a5833936.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

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

For the transition period from to

Commission File Number 0-10832

AFP Imaging Corporation

(Exact Name of Registrant as Specified in Its Charter)

New York		13-2956272
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

250 Clearbrook Road, Elmsford, New York		10523
(Address of Principal Executive Offices)		(Zip Code)

914-592-6100

(Registrant's Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No____

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

Large accelerated filer_____	Accelerated filer______		Non-accelerated filer_____
		(Do not check if a smaller reporting company)
Smaller reporting company __X___

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

The registrant had 17,928,800 shares of its common stock outstanding as of November 10, 2008.

AFP Imaging Corporation

Table of Contents

		Page

Part I.	Financial Information

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets as of September 30, 2008 (unaudited) and June 30, 2008	4

	Condensed Consolidated Statements of Operations for the three months ended September 30, 2008 and 2007 (unaudited)	5

	Condensed Consolidated Statements of Shareholders’ Equity for the three months ended September 30, 2008 and 2007 (unaudited)	6

	Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2008 and 2007 (unaudited)	7

	Notes to Consolidated Interim Financial Statements	8-14

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15-21

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	21

Item 4T.	Controls and Procedures	21-22

Part II.	Other Information

Item 1.	Legal Proceedings	23

Item 6.	Exhibits	23

Signatures		24-30

This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve known and unknown risks and uncertainties and other factors that could cause the actual results of AFP Imaging Corporation (collectively with its subsidiaries, the “Company”) or achievements expressed or implied by such forward-looking statements to not occur, not be realized or differ materially from that stated in such forward-looking statements. Forward-looking statements may be identified by terminology such as “plan,” “may,” “will,” “could,” “would,” “project,” “expect,” “believe,” “estimate,” “anticipate,” ”intend,” “continue,” “potential,” “opportunity” or similar terms, variations of such terms, or the negative of such terms or variations. Potential risks, uncertainties and factors include, but are not limited to:

●	adverse changes in general economic conditions,

●	the Company’s ability to cure the default situation with its senior secured lender,

●	the Company’s ability to repay its debts when due,

●	changes in the markets for the Company’s products and services,

●	the ability of the Company to successfully design, develop, manufacture and sell new products,

●	the Company’s ability to successfully market its existing and new products,

●	adverse business conditions,

●	changing industry and competitive conditions,

●	the effect of technological advancements on the marketability of the Company’s products,

●	the Company’s ability to protect its intellectual property rights and/or where its intellectual property rights may infringe on the intellectual property rights of others,

●	maintaining operating efficiencies,

●	pricing pressures,

●	risks associated with foreign sales,

●	risks associated with the loss of services of the key executive officers,

●	the Company’s ability to attract and retain key personnel,

●	difficulties in maintaining adequate long-term financing to meet the Company’s obligations and fund the Company’s operations,

●	changes in the nature or enforcement of laws and regulations concerning the Company’s products, services, suppliers, or customers,

●	determinations in various outstanding legal matters,

●	the success of the Company’s strategy to increase its market share in the industries in which it competes,

●	the Company’s ability to successfully integrate the operations of any entity acquired by the Company with the Company’s operations,

●	changes in currency exchange rates and regulations, and

●	other factors set forth in this Quarterly Report on Form 10-Q, and the Company’s Annual Report on Form 10-K for the year ended June 30, 2008, and from time to time in the Company’s other filings with the Securities and Exchange Commission.

Readers are urged to carefully review and consider the various disclosures made by the Company in this Quarterly Report on Form 10-Q, the Company’s Annual Report on Form 10-K for the year ended June 30, 2008, and the Company’s other filings with the SEC. These reports attempt to advise interested parties of the risks and factors that may affect the Company’s business, financial condition and results of operations and prospects. The forward-looking statements made in this Form 10-Q speak only as of the date hereof and the Company disclaims any obligation to provide updates, revisions or amendments to any forward-looking statements to reflect changes in the Company’s expectations or future events.

PART I

FINANCIAL INFORMATION

The consolidated financial statements included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. While certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations, the Company believes that the disclosures made herein are adequate to make the information presented not misleading. It is recommended that these consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 2008.

In the opinion of the Company, all adjustments necessary to present fairly the Company’s consolidated financial position as of September 30, 2008, and its results of operations for the three-month periods ended September 30, 2008 and 2007, and its cash flows for the three-month periods ended September 30, 2008 and 2007, consisting of normal recurring adjustments, have been included. The accompanying unaudited interim consolidated financial statements include all adjustments (consisting only of those of a normal recurring nature) necessary for a fair statement of the results of the interim periods.

Item 1: FINANCIAL STATEMENTS

AFP Imaging Corporation and Subsidiaries

Condensed Consolidated Balance Sheets – September 30, 2008 and June 30, 2008

Assets	September 30, 2008			June 30, 2008			Liabilities and Shareholders' Equity	September 30, 2008			June 30, 2008
	(Unaudited)							(Unaudited)
Current Assets:							Current Liabilities:
Cash and cash equivalents	$	469,495		$	819,444		Current portion of long-term debt	$	9,678,116		$	8,578,056
Accounts receivable, less allowance for doubtful accounts of $870,049 and $919,483, respectively		2,812,008			4,281,796		Accounts payable		3,676,746			3,557,357
							Accrued expenses and other current liabilities		2,579,715			3,525,308
							Deferred revenue		330,000			822,000
							Total current liabilities		16,264,577			16,482,721
Inventories		6,964,684			6,950,129
Prepaid expenses and other current assets		311,019			557,947		Deferred liabilities		278,595			718,358
Deferred income taxes		51,108			76,921		Long-term debt		20,809			22,957
Total current assets		10,608,314			12,686,237		Total liabilities		16,563,981			17,224,036

							Commitments and Contingencies (Note 9)

Property and equipment							Shareholders’ Equity:
At cost		2,264,890			2,252,099		Preferred stock - $.01 par value; authorized
Less accumulated depreciation		(1,835,315	)		(1,778,510	)	5,000,000 shares, none issued		-			-
		429,575			473,589		Common stock, $.01 par value; authorized
							30,000,000 shares, issued and outstanding
							17,928,800 shares at September 30, 2008,
							and June 30, 2008		179,288			179,288
Deferred income taxes		485,761			466,022		Common stock warrants		91,131			91,131
Other assets		161,425			323,813		Paid-in capital		25,444,176			25,444,176
Goodwill		3,981,878			4,453,627		Accumulated deficit		(25,142,136	)		(21,809,709	)
Other intangibles, net		2,568,612			2,997,551		Cumulative translation adjustment		1,099,125			271,917
							Total shareholders’ equity		1,671,584			4,176,803

							Total Liabilities and Shareholders’
Total Assets	$	18,235,565		$	21,400,839		Equity	$	18,235,565		$	21,400,839

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

AFP Imaging Corporation and Subsidiaries

Condensed Consolidated Statements of Operations

(Unaudited)

	Three Months Ended September 30,

	2008			2007

Net sales	$	6,648,264		$	7,448,055

Cost of sales		3,846,432			4,355,416

Gross profit		2,801,832			3,092,639

Selling, general and administrative expenses		3,571,353			3,111,501
Amortization of intangibles		118,854			288,454
Research and development expenses		480,465			433,997
		4,170,672			3,833,952

Operating loss		(1,368,840	)		(741,313	)

Foreign currency (loss)/gain on intercompany note		(1,362,375	)		577,123

Interest expense, net		1,057,637			253,659

Loss before provision for income taxes		(3,788,852	)		(417,849	)

(Benefit)/provision for income taxes		(456,425	)		295,662

Net loss	$	(3,332,427	)	$	(713,511	)


Net loss per common share:
Basic	$	(.19	)	$	(.04	)
Diluted	$	(.19	)	$	(.04	)

Weighted average shares outstanding common stock:
Basic		17,928,800			17,928,800
Diluted		17,928,800			17,928,800

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

AFP Imaging Corporation and Subsidiaries Condensed Consolidated Statements of Shareholders’ Equity For the Three Months Ended September 30, 2008 and 2007 (Unaudited)
	Comprehensive Loss			Common Stock		Common Stock Warrants		Paid-in-Capital		Accumulated Deficit			Foreign Currency Translation Adjustment			Total
Balance June 30, 2007	$	--		$	179,288	$	91,131	$	25,404,045	$	(10,760,543	)	$	(38,488	)	$	14,875,433
Foreign currency translation gain		187,872			--		--		--		--			187,872			187,872
Net loss for three months ended September 30, 2007		(713,511	)		--		--		--		(713,511	)		--			(713,511	)
Comprehensive loss		(525,639	)		--		--		--		--			--			--
Balance September 30, 2007	$	--		$	179,288	$	91,131	$	25,404,045	$	(11,474,054	)	$	149,384		$	14,349,794




Balance June 30, 2008	$	--		$	179,288	$	91,131	$	25,444,176	$	(21,809,709	)	$	271,917		$	4,176,803
Foreign currency translation gain		827,208			--		--		--		--			827,208			827,208
Net loss for three months ended September 30, 2008		(3,332,427	)		--		--		--		(3,332,427	)		--			(3,332,427	)
Comprehensive loss		(2,505,219	)		--		--		--		--			--			--
Balance September 30, 2008	$	--		$	179,288	$	91,131	$	25,444,176	$	(25,142,136	)	$	1,099,125		$	1,671,584

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

AFP Imaging Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

	Three Months Ended September 30,

	2008			2007
Cash flows from operating activities:
Net loss	$	(3,332,427	)	$	(713,511	)
Adjustments to reconcile net loss to net cash used by operating activities-
Depreciation and amortization		342,516			372,133
Amortization of discount on term loan		861,626			50,316
Provision for bad debts on accounts receivable		(5,000	)		---
Exchange rate effect on intercompany note		1,362,375			(554,120	)
Deferred income taxes		(482,651	)		---
Change in assets and liabilities:
Decrease in accounts receivable		1,315,856			876,387
Increase in inventories		(205,641	)		(615,505	)
Decrease/(increase) in prepaid expenses and other assets		9,108			(13,300	)
Increase in accounts payable		326,675			249,302
(Decrease) in accrued expenses and other current liabilities		(551,203	)		(325,169	)
(Decrease) in deferred liabilities		(502,339	)		(11,833	)
Total adjustments		2,471,322			28,211

Net cash used by operating activities		(861,105	)		(685,300	)

Cash flows from investing activities:
Purchases of property and equipment		(19,402	)		(37,077	)

Net cash used in investing activities		(19,402	)		(37,077	)

Cash flows from financing activities:
Borrowing of debt		626,748			355,345
Repayment of debt		(94,486	)		---

Net cash provided by financing activities		532,262			355,345

Exchange rate effect on cash and cash equivalents		(1,704	)		187,872

Net decrease in cash and cash equivalents		(349,949	)		(179,160	)

Cash and cash equivalents, at beginning of period		819,444			921,632

Cash and cash equivalents, at end of period	$	469,495		$	742,472


Supplemental cash flow disclosures: Cash paid during the periods for-
Interest	$	185,567		$	247,038
Income taxes, net of refunds	$	226,648		$	466,762

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

AFP Imaging Corporation and Subsidiaries

Notes to Consolidated Financial Statements

September 30, 2008

(Unaudited)

(1) General:

AFP Imaging Corporation (together with its subsidiaries, the “Company”) was organized on September 20, 1978 under the laws of the State of New York. Since such date, the Company has been engaged in the business of designing, developing, manufacturing and distributing equipment for generating and/or capturing medical and dental diagnostic images. The products utilize electronic and radiographic technologies, as well as the chemical processing of photosensitive materials. The Company is ISO 9001 certified. Medical, dental, veterinary and industrial professionals use these products. The Company’s products are sold and distributed to worldwide markets under various brand names and trademarks through a network of independent and unaffiliated dealers and independent sales representatives. The Company has one business segment – medical and dental x-ray imaging.

The Company’s primary objective is to be a leading provider of cost effective, diagnostic radiographic products for applications in the medical, dental, veterinary and industrial imaging fields. The Company is concentrating on:

●	continually broadening its product offerings in the transition from x-ray film to electronic imaging,

●	enhancing both its domestic and international distribution channels, and

●	expanding its worldwide market presence in the diagnostic dental and medical imaging fields.

On April 19, 2007, the Company completed the acquisition of Quantitative Radiology srl, an Italian corporation (“QR”), by acquiring all of the outstanding share capital of QR from its shareholders. QR is a global supplier of state-of-the-art, in-office three-dimensional dental and medical computed tomography (CT). QR uses an imaging technology that features a cone shaped beam of x-rays (a CBCT scanner). The Company, prior to April 19, 2007, had acted as QR’s exclusive distributor in North and South America, excluding Brazil.

The Company presently believes that its senior secured credit facility and foreign lines of credit will not be sufficient to finance the Company’s ongoing worldwide working capital requirements for the next twelve months. As previously disclosed, the Senior Secured Lender agreed to lend to the Company an aggregate of up to $8 million in the form of a $5 million term loan and a $3 million revolving loan facility (“Revolver”). The Company’s aggregate outstanding advances under the Revolver exceed the maximum revolving credit commitment permissible under the Loan Agreement as a direct result of additional borrowings made by the Company under the Revolver to pay the term loan principal and interest charges and revolver interest charges for August, September and October 2008. The Company is in default under the Revolving Credit and Term Loan Agreement with respect to the Company’s obligation to repay the outstanding advances in excess of the permissible maximum. The Senior Secured Lender has not accelerated the Revolver. Additionally, the Company’s foreign subsidiary, QR, has failed to make payment with respect to certain invoices payable to one of its financial institutions pursuant to a line of credit agreement. The lender has notified QR that such invoices are past due, but has taken no further action at the present time in respect thereof. All of the Company’s debt, except for the capitalized lease, has been classified as a current liability in the accompanying consolidated financial statements.

The Company has instituted cost cutting measures to reduce its cash requirements. The Company is also currently in the process of seeking out additional financing alternatives, including potential private equity sales of its securities, or seeking out a domestic or foreign strategic and/or financial partner to negotiate a transaction to best serve their long-term goals and needs. There can be no assurance that the Company will be able to obtain any such financing upon favorable terms to the Company, or at all. In the event that the Company is unable to secure sufficient financing to maintain its operations, its business and financial condition would be materially adversely affected. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments regarding this uncertainty.

The consolidated financial statements include AFP Imaging Corporation and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.

The accounting policies followed during the interim periods reported on herein are in conformity with accounting principles generally accepted in the United States and are consistent with those applied for annual periods, as described in the Company's consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended June 30, 2008. The Condensed Consolidated Balance Sheet at June 30, 2008 has been derived from the audited financial statements.

Certain prior-period amounts have been reclassified to conform to the current-period presentation.

(2) Stock Option Plans:

Effective July 1, 2005, the Company adopted the fair value based method of accounting for stock-based employee compensation under the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004), Share Based Payment (“SFAS 123R”), using the modified prospective method without restatement of the interim periods prior to the adoption date, as described in SFAS 123R. As a result, the Company began recognizing expense in an amount equal to the fair value of share-based payments (including stock option awards) on their date of grant over the vesting period of the awards. Under SFAS 123R, the Company must recognize compensation expense for (1) all share-based payments granted on or after July 1, 2005 and (2) any partially vested options as of July 1, 2005. Prior to the adoption of SFAS 123R, the Company accounted for these plans pursuant to Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees. Therefore, compensation expense related to stock option awards was not reflected in operating expenses in any period prior to July 2005 (first quarter of Fiscal Year 2006), and prior period results have not been restated. For the three months ended September 30, 2008 and September 30, 2007, no incentive stock options were granted, and therefore, there was no non-cash stock based compensation expense related to stock option awards.

When granting incentive stock options, the fair value of each option granted under the Company’s incentive stock plans is estimated on the date of grant using the Black-Scholes option pricing method. Using this model, fair value is calculated based on assumptions with respect to (a) expected volatility of the market price of Company common stock, (b) the periods of time over which employees, directors and other option holders are expected to hold their options prior to exercise (expected lives), (c) expected dividend yield on Company common stock and (d) risk-free interest rates which are based on quoted US Treasury rates for securities with maturities approximating the options’ expected lives. Expected volatility has been estimated based on actual movements in the Company’s stock price over the most recent historical period’s equivalent to the options’ expected lives. Expected lives are principally based on the Company’s limited historical exercise experience with option grants with similar prices. The expected dividend yield is zero as the Company has never paid dividends and does not currently anticipate paying any dividends in the foreseeable future.

In April 2007, the Company granted an aggregate of 50,000 shares of Company common stock to an employee, half of which vested immediately and the remainder of which vested in April 2008. These options were issued with a ten-year useful life.

(3) Per Share Data and Significant Capital Transactions:

The Company’s basic net loss per share amounts are calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is based upon the weighted average number of common shares and common share equivalents outstanding, when dilutive. Common stock equivalents include (1) outstanding stock options and (2) outstanding warrants.

The following is a reconciliation from basic to diluted shares for the three months ended September 30, 2008 and 2007:

	Three months ended September 30,
	2008		2007
Basic Shares		17,928,800		17,928,800
Dilutive:
Options		---		---
Warrants		---		---
Diluted Shares		17,928,800		17,928,800

The diluted weighted average number of shares outstanding for the three months ended September 30, 2008 and 2007 does not include the potential exercise of the following stock options and warrants as such amounts were anti-dilutive.

	Three months ended September 30,
	2008		2007
Options		862,400		868,900
Warrants		850,000		850,000
Diluted Shares		1,712,400		1,718,900

(4) Long and Short Term Debt:

On April 13, 2007, the Company entered into a new senior secured facility (“Revolving Credit and Term Loan”) with a new lender (“Senior Secured Lender”) that replaced the Company’s existing $2.5 million revolving line of credit that was due to expire on September 21, 2007. The Revolving Credit and Term Loan consists of a $5 million convertible term note and a $3 million revolving loan facility. The convertible term note bears interest at a rate of ten percent (10%) per annum and provides for repayment over five years commencing in November 2007 with a final balloon payment of all remaining amounts due there-under on April 30, 2012. The revolving loan bears interest at a rate of two percent plus prime rate per annum, has a specific formula to calculate available funds based on eligible accounts receivable and inventory, is subject to maximum “borrowing base” limitations, and has certain reporting requirements to the lender. The convertible term note, in addition to being convertible by the Company upon the satisfaction of certain conditions, is convertible by the lender at any time into shares of common stock at a conversion price of $2.37 per share or 2,109,705 shares based on the initial principal amount of the convertible term note.

The Company and each of its wholly-owned subsidiaries executed a collateral agreement pursuant to which each such party agreed to grant a security interest in all of its respective assets to the Senior Secured Lender as collateral security for repayment of the loans. The Revolving Credit and Term Loan is secured by all of the Company’s and its wholly-owned subsidiaries’ inventory, accounts receivable, equipment, officer life insurance policies and proceeds thereof, trademarks, licenses, patents and general intangibles.

The Company’s aggregate outstanding advances under the Revolver exceed the maximum revolving credit commitment permissible under the Loan Agreement as a direct result of additional borrowings made by the Company under the Revolver to pay the term loan principal and interest charges and revolver interest charges for August, September and October 2008. The Company is in default under the Revolving Credit and Term Loan Agreement with respect to the Company’s obligation to repay the outstanding advances in excess of the permissible maximum borrowings. The Senior Secured Lender has not accelerated the Revolver. As described in Note 1, factors exist that result in doubt as to the Company’s ability to continue as a going concern. The Company’s Revolving Credit and Term Loan Agreement contains a subjective acceleration clause and accordingly, all such debt has been classified as a current liability as of September 30, 2008 and June 30, 2008 in accordance with FASB Technical Bulletin No. 79-3 “Subjective Acceleration Clauses in Long-Term Debt Agreements”. As of September 30, 2008, the Company wrote-off the balance of the deferred financing costs related to this debt, approximately $152,250, which has been recorded as selling, general and administrative costs in the accompanying consolidated statements of operations, as the Company has not been able to successfully negotiate a waiver, a forbearance agreement or renegotiate this debt. The Company was in compliance with all other terms and conditions of the Revolving Credit and Term Loan Agreements as of June 30, 2008.

As part of the original transaction, the Company granted to the Senior Secured Lender an aggregate of 800,000 five-year warrants to purchase shares of the Company’s common stock at exercise prices per share equal to $1.85 with respect to 266,666 warrants, $2.02 with respect to an additional 266,666 warrants, and $2.19 with respect to the remaining 266,668 warrants. The Company classified the warrants as equity, using the Black-Scholes Method to value these detachable warrants. They have been recorded in the accompanying Consolidated Balance Sheets at $1,114,784.

The fair value of the warrants issued to the Senior Secured Lender is being treated as debt discount, and was originally accreted as interest expense utilizing the interest method over the 60-month term of the Term Loan. As the Company has reclassified this debt as a current liability and has not been able to successfully negotiate a waiver, a forbearance agreement or renegotiate this debt, the balance of the debt discount, approximately $808,701, has been completely accreted as interest expense in the accompanying consolidated statements of operations. The original assumptions used for the Black-Scholes option pricing model were as follows: a risk-free interest rate of 4.66%, an expected volatility of 123%, an expected life of five years, and no expected dividends. A summary of the balances of the Term Loan are as follows:

	September 30, 2008			June 30, 2008
Term Loan	$	5,000,000		$	5,000,000
Fair value of warrants (recorded as capital in excess of par)		(1,114,784	)		(1,114,784	)
Principal payments		(833,334	)		(740,741	)
Accretion of debt discount (recorded as interest expense)		1,114,784			253,158
Recorded value of Term Loan	$	4,166,666		$	3,397,633

QR has the ability to borrow up to 2,000,000 Euros under various lines of credit with two different financial institutions, and all such borrowings are classified as short term debt. Most of these lines are guaranteed by its accounts receivables and inventory. These lines of credit were granted in August 2007 and increased from 1,750,000 Euros to 2,000,000 Euros in April 2008. There were 1,868,948 Euros outstanding as of September 30, 2008 and 1,652,712 Euros outstanding as of June 30, 2008. The funds borrowed in Italy are guaranteed by specific outstanding accounts receivable and inventory, and the current rate of borrowing is a function of Euribor plus .75% to 1.5%. QR has failed to make payment with respect to certain invoices payable to one of its financial institutions pursuant to one of its line of credit agreements. The lender has notified QR that such invoices are past due, but has taken no further action at the present time in respect thereof.

As of September 30, 2008 and June 30, 2008, debt consisted of the following:

	September 30, 2008		June 30, 2008
Senior Secured Lender Term Loan, net of debt discount, where applicable	$	4,166,666	$	3,397,633
$3.0 Million Revolving Senior Credit Facility		2,871,957		2,569,952
Capitalized lease		29,010		30,903
Foreign line of credit borrowings		2,631,292		2,602,525
		9,698,925		8,601,013
Less current portion		9,678,116		8,578,056
Total long-term debt	$	20,809	$	22,957

At September 30, 2008, the Company had no unused lines of credit available.

Due to the short-term nature of all of the debt, as well as borrowing rates currently available to the Company, the fair market value of all of the Company's debt approximated its carrying value.

(5) Inventories:

Inventories, which include material, labor and manufacturing overhead, are stated at the lower of cost (first-in, first-out) or market (net realizable value). Inventory reserves are provided for risks relating to slow moving items. Demonstration equipment which is on consignment with customers is valued at cost, reduced for reductions in value due to technical obsolescence and/or wear and tear over periods up to five years. At September 30, 2008 and June 30, 2008, inventories, consisted of the following:

	September 30, 2008		June 30, 2008
Raw materials and sub-component parts	$	4,694,685	$	3,675,763
Work-in-process and finished goods		2,269,999		3,274,366
	$	6,964,684	$	6,950,129

(6) Income Taxes:

Income taxes are accounted for under the asset and liability method. Deferred income taxes are recorded for temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets reflect the tax rates expected to be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to reduce its deferred tax asset to an amount that is more likely than not to be realized. As of September 30, 2008, the Company has recorded net deferred tax assets of approximately $329,000 and as of June 30, 2008, net deferred tax liabilities of approximately $155,000, all of which relates to its foreign operations. The September 30, 2008 net deferred tax assets are comprised of approximately $537,000 of deferred tax assets and $208,000 of deferred tax liabilities. The June 30, 2008 net deferred tax liabilities are comprised of approximately $698,000 of deferred tax liabilities and $543,000 of deferred tax assets. The deferred tax liabilities are related to the previously recorded net unrealized exchange gain on the intercompany note denominated in U.S. dollars, as it will only be taxed when realized and when repayment is made; and the deferred tax assets are mainly related to the temporary differences on the intangible assets amortization.

The net tax benefit recorded for the period ended September 30, 2008 and net tax expense for the period ended September 30, 2007 include foreign taxes at the statutory rates on the Company’s foreign operations, changes to the deferred tax accounts, and state income and capital taxes generated in the United States. As of September 30, 2008, the Company had approximately $12.0 million in federal net operating loss carry forwards, and approximately $16.4 million in state net operating loss carry forwards. These NOL’s will begin to expire in 2010 and are subject to review by the Internal Revenue Service. Past and future changes in ownership of the Company as defined in Section 382 of the Internal Revenue Code, may limit the amount of NOL’s available for use in any one year.

Effective July 1, 2007, the Company adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”), Accounting for Uncertainties in Income Taxes – an interpretation of FASB Statement No. 109. In accordance with FIN 48, the Company classifies interest as a component of income tax expense. The implementation of FIN 48 had no impact on the Company’s financial statements, and no interest and penalties related to uncertain tax positions were accrued at September 30, 2008 and June 30, 2008.

(7) Intangible Assets and Goodwill:

On April 19, 2007 the Company acquired QR, an Italian corporation located in Verona, Italy. The carrying values of QR’s assets and liabilities were adjusted to their fair values on April 19, 2007 and the difference between the purchase price and the fair value of the net assets and liabilities was recorded as goodwill. The goodwill and intangible amounts are maintained in Euros on the subsidiary’s books and converted into US dollars at the respective exchange rate.

The Company performed the required annual impairment tests as of June 30, 2008, in accordance with FASB Statements No. 142, Goodwill and Other Intangibles, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The Company expressly tested the developed technologies and customer relationships for impairment and determined that there had been impairment of $5,615,880 in their respective values. The impairment was calculated by a comparison of the fair values of the assets, using discounted cash flows. The impairment charge was booked in the fourth quarter of Fiscal Year 2008.

The Company tested goodwill for impairment by a comparison of the fair value of the reporting unit to its respective carrying value and determined that there was no impairment to the carrying value as of June 30, 2008.

The following is a summary of the intangible assets subject to amortization:

June 30, 2008	Gross carrying amount		Impairment		Adjusted carrying amount		Accumulated amortization		Net
Developed technologies	$	6,159,856	$	4,006,292	$	2,153,564	$	1,053,564	$	1,100,000
Customer relationships		3,646,125		1,609,588		2,036,537		436,537		1,600,000
Non-compete contracts and other		389,044		---		389,044		91,493		297,551
Total	$	10,195,025	$	5,615,880	$	4,579,145	$	1,581,594	$	2,997,551

September 30, 2008	Gross carrying amount		Accumulated amortization		Net
Developed technologies	$	1,925,448	$	984,317	$	941,131
Customer relationships		1,820,816		441,976		1,378,840
Non-compete contracts and other		347,835		99,194		248,641
Total	$	4,094,099	$	1,525,487	$	2,568,612

Amortization for the three months ended September 30, 2008 and 2007 were $118,854 and $288,454, respectively.

The change in the value of the other intangibles from the date of acquisition to September 30, 2008, and the change in accumulated amortization include changes in the US Dollar/Euro exchange rates, which fluctuated during the periods. For the three months ended September 30, 2008 the impact was approximately $310,085 on the long-lived intangibles subject to amortization.

The changes in the carrying amount of goodwill are as follows:

For the period ended	Fiscal Year 2008		Three Months September 30, 2008
Balance as of July 1,	$	3,846,405	$	4,453,627
Foreign currency translation difference		607,222		(471,749	)
Balance as of September 30, 2008		---	$	3,981,878
Balance as of June 30, 2008	$	4,453,627		---

(8) Segment Information:

As of September 30, 2008 and 2007, and June 30, 2008, the Company had one business segment, medical and dental x-ray imaging. The medical and dental segment operations are conducted under the Dent-X, EVA, NewTom and AFP trade names and consist of the design, development, manufacturing, marketing and distribution of medical and dental x-ray imaging systems and all related accessories. The amortization and impairment of the intangibles associated with the acquisition of QR has been attributed to the Italian operations. Geographical financial information is as follows:

	Three months ended September 30,
	2008			2007
Net sales:
United States	$	3,665,634		$	3,674,784
Europe		1,918,879			1,821,114
Other		1,063,751			1,952,157
	$	6,648,264		$	7,448,055
Net (loss)/income
United States	$	(2,302,877	)	$	(1,311,202	)
Europe		(1,029,550	)		597,691
	$	(3,332,427	)	$	(713,511	)


	September 30, 2008			June 30, 2008
Identifiable assets:
United States	$	6,549,027		$	8,282,539
Europe		11,686,538			13,118,300
Total	$	18,235,565		$	21,400,839

(9) Commitments and Contingencies:

The Company is a defendant in an environmental claim relating to a property in New Jersey owned by the Company between August 1984 and June 1985. This claim relates to the offsite commercial disposition of trash and waste in a landfill in New Jersey. The Company maintains that its waste materials were of a general commercial nature. This claim was originally filed in 1998 by the federal government in United States District Court for the District of New Jersey, Newark Vicinage, citing several hundred other third-party defendants. The Company (through its former subsidiary, Kenro Corporation) was added, along with many other defendants, to the suit. The Company's claimed liability was potentially assessed by the plaintiff at $150,000. The Company joined, along with other involved defendants in an alternative dispute resolution (ADR) process for smaller claims. On May 7, 2008, a tentative mediated settlement was reached by all parties, and the Consent Decree memorializing the settlement is being negotiated by the governments and each group’s liaison counsel and is presently scheduled to be finalized by December 2008. The Company’s share is $82,880 of which the Company’s insurance carrier has agreed to pay 50% of the settlement offer. In October 2008, the Company and its insurance carrier each contributed $41,440 to the escrow account to settle this outstanding environment claim. The Company cannot, at this time, assess the amount of liability that could result if this settlement is not finalized. The Company's insurance carrier has agreed to equally share with the Company the defense costs incurred in this environmental claim.

On May 5, 2008, the Company and Dent-X International, Inc. commenced litigation in the United States District Court, Southern District of New York, against Genexa Medical, Inc. (“Genexa”) to recover $394,610 for goods sold and delivered to Genexa during the period from December 11, 2007 through March 13, 2008, after Genexa failed and refused to pay the amount due. On June 27, 2008, Genexa filed an Answer and Counterclaims alleging several causes of action which are potentially material. Although the Company intends to vigorously defend all such counterclaims, a determination as to the likelihood of Genexa prevailing on the merits with respect to such counterclaims is premature as of the date hereof. The case was scheduled for an initial conference before Judge Charles L. Brieant on July 25, 2008, but Judge Brieant passed away and the case was reassigned. In November 2008, both parties were instructed by the court to attempt to negotiate through a court appointed mediator. The next court date has been set for January 9, 2009. The Company intends to vigorously defend all counterclaims, however the Company cannot, at this time, assess the amount of liability that could result if there is an adverse decision.

The Company is involved in two other product liability claims; however, to date, no lawsuits have been filed. The Company maintains that its equipment was not the cause of the respective incidents or the resultant damage. The Company’s insurance carriers, and their attorneys, are assisting in the Company’s defense in these matters. The Company does not believe that the final outcome of either of these matters will have a material adverse effect on the Company.

The Company has received notification of a customer complaint filed in the Superior Court of California, County of Placer, on December 19, 2007. The Complaint seeks damages in excess of $25,000. The Company has not yet been formally served with this Complaint. The Company, through its attorneys, has repeatedly agreed to a settlement, but to date, no settlement has been reached.

From time to time, the Company may be party to other claims and litigation arising in the ordinary course of business. The Company does not believe that any adverse final outcome of any of these matters, whether covered by insurance or otherwise, would have a material adverse effect on the Company.

As part of the acquisition of QR, the Company granted employment agreements to each of the four former owners, for a total yearly commitment of 500,000 Euros. Each agreement is for a period of five years and contains a non-compete clause. The Company can terminate each agreement after the first year of employment (April 2008), in which event, any employee so terminated is entitled to one-half of the salary for the remaining term. Effective July 2008, two of these employment agreements were modified so that the total yearly commitment is 420,000 Euros.

(10) New Accounting Standards:

Management does not believe that there were any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the accompanying consolidated financial statements.

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

The following should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This discussion may contain certain forward-looking statements based on current expectations that involve risks and uncertainties. Actual results and timing of certain events may differ significantly from those projected in such forward-looking statements due to a number of factors, including those set forth in elsewhere in this report. Except as otherwise disclosed, all amounts are reported in U.S. dollars ($).

Capital Resources and Liquidity

The Company believes that its senior secured credit facility and foreign lines of credit will not be sufficient to finance the Company’s ongoing worldwide working capital requirements for the next twelve months. As previously disclosed, the Senior Secured Lender agreed to lend to the Company an aggregate of up to $8 million in the form of a $5 million term loan and a $3 million revolving loan facility (“Revolver”). The Company’s aggregate outstanding advances under the Revolver exceed the maximum revolving credit commitment permissible under the Loan Agreement as a direct result of additional borrowings made by the Company under the Revolver to pay the term loan principal and interest charges and revolver interest charges for August, September and October 2008. The Company is in default under the Revolving Credit and Term Loan Agreement with respect to the Company’s obligation to repay the outstanding advances in excess of the permissible maximum. The Senior Secured Lender has not accelerated the Revolver. Additionally, the Company’s foreign subsidiary, QR, has failed to make payment with respect to certain invoices payable to one of its financial institutions pursuant to a line of credit agreement. The lender has notified QR that such invoices are past due, but has taken no further action at the present time in respect thereof. All of the Company’s debt, except for the capitalized lease, has been classified as a current liability in the accompanying consolidated financial statements. The Company has instituted cost cutting measures to reduce its cash requirements.

The Company is also currently in the process of seeking out additional financing alternatives, including potential private equity sales of its securities, or seeking out a domestic or foreign strategic and/or financial partner to negotiate a transaction to best serve the Company’s long-term goal and needs. There can be no assurance that the Company will be able to obtain any such financing upon favorable terms to the Company, or at all. In the event that the Company is unable to secure sufficient financing to maintain its operations, its business and financial condition would be materially adversely affected. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments regarding this uncertainty.

The Company’s working capital at September 30, 2008 decreased by approximately $1.86 million from June 30, 2008. This decrease is principally due to a decrease in accounts receivable due to lower sales in the current quarter. These lower sales are attributable to the current worldwide economic liquidity crisis which has, in turn, delayed the purchasing decisions for the Company’s high technology products and reduced the ability for potential customers to obtain financing for these products. There was an increase in the current portion of the outstanding debt due to the acceleration and write-off of the balance of the imputed debt discount related to the warrants issued to the Senior Secured Lender of approximately $808,701, as the Company has currently not been able to successfully negotiate a waiver, a forbearance agreement or renegotiate the debt. The Company also utilized a significant portion of its cash to satisfy previously contracted obligations.

Operating cash flows were negatively impacted in the three months ended September 30, 2008 principally due to the loss from operations. This loss is mainly attributable to lower sales in this first quarter, increased worldwide marketing, sales and administrative costs related to the support and distribution of the Company’s high-tech products, the acceleration and write-off the deferred financing costs and the write-off of the imputed debt discount on the Term Note. These factors caused the Company to utilize all of its cash resources. The Company requires advance deposits from its customers on its high dollar valued equipment prior to shipment. The Company has neither changed its payment policies to its vendors nor revised its payment terms with its customers; however, the Company has had to delay payments to vendors based on available cash resources, as the Company does not have any access to additional funds for working capital requirements. The Company does not have the capacity to borrow on either its senior secured debt in the United States or its lines of credit in Europe.

Capital expenditures for the first three months of Fiscal Year 2009 were $19,402, consisting mainly of small tooling expenditures related to the redesign, development and production of new imaging equipment, and some new computer equipment. The Company expects to continue to finance any future capital requirements principally from internally generated funds. The total amount of capital expenditures is not limited under the Company’s Revolving Credit and Term Loan Agreement; however, the Company has significantly reduced or delayed its capital purchases in the current period due to the existing cash flow situation.

On April 12, 2007, the Company completed the sale of an aggregate of 5,500,000 shares of its common stock to certain accredited investors for an aggregate consideration of $8,140,000. The Company has registered these shares for resale. The common stock was issued and sold pursuant to the exemption from registration pursuant to Regulation D of the Securities Act. In connection with the transaction, the Company paid the placement agent a five percent fee. The net proceeds were used to fund a portion of the purchase price of QR, which was completed on April 19, 2007.

On April 13, 2007, the Company entered into a Revolving Credit and Term Loan Agreement with the Senior Secured Lender, whereby the Senior Secured Lender agreed to lend the Company an aggregate of up to $8 million in the form of a $5 million term loan and a $3 million revolving loan facility. The term loan bears interest at a rate of ten percent (10%) per annum and provides for repayment over five years commencing in November 2007 in 53 equal monthly installments of $92,593 with a final balloon payment of all remaining amounts due there under on April 30, 2012. The Company has not made any of the required term loan principal payments since July 2008 due to continuing cash flow problems. The term loan is further subject to mandatory prepayment to the extent of 50% of proceeds received by the Company in connection with the sale of its capital stock unless such proceeds are utilized to acquire another business. The revolving loans bear interest at a rate per annum of two percent (2%) plus the prime rate and are payable in full on April 30, 2012, have a specific formula to calculate available funds based on eligible accounts receivable and inventory, are subject to maximum “borrowing base” limitations, and has certain reporting requirements. This senior secured Revolving Credit and Term Loan Agreement replaced the Company’s previous $2.5 million senior secured credit facility, which was due to expire on September 21, 2007. The proceeds were used to fund a portion of the purchase price of QR srl, and for ongoing working capital requirements.

Both loans are subject to mandatory prepayment in full in the event of certain events deemed to be a “sale,” including, but not limited to, a merger, sale of assets or change in control. The term loan is convertible by the Senior Secured Lender at any time into shares of Common Stock at a conversion price of $2.37 per share. The term loan is convertible at the Company’s option upon the satisfaction of certain conditions, including a reported trading price equal to 175% of the conversion price, the common stock being traded on NASDAQ, and a certain minimum trading volume, among others. In addition, the Company and each of its wholly-owned subsidiaries executed a Collateral Agreement pursuant to which each such party agreed to grant a security interest in all of its respective assets to the Senior Secured Lender as collateral security for repayment of the loans. Further, each subsidiary agreed to guaranty performance of all of the Company’s obligations to the Senior Secured Lender.

As part of the transaction, the Company granted to the Senior Secured Lender an aggregate of 800,000 warrants to purchase shares of Common Stock at exercise prices per share equal to $1.85 with respect to 266,666 warrants, $2.02 with respect to an additional 266,666 warrants, and $2.19 with respect to the remaining 266,668 warrants. The Company registered the shares of common stock issuable upon the exercise of the warrants and conversion of the term note and must use its best efforts to keep the registration statement effective during the applicable registration period.

The Company’s foreign subsidiary maintains various lines of credit with two separate financial institutions. In April 2008, these lines were increased from 1,750,000 to 2,000,000 Euros. The borrowings under most of these lines of credit are guaranteed by specific foreign accounts receivable and inventory. These lines of credit were granted in August 2007 and there are no restrictive covenants, subordination clauses or corporate guarantees. As of September 30, 2008, there was 1,868,948 Euros outstanding in connection therewith. The Company’s foreign subsidiary has failed to make payment with respect to certain invoices payable to one of these financial institutions pursuant to a line of credit agreement. The lender has notified QR that such invoices are past due, but has taken no further action at the present time in respect thereof.

The Company is dependent upon its Revolving Credit and Term Loan Agreement with the Senior Secured Lender, its foreign lines of credit, and continued minimum sales levels to finance its ongoing operations. As of September 30, 2008, and the current date, the Company did not have any unused credit under the Revolving Credit and Term Loan Agreement as described above.

The Company is continuing to investigate various strategic alliances to increase its market share. Some of these strategies could involve the acquisition or joint venturing of one or more businesses or product line distributions. There are no assurances that the Company will be able to identify any suitable candidate(s), or, if so identified, be able to enter into a definitive agreement with such candidates on terms favorable to the Company.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet financing arrangements or interests in so-called special purpose entities.

Results of Operations

Fluctuations in Operating Results

The results of operations for the Company have changed significantly as a result of the acquisition of QR. QR, located in Verona, Italy is a global supplier of state-of-the-art, in-office three-dimensional dental computed tomography (CT). QR uses an imaging technology that features a cone shaped beam of x-rays (a CBCT scanner). The carrying values of QR’s assets and liabilities were adjusted to their fair values and the difference between the purchase price and the fair value of the net assets was recorded as goodwill and other intangibles, and is subject to periodic impairment testing. The Company’s results of operations have been and will continue to be materially affected by the amortization costs associated with these other intangibles and any impairment charges.

The U.S. dollar is the Company’s reporting currency; however, a significant portion of the consolidated operating results are denominated in Euros. Since the acquisition in April 2007, the U.S. dollar/Euro exchange rate has fluctuated significantly, thereby impacting the Company’s financial results. Between April 2007 and September 2008, the U.S. dollar/Euro exchange rate ranged from as low as $1.35 to as high as $1.57. In the current quarter ended September 30, 2008, the U.S. dollar/Euro exchange rate varied from $1.57 to $1.40, based on the current worldwide economic conditions and marketplace uncertainty. The Company does not usually use foreign exchange contracts to manage foreign currency exposure. As of September 30, 2008, there were no outstanding foreign exchange contracts.

Based on the recent losses, the Company has instituted significant cost cutting measures in the first quarter of Fiscal 2009, which should begin to take effect in the second quarter Fiscal 2009. These measures include reductions in operating costs and worldwide marketing and distribution costs, including payroll, employee benefits and operating overhead charges.

The Company’s operating results have varied in the past and are likely to vary in the future. Due to variations that the Company has experienced in operating results, management does not believe that period-to-period comparisons of results of operations are necessarily meaningful or reliable as indicators of future performance. These variations result from several factors, many of which are not in the Company’s control, including, but not limited to:

●	Changes in technology, specifically imaging modalities,

●	Demand for products and services,

●	The level of product, price and service competition,

●	Changes in product mix, which could affect profit margins,

●	Federal, state or local government regulation,

●	The timing of industry trade shows,

●	Currency fluctuations,

●	Capital spending budgets of customers,

●	General economic trends and conditions specific to the Company’s industry,

●	Changes in the prime rate of borrowing in the United States,

●	Changes in federal and foreign tax laws,

●	The timing of new product introductions by the Company as well as by its competitors,

●	Worldwide economic events which have negatively impacted potential customers’ purchasing decisions, and

●	Worldwide economic events which have negatively impacted the ability of customers to obtain financing.

Three Months Fiscal 2009 Versus Three Months Fiscal 2008

Sales decreased approximately $800,000 or 10.7% between the Fiscal 2008 and Fiscal 2009 three-month comparable periods. The Company experienced lower sales in the current quarter, which can be attributable to the current worldwide economic liquidity crises which has negatively impacted the potential purchasing decisions for the Company’s high technology products and reduced the ability for customers to obtain financing for these products. Many customers continue to reconsider their purchases for the Company’s equipment, based on their own economic circumstances and evolving worldwide market conditions. There was an increase of approximately $540,000 related to sales of the three-dimensional dental x-ray imaging systems, most of which related to the reclassification from deferred revenue to revenue, based on completion of certain contractual obligations. The Company’s veterinary products business increased approximately $100,000 mainly due to increased sales of general purpose digital x-ray systems designed for general veterinary applications. Demand for the Company’s two-dimensional filmless digital dental radiography system for veterinary applications remained strong in the current quarter. The Company’s two-dimensional filmless digital dental radiography system for human sales decreased approximately $240,000 due to the loss of the Company’s Canadian distributor and lower sales in the United States as dentists continue to delay their purchasing decisions. The Company’s other dental x-ray systems showed a decrease of approximately $150,000 in the current three-month period as intra-oral x-rays have become a commodity product. The Company’s analog film processor business including spare parts and chemistry showed a decrease of approximately $1.06 million in the current three-month period, due to the continuing transition from analog to digital imaging processing as U.S. healthcare professionals continue to migrate to digital imaging equipment, which the Company also supplies, and the postponement of a large international order until the third quarter of the current year. The Company has continued its efforts to increase worldwide distribution and expand and develop new international markets for its digital products.

Gross profit as a percent of sales stayed relatively constant between the Fiscal 2008 and Fiscal 2009 three-month comparable periods.

Selling, general, and administrative costs increased approximately $460,000 or 14.8%, between the Fiscal 2008 and Fiscal 2009 three-month comparable periods. Approximately $380,000 of this increase is due to increased operating costs in Italy, and the balance relates to operations in the United States. During the second half of Fiscal Year 2008, the Company increased administrative and sales personnel in Italy to properly produce, position, market and distribute the three-dimensional products worldwide, and a senior executive relocated to Italy from the US. The Company also leased additional R & D space in Italy in January 2008, to allow for a realignment of factory production and distribution demands. The Company sponsored “NewTom” day in July 2008, for its existing dealers and potential new customers to promote awareness of the Company’s three-dimensional imaging products and product improvements; this event is held every other year. The increase in the United States is due to the write-off of approximately $152,250 related to the deferred financing costs which had been capitalized in April 2007, as the Company has not currently been able to successfully negotiate a waiver, a forbearance agreement or renegotiate its senior secured debt. There was a net decrease of approximately $70,000 related to the Company’s administrative, marketing/sales and technical support costs. The Company reduced the number of exhibitions it attended in the current three-month period and reduced its outside consultants due to the current restraints on available funding. The Company continued to increase its technical support costs related to the new digital equipment, as the installed base increased in the United States in the past year. The three-dimensional imaging systems require a devoted infrastructure support system, including installation, training and related costs to assist users.

Amortization of intangibles decreased approximately $169,600 or 58.8% due to the impairment charge of $5.6 million recorded in Fiscal Year 2008, which lowered the gross value of the other intangibles being amortized.

Research and development costs increased approximately $46,500, or 10.7%, between the Fiscal 2008 and Fiscal 2009 three-month comparable periods. The Company’s research and development efforts and technologies were significantly enhanced by the acquisition of QR. All of this increase is due to research and development efforts in Italy. The Company continues to invest in the design, development and refinement of its existing digital imaging products, as well as the design and development of new digital imaging products for the human dental and broad veterinary applications, including both hardware and software enhancements. Research and development costs may fluctuate between reporting periods, due to changing research and development consulting agreements, initiation or completion of certain project tasks, and market demands. Research and development costs may continue to increase over the next several years as the Company evaluates its strategy to develop and market additional high-tech digital products.

For the three-month period ended September 30, 2008, the loss on foreign currency transactions amounted to $1,362,375 due to the significant decrease in the value of the Euro in relation to the U.S. dollar during this time period. A deferred tax asset has been recorded in Italy for this unrealized loss, in accordance with local laws. For the three-month period ended September 30, 2007, the gain on foreign currency transactions amounted to $577,123 due to the increase in the value of the Euro in relation to the U.S. dollar during this time period. A deferred tax liability was recorded in Italy for this unrealized gain. This is an unrealized non-cash foreign currency transaction related to the US dollar denominated intercompany note and recorded by QR in Euros.

For the three-month period ended September 30, 2008, net interest expense was approximately $1.058 million. For the three-month period ended September 30, 2007, net interest expense was approximately $253,700. This increase of approximately $804,000 is mainly attributable to the acceleration and write-off of the balance of the Term Note imputed debt discount of $808,701, as the Company has not been able to successfully negotiate a waiver, a forbearance agreement or renegotiate its senior secured debt. There was also approximately $1.7 million more in average borrowings during the current three-month period offset by a lower rate of borrowing on the Revolver, due to recent decreases in the prime rate of borrowing.

The net tax benefit recorded for the period ended September 30, 2008 and net tax expense for the period ended September 30, 2007, include foreign taxes at the statutory rates on the Company’s foreign operations, changes to the deferred tax accounts, and state income and capital taxes generated in the United States. As of September 30, 2008, the Company had approximately $12.0 million in federal net operating loss carry forwards, and approximately $16.4 million in state net operating loss carry forwards. These NOL’s will begin to expire in 2010 and are subject to review by the Internal Revenue Service. Past and future changes in ownership of the Company as defined in Section 382 of the Internal Revenue Code, may limit the amount of NOL’s available for use in any one year.

As of September 30, 2008, the Company has recorded net deferred tax assets of approximately $329,000 and as of June 30, 2008, net deferred tax liabilities of approximately $155,000, all of which relates to its foreign operations. The September 30, 2008 net deferred tax assets are comprised of approximately $537,000 of deferred tax assets and $208,000 of deferred tax liabilities. The June 30, 2008 net deferred tax liabilities are comprised of approximately $698,000 of deferred tax liabilities and $543,000 of deferred tax assets. The deferred tax liabilities are related to the previously recorded net unrealized exchange gain on the intercompany note denominated in US dollars, as it will only be taxed when realized and when repayment is made; and the deferred tax assets are mainly related to the temporary differences on the intangible assets amortization.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to makes estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses. These estimates and assumptions are evaluated on an ongoing basis based on historical internal operations, industry trends and conditions, market conditions and other information that management believes to be reasonable or applicable under the circumstances. There can be no assurances that actual results of operations will be consistent with management’s estimates and assumptions, and that reported results of operations will not be adversely affected by the requirement to make accounting adjustments to reflect changes in these estimates from time to time. The following policies are those that management believes to be the most sensitive to estimates and judgments:

Revenue Recognition

The Company recognizes revenue net of related discounts and allowances for its consolidated operations when persuasive evidence of the arrangement exists, the price is fixed or determinable, collectability is reasonably assured, and delivery or title and risk of loss has passed to the customer, based on the specific shipping terms. The Company includes shipping and handling costs as a component of cost of sales. Revenue related to equipment orders that contain one or more elements to be delivered at a future date is recognized in accordance with EITF 00-21 “Accounting for Revenue Arrangements with Multiple Deliverables”. The Company allocates revenue between the various elements using the relative fair value method, based on evidence of fair value for the respective elements. The revenue allocated to deferred service contracts, installation and training for the three-dimensional imaging equipment is deferred until service is provided. Amounts received from customers in advance of equipment deliveries are recorded as deferred income until the revenue can be recognized in accordance with the Company’s revenue recognition policy.

Accounts Receivable

The Company reports accounts receivable net of reserves for doubtful accounts. Credit is extended to distributors on varying terms, usually between 30 and 90 days. Most of the sales to our direct users are payment in advance. Letters of Credit or payment in advance is required for certain foreign sales. The reserve for doubtful accounts is management’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable and is based upon continual analysis of the accounts receivable aging including credit risk of specific customers, historical trends and other related information. The Company writes off accounts receivable when they become uncollectible. There have been no significant changes in the computation methodology of the reserve for doubtful accounts in the past three years. The Company has not had significant bad debt write-offs in the past few years, except for Fiscal Year 2008, when the company recorded certain write-offs related to the receivables associated with the acquisition of QR srl and the write-off related to an exclusive Canadian distributor. The allowance for doubtful accounts is based on the Company’s analysis of aged accounts receivable. Management believes that any potential risk associated with the estimate of reserve for doubtful accounts is therefore limited.

Inventories

Inventories, which include material and a small component of work-in-process labor and overhead, are stated at the lower of cost (first in, first out) or market (net realizable value). The Company has established inventory reserves based on inventory estimated to be obsolete, slow moving, or unmarketable due to changing technological and/or market conditions. If actual market and technical conditions are less favorable than those anticipated, additional inventory reserves would be required. There have been no significant changes in the computation methodology of the reserves for inventory in the past two years.

Warranties

The Company records a liability for an estimate of costs that it expects to incur under its limited warranty based on revenues. Various factors affect the Company’s warranty liability, including: (1) number of units sold, (2) historical rates of claims, (3) anticipated rates of claims, and (4) costs per claim. The Company periodically assesses the adequacy of its warranty liability based on changes in these factors.

In March 2005, the Company began to include an extended warranty with its digital sensors. The Company continues to monitor the rate and costs of claims and review the adequacy of its warranty liability and has made changes in the warranty reserve, as necessary based upon the number of units sold, the actual amount of warranty claims processed, and the specific warranty period. The increase in the warranty reserve has resulted in decreased gross profit.

In Fiscal 2008, the Company’s Italian subsidiary began to separately account for warranty costs related to its three-dimensional digital imaging equipment and has recorded a warranty reserve as of June 30, 2008 and September 30, 2008.

Stock-based Compensation

Effective July 1, 2005, the Company began to account for stock based compensation under Financial Accounting Standards Board Statement No. 123R, Share Based Payment. The Company determines the fair value of options based on the Black-Scholes model, which is based on specific assumptions including (1) expected life of the option, (2) risk free interest rates, (3) expected volatility and (4) expected dividend yield.

Deferred Tax Asset and Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred income taxes are recorded for temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets and liabilities reflect the tax rates expected to be in effect in the period in which the differences are expected to reverse. Any changes in tax laws which affect the effective tax rates will affect the deferred tax asset and will be reflected in the accompanying current tax provision. The Company records a valuation allowance to reduce its deferred tax asset when it is more likely than not that a portion of the amount may not be realized. The Company estimates its valuation allowance based on an estimated forecast of its future profitability. Any significant changes in future profitability resulting from variations in future revenues or expenses could affect the valuation allowance on the deferred tax asset and operating results could be affected. In reviewing the valuation allowance, the Company considers future taxable income and determines whether it is more likely than not that a portion of the deferred tax asset will be realized. Changes in these circumstances, such as an increase or decline in estimated future taxable income, would result in a re-determination of the valuation allowance. In Fiscal Year 2008, the Company increased its valuation allowance on the U.S. portion of its deferred tax asset by approximately $4,398,000, as it does not believe that it is more likely than not that it will be able to utilize the net operating loss carry forwards based on recent losses and anticipated market conditions.

The Company has recorded deferred tax assets and liabilities associated with its foreign operations. Certain tax assets were acquired upon the acquisition of QR in April 2007 and primarily relate to the financial statement carrying amount of existing assets and liabilities and their respective tax bases.

The Company has recorded NOLs amounting to approximately $12.0 million in federal NOLs and $16.4 million in state NOLs at September 30, 2008. The NOLs are subject to review by the Internal Revenue Service. Past and future changes in ownership of the Company, as defined in Section 382 of the Internal Revenue Code, may limit the amount of NOLs available for use in any one year.

Goodwill and other intangibles

Prior to April 2007, the Company did not have any long-lived assets or goodwill. Long-lived assets held for use by the Company will be reviewed for impairment whenever circumstances provide evidence that suggests the carrying amount of the asset may not be recoverable, at which time, the Company will perform an impairment analysis primarily related to technology and customer relationships. Determination of whether impairment exists will be based upon comparison of the fair value of the assets to the carrying values of the respective assets. This could result in a material charge to earnings. The Company considers factors such as operating results, market trends, technological developments, competition, other economic factors, and the effects of obsolescence for this assessment.

Goodwill is not amortized, but will be tested for impairment on an annual basis each June 30th, or whenever circumstances or events indicate that the carrying amount may not be recoverable. These events include a significant change in the business climate, operating performance indicators, legal factors, competition or a significant change in the business entity. The first step of the goodwill impairment tests will be based upon a comparison of the fair value of the reporting unit to the respective carrying value. If the fair value of the reporting unit exceeds its carrying amount, no impairment exists. If, however, the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test will be performed to measure the amount of impairment loss, if any. The implied fair value requires a fair value process similar to a business combination, where the individual assets and liabilities are valued at fair value with the difference between the fair value of the reporting unit being the implied fair value of goodwill. If the carrying amount of the reporting unit exceeds its fair value, the goodwill impairment loss is measured as the excess of the carrying amount of goodwill over its implied fair value. Any identified impairment will result in a charge to reduce the carrying value of the associated goodwill. This could result in a material charge to earnings.

Litigation and Contingencies

The Company is party to lawsuits arising out of its respective operations. The Company records a liability when it is probable and can be reasonably estimated. The Company believes it has properly estimated in the past; however, court decisions and/or other unforeseen events could cause liabilities to be incurred in excess of estimates.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not Applicable.

Item 4T. Controls and Procedures.

a) Evaluation of disclosure controls and procedures

The Company conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of September 30, 2008. The controls evaluation was conducted under the supervision and with the participation of our management, including our Co-Chief Executive Officers and Chief Financial Officer. Based upon that evaluation, the Co-Chief Executive Officers and Chief Financial Officer have concluded that, as a result of the identification of the material weaknesses identified below, as of the end of the period covered by this report, our disclosure controls and procedures were not effective.

In its assessment of the effectiveness of internal control over financial reporting as of September 30, 2008, management concluded that the Company's internal controls over financial reporting were not operating effectively. It was determined that there were control deficiencies that when aggregated, may possibly be viewed as a material weakness in our internal control over financial reporting as of September 30, 2008. Those deficiencies were as follows:

We do not employ an Audit Committee as defined by Section 3(a)(58) of the Exchange Act and none of the Company’s directors are independent. While not being legally obligated to have an audit committee, it is the Company's view that such a committee, including a financial expert, is an utmost important entity level control over the Company's financial statements. Currently, the full Board of Directors acts in the capacity of the Audit Committee.

The Company does not have an individual who meets the criteria to be defined as a financial expert on its Board of Directors. The financial expert could lead the Audit Committee to provide additional oversight of the Company’s Chief Financial Officer, as well as provide the Company’s financial management with enhanced segregation of duties and controls which would minimize the risk of a material misstatement.

3.	There are no processes in place for someone to review and determine financial impacts of contracts and agreements. The financial expert could assist in this review prior to the legal review and minimize any potential financial exposures.

In light of this identified material weakness, the Company’s Board interacts with management frequently and management performed (1) significant additional substantive review of the financial information, (2) performed additional analyses, including but not limited to a substantive analytical review that compared changes from the prior period's financial statements and analyzed all significant amounts that deviated from expectations, and (3) utilized an outside consultant to provide assistance with technical accounting and reporting matters. These enhanced procedures were completed to mitigate the entity level control deficiencies noted above.

Remediation of Material Weaknesses

Management concluded that the above identified material weakness did not result in material audit adjustments to our 2008 financial statements. However, it is reasonably possible that, if not remediated, one or more of the identified deficiencies noted above could result in a material misstatement in our financial statements that might result in a material misstatement in a future annual or interim period.

In an effort to remediate the identified material weaknesses, the recommendations are as follows:

1. Management will consider seeking candidates to expand the Board of Directors in order to ensure a majority of the Board is independent.

2. Once the expansion of the Board is completed, the Company’s Board of Directors will nominate an Audit Committee, which includes a financial expert that has an understanding of U.S. generally accepted accounting principles and financial statements; the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves; experience in preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising one or more persons engaged in such activities; an understanding of internal controls and procedures for financial reporting; and an understanding of audit committee functions.

This person will have acquired such attributes through any one or more of the following:

●	Education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;

●	Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;

●	Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or

●	Other relevant experience.

Limitations of Effectiveness of Controls

As of the date of this filing, the Company is satisfied that actions implemented to date and those in progress will remediate the material weaknesses and deficiencies in the internal controls that have been identified. The Company notes that, like other companies, any system of internal controls, however well designed and operated, can provide only reasonable assurance, and not absolute assurance, that the objectives of the internal control system will be met. The design of any control system is based, in part, upon the benefits of the control system relative to its costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of control. In addition, over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of the limitations inherent in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

(b) Changes in internal controls

During the quarter ended September 30, 2008, there were no significant changes in the Company’s internal controls over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

Reference is made to Item 3 in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2008, and to the references therein, for a discussion of all material pending legal proceedings to which the Company and its subsidiaries are parties.

In October 2008, the Company and its insurance carrier each contributed $41,440 to the escrow account to settle the outstanding environment claim relating to property owned by the Company in New Jersey between August 1984 and June 1985. The Consent Decree memorializing the settlement is presently scheduled to be finalized by December 2008.

In November 2008, the Company and Genexa Medical, Inc., were instructed by the court to attempt to negotiate through a court appointed mediator the outstanding litigation which had originally been filed on May 5, 2008 in the United States District Court, Southern District of New York. The next court date has been set for January 9, 2009.

Item 6. Exhibits.

	31.1 - Certification of Co-Chief Executive Officer pursuant to Exchange Act Rule 13a – 14 (a) or Rule 15d-14(a).*
	31.2 - Certification of Co-Chief Executive Officer pursuant to Exchange Act Rule 13a – 14 (a) or Rule 15d-14(a).*
	31.3 - Certification of Chief Financial Officer pursuant to Exchange Act Rule 13a – 14 (a) or Rule 15d-14(a).*
	32.1 - Certification of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes – Oxley Act of 2002.*
	32.2 - Certification of Co-Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes – Oxley Act of 2002.*
	32.3 - Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes – Oxley Act of 2002.*
*Filed herewith.

SIGNATURES

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

	AFP IMAGING CORPORATION
	(Registrant)



	By:	/s/ David Vozick
	David Vozick
	Chairman of the Board,
	(Co-Chief Executive Officer)
	Secretary, Treasurer
	Date: November 19, 2008



	By:	/s/ Donald Rabinovitch
	Donald Rabinovitch
	President
	(Co-Chief Executive Officer)
	Date: November 19, 2008



	By:	/s/ Elise Nissen
	Elise Nissen
	Chief Financial Officer
	(Principal Financial and Accounting Officer)
	Date: November 19, 2008