The Wall Street Journal cited "people familiar with the situation" as saying that Apple is now testing the new small screen tablet, previously referred to as the 'iPad Mini'.
Unnamed sources at Apple's suppliers said that the company has already shared screen designs for the new device, revealing that it will have a display of around 8-inches, smaller than the 9.7-inch panel in the iPad 2.
One person indicated that the iPad Mini will have a similar screen resolution to its bigger brother. Apple is said to be testing the new panels with various screen makers, including Taiwan's AU Optronics and LG Display of South Korea.
Apple declined to comment on the speculation.
The report comes as Apple is expected to launch the third iteration of the full-screen iPad on March 7, featuring a high resolution Retina display and support for 4G.
A smaller screen tablet has been widely rumoured as a way for Apple to broaden its product portfolio in response to growing competition from rival firms.
The iPad Mini would particularly be a response to the success of Samsung's 5.3-inch Galaxy Note, and 7-inch and 8.9-inch Galaxy Tab products, along with the hugely popular Amazon 7-inch Kindle Fire.
The Wall Street Journal also noted that the strategy would mirror the approach taken with the iPod, as Apple released a number of different shapes and sizes of the MP3 player over the years to keep the line fresh (although that approach was not replicated with the iPhone).
Analysts told the Rupert Murdoch-owned newspaper that a tablet with a smaller screen size will help Apple retain and expand its dominant position in the tablet market.
Apple's iPad held more than 61.5% of worldwide tablet shipments in the third quarter of 2011, but that was down from 68.3% in the second quarter, according to market researcher IDC.
"Samsung's 5.3-inch Galaxy Note and Amazon's 7-inch Kindle Fire have been selling well. It means consumers want a tablet that is smaller than the existing 9.7-inch iPad," said Diana Wu, from Capital Securities in Taipei.
"IPad's features are good enough but pricing would be an important factor in the mass market, especially in big emerging markets like China and India."
However, a smaller screen iPad would mark a shift in strategy from that fostered by Steve Jobs, as the late Apple co-founder said in 2010 that the iPad's 9.7-inch display was "the minimum size required to create great tablet apps".