**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM10-Q**

 
| **(Mark One)**                                           |
|----------------------------------------------------------|
| **ý**                                               | ** ** | **QUARTERLY REPORT UNDER  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** **                                               | ** ** | ** ** |
| **For the Quarterly Period Ended  March 31, 2006.** |
|                                                     |   |   |
| **OR**                                                   |
|                                                     |   |   |
| **o**                                                    | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                          |  |  |  |

 

**For the transition period from                               to                                  .**

 

**CommissionFile Number 0-15935**

 

**SPESCOMSOFTWARE INC.**

(Exact name of registrantas specified in its charter)

 

| **CALIFORNIA**                   | ** ** | **95-3634089**      |
|----------------------------------|------------|---------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer    |
| incorporation or  organization)  |       | Identification No.) |

 

**10052MESA RIDGE COURT, SUITE 100, SAN DIEGO, CA 92121**

(Address of principalexecutive offices and zip code)

 

**(858)625-3000**

(Registrants telephonenumber, including area code)

 

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

 

YES        ý        NO        o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12-b-2 of the Exchange Act).

 
| Large Accelerated Filer   o                 Accelerated Filer   o                 Non-Accelerated Filer   ý |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 126-2 of the Exchange Act).

 

YES        o        NO        ý

 

Number of shares of Common Stock outstanding at May 12,2006:  37,144,494

 

 

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**ITEM 1.  FINANCIAL STATEMENTSAND SUPPLEMENTARY DATA**

 

**SPESCOMSOFTWARE INC.**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                  | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2006**           | ** ** | **2005**               | ** ** |
| ** **                                                                                                                                                                  | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                  |       |               |       |                   |       |
| Current assets:                                                                                                                                                             |       |               |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                  | 620,000    |                   | $          | 285,000 |   |
| Receivables, net                                                                                                                                                            |       | 712,000            |       | 613,000                |       |
| Other current  assets                                                                                                                                                       |       | 209,000            |       | 72,000                 |       |
| Total current  assets                                                                                                                                                       |       | 1,541,000          |       | 970,000                |       |
|                                                                                                                                                                        |       |               |       |                   |       |
| Property and  equipment, net                                                                                                                                                |       | 169,000            |       | 168,000                |       |
| Computer  software, net                                                                                                                                                     |       | 477,000            |       | 477,000                |       |
| Other assets                                                                                                                                                                |       | 30,000             |       | 30,000                 |       |
| Total assets                                                                                                                                                                |       | $                  | 2,217,000  |                   | $          | 1,645,000 |   |
|                                                                                                                                                                        |       |               |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ DEFICIT**                                                                                                                              |       |               |       |                   |       |
| Current  liabilities:                                                                                                                                                       |       |               |       |                   |       |
| Accounts payable                                                                                                                                                            |       | $                  | 732,000    |                   | $          | 374,000 |   |
| Payable to  Spescom Ltd.                                                                                                                                                    |       | 186,000            |       | 213,000                |       |
| Preferred stock  dividend payable to Spescom Ltd.                                                                                                                           |       | 735,000            |       | 568,000                |       |
| Accrued  liabilities                                                                                                                                                        |       | 1,167,000          |       | 1,407,000              |       |
| Lease  obligations– current portion                                                                                                                                    |       | 44,000             |       | 41,000                 |       |
| Notes and  accrued interest payable to Spescom Ltd.                                                                                                                         |       | 968,000            |       | —                 |       |
| Deferred revenue                                                                                                                                                            |       | 2,743,000          |       | 3,026,000              |       |
| Series I  redeemable preferred stock, par value $0.01 per share, 2,450 remaining shares  authorized; 1,950 shares issued and outstanding at March 31, 2006                  |       | 2,450,000          |       | —                 |       |
| Total current  liabilities                                                                                                                                                  |       | 9,025,000          |       | 5,629,000              |       |
|                                                                                                                                                                        |       |               |       |                   |       |
| Notes and  accrued interest payable to Spescom Ltd.                                                                                                                         |       | —             |       | 917,000                |       |
| Lease  obligations                                                                                                                                                          |       | 35,000             |       | 59,000                 |       |
| Total  liabilities                                                                                                                                                          |       | 9,060,000          |       | 6,605,000              |       |
|                                                                                                                                                                        |       |               |       |                   |       |
| Shareholders’  deficit:                                                                                                                                                |       |               |       |                   |       |
| Convertible  preferred stock, 243,239 remaining shares authorized                                                                                                           |       |               |       |                   |       |
| Series F - par  value $1.00 per share; 5,291 shares authorized, issued and outstanding at March  31, 2006 and September 30, 2005                                            |       | 6,790,000          |       | 6,790,000              |       |
| Series G - par  value $0.01 per share; 1,670 remaining shares authorized; 1,450 shares issued  and outstanding in issued and outstanding at September 30, 2005              |       | —             |       | 1,450,000              |       |
| Common stock, no  par value, 100,000,000 shares authorized; 37,144,494 and 36,818,528 shares issued  and outstanding at March 31, 2006 and September 30, 2005, respectively |       | 76,488,000         |       | 75,938,000             |       |
| Common stock  warrants                                                                                                                                                      |       | 1,784,000          |       | 1,506,000              |       |
| Accumulated  other comprehensive loss                                                                                                                                       |       | (333,000           | )          | (353,000               | )          |
| Accumulated deficit                                                                                                                                                         |       | (91,572,000        | )          | (90,291,000            | )          |
| Total  shareholders’ deficit                                                                                                                                           |       | (6,843,000         | )          | (4,960,000             | )          |
|                                                                                                                                                                        |       |               |       |                   |       |
| Total  liabilities and shareholders’ deficit                                                                                                                           |       | $                  | 2,217,000  |                   | $          | 1,645,000 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

2

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**SPESCOMSOFTWARE INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                          | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                          | ** ** | **March 31,**                                 | ** ** | **March 31,**                               | ** ** |
| ** **                                          | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                           |       |                                               |       |                                             |       |   |   |   |   |
| Licenses                                            |       | $                                                  | 652,000    |                                             | $          | 86,000 |   | $ | 1,216,000 |   | $ | 354,000 |   |
| Services and  other                                 |       | 1,408,000                                          |       | 1,587,000                                        |       | 2,676,000 |   | 2,972,000 |   |
| Total revenues                                      |       | 2,060,000                                          |       | 1,673,000                                        |       | 3,892,000 |   | 3,326,000 |   |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Cost of  revenues:                                  |       |                                               |       |                                             |       |   |   |   |   |
| Licenses                                            |       | 72,000                                             |       | 64,000                                           |       | 194,000 |   | 108,000 |   |
| Services and  other                                 |       | 721,000                                            |       | 620,000                                          |       | 1,261,000 |   | 1,234,000 |   |
| Total cost of  revenues                             |       | 793,000                                            |       | 684,000                                          |       | 1,455,000 |   | 1,342,000 |   |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Gross profit                                        |       | 1,267,000                                          |       | 989,000                                          |       | 2,437,000 |   | 1,984,000 |   |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Operating  expenses:                                |       |                                               |       |                                             |       |   |   |   |   |
| Research and  development                           |       | 282,000                                            |       | 174,000                                          |       | 485,000 |   | 520,000 |   |
| Marketing and  sales                                |       | 685,000                                            |       | 914,000                                          |       | 1,338,000 |   | 1,738,000 |   |
| General and  administrative                         |       | 353,000                                            |       | 373,000                                          |       | 794,000 |   | 772,000 |   |
| Total operating  expenses                           |       | 1,320,000                                          |       | 1,461,000                                        |       | 2,617,000 |   | 3,030,000 |   |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Loss from  operations                               |       | (53,000                                            | )          | (472,000                                         | )          | (180,000 | ) | (1,046,000 | ) |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Interest and  other income                          |       | 4,000                                              |       | 2,000                                            |       | 4,000 |   | 2,000 |   |
| Interest and  other expense                         |       | (53,000                                            | )          | (38,000                                          | )          | (105,000 | ) | (68,000 | ) |
| Net loss                                            |       | (102,000                                           | )          | (508,000                                         | )          | (281,000 | ) | (1,112,000 | ) |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Deemed preferred  dividend                          |       | (500,000                                           | )          | —                                           |       | (1,000,000 | ) | (2,200,000 | ) |
| Net loss  available after deemed preferred dividend |       | (602,000                                           | )          | (508,000                                         | )          | (1,281,000 | ) | (3,312,000 | ) |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Cumulative  preferred dividends                     |       | (98,000                                            | )          | (86,000                                          | )          | (186,000 | ) | (169,000 | ) |
| Net loss  available to common shareholders          |       | $                                                  | (700,000   | )                                                | $          | (594,000 | ) | $ | (1,467,000 | ) | $ | (3,481,000 | ) |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| Earnings (loss)  per share:                         |       |                                               |       |                                             |       |   |   |   |   |
| Basic and  diluted                                  |       | $                                                  | (0.02      | )                                                | $          | (0.02 | ) | $ | (0.04 | ) | $ | (0.10 | ) |
| Weighted average  shares outstanding:               |       |                                               |       |                                             |       |   |   |   |   |
| Basic and  diluted                                  |       | 36,895,000                                         |       | 34,215,000                                       |       | 36,857,000 |   | 34,187,000 |   |
|                                                |       |                                               |       |                                             |       |   |   |   |   |
| **Statement  of Comprehensive Loss**                |       |                                               |       |                                             |       |   |   |   |   |
| Net loss                                            |       | $                                                  | (102,000   | )                                                | $          | (508,000 | ) | $ | (281,000 | ) | $ | (1,112,000 | ) |
| Other  Comprehensive income (loss):                 |       |                                               |       |                                             |       |   |   |   |   |
| Foreign currency  translation adjustment            |       | (14,000                                            | )          | 5,000                                            |       | 20,000 |   | (49,000 | ) |
| Comprehensive  loss                                 |       | $                                                  | (116,000   | )                                                | $          | (503,000 | ) | $ | (261,000 | ) | $ | (1,161,000 | ) |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

3

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**SPESCOMSOFTWARE INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**                               | ** ** |
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                                             |       |   |   |
| Net loss                                                                     |       | $                                                | (281,000   | ) | $ | (1,112,000 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                             |       |   |   |
| Depreciation and  amortization                                               |       | 73,000                                           |       | 38,000 |   |
| Unpaid interest  on notes payable                                            |       | 98,000                                           |       | 66,000 |   |
| Share-based  compensation                                                    |       | 92,000                                           |       | — |   |
| Compensation for  warrants issued to consultants                             |       | 40,000                                           |       | — |   |
| Changes in  assets and liabilities:                                          |       |                                             |       |   |   |
| Receivables, net                                                             |       | (102,000                                         | )          | 58,000 |   |
| Other current  assets                                                        |       | (136,000                                         | )          | 31,000 |   |
| Accounts payable                                                             |       | 361,000                                          |       | (1,000 | ) |
| Payable to  Spescom Ltd.                                                     |       | (22,000                                          | )          | (7,000 | ) |
| Accrued  liabilities                                                         |       | (260,000                                         | )          | 52,000 |   |
| Deferred revenue                                                             |       | (268,000                                         | )          | 287,000 |   |
| Net cash used in  operating activities                                       |       | (405,000                                         | )          | (588,000 | ) |
|                                                                         |       |                                             |       |   |   |
| Cash flows from  investing activities:                                       |       |                                             |       |   |   |
| Purchases of  property and equipment                                         |       | (40,000                                          | )          | (13,000 | ) |
| Capitalization  of development costs                                         |       | (35,000                                          | )          | (209,000 | ) |
| Purchases of  software                                                       |       | —                                           |       | (37,000 | ) |
| Net cash used in  investing activities                                       |       | (75,000                                          | )          | (259,000 | ) |
|                                                                         |       |                                             |       |   |   |
| Cash flows from  financing activities:                                       |       |                                             |       |   |   |
| Proceeds from  exercise of stock options                                     |       | —                                           |       | 2,000 |   |
| Proceeds from  exercise of warrants                                          |       | —                                           |       | 17,000 |   |
| Net proceeds  from private placement                                         |       | 838,000                                          |       | 1,767,000 |   |
| Payments on  capital lease obligations                                       |       | (21,000                                          | )          | (11,000 | ) |
| Net cash  provided by financing activities                                   |       | 817,000                                          |       | 1,775,000 |   |
|                                                                         |       |                                             |       |   |   |
| Effect of  exchange rate changes on cash                                     |       | (2,000                                           | )          | (6,000 | ) |
|                                                                         |       |                                             |       |   |   |
| Net increase in  cash and cash equivalents                                   |       | 335,000                                          |       | 923,000 |   |
| Cash and cash equivalents  at beginning of period                            |       | 285,000                                          |       | 109,000 |   |
|                                                                         |       |                                             |       |   |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                | 620,000    |   | $ | 1,031,000 |   |

 

See Note 2 for supplemental cash flow information.

 

The accompanying notesare an integral part of these consolidated financial statements.

 

4

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**SPESCOM SOFTWARE INC.**

**CONDENSED NOTES TO THE CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1 - Basis of Presentation**

 

The accompanying consolidated financial statements as of March 31, 2006and for the three and six months ended March 31, 2006 and 2005 areunaudited. The consolidated financial statements and related notes have beenprepared in accordance with generally accepted accounting principles applicableto interim periods.  In the opinion of management, the consolidatedfinancial statements reflect all adjustments, consisting only of normalrecurring adjustments, necessary for a fair presentation of the consolidatedfinancial position, operating results and cash flows for the periods presented.

 

The information contained in the following Condensed Notes to theConsolidated Financial Statements is condensed from that which would appear inthe annual consolidated financial statements; accordingly, the consolidatedfinancial statements included herein should be reviewed in conjunction with theconsolidated financial statements and related notes thereto contained in theCompany’s Annual Report on Form 10-K/A for the year ended September 30,2005.  It should be understood that the accounting measurements at aninterim date inherently involve greater reliance on estimates than atyear-end.  The results of operations for the interim periods presented arenot necessarily indicative of the results expected for the entire year.

 

**Note 2 – Summary of SignificantAccounting Policies**

 

*Principles of Consolidation*

 

The consolidated financial statements are prepared using accountingprinciples generally accepted in the United States of America and include theaccounts of the Company and its wholly-owned United Kingdom subsidiary, SpescomSoftware, Ltd. All significant intercompany balances and transactions have beeneliminated.

 

*Foreign Currency*

 

The functional currency of the Company’s United Kingdom subsidiary isthe pound sterling. Assets and liabilities are translated into U.S. dollars atend-of-period exchange rates. Revenues and expenses are translated at averageexchange rates in effect for the period. Net currency exchange gains or lossesresulting from such translations are excluded from net income and areaccumulated in a separate component of shareholders’ deficit as accumulatedother comprehensive income (loss). Gains and losses resulting from foreigncurrency transactions, which are not significant, are included in theconsolidated statements of operations.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and also requires disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting periods. Actual results could differfrom those estimates. Significant estimates made by management include revenuerecognition estimates, the viability of recognizing deferred income tax assets,capitalized software costs and the valuation of equity instruments, and theallowance for doubtful accounts.  Significant changes in these estimatesmay have a material impact on the financial statements.

 

*Revenue Recognition*

 

The Company’s revenues are derived from sales of its document andconfiguration management systems that are primarily composed of software andservices, including maintenance, training and consulting services, and thirdparty software and hardware. The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2 “Software Revenue Recognition,”  SOP 98-9, “Modification of SOP 97-2, SoftwareRevenue Recognition with Respect to Certain Transactions”, Staff AccountingBulletin (“SAB”) No. 101, updated by SAB’s 103 and 104 “Update of Codificationof Staff Accounting Bulletins,” and Emerging Issues Task Force No. 00-21 (“EITF00-21”) “Accounting for Revenue Arrangements with Multiple Deliverables.”  Revenue through the Company’s Value AddedResellers (“VARS”) are net of any VAR discount in accordance with EITF 99-19 “ReportingRevenue Gross as a Principal versus Net as an Agent.”

 

Software license and third party product revenues are recognized uponshipment of the product if no significant vendor obligations remain andcollection is probable. In cases where a significant vendor obligation exists,revenue recognition is delayed until such obligation has been satisfied. Fornew software products where a historical record has not yet been demonstratedthat acceptance is perfunctory, the Company defers recognition of revenue untilacceptance has occurred.  If an undelivered element of the arrangement 

 

5

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exists under the license arrangement, a portion of revenue is deferredbased on vendor-specific objective evidence (VSOE) of the fair value of theundelivered element until delivery occurs.  If VSOE does not exist for allundelivered elements, all revenue is deferred until sufficient evidence existsor all elements have been delivered.  Annual maintenance revenues, whichconsist of ongoing support and product updates, are recognized on astraight-line basis over the term of the contract. Payments received in advanceof performance of the related service for maintenance contracts are recorded asdeferred revenue. Revenues from training and consulting services are recognizedwhen the services are performed and adequate evidence of providing suchservices is available. Contract revenues for long-term contracts or programsrequiring specialized systems are recognized using the percentage-of-completionmethod of accounting, primarily based on contract labor hours incurred to datecompared with total estimated labor hours at completion. Provisions foranticipated contract losses are recognized at the time they become known.

 

Contracts are billed based on the terms of the contract. There are no retentionsin billed contract receivables. Unbilled contract receivables relate torevenues earned but not billed at the end of the period.

 

The Company considers many factors when applying accounting principlesgenerally accepted in the United States of America related to revenuerecognition.  These factors include, but are not limited to:

 
| • |   | The actual contractual terms, such as payment terms,  delivery dates, and pricing of the various product and service elements of a  contract |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Availability of products to be delivered                                                                                                     |
| • |   | Time period over which services are to be performed                                                                                          |
| • |   | Creditworthiness of the customer                                                                                                             |
| • |   | The complexity of customizations to the Company’s  software required by service contracts                                               |
| • |   | The sales channel through which the sale is made  (direct, VAR, distributor, etc.)                                                           |
| • |   | Discounts given for each element of a contract                                                                                               |
| • |   | Any commitments made as to installation or  implementation of “go live” dates                                                      |

 

Each of the relevant factors is analyzed to determine its impact,individually and collectively with other factors, on the revenue to berecognized for any particular contract with a customer.  Management isrequired to make judgments regarding the significance of each factor inapplying the revenue recognition standards, as well as whether or not eachfactor complies with such standards.  Any misjudgment or error bymanagement in its evaluation of the factors and the application of thestandards, especially with respect to complex or new types of transactions,could have a material adverse effect on the Company’s future operating results.

 

*Fair Value of Financial Instruments*

 

Statement of Financial Accounting Standards (“SFAS”) No. 107, “DisclosuresAbout Fair Value of Financial Instruments”, requires management to disclose theestimated fair value of certain assets and liabilities defined by SFASNo. 107 as cash or a contractual obligation that both conveys to oneentity a right to receive cash or other financial instruments from anotherentity, and imposes on the other entity the obligation to deliver cash or otherfinancial instruments to the first entity. At March 31, 2006 andSeptember 30, 2005, management believes that the carrying amounts of cashand cash equivalents, short-term investments, accounts receivable and accountspayable, and accrued expenses approximate fair value because of the shortmaturity of these financial instruments. The Company believes that the carryingvalue of its loans approximate their fair values based on current market ratesof interest.

 

*Concentration of Credit Risk*

 

The Company provides products and services to customers in a variety ofindustries worldwide, including local governments, petrochemicals, utilities,manufacturing and transportation. Concentration of credit risk with respect totrade receivables is limited due to the geographic and industry dispersion ofthe Company’s customer base. The Company has not experienced significant creditlosses on its customer accounts. Constellation Energy Group and City ofLancaster accounted for 38% and 20%, respectively, of trade accounts receivableat March 31, 2006 as compared to W.H. Smith Ltd. and Entergy Operations,which accounted for 33% and 28%, respectively, of trade accounts receivable atSeptember 30, 2005.

 

A small number of customers have typically accounted for a largepercentage of the Company’s annual revenues. Constellation Energy Group accountedfor 15% of revenue for the six months ended March 31, 2006 while NetworkRail and Computer Science Corporation accounted for 19% and 12%, respectively,of revenue for the six months ended March 31, 2005.  The Company’sreliance on relatively few customers could have a material adverse effect onthe results of its operations on a quarterly basis.

 

6

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*Property and Equipment*

 

Property and equipment is recorded at cost and depreciated using thestraight-line method over useful lives of two to seven years. Leaseholdimprovements are amortized on a straight-line basis over the shorter of theiruseful life or the term of the related lease. Expenditures for ordinary repairsand maintenance are expensed as incurred while major additions and improvementsare capitalized.

 

*Software Development Costs*

 

Software development costs are capitalized when technologicalfeasibility and marketability of the related product have been established.Software development costs incurred solely in connection with a specificcontract are charged to cost of revenues. Capitalized software developmentcosts are amortized on a product-by-product basis, beginning when the productis available for general release to customers. Annual amortization expense iscalculated using the greater of the ratio of each product’s current grossrevenues to the total of current and expected gross revenues or the straight-linemethod over the estimated useful life of three to five years. While there wasno capitalized software cost for the three months ended March 31, 2006, there was$35,000 of capitalized software development costs for the six months ended March31, 2006. Amortization expense for the three and six months ended March 31,2006 totaled $26,000 and $35,000, respectively. As of March 31, 2006 andSeptember 30, 2005, the balance of software development capitalized totaled$513,000 and $478,000, respectively, with accumulated amortization of $36,000and $1,000, respectively.

 

*Long-lived Assets*

 

The Company assesses potential impairments to its long-lived assetswhen there is evidence that events or changes in circumstances have maderecovery of the assets’ carrying value unlikely. An impairment loss would berecognized when the sum of the expected future net cash flows is less than thecarrying amount of the asset.

 

*Share-Based Payments*

 

In April 1996, the Company adopted its 1996 Stock Incentive Plan(the “1996 Plan”).  The 1996 Plan is administered by either the Board ofDirectors or a committee designated by the Board to oversee the plan.  Thetotal number of authorized shares under the 1996 Plan is 7,425,000.  As ofMarch 31, 2006, options to purchase 6,390,000 shares are outstanding. The1996 Plan expired as of March 31, 2006 and therefore no further grants areavailable from this Plan.

 

The option vesting period under the plan is determined by the Board ofDirectors or a Stock Option Committee and usually provides that 25% of theoptions granted can be exercised 90 days from the date of grant, andthereafter, those options vest and become exercisable in additional cumulativeannual installments of 25% commencing on the first anniversary of the date ofgrant. Options granted are generally due to expire upon the sooner of ten yearsfrom date of grant, thirty days after termination of services other than byreason of convenience of the Company, three months after disability, or oneyear after the date of the option holder’s death. The option exercise price isequal to the fair market value of the common stock on the date of grant. Options granted to employees under the 1996 Plan were either incentive stockoptions or nonqualified options. Only nonqualified options were granted tononemployee directors.

 

In December 2004, the Financial Accounting Standards Board (FASB)revised Statement of Financial Accounting Standards No. 123 (FAS 123R), “Share-BasedPayment,” which establishes accounting for share-based awards exchanged foremployee services and requires companies to expense the estimated fair value ofthese awards over the requisite employee service period. On April 14,2005, the U.S. Securities and Exchange Commission adopted a new rule amendingthe effective dates for FAS 123R. In accordance with the new rule, theaccounting provisions of FAS 123R are effective for the Company beginning inthe quarter ended December 31, 2005.

 

Under FAS 123R, share-based compensation cost is measured at the grantdate, based on the estimated fair value of the award, and is recognized asexpense over the employee’s requisite service period. The Company has no awardswith market or performance conditions. The Company adopted the provisions ofFAS 123R on October 1, 2005, the first day of the Company’s fiscal year 2006,using a modified prospective application, which provides for certain changes tothe method for valuing share-based compensation. Under the modified prospectiveapplication, prior periods are not revised for comparative purposes. Thevaluation provisions of FAS 123R apply to new awards and to awards that areoutstanding on the effective date and subsequently modified or cancelled.Estimated compensation expense for awards outstanding at the effective datewill be recognized over the remaining service period using the compensationcost calculated for pro forma disclosure purposes under FASB StatementNo. 123, “Accounting for Stock-Based Compensation” (FAS 123).

 

On November 10, 2005, the FASB issued FASB Staff Position No. FAS123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards.” The Company has elected to adopt the alternativetransition method provided in this FASB Staff Position for calculating the taxeffects of share-based compensation pursuant to FAS 123R. The alternativetransition method includes a simplified method to establish the beginningbalance of the additional paid-in capital pool (APIC pool) related to the tax 

 

7

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effects of employee share-based compensation, which is available toabsorb tax deficiencies recognized subsequent to the adoption of FAS 123R.

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model with the following weightedaverage assumptions used for grants:

 
| ** **               | ** ** | **For the three  months ended** | ** ** | **For the six  months ended** | ** ** |
|--------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **March 31,**                             | ** ** | **March 31,**                           | ** ** |
| ** **               | ** ** | **2006**                                       | ** ** | **2006**                                     | ** ** |
| Dividend Yield           |       | 0                                              | %          | 0                                            | %          |
| Expected  Volatility     |       | 165                                            | %          | 165                                          | %          |
| Risk free  interest rate |       | 4.7                                            | %          | 4.7                                          | %          |
| Expected lives  (years)  |       | 10                                             |       | 10                                           |       |

 

The weighted–average estimated fair value of employee stock optionsgranted during the three and six months ended March 31, 2006 using theBlack-Scholes model were as follows:

 
| ** **                                                                     | ** ** | **For the three  months ended** | ** ** | **For the six  months ended** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                     | ** ** | **March 31,**                             | ** ** | **March 31,**                           | ** ** |
| ** **                                                                     | ** ** | **2006**                                       | ** ** | **2006**                                     | ** ** |
| Research and  development                                                      |       | $                                              | 2,000      |                                         | $          | 5,000 |   |
| Marketing and  sales                                                           |       | 12,000                                         |       | 30,000                                       |       |
| General and  administrative                                                    |       | 24,000                                         |       | 57,000                                       |       |
|                                                                           |       |                                           |       |                                         |       |
| Share-based  compensation                                                      |       | $                                              | 38,000     |                                         | $          | 92,000 |   |
|                                                                           |       |                                           |       |                                         |       |
| Basic and  diluted net loss per share attributable to common shareholders |       |                                           |       |                                         |       |
| Basic                                                                          |       | —                                         |       | —                                       |       |
| Diluted                                                                        |       | —                                         |       | —                                       |       |

 

A summary of option activity under the Plan as of March 31, 2006,and changes during the six months then ended is presented below:

 
| ** **                                 | ** ** | ** ** | ** ** | ** **    | ** ** | **Weighted-**   | ** ** | ** **    | ** ** |
|--------------------------------------------|------------|------------|------------|---------------|------------|-----------------|------------|---------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | **Weighted-** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | **Average**   | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | **Exercise**  | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| **Options**                                | ** ** | **Shares** | ** ** | **Price**     | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                                       |       | **(000)**  |       |          |       |            |       |          |       |
| Outstanding  Options at September 30, 2005 |       | 4,856      |       | $             | 0.30       |            |       |          |       |   |
|                                       |       |       |       |          |       |            |       |          |       |
| Granted                                    |       | 2,194      |       | $             | 0.12       |            |       |          |       |   |
|                                       |       |       |       |          |       |            |       |          |       |
| Exercised                                  |       | —     |       | $             | —     |            |       |          |       |   |
|                                       |       |       |       |          |       |            |       |          |       |
| Forfeited or  expired                      |       | (660       | )          | $             | 0.26       |            |       |          |       |   |
|                                       |       |       |       |          |       |            |       |          |       |
| Outstanding at  March 31, 2006             |       | 6,390      |       | $             | 0.25       |            | 7.7        |          | $          | 17,400 |   |
|                                       |       |       |       |          |       |            |       |          |       |
| Exercisable at March  31, 2006             |       | 3,532      |       | $             | 0.31       |            | 6.5        |          | $          | 4,350 |   |

 

The weighted average grant-date fair values of options granted duringthe six months ended March 31, 2006 were $0.12 per share.  There wereno options exercised for the six months ended March 31, 2006.

 

8

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*Pro Forma Information under FAS 123for Periods Prior to Fiscal 2006*

 

The Company measures compensation expense for its stock-based employeecompensation plans using the intrinsic value method and provides pro formadisclosures of net loss and basic and diluted net loss per share as if the fairvalue-based method had been applied in measuring compensation expense. TheCompany applies SFAS No.123,*Accounting forStock-Based Compensation* and Accounting Principles Board OpinionNo. 25 and related Interpretations in accounting for its employeestock-based compensation plan.

 

No compensation cost was recognized for employee stock option grantsduring 2005 based upon the intrinsic value method, which were fixed in nature,as the options were granted at exercise prices equal to fair market value onthe date of grant. Had compensation cost for the Company’s employee stock-basedcompensation plan been determined based on the fair value at the grant datesthe disclosure requirements of SFAS No. 148, which amends the disclosurerequirements of FAS 123, would have been as follows:

 
| ** **                                                                                                                    | ** ** | **For the three  months ended** | ** ** | **For the six  months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **March 31,**                             | ** ** | **March 31,**                           | ** ** |
| ** **                                                                                                                    | ** ** | **2005**                                       | ** ** | **2005**                                     | ** ** |
| Net loss used in  computing net loss per share                                                                                |       |                                           |       |                                         |       |
| As reported                                                                                                                   |       | $                                              | (594,000   | )                                            | $          | (3,481,000 | ) |
| Subtract:                                                                                                                     |       |                                           |       |                                         |       |
| Total stock  based employee compensation expense determined under fair value based method  for all awards, net of related tax |       | (56,000                                        | )          | (114,000                                     | )          |
| Pro forma net  loss                                                                                                           |       | $                                              | (650,000   | )                                            | $          | (3,595,000 | ) |
|                                                                                                                          |       |                                           |       |                                         |       |
| Basic and  diluted net loss per share attributable to common shareholders                                                     |       |                                           |       |                                         |       |
| As reported                                                                                                                   |       | $                                              | (0.02      | )                                            | $          | (0.10 | ) |
| Pro forma                                                                                                                     |       | $                                              | (0.02      | )                                            | $          | (0.10 | ) |

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model with the following weightedaverage assumptions used for grants:

 
| ** **               | ** ** | **For the three  months ended** | ** ** | **For the six  months ended** | ** ** |
|--------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **March 31,**                             | ** ** | **March 31,**                           | ** ** |
| ** **               | ** ** | **2005**                                       | ** ** | **2005**                                     | ** ** |
| Dividend Yield           |       | 0                                              | %          | 0                                            | %          |
| Expected  Volatility     |       | 261                                            | %          | 261                                          | %          |
| Risk free interest  rate |       | 4.5                                            | %          | 4.5                                          | %          |
| Expected lives           |       | 10                                             |       | 10                                           |       |

 

*Income Taxes*

 

Current income tax expense is the amount of income taxes expected to bepayable for the current year. A deferred income tax asset or liability isestablished for the expected future consequences resulting from the differencesin the financial reporting and tax bases of assets and liabilities. Deferredincome tax expense (benefit) is the change during the year in the deferredincome tax asset or liability.

 

Valuation allowances are established when necessary to reduce deferredtax assets to the amount expected to be “more likely than not” realized in thefuture based on the Company’s current and expected operating results.

 

*Net Income (Loss) per Common Share*

 

Basic net income (loss) per common share is computed as net income(loss) divided by the weighted average number of common shares outstandingduring the year. Diluted net income (loss) per common share is computed as netloss divided by the weighted average number of common shares and potentialcommon shares, using the treasury stock method, outstanding during the year andassumes conversion into common stock at the beginning of each period of alloutstanding shares of convertible preferred stock, stock options, warrants andother potential common stock. Computations of diluted net income (loss) pershare do not give effect to individual potential common stock for any period inwhich their inclusion would be anti-dilutive.

 

9

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*Statements of Cash Flows*

 

The following table provides supplemental cash flow information:

 
| ** **                                    | ** ** | **For the six months ended** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **March 31,**                               | ** ** |
| ** **                                    | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Supplemental  cash flow information:          |       |                                             |       |   |   |
| Interest paid                                 |       | $                                                | 7,000      |   | $ | 4,000 |   |
|                                          |       |                                             |       |   |   |
| Non-cash  financing and investing activities: |       |                                             |       |   |   |
| Accrued  preferred stock dividends            |       | $                                                | 187,000    |   | $ | 132,000 |   |
| Warrants issued  for services                 |       | 40,000                                           |       | 30,000 |   |
| Deemed dividend  on private placement         |       | 1,000,000                                        |       | 2,200,000 |   |
| Expiration of  warrants                       |       | —                                           |       | 133,000 |   |
|                                          |       | $                                                | 1,227,000  |   | $ | 2,495,000 |   |

 

**Note 3 – Spescom Ltd. Transactionsand Related Parties**

 

As of March 31, 2006 and September 30, 2005 there were 5,291shares of Series F Convertible Preferred Stock with a stated value of $1,000per share held by Spescom Ltd., the majority shareholder of the Company. TheSeries F Convertible Preferred Stock is convertible into common stock, at astated conversion price of $0.45 per share subject to certainadjustments.  The conversion is at the option of Spescom Ltd. throughSeptember 30, 2008. The outstanding Series F Convertible Preferred Stockis entitled to receive dividends of 5% of the stated value of $1,000 per shareper annum, payable on a quarterly basis in cash or common stock (valued on thebasis of the average per share market value on the 30 trading days immediatelyprior to the date on which such dividend is declared by the Board ofDirectors).  Unpaid dividends accrue interest at the rate of 8% perannum.  As of March 31, 2006, unpaid dividends and accrued interestamounted to $661,000 and $63,000, respectively. As of September 30, 2005,unpaid dividends and accrued interest amounted to $529,000 and $39,000,respectively.

 

Related party liabilities consist of the following:

 
| ** **                                                      | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                      | ** ** | **2006**           | ** ** | **2005**               | ** ** |
|                                                            |       |               |       |                   |       |
| Payable to Spescom  Ltd. UK                                     |       | $                  | 186,000    |                   | $          | 213,000 |   |
|                                                            |       |               |       |                   |       |
| Payable to  Spescom Ltd. S.A.                                   |       | $                  | 321,000    |                   | $          | 302,000 |   |
| Notes and  accrued interest payable on demand - Spescom Ltd. UK |       | 647,000            |       | 615,000                |       |
|                                                            |       | $                  | 968,000    |                   | $          | 917,000 |   |

 

The Company has two existing demand notes payable to Spescom Ltd. UK, awholly owned subsidiary of Spescom Ltd., for $400,000 and $100,000, eachbearing interest rate of 10% per annum.  As of March 31, 2006 andSeptember 30, 2005, the balance owed on the notes including interest was $647,000and $615,000, respectively. Spescom Ltd. has agreed that it will not causeSpescom Ltd. UK to demand repayment under the two notes prior toOctober 1, 2006.  Interest expense on the notes was $16,000 and $14,000for the three months ended March 31, 2006 and 2005, respectively. These notes are collateralized by a security interest in favor of both SpescomLtd. and Spescom Ltd. UK in respect of all the Company’s assets. In November2005 the Company’s wholly owned subsidiary, Spescom Software Ltd. agreed toguarantee certain loan obligations of Spescom Ltd. totaling $5.4 million as of March 31,2006.  The proceeds of these loans had been used by Spescom Ltd. in prioryears to provide working capital to the Company. The guarantee is secured bythe assets of Spescom Software Ltd. which totaled $369,000 as of March 31,2006.

 

Under a royalty arrangement beginning in fiscal 2004, Spescom Ltd.resells the Company’s software and maintenance services in South Africa. Royalty revenue recognized under this agreement for the three and six monthsended March 31, 2006 totaled $34,000 and $117,000, respectively.   In February 2006 the royalty arrangement withSpescom Ltd. was terminated and the company entered into a new resellerarrangement with a third party company DocQnet International for the SouthAfrican market. In September 2005, Spescom Ltd. performed certain marketing andbusiness development projects for the company along with assisting in raisingworking capital. Spescom Ltd. had agreed to defer payment for these servicesuntil after October 1, 2006. However, interest will accrue on the balance owedat a rate of 11%. The total expense relating to these services was $302,000 forthe year ended September 30, 2005 and 

 

10

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additional expense of $2,000 was recorded for the six months ended March 31,2006. As of March 31, 2006, the total unpaid services and interestamounted to $304,000 and $17,000, respectively. At March 31, 2006 therewere no personnel related charges due to Spescom, Ltd. S.A.

 

Spescom Ltd. UK provides certain administrative and accountingfunctions for the Company’s United Kingdom subsidiary.  The Company isbilled a monthly fee by Spescom Ltd. UK for reimbursement of certain costs inthe United Kingdom including the office facilities, all accounting and humanresources services, and certain corporate marketing activities.  For thethree and six months ended March 31, 2006 the administrative fees totaled$83,000 and $226,000, respectively, as compared to $155,000 and $309,000,respectively, for the same periods in 2005.  The office rent for theCompany’s United Kingdom operations included in the administrative fee totaled$48,000 and $132,000 for the three and six months ended March 31, 2006,respectively, as compared to $91,000 and $180,000, respectively, for the sameperiods in 2005.   At March 31, 2006 and September 30, 2005 theCompany had a payable to Spescom Ltd. UK of $186,000 and $213,000,respectively. In 1999, as part of an agreement to sell a 60% interest in itsUnited Kingdom subsidiary to Spescom Ltd., the lease for the United Kingdomoffice facility was to be assigned to Spescom Ltd. UK; however, the landlorddid not grant its consent to the assignment and as such Spescom Ltd.UK has paidthe lease for the entire office directly to the landlord.  The leaseexpired on March 14, 2006.  The landlord has claimed that the Companyowes certain dilapidation payments under the lease. The Company has disputedsuch claims and believes there will be no material effect once resolved.

 

Spescom Ltd. and the Company have entered into a license agreementpursuant to which Spescom Ltd. has licensed to the Company the right to use thename “Spescom” and to use a trademark owned by Spescom Ltd. related to certaincomputer software. The Company will not pay any royalties to Spescom Ltd. inconnection with this license. The license is for an indefinite term, but is terminableby either party upon 60 days prior written notice. Under the license agreement,Spescom Ltd. has agreed to indemnify and hold harmless the Company and itsdirectors, officers, employees and agents against liabilities arising from anyclaim brought against the Company that alleges that Spescom Ltd.’s or theCompany’s use of the licensed trademark infringes the rights of any thirdparty, provided that the Company is in material compliance with the provisionsof the license agreement.

 

**Note 4 – Receivables**

 

A summary of receivables and allowance for doubtful accounts as ofMarch 31, 2006 and September 30, 2005 are as follows:

 
| ** **                                   | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **2006**           | ** ** | **2005**               | ** ** |
| **Receivables  consist of:**                 |       |               |       |                   |       |
| Receivables                                  |       | $                  | 719,000    |                   | $          | 621,000 |   |
| Less:   allowance for doubtful accounts |       | (7,000             | )          | (8,000                 | )          |
|                                         |       | $                  | 712,000    |                   | $          | 613,000 |   |

 

**Note 5 – Reconciliation of Net Income(Loss) and Shares Used in Per Share Computations:**

 
| ** **                                  | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                  | ** ** | **March 31,**                                 | ** ** | **March 31,**                               | ** ** |
| ** **                                  | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss  available for common shareholders |       | $                                                  | (700,000   | )                                                | $          | (594,000 | ) | (1,467,000 | ) | (3,481,000 | ) |
|                                        |       |                                               |       |                                             |       |   |   |   |   |
| Common stock and  common stock equivalents  |       | 36,895,000                                         |       | 34,215,000                                       |       | 36,857,000 |   | 34,187,000 |   |
|                                             |            |                                                    |            |                                                  |            |  |  |  |  |  |  |

 

Basic net income (loss) per share is computed using the weightedaverage number of common shares outstanding during the period.  Contingentlyissued shares are included in the computation of basic net income (loss) pershare when the related conditions are satisfied.  Diluted net income(loss) per share is computed using the weighted average number of common sharesand potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of contingently issued shares, thecommon shares issuable upon conversion of preferred stock or convertible debtand shares issuable upon the exercise of stock options and common stockwarrants.  Potentially dilutive securities are excluded from thecomputation if their effect is anti-dilutive.

 

As of March 31, 2006, a total of 6,390,000 stock options,7,644,354 common stock warrants, and 5,291 and 2,450 shares of Series F andSeries I Convertible Preferred Stock, respectively, were excluded from thediluted net income (loss) per share calculation, as their effect would beanti-dilutive. There were no shares of Series H Convertible Preferred Stock at March 31,2006 as the shares were exchanged for Series I Convertible Preferred Stock onMarch 10, 2006. As of March 31, 2005, a total of 3,919,860 stock options,3,758,335 common stock warrants, and 5,291 and 2,200 shares of Series F andSeries G Convertible Preferred Stock, respectively, were excluded from thediluted net income (loss) per share calculation, as their effect would beanti-dilutive.

 

11

----

 

**Note 6 – Segment and GeographicInformation**

 

The Company has one business segment, which consists of the developmentand sale of a suite of integrated document, configuration and recordsmanagement software product.

 

Revenues by customer location and identifiable assets by location areas follows:

 
| ** **                        | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                        | ** ** | **March 31,**                                 | ** ** | **March 31,**                               | ** ** |
| ** **                        | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales:                        |       |                                               |       |                                             |       |   |   |   |   |
| United States                     |       | $                                                  | 1,305,000  |                                             | $          | 730,000 |   | $ | 2,421,000 |   | $ | 1,647,000 |   |
| Europe,  primarily United Kingdom |       | 407,000                                            |       | 934,000                                          |       | 986,000 |   | 1,657,000 |   |
| Other International               |       | 348,000                                            |       | 9,000                                            |       | 485,000 |   | 22,000 |   |
|                              |       | $                                                  | 2,060,000  |                                             | $          | 1,673,000 |   | $ | 3,892,000 |   | $ | 3,326,000 |   |

 
| ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|---------------|------------|-------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2006**      | ** ** | **2005**          | ** ** |
| Identifiable  assets from continuing operations: |       |       |       |       |       |          |       |              |       |
| United States                                    |       |       |       |       |       | $             | 1,848,000  |              | $          | 1,300,000 |   |
| Europe, United  Kingdom                          |       |       |       |       |       | 369,000       |       | 345,000           |       |
|                                             |       |       |       |       |       | $             | 2,217,000  |              | $          | 1,645,000 |   |

 

**Note 7—Redeemable PreferredStock**

 

**October 2005 Private Placement**

 

On October 25, 2005, the Company completed a private placement issuing1,950 shares of Series H Preferred Stock and warrants for the purchase of925,926 common shares in exchange for cash of $500,000 and 1,450 shares ofpreviously issued Series G Preferred Stock. The common stock warrants have anexercise price of $0.27 per share and expire October 25, 2008. Inconnection with this transaction, the 1,450 shares of Series G PreferredStock were cancelled by the Company. Expenses relating to the transactiontotaled $64,000 primarily relating to legal and accounting fees. In accordancewith EITF 00-27 “Application of Issue No 98-5 to Certain ConvertibleInstruments,” the Company calculated, using the Black–Scholes method, theintrinsic value of the convertible instruments issued and determined that therewas a deemed preferred dividend equal to the gross proceeds received of$500,000. In March 2006 the Company completed a private placement exchangingall of the Series H Preferred Stock for Series I Convertible Preferred Stock. SeeMarch 2006 Private Placement below.

 

The shares of Series H Preferred Stock issued were convertible intocommon stock at the conversion rate in effect at the time of conversion. The conversion price per share of the Series H Preferred Stock was equal to 85%of the market price (the volume weighted average price of the Company’s commonstock during the 5 immediately preceding trading days), provided that in noevent shall the conversion price exceed a ceiling price of $0.40 per share, orbe less than a floor price which varies with the aggregate gross revenues of theCompany during the last four fiscal quarters for which revenues have beenreported by the Company prior to such time, but which will not be lower than$0.0725 per share and not higher than $0.16 per share. The Series H PreferredStock accrued dividends at 6.75% of the stated value of $1,000 per share perannum. On March 31, 2006 the Company issued 325,966 shares of common stock inpayment of declared Series H Preferred Stock dividends of $44,000 based on afair market value of $0.13 per share.

 

The terms of the October 2005 financing also provided for a secondclosing to have occurred no later than January 20, 2006, under which theCompany would issue an additional 500 shares of Series H Preferred Stock andadditional warrants for the purchase of 925,926 common shares in exchange forcash of $500,000. The obligations of the purchasers to consummate the secondclosing were subject to certain conditions, including that the closing price ofthe Company’s common stock would be $0.16 or greater for 20 consecutive tradingdays. This stock price condition was not satisfied and the second closing wasnot completed.

 

## **March 2006 PrivatePlacement**

## ** **

On March 10, 2006, the Company completed a private placementissuing 2,450 shares of Series I Convertible Preferred Stock (“Series IPreferred Stock”) and warrants, expiring March 10, 2009, to purchase925,926 shares of common stock at $0.27 per share in exchange for cash $500,000and 1,950 shares of the Company’s Series H Convertible Preferred Stock,which have been cancelled. Expenses relating to the transaction totaled $98,000primarily relating to legal and accounting fees. In accordance with EITF 00-27 “Applicationof Issue No. 98-5 to Certain Convertible Instruments,” the Company calculated,using the Black–Scholes method, the 

 

12

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intrinsic value of the convertible instruments issued and determinedthat there was a deemed preferred dividend equal to the gross proceeds receivedof $500,000. Pursuant to the terms of the financing, the Company filed aregistration statement on April 7, 2006 for the common shares issuable underthe Series I Preferred Stock and related warrants.

 

Each share ofSeries I Preferred Stock is convertible into a number of shares of common stockdetermined by dividing $1,000 by the conversion price per share in effect atthe time of conversion. The conversion price per share is equal to 85% of themarket price (the volume-weighted average price of the Company’s common stockduring the 5 immediately preceding trading days, subject to adjustment),provided that in no event shall the conversion price exceed a ceiling price of$0.21 per share, or be less than a floor price of $0.0725 per share.

 

Under the terms of the Series I Preferred Stock, if the Company didnot entered into a binding agreement to consummate a consolidation, merger,reclassification of the stock of the Company (subject to certain exceptions),or disposition of all or substantially all of the assets of the Company on orbefore April 30, 2006, the holders of Series I Preferred Stock may,by the vote not later than December 31, 2006 of at least two-thirds of thethen-outstanding shares, elect to have all of the outstanding shares ofSeries I Preferred Stock redeemed by the Company. Upon such election, theCompany would be obligated to redeem the Series I Preferred Stock at anamount equal to $1,000 per share plus all declared but unpaid dividends. In theevent that the holders of Series I Preferred Stock exercise theirredemption right but the Company does not have sufficient funds available toredeem the Series I Preferred Stock in accordance with applicable law, theholders of Series I Preferred Stock as a class will be entitled toelect the smallest number of directors of the Company constituting a majorityof the authorized number of directors. As of April 30, 2006 the Company has notentered into a binding agreement to consummate a consolidation, merger,reclassification of the stock of the Company; or disposition of all orsubstantially all of the assets of the Company; presently, however, the holdersof the Series I Preferred Stock have not taken any action in regard to theirrights under these terms. In the event the holders of the Series I PreferredStock exercise their redemption right, the Company would not have sufficientfunds available to redeem the Series I Preferred Stock and those holders wouldbe entitled to elect a majority of the authorized directors of theCompany.  In this event, those holders, through their majority control ofthe Board of Directors, would be able to control or (with respect to mattersrequiring shareholder approval) exert significant influence over all mattersaffecting the Company.  Under FAS 150 “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” and EITF D-98 “Classification and Measurement of Redeemable Securities”and since a binding agreement was not entered into by April 30, 2006, theCompany has reclassified the Series I Preferred Stock to liabilities as ofMarch 31, 2006 as the Company may be obligated to repay the proceeds received.

 

Each holder ofSeries I Preferred Stock is entitled to a liquidation preference equal tothe greater of (i) $1,000 per share plus declared but unpaid dividends pershare and (ii) the amount such holder would be entitled to receive had suchholder’s shares been converted into shares of common stock immediately prior tothe distribution in accordance with the terms of the Series I Preferred Stock. Commencingon the issuance date of the Series I Preferred Stock, the Series I PreferredStock is entitled to receive dividends of 6.75% of the stated value of $1,000per share per annum, only payable until the registration statement for thecommon stock underlying the Series I Preferred Stock is declared effective bythe Securities and Exchange Commission.

 

**Note 8—Equity**

 

**November 2004 Private Placement**

 

On November 5, 2004, the Company completed a financing arrangementwhereby the Company issued 2,200 shares of our Series G Preferred Stock alongwith 2,750,000 common stock warrants for gross proceeds of $2,200,000. TheSeries G Preferred Stock was convertible into common stock at a price equal to85% of the volume weighted average price of the Company’s common stock duringthe five trading days immediately preceding the conversion date; however, theconversion price could be no higher than $0.40 per share and no lower than$0.30 per share. The 2,750,000 warrants have an exercise price of $0.44 pershare and expire November 5, 2007. The Company incurred $418,000 in expensesrelated to the transaction and issued 825,000 common stock warrants to aninvestment consulting firm. The 825,000 warrants were comprised of 550,000warrants with an exercise price of $0.40 per share which expire November 5,2009 and 275,000 warrants with an exercise price of $0.44 per share whichexpire on November 5, 2007. In connection with the financing, the Companyrecorded a beneficial conversion of $2,200,000 on the Series G Preferred Stockas a deemed dividend for the three months ended December 31, 2004. Duringfiscal 2005, 750 shares of the Series G Preferred Stock were converted into2,428,000 shares of common stock. As part of the private placement in October2005 the Company exchanged the 1,450 remaining shares of Series G PreferredStock for 1,450 shares of Series H Preferred Stock. Those 1,450 shares ofSeries H Preferred Stock were exchanged for Series I Preferred Stock in March2006. The shares of the Series G and H Preferred Stock have been cancelledby the Company. (See Note 7)

 

**Issuance of Warrants to InvestorRelations Firm**

 

During November 2005, the Company entered into a six-month engagementwith an investment relations firm to develop and implement a marketing programto promote financial market and investor awareness for the Company. Under theengagement agreement, the investor relations firm was entitled to receive,every month the agreement is effective, a warrant, expiring three years fromthe date of issuance, to purchase 50,000 shares of the Company’s common stock atan exercise price of $0.10 per share for a 

 

13

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total of 300,000 shares over the six-month contract. In addition, theinvestment relations firm was entitled under the agreement to a one timeperformance warrant to purchase 500,000 shares of the Company’s common stock at$0.25 per share, which would vest if, during the term of the agreement, thevolume weighted-average price of the Company’s common stock were to exceed $0.50for five consecutive days. On March 31, 2006, the Company issued to theinvestor relations firm a warrant, expiring on the third anniversary of itsdate of issuance, for the purchase of 300,000 shares of the Company’s commonstock at an exercise price of $0.10 per share. The investor relations firmagreed to accept that warrant for 300,000 in lieu of all of the warrantsissuable to the investor relations firm as monthly compensation during thesix-month term of the agreement and in lieu of the performance warrant. UnderEITF 96-19 the fair value of the warrant to purchase 300,000 shares of commonstock was determined to be $39,000 and has been expensed ratably over the sixmonth term of the engagement agreement.

 

**Note 9 - Recent Pronouncements**

 

There have not been any recent accounting pronouncements since theCompany’s last filing that would have a material effect on the financialstatements of the Company.

 

14

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**ITEM 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Forward –Looking Statements**

 

*This report contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934. Theseforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results oranticipated results, including those set forth under “Certain Factors ThatMay Affect Future Results” below and elsewhere in, or incorporated byreference into, this report.*

 

*In some cases, you can identifyforward looking statements by terms such as “may,” “intend,” “might,” “will,” “should,”“could,” “would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,”or the negative of these terms, and similar expressions are intended toidentify forward-looking statements. When used in the following discussion, thewords “believes,” “anticipates” and similar expressions are intended toidentify forward-looking statements. Such statements are subject to certainrisks and uncertainties, which could cause actual results to differ materiallyfrom those projected. Readers are cautioned not to place undue reliance onthese forward-looking statements, which speak only as of the date hereof. Theforward-looking statements in this report are based upon management’s currentexpectations and belief, which management believes are reasonable.  Thesestatements represent our estimates and assumptions only as of the date of thisQuarterly Report on Form 10-Q, and we undertake no obligation to publiclyrelease the result of any revisions to these forward-looking statements, whichmay be made to reflect events or circumstances after the date hereof or toreflect the occurrence of unanticipated events.*

 

*The following discussion should beread in conjunction with the Selected Consolidated Financial Data and theConsolidated Financial Statements, including the Notes thereto.*

 

**OVERVIEW**

 

The Company develops, markets and supports*e*B, its integrated suite of collaborative document,configuration and records management software solutions. The*e*B suite enables organizations in a broadrange of industries to create, capture, store, manage, share and distributecritical business information regarding their customers, products, assets andprocesses in an efficient manner. The*e*Bsuite also enables them to maintain complete, up-to-date information about theconfiguration of their products, assets and infrastructures so that they canachieve operational excellence and compliance with regulatory requirements.*e*B provides the capabilities of anEnterprise Content Management (ECM)/Electronic Document Management (EDM)System, but extends these capabilities by also managing the “things’ that thecontent/documents relate to such as products, assets , functions, processes,requirements, projects, organizations, locations, work orders, etc. As aresult,*e*B can be used to managethe lifecycle of physical items (e.g. products, equipment or assets), and the requirements(e.g. functional, safety, performance, environmental, etc.) that govern them.It enables intelligent relationships to be defined between these items therebycreating an interdependency model. As a result, the effects of any change onrequirements, documents and items can be determined and change can be managedto effectively ensure information integrity. In particular,*e*B enables organizations with extensiveand complex physical infrastructures to efficiently identify, classify,structure, link, and manage documents, physical items, and requirementsthroughout their lifecycles and ensure that conformance between these ismaintained by means of an automated change process.

 

We develop, market and support*e*B,our integrated suite of collaborative document, configuration and recordsmanagement software solutions. Our revenues in the three months ended March 31,2006 increased by 23% from the same period in the prior fiscal year due tohigher license sales as a result of a new South African partner DocQnetInternational and large software license sales sold to JEA and ConstellationEnergy Group. During the three months ended March 31, 2005 there were no largelicense sales. Our revenues in the six months ended March 31, 2006increased by 17% from the same period in the prior fiscal year as a result ofsuch higher license sales through DocQnet International and to Florida Power& Light, Constellation Energy Group and JEA. The Company’s license revenuefluctuates from quarter to quarter as reflected by the increase in licensesales during the quarter.

 

Our revenues are derived from licenses of our software to ourcustomers, services that we provide under maintenance support contracts and ournon-maintenance services, consisting primarily of design studies, systemimplementation and training. Of our total revenues for the three months ended March 31,2006, license revenues accounted for 32%, maintenance services revenuesaccounted for 35% and non-maintenance services represented 33%. For the sixmonths ended March 31, 2006, license revenue accounted for 31%, maintenanceservices revenues accounted for 37% and non-maintenance services revenuesrepresented 32%.

 

Many of our customers are located outside the United States, withforeign-originated revenues accounting for 37% and 57% of revenues for thethree months ended March 31, 2006 and 2005, respectively, and 38% and 50%of revenues for the six months ended March 31, 2006 and 2005, respectively. Ourrevenue for the three and six months ended March 31, 2006 reflected a foreigncurrency loss of $42,000 and $108,000, respectively, as compared to last yeardue to the declining value of the British pound to the dollar.

 

15

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While revenues increased, our cost of revenues increased slightly dueto third party scanning services when compared to the same period in the priorfiscal year. Operating expenses decreased by 14% primarily as a result of areduction in personnel implemented in the second half of fiscal 2005 and lowerprofessional fees during the current period.

 

At March 31, 2006, our principal sources of liquidity consisted of$620,000 of cash and cash equivalents, compared to $285,000 at September 30,2005. On October 25, 2005 and March 10, 2006 we completed private placements ofpreferred stock which resulted in gross proceeds of $1,000,000.

 

**CRITICAL ACCOUNTING POLICIES**

 

The consolidated financial statements are prepared in conformity withaccounting principles generally accepted in the United States of America. Assuch, management is required to make judgments, estimates and assumptions thataffect the reported amounts of assets and liabilities at the date of theconsolidated financial statements and the reported amounts of revenues andexpenses during the reporting period. The significant accounting policies whichare most critical to aid in fully understanding and evaluating reportedfinancial results include the following:

 

*Revenue Recognition*

 

The Company enters into contractual arrangements with end-users thatmay include licensing of the Company’s software products, product support andmaintenance services, consulting services or various combinations thereof,including the sale of such products or services separately.  The Companyrecognizes revenue in accordance with Statement of Position (“SOP”) 97-2 “SoftwareRevenue Recognition,”  SOP 98-9, “Modificationof SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions”,Staff Accounting Bulletin (“SAB”) No. 101, updated by SAB’s 103 and 104 “Updateof Codification of Staff Accounting Bulletins,” and Emerging Issues Task ForceNo. 00-21 (“EITF 00-21”) “Accounting for Revenue Arrangements with MultipleDeliverables.” Revenue through the Company’s Value Added Resellers (“VARS”) arenet of any VAR discount in accordance with EITF 99-19 “Reporting Revenue Grossas a Principal versus Net as an Agent.”

 

 Software license and third party product revenues are recognizedupon shipment of the product if no significant vendor obligations remain andcollection is probable. In cases where a significant vendor obligation exists,revenue recognition is delayed until such obligation has been satisfied. Fornew software products where a historical record has not yet been demonstratedthat acceptance is perfunctory, the Company defers recognition of revenue untilacceptance has occurred. If an undelivered element of the arrangement existsunder the license arrangement, a portion of revenue is deferred based onvendor-specific objective evidence (VSOE) of the fair value of the undeliveredelement until delivery occurs.  If VSOE does not exist for all undeliveredelements, all revenue is deferred until sufficient evidence exists or allelements have been delivered.  Annual maintenance revenues, which consistof ongoing support and product updates, are recognized on a straight-line basisover the term of the contract. Payments received in advance of performance ofthe related service for maintenance contracts are recorded as deferred revenue.Revenues from training and consulting services are recognized when the servicesare performed and adequate evidence of providing such services is available.Contract revenues for long-term contracts or programs requiring specializedsystems are recognized using the percentage-of-completion method of accounting,primarily based on contract labor hours incurred to date compared with totalestimated labor hours at completion. Provisions for anticipated contract lossesare recognized at the time they become known.

 

Contracts are billed based on the terms of the contract. There are noretentions in billed contract receivables. Unbilled contract receivables relateto revenues earned but not billed at the end of the period.

 

The Company considers many factors when applying accounting principlesgenerally accepted in the United States of America related to revenuerecognition.  These factors include, but are not limited to:

 
| • |   | The actual contractual terms, such as payment terms,  delivery dates, and pricing of the various product and service elements of a  contract |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Availability of products to be delivered                                                                                                     |
| • |   | Time period over which services are to be performed                                                                                          |
| • |   | Creditworthiness of the customer                                                                                                             |
| • |   | The complexity of customizations to the Company’s  software required by service contracts                                               |
| • |   | The sales channel through which the sale is made  (direct, VAR, distributor, etc.)                                                           |
| • |   | Discounts given for each element of a contract                                                                                               |
| • |   | Any commitments made as to installation or  implementation of “go live” dates                                                      |

 

Each of the relevant factors is analyzed to determine its impact,individually and collectively with other factors, on the revenue to berecognized for any particular contract with a customer.  Management isrequired to make judgments regarding the significance of each factor in applyingthe revenue recognition standards, as well as whether or not each factorcomplies with such standards.  Any 

 

16

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misjudgment or error by management in its evaluation of the factors andthe application of the standards, especially with respect to complex or newtypes of transactions, could have a material adverse effect on the Company’sfuture operating results.

 

*Software Development Costs*

 

Software development costs are capitalized when technologicalfeasibility and marketability of the related product have been established.Software development costs incurred solely in connection with a specificcontract are charged to cost of revenues. Capitalized software costs areamortized on a product-by-product basis, beginning when the product isavailable for general release to customers.   Annual amortizationexpense is calculated using the greater of the ratio of each product’s currentgross revenues to the total of current and expected gross revenues or thestraight-line method over the estimated useful life of three to five years.

 

*Allowance for Doubtful Accounts*

 

The Company sells its products directly to end-users, generallyrequiring a significant up-front payment and remaining terms appropriate forthe creditworthiness of the customer. The Company also sells its products toVARs and other software distributors generally under terms appropriate for thecreditworthiness of the VAR or distributor. The Company retains no continuingobligations on sales to VARs.  Receivables from customers are generallyunsecured. The Company continuously monitors its customer account balances andactively pursues collections on past due balances. The Company maintains anallowance for doubtful accounts which is comprised of a general reserve basedon historical collections performance plus a specific reserve for certain knowncustomer collections issues. If actual bad debts are greater than the reservescalculated based on historical trends and known customer issues, the Companymay be required to book additional bad debt expense which could have a materialadverse effect on our business, results of operations and financial conditionfor the periods in which such additional expense occurs.

 

**RESULTS OF OPERATIONS**

 

The following table sets forth the condensed consolidated statement ofoperations expressed as a percentage of total revenue for the periodsindicated:

 
| ** **                                 | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                 | ** ** | **March 31,**                                 | ** ** | **March 31,**                               | ** ** |
| ** **                                 | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                   |       |                                               |       |                                             |       |   |   |   |   |
| Licenses                                   |       | 32                                                 | %          | 5                                                | %          | 31 | % | 11 | % |
| Services and  other                        |       | 68                                                 | %          | 95                                               | %          | 69 | % | 89 | % |
| Total revenues                             |       | 100                                                | %          | 100                                              | %          | 100 | % | 100 | % |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Cost of revenues                           |       |                                               |       |                                             |       |   |   |   |   |
| Licenses                                   |       | 3                                                  | %          | 4                                                | %          | 5 | % | 3 | % |
| Services and  other                        |       | 35                                                 | %          | 37                                               | %          | 32 | % | 37 | % |
| Total cost of  revenues                    |       | 38                                                 | %          | 41                                               | %          | 37 | % | 40 | % |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Gross profit                               |       | 62                                                 | %          | 59                                               | %          | 63 | % | 60 | % |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Operating  expenses:                       |       |                                               |       |                                             |       |   |   |   |   |
| Research and  development                  |       | 14                                                 | %          | 10                                               | %          | 12 | % | 16 | % |
| Marketing and  sales                       |       | 34                                                 | %          | 55                                               | %          | 34 | % | 52 | % |
| General and  administrative                |       | 17                                                 | %          | 22                                               | %          | 21 | % | 23 | % |
| Total operating  expenses                  |       | 65                                                 | %          | 87                                               | %          | 67 | % | 91 | % |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Income (loss)  from operations             |       | (3                                                 | )%         | (28                                              | )%         | (4 | )% | (31 | )% |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Interest and  other                        |       | (2                                                 | )%         | (2                                               | )%         | (3 | )% | (2 | )% |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Net loss                                   |       | (5                                                 | )%         | (30                                              | )%         | (7 | )% | (33 | )% |
|                                       |       |                                               |       |                                             |       |   |   |   |   |
| Deemed dividend                            |       | (24                                                | )%         | —                                           |       | (26 | )% | (66 | )% |
| Cumulative  preferred dividends            |       | (5                                                 | )%         | (5                                               | )%         | (5 | )% | (5 | )% |
| Net loss  available to common shareholders |       | (34                                                | )%         | (35                                              | )%         | (38 | )% | (104 | )% |

 

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**Revenues**

 

*License Revenues*

(in thousands)

 
| ** **                    | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                    | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| License revenues              |       | $                                                  | 652        |        | $          | 86                                               |       | 658         | %          | $ | 1,216 |   | 354 |   | 244 | % |
| Percentage of  total revenues |       | 32                                                 | %          | 5           | %          |                                             |       | 31          | %          | 11 | % |   |   |
|                               |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |

 

License revenues increased by $566,000, or 658%, to $652,000 from $86,000for the three months ended March 31, 2006 compared to the same period ayear ago.  The Company’s license revenues fluctuate from quarter toquarter which is reflected by the increase in license sales in the currentquarter. In the current quarter, large license sales to DocQnet International, JEAand Constellation Energy Group totaled $261,000, $200,000 and $132,000, respectively,while there were no similar size sales in the prior year. License revenuesincreased $862,000, or 244%, to $1,216,000 from $354,000 for the six monthsended March 31, 2006 as compared to the same period a year ago. During thecurrent fiscal year large license sales through DocQnet International of $261,000and to Florida Power & Light, Constellation Energy Group, and JEA totaled $269,000,$206,000 and $200,000, respectively, while there was no similar size sales inthe prior year.

 

We anticipate that the demand for our products will increase if overalleconomic conditions continue to strengthen leading to an increase in overalldemand for enterprise document, configuration and records management softwaresolutions.  The Company’s license revenues can fluctuate from quarter toquarter, based on the timing of customer orders due to the long sales cycle andchanges in customers’ internal plans of the rollout of software licenses.

 

Although the Company has historically generated the majority of itsrevenues from its direct sales force, the Company has also established anetwork of third-party VARs, system integrators and OEMs who build and sellsystems (with components or complete systems provided by the Company) thataddress specific customer needs within various industries, including thosetargeted directly by the Company.  Sales through indirect channels for thethree months ended March 31, 2006 amounted to $348,000 or 17% compared to$65,000, or 4% for the same period in the prior year. Sales through indirectchannels for the six months ended March 31, 2006 amounted to $520,000 or 13%compared to $232,000, or 7% for the same period in the prior year consistentwith the Company’s efforts to increase its indirect channel business as a percentageof overall revenue.

 

A small number of customers have typically accounted for a largepercentage of the Company’s annual revenues. Constellation Energy Group, DocQnetInternational, and JEA accounted for 18%, 13% and 11%, respectively, of revenuefor the three months ended March 31, 2006, while Network Rail and ComputerScience Corporation each accounted for 19% of revenue for the three months ended March 31, 2005.  ConstellationEnergy Group accounted for 15% of revenue for the six months endedMarch 31, 2006 while Network Rail and Computer Science Corporation accountedfor 19% and 12%, respectively, of revenue for the six months endedMarch 31, 2005.  The Company’s reliance on relatively few customerscould have a material adverse effect on the results of its operations on aquarterly basis.

 

*Services and Other Revenues*

(in thousands)

 
| ** **                    | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                    | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| Services and  other revenues  |       | $                                                  | 1,408      |        | $          | 1,587                                            |       | -11         | %          | $ | 2,676 |   | $ | 2,972 |   | -10 | % |
| Percentage of  total revenues |       | 68                                                 | %          | 95          | %          |                                             |       | 69          | %          | 89 | % |   |   |
|                               |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

Services and other revenues are comprised of maintenance andnon-maintenance services.  Non-maintenance services typically relate tobusiness process studies, implementation of systems and training which varywith the level of license revenues while maintenance revenue is primarilydependent on customers renewing their annual maintenance support contracts.

 

Services and other revenues decreased $179,000, or 11%, from $1,587,000to $1,408,000 for the three months ended March 31, 2006 compared to thesame period a year ago.  The non-maintenance portion of service revenuedecreased $110,000 or 14% from $796,000 to $686,000 primarily due to onecustomer delaying services until the beginning of its new fiscal year,April 1, 2006.   Also in this quarter, maintenance revenuedecreased $69,000, or 9% from $791,000 to $722,000. The decrease in maintenanceis primarily the result of a customer that did not renew its maintenance contractas a result of its acquisition by another entity.

 

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Services and other revenue decreased $296,000, or 10%, from $2,972,000to $2,676,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The non-maintenance portion of service revenuedecreased $165,000, or 12% from $1,386,000 to $1,221,000 primarily due to onecustomer delaying services until the beginning of its new fiscal year,April 1, 2006.   Also in the current fiscal year, maintenancerevenue decreased $131,000, or 8% from $1,586,000 to $1,455,000. The decreasein maintenance is primarily the result of a customer that did not renew itsmaintenance contract as a result of its acquisition by another entity.

 

We anticipate that service and other revenue will fluctuate primarilydue to sales to new customers because they require more services that typicallyinclude a business process study, integration with other business systems andtraining.  In addition, service and other revenues will continue to fluctuatefrom quarter to quarter based on the timing of customer orders.

 

**Cost of Revenues**

 

*Cost of License Revenues*

(in thousands)

 
| ** **                    | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                    | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| Cost of license  revenues     |       | $                                                  | 72         |        | $          | 64                                               |       | 13          | %          | $ | 194 |   | $ | 108 |   | 80 | % |
| Percentage of  total revenues |       | 3                                                  | %          | 4           | %          |                                             |       | 5           | %          | 3 | % |   |   |
|                               |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

Cost of licenses revenues consists of costs associated with resellingthird-party products and amortization of capitalized software developmentcosts.

 

Cost of license revenue increased by $8,000, or 13%, from $64,000 to $72,000for the three months ended March 31, 2006 compared to the same period ayear ago.  The increase is primarily due to amortization expense of capitalizedsoftware of $26,000 with completion and general release of our eB Version 14software product during the previous quarter, offset by a decrease of $18,000for third-party products sold to our customers. The gross profit percentage oflicense revenues increased to 89% for the three months ended March 31,2006 as compared to 26% for the same period a year ago, primarily due to thesignificant increase in license revenue during the current quarter.

 

Cost of license revenue increased by $86,000, or 80%, from $108,000 to$194,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The increase is primarily due to third-party costs of$55,000 associated with the sale in the current fiscal year of a third-partyproduct to one particular customer.  In addition, amortization expense ofcapitalized software costs increased $35,000 with completion and generalrelease of our eB Version 14 software product in November 2005.  The grossprofit percentage of license revenues increased to 84% for the six months endedMarch 31, 2006 as compared to 69% for the same period a year ago,primarily due to the increase in license revenue during the current fiscalperiod.

 

We expect the cost of license revenues to fluctuate based onfluctuations in license revenues and in customer requirements for third-partysoftware products since the cost of meeting these customer requirements havethe largest impact on cost of license revenues.

 

*Cost of Services and Other Revenues*

(in thousands)

 
| ** **                                 | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                                 | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                                 | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| Cost of services  and other revenues       |       | $                                                  | 721        |        | $          | 620                                              |       | 16          | %          | $ | 1,261 |   | $ | 1,234 |   | 2 | % |
| Percentage of  services and other revenues |       | 35                                                 | %          | 37          | %          |                                             |       | 32          | %          | 37 | % |   |   |
|                                            |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

Cost of services and other revenues consists primarily ofpersonnel-related costs in providing consulting services, training to customersand support.  It also includes costs associated with reselling third-partyhardware and maintenance, which includes telephone support costs.

 

Cost of services and other revenue increased $101,000, or 16%, from $620,000to $721,000 for the three months ended March 31, 2006 compared to the sameperiod a year ago.  The increase was primarily due to third-party relatedservices that amounted to $109,000 for two major projects during the quarter. The gross profit from services and other revenue as a percentage of servicesand other revenues decreased to 49% for the three months ended March 31,2006 as compared to 61% for the same period a year ago. We expect the cost ofservice and other revenues to fluctuate in absolute dollar amounts and as apercentage of total revenues as the related service revenue fluctuates.

 

19

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Cost of services and other revenue increased $27,000, or 2%, from $1,234,000to $1,261,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The decrease was primarily due to third-party relatedservices that amounted to $217,000 for two major projects during the currentfiscal year, offset by a reduction of personnel in the fourth quarter of fiscal2005 and lower travel related costs.  The gross profit from services andother revenue as a percentage of services and other revenues decreased to 53%for the six months ended March 31, 2006 as compared to 58% for the sameperiod a year ago.

 

We expect the cost of service and other revenues to fluctuate inabsolute dollar amounts and as a percentage of total revenues as the relatedservice revenue fluctuates.

 

**Operating Expenses**

 

*Research and Development*

(in thousands)

 
| ** **                         | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|------------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                         | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                         | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| Research and  development expenses |       | $                                                  | 282        |        | $          | 174                                              |       | 62          | %          | $ | 485 |   | $ | 520 |   | -7 | % |
| Percentage of  total revenue       |       | 14                                                 | %          | 10          | %          |                                             |       | 12          | %          | 16 | % |   |   |
|                                    |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

Research and development expenses consist of salaries and benefits forsoftware developers as well as an allocation of corporate expenses, calculatedon the basis of headcount, such as corporate insurance, facilities, telephoneand other.

 

Research and development expenses increased $108,000, or 62%, from $174,000to $282,000 for the three months ended March 31, 2006 compared to the sameperiod a year ago.  The increase was due primarily to the eB Version 14upgrade development project was completed in November 2005 resulting in nocapitalized labor cost in the current quarter, while there was $197,000 ofcapitalized labor cost for this project in the same quarter of the prior year.This difference was offset by a decrease in personnel related cost of $89,000due to reductions in engineering personnel implemented in June 2005 anddevelopment staff working on customer projects rather than research anddevelopment projects in the current quarter.

 

Research and development expenses decreased $35,000, or 7%, from $520,000to $485,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The decrease was due primarily to lower personnelrelated cost of $197,000 as a result of reductions in engineering personnelimplemented in June 2005 and due to current development staff working oncustomer projects rather than research and development projects. This decreasewas offset by $162,000 lower capitalized software development costs relating tothe eB Version 14 upgrade development project during the six months ended March31, 2006 as compared to the six months ended March 31, 2005.

 

We believe that continued investment in research and development is acritical factor in maintaining our competitive position and we expect researchand development costs to remain at the current levels in absolute dollaramounts in the next several quarters.  However,our ability to maintain research and development spending may be adverselyimpacted by our limited cash flow and liquidity.

 

*Marketing and Sales*

(in thousands)

 
| ** **                      | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                      | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                      | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| Marketing &  sales expenses |       | $                                                  | 685        |        | $          | 914                                              |       | -25         | %          | $ | 1,338 |   | $ | 1,738 |   | -23 | % |
| Percentage of  total revenue    |       | 34                                                 | %          | 55          | %          |                                             |       | 34          | %          | 52 | % |   |   |
|                                 |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

Marketing and sales expenses consist of salaries, cost of benefits,sales commissions and other expenses related to the direct sales force, as wellas allocation of overall corporate expenses, calculated on the basis ofheadcount, related to items such as corporate insurance, facilities, telephoneand other.

 

Marketing and sales expenses decreased $229,000, or 25%, from $914,000to $685,000 for the three months ended March 31, 2006 compared to the sameperiod a year ago.  The decrease in marketing and sales expenses isprimarily due to lower personnel related costs of $89,000 in connection with thestaff reductions the Company implemented in September 2005. The Company alsoreduced marketing costs by $108,000 related to professional services and $32,000related to trade shows and travel.

 

20

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Marketing and sales expenses decreased $400,000, or 23%, from $1,738,000to $1,338,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The decrease in marketing and sales expenses isprimarily due to lower personnel related costs of $134,000 in connection withthe staff reductions the Company implemented in September 2005. The Companyalso reduced marketing costs by $183,000 primarily related to professionalservices and $38,000 related to trade shows and travel.

 

We expect marketing and sales expense to decrease in absolute dollaramounts and as a percentage of total revenue in the current fiscal year.

 

*General and Administrative*

(in thousands)

 
| ** **                           | ** ** | **For the three months ended** | ** ** | ** **  | ** ** | **For the six months ended** | ** ** | ** **  | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|-------------|------------|--------------------------------------------------|------------|-------------|------------|
| ** **                           | ** ** | **March 31,**                                 | ** ** | **Percent** | ** ** | **March 31,**                               | ** ** | **Percent** | ** ** |
| ** **                           | ** ** | **2006**                                           | ** ** | **2005**    | ** ** | **Change**                                       | ** ** | **2006**    | ** ** | **2005** | ** ** | **Change** | ** ** |
| General and  administrative expenses |       | $                                                  | 353        |        | $          | 373                                              |       | -5          | %          | $ | 794 |   | $ | 772 |   | 3 | % |
| Percentage of  total revenue         |       | 17                                                 | %          | 22          | %          |                                             |       | 21          | %          | 23 | % |   |   |
|                                      |            |                                                    |            |             |            |                                                  |            |             |            |  |  |  |  |  |  |  |  |

 

General and administrative expenses consist primarily of personnelcosts for finance, information technology, human resources and generalmanagement, as well as outside professional services and an allocation ofoverall corporate expenses, calculated on the basis of headcount, such ascorporate insurance, facilities, telephone and other.

 

General and administrative expenses decreased by $20,000, or 5%, from $373,000to $353,000 for the three months ended March 31, 2006 compared to the sameperiod a year ago.  The overall decrease was due primarily to lower legaland professional fees of $88,000 related to SEC filings and Sarbanes-Oxleyreporting requirements along with lower personnel related cost of $33,000,offset by increased cost for FAS 123R of $24,000, and an increase of $78,000due to a minimal reduction in the allowance for uncollectible accounts ascompared to the three months ended March 31, 2005.

 

General and administrative expenses increased by $22,000, or 3%, from $772,000to $794,000 for the six months ended March 31, 2006 compared to the sameperiod a year ago.  The increase resulted from FAS 123R in the amount of $57,000and personnel related costs of $41,000, and an increase of $78,000 due to aminimal reduction in the allowance for uncollectible accounts as compared tothe six months ended March 31, 2005. These increases were offset by lower legaland professional fees of $107,000 related to SEC filings and $48,000 related toSarbanes-Oxley reporting requirements when compared to the six months endedMarch 31, 2005.

 

We expect that general and administrative expenses will increase inabsolute dollars in comparison to the prior year due to the share basedcompensation expense under the newly implemented SFAS 123R.

 

**Interest Expense**

 

Interest expense consists primarily of fixed interest obligations onour outstanding debt to Spescom Ltd. as well as interest paid on capital leaseobligations.  Interest expense was $53,000 and $105,000 for the three andsix months ended March 31, 2006 as compared to $38,000 and $68,000 for thesame period a year ago.  The increase is due primarily to increased debtbalances owed to Spescom Ltd. on several outstanding notes payable as well asinterest on accrued preferred dividends and certain accounts payable.

 

**Deemed Dividends**

 

In March 2006 the Company completed a financing arrangement whereby theCompany issued 2,450 shares of Series I Preferred Stock along with 925,926common stock warrants for gross proceeds of $500,000 and the exchange andcancellation of 1,950 shares of Series H Convertible Preferred Stock. Inaccordance with EITF 00-27 “Application of issue No 98-5 to Certain ConvertibleInstruments,” the Company calculated using the Black –Scholes method theintrinsic value of the convertible instruments issued and determined that therewas a deemed preferred dividend equal to the gross proceeds received of$500,000.

 

In addition in October 2005 the Company completed a similar financingarrangement whereby the Company issued 1,950 shares of our Series HPreferred Stock along with 925,926 common stock warrants for gross proceeds of$500,000 and the exchange and cancellation of 1,450 shares of Series GConvertible Preferred Stock. In accordance with EITF 00-27 “Application ofissue No 98-5 to Certain Convertible Instruments,” the Company calculated usingthe Black –Scholes method the intrinsic value of the convertible instrumentsissued and determined that there was a deemed preferred dividend equal to thegross proceeds received of $500,000.

 

In the prior year the Company also had a deemed dividend in connectionwith a financing arrangement whereby the Company issued 2,200 shares ofSeries G Preferred Stock along with 2,750,000 common stock warrants forgross proceeds of $2,200,000. The Company calculated using the Black –Scholesmethod the intrinsic value of the convertible instruments issued and determinedthat there was a deemed preferred dividend equal to the gross proceeds receivedof $2,200,000.

 

21

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**Cumulative Preferred Dividends**

 

The outstanding Series F Convertible Preferred Stock is entitled toreceive dividends of 5% of the stated value of $1,000 per share per annum,payable on a quarterly basis in cash or common stock (valued on the basis ofthe average per share market value on the 30 trading days immediately prior tothe date on which such dividend is declared by the Board of Directors). Series F cumulative preferred dividends earned for the three and six monthsended March 31, 2006 and 2005 were $66,000 and $132,000, respectively, foreach period. Unpaid dividends accrue interest at the rate of 8% perannum.  As of March 31, 2006, unpaid dividends and accrued interestamounted to $725,000.

 

Prior to the exchange on March 10, 2006 of Series I Preferred Stock forall the outstanding Series H Preferred Stock, the Series H Preferred Stock wasentitled to receive dividends of 6.75% of the stated value of $1,000 per shareper annum, payable monthly in arrears on the last day of each month based onthe number of Series H Preferred Stock outstanding as of the first day of eachsuch month. For the three and six months ended March 31, 2006 dividends onthe Series H Preferred Stock totaled $22,000 and $44,000, respectively, andthere was no Series H Preferred Stock outstanding for the same periods in theprior year. A total of 325,966 shares of common stock were issued on March 31, 2006based on a $0.13 per share fair market price in payment of Series H PreferredStock dividends due as of March 10, 2006, when the Series H preferred Stock wasexchanged for Series I Preferred Stock.

 

The outstanding Series I Preferred Stock is entitled to receivedividends of 7.25% of the stated value of $1,000 per share per annum, payablemonthly in arrears on the last day of each month based on the number of SeriesI Preferred Stock outstanding as of the first day of each such month. For thequarter ended March 31, 2006 accrued dividends on the Series I PreferredStock totaled $10,000.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At March 31, 2006, our principal sources of liquidity consisted of $620,000of cash and cash equivalents compared to $285,000 at September 30,2005.  Our liquidity could be negatively impacted by a decrease in demandfor our products, which are subject to rapid technological changes, reductionsor delays in capital expenditures by our customers and intense competition,among other factors.

 

The Company has received loans from Spescom Ltd. in the past to meetits obligations.  The outstanding balance of our demand notes owed toSpescom Ltd. including interest was $968,000 at March 31, 2006 as compared to$917,000 at September 30, 2005.  Spescom Ltd. has agreed not to callthe notes prior to October 1, 2006.

 

We used cash in operating activities of $405,000 during the six monthsended March 31, 2006 primarily related to a net loss during the six monthperiod of $281,000 and reductions in deferred revenue and accrued liabilitiesof $268,000 and $260,000, respectively. During the six months ended March 31,2005 we used cash in operating activities of $588,000 primarily related to anet loss for the period of $1,112,000, offset by increases in deferred revenuesand accrued liabilities of $287,000 and $52,000, respectively.

 

Our investing activities used $75,000 and $259,000 for six months endedMarch 31, 2006 and 2005, respectively, primarily relating to the capitalizationof software development costs for our eB Version 14 product.

 

Financing activities provided cash of $817,000 for the six months endedMarch 31, 2006, primarily from the issuance of preferred stock through aprivate placement on October 25, 2005 and March 10, 2006. The Company intendsto use the funds from this private placement to expand its sales and marketingefforts and for liquidity. Financing activities provided cash of $1,775,000 forthe six months ended March 31, 2005, primarily from the issuance of preferredstock through a private placement on November 5, 2004.

 

The Company believes its capital requirements will continue to varygreatly from quarter to quarter, depending on, among other things, capitalexpenditures, fluctuations in its operating results, financing activities, andinvestments and third party products and receivables management.  TheCompany’s future liquidity will depend on its ability to generate new systemsales of its*e*B product suite inthe near term, which cannot be assured.  Failure to generate sufficientsystem sales to meet the Company’s cash flow needs can be expected to have amaterial adverse effect on the Company’s business, results of operations, andfinancial condition.  Management believes that the Company’s current cashand receivables, as well as additional cash provided by the financing describedabove and cash that may be generated from operations, will be sufficient tomeet its short-term needs for working capital for at least the next year. However, the Company may not be able to obtain sufficient orders to enable theCompany to continue on a cash flow break-even level, which would be necessaryto continue operations in the absence of further financing.  Future equityfinancings, if available to the Company, would be dilutive to the existingholders of the Company’s common stock.  Future debt financings, ifavailable to the Company, would likely involve restrictive covenants.

 

**Off-Balance Sheet Arrangements**

 

At March 31, 2006 and September 30, 2005, we did not have anyrelationships with unconsolidated entities or financial partnerships, includingentities often referred to as structured finance or special purpose entitiesthat would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. Therefore, we are not materially exposed to any financing, liquidity,market or credit risk that could arise if we were engaged in suchrelationships.

 

22

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**Inflation**

 

The Company believes that inflation has not had a material effect onits operations to date. Although the Company enters into fixed-price contracts,management does not believe that inflation will have an adverse material impacton its operations for the foreseeable future, as the Company takes into accountexpected inflation in its contract proposals and is generally able to projectits costs based on forecasted contract requirements.

 

**Contractual Obligations and CommercialCommitments**

 

The following summarizes our contractual obligations and othercommitments at March 31, 2006, and the effect such obligations could have onour liquidity and cash flow in future periods:

 
| ** **                                  | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                                           | ** ** | **Less** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** **                                                           | ** ** | **Than** | ** ** | **Years** | ** ** | **Years** | ** ** | **Over 5** | ** ** |
| ** **                                  | ** ** | **Total**                                                            | ** ** | **1 Year** | ** ** | **1 - 3** | ** ** | **3-5** | ** ** | **Years** | ** ** |
| Notes and  Accounts Payable to Spescom Ltd. |       | $                                                                    | 1,216,000  |   | $ | 1,216,000 |   | — |   | — |   | — |   |
| Lease  commitments – Operating Leases  |       | $                                                                    | 1,285,000  |   | $ | 331,000 |   | $ | 676,000 |   | $ | 278,000 |   | — |   |
| Lease  commitments – Capital Leases    |       | $                                                                    | 79,000     |   | $ | 44,000 |   | $ | 35,000 |   | — |   | — |   |
| Total                                       |       | $                                                                    | 2,580,000  |   | $ | 1,591,000 |   | $ | 711,000 |   | $ | 278,000 |   | — |   |

 

**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

**Interest Rate Risk**

 

The Company’s exposure to market rate risk for changes in interestrates relates primarily to the Company’s investment portfolio.  TheCompany does not use derivative financial instruments in its investmentportfolio. The Company places its investment with high quality issuers andfollows internally developed guidelines to limit the amount of credit exposureto any one issuer. Additionally, in an attempt to limit interest rate risk, theCompany follows guidelines to limit the average and longest single maturitydates. The Company is adverse to principal loss and ensures the safety andpreservation of its invested funds by limiting default, market and reinvestmentrisk. As of March 31, 2006 and September 30, 2005, the Company did nothave any investments in money market accounts.

 

**Foreign Currency Exchange Risk**

 

The Company’s geographic markets are primarily in the United States andEurope, with some sales in other parts of the world. For the three months endedMarch 31, 2006, revenues recorded in the United States were 63% of totalrevenues, and revenues from Europe and other locations were 37% of totalrevenues. This compares to 44% and 56% for the same period a year ago.

 

For the six months ended March 31, 2006, revenues recorded in theUnited States were 62% of total revenues, and revenues from Europe and otherlocations were 38% of total revenues. This compares to 50% and 50% for the sameperiod a year ago.

 

Revenues from our United Kingdom subsidiary can fluctuate from quarterto quarter based on the timing of customer orders. Our revenue for thethree and six months ended March 31, 2006 reflected a foreign currency loss of$42,000 and $108,000, respectively, as compared to last year due to thedeclining value of the British pound to the dollar. Changes in foreign currencyrates, the condition of local economies, and the general volatility of softwaremarkets may result in a higher or lower proportion of foreign revenues in thefuture. Although the Company’s operating and pricing strategies take intoaccount changes in exchange rates over time, future fluctuations in the valueof foreign currencies may have a material adverse effect on the Company’sbusiness, operating results and financial condition.

 

**ITEM4.    CONTROLS AND PROCEDURES**

 

The Company carried out an evaluation under the supervision and withthe participation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures as of March31, 2006 pursuant to Exchange Act Rule 15d-15. Based upon that evaluation,we have concluded that as of March 31, 2006, the Company’s disclosure controlsand procedures are effective in recording, processing, summarizing andreporting within the time periods specified in the SEC’s rules and formsmaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in the Company’s periodic SEC filings.

 

During the last fiscal quarter, there was no change in the Company’sinternal control over financial reporting that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

23

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**PARTII.   OTHER INFORMATION**

 

**ITEM 1 – LEGAL PROCEEDINGS**

 

The Company is involved from time to time in litigation arising in thenormal course of business. Management believes that any liability with respectto such routine litigation, individually or in the aggregate, is not likely tobe material to the Company’s consolidated financial position or results ofoperations.

 

**ITEM 1A – RISK FACTORS**

 

***Certain affiliates of M.A.G. Capital, LLC,as holders of Series I Convertible Preferred Stock, may become entitled toelect a majority of the Board of Directors.***

 

The Certificate of Determination for theSeries I Convertible Preferred Stock provides that, if the Company has notentered into a binding agreement to consummate a consolidation, merger, orcertain other corporate transactions meeting certain requirements on or beforeApril 30, 2006, the holders of Series I Preferred Stock may, by atwo-thirds vote not later than December 31, 2006, elect to have all of theoutstanding Series I Preferred Stock redeemed by the Company at an amountequal to $1,000 per share plus all declared but unpaid dividends.  If suchelection is made and the Company does not have sufficient funds to carry outthe redemption, the holders of Series I Preferred Stock as a class will beentitled to elect a majority of the authorized directors of the Company.

 

There are currently 2,450 shares ofSeries I Preferred Stock outstanding, which are held by Monarch PointeFund, Ltd. (“Monarch”) and Mercator Momentum Fund III, L.P. (“MMF”), each anaffiliate of M.A.G. Capital, LLC (“MAG”).  A corporate transaction of thevariety discussed in the preceding paragraph did not occur on or beforeApril 30, 2006. Monarch and MMF are therefore entitled to elect to haveall of the outstanding Series I Preferred Stock redeemed as discussed in thepreceding paragraph. If such an election is made, the redemption price isanticipated to be $2,450,000, plus all declared but unpaid dividends.  Inthe event of such an election, unless the Company is able to raise additionaldebt or equity funds, the Company anticipates that it would not have sufficientfunds to carry out the redemption.  If the Company were able to raiseadditional funds, it is likely that existing shareholders would sufferadditional substantial dilution.  If the election to redeem theSeries I Preferred Stock is made and the Company is unable to pay theredemption price, Monarch and MMF would become entitled to elect a majority ofthe authorized directors of the Company.  In this event, those entities,through their majority control of the Board of Directors, would be able tocontrol or (with respect to matters requiring shareholder approval) exertsignificant influence over all matters affecting the Company, including:

 
| • |   | any  determination with respect to the Company’s business direction and policies,  including the appointment and removal of officers; |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                       |
| • |   | the  allocation of business opportunities that may be suitable for the Company and  Spescom Ltd.;                                          |
|   |   |                                                                                                                                       |
| • |   | any  determinations with respect to mergers or other business combinations or  extraordinary transactions;                                 |
|   |   |                                                                                                                                       |
| • |   | the  Company’s acquisition or disposition of assets; and                                                                              |
|   |   |                                                                                                                                       |
| • |   | the  Company’s financing.                                                                                                             |

 

**ITEM 2 – UNREGISTERED SALES OF EQUITYSECURITIES**

 

The Company believes that the sale of securities in each of thetransactions described below were exempt from the registration requirements ofthe Securities Act by virtue of Section 4(2) thereof and/orRegulation D promulgated thereunder.  The Company believes that eachperson to whom securities were sold as described below, at the time of thesale, was an “accredited investor” as defined in Regulation D and/or had suchknowledge and experience in financial and business matters that such person wascapable of evaluating the merits and risks of the prospective investment. No underwriter participated in any of the transactions described below.

 

On November 15, 2005, the Company entered into an agreement withLiolios Group, Inc. (“Liolios”), a public relations firm for the provision ofpublic relations services to the Company. As part of the compensation dueLiolios, the Company agreed to issue to it, every month the agreement iseffective, a warrant to purchase up to 50,000 shares of the Company’s commonstock at an exercise price of $0.10 per share. The Company also agreed to issueto Liolios, as part of the compensation due it, a one-time performance warrantto purchase 500,000 shares of the Company’s common stock at $0.25 per share,which shall vest if during the term of the agreement the volume weighted averageprice of the Company’s common stock is above $0.50 for five consecutive days. OnMarch 31, 2006 the investor relations firm agreed to accept a warrant topurchase 3000,000 shares of common stock in lieu of all of the warrantsissuable to the investor relations firm as monthly compensation during thesix-month term of the agreement and in lieu of the 

 

24

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performance warrant. The warrant has an exercise price of $.10 pershare and expires on March 31, 2009. The Company believes that the issuance ofwarrants to Liolios under the agreement is exempt from the registrationrequirements of the Securities Act by virtue of Section 4(2) thereof and/orRegulation D promulgated thereunder. Pursuant to notice provided by the Companyto Liolios in accordance with the agreement, the agreement will terminate sixmonths from November 15, 2005. On March 31, 2006, the Company issued to Lioliosa warrant, expiring on the third anniversary of its date of issuance, for thepurchase of 300,000 shares of the Company’s common stock at an exercise priceof $0.10 per share. Liolios agreed to accept that warrant in lieu of all of thewarrants issuable to Liolios as monthly compensation during the six-month termof the agreement and in lieu of the performance warrant.

 

On March 10, 2006, the Company issued 1) an aggregate of 2,450 sharesof Series I Convertible Preferred Stock to Monarch and Mercator Momentum FundIII, L.P. (“MMF”) and 2) warrants, which expire March 10, 2009, to purchase anaggregate of 925,926 shares of common stock at $0.27 per share to Monarch, MMF,and MAG. The aggregate consideration received by the Company for the Series IConvertible Preferred Stock and warrants was $500,000 and 1,950 shares of theCompany’s Series H Convertible Preferred Stock, which has been cancelled.

 

25

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**ITEM 6 – EXHIBITS**

 
| **(a)(3)** | ** ** | **Exhibits**                                                                                                                                                            |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                    |
| 4.1 (1)    |       | Certificate of Determination of Series I  Convertible Preferred Stock of Spescom Software Inc., dated March 9, 2006.                                               |
|       |       |                                                                                                                                                                    |
| 10.1 (2)   |       | Registration Rights Agreement by and among the  Company, Monarch Pointe Fund, Ltd. Mercator Momentum Fund III, L.P and M.A.G.  Capital, LLC, dated March 10, 2006. |
|       |       |                                                                                                                                                                    |
| 10.2 (3)   |       | Warrant to Purchase Common Stock issued to M.A.G.  Capital, LLC, dated March 10, 2006.                                                                                  |
|       |       |                                                                                                                                                                    |
| 10.3 (4)   |       | Warrant to Purchase Common Stock issued to Monarch  Pointe Fund, Ltd., dated March 10, 2006.                                                                       |
|       |       |                                                                                                                                                                    |
| 10.3(5)    |       | Warrant to Purchase Common Stock issued to Mercator  Momentum Fund III, L.P, dated March 10, 2006.                                                                 |
|       |       |                                                                                                                                                                    |
| 10.4 (6)   |       | Letter Amendment to Public Relations Agreement  Between Liolios Group, Inc. and the Company, dated March 31, 2006.                                            |
|       |       |                                                                                                                                                                    |
| 10.5 (6)   |       | Warrant to Purchase Common Stock issued to Liolios  Group, Inc., dated March 31, 2006.                                                                        |
|       |       |                                                                                                                                                                    |
| 10.6 (7)   |       | Subscription Agreement by and among the Company,  Monarch Pointe Fund, Ltd., Mercator Momentum Fund III, L.P. and M.A.G.  Capital, LLC, dated March 10, 2006.           |
|       |       |                                                                                                                                                                    |
| 10.7 (8)   |       | Lease between Rowlandson Properties Limited and  Spescom Software Limited, dated February 10, 2006.                                                                |
|       |       |                                                                                                                                                                    |
| 10.8       |       | Retention Agreement between the Company and Keith  Stentiford, dated May 3, 2006                                                                                        |
|       |       |                                                                                                                                                                    |
| 10.9       |       | Retention Agreement between the Company and John W.  Low, dated April 27, 2006                                                                                          |
|       |       |                                                                                                                                                                    |
| 10.10      |       | Retention Agreement between the Company and Glenn  Cox, dated April 25, 2006                                                                                            |
|       |       |                                                                                                                                                                    |
| 10.11      |       | Retention Agreement between the Company and Pierre  DeWet, dated April 26, 2006                                                                                         |
|       |       |                                                                                                                                                                    |
| 10.12      |       | Retention Agreement between the Company and Alan  Kiraly, dated April 25, 2006                                                                                          |
|       |       |                                                                                                                                                                    |
| 31.1       |       | Section 302 Certification by Keith Stentiford,  Chief Executive Officer                                                                                            |
|       |       |                                                                                                                                                                    |
| 31.2       |       | Section 302 Certification by John W. Low, Chief  Financial Officer                                                                                                 |
|       |       |                                                                                                                                                                    |
| 32.1       |       | Certification pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to section 906 of the  Sarbanes-Oxley Act of 2002.                                     |

 

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| (1) |   | Incorporated by reference to Exhibit 3.1 to the  Form 8-K filed on March 16, 2006.           |
|-----|--------|--------------------------------------------------------------------------------------------------------|
| (2) |   | Incorporated by reference to Exhibit 10.2 to  the Form 8-K filed on March 16, 2006.          |
| (3) |   | Incorporated by reference to Exhibit 10.3 to  the Form 8-K filed on March 16, 2006.          |
| (4) |   | Incorporated by reference to Exhibit 10.4 to  the Form 8-K filed on March 16, 2006.          |
| (5) |   | Incorporated by reference to Exhibit 10.51 to  the Form 8-K filed on March 16, 2006.         |
| (6) |   | Incorporated by reference to Exhibits 4.21 and 4.22  to the Form S-1 filed on April 7, 2006. |
| (7) |   | Incorporated by reference to Exhibit 10.1 to the  Form 8-K filed on March 16, 2006.                    |
| (8) |   | Incorporated by reference to Exhibit 10.20 to  the Form S-1 filed on April 7, 2006.     |

 

26

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**SIGNATURES**

 

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

 
| **Signature**        | ** ** | **Title**                         | ** **                                       | **Date**          |
|----------------------|------------|-----------------------------------|--------------------------------------------------|-------------------|
| ** **           | ** ** | ** **                        | ** **                                       | ** **        |
| /s/ Keith Stentiford |       |                              | Director and Chief Executive Officer (Principal  |              |   |
| Keith Stentiford     |       | Executive Officer)                |                                             | May 15, 2006 |
|                 |       |                              |                                             |              |
| /s/ John W. Low      |       |                              | Chief Financial Officer and Secretary (Principal |              |   |
| John W. Low          |       | Financial and Accounting Officer) |                                             | May 15, 2006 |
|                      |            |                                   |                                                  |                   |  |  |

 

27

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