares rights plan, certificate of incorporation, bylaws and Delaware law contain provisions that could prevent or delay a takeover of Applied Imaging and negatively impact shareholder value.

On May 28, 1998, we adopted a preferred shares rights plan. The purpose of the plan is to assure fair value in the event of a future unsolicited business combination or similar transaction involving Applied Imaging. If an individual or entity accumulates or solicits a tender or exchange offer for 20% of our common stock, or 25% in the case of Special Situation Funds and affiliates, the rights become exercisable for additional shares of our preferred stock. The intent of these rights is to encourage a potential acquirer to negotiate with our Board of Directors to increase the consideration paid for our stock. The existence of this plan, however, may deter a potential acquirer, which could negatively impact stockholder value. We also are authorized to issue 6,000,000 shares of undesignated preferred stock, which we may issue without stockholder approval and upon such terms as our Board of Directors may determine.

In addition, our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. Any of these provisions might discourage, delay or prevent a change in the control of Applied Imaging or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

Changes in, or interpretations of, accounting principles, such as expensing of stock options, could result in unfavorable accounting charges.

We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting principles. A change in these principles can have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting principles that recently have been or may be affected by changes in the accounting principles are as follows:

• software revenue recognition

• accounting for share-based payments

• accounting for business combinations and related goodwill

In particular, the FASB recently issued SFAS 123R which requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. The accounting provisions of SFAS 123R are effective for annual periods beginning after June 15, 2005. We are required to adopt SFAS 123R in the first quarter of fiscal year 2006. We believe that the adoption of SFAS 123R will have a significant adverse effect on our reported financial results and may impact the way in which we conduct our business. Please refer to the section entitled “Recent Accounting Pronouncements” for further information regarding SFAS 123R.

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds
	None.
ITEM 3.	Defaults Upon Senior Securities
	None.
ITEM 4.	Submission of Matters to a Vote of Security Holders

We held our Annual Meeting of Stockholders on May 16, 2006. At our 2006 Annual Meeting the following matters were voted:

Elected the following individuals as Class I directors to serve for terms of three years on our Board of Directors until our 2009 Annual Meeting of Stockholders or until their successors are duly qualified and elected:

Proposal	Name	Yes	Withheld
Proposal 1	Carl W. Hall	4,183,241	70,708
	Robin Stracey	4,173,890	61,357

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Approved the adoption of the Company’s 2006 Employee Stock Purchase Plan (the “2006 Purchase Plan”) and reservation of a total of 175,000 shares of common stock for purchase under the 2006 Purchase Plan.

Proposal	Yes	No	Abstain	Broker Non Vote
Proposal 2	1,580,697	119,610	2,621	2,541,670

Approved an amendment to the Company’s 1998 Stock Plan, as amended, to increase the aggregate number of shares of common stock authorized for issuance there under by 300,000 shares.

Proposal	Yes	No	Abstain	Broker Non Vote
Proposal 3	1,612,459	88,173	2,296,000	2,541,670

Ratified the appointment of Burr, Pilger & Mayer LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2006.

Proposal	Yes	No	Abstain	Broker Non Vote
Proposal 4	4,202,173	37,420	5,005	—

ITEM 5. Other Information

On August 10, 2006, our board of directors clarified our Retention Incentive Program effective October 19, 2001, as amended on February 13, 2002. In particular, the board clarified the definition of an “Officer” under the program. A copy of the program, as clarified, is attached hereto as Exhibit 10.65.

Item 6. Exhibits.

(a) Exhibits.

Exhibit No.	Description
10.65	Retention Incentive Program, as clarified on August 10, 2006
31.1	Chief Executive Officer’s Certification Pursuant to 15 U.S.C. Section 7241
31.2	Chief Financial Officer’s Certification Pursuant to 15 U.S.C. Section 7241
32.1	Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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APPLIED IMAGING CORP.

SIGNATURES

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

	APPLIED IMAGING CORP.             (Registrant)
Date: August 14, 2006	By:	/S/ ROBIN STRACEY
		Robin Stracey
		Chief Executive Officer

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