# UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549

# FORM 10-KSB

| | (X) | Annual Report Under Section 13 or 15(D) of the Securities Exchange Act of 1934
          for the Fiscal Year Ended September 30, 2005
| | --- | -------------------------------------------------------------------------------------------------------------------------------------

| | (   ) | 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:
0-26362

# ADVANCED NUTRACEUTICALS, INC.(Name
of small business issuer in its charter)

|                                                                              |                                                          
|----------------------------------------------------------------------------- | ---------------------------------------------------------
|Texas         
(State or other jurisdiction of
incorporation or organization) | 76-0642336          
(I.R.S. Employer Identification No.)

|                                                                                             |                 
|-------------------------------------------------------------------------------------------- | ----------------
|106 South University Blvd., Unit 14Denver, Colorado
 (Address of principal executive office) | 80209
(Zip Code)

Issuer's telephone number, including area code:   
(303) 722-4008

Securities Registered
Pursuant to Section 12(b) of the Act:

| |                                 |                                                               | 
| | ------------------------------- | ------------------------------------------------------------- | 
| | Title of each Class
       None | Name of each
      Exchange
 on Which Registered
        None | 

Securities Registered
Pursuant to Section 12(g) of the Act:

$.01 par value common
stock (Title of Class)

Check whether the issuer is not
required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.  
 Yes  [  ]    No  [X]

Check whether the issuer (1) filed
all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act
during the past 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  [  ]

---



Check if there is no disclosure of
delinquent filers in response to Item 405 of Regulation S-B  contained in this form,
and no disclosure will be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this
Form 10-KSB or any amendment to this Form 10-KSB.   [  ]

The Registrant had revenues of
$22,932,000 for its most recent fiscal year ended September 30, 2005.

The aggregate market value of the
voting stock held by non-affiliates of the Registrant on December 22, 2005 was $5,972,000.

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 number of shares outstanding of
the Registrants common stock on December 22, 2005 was 4,662,410.

DOCUMENTS INCORPORATED
BY REFERENCE

Not Applicable

Transitional Small Business
Disclosure Format (Check one):   Yes   [   ]
   No   [X]

DISCLOSURE REGARDING
FORWARD-LOOKING STATEMENTS

The Company is including the
following cautionary statement in this Annual Report on Form 10-KSB to make applicable and
take advantage of the safe harbor provision of the Private Securities Litigation Reform
Act of 1995 for any forward looking statements made by, or on behalf of the Company.
Forward looking statements include statements concerning plans, objectives, goals,
strategies, future events or performance and underlying assumptions and other statements
which are other than statements of historical facts. Certain statements contained herein
are forward looking statements and, accordingly, involve risks and uncertainties which
could cause actual results or outcomes to differ materially from those expressed in the
forward looking statements. The Companys expectations, beliefs and projections are
expressed in good faith and are believed by the Company to have a reasonable basis,
including without limitation, managements examination of historical operating
trends, data contained in the Companys records and other data available from third
parties, but there can be no assurance that managements expectation, beliefs or
projections will result or be achieved or accomplished. Actual events or results may
differ materially as a result of risks facing the Company. Such risks include, but are not
limited to, changes in business conditions, the general economy, competition, changes in
product offerings, as well as regulatory developments that could cause actual results to
vary materially from the future anticipated results indicated, expressed or implied, in
such forward-looking statements. The Company disclaims any obligation to update any
forward-looking statement to reflect events or circumstances after the date hereof.

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PART I

|ITEM 1. | DESCRIPTION OF BUSINESS
|------- | -----------------------

Advanced Nutraceuticals, Inc.
(ANI or the Company), www.advancednutraceuticals.com or
www.anii.cc, a holding company, organized in March 2000, has one operating subsidiary,
Bactolac Pharmaceutical Inc. (Bactolac),www.bactolac.com, a private
label contract manufacturer of vitamins and supplements. Information contained on the
Companys and its subsidiarys web sites do not comprise a part of this Form
10-KSB.

Bactolac, located in Hauppauge, New
York, was founded in 1995 and is engaged in the formulation, manufacturing, coating and
packaging of encapsulated and compressed tablets and powder blended vitamins and related
nutritional supplements. Bactolac operates out of a state of the art, approximate 32,700
square foot facility. Continued investments in high-tech lab equipment, high speed
manufacturing equipment, in-house thin film coating equipment and flexible packaging
equipment have resulted in faster turn around times and greater control of the quality and
production processes. During late 2004 and early 2005, Bactolac expanded into an
additional 29,000 sq. ft. facility under a five-year lease with an unrelated party to
provide additional manufacturing, materials handling and lab space in a building adjacent
to the existing facility.
Total facility space currently exceeds 65,000 square feet.
 Bactolac provides private label contract manufacturing services,
with over 1,000 different formulations of vitamins and supplements to various companies
engaged in the marketing and distribution of vitamins, mineral supplements, herbs and
other health and nutrition consumer products.

Bactolacs growth and
profitability have been driven by its reputation for creating exciting, innovative
formulas including weight loss, sport nutrition, energy products, antioxidants, formulas
designed specifically for men, women and children, stress formulas, relaxation formulas,
life extension, immune enhancement, brain products, cleansing products, cholesterol
products, liver formulas, heart formulas and hundreds of herbal remedies. Additionally,
Bactolac custom formulates products in response to, and in conjunction with, customer
demand. Bactolac strives to provide high quality nutritional products that promote the
health and vitality of its users.

In November 2005, Bactolac joined the
National Nutritional Foods Association (NNFA) and is seeking to
obtain certification as an NNFA Good Manufacturing Practices (GMP)  approved
manufacturer. This certification is anticipated to be completed in early 2007,
although no assurance can be given that such certification will be obtained. The
NNFA is the leading organization in the industry in promoting high quality
standards and certifying GMP manufacturers. Additional information concerning
the NNFA can be found on their web site at www.nnfa.org.

The Federal Food, Drug, and Cosmetic
Act, (FDCA), regulates the formulation, manufacturing, packaging, labeling,
distribution and sale of dietary supplements, including vitamins, minerals and herbs,
while the Federal Trade Commission (FTC) regulates the advertising of these
products, and the Postal Service regulates advertising claims with respect to such
products sold by mail order.

The FDCA has been amended several
times with respect to dietary supplements, in particular by the Dietary Supplement Health
and Education Act of 1994, (DSHEA). DSHEA established a new framework
governing the composition and labeling of dietary supplements. As authorized by DSHEA, the
Food and Drug Administration (FDA) has recently proposed
GMP's specifically for dietary supplements. These new GMP
regulations, if finalized (which is predicted to occur in the near future), would be more
detailed and strict than the GMPs that currently apply to dietary supplements and
may, among other things, require dietary supplements to be prepared, packaged and held in
compliance with certain rules, and might require quality control provisions similar to
those in the GMP regulations for drugs. Bactolac has made significant changes to its
processes to improve its quality control and manufacturing processes as well as expansions to its
lab facilities and equipment in advance of
applying for the NNFA certification which is believed will assist in meeting proposed new
FDA regulations. There can be no assurance that, if the FDA adopts GMP regulations for
dietary supplements, Bactolac will be able to comply with the new rules without incurring
additional expenses. It is believed that with more customers requiring that their
suppliers be certified by the NNFA and if the proposed new FDA regulations are adopted,
many of the low-cost and non-qualifying suppliers in the industry over the next few years, will
either be forced to raise their prices to comply, or be forced out of business.

1

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On March 23, 2004, the Company
completed the sale of substantially all of the assets and operations of the Companys
subsidiary, ANI Pharmaceuticals, Inc. (ANIP), formerly also referred to as
ASHCO, to an unrelated third party. The historical operations and results of the sale
transaction of ANIP are accounted for as a discontinued operation within the accompanying
consolidated financial statements.

The Companys  strategy
is to continue to grow its Bactolac subsidiary, thereby improving the Companys
financial position, by generating profits and positive cash flow.
The Company believes it can successfully implement this strategy by continuing in its
aggressive efforts to obtain new customers, focusing on expanded sales opportunities with
its existing customers and through emphasizing its competitive manufacturing operations
while at the same time maintaining a stringent cost containment program. The Company may
also consider strategic acquisition opportunities in the distribution
segments of the nutritional industry. The Company intends to continue to consider other
strategic initiatives to enhance shareholder value, including without limitation, the
sale or merger of the Company.

FINANCIAL INFORMATION ABOUT THE
COMPANY'S BUSINESS SEGMENTS

Following the completion of the sale
of ANIP in March 2004, the Company now operates in one segment. Bactolac is a private
label contract manufacturer of vitamins and supplements located in Hauppauge, New York.
Additional
financial information can be found in ITEM 7, FINANCIAL STATEMENTS.

Vitamin and Supplement
Business

Bactolac manufactures a comprehensive assortment of vitamin, mineral and
nutritional supplement products, which include a variety of vitamins, powders,
glucosumine, beta carotene, magnesium, folic acid, calcium and potassium, as
well as various herbs such as Echinacea, St. Johns Wort, Ginko Biloba, Saw
Palmetto, Ginseng, and various multivitamin combinations, with no single product
representing a sales concentration.

The Company has the capacity to
produce millions of tablets per day using technologically advanced high-speed
manufacturing equipment. Bactolac regularly increases its production capacity through
additional equipment purchases and replacing slower speed equipment with faster and
computer controlled automatic feed equipment, as well as vertically integrating processes
that have previously been performed by outside subcontractors.

Capital expenditures at Bactolac during 2005 approximated $661,000. Capital
expenditures at Bactolac over the past three years have resulted in
significantly higher production capacities, with shorter production turnaround
times. Expansions to its lab space, as well as additions to personnel and
equipment in its lab facilities have resulted in much higher levels of quality
control, including virtually all raw materials, in-process and finished goods,
being tested. Bactolac custom formulates products in response to, and in
conjunction with, customer demand. The Company also has in-house thin film
coating line and a fully automated packaging line.

2

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Raw materials used in Bactolacs
products consist of nutrient powders, excipients, empty gelatin capsules, and necessary
components for packaging and distribution of finished vitamin and nutritional supplement
products. The nutrient powders and the empty gelatin capsules are purchased from
manufacturers, distributors and growers in the United States and foreign countries. All materials procured by
Bactolac undergo quality control review to ensure conformance to product specification
prior to acceptance and release into materials inventory. To date, the Company has not
experienced any material difficulty in obtaining adequate sources of supply, and generally
a number of suppliers are available for most raw materials. Although there can be no
assurance that adequate sources will continue to be available, Bactolac believes it should
be able to secure sufficient raw materials in the future.

Bactolac generated net sales of $22,932,000 and $17,639,000 for the years ended
September 30, 2005 and 2004, respectively. The top three unrelated customers
accounted for approximately 30% and 39% of Bactolacs net sales for each of the
fiscal years ended September 30, 2005 and 2004, respectively. Seasonality is
generally not a major factor in Bactolacs business, except that revenues during
late summer and fall are typically slightly higher than other periods. Days with
high heat and humidity can negatively affect Bactolacs ability to manufacture
certain products. Backlog of open orders at Bactolac is fairly short term in
nature due to quick production turn around, with recent backlog less than one
months sales.

Customers and Markets

The Company manufactures a broad range of products and uses a variety of methods
to market and sell its products and services including word of mouth referrals
from one customer to another, sales personnel, contract sales representatives,
trade show participation, and press publicity, as well as web site exposure
 and reliance on name recognition and its reputation in
the industry.

Bactolacs customer base includes customers with a wide range of distribution
methods. Customers include direct marketing companies, network-marketing
companies, retail chain distribution and customers who re-package bulk products
for re-sale to others. During the current fiscal year, Bactolac concentrated on
increasing its customer base through expanded marketing and sales efforts,
including developing marketing materials in addition to commencing attendance at
trade shows.

The Companys operations are
subject to the risks normally associated with manufacturing vitamins and nutritional
products, including shortage of certain raw materials.

3

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Financial Information Relating to
Export Sales  Continuing Operations:

For the year ended September 30, 2005, sales to unaffiliated customers totaled
$22,932,000. Of this total, $1,933,000 related to customers in Russia. For the
year ended September 30, 2004, sales to unaffiliated customers totaled
$17,639,000. Of this total, $1,123,000 related to customers in Russia. All
identifiable assets as of September 30, 2005 were located in the United States.

Research and Development

The primary areas of the
Companys research and development activities are focused in working with customers
in the development of new products and expansion of the product line offerings for the
private label market. Such assistance is normally in the form of product component
identification and formulation, as well as product and packaging trends. In addition, as
part of its quality control procedures, the Company produces pilot or sample runs of
product formulation prototypes to ensure stability and/or efficacy and to determine
ingredient interaction. The Company has implemented quality control procedures to verify
that all products comply with established specifications and standards in compliance with
both United States Pharmacopoeia (USP) and GMP promulgated by the Food and
Drug Administration (FDA). Research of this type is a part of the internal
overhead operating expenses incurred by the Company and the associated incremental outside
costs of research and development activities have not been significant to date.

Competition

The Companys products are sold
primarily in domestic as well as limited foreign markets in competition with other private
label manufacturing and marketing companies. The vitamin and nutritional supplement
industries are highly competitive, and competition continues to increase. Competition for
the sale of products comes from many sources, including companies that sell nutraceuticals
to supermarkets, large chain discount retailers, drug store chains and independent drug
stores, health food stores, and others who sell to wholesalers, as well as mail order
vendors, electronic commerce and network marketing companies. The Company does not believe
it is possible to accurately estimate the number or size of its many competitors, as the
vitamin industry is largely privately held and highly fragmented.

The Company believes the industries
it operates in continue to see significant changes through merger and acquisition
consolidations, as well as contractions due to a general slowing of the prior growth
trend. Many industry experts expect this trend to continue for the foreseeable future in
food and nutrition companies, multilevel marketing and direct marketing organizations and
electronic commerce firms.

Based on industry data, the
botanicals and supplements industry is experiencing a trend of slowed to contracting
growth. The industry, while still estimated at approximately $20 billion annually, is
believed to be moving into a mature stage where greater price pressure and modest market
expansion will continue to increase competition.

4

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Employees

At September 30, 2005, the Company
employed 125 full-time and two part-time employees in its operations, with Bactolac
employing 123 people and four employed (two full-time and two part-time) in holding company
executive management. The employees at Bactolac are engaged in management and sales,
quality control, production and administration.

The Company has never experienced a
work stoppage, and none of its employees is currently represented by a union or any other
form of collective bargaining unit. The Company believes its relations with its employees
are good.

Government Regulation

The formulation, manufacturing,
packaging, labeling, advertising and distribution of the Companys products are
subject to regulation by one or more federal agencies, including the Food and Drug
Administration (FDA), the Federal Trade Commission (FTC), the
Consumer Product Safety Commission (CPSC), the United States Department of
Agriculture (DOA), the United States Postal Service (USPS) and the
Environmental Protection Agency (EPA). These activities are also regulated by
various agencies of the states and localities in which the Companys products are
sold, including without limitation the California Department of Health Services, Food and
Drug branch. The FDA and FTC in particular regulate the advertising, labeling and sales of
vitamin and mineral supplements and may take regulatory action concerning medical claims,
misleading or untruthful advertising, and product safety issues. These regulations include
the FDAs Good Manufacturing Practices (GMPs) for foods.

The Federal Food, Drug, and Cosmetic
Act, (FDCA), regulates the formulation, manufacturing, packaging, labeling,
distribution and sale of dietary supplements, including vitamins, minerals and herbs,
while the FTC regulates the advertising of these products, and the USPS regulates
advertising claims with respect to such products sold by mail order.

The FDCA has been amended several times with respect to dietary supplements, in
particular by the Dietary Supplement Health and Education Act of 1994,
(DSHEA). DSHEA established a new framework governing the composition and
labeling of dietary supplements. As authorized by DSHEA, the FDA has recently
proposed GMPs specifically for dietary supplements. These new GMP regulations,
if finalized (which is predicted to occur in the near future), would be more
detailed and strict than the GMPs that currently apply to dietary supplements
and may, among other things, require dietary supplements to be prepared,
packaged and held in compliance with certain rules, and might require quality
control provisions similar to those in the GMP regulations for drugs. Bactolac
has made significant changes to its processes to enhance and expand its quality
control and manufacturing processes in advance of applying for the NNFA
certification which is believed will assist in meeting proposed new FDA
regulations. There can be no assurance that, if the FDA adopts GMP regulations
for dietary supplements, Bactolac will be able to comply with the new rules
without incurring additional expenses. It is believed that with more customers
requiring their suppliers be certified by the NNFA and if the proposed new FDA
regulations are adopted, many of the low-cost suppliers in the industry over
the next few years will either be forced to raise their prices to comply, or be
forced out of business.

5

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The Company may be subject, from time
to time, to additional laws or regulations administered by the FDA or other federal, state, local
or foreign regulatory authorities, or to revised interpretations of current laws or
regulations. The Company is unable to predict the nature of such future laws, regulations,
interpretations or applications, nor can it predict what effect additional governmental
regulations or administrative orders, when and if promulgated, would have on its business
in the future. They could, however, require the Company to: reformulate certain products
to meet new standards; recall or discontinue certain products not able to be reformulated;
expand documentation of the properties of certain products; expand or provide different
labeling and scientific substantiation; or, impose additional record keeping requirements.
Any or all such requirements could have a material adverse effect on the Companys
results of operations and financial position.

Discontinued Operations
 ANIP

On March 23, 2004, the Company
completed the sale of substantially all of the assets and operations of the Companys
subsidiary, ANIP, to an unrelated third party. In connection with the sale the Company
received cash of approximately $3.4 million and the buyer assumed approximately $1.7
million in liabilities, primarily trade accounts payable. The Company used the entire cash
proceeds, net of closing expenses and a $250,000 escrow requirement, to repay the
outstanding balance on the mortgage on the ANIP facility and the balance to reduce the
Companys senior credit facility. As a result of the sale, the Company recorded a
loss of approximately $1,187,000 net of a deferred income tax benefit of $663,000. ANIP
had previously been reported as a separate segment of the Company and was a contract and
private label manufacturer of over-the-counter liquid and powder pharmaceutical products,
primarily liquid stomach remedies, located in Gulfport, Mississippi. As a result of the
sale, the Companys consolidated financial statements and related notes thereto have
been reclassified to present the operations of ANIP as discontinued operations. The
Company now operates in only one segment.

The agreement for the sale of ANIP
included a provision for a potential post-closing adjustment to the purchase price
depending upon the final adjusted net working capital of the net assets sold, as defined
under the agreement. The parties agreed during the fourth quarter of fiscal 2004 to a
final adjusted net working capital settlement with the buyer remitting approximately
$10,000 to the Company. Under the terms of the purchase agreement typical representations
and warranties were made by the Company to the buyer, which are the only remaining
outstanding items from the sale transaction.

During November 2004, the Company
closed on the sale of the remaining asset that had been held for sale relating to the ANIP
operations. The sale resulted in cash proceeds of approximately $109,000 and no gain or
loss on the disposal.

RISK FACTORS

Important factors that could cause
actual results to differ materially from the Companys expectations are disclosed in
this Report, including without limitation in conjunction with the forward-looking
statements included in this Report, and the following risk factors.

Dependence on Significant Customers.  
Approximately 30% of the Companys revenues for the year ended September 30,
2005 were generated from three customers and 39% of the Companys total revenues
in the fiscal year ended September 30, 2004 were generated from three customers.
Of these sales, approximately $1.9 million and $1.1 million of sales are to
customers in Russia for the years ended September 30, 2005 and 2004,
respectively. The Company is aggressively continuing to attempt to expand its
customer base to reduce its dependence on these customers. The loss of any one
of these significant customers could have a material adverse effect on the
Companys business and financial condition.

6

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Dependence on Key Personnel.  ANIs future success depends on the continued availability of certain key management
personnel, including Dr. Pailla M. Reddy, founder of Bactolac and Chairman and Director of ANI, Greg
Pusey, Director and President of ANI and Jeffrey McGonegal, Chief Financial
Officer of the Company. ANI has obtained key man insurance on the life of Dr.
Reddy. ANIs growth and profitability also depend on its ability to attract and
retain other key management personnel.

Bulletin Board Listing.  The
Companys common stock is currently traded under the symbol ANII on the
OTC Bulletin Board System. Trading on this system can have a negative impact on the
trading activity and price of the Companys common stock resulting from a limited
trading market for our common stock and certain trading restrictions placed on
broker-dealers recommending the purchase or sale of securities traded on the Bulletin
Board System.

Government Regulations.  The
manufacturing, processing, formulation and packaging of the Companys products are
subject to regulation by federal, state and foreign agencies, including the FDA, the FTC,
the CPSC, the DOA, the USPS and the EPA. Such agencies have a variety of remedies and
processes available to them, including initiating investigations, issuing warning letters
and cease and desist orders, requiring corrective labels or advertising, requiring
consumer redress (for example, by requiring that a company offer to repurchase products
previously sold to consumers), seeking injunctive relief or product seizure, imposing
civil penalties, or commencing criminal prosecution.

There can be no assurance that the
regulatory environment in which the Company operates will not change or that such
regulatory environment, or any specific action taken against the Company, will not result
in a material adverse effect on the Companys business, financial condition or
results of operations. The Company also cannot predict whether new legislation regulating
its activities will be enacted, which new legislation could have a material adverse effect
on its operations.

Product Liability.  The Company, like
other manufacturers and distributors of products that are ingested, faces an inherent risk
of exposure to product liability claims if, among other things, the use of its products
results in injury. The Company currently has product liability insurance for its
operations in amounts the Company believes are adequate for its operations. There can be
no assurance, however, that such insurance will continue to be available at a reasonable
cost, or if available, will be adequate to cover liabilities.

Ability to Implement Business
Strategy; Integration of Acquisitions.  The Companys future results and financial
condition are dependent on the successful implementation of its business strategy. A
component of the Companys long-term business strategy may involve strategic
acquisitions.

Risks Related to Working Capital
Financing; Leverage.  Financing for the Companys earlier acquisitions, as well as
ongoing working capital and capital equipment needs is provided primarily through a
leveraged lending arrangement. The loan facility is secured by substantially all the
assets of the Company and its subsidiaries. The Companys loan facility contains
various covenants that require the maintenance of certain financial ratios, as well as
additional covenants and significant restrictions on dividend payments, issuance of debt
and equity, mergers, changes in business operations and sales of assets. Should the
Company not be successful in continuing to comply with the covenant restrictions and repay
the obligations under their terms, the financial position and liquidity of the Company
could be adversely affected.

7

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Dividends.  
The Company has not paid any dividends since 1998. The Companys credit
facility prohibits dividend payments without the consent of the lender. The
determination of whether to pay dividends in the future will be made by the
Board of Directors and will depend on the earnings, capital requirements, and
operating and financial condition of the Company, among other factors. It is not
anticipated that the Company will pay dividends in the fiscal year ending
September 30, 2006 or in the foreseeable future.

Competition.  
The market for the Companys products is highly competitive. The Company
competes with other dietary supplement producers. Among other factors,
competition among these manufacturers is based upon price. If one or more
manufacturers significantly reduces its prices in an effort to gain market
share, the Companys business, operations and financial condition could be
adversely affected. The Company is a contract manufacturer that sells
substantially all of its supplement products to customers who re-sell and
distribute the products.

|ITEM 2. | DESCRIPTION OF PROPERTY
|------- | -----------------------

Properties

Bactolac, headquartered in Hauppauge, New York, conducts its operations in a
leased facility comprising approximately 32,700 square feet. Bactolacs current
monthly rental is approximately $30,000, (of which approximately $6,000 pertains
to improvements made by a related party), that escalates over the remaining term
on the lease, through December 2010. Bactolac has agreed to lease an additional
4,000 sq. ft. in the current facility, beginning January 1, 2006, for the same
terms as the existing lease, initially at $5,250 per month. The Company has an
additional five-year renewal option on the facility. Bactolac leases this
facility from Shilpa Saketh Realty, Inc., an entity owned by Dr. Pailla M.
Reddy, Chairman of the Board of Directors of the Company and President of
Bactolac. During the third quarter of 2004, Bactolac leased an additional 29,000
square feet under a five-year agreement, from an unrelated third party, as
expansion space. In addition, ANI currently rents administrative office space in
Houston, TX, on a temporary, month-to-month basis for approximately $600 per
month. Management of the Company believes that its properties are adequately
covered by insurance. Management also believes that its facilities are suitable
and adequate and will be sufficient for anticipated growth.

See Item 6.
Managements Discussion and Analysis and Item 7. Financial Statements

|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

The Company is not a party to any
legal proceedings, the adverse outcome of which would, in managements opinion, have
a material adverse effect on the Companys business, financial condition and results
of operations.

|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------

Item not applicable.

8

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PART II

|ITEM 5. | MARKET
FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
|------- | ---------------------------------------------------------------------

The Companys common stock is traded on the OTC Bulletin Board System under the
symbol ANII. The following chart illustrates the high and low closing prices of the
Companys common stock for the periods indicated:

|Quarter Ended      |  |  | High |   | Low
|------------------ |  |  | ---- | - | ---
|Fiscal 2004:       |  |  |      |   |    
|December 31, 2003  |  |  | $    | 0 | .75
|March 31, 2004     |  |  |      | 1 | .05
|June 30, 2004      |  |  |      | 5 | .25
|September 30, 2004 |  |  |      | 4 | .70
|                   |  | 
|Fiscal 2005:       |  | 
|December 31, 2004  |  |  |      | 4 | .10
|March 31, 2005     |  |  |      | 4 | .95
|June 30, 2005      |  |  |      | 4 | .70
|September 30, 2005 |  |  |      | 4 | .50

As
of December 22, 2005, there were approximately 2,500 record holders of the Companys common stock.

No dividends have been declared by
the Company in the prior two years. It is not likely that dividends will be declared in
the fiscal year ending September 30, 2006. Under its current loan agreement, the Company
may not declare any dividends without the consent of its lender. Subject to obtaining the
lenders consent, the determination of the payment of dividends in the future will be
within the discretion of the Companys Board of Directors and will depend on the
earnings, capital requirements and operating and financial condition of the Company, among
other factors.

|ITEM 6. | MANAGEMENT'S DISCUSSION AND ANALYSIS
|------- | ------------------------------------

Results of Operations

Following is a summary table of the
key operating statistics of the Company for the years ended September 30, 2005 and 2004:

|              | Year ended September 30, | 
|------------- | ------------------------ | 
|
|Net sales     |                          | 
|Cost of sales |                          | 
|Gross profit  |                          | 

9

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Fiscal Year 2005 Compared
to Fiscal Year 2004

Net sales from continuing operations for the 2005 period increased to
$22,932,000, a $5,293,000 or 30.0% increase over the 2004 period. The increase
was attributable to an approximate $2.5 million net increase in the sales of
products to existing customers and an approximate increase of $2.8 million in
sales to new customers in 2005.

Gross profit from continuing
operations for the 2005 period increased to $6,330,000, a $302,000 increase over the 2004
amount. Gross profit as a percentage of net sales decreased to 27.6% in 2005, as compared
to 34.2% in the 2004 period. The change resulted from incremental additional costs in
processing initial orders to new customers, changes in the product mix during the period
and increases in raw material costs that were not able to be passed on to customers for
those orders in process when material price increase notices were received. Additional
costs are also being incurred for the expanded quality control verification steps and
testing that have recently been implemented.

Total general and administrative expenses for continuing operations, increased
to $3,309,000 in 2005, from $2,849,000, in 2004. This represents an increase of
$460,000, or 16.1%. The majority of the increase relates to approximately a
$152,000 increase in administrative payroll costs associated with additional
management, sales and quality staff, an approximate $58,000 increase in bad
debts associated with higher sales levels, and a $51,000 increase in sales
commissions due to higher sales and changes in customer mix in 2005.

During the year ended September 30, 2005 an income tax expense, primarily a
deferred tax charge, was recorded totaling $918,000. During the year ended
September 30, 2004, a deferred income tax benefit of $1,332,000 was recorded on
continuing operations, resulting primarily from the recognition of the deferred
income tax benefit associated with tax loss carryforwards. Due to the tax loss
carryforwards, the deferred tax charges have not required cash payments be made
for income taxes. Previously, a valuation allowance had been recorded, as the
Company, until 2004, was not able to determine that it was more likely than not
that such losses would be utilized.

Discontinued Operations

On March 23, 2004, the Company completed the sale of substantially all of the
assets and operations of the Companys subsidiary, ANIP, to an unrelated entity.
ANIP manufactures high quality pharmaceutical products, primarily liquid and
powder pharmaceutical products. As a result of the sale of ANIP, the Companys
consolidated financial statements and related notes thereto have been
reclassified to present the operations of ANIP as discontinued operations. For
further discussion see Note 10 of the Notes to Consolidated Financial Statements
in Item 7. The Company now operates in only one segment.

Liquidity and Capital
Resources

ANI meets its working capital and
capital expenditure requirements, including funding for debt repayments, mainly through
net cash provided from operations of the Companys subsidiary, Bactolac. Management
plans to continue to strive to maintain and enhance the profitability of the Bactolac
operation to meet currently anticipated funding requirements. The Company has a $2.5
million revolving credit facility as part of its credit agreement that is generally used
monthly to fund intra-month working capital needs primarily for inventory purchases.

10

---



The Company has a $6.5 million credit facility with a bank that
provides the Company with a $2.5 million revolver and a $4.0 million term loan
(the Credit Facility). Interest on the outstanding loan balance is
paid monthly and the term loan portion of the facility provides for quarterly
principal payments of approximately $250,000 commencing September 1, 2005 and
increasing to $437,500 over the three-year life of the loan. Additional annual
payments are due, as defined under the Credit Facility, commencing with the year
ending September 30, 2006. As of September 30, 2005, an overpayment of $304,000
had been made on the revolver. The Company had additional borrowings available
under its revolver of approximately $2,804,000, at September 30, 2005, based
upon the overpayment, and accounts receivable and inventory levels.

During the fourth quarter of 2005,
the Company completed a tender offer to buy back 1,058,824 shares of its outstanding
common stock at a price of $4.25 per share from stockholders of record as of July 27,
2005. The Company obtained all of the funds necessary to purchase shares tendered in the
offer, and to pay related fees and expenses, by borrowing $4,000,000 under its secured
credit facility, which had been amended to provide for that use. As of September 1, 2005,
the initial $250,000 quarterly payment on the term debt was paid and as of September 30,
2005, $3,750,000 was outstanding on the term loan.

Borrowings under the Credit Facility
mature in July 2008, are collateralized by substantially all of the Companys
assets, and bear interest at rates that fluctuate with the prime rate, with the revolver
at 0.5% over prime (not to be less than a total rate of 6.25%), 6.98% at September 30,
2005, and the term loan at 3.0% over prime (not to be less than a total rate of 8.75%).
Due to the floor interest amounts under the Companys credit facility,
the 2003-2004 prime rate levels have not impacted the Companys interest rate.
Increases in the prime rate in late 2004 and into 2005, have increased the Companys
interest expense.

The revolver portion of the Credit Facility requires a
lockbox arrangement, which requires all receipts to be swept daily to reduce borrowings
outstanding under the credit facility. This arrangement, combined with a Subjective
Acceleration Clause (SAC) in the credit facility, cause the revolving credit
facility to be classified as a current liability, per guidance in the FASBs
Emerging Issues Task Force Issue 95-22, Balance Sheet Classification of Borrowings
Outstanding under Revolving Credit Agreements that Include Both a Subjective Acceleration
Clause and a Lock-Box Arrangement.

The Credit Facility, as amended, contains a
number of covenants, which include, among other items, maintenance of specified minimum
EBITDA, fixed charge ratios and maximum senior debt leverage ratios, as well as
limitations on capital expenditures and the payment of dividends. As of September 30,
2005, after giving effect to waivers granted by the lender relating to capital
expenditures, the Company was in compliance with the covenants of the Credit Facility, as
amended.

In connection with continued
expansion and upgrades of the business including the recent 4,000 square foot increase to
the leased facility in Hauppauge, New York, the Company estimates that capital needs for equipment purchases and
leasehold improvements during the 2006 fiscal year will total $300,000 to $400,000. It is
expected that funding for the majority of the capital additions will be provided out of
working capital with a portion funded out of the credit facility.

11

---



At September 30, 2005, the Company had working capital of $4,572,000. As of
September 30, 2005, there was an overpayment of $304,000 on the revolver. The
Company had additional borrowings available under the revolver, of approximately
$2,804,000, at September 30, 2005, based upon the overpayment, and accounts
receivable and inventory levels. The balance on the term loan portion of the
Credit Facility was $3,750,000.

Operating Activities

Net cash flows from continuing
operating activities generated approximately $2,918,000 in 2005 and generated
approximately $2,594,000 in 2004.

The net cash generated in 2005
consisted primarily of the $1,879,000 income from continuing operations plus the non cash
expenses of $415,000 of depreciation and amortization expense and $843,000 in deferred
income tax expense. Additionally, an increase of approximately $1,354,000 in accounts
payable provided cash. A $648,000 increase in accounts receivable and a $994,000 increase
in inventories consumed cash. These increases in working capital items primarily related
to higher sales levels in 2005.

The net cash generated in 2004
consisted primarily of the $4,235,000 income from continuing operations plus the non cash
expenses which included $358,000 of depreciation and amortization expense, a $254,000
decrease in the allowance for doubtful accounts less the $1,362,000 deferred income tax
benefit. This was offset by cash used for increases of accounts receivable and inventories
totaling $1,031,000 and the $102,000 decrease in accounts payable.

Discontinued operations consumed
$492,000 in 2004. The majority of this related to the net loss incurred during the periods
net of the changes in working capital items.

Investing Activities

Investing activities from continuing
operations consumed approximately $2,067,000 in 2005, used for $661,000 in additions to
equipment and $1,406,000 land held for expansion.

Investing activities from continuing
operations consumed approximately $243,000 in 2004, used for additions to equipment.

Discontinued operations generated $109,000 in 2005 and $3,390,000 in 2004. The
2005 amount related primarily to the sale of ANIP land that had been held for
sale and the 2004 amount related to the sale of ANIP.

Financing Activities

Financing activities from continuing
operations consumed approximately $2,069,000 in 2005. The tender offer share repurchase by
the Company consumed $4.5 million of cash which was financed primarily by a $4.0 million
advance on the new term loan. Repayment of debt of $736,000 under the terms loans and
$1,041,000 under the revolver and payment of loan fees for the new facility of $118,000
all consumed cash. The exercise of stock options by several employees generated
approximately $298,000 in cash.

Financing activities from continuing
operations consumed approximately $168,000 in 2004. The outstanding balance on the
revolving portion of the credit facility was reduced by $122,000 and other long-term notes
payable were reduced by $82,000 during the year.

12

---



Discontinued operations consumed
approximately $4,338,000 in 2004. These amounts consisted primarily of debt repayments
following the ANIP sale in 2004.

The Companys revolving credit facility, as amended provides for borrowings,
based upon outstanding amounts of eligible accounts receivable and allowable
inventories. Additionally, there is a term loan facility with the secured lender
that requires principal payments of approximately $250,000 quarterly for the
first year which began September 1, 2005, and increasing each of the next two
years thereafter. The Agreement matures in July 2008. Interest on amounts
outstanding under the Agreement is payable monthly based upon the lenders prime
rate plus one half of one percent (0.50%) for the revolving portion of the
facility and the prime rate plus three percent (3.0%) for the equipment term
loan portion. The credit facility is secured by substantially all of the
Companys assets. The Agreement contains a number of covenants, which include
among other items; maintenance of specified minimum net worth and fixed charge
ratios, as well as limitations on capital expenditures and restrictions on the
payment of dividends. After giving effect to a waiver granted by the lender,
relating to capital expenditures, the Company is in compliance with the
covenants of the loan agreement as amended.

Capital expenditures, primarily for
manufacturing and facility improvement costs for the fiscal year ending September 30,
2005, were approximately $661,000. Additionally, $1,041,000 was expended for raw land that
is being held for future expansion, adjacent to the current facility.

Critical Accounting
Policies

The Companys financial
position, results of operations and cash flows are impacted by the accounting policies the
Company has adopted. In order to get a full understanding of the Companys financial
statements, one must have a clear understanding of the accounting policies employed. A
summary of the Companys critical accounting policies follows:

Accounts Receivable:  Accounts
receivable balances are stated net of allowances for doubtful accounts. The Company
records allowances for doubtful accounts when it is probable that the accounts receivable
balance will not be collected. When estimating the allowances for doubtful accounts, the
Company takes into consideration such factors as its day-to-day knowledge of the financial
position of specific clients, the industry and size of its clients. A financial decline of
any one of the Companys large clients could have an adverse and material effect on
the collectibility of receivables and thus the adequacy of the allowance for doubtful
accounts. Increases in the allowance for doubtful accounts are recorded as charges to bad
debt expense and are reflected in other operating expenses in the Companys
consolidated statements of operations. Write-offs of uncollectible accounts are charged
against the allowance for doubtful accounts.

Inventories:  The Companys
inventory is a significant component of current assets and is stated at the lower of cost
or market. The Company regularly reviews inventory quantities on hand and records
provisions for excess or obsolete inventory based primarily on its estimated forecast of
product demand, market conditions, production requirements and technological developments.
Significant or unanticipated changes to the Companys forecasts of these items,
either adverse or positive, could impact the amount and timing of any additional
provisions for excess or obsolete inventory that may be required.

13

---



Long-Lived Assets:  The Company
records property and equipment at cost. Depreciation of the assets is recorded on the
straight-line basis over the estimated useful lives of the assets. Dispositions of
property and equipment are recorded in the period of disposition and any resulting gains
or losses are charged to income or expense when the disposal occurs. The carrying value of
the Companys long-lived assets is periodically reviewed to determine that such
carrying amounts are not in excess of estimated market value. Goodwill is reviewed
annually for impairment by comparing the carrying value of each reporting unit to the
present value of its expected cash flows. For fiscal 2004 and 2005, the required annual
testing resulted in no impairment charges.

Deferred Income Taxes:  Deferred tax
assets and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. In addition, a valuation allowance is
established to reduce any deferred tax asset for which it is determined that it is more
likely than not that some portion of the deferred tax asset will not be realized.

Revenue Recognition:  The
Companys revenues are recognized when products are shipped to unaffiliated
customers. The Securities and Exchange Commissions Staff Accounting Bulletin (SAB)
No. 104, Revenue Recognition provides guidance on the application of generally
accepted accounting principles to select revenue recognition issues. The Company has
concluded that its revenue recognition policy is appropriate and in accordance with SAB
No. 104.

Recent Accounting
Pronouncements

In December 2004, the Financial
Accounting Standards Board (FASB) issued SFAS No. 123(R) Share-Based
Payment, which addresses the accounting for share-based payment transactions. SFAS
No. 123(R) eliminates the ability to account for share-based compensation transactions
using APB 25, and generally requires instead that such transactions be accounted and
recognized in the statement of operations based on their fair value. SFAS No. 123(R) will
be effective for public companies that file as small business issuers as of the first
interim or annual reporting period that begins after December 15, 2005. The Company is
evaluating the provisions of the standard. Depending upon the number of and terms for
options that may be granted in future periods, the implementation of this standard could
have a significant non-cash impact on results of operations in future periods.

14

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|ITEM 7. | FINANCIAL STATEMENTS
|------- | --------------------

Advanced Nutraceuticals,
Inc.

INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS

|                                                              | Page | 
|------------------------------------------------------------- | ---- | 
|Report of Independent Registered Public Accounting Firm       |      | 
|                                                              |      | 
|Consolidated Balance Sheet as of September 30, 2005           |      | 
|                                                              |      | 
|Consolidated Statements of Income for the Years Ended         |      | 
|September 30, 2005 and 2004                                   |      | 
|                                                              |      | 
|Consolidated Statements of Stockholders' Equity for the Years |      | 
|Ended September 30, 2005 and 2004                             |      | 
|                                                              |      | 
|Consolidated Statements of Cash Flows for the Years Ended     |      | 
|September 30, 2005 and 2004                                   |      | 
|                                                              |      | 
|Notes to Consolidated Financial Statements                    |      | 

F-1

---



REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and
StockholdersAdvanced Nutraceuticals, Inc. and Subsidiaries

We
have audited the accompanying consolidated balance sheet of Advanced Nutraceuticals, Inc.
(a Texas corporation) and subsidiaries (the Company) as of September 30, 2005,
and the related consolidated statements of income, stockholders equity, and cash
flows for each of the years in the two-year period then ended. These consolidated financial
statements are the responsibility of the Companys management. Our responsibility is
to express an opinion on these financial statements based on our audits.

We
conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In
our opinion, the consolidated financial statements referred to above present fairly, in
all material respects, the financial position of Advanced Nutraceuticals, Inc. and
subsidiaries as of September 30, 2005, and the results of their operations and their cash
flows for each of the years in the two-year period then ended in conformity with
accounting principles generally accepted in the United States of America.

GHP Horwath, P. C.

/s/ GHP Horwath, P. C.

Denver, ColoradoDecember 2, 2005, except for the last paragraph of Note 5, as to which  
   the date is December 27, 2005

F-2

---



# ADVANCED
NUTRACEUTICALS, INC.                            CONSOLIDATED BALANCE SHEET
                               SEPTEMBER 30, 2005

|                                                            | 
|----------------------------------------------------------- | 
|ASSETS                                                      | 
|                                                            | 
|Current Assets:                                             | 
|Cash and cash equivalents                                   | 
|Credit facility overpayment (Note 5)                        | 
|Receivables, net (Note 5)                                   | 
|Inventories (Notes 2 and 5)                                 | 
|Deferred tax assets (Note 4)                                | 
|Prepaid expenses and other assets                           | 
|                                                            | 
|Total Current Assets                                        | 
|                                                            | 
|Property and equipment, net (Notes 3 and 5)                 | 
|Land held for expansion                                     | 
|Goodwill                                                    | 
|Deferred tax assets (Note 4)                                | 
|Other assets                                                | 
|                                                            | 
|                                                            | 
|                                                            | 
|LIABILITIES AND STOCKHOLDERS' EQUITY                        | 
|                                                            | 
|Current Liabilities:                                        | 
|Accounts payable                                            | 
|Accrued compensation                                        | 
|Accrued expenses and other liabilities                      | 
|Credit facility (Note 5)                                    | 
|Current portion of long-term debt                           | 
|                                                            | 
|Total Current Liabilities                                   | 
|                                                            | 
|Long-term Debt, net of current portion:                     | 
|Credit facility (Note 5)                                    | 
|Other long-term debt                                        | 
|                                                            | 
|Total Liabilities                                           | 
|                                                            | 
|                                                            | 
|Commitments and contingencies (Note 7)                      | 
|                                                            | 
|Stockholders' Equity (Note 8 and 9):                        | 
|Preferred stock, $.001 par value; 1,000,000 shares          | 
|authorized; none issued                                     | 
|Common stock; $.01 par value; 20,000,000 shares authorized; | 
|4,662,410 issued and outstanding                            | 
|Additional paid-in capital                                  | 
|Accumulated deficit                                         | 
|                                                            | 
|Total Stockholders' Equity                                  | 
|                                                            | 
|                                                            | 
|                                                            | 

See
accompanying notes to consolidated financial statements.

F-3

---



# ADVANCED
NUTRACEUTICALS, INC.                       CONSOLIDATED STATEMENTS OF INCOME
                        FOR THE YEARS ENDED SEPTEMBER 30,

|                                                      | 2005 |  | 2004 |           
|----------------------------------------------------- | ---- |  | ---- | ----------
|Net sales                                             |      |  | $    | 22,931,989
|Cost of sales                                         |      |  |      | 16,601,624
|                                                      |      |  |      |           
|Gross profit                                          |      |  |      | 6,330,365 
|                                                      |      | 
|General and administrative expenses                   |      |  |      | 3,309,265 
|                                                      |      |  |      |           
|Operating income                                      |      |  |      | 3,021,100 
|                                                      |      |  |      |           
|Other income (expense):                               |      | 
|Interest expense, net                                 |      |  |      | (251,177  
|Other, net                                            |      |  |      | 27,162    
|                                                      |      |  |      |           
|                                                      |      |  |      | (224,015  
|                                                      |      |  |      |           
|Income from continuing operations                     |      | 
|before income tax (expense) benefit                   |      |  |      | 2,797,085 
|                                                      |      | 
|Income tax (expense) benefit (Note 4)                 |      |  |      | (918,000  
|                                                      |      |  |      |           
|Income from continuing operations                     |      |  |      | 1,879,085 
|                                                      |      | 
|Discontinued operations (Note 10):                    |      | 
|Loss from discontinued operations                     |      |  |      |          
|Income tax benefit - deferred                         |      |  |      |          
|                                                      |      |  |      |           
|Loss from discontinued operations                     |      |  |      |          
|                                                      |      |  |      |           
|Net income                                            |      |  | $    | 1,879,085 
|                                                      |      |  |      |           
|Basic income (loss) per common share:                 |      | 
|Income from continuing operations                     |      |  | $    | .36       
|Loss from discontinued operations                     |      |  |      |          
|                                                      |      |  |      |           
|Net income                                            |      |  | $    | .36       
|                                                      |      |  |      |           
|Diluted income (loss) per common share:               |      | 
|Income from continuing operations                     |      |  | $    | .32       
|Loss from discontinued operations                     |      |  |      |          
|                                                      |      |  |      |           
|Net income                                            |      |  | $    | .32       
|                                                      |      |  |      |           
|Weighted average number of common shares outstanding: |      | 
|Basic                                                 |      |  |      | 5,190,782 
|                                                      |      |  |      |           
|Diluted                                               |      |  |      | 5,897,438 
|                                                      |      |  |      |           

See accompanying
notes to consolidated financial statements.

F-4

---



# ADVANCED
NUTRACEUTICALS, INC.                  CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                 FOR THE YEARS ENDED SEPTEMBER 30, 2005 AND 2004

|                             | Common Stock |  | Additional
Paid-In |            | Accumulated |   | Total
Stockholders' |  
|---------------------------- | ------------ |  | ------------------ | ---------- | ----------- | - | ------------------- | -
|
|Balance at                   |              |  |                    |            |             |   |                     |  
|September 30, 2003           |              |  |                    | 4,992,789  |             | $ | 49,928              |  
|                             |              | 
|Common stock issued upon     |              | 
|exercise of options and      |              | 
|warrants (Note 8)            |              |  |                    | 105,041    |             |   | 1,050               |  
|                             |              | 
|Net income for the year      |              |  |                    |           |             |   |                    |  
|                             |              |  |                    |            |             |   |                     |  
|Balance at                   |              | 
|September 30, 2004           |              |  |                    | 5,097,830  |             |   | 50,978              |  
|                             |              | 
|Common stock repurchased and |              | 
|retired (Note 8)             |              |  |                    | (1,058,824 | )           |   | (10,588             | )
|                             |              | 
|Common stock issued upon     |              | 
|exercise of options (Note 8) |              |  |                    | 623,404    |             |   | 6,234               |  
|                             |              | 
|Net income for the year      |              |  |                    |           |             |   |                    |  
|                             |              |  |                    |            |             |   |                     |  
|Balance at                   |              | 
|September 30, 2005           |              |  |                    | 4,662,410  |             | $ | 46,624              |  
|                             |              |  |                    |            |             |   |                     |  

See
accompanying notes to consolidated financial statements.

F-5

---



# ADVANCED
NUTRACEUTICALS, INC.                       CONSOLIDATED STATEMENTS OF CASH FLOWS
                        FOR THE YEARS ENDED SEPTEMBER 30,

|                                                     | 2005 |  | 2004 |           
|---------------------------------------------------- | ---- |  | ---- | ----------
|Cash flows from operating activities:                |      |  |      |           
|Income from continuing operations                    |      |  | $    | 1,879,085 
|Adjustments to reconcile income from continuing      |      | 
|operations to net cash provided by (used in)         |      | 
|operating activities:                                |      | 
|Depreciation and amortization                        |      |  |      | 415,392   
|Bad debt provision                                   |      |  |      | 3,700     
|Deferred tax expense (benefit)                       |      |  |      | 843,000   
|Changes in assets and liabilities:                   |      | 
|Receivables                                          |      |  |      | (647,696  
|Inventories                                          |      |  |      | (994,479  
|Prepaid expenses and other assets                    |      |  |      | (16,338   
|Accounts payable                                     |      |  |      | 1,353,679 
|Accrued expenses and other liabilities               |      |  |      | 81,373    
|                                                     |      |  |      |           
|Net cash flows from continuing operations            |      |  |      | 2,917,716 
|Net cash flows from discontinued operations          |      |  |      |          
|                                                     |      |  |      |           
|Net cash flows from operating activities             |      |  |      | 2,917,716 
|                                                     |      |  |      |           
|Cash flows from investing activities:                |      | 
|Acquisition of property and equipment                |      |  |      | (661,085  
|Acquisition of land held for expansion               |      |  |      | (1,405,867
|                                                     |      |  |      |           
|Net cash flows from continuing operations            |      |  |      | (2,066,952
|Net cash flows from discontinued operations          |      |  |      | 109,118   
|                                                     |      |  |      |           
|Net cash flows from investing activities             |      |  |      | (1,957,834
|                                                     |      |  |      |           
|Cash flows from financing activities:                |      | 
|Net payments on revolving credit facility            |      |  |      | (1,040,516
|Borrowings on long-term debt                         |      |  |      | 4,026,837 
|Payments on long-term debt                           |      |  |      | (735,800  
|Repurchase of common stock                           |      |  |      | (4,500,000
|Proceeds from issuance of common stock               |      |  |      | 298,371   
|Loan costs paid                                      |      |  |      | (117,500  
|                                                     |      |  |      |           
|Net cash flows from continuing operations            |      |  |      | (2,068,608
|Net cash flows from discontinued operations          |      |  |      |          
|                                                     |      |  |      |           
|Net cash flows from financing activities             |      |  |      | (2,068,608
|                                                     |      |  |      |           
|Net (decrease) increase in cash and cash equivalents |      |  |      | (1,108,726
|                                                     |      |  |      |           
|Cash and cash equivalents, beginning of year         |      |  |      | 1,786,508 
|                                                     |      |  |      |           
|Cash and cash equivalents, end of year               |      |  | $    | 677,782   
|                                                     |      |  |      |           

See accompanying
notes to consolidated financial statements.

F-6

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1  ORGANIZATION,
BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Advanced Nutraceuticals, Inc.
(ANI or the Company), a Texas corporation, was formed in 2000. The
Company operates as a contract and private label manufacturer of nutritional products
through its operating subsidiary, Bactolac Pharmaceutical Inc. On March 23, 2004, the
Company completed the sale of substantially all of the assets and operations of the
Companys subsidiary, ANI Pharmaceuticals, Inc. (ANIP), to an unrelated
 entity (Note 10).

Principles of
Consolidation

The consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated in consolidation.

Cash and Cash Equivalents

For purposes of reporting cash flows,
cash and cash equivalents include cash on hand and in short-term, interest bearing
deposits with maturities of three months or less at the time of purchase.

Fair Value of Financial
Instruments

The Companys financial instruments
include accounts receivable, accounts payable, the Credit Facility and long-term debt. The fair value of
accounts receivable and accounts payable approximate their carrying values because their
maturities are generally less than one year. The fair value of debt obligations are
estimated to approximate their carrying values based upon their stated interest rates.

Revenue Recognition

The Company sells its products to
retailers and distributors primarily located in the United States. Revenues from the sale
of products are recognized upon shipment to the customer.
 Net sales represent product shipped less actual and estimated returns, rebates and other expenditures.
Estimates and allowances are based upon known claims and an estimate of additional returns when the amount of
future returns can be reasonably estimated.
The Company records freight-out
expenses as a general and administrative expense. For the years ended September 30, 2005
and 2004, freight out expenses (continuing operations) totaled $59,000 and $6,000.

Accounts receivable are customer
obligations due under normal trade terms. Generally the Company does not require
collateral. Management provides an estimated allowance for uncollectable accounts based
upon an assessment of amounts outstanding and evaluation of specific customer account
balances. Write-offs of uncollectible accounts are charged against the allowance. The
allowance for doubtful accounts at September 30, 2005 was $284,000.

Inventories

Inventories are valued primarily at
the lower of cost (first-in, first-out basis) or market.

Deferred Loan Costs

Deferred loan costs, which have a
carrying value at September 30, 2005 of $128,000, are included in other assets and are
amortized on a straight-line basis over the three-year terms of the respective debt agreement.

F-7

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Long-lived Assets

Management of the Company reviews the carrying value of its long-lived assets,
including property and equipment, whenever events or changes in circumstances
indicate that the carrying value of the assets may not be recovered. An
impairment loss may be recognized when estimated undiscounted future cash flows
expected to result from the use of the asset, including disposition, is less
than the carrying value of the asset. The measurement of the impairment loss to
be recognized is based on the difference between the fair value and the carrying
amounts of the assets. In order to determine if an asset has been impaired,
assets are tested by operating segment and geographic location.

Property and Equipment

Property and equipment are stated at
cost. Depreciation on property and equipment is provided using the straight-line method
over the estimated useful lives of the assets. Leasehold improvements are amortized over
the terms of the respective leases, not in excess of their estimated useful lives. For
income tax purposes, depreciation on fixed assets is calculated using accelerated methods.

Land Held for Expansion

Land held for expansion is carried
at cost with no depreciation recorded.  When and if the land begins to be used in the
business, it will be reclassified into property and equipment.

Goodwill

Goodwill represents the excess of cost over net assets acquired. Management of
the Company evaluates the carrying value of goodwill annually or whenever a
possible impairment is indicated.

Stock Options and Warrants

The Company accounts for stock
options issued to employees in accordance with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25). During the
years ended September 30, 2005 and 2004, all options issued to officers and employees were
granted at an exercise price which equaled or exceeded the market price per share at the
date of grant and accordingly, based upon an intrinsic valuation, no compensation expense
was recorded relative to those grants.

The Company has adopted the
disclosure requirements of Statement of Financial Accounting Standards (SFAS)
No.123 Accounting for Stock-based Compensation (SFAS No. 123).
This statement requires that the Company provide proforma information regarding net income
(loss) and basic and diluted earnings (loss) per share as if compensation cost for the
Companys employee stock options granted had been determined in accordance with the
fair value based method prescribed in SFAS No. 123. Additionally, SFAS No. 123 generally
requires that the Company record options issued to non-employees, based on the fair value
of the options.

SFAS No. 123 Pro Forma
Computation

The Company estimates the fair value of each stock option at the grant date by
using the Black-Scholes option pricing model with the following weighted average
assumptions used for grants in 2005 and 2004: a dividend yield of 0%; a
risk-free interest rate of 4.22% and 4.2%; an expected life ranging from 5-10
years; and an expected volatility of 136% and 114%, respectively. Had
compensation cost been determined on the basis of fair value pursuant to SFAS
No. 123 for stock options issued to employees, net income and earnings per share
for the years ended September 30, 2005 and 2004 would have been as follows:

F-8

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                         | 2005 |  | 2004 |          
|---------------------------------------- | ---- |  | ---- | ---------
|Net income as reported                   |      |  | $    | 1,879,000
|Add: Stock-based employee compensation   |      | 
|expense included in reported net income, |      | 
|net of related tax effects               |      |  |      |         
|Deduct: Total stock-based employee       |      | 
|compensation expense determined          |      | 
|under fair value method for all awards,  |      | 
|net of related tax effects               |      |  |      | (912,700 
|                                         |      |  |      |          
|Pro forma                                |      |  | $    | 966,300  
|                                         |      |  |      |          
|Income per share:                        |      | 
|As reported:                             |      | 
|Basic                                    |      |  | $    | .36      
|Diluted                                  |      |  | $    | .32      
|                                         |      |  |      |          
|Pro forma:                               |      | 
|Basic                                    |      |  | $    | .19      
|Diluted                                  |      |  | $    | .16      
|                                         |      |  |      |          

Income Taxes

The Company recognizes income tax
expense using the liability method of accounting for deferred income taxes. A deferred tax
asset or liability is recorded based upon the tax effect of temporary differences between
the tax bases of assets and liabilities and their carrying value for financial reporting
purposes. Deferred tax expense or benefit is the result of changes in the deferred tax
assets and liabilities during the year. The Company adjusts the deferred tax asset
valuation allowance based upon the anticipated future realization of the deferred tax
benefits supported by demonstrated trends in the Companys operating results.

Earnings (Loss) Per
Common Share

Basic earnings per share includes no
dilution and is computed by dividing net earnings available to common stockholders by the
weighted average number of common shares outstanding for the period. Diluted earnings per
share reflects the potential dilution of securities that could share in the Companys
earnings. Options to purchase approximately
 279,000 shares of common stock were not included in the dilutive
EPS calculation for the year ended September 30, 2005 as the assumed exercise
would be antidilutive
 using the treasury stock method.

Options to purchase 700,062 shares of
common stock were included in the dilutive EPS calculation for the year ended September
30, 2004 using the treasury stock method.

Managements
Estimates and Assumptions

The preparation of consolidated
financial statements in conformity with accounting principles generally accepted in the
United States of America (US GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the consolidated financial statements and
the reported amounts of revenues and expenses during the reporting period. The actual
results could differ from those estimates.

F-9

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Recent Accounting
Pronouncements

In December 2004, the Financial
Accounting Standards Board (FASB) issued SFAS No. 123(R) Share-Based
Payment, which addresses the accounting for share-based payment transactions. SFAS
No. 123(R) eliminates the ability to account for share-based compensation transactions
using APB 25, and generally requires instead that such transactions be accounted and
recognized in the statement of operations based on their fair value. SFAS No. 123(R) will
be effective for public companies that file as small business issuers as of the first
interim or annual reporting period that begins after December 15, 2005. The Company is
evaluating the provisions of the standard. Depending upon the number of and terms for
options that may be granted in future periods, the implementation of this standard could
have a significant non-cash impact on results of operations in future periods.

NOTE 2  INVENTORIES

Inventories at September 30, 2005
consisted of the following:

|                  | 
|----------------- | 
|Finished goods    | 
|Work in process   | 
|Raw materials     | 
|                  | 
|Total inventories | 
|                  | 

NOTE 3  PROPERTY
AND EQUIPMENT

As of September 30, 2005, property
and equipment and their estimated useful lives are summarized as follows:

|                                                 | Lives |  |     
|------------------------------------------------ | ----- |  | ----
|Equipment                                        |       |  | 7-12
|Leasehold improvements                           |       |  | 7   
|Furniture and fixtures                           |       |  | 5-10
|                                                 |       |  |     
|                                                 |       |  |     
|                                                 |       | 
|Less:  Accumulated depreciation and amortization |       |  |     
|                                                 |       |  |     
|                                                 |       |  |     
|                                                 |       |  |     

F-10

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4  INCOME TAXES

Deferred income taxes are determined
based on the temporary differences between the financial statement and income tax basis of
assets and liabilities as measured by the enacted tax rates, which are estimated to be in
effect when these differences reverse.

The expense (benefit) for income
taxes on continuing operations for the years ended September 30, 2005 and 2004 consisted
of the following:

|                                         | 2005 |  | 2004 |        
|---------------------------------------- | ---- |  | ---- | -------
|Federal tax expense (benefit) - current  |      |  | $    |       
|Federal tax expense (benefit) - deferred |      |  |      | 843,000
|State tax expense                        |      |  |      | 75,000 
|                                         |      |  |      |        
|                                         |      |  | $    | 918,000
|                                         |      |  |      |        

The following reconciles federal
income tax expense (benefit) computed at the statutory rate with income taxes as reported
for continuing operations for the years ended September 30:

|                                    | 2005 |  | 2004 |           
|----------------------------------- | ---- |  | ---- | ----------
|Expected income tax expense at 34%  |      |  | $    | 951,000   
|State taxes, net of federal benefit |      |  |      | 50,000    
|Decrease in valuation allowance     |      |  |      | (1,200,000
|Utilization of loss carryforwards   |      |  |      | 1,139,000 
|Other items, net                    |      |  |      | (22,000   
|                                    |      |  |      |           
|Income tax expense (benefit)        |      |  | $    | 918,000   
|                                    |      |  |      |           
|                                    |      | 

Deferred tax assets and liabilities
consisted of the following net tax effects of operating losses and temporary differences
between the carrying amounts of assets and liabilities for financial reporting and tax
purposes at September 30, 2005:

F-11

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                           | 
|------------------------------------------ | 
|Current assets:                            | 
|Loss carryforwards                         | 
|Allowance for doubtful accounts receivable | 
|Inventory valuation                        | 
|Other                                      | 
|Less valuation allowance                   | 
|                                           | 
|Net current deferred tax assets            | 
|                                           | 

|                                    | 
|----------------------------------- | 
|Non-current assets:                 | 
|Loss carryforwards                  | 
|Fixed assets                        | 
|Less valuation allowance            | 
|                                    | 
|Net non-current deferred tax assets | 
|                                    | 

At September 30, 2005, the Company has a net operating loss carryforward of
approximately $2.6 million, which expires through 2023. Additionally, the
Company has obtained net operating losses of approximately $2.3 million, which
expire primarily in 2011 and are subject to annual usage limitations. As the
Company is unable to determine that it is more likely than not that the future
taxable income of the Company will be sufficient to utilize the operating loss
carryforwards subject to the annual usage limitations, a valuation allowance has
been established against those assets. The net change during the year in the
valuation allowance was $37,000.

NOTE 5  CREDIT
FACILITY

The Company has a $6.5 million credit facility with a bank
 that provides the
Company with a $2.5 million revolver and a $4.0 million term loan (the Credit
Facility). Interest on the outstanding loan balance is paid monthly and the
term loan portion of the facility provides for quarterly principal payments of
approximately $250,000 commencing September 1, 2005 and increasing to $437,500
over the three-year life of the loan. Additional annual payments are due, as
defined under the Credit Facility commencing with the year ending September 30,
2006. At September 30, 2005, future minimum payments due on the term loan are
$1,062,500 in 2006, $1,375,000 in 2007 and $1,312,500 in 2008. As of September
30, 2005, an overpayment of $304,000 had been made on the revolver. The Company
had additional borrowings available under its revolver of approximately
$2,804,000, at September 30, 2005, based upon the overpayment, and accounts
receivable and inventory levels.

F-12

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Borrowings under the Credit Facility
mature in July 2008, are collateralized by substantially all of the Companys
assets, and bear interest at rates that fluctuate with the prime rate, with the revolver
at 0.5% over prime (not to be less than a total rate of 6.25%), 6.98% at September 30,
2005, and the term loan at 3.0% over prime (not to be less than a total rate of 8.75%).
Due to the floor interest amounts under the Companys credit facility,
the 2003-2004 prime rate levels have not impacted the Companys interest rate.
Increases in the prime rate in late 2004 and into 2005, have increased the Companys
interest expense.

The revolver portion of the Credit Facility requires a
lockbox arrangement, which requires all receipts to be swept daily to reduce borrowings
outstanding under the Credit Facility. This arrangement, combined with a Subjective
Acceleration Clause (SAC) in the credit facility, cause the revolving Credit
Facility to be classified as a current liability, per guidance in the FASBs
Emerging Issues Task Force Issue 95-22, Balance Sheet Classification of Borrowings
Outstanding under Revolving Credit Agreements that Include Both a Subjective Acceleration
Clause and a Lock-Box Arrangement.

The Credit Facility, as amended, contains a
number of covenants, which include, among other items, maintenance of specified minimum
EBITDA, fixed charge ratios and maximum senior debt leverage ratios, as well as
limitations on capital expenditures and the payment of dividends. As of September 30,
2005, after giving effect to waivers granted by the lender relating to capital
expenditures, the Company was in compliance with the covenants of the Credit Facility, as
amended.

NOTE 6  INDUSTRY
SEGMENTS AND MAJOR CUSTOMERS

Segments

As described in Note 10, on March 23,
2004, the Company completed the sale of substantially all of the assets and operations of
the Companys subsidiary, ANIP, to an unrelated entity. Accordingly, the
operations of ANIP are accounted for as a discontinued operation within these financial
statements. The Companys operations are currently conducted through its operating
subsidiary, Bactolac. The Company determines its operating segment results consistent with
its management reporting and consolidated accounting policies. All of the assets and
operating results as presented in the accompanying financial statements from continuing
operations are associated with the Bactolac operation.

Major Customers

Other than as detailed under foreign
sales, the Companys revenues from continuing operations are generated from customers
located in the United States. The following represents customers comprising more than 10%
of the Companys net sales from continuing operations  for the years ended September 30:

|Customer |  | 2005 |    | 2004 | 
|-------- |  | ---- | -- | ---- | 
|A        |  |      | 12 | .1%  | 
|B        |  |      | 11 | .7%  | 
|C        |  |      | 5  | .8%  | 

Foreign Sales

Export sales from continuing
operations were approximately $1,933,000 and $1,123,000 for the years ended September 30,
2005 and 2004, respectively, arising primarily from customers in Russia. The Company has
no foreign assets.

F-13

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7  COMMITMENTS
AND CONTINGENCIES

Operating Leases

The Company has non-cancelable operating leases, primarily for manufacturing and
office space and equipment. Rental expense under all operating leases for the
years ended September 30, 2005 and 2004 amounted to approximately $595,000 and
$456,000, respectively, including $409,000 and $413,000, respectively, paid
under the related party lease agreement. The lease for the primary Bactolac
facility is with an entity owned by a member of the Companys Board of
Directors. The lease requires monthly payments through December 2010 and
contains a renewal option for an additional five-year term.

In April 2004, Bactolac began leasing an additional 29,000 square feet of
manufacturing space under a five-year agreement, from an unrelated third party.

Subsequent to September 30, 2005, Bactolac agreed to lease an additional 4,000
square feet in the facility leased from a related party, beginning January 1,
2006, for the same term as the existing lease, initially at $5,250 per month.

Future minimum rental payments
required under operating leases that have initial or remaining non-cancelable lease terms
in excess of one year, including the lease for the additional 4,000 square feet,
commencing January 1, 2006, are as follows for the years ending September 30:

|     | Related
party |  | Third
party |           | Totals |  
|---- | ------------- |  | ----------- | --------- | ------ | -
|2006 |               |  | $           | 350,000   |        | $
|2007 |               |  |             | 370,000   |        |  
|2008 |               |  |             | 370,000   |        |  
|2009 |               |  |             | 380,000   |        |  
|2010 |               |  |             | 380,000   |        |  
|2011 |               |  |             | 90,000    |        |  
|     |               |  |             |           |        |  
|     |               |  | $           | 1,940,000 |        | $
|     |               |  |             |           |        |  

F-14

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Employment Agreements

The Company has employment agreements
with certain of its management personnel. The agreements contain customary provisions
regarding employment terms, confidentiality and non-solicitation provisions. Two of the
agreements provide for a commitment extending beyond one year, requiring monthly payments
of approximately $41,700 to January 2006, and thereafter decreasing to $29,100 per month
through November 2007.

Government Regulations

The Companys activities are
subject to regulations by various federal and state agencies, including the Food and Drug
Administration (the FDA). The Company believes that it is in compliance with
all federal and state regulations. However, the Company cannot predict whether new
legislation regulating its activities will be enacted, which could have a material adverse
effect on the Company.

NOTE 8 
STOCKHOLDERS EQUITY

During the fourth quarter of 2005, the Company completed a tender offer to buy
back 1,058,824 shares of its outstanding common stock at a price of $4.25 per
share from stockholders of record as of July 27, 2005. The Company obtained the
funds necessary to purchase shares tendered in the offer, and to pay related
fees and expenses, by borrowing $4,000,000 under its secured credit facility,
which had been amended to provide for that use.

During April to July 2005, the holders of options outstanding under the
Companys 1995 Stock Option Plan exercised their options and acquired
approximately 680,000 shares of common stock, with the Company receiving cash
proceeds of approximately $298,000. The options exercised included the issuance
of approximately 292,000 common shares in exchange for the surrender of
approximately 57,000 common shares held by the individual, with such shares then
retired by the Company.

During April 2004, the holders of
options outstanding under the Companys 1995 Stock Option Plan exercised their
options and acquired approximately 36,000 shares of common stock, with the Company
receiving cash proceeds of $35,283.

During June 2004, warrants to purchase 85,000 shares of common stock at $1.00
per share were converted into approximately 69,000 shares common stock on a
cashless basis, as provided for under the terms of the warrant agreements.

F-15

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9  STOCK
OPTIONS AND WARRANTS

1995 Discretionary Plan

The Companys 1995 Stock Option
Plan (the 1995 Plan) as amended provides for a total of 1,250,000 shares of
common stock to be reserved for the grant of options to purchase common stock of the
Company. The terms of the options generally provide for grants by the Board at fair market
value and such options are subject to vesting and expire if an employee leaves the
Company. At September 30, 2005, there were 655,354 shares reserved for the grant of
options under the 1995 plan.

The following is a summary of the
status of options and warrants during the years ended September 30:

|                                      | Options |  | Warrants
|------------------------------------- | ------- |  | --------
|
|Outstanding as of September 30, 2003  |         |  |         
|Granted                               |         |  |         
|Exercised                             |         |  |         
|Forfeited                             |         |  |         
|Cancelled                             |         |  |         
|                                      |         |  |         
|Outstanding as of September 30, 2004  |         |  |         
|Granted                               |         |  |         
|Exercised                             |         |  |         
|Forfeited                             |         |  |         
|Cancelled                             |         |  |         
|                                      |         |  |         
|Outstanding as of September 30, 2005  |         |  |         
|                                      |         |  |         
|Exercisable as of September 30,       |         | 
|2004                                  |         |  |         
|2005                                  |         |  |         
|Weighted average fair value of grants |         | 
|during the year ended September 30,   |         | 
|2004                                  |         |  |         
|2005                                  |         |  |         
|                                      |         |  |         

|                          | Options Outstanding |  |  | Options Exercisable | 
|------------------------- | ------------------- |  |  | ------------------- | 
|
|$    .46  -    $      .65 |                     |  |  | 174,910             | 
|.66  -       1.15         |                     |  |  | 108,744             | 
|1.16  -       4.35        |                     |  |  | 315,375             | 
|4.36  -     11.36         |                     |  |  | 56,325              | 
|                          |                     |  |  |                     | 
|                          |                     |  |  |                     | 
|                          |                     |  |  | 655,354             | 
|                          |                     |  |  |                     | 
|                          |                     |  |  |                     | 

F-16

---



# ADVANCED
NUTRACEUTICALS, INC.                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10  SALE OF ANI
PHARMACEUTICALS, INC.  DISCONTINUED OPERATIONS

On March 23, 2004, the Company
completed the sale of substantially all of the assets and operations of the Companys
subsidiary, ANIP, to an unrelated entity. The terms of the sale were cash of
approximately $3.4 million and the assumption by the buyer of approximately $1.7 million
in liabilities, primarily trade accounts payable. The Company used the entire cash
proceeds, net of closing expenses and a $250,000 escrow requirement, to repay the
outstanding balance on the mortgage on the ANIP facility and the balance to reduce the
Companys senior credit facility. The funds under the escrow requirement were
released to the Company in September 2004. As a result of the sale of the assets, the
Company recorded a loss of approximately $1,187,000 net of a deferred income tax benefit
of $663,000. ANIP had previously been reported as a separate segment of the Company and
was a contract and private label manufacturer of over-the-counter liquid and powder
pharmaceutical products, primarily liquid stomach remedies, located in Gulfport,
Mississippi. As a result of the sale of ANIP, the Companys consolidated financial
statements and related notes thereto have been reclassified to present the operations of
ANIP as discontinued operations. The Company now operates in only one segment.

Certain
information with respect to discontinued operations of ANIP for the year ended September
30, 2004 through the date of sale follows:

|                                   | 2004 | 
|---------------------------------- | ---- | 
|Net sales                          |      | 
|                                   |      | 
|Gross profit                       |      | 
|Operating expenses                 |      | 
|                                   |      | 
|Operating loss                     |      | 
|Other expenses, including interest |      | 
|Loss on disposal                   |      | 
|                                   |      | 
|Loss before income tax benefit     |      | 
|Income tax benefit - deferred      |      | 
|                                   |      | 
|Loss from discontinued operations  |      | 
|                                   |      | 

The agreement for the sale of ANIP
included a provision for a potential adjustment to the purchase price depending upon the
final adjusted net working capital as defined under the agreement. The buyer and the
Company agreed during the fourth quarter of fiscal 2004 to a final adjusted net working
capital settlement with the buyer remitting approximately $10,000 to the Company. Under
the terms of the purchase agreement, certain representations and warranties concerning
environmental matters were made by the Company to the buyer, which are the only remaining
outstanding items from the sale transaction.

Following the ANIP sale the only
remaining asset from the former ANIP segment was a parcel of undeveloped land that was
carried at its estimated market value of approximately $109,000, and was held for sale. In
November 2004, the Company sold the land. Gross proceeds from the sale totaled $125,000,
and after deducting expenses, the transaction resulted in no material gain or loss.

NOTE 11 
SUPPLEMENTAL CASH FLOW INFORMATION

Supplemental disclosure of non-cash
investing and financing activities:

|                                                  | 2005 |  | 2004 |        
|------------------------------------------------- | ---- |  | ---- | -------
|Issuance of 291,667 and 68,653 shares of common   |      |  |      |        
|stock in 2005 and 2004, respectively,             |      | 
|for cashless exercise of options and warrants     |      |  | $    |       
|                                                  |      | 
|Supplemental disclosure of cash flow information: |      | 
|                                                  |      | 
|Federal and state income taxes paid               |      |  | $    | 5,000  
|                                                  |      | 
|Interest paid                                     |      |  | $    | 217,000

F-17

---



ITEM 8.   CHANGES IN AND
DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

NONE

Item 8 A.    CONTROLS AND
PROCEDURES

|(a) | Evaluation
of Disclosure Controls and Procedures
|--- | ------------------------------------------------

The management of the Company, including the Chief Executive Officer and the
Chief Financial Officer, has conducted an evaluation of the effectiveness of the
Companys disclosure controls and procedures pursuant to Rule 13a-14 under the
Securities Exchange Act of 1934 as of the last day of the period of the
accompanying financial statements (the Evaluation Date). Based on that evaluation, the Chief Executive
Officer and the Chief Financial Officer concluded that, as of the Evaluation
Date, the Companys disclosure controls and procedures were effective in
ensuring that all material information relating to the Company required to be
filed in the annual report has been made known to them in a timely manner.

|(b) | Changes
in Internal Controls
|--- | ----------------------------

There have been no significant
changes made in the Companys internal controls or in other factors that have
significantly affected internal controls subsequent to the Evaluation Date.

Item 8 B.   OTHER INFORMATION

NONE

15

---



PART III

ITEM 9.   DIRECTORS AND
EXECUTIVE OFFICERS OF REGISTRANT

Directors

Set forth below is biographical
information regarding the members of the Board of Directors of Advanced Nutraceuticals,
Inc. (ANI or the Company). The Company reorganized into a holding
company structure in 2000 and NFLI became a wholly-owned subsidiary. NFLI was sold by the
Company in 2001. References to the Company include Nutrition For Life
International, Inc. (NFLI).

F.
          Wayne Ballenger, age 58, serves as a loan officer for Small Business Loan
          Source, LLC, a position he has held since 2003. From 2000 to 2003 he served as a
          consultant in various financial consulting capacities. He served as President of
          First Commercial Capital from 1995 to 2000. He has also served as President of
          Puncture Guard LLC since December 1994. From March 1992 to December 1994, he
          served as director of sales and marketing for Petrolon, Inc., a multi-level
          marketing organization. Immediately prior thereto, he served as a vice president
          of Southwest Bank of Texas with commercial lending responsibilities. Mr.
          Ballenger received a B.B.A. degree from the University of the South in 1968. Mr.
          Ballenger became a director of the Company in November 1995.

Randall D. Humphreys, age 50, is
Chairman and Managing Director of Glenwood Capital, LLC., a position he had held since
2001. From 1997 to 2001 he was the Chairman and Managing Director of Enterprise Merchant
Banc, L.L.C. During 1997 he led the diversification effort of St. Joseph Light and Power,
a New York Stock Exchange listed utility. During 1996 he served as a financial consultant.
From 1986 through 1995, Mr. Humphreys served as the Senior Operations Officer of Brierly
Investments Limited. Mr. Humphreys is a graduate of Kansas State University. Mr. Humphreys
became a director of the Company in June 2001.

David E. Welch, age 58, has been a
director of the Company since February 2003. Mr. Welch has served as Vice President and
Chief Financial Officer of American Millennium Corporation, Inc., a public company located
in Golden, Colorado, since April 2004. He also is a self-employed financial consultant.
From July 1999 to June 2002, Mr. Welch served as Chief Financial Officer, Secretary and
Treasurer of Active Link Communications, Inc., another publicly traded company. During
1998, he served as Chief Information Officer for Language Management International, Inc.,
a multinational translation firm located in Denver, Colorado. From 1996 to 1997, he was
Director of Information Systems for Mircromedex, Inc., an electronic publishing firm,
located in Denver, Colorado. Mr. Welch also serves on the Boards of Directors of AspenBio,
Inc., and Communication Intelligence Corporation, both publicly traded companies.

Gregory Pusey, age 53, has been a
director of the Company since November 1999. Until May 31, 2004, he also served as
Chairman of the Board of Directors of the Company. Effective June 1, 2004 he was elected
Chief Executive Officer and President of the Company. He has served as President of
Livingston Capital, Ltd., a private venture capital firm since 1987. From 1986 to 1994, he
served as a consultant to the Company, including its predecessors, and from 1994 to 1998,
he served as a director and consultant to the Company. Since 1988, Mr. Pusey has been the
President and a director of Cambridge Holdings, Ltd., a publicly held real estate and
business development firm. Mr. Pusey also serves as Chairman and a director of AspenBio
Pharma, Inc., and A4S Security, Inc., both publicly traded companies. Mr. Pusey graduated
summa cum laude from Boston College with a B.S. degree in finance in 1974.

16

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Pailla M. Reddy, age 45, has been a
director of the Company since 1999 and is currently Chairman of the Board of Directors of
the Company and Chief Executive Officer and President of Bactolac Pharmaceutical Inc. The
Company acquired Bactolac in November 1999. Dr. Reddy founded Bactolac and has served as
an officer and director of Bactolac since 1995. From 1991 to 1995, he was production
manager for Max Pharmaceutical, Inc. From 1983 to 1991, Dr. Reddy held various positions
with Wellcome Pharmaceuticals Ltd., including research chemist and production manager. Dr.
Reddy received a B.Sc. degree in chemistry from Osmania University in India, and M.Sc. and
Ph.D. degrees in organic chemistry from Kanpur University in India.

Officers

Our Board has elected the following
executive officer who is not a member of the Board. It is expected that the Board will
elect officers annually following each annual meeting of shareholders.

Jeffrey G. McGonegal, age 54, became
Senior Vice President  Finance of the Company in February 2000. Mr. McGonegal also
serves as Secretary of the Company. Since 1997, Mr. McGonegal has served as Managing
Director of McGonegal and Co., a company engaged in providing accounting and business
consulting services. Mr. McGonegal served as a consultant to us in connection with the
acquisitions we made in 1999. From 1974 to 1997, Mr. McGonegal was an accountant with BDO
Seidman LLP. While at BDO Seidman LLP, Mr. McGonegal served as managing partner of the
Denver, Colorado office. Mr. McGonegal also serves as Chief Financial Officer of AspenBio
Pharma, Inc., and A4S Security, Inc., both publicly held companies, in the bio-pharma and
security industries, respectively. Mr. McGonegal was elected in 2005 to serve on the board
of Imagenetix, Inc., a publicly held company in the nutritional supplements industry and
he is a member of the board of directors of The Rockies Venture Club, Inc. He received a
B.A. degree in accounting from Florida State University.

Compliance with Section
16(a) of the Exchange Act

Based solely on the Companys
review of copies of Section 16(a) reports filed by officers, directors and
greater than 10% shareholders with the Securities and Exchange Commission, which
have been received by the Company and written representations from these persons
that no other reports were required for those persons, the Company believes that
all filing requirements applicable to those persons were complied with for the
fiscal year ended September 30, 2005, with the exception of one late report on
Form 4 for each of Mr. Humphreys, Mr. Pusey, Dr. Reddy, Mr. McGonegal, Mr. Welch
and Mr. Ballenger, filed on January 18, 2005, to report a January 12, 2005 grant
of options to purchase shares of the Companys common stock.

Audit Committee
Composition

The Company has a separately
designated standing audit committee established in accordance with Section 3(a)(58)(A) of
the Securities Exchange Act of 1934, as amended (the Exchange Act). David E
Welch (Chairman), Randall D. Humphreys and F. Wayne Ballenger are members of the audit
committee. The Board has determined that at least one person on the Audit Committee, David
E. Welch, qualifies as a financial expert as defined by Item 401 of Regulation
S-B of the Sarbanes-Oxley Act. Mr. Welch also meets the SEC definition of an
independent director.

Code of Ethics

The Company has adopted a Code of
Ethics (as defined in Item 406 of Regulation S-B) that applies to its principal executive,
financial and accounting officers. Advanced Nutraceuticals, Inc. will provide a copy of
its code of ethics, without charge, to any investor that requests it. Requests should be
addressed in writing to Mr. Jeffrey G. McGonegal, Senior Vice President  Finance,
106 South University Unit #14, Denver, CO 80209.

17

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ITEM 10.   EXECUTIVE
COMPENSATION

The following table sets forth
certain information regarding compensation paid by us to the chief executive officer and
each of the other executive officers of the Company (the named executive
officers) during the fiscal years ended September 30, 2003, 2004 and 2005.

Summary Compensation Table

|                              |  |  |      |  | LONG TERM COMPENSATION |  
|----------------------------- |  |  | ---- |  | ---------------------- | -
|
|
|Greg Pusey                    |  |  |      |  |                        |  
|President, and                |  |  | 2003 |  |                        | $
|Chairman of the Board         |  |  | 2004 |  |                        |  
|of Directors of ANI           |  |  | 2005 |  |                        |  
|                              |  |  |      |  |                        |  
|Jeffrey G. McGonegal          |  | 
|Senior Vice President         |  |  | 2003 |  |                        |  
|- Finance of ANI              |  |  | 2004 |  |                        |  
|                              |  |  | 2005 |  |                        |  
|Pailla M. Reddy (1)           |  | 
|Chairman of the Board of ANI, |  | 
|President, Chief Executive    |  |  | 2003 |  |                        |  
|Officer and Chairman of the   |  |  | 2004 |  |                        |  
|Board of Directors of         |  |  | 2005 |  |                        |  
|Bactolac                      |  | 

|(1) | Under the terms of Dr. Reddys Employment Agreement, Bactolac provides the use
of a company car to Dr. Reddy. Payments of approximately $600 per month are made
for the car, plus approximately $200 per month in normal operating expenses,
including gas and insurance. The Company has obtained a life insurance policy on
Dr. Pailla M. Reddy. The benefit amount of $7,000,000 constitutes key-man
insurance and is payable to the Company.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Company provides medical, dental, life and disability coverage as a benefit
to its employees. Net coverage paid by the Company on behalf of each of the
listed officers totals approximately $860 per month for each of Greg Pusey and
Jeffrey McGonegal and approximately $975 per month for Dr. Pailla M. Reddy.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Employment Agreements

In anticipation of the expiration of its employment agreement with Dr. Pailla
Reddy, the President of Bactolac, in November 2005 a new two year agreement was
signed. Under the agreement, Dr. Reddy receives an annual salary of $350,000, is
entitled to participation in all of Bactolacs benefit plans which shall be
available from time to time to Bactolacs domestic management employees, and may
receive a performance bonus at the discretion of Bactolacs board of directors.
He is also entitled to continued use of the vehicle that is leased by Bactolac.
If Dr. Reddys employment is terminated by Bactolac prior to the expiration of
the term of the employment agreement, Dr. Reddy shall continue to receive his
salary until the earlier of (a) 12 months following such date of termination or
(b) November 1, 2007. If Dr. Reddy terminates his employment for Good Reason
(as such term is defined in the employment agreement), Dr. Reddy will be
entitled to severance benefits consisting of a lump-sum payment equal to the
lesser of (a) his monthly base salary in effect on the date of termination for
Good Reason multiplied by a factor of 12 or (b) his monthly base salary in
effect on the date of termination multiplied by the number of months remaining
until November 1, 2007. Dr. Reddys employment agreement also contains customary
confidentiality and non-solicitation provisions.

18

---



In February 2003, the Company entered
into an employment agreement with Jeffrey G. McGonegal, Senior Vice President 
Finance for a two year term under which he currently receives an annual salary of $150,000
and may receive a performance bonus at the Companys discretion. The agreement
automatically renews annually, unless cancelled by either party.

Equity Compensation Plan
Information

The following table gives information
about the Companys common stock that may be issued upon the exercise of options
under the 1995 Stock Option Plan as of September 30, 2005.

|Plan Category             |  | (a) Number of
Securities to be
Issued Upon Exercise
of Outstanding
Options, Warrants and
Rights |  | (b) Weighted
Average Exercise
Price of
Outstanding
Options, Warrants
and Rights |  | (c) Number of
Securities
Remaining
Available for
Future Issuance
Under Equity
Compensation Plans
(Excluding
Securities
Reflected in
Column (a)) |      | (d) Total of Securities
Reflected in Columns
(a) and (c) | 
|------------------------- |  | ----------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------- | ---- | -------------------------------------------------------- | 
|Equity Compensation Plans |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                 |      |                                                          | 
|Approved by Stockholders  |  |                                                                                                 |  | 655,354                                                                         |  | $                                                                                                                                               | 2.75 |                                                          | 
|                          |  |                                                                                                
|Equity Compensation Plans |  |                                                                                                
|Not Approved  by          |  |                                                                                                
|Stockholders              |  |                                                                                                 |  | None                                                                            |  |                                                                                                                                                 |     |                                                          | 
|                          |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                 |      |                                                         
|                          |  |                                                                                                
|TOTAL                     |  |                                                                                                 |  | 655,354                                                                         |  | $                                                                                                                                               | 2.75 |                                                          | 
|                          |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                 |      |                                                         

Option Grants in Fiscal
Year Ended September 30, 2005

The following table sets forth
information with respect to stock option grants to the named executive officers during the
fiscal year ended September 30, 2005:

|                     | Individual Grants |  |  |        | Potential Realizable Value at
Assumed Annual Rates of
Stock Price Appreciation
For Option Term | 
|-------------------- | ----------------- |  |  | ------ | ---------------------------------------------------------------------------------------------- | 
|
|Gregory Pusey        |                   |  |  | 60,000 |                                                                                                | 
|Jeffrey G. McGonegal |                   |  |  | 60,000 |                                                                                                | 
|Pailla M. Reddy      |                   |  |  | 70,000 |                                                                                                | 

Option Exercises and
Year-End Values

The following table shows option
exercises by the named executive officers during the fiscal year ended September 30, 2005
and the number and value of unexercised options at September 30, 2005.

19

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|Name                 |  | Number of
Shares Under-
Lying Options
Exercised (#) |  | Value
Realized
($) |  | Number of
Unexercised Options
At Year End (#)
Exercisable/
Unexercisable |           | Value of
Unexercised
In-the-Money
Options at
Year End ($)
Exercisable/
Unexercisable (1) |           
|-------------------- |  | --------------------------------------------------- |  | ------------------ |  | ------------------------------------------------------------------------ | --------- | ---------------------------------------------------------------------------------------- | ----------
|Gregory Pusey        |  |                                                     |  | 187,500            |  | $                                                                        | 750,000   |                                                                                          | 97,500/ 0 
|Jeffrey G. McGonegal |  |                                                     |  | 175,000            |  | $                                                                        | 708,750   |                                                                                          | 135,000/ 0
|Pailla M. Reddy      |  |                                                     |  | 291,667            |  | $                                                                        | 1,312,502 |                                                                                          | 103,333/ 0

|(1) | Based
on the price of the common stock of $ 3.90 on September 30, 2005 as           reported by
the OTC Bulletin Board.
|--- | -----------------------------------------------------------------------------------------------------------------------

Compensation Committee
Report

The compensation committee (the
Committee) of the Board has been established by the Board to periodically
review the compensation philosophy for our executives, and to recommend to the Board
compensation packages for our executives. The Committee also reviews and recommends to the
Board any additions to or revisions of our stock option plans. The Committee consists
exclusively of non-employee directors, appointed by resolution of the entire Board.

The Committees objective is to
set executive compensation at levels which (i) are fair and reasonable to the
shareholders, (ii) link executive compensation to long-term and short-term interest of the
shareholders, and (iii) are sufficient to attract, motivate and retain outstanding
individuals for executive positions.

Fairness to the shareholders is
balanced with the need to attract, retain and motivate outstanding individuals by
comparing our executive compensation with the compensation of executives at other
companies. The Committees overall goal is to achieve strong performance by the
Company and its executives by affording the executives the opportunity to be rewarded for
strong performance. The Committee attempts to provide both short-term and long-term
incentive pay. To accomplish its objectives, the Committee has structured the executive
compensation program with three primary components. These primary components are base
salary, annual incentives, and long-term incentives.

20

---



The Committee periodically reviews
executive salaries. In addition to the external competitive compensation market, base
salary levels reflect each officers performance over time and each individuals
role in the Company. Consequently, employees with higher levels of sustained performance
over time and/or employees assuming greater responsibilities will typically be paid
correspondingly higher salaries. Individual performance criteria used to assess
performance include leadership, professionalism, initiative and dependability. However,
individual performance assessments are made qualitatively and in total, and no specific
weightings are attached to these performance indicators, nor is a formula utilized in
determining appropriate salary increases or salary levels. Information regarding salary
levels is included in the Executive Compensation Table.

The Committee periodically reviews
the performance of executive officers to determine whether bonuses should be paid to those
persons. The Committee has not established specific performance measures for determining
the award of bonuses. The Committee believes that bonuses should be provided to reward key
employees based on Company and individual performance and to provide competitive cash
compensation opportunities to the Companys executives. During the year ended
September 30, 2005, bonuses of $109,615, $4,808 and $5,769 were paid to Messrs. Reddy,
Pusey and McGonegal, respectively. During the year ended September 30, 2004, bonuses of
$109,615, $19,808 and $40,769 were paid to Messrs. Reddy, Pusey and McGonegal,
respectively.

Our stock option plans are designed
to focus executive efforts on our long-term goals and to maximize total return to our
shareholders. The Committee believes that stock options advance the interests of employees
and shareholders by providing value to the executives through stock price appreciation
only. Options terminate if the employees employment with us is terminated. All
options awarded must have an exercise price of at least 100% of fair market value on the
date of grant.

The exact number of shares granted to
a particular participant reflects both the participants performance and role in the
Company, as well as our financial success, and our future business plans. All of these
factors are assessed subjectively and are not weighted. In determining each grant, the
Committee also considers the number of stock options which are outstanding, and the total
number of options to be awarded.

In making grants during the fiscal
year ended September 30, 2005, the Committee also considered the number of outstanding
options previously granted to each officer. The Committee believes that its awards were
consistent with our compensation philosophy to increase the emphasis placed on long-term
incentives and to be competitive in its total compensation program.

Under Section 162(m) of the Internal
Revenue Code of 1986, as amended, public companies are precluded from receiving a tax
deduction on compensation paid to executive officers in excess of $1,000,000, unless the
compensation is excluded from the $1,000,000 limit as a result of being classified
performance-based. At this time, our executive officers cash compensation levels do not
exceed the payment limit and will most likely not be affected by the regulations in the
near future. Nonetheless, the Committee intends to review its executive pay plans over
time in light of these regulations.

| |                                                                     
| | --------------------------------------------------------------------
| | COMPENSATION COMMITTEE
   F. Wayne Ballenger
   Randall D. Humphreys

21

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Compensation of Directors

Effective in November 2001, our
policy is to pay directors who are not employees of the Company $12,000 per year, payable
monthly. Directors who are also employees of the Company receive no additional
compensation for serving as directors. We reimburse our directors for expenses incurred
for attendance at meetings of the Board.

During the fiscal year ended
September 30, 2001, we granted options to purchase 12,500 shares of Common Stock at a
price of $1.16 per share to F. Wayne Ballenger and 12,500 shares of Common Stock at a
price of $1.26 per share to Randall D. Humphreys. During the fiscal year ended September
30, 2002, we granted options to each of these non-employee directors to purchase 10,000
shares of Common Stock at a price of $.46 per share. During the year ended September 30,
2003, we granted options to purchase 10,000 shares of Common Stock at a price of $.63 per
share to David E. Welch, upon his becoming a director of the Company. During the fiscal
year ended September 30, 2004, we granted options to purchase 15,000 shares of Common
Stock (10,000 at a price of $.52 and 5,000 at a price of $.72 per share) to F. Wayne
Ballenger, 15,000 shares of Common Stock (10,000 at a price of $.52 and 5,000 at a price
of $.72 per share) to David E. Welch, and 15,000 shares of Common Stock (10,000 at a price
of $.52 and 5,000 at a price of $.72 per share) to Randall D. Humphreys. During the fiscal
year ended September 30, 2005, we granted options to each of F. Wayne Ballenger, David E.
Welch and Randall D. Humphreys to purchase 10,000 shares each of Common Stock at a price
of $3.95 per share. The option grants were made pursuant to the Companys 1995 Stock
Option Plan, as amended. Each option will expire ten years from the date of grant, except
that an option will expire, if not exercised, 30 days after the optionee ceases to be a
consultant to the Company. Each grant was made at an expense price equivalent to the
trading price of the Common Stock at the date of grant.

|ITEM 11. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
|-------- | ----------------------------------------------------------------------------------------------

The following table sets forth, as of
December 23, 2005, the ownership of our common stock held by:

| | (1) | Each
person who owns of record or who is known by us to own beneficially more           than
5% of such stock;
| | --- | --------------------------------------------------------------------------------------------------------------

| | (2) | Each
of the directors and nominees for election as directors;
| | --- | -------------------------------------------------------------

| | (3) | Each
of the current executive officers; and
| | --- | -------------------------------------------

| | (4) | All
of our directors and executive officers as a group.
| | --- | -------------------------------------------------------

The
number of shares and the percentage of the class beneficially owned by the persons named
in the table and by all directors and executive officers as a group, includes, in addition
to shares actually issued and outstanding, unissued shares which are subject to issuance
upon exercise of certain options or warrants described in the notes of the table.

22

---



|Beneficial Owner             |  | Number of Shares
Owned |  | Percentage
of Ownership
|---------------------------- |  | ---------------------- |  | -----------------------
|Pailla M. Reddy              |  |                        |  | 2,431,457              
|7 Oser Avenue                |  |                       
|Hauppauge, NY 11788          |  |                       
|                             |  |                       
|Gregory Pusey                |  |                        |  | 516,509                
|106 S. University, #14       |  |                       
|Denver, CO 80209             |  |                       
|                             |  |                       
|Jeffrey G. McGonegal         |  |                        |  | 282,148                
|1905 West Valley Vista Drive |  |                       
|Castle Rock, CO 80109        |  |                       
|                             |  |                       
|F. Wayne Ballenger           |  |                        |  | 50,417                 
|3134 Meadway Drive           |  |                       
|Houston, TX 77082            |  |                       
|                             |  |                       
|Randall D. Humphreys         |  |                        |  | 363,937                
|9150 Glenwood                |  |                       
|Overland Park, KS 66212      |  |                       
|                             |  |                       
|David E. Welch               |  |                        |  | 26,072                 
|1729 E. Otero Ave            |  |                       
|Centennial, CO 80122         |  |                       
|                             |  |                       
|All Officers and             |  |                        |  | 3,670,540              
|Directors as a Group         |  |                       
|(Six Persons)                |  |                       

|(1) | Includes
options to acquire 33,333 shares of Common Stock at $.506 per share 70,000 shares of
Common               Stock at $4.345 per share.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes 28,768 shares held by his wife and children and 174 shares held by
Cambridge Holdings, Ltd., a corporation in which he is the President and a principal shareholder
and options to acquire (i) 12,500 shares of Common Stock at $11.36 per share
(ii) 25,000 shares of Common Stock at $.506 per share, and (iii) 60,000 shares
of Common Stock at $4.345 per share.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Includes
1,371 shares held in the name of McGonegal Family Partnership          and options to
acquire (i) 25,000 shares of Common Stock at $9.00 per          share (ii) 25,000 shares
at $2.25 per share (iii) 25,000 shares of          Common Stock at $.46 per share, and
(iv) 60,000 shares at $3.95 per share.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

23

---



|(4) | Includes
options to acquire (i) 6,250 shares of Common Stock at $11.36          per share, (ii)
12,500 shares at $1.16 per share, (iii) 10,000 shares at $.46 per share, (iv) 6,667
              shares at $.52 per share, (v) 5,000 shares at $.72 and (vi) 10,000 shares
at $3.95. Does not               include options to acquire 3,333 shares at $.52 per
share which become exercisable in December 2006.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Includes
319,770 shares of common stock held by Glenwood Capital          Partners I, LP, a
partnership in which he is the general partner,          options to acquire (i) 12,500
shares of common stock at $1.26 per          share, (ii) 10,000 shares of Common Stock at
$.46 per share, (iii) 6,667 shares at $.52, (iv) 5,000               shares at $.72 per
share and (v) 10,000 shares at $3.95. Does not include options to acquire 3,333
              shares at $.52 per share which become exercisable in December 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Includes options to acquire (i) 3,333 shares of Common Stock at $.63 per share,
(ii) 3,333 shares at $.52, and (iii) 10,000 shares at $3.95. Does not include
options to acquire 3,333 shares at $.52 per share which become exercisable in
December 2006.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 12. | CERTAIN RELATIONSHPS AND RELATED TRANSACTIONS
|-------- | ---------------------------------------------

Bactolac, headquartered in Hauppauge, New York, conducts its operations in a
facility leased from Shilpa Saketh Realty, Inc., an entity owned by Dr. Pailla
M. Reddy, Chairman of the Board of Directors of the Company and President of
Bactolac, comprising approximately 32,700 square feet. Bactolacs current
monthly rental is approximately $30,000, of which approximately $6,000 pertains
to improvements made by Shilpa Saketh Realty, Inc., that escalates over the
remaining term of the lease through December 2010. Bactolac has a five-year
renewal option on the facility. Subsequent to September 30, 2005, Bactolac
agreed to lease an additional 4,000 sq. ft. in the existing facility, beginning
January 1, 2006, for the same term as the existing lease, initially at $5,250
per month, which escalates over the term of the lease through December 2010.
Bactolac has a five-year renewal option on the facility.

During November 2005, Bactolac and Dr. Reddy entered into a new employment
agreement extending Dr. Reddys employment to November 1, 2007. In addition to a
base annual salary of $350,000, and performance bonus features, the agreement
contains customary confidentiality and benefit provisions.

In February 2003, the Company entered into an employment agreement, which renews
annually unless terminated by either party, with Jeffrey G. McGonegal, Senior
Vice President, for a two year term under which he currently receives an annual
salary of $150,000 and may receive a performance bonus at the Companys
discretion

During June 2004, a total of 85,000
warrants that were held by Cambridge Holdings, Ltd. and Glenwood Capital Partners I, LP
were converted into 68,653 shares of the Companys Common Stock on a cashless basis,
as provided for under the terms of the warrant agreements.

24

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|ITEM 13. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES
|-------- | ---------------------------------------

|Exhibit 3.1 | Articles of Incorporation of Advanced Nutraceuticals, Inc.,                 filed as
an Exhibit to the Report on Form 8-K, filed on March                 21, 2000, which
Exhibit is incorporated herein by this reference.
|----------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 3.2 | Amendment to Articles of Incorporation of Advanced Nutraceuticals, Inc., filed
as an Exhibit to the Report on Form 10-K for the fiscal year ended September 30,
2001, which Exhibit is incorporated herein by reference.
|----------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 3.3 | Bylaws
of Advanced Nutraceuticals, Inc., filed as an Exhibit to                 the Report on
Form 8-K, filed on March 21, 2000, which Exhibit                 is incorporated herein
by this reference.
|----------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 4 | Specimen Certificate of Nutrition for Life International, Inc.'s Common Stock,
filed as an Exhibit to the Registration Statement on Form SB-2 (File No.
33-92274), which Exhibit is incorporated herein by reference.
|--------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.1 | 1995 Stock Option Plan, as amended, filed as an Exhibit to the Report on Form
10-K for the fiscal year ended September 30, 2001, which Exhibit is incorporated
herein by reference.
|------------ | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.2 | Employment Agreement, effective November 1, 2005, between Bactolac Pharmaceutical Inc. and Pailla Reddy, filed as an
Exhibit to the Report on Form 8-K, filed on December 8, 2005, which Exhibit is incorporated herein by this
reference.
|------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.3 | Employment Agreement dated February 28, 2003, between the Company and Jeffrey G. McGonegal, filed as an Exhibit
to the Report on Form 10-K/A for the fiscal year ended September 30, 2003, which Exhibit is incorporated herein
by reference.
|------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.4 | Agreement dated July 7, 2000, between Shilpa-Saketh Realty, Inc. and Bactolac Pharmaceutical Inc., filed as an
Exhibit to the Report on Form 10-K/A for the fiscal year ended September 30, 2000, which Exhibit is incorporated
herein by reference.
|------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.5 | Loan and Security Agreement among CapitalSource Finance LLC, Advanced
Nutraceuticals, Inc., Bactolac Pharmaceutical Inc. and ANI Pharmaceuticals,
Inc., filed on Form 8-K dated March 27, 2003, and incorporated by reference
herein.
|------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.6 | First Amendment to Loan and Security Agreement with CapitalSource Finance, LLC, dated December 31, 2003, filed as
an Exhibit to the Report on Form 10-K for the fiscal year ended September 30, 2003, which Exhibit is incorporated
herein by reference.
|------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.7 | Second Amendment to Loan and Security Agreement with CapitalSource Finance, LLC, dated December 31, 2003, filed
as an Exhibit to the Schedule TO-I, as filed with the Securities and Exchange Commission on July 26, 2005, which
Exhibit is incorporated herein by reference.
|------------ | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.8 | Third Amendment to Loan and Security Agreement with CapitalSource Finance, LLC, dated January 6, 2005, filed as
an Exhibit to the Report on Form 10-KSB for the fiscal year ended September 30, 2004, which Exhibit is
incorporated herein by reference.
|------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 10.9 | Fourth Amendment to Loan and Security Agreement with CapitalSource Finance, LLC, dated July 26, 2005, filed as an
Exhibit to the Schedule TO-I, as filed with the Securities and Exchange Commission on July 26, 2005, which
Exhibit is incorporated herein by reference.
|------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

25

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|Exhibit 14 | Code of Ethics of Advanced Nutraceuticals, Inc., filed as an Exhibit to the Report on Form 10-KSB for the
fiscal year ended September 30, 2003, which Exhibit is incorporated herein by reference.
|---------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Exhibit 21 | Subsidiaries
of the Company.
|---------- | ----------------------------

|Exhibit 23 | Consent of GHP Horwath, P. C.
|---------- | -----------------------------

|Exhibit 31.1 | Chief Executive Officer certification pursuant to Section                 302 of the
Sarbanes-Oxley Act of 2002.
|------------ | ----------------------------------------------------------------------------------------------------------------

|Exhibit 31.2 | Chief Financial Officer certification pursuant to Section                 302 of the
Sarbanes-Oxley Act of 2002.
|------------ | ----------------------------------------------------------------------------------------------------------------

|Exhibit 32 | Chief Executive Officer and Chief Financial Officer                 certification
pursuant to Section 906 of the Sarbanes-Oxley Act                 of 2002.
|---------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

During fiscal 2005 and 2004, we
retained our principal auditor, GHP Horwath, P. C., to provide services. Aggregate fees
were billed in the following categories and amounts:

|                   | Years Ended September 30, | 
|------------------ | ------------------------- | 
|
|Audit Fees         |                           | 
|Audit Related Fees |                           | 
|Tax Related Fees   |                           | 
|All Other Fees     |                           | 

All of the services described above
were approved by the Companys audit committee and prior to performance. The audit
committee has determined that the payments made to its independent accountants for these
services are compatible with maintaining such auditors independence.

26

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SIGNATURES

In accordance with Section 13 or
15(d) of the Exchange Act, the Registrant caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.

|                            |                                                                                   
|--------------------------- | ----------------------------------------------------------------------------------
|                            | ADVANCED NUTRACEUTICALS, INC.
(Registrant)                                        
|Date:      January 13, 2006 | By: /s/ Gregory Pusey
    Gregory Pusey, President and
    Chief Executive Officer

In accordance with the Exchange Act,
this report has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.

|                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                             
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Date:      January 13, 2006    
                              
                              
Date:       January 13, 2006 
                              
                              
                              
Date:       January 13, 2006    
                              
Date:     January 13, 2006 
                              
Date:      January 13, 2006  
                              
Date:      January 13, 2006 | /s/ Gregory Pusey
Gregory Pusey, President,
Chief Executive Officer and Director
 /s/ Jeffrey G. McGonegal
Jeffrey G. McGonegal, Senior Vice
President of Finance, Chief Financial
Officer and Secretary
 /s/ F. Wayne Ballenger
F. Wayne Ballenger, Director
 /s/ Randall D. Humphries
Randall D. Humphries, Director
 /s/ David E. Welch
David E. Welch, Director
 /s/ Pailla Reddy
Pailla Reddy, Director

27

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