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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period ended March 31, 2005

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 May 20, 2005 there were 4,784,039 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

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

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APPLIED IMAGING CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(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

Condensed Consolidated Statements of Operations

and Comprehensive Loss

(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 – Restatement

The Company has restated its consolidated financial statements for the quarterly period ended March 31, 2004. All applicable financial information contained in this Form 10-Q gives effect to this restatement.

NOTE 2 - 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 months ended March 31, 2005 and 2004. These financial statements are unaudited and reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position, operating results and cash flows for those interim periods presented.

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

The results of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2005. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, for the year ended December 31, 2004, contained in our Form 10-K filed with the Securities and Exchange Commission on April 27, 2005.

Going Concern

The accompanying consolidated financial statements of the Company were prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The realization of assets and the satisfaction of liabilities in the normal course of business are dependent on, among other things, the Company’s ability to operate profitably, to generate cash flows from operations, collections of receivables to fund its obligations, as well as the Company’s ability to maintain credit facilities adequate to conduct its business. In the course of its operations, the Company has sustained operating losses and negative cash flows from operations and expects such losses to continue in the foreseeable future. As of March 31, 2005, the Company had cash and cash equivalents on hand of $2.8 million, negative working capital of $15,000, and an accumulated deficit of $49.8 million. The Company intends to finance its operations primarily through its cash and cash equivalents, future financing and future revenues.

Expenditures required to achieve the Company’s growth or the cash flow used in operations may be greater than projected. As a result, the Company’s capital needs may require the Company to seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. There can be no assurance that the Company will be able to obtain additional debt or equity financing on terms acceptable to the Company, or at all. If adequate funds are 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 failure of the Company to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on the Company’s ability to achieve its longer term business objectives.

The Company’s inability to operate profitably and to consistently generate cash flows from operations, its reliance therefore on external funding either from loans or equity raises substantial doubt about the Company’s ability to continue as a going concern.

The Company has a loan agreement with Silicon Valley Bank, SVB, which provides for borrowing of up to $3.5 million based on the level of certain of its North American accounts receivable. The Company was not in compliance with the covenant requiring it to maintain $2.6 million in tangible net worth as of December 31, 2004 and the Company subsequently obtained a waiver for this covenant.

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On February 25, 2005, the Company’s loan agreement with SVB was amended to extend the term of the loan through March 29, 2007 and set the minimum net worth covenant to $1.0 million at the end of each fiscal quarter. In April 2005, the loan agreement was amended to set the minimum net worth covenant commencing April 2005 to $1,000 at the end for each month plus 70% of all consideration received from and after March 2005 for equity securities and subordinated debt and 50% of any quarterly profits in the current quarter. As part of the April 2005 amendment to the loan agreement, the minimum tangible net worth requirement for March 2005 was waived.

At March 31, 2005, the Company had used $983,000 of the facility with $72,000 available but not used. The interest rate on the facility was 7.75% at March 31, 2005, 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 its 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 ($188,000) at March 31, 2005.

NOTE 3 – Inventories (in thousands)

NOTE 4 – Net income (loss) per share

The computation of basic and diluted net loss per share (“EPS”) for the three months ended March 31, 2005 and March 31, 2004 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):

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 5 – 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.

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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.

All of the above assumptions were used for the Employee Stock Purchase Plan except that the expected life is six months and volatility was 95%.

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 6 – Product Warranty

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

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

NOTE 7 – Commitments and Contingencies

In February 2004, the Company was sued by Clarient, Inc. The lawsuit claimed that the Company’s Ariol system infringed on three Clarient patents. Clarient sought damages, as well as an injunction barring the Company from, among other things, making, using, or selling any device in the United States that used Clarient’s patents-in-suit. The case settled in March 2005. Under terms of the settlement, the two companies have granted each other non-exclusive, worldwide licenses allowing for use of their respective brightfield and fluorescent microscopy patent portfolios for pathology applications. Also, as part of the settlement, Clarient will assume non-exclusive distribution rights to the Company’s Ariol, pathology workstation for select applications in drug discovery and development.

On July 8, 2004, the Company renewed its 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 2005 is $108,000.

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 that the Company transferred 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). 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 tax of approximately £585,000 ($1.1 million). The Company plans to have further discussions with the Inland Revenue to support its original valuation of the transferred assets. The Company intends to vigorously defend its position and management believes that an estimate of an accrual is not probable or estimable at this time and therefore it has not accrued for any amount in respect of this matter.

NOTE 8 – Segment and Foreign Operations

The Company operates in one segment. The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. The consolidated financial information is identical to the information presented in the accompanying consolidated statements of operations. The following table presents revenues by geographic area, since it is impracticable for the Company to present the information by individual country except where noted (in thousands):

The following table presents net revenues by geographic region:

NOTE 9 – Subsequent Events

In April 2005, the loan agreement with SVB was amended to set the minimum net worth covenant commencing April 2005 to $1,000 at the end for each month plus 70% of all consideration received from and after March 2005 for equity securities and subordinated debt and 50% of any quarterly profits in the current quarter. As part of the April 2005 amendment to the loan agreement, the minimum tangible net worth requirement for March 2005 was waived.

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On May 20, 2005, the Company executed a one share for each existing four shares reverse stock split. The Company had approximately 19,136,159 common shares outstanding before the reverse stock split and had approximately 4,784,039 common shares outstanding after the reverse stock split.

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, 2004.

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 11 and 24 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004. 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 months ended March 31, 2005 and 2004 were $4.9 million and $5.0 million, respectively.

Sales of systems were $3.5 million and $3.6 million in the three months ended March 31, 2005 and 2004, respectively. System sales were flat in the first quarter of 2005 as compared to 2004.

Service contract and software maintenance revenues were $1.4 million and $1.4 million in the three months ended March 31, 2005 and 2004, respectively. Service contract and software maintenance revenues were flat in the first quarter of 2005 as compared to 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 months ended March 31, 2005 and 2004 were $2.0 million and $1.9 million, respectively. Cost of revenues, as a percentage of total revenues, for the three months ended March 31, 2005 and 2004 were 41% and 38%, respectively.

Research and development expenses. Research and development expenses for the three months ended March 31, 2005 and 2004 were $890,000 and $891,000, respectively. Research and development expenses in the first quarter of 2005 included increased costs for our circulating tumor development initiative and lower costs for our developed Ariol system.

Sales and marketing expenses. Sales and marketing expenses for the three months ended March 31, 2005 and 2004 were $1.4 million and $1.7 million, respectively. Sales and marketing expenses were lower in the first quarter of 2005 as compared to 2004 due to reduced headcount in sales and marketing and lower overall marketing costs.

General and administrative expenses. General and administrative expenses for the three months ended March 31, 2005 and 2004 were $1.1 million and $1.0 million, respectively. General and administration expenses in the first quarters of 2005 and 2004 included costs associated with the patent infringement lawsuit with Clarient that was initiated March 2004 and settled in March 2005.

Other income (expense), net. Other income and expense was $37,000 and $45,000, for the three months ended March 31, 2005 and 2004, respectively.

Liquidity and Capital Resources

At March 31, 2005, we had cash and cash equivalents of $2.8 million and working capital deficit of $15,000, compared to $3.9 and $603,000, respectively, at December 31, 2004. Restricted cash, which collateralizes various credit card and bank guarantees in the United Kingdom, amounted to $188,000 at March 31, 2005 and $193,000 at December 31, 2004.

Cash used by operations in the three months ended March 31, 2005 was $531,000 and cash provided by operations in three months ended March 31, 2004 was $565,000. Cash used by operations in 2005 included a net loss of $511,000 and payments of $623,000 for accrued expenses. Accrued expenses included audit fees related to the restatement of the Company’s prior financial statements as well as expenses related to recently settled patent litigation. Cash provided by operations in 2005 included $449,000 for collection of accounts receivable. Cash provided by operations in 2004 included primarily $956,000 of accounts receivable collections while cash used in operations in 2004 included a net loss of $643,000.

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Accounts receivable as a percent of quarter revenues were 74% at March 31, 2005, compared to 105% at March 31, 2004 and 71% at December 31, 2004. 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 in the three months ended March 31, 2005 and 2004 was $89,000 and $147,000, respectively.

Cash used in financing activities in the three months ended March 31, 2005 and 2004 was $543,000 and $620,000, respectively. Financing activities in the first quarters of 2005 and 2004 were primarily related to the net pay down of the Company’s secured loan with SVB.

We have a loan agreement with Silicon Valley Bank “SVB” which provides for borrowing of up to $3.5 million based on the level of certain of its North American accounts receivable. We were not in compliance with the covenant requiring us to maintain $2.6 million in tangible net worth as of December 31, 2004 and we subsequently obtained a waiver for this covenant.

On February 25, 2005, our loan agreement with SVB was amended to extend the term of the loan through March 29, 2007 and set the minimum net worth covenant to $1.0 million at the end of each fiscal quarter. In April 2005, the loan agreement was amended to set the minimum net worth covenant commencing April 2005 to $1,000 at the end for each month plus 70% of all consideration received from and after March 2005 for equity securities and subordinated debt and 50% of any quarterly profits in the current quarter. As part of the April 2005 amendment to the loan agreement, the minimum tangible net worth requirement for March 2005 was waived.

At March 31, 2005, we had used $983,000 of the facility with $72,000 available but not used. The interest rate on the facility was 7.75% at March 31, 2005, 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 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 $188,000 at March 31, 2005.

We believe that our current cash balances may not be sufficient to fund planned expenditures. This raises substantial doubt about our ability to continue as a going concern. During 2005, we may have to raise additional funds through the issuance of equity or debt securities, or a combination thereof, in the public or private markets in order to continue operations, or sell the company. Additional financing and merger opportunities may not be available, or if available, may not be on favorable terms. The availability of financing or merger opportunities will depend, in part, on market conditions, and the outlook for our company. Any future equity financing would result in substantial dilution to our stockholders. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, through debt covenants or other restrictions. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products or license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing, customer support or other resources devoted to our products. Any of these options could reduce our sales growth and result in continued net losses.

On May 20, 2005 we implemented a one share for each existing four shares reverse stock split. Nasdaq has conditioned our continued listing on our share price trading above $1.00 per share for ten consecutive trading days after May 20, 2005 and on our ability to timely file all our periodic reports for all reporting periods through December 31, 2005. Our share price after the 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, we may not complete our filings on a timely basis. If we are not able to comply with the conditions specified by the Nasdaq, our shares could be delisted from the Nasdaq SmallCap Market. Additionally the reverse stock split may adversely impact our stock price.

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If delisted, our stock may be quoted using the Pink Sheets, LLC or other similar market. A delisting 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.

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

For the three months ended March 31, 2005, there were no material changes from the disclosures made in our Form 10-K for the year ended December 31, 2004. 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 annualized interest rate of 2.9% the first quarter of 2005. 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 Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”) were 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.

In March 2005, we restated our financial results for the years ended December 31, 2003 and 2002 and for the quarters ended March 31, 2004 and June 30, 2004 to reflect adjustments to our previously reported financial results. The restatements arose out of an investigation by the Audit Committee.

As a result of the investigation, the Audit Committee determined that we 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 we 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 we 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 we 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 we had material weaknesses in our system of internal controls as follows:

The Audit Committee therefore directed management to implement a number of additional measures designed to further ensure that our financial results are reported accurately. These measures included:

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The status of the implementation of these measures is as follows:

In Q4 2004, we

In Q1 2005, we

In Q2 2005, we

We believe that with already planned and implemented changes to our system of internal controls, 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 our Chief Financial 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 our 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. During the last fiscal quarter of 2004 and the first quarter of 2005, as described in section (a) we initiated a number of actions to improve our system of internal controls over revenue recognition. Other than the actions to improve our internal controls over revenue recognition, there were no changes in our internal control over financial reporting or in other factors during the first fiscal quarter of 2005 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 1. Legal Proceedings

On February 24, 2004, we received notice of a lawsuit alleging patent infringement filed against us by Clarient, Inc. (formerly known as ChromaVision Medical Systems). The lawsuit claimed that our Ariol system willfully infringed three Clarient patents. Clarient sought unspecified damages, as well as an injunction barring us from, among other things, making, using, or selling any device in the United States that used Clarient’s patents-in-suit. The case was settled through a cross-license and distribution agreement in March 2005.

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

Item 6. Exhibits.

(a) Exhibits.

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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.

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