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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period ended September 30, 2004

OR

For the Transition Period From              To              .

Commission File Number: 0-21371

APPLIED IMAGING CORP.

(Exact name of registrant as specified in its charter)

120 Baytech Drive,

San Jose, California 95134

(Address of principal executive offices including zip code)

(408) 719-6400

(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 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)    Yes  ¨    No  x

As of February 15, 2005 there were 19,088,018 shares of the Registrant’s Common Stock outstanding.

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APPLIED IMAGING CORP.

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(Unaudited, in thousands)

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

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APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(Unaudited)

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

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APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

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

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 - 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 nine months ended September 30, 2004 and 2003. 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. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2004. The December 31, 2003 balance sheet has been restated and has been derived from the audited balance sheet included on Amendment No. 2 on Form 10-K. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, for the year ended December 31, 2003, contained in our Amendment No. 2 on Form 10-K/A filed with the Securities and Exchange Commissions on February 25, 2005.

Restatement of Previously Issued Financial Statements:

On November 15, 2004, the Company announced its intent to restate the financial results for the fiscal year ended December 31, 2003 and the quarterly financial results for the first and second quarters of the fiscal year ending December 31, 2004. During the third quarter of 2004, a transaction which was recorded in June, 2004 was identified where revenue was recognized in a manner inconsistent with the Company’s policies and procedures then in effect. Following the identification of this transaction, the Audit Committee commenced an investigation. During the course of its investigation, the Audit Committee identified several revenue transactions principally recorded in fiscal 2003 involving its Cytovision and Ariol systems in which commitments were made for the future delivery of software applications then under development. Statement of Position (SOP) 97-2 “Software Revenue Recognition” requires that vendor specific objective evidence (VSOE) of the price attributable to the fair value of such “future deliverables” be established in order to recognize a portion of revenue in the reporting period in which the sale was originally made. The Company did not have VSOE established for these “future deliverables” at the time revenue was initially recognized. During the investigation, there were certain other transactions identified where the Company recognized revenue (a) upon the shipment of a product to a customer but had not met all the customer acceptance criteria necessary to recognize revenue; (b) upon shipment of product to customer, but had not met all the revenue recognition criteria as it was a sales with participation by a third party financing company. Additionally, during the investigation, certain transactions were identified where revenue on extended warranty/post customer support (software maintenance and service) arrangements were inappropriately recognized resulting in incorrect revenue being recognized and deferred at the time of product shipment. As a result, the Company subsequently decided to restate its 2002 financial results as well.

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following tables present amounts from operations as previously reported and as restated (In thousands, except per share data):

The restated revenues resulted in a corresponding adjustment to cost of revenues. Cost of revenues decreased by $313,000 and $537,000 for the quarter and nine months ended September 30, 2003 over the amount previously reported for the quarter and nine months ended September 30, 2003;

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

$699,000 for the quarter and nine months ended September 30, 2003 over the amount previously reported for the quarter and nine months ended September 30, 2003. Net loss per share increased $.03 and $.04 for the quarter and nine months ended September 30, 2003.

Liquidity

The Company expects negative cash flow from operations through at least 2005, as the Company continues research and development of new applications for the Company’s OncoPath^™ systems, conducts clinical trials required for the U.S. Food and Drug Administration (“FDA”) clearance of new products, litigates against ChromaVision and expands its program to detect circulating tumor cells in peripheral blood. The Company currently estimates that its capital resources will enable the Company to meet its capital needs for operating and investing activities for at least the next twelve months.

However, expenditures required to achieve growth and profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, the Company’s long-term capital needs may require it to try to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. The Company has expended and will continue to expend substantial amounts of money for research and development, litigation, preclinical testing, conducting clinical trials for FDA clearance of new products, capital expenditures, working capital needs and manufacturing and marketing of its products. The Company’s future research and development efforts, in particular, are expected to include development of additional applications of its current cytogenetic products, additional applications for the OncoPath^™ systems and an expanded program to detect circulating tumor cells in peripheral blood, which may require additional funds.

There can be no assurance that the Company will be able to obtain additional debt or equity financing if needed and on terms acceptable to the Company. If adequate and acceptable funding is not available, the Company could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that the Company would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, the Company’s failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on its ability to achieve the Company’s long-term business objectives.

On April 13, 2004, the Company completed the private placement of 3.1 million shares of common stock and warrants to purchase 620,000 additional shares of common stock for an aggregate purchase price of $4.25 million. The Company received approximately $3.9 million net after expenses associated with the placement. Each warrant is exercisable for one share of common stock at an exercise price of $1.70 per share, from six months following the closing date of April 13, 2004 until October 13, 2009.

The Company established a loan agreement with Silicon Valley Bank (SVB) on September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for the

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Company to maintain a minimum level of tangible net worth. On September 3, 2003, the loan agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to establish the minimum level of net tangible worth that the Company had to maintain through the end of the loan agreement. The Company was not in compliance with the covenant requiring it to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and the Company obtained a waiver for this covenant violation and potential non-compliance with the minimum net tangible worth covenant in January and February 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March 31, 2005 and to establish the minimum level of net tangible worth that the Company had to maintain through the end of the loan agreement. The Company was in compliance with the loan covenant at September 30, 2004. See also Note 9, Subsequent Events.

At September 30, 2004, the Company had used $1.1million of the facility with $1.1 million available but not used. The interest rate on the facility was 6.75% at September 30, 2004, computed as the SVB prime rate plus 2.0 percent. The loan is collateralized by substantially all of the assets of the U.S. corporation and requires maintenance of a minimum level of tangible net worth. Other loan covenants include the need to maintain insurance on the Company’s 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 subsidiary.

The Company collateralizes 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 £100,000 ($180,000) at September 30, 2004.

NOTE 2 – Inventories (in thousands)

NOTE 3 – Net income (loss) per share

The computation of basic and diluted net loss per share (“EPS”) for the three and nine months ended September 30, 2004 and September 30, 2003 is determined by dividing net loss as reported as the numerator by the number of shares included in the denominator as shown in the following table (in thousands):

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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):

NOTE 4 – Stock Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, compensation expense is based on the difference, if any, between the fair value of our stock and the exercise price on the date of the grant.

The Company has adopted the pro forma disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148 “Accounting for Stock-Based Compensation—Transition and Disclosure – An amendment of FASB No. 123” for the 1998 Stock Plan and Employee Stock Purchase Plan. The fair value of the stock options granted to employees is calculated using the Black-Scholes option pricing model as of the date of grant. Had compensation cost for our stock-based compensation plans been determined in a manner consistent with the fair value approach described in SFAS No. 123, our net loss and net loss per share as reported would have been changed to the pro forma amounts indicated below (in thousands, except per share data):

The fair value of each option is estimated on the date of grant using the fair value method with the following weighted-average assumptions:

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

All of the above assumptions were used for the Employee Stock Purchase Plan except that the expected life is six months.

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 “Accounting for Stock-based Compensation” and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods and Services.”

NOTE 5 – 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 for the nine months ended September 30, 2004 and September 30, 2003 are as follows (in thousands):

NOTE 6 – Commitments and Contingencies

On February 24, 2004 the Company received notice of a lawsuit alleging patent infringement filed against the Company by ChromaVision Medical Systems, Inc. The lawsuit, as subsequently amended, claims that the Company’s Ariol^® system infringes on four ChromaVision patents. ChromaVision is seeking unspecified damages, as well as an injunction barring the Company from, among other things, making, using, or selling any device in the United States that incorporates ChromaVision’s patented technology.

On April 20, 2004, the Company responded to ChromaVision’s complaint by denying ChromaVision’s infringement allegations and by asserting the invalidity of ChromaVision’s alleged patents, trademarks and copyrights. In addition, the Company is countersuing ChromaVision for infringing its valid US Patent 6,633,662. The Company is seeking an injunction against ChromaVision’s continued manufacture, sale and use of the Automated Cellular Imaging System (ACIS^®) in the United States and enhanced economic damages for ChromaVision’s willful infringement. The Company has also asserted claims against ChromaVision for intentionally interfering with relationships with its customers, unfair competition and false advertising under the Lanham Act, as well as misappropriation of trade secrets.

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The companies met in a settlement conference in US District Court on August 2, 2004. Discussions are continuing between the companies and will be reviewed periodically by the US Magistrate Judge supervising the case. The next scheduled review date is scheduled for February 1, 2005.

Because of the inherent complexity and unpredictable nature of patent litigation the Company is not able to make any predictions regarding the outcome of this litigation and is not able to estimate a gain or loss. As a result, the Company has not made any provisions for either a favorable or unfavorable outcome to this litigation.

On July 8, 2004, the Company renewed it’s exclusive supply agreement with StemCell Technologies Inc. for the use of StemCell’s RosetteSep^® reagent technology for the isolation of circulating tumor cells in the blood of cancer patients. The Company’s minimum purchase commitment for 2004 is $109,000.

In September 2004, the Inland Revenue, the UK taxing authority, notified the Company that it disputed the valuation the Company applied to its Cytogenetics technology on transfer from its UK subsidiary to its US parent entity, a transaction which occurred in 2000, claiming that such valuation understated the fair value of the transferred assets. The Company originally valued the assets at £1.8 million ($3.5 million) and paid tax based upon that valuation. The Inland Revenue has indicated that it believes the value of the assets should have been £4.0 million ($7.7 million), which would result in the Company owing additional tax of over $1.1 million. The Company plans to have further discussion with Inland Revenue to support its original valuation of the transferred assets. A final adverse determination would result in the Company having to pay additional tax, which could significantly harm its operations. The Company cannot predict the outcome and does not know the range of loss, and accordingly no amount has been accrued as of September 30, 2004 in respect of this case.

NOTE 7 - Issuance of Common Stock and Warrants

On April 13, 2004, the Company raised approximately $4.25 million in gross proceeds from the private placement of common stock and warrants to several institutional investors. Net proceeds to the Company after estimated offering costs and expenses were approximately $3.9 million. The transaction involved the sale of 3,100,000 newly issued shares of the Company’s common stock at a price of $1.37 per share and warrants to purchase an aggregate of 620,000 shares of common stock an exercise price of $1.70 per share. The common stock warrants have a five-year term and become exercisable on or after October 13, 2004. The aggregate value of the common stock warrants was determined to be a part of the purchase price and has been classified within additional paid-in capital.

NOTE 8 - Relocation

The Company relocated from its facilities in Santa Clara to San Jose. As part of the relocation, the Company incurred expenses amounting to $222,000 during the first six months of 2004 and $2,000 during the quarter ended September 30, 2004 for overlapping rent of the two facilities, moving and legal expenses and $501,000 during the first six months of 2004 and $55,000 during the quarter ended September 30, 2004 for leasehold improvements and furniture/fixtures at its new facilities. The leasehold improvements are being amortized over the occupancy period and the furniture/fixtures over their useful life. The Company has received $733,000 as incentive at the new facilities and this is being amortized to offset rent expense over the occupancy period. The Company has minimum lease payments for the San Jose office as follows: The Company has minimum lease payments for the San Jose office as follows:

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 9 – Subsequent Events

On November 17, 2004 the Board of Director’s approved a reduction in force plan recommended by management that resulted in a reduction in the Company’s workforce of approximately ten people. The Company executed the reduction in force in early January 2005.

As previously reported on Applied Imaging Corp.’s Form 8-K filed on December 3, 2004, Applied Imaging Corp. issued a press release announcing its plan of succession for its Chief Executive Officer. Pursuant to this previously announced plan of succession, Carl Hull, the Company’s Chief Executive Officer resigned on December 31, 2004. Mr. Hull was also the Company’s principal executive officer. The Company entered into a severance and release agreement with Mr. Hull. Effective on January 1, 2005, Robin Stracey, the Company’s President and Chief Operating Officer, replaced Mr. Hull and assumed the position of President and Chief Executive Officer. Mr. Stracey also became the Company’s principal executive officer.

Due to the investigation commenced by the Audit Committee, the Company was unable to file its September 30, 2004 Form 10-Q on a timely basis. As a result, the Nasdaq Listing Qualifications Department notified the Company that it was not in compliance with the requirements of Nasdaq Marketplace Rule 4310(c)(14), affixed an ‘E’ to the end of the Company’s trading symbol, and subjected it to delisting proceedings. The Company appealed this delisting determination and participated in a hearing before a Nasdaq panel in December 2004. On July 29, 2004, the Company received notice from Nasdaq that the stock price had closed below $1.00 per share for 30 consecutive business days. As a result, the Company failed to comply with the minimum bid price requirement for continued listing on The Nasdaq SmallCap Market. The Nasdaq staff further notified the Company that its stock might be subject to delisting from the Nasdaq SmallCap Market if the Company fails to regain compliance with the minimum bid price requirement by having the bid price on its stock close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005. Since the Company’s stock price failed to close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005, the Company requested an additional 180 day period to regain compliance with the minimum bid price requirement to continue its listing on the Nasdaq SmallCap Market and avoid delisting.

On February 10, 2005, the Nasdaq notified the Company that it had determined to grant our request for continued listing on the Nasdaq SmallCap Market subject to several conditions, including: 1.) the filing of the Company’s Form 10-Q for the quarter ended September 30, 2004 and any required restatements on or before February 25, 2005; 2.) the receipt of board approval to implement a reverse stock split sufficient to remedy the bid price deficiency on or before March 1, 2005 and the filing of a proxy statement evidencing the Company’s intent to seek stockholder approval for such reverse stock split on or before March 30, 2005; 3.) evidence of a closing bid price of $1.00 per share on or before May 20, 2005 and a closing bid price of at least $1.00 per share for a minimum of ten consecutive business days immediately thereafter, and 4.) the timely filing of all periodic reports for all reporting periods ending on or before December 31, 2005.

On February 25, 2005, the Company’s loan agreement with SVB was amended to extend the term of the loan through March 29, 2007.

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APPLIED IMAGING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

While the Company’s board of directors has given approval to seek shareholder approval to implement a reverse stock split for up to one share for each existing four shares, the shareholders may not approve a reverse stock split. The Company share price post a reverse stock split may not trade above a $1.00 per share for ten consecutive trading days. While it is our intent to make timely filings of all periodic reports for all reporting periods ending on or before December 31, 2005, the company may not complete its filings on a timely basis. If any of these events were to occur, the Company’s shares would be delisted from the Nasdaq SmallCap Market. Additionally, should our shareholders approve a reverse stock split, the reverse stock split may adversely impact our stock price.

If de-listed, the Company’s stock may be quoted using the Pink Sheets, LLC or other similar market. A de-listing from the Nasdaq SmallCap Market may adversely impact the Company’s stock price, as well as the Company’s liquidity and the ability of the Company’s stockholders to purchase and sell their shares in an orderly manner, or at all. Furthermore, a delisting of the Company’s shares from the Nasdaq SmallCap Market could damage its general business reputation and impair its ability to raise additional funds. Any of the foregoing events could have a material adverse effect on the Company’s business, financial condition and operating results.

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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, 2003 as restated.

This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 12 and 24 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003. 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. Our revenues are derived primarily from the sale of systems, service contracts, software maintenance and grant revenues. Revenues for the three and nine months ended September 30, 2004 were $5.7 million and $14.9 million, respectively, compared to $4.1 million and $13.8 million, as restated for the corresponding periods in 2003. The $1.6 million increase in revenues in the third quarter and $1.1 million increase in nine months were due primarily to the recognition of revenue on Ariol^® systems from sales contracts entered into in prior periods and where the company has now fulfilled all obligations under the terms of the sales contract. The revenue from these sales contracts was deferred in prior periods because the company had not fulfilled all the obligations under the terms of each sales contract.

Sales of systems were $4.2 million and $10.7 million in the three and nine months ended September 30, 2004, respectively, compared to $2.5 million, as restated and $9.4 million, as restated for the corresponding periods in 2003. The $1.7 million increase in system revenues in the third quarter of 2004 versus 2003 and $1.3 million increase in the nine months of 2004 versus 2003 were due primarily to an increase in sales of our Ariol^® systems and from sales contracts entered into in prior periods and where the company has now fulfilled all obligations under the terms of the sales contract. The revenue from these sales contracts was deferred in prior periods because the company had not fulfilled all the obligations under the terms of each sales contract.

Service contract, software maintenance and grant revenues were $1.5 million and $4.2 million in the three and nine months ended September 30, 2004, respectively, compared to $1.5 million, as restated and $4.4 million, as restated for the corresponding periods in 2003. The decrease in the nine month period is primarily related to $363,000 of grant revenues during the nine months of 2003 compared to $127,000 of grant revenues in the nine months of 2004.

Cost of revenues. Cost of revenues includes direct material and labor costs, manufacturing overhead, installation costs, warranty-related expenses and service and application support expenses. Costs of revenues for the three and nine months ended September 30, 2004 were $2.5 million and $6.1 million, respectively, compared to $1.8 million and $5.8 million for the corresponding periods in 2003, as restated. Cost of revenues, as a percentage of total revenues, for the three and nine months ended September 30, 2004 were 44% and 41%

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respectively, compared to 45% and 42%, as restated, for the corresponding prior year periods. The increase is primarily due to the sale of a number of our Ariol^® systems at a lower gross margin percent for market development purposes.

Research and development expenses. Research and development expenses for the three and nine months ended September 30, 2004 were $887,000 and $2.6 million, respectively, compared to $980,000 and $2.8 million in the comparative prior year periods. This decrease in the third quarter of 2004 as compared to 2003 is due primarily to $65,000 of consulting services and $19,000 in incremental spending in support of the Sanger Institute project in the third quarter of 2003, compared to no such spending in the third quarter of 2004. The decline for the nine month period of 2004 as compared to 2003 is primarily due to $96,000 of consulting services, $40,000 in personnel recruitment fees and $35,000 for the Sanger institute project expenses incurred in 2003 compared to no such spending in the first three quarters of 2004.

Sales and marketing expenses. Sales and marketing expenses for the three and nine months ended September 30, 2004 were $1.6 million and $5.0 million, respectively, compared to $1.8 million and $5.4 million in the comparative prior year periods. The decline in both periods of 2004 as compared to 2003 was due primarily to sales commission paid to distributors outside North America in 2003 ($108,000 in the third quarter and $302,000 in the first nine months of 2003) and a decline in personnel recruitment fees in 2004 ($42,000 in the third quarter and $136,000 in the first nine months of 2004).

General and administrative expenses. General and administrative expenses for the third quarter and nine months of 2004 were $910,000 and $3.0 million respectively, compared to $709,000 and $2.0 million in the comparative prior year periods. The increase in general and administrative expenses in the third quarter of 2004 as compared to 2003 was attributable to the reversal of a reserve for bad debts in 2003 in the amount of $180,000 that was no longer deemed necessary. In the first nine months of 2004, the increase in general and administrative costs as compared to the same period in 2003 was primarily due to increases ($411,000) in patent and legal fees, one-time expenses associated with the relocation to our new office facilities in San Jose ($246,000), increased audit fees ($145,000) and the reversal of bad debts reserve ($278,000).

Other income (expense), net. The other income of $5,000 in the third quarter of 2004 was due primarily to $20,000 of foreign exchange gains incurred in the translation of various balance sheet items from foreign currencies into U.S. dollars and interest expense of $17,000 on our bank borrowings. Other expense of $85,000 in the first nine months of 2004 was primarily comprised of $35,000 in foreign exchange losses incurred in the translation of various balance sheet items from foreign currencies into U.S. dollars and $16,000 of income tax expense. Other income of $30,000 in the first nine months of 2003 was primarily comprised of $74,000 in net interest expense on our bank borrowings and $100,000 of foreign currency gains incurred in the translation of various balance sheet items from foreign currencies into U.S. dollars.

Liquidity and Capital Resources

At September 30, 2004, we had cash and cash equivalents of $4.0 million and working capital of $2.0 million, compared to $2.0 million and $340,000, respectively, at December 31, 2003. Restricted cash, which collateralizes various credit card and bank guarantees in the United Kingdom, amounted to $180,000 at September 30, 2004 and $178,000 at December 31, 2003.

Cash used by operations in the nine months ended September 30, 2004 was $476,000, compared to $615,000 provided in the first nine months of 2003. Net cash used in operations in

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the first nine months of 2004 resulted primarily from a $1.9 million operating loss while much of this was offset by a reduction of $1.4 million in accounts receivable and an increase in deferred rent incentive received for our new office facilities of $695,000. Net cash provided by operations for the nine months of 2003 resulted primarily from a $2.1 million operating loss offset by a $2.7 million decrease in accounts receivable.

Trade accounts receivable as a percent of third quarter revenues were 84% at September 30, 2004, compared to 110% at September 30, 2003 and 119% at December 31, 2003, reflecting improved collections in the quarter. This strong relationship between quarter-end receivables and that quarter’s sales is primarily due to the fact that most of our sales occur late in the quarter as is typical of a capital equipment business. Although our payment terms are net 30 days, certain customers, specifically government, university, Asian and European customers, tend to take longer to pay their receivable balances.

Cash used in investing activities was $884,000 in the first nine months of 2004, compared to $259,000 in the first nine months of 2003. In the first nine months of 2004 we invested $884,000 for purchases of capital equipment and leasehold improvements related to the San Jose office move compared to $259,000 of capital equipment purchases in the first nine months of 2003.

Cash provided by financing activities was $3.3 million in the first nine months of 2004, compared to $1.1 million cash used in financing activities for the first nine months of 2003. We received $3.9 million net from the issuance of common stock in a private placement in the first nine months of 2004. Total bank borrowings for the nine months ended September 30, 2004 were $8.5 million and $9.0 million for the nine months ended September 30, 2003. Repayments were made on our bank line with Silicon Valley Bank (SVB) in the first nine months of 2004 and 2003, of $9.1 million and $10.2 million respectively.

On April 13, 2004, we completed the private placement of 3.1 million shares of common stock and warrants to purchase 620,000 additional shares of common stock for an aggregate purchase price of $4.25 million. We received approximately $3.9 million net after expenses associated with the placement. Each warrant is exercisable for one share of common stock at an exercise price of $1.70 per share, from six months following the closing date of April 13, 2004 until October 13, 2009.

We established a loan agreement with SVB on September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for us to maintain a minimum level of tangible net worth. On September 3, 2003, the loan agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to establish the minimum level of net tangible worth that we had to maintain through the end of the loan agreement. We were not in compliance with the covenant requiring us to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and we obtained a waiver for this covenant violation and potential non-compliance with the minimum net tangible worth covenant in January and February, 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March 31, 2005 and to establish the minimum level of net tangible worth that we had to maintain through the end of the loan agreement. We were in compliance with the loan covenant at September 30, 2004.

On February 25, 2005, the Company’s loan agreement with SVB was amended to extend the term of the loan through March 29, 2007.

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At September 30, 2004, we had used $1.1 million of the facility with $1.1 million available but not used. The interest rate on the facility was 6.75% at September 30, 2004, 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 level of tangible net worth. 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 subsidiary.

We have received from SVB various waivers of our non-compliance with the loan covenant requiring us to maintain a minimum level of tangible net worth. There is no assurance that SVB will continue to provide such waivers in the future. In the event that we are unable to remain in compliance with this covenant, we would have to repay any outstanding balance on the SVB loan, which could limit our ability to fund our working capital and growth objectives.

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 £100,000 ($180,000) at September 30, 2004.

We expect negative cash flow from operations through at least 2005, as we continue research and development of new applications for our OncoPath^TM systems, conduct clinical trials required for the U.S. Food and Drug Administration (“FDA”) clearance of new products, litigate against ChromaVision and expand our program to detect circulating tumor cells in peripheral blood. On July 8, 2004, the Company incorporated a wholly-owned subsidiary, Circulating Tumor Cells, Inc., in Delaware. This company was formed to conduct research and development, clinical trials and future commercial activities in the area of circulating tumor cells. We currently estimate that our capital resources will enable us to meet our capital needs for operating and investing activities for at least the next twelve months.

However, expenditures required to achieve growth and profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, our long-term capital needs may require us to try to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, conducting clinical trials for FDA clearance of new products, capital expenditures, 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 of our current cytogenetic products, additional applications for the OncoPath^™ systems and an expanded program to detect circulating tumor cells in peripheral blood, which may require additional funds.

There can be no assurance that we will be able to obtain additional debt or equity financing if needed and on terms acceptable to us. If adequate and acceptable funding is not available, we could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that we would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our ability to achieve our long-term business objectives.

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We transferred our listing from the Nasdaq National Market to the Nasdaq SmallCap Market, which has less stringent listing requirements, as of February 4, 2003. As a result, we may find it more difficult to raise additional capital should the need arise in the future.

We are restating our consolidated financial statements to reflect adjustments to our previously reported financial information. The adjustments arose out of an investigation by our Audit Committee, as reported in our Form 8-K filed with the SEC on November 15, 2004. As a result of the then active 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.

As part of the Audit Committee’s investigation, the Audit Committee evaluated the effectiveness of certain internal controls and procedures. The Audit Committee concluded that there existed material weaknesses in a number of areas in our system of internal controls and procedures as of the date of our initial filing of our December 31 2003 Form 10-K. As a result of the evaluation, the Audit Committee has directed management to implement and management is in the process of implementing measures designed to ensure that information required to be disclosed in our periodic reports is complete, recorded, processed, summarized accurately and reported timely. These measures include:

adoption of a disclosure policy, which specifically addresses documentation on commitments made to customers;

hiring of a contracts administrator to review all sales contracts and identify all commitments made to customers in each contract;

moving of the international sales order processing and finance functions from our UK office to our US headquarters office;

adoption of a policy regarding future software application commitments;

priority given to the hiring of a new CFO;

updating of our revenue recognition policy to specifically address the revenue recognition requirements of SOP 97-2 as it relates to our business; and

creation of an education program with our sales force and management team on our new policies and procedures.

Once these additional measures have been fully implemented, we believe that our internal controls and procedures will be effectively designed to ensure that information we are required to disclose in reports that we file with the SEC is recorded, processed, summarized accurately and reported within the time periods specified in Securities and Exchange Commission rules and forms. However, the effectiveness of our controls ands procedures is still limited by a variety of factors including:

Faulty human judgment and simple error, omissions or mistakes;

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 delisting, and to civil and criminal sanctions.

Due to the investigation commenced by our Audit Committee, we were unable to file our September 30, 2004 Form 10-Q on a timely basis. As a result, the Nasdaq Listing

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Qualifications Department notified us that we were not in compliance with the requirements of Nasdaq Marketplace Rule 4310(c)(14), affixed an ‘E’ to the end of our trading symbol, and subjected us to delisting proceedings. We appealed this delisting determination and participated in a hearing before a Nasdaq panel in December 2004. On July 29, 2004, we received notice from Nasdaq that our stock price had closed below $1.00 per share for 30 consecutive business days. As a result, we had failed to comply with the minimum bid price requirement for continued listing on The Nasdaq SmallCap Market. The Nasdaq staff further notified us that our stock might be subject to delisting from the Nasdaq SmallCap Market if we fail to regain compliance with the minimum bid price requirement by having the bid price on our stock close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005. Since our stock price failed to close above $1.00 per share for a minimum of 10 consecutive business days by January 25, 2005, we requested an additional 180 day period to regain compliance with the minimum bid price requirement to continue our listing on the Nasdaq SmallCap Market and avoid delisting.

On February 10, 2005, the Nasdaq notified the Company that it had determined to grant our request for continued listing on the Nasdaq SmallCap Market subject to several conditions, including: 1.) the filing of the Company’s Form 10-Q for the quarter ended September 30, 2004 and any required restatements on or before February 25, 2005 2.) the receipt of board approval to implement a reverse stock split sufficient to remedy the bid price deficiency on or before March 1, 2005 and the filing of a proxy statement evidencing the Company’s intent to seek stockholder approval for such reverse stock split on or before March 30, 2005 3.) evidence of a closing bid price of $1.00 per share on or before May 20, 2005 and a closing bid price of at least $1.00 per share for a minimum of ten consecutive business days immediately thereafter, and 4.) the timely filing of all periodic reports for all reporting periods ending on or before December 31, 2005.

While our board of directors has given approval to seek shareholder approval to implement a reverse stock split for up to one share for each existing four shares, our shareholders may not approve a reverse stock split. Our share price post a reverse stock split may not trade above a $1.00 per share for ten consecutive trading days. While it is our intent to make timely filings of all periodic reports for all reporting periods ending on or before December 31, 2005, the company may not complete its filings on a timely basis. If any of these events were to occur, our shares would be delisted from the Nasdaq SmallCap Market. Additionally, should our shareholders approve a reverse stock split, the reverse stock split may adversely impact our stock price.

If de-listed, our stock may be quoted using the Pink Sheets, LLC or other similar market. A de-listing from the Nasdaq SmallCap Market may adversely impact our stock price, as well as our liquidity and the ability of our stockholders to purchase and sell their shares in an orderly manner, or at all. Furthermore, a delisting of our shares from the Nasdaq SmallCap Market could damage our general business reputation and impair our ability to raise additional funds. Any of the foregoing events could have a material adverse effect on our business, financial condition and operating results.

We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the Securities and Exchange Commission (the “SEC”) and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. In particular, changes to FASB guidelines relating to accounting for stock-based compensation will likely increase our compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.

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

For the nine months ended September 30, 2004, there were no material changes from the disclosures made in our Amendment No. 2 on Form 10-K for the year ended December 31, 2003. 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 0.87% during the third quarter of 2004. These investments are not subject to interest rate risk.

Item 4. Disclosure 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 principal accounting officer has 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 not 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.

We have restated our financial results for the years ended December 31, 2003 and 2002 and for the quarters ended June 30, 2004 and March 31, 2004 to reflect adjustments to our previously reported financial results. The restatements arose out of an investigation by the Audit Committee.

As a result of the investigation, the Audit Committee determined that the Company had incorrectly recorded revenue on sales contracts that included commitments for as yet undeveloped software upgrade applications for which vendor specific objective evidence (“VSOE”) for the fair value had not yet been established. The Audit Committee further determined that the Company had incorrectly recorded revenue on certain sales contracts upon shipment rather than recording revenue when customer acceptance criteria had been met; and on certain other transactions where the Company had recorded revenue upon shipment of sales with participation by a third party financing company, but had not met all the revenue recognition criteria necessary to recognize revenue. In addition, the Audit Committee determined that the Company had incorrectly recorded revenue on certain transactions where additional revenue on extended warranty/post customer support (software maintenance and service) arrangements were inappropriately recognized resulting in incorrect revenue being recognized and/or deferred at the time of product shipment.

As a result, the Audit Committee concluded that the Company had material weaknesses in its system of internal controls as follows:

The Audit Committee has therefore directed management to implement a number of additional measures designed to further ensure that the Company’s financial results are reported accurately. These measures include:

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These changes either have been, or are in the process of being implemented. We believe the planned and implemented changes to our system of internal controls and our disclosure controls and procedures will be adequate to provide reasonable assurance that the information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Principal Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure based closely on the definition of “disclosure controls and procedures” in Rule 13-a-14(c). However, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake.

(b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting or in other factors during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II - OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits.

(b) Reports on Form 8-K

On August 12, 2004, we filed a Current Report on Form 8-K which contained as an exhibit a copy of our press release announcing earnings for the second quarter of fiscal 2004.

On August 31, 2004, we filed a Current Report on Form 8-K which contained as an exhibit a copy of our press release announcing the resignation of our Executive Vice President and Chief Financial Officer, Barry Hotchkies.

On November 15, 2004, we filed a Current Report on Form 8-K which contained as an exhibit a copy of our press release announcing an ongoing investigation directed by the Company’s Audit Committee, the Committee concluded that the previously issued financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 and Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2004, and June 30, 2004 should no longer be relied upon because of errors in those financial statements and that the Company would restate those financial statements accordingly.

On December 3, 2004, we filed a Current Report on Form 8-K which contained as an exhibit a copy of our press release announcing the resignation of our Chief Executive Officer, Carl W. Hull and the promotion of Robin Stracey to Chief Executive Officer.

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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)

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