**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**




**x
      QUARTERLY REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**





**For
      the quarterly period ended September 30, 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 _________**





**Commission
      file number 000 -32421**





**Fusion
                Telecommunications International, Inc.****(Exact
                name of registrant as specified in its charter)********Delaware**
            **58-2342021****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            **(I.R.S.
                Employer**
              **Identification
                No.)********420
                Lexington Avenue, Suite 1718, New York, New
                York**
            **10170****(Address
                of principal executive offices)**
            **(Zip
                Code)********(212)
                201-2400****Registrant’s
                telephone number, including area
                code**




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





Yes
      **x**      
No **o**





Indicate
      by check mark whether the registrant is a large accelerated filer, accelerated
      filer, or non-accelerated filer. See definition of “accelerated filer and large
      accelerated filer” as defined in Rule 12b-2 of the Exchange Act.




Large
                Accelerated Filer**o**
            Accelerated
                Filer**o**
            Non-Accelerated
                Filer **x**




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





Yes
**o**      
      No **x**




The
      number of shares outstanding of the Registrant's capital stock as of November
      7,
      2006, is as follows:





**Title
                of each Class**
            
            
            **Number
                of Shares****Outstanding**Common
                Stock, $0.01 par value
            
            
            26,971,465Redeemable
                Common Stock Purchase Warrants
            
            
            7,641,838







**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**INDEX**





PagePart
                I. Financial InformationItem
                l. Financial Statements
            3Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            18Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            27Item
                4. Controls and Procedures
            27Part
                II. Other InformationItem
                1. Legal Proceedings
            29Item
                1A. Risk Factors
            29Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            30Item
                3. Defaults Upon Senior Securities
            31Item
                4. Submission of Matters to a Vote of Security Holders
            31Item
                5. Other Information
            31Item
                6. Exhibits
            31





2


**Item
      1. FINANCIAL STATEMENTS**




**PART
      1 - FINANCIAL INFORMATION**


**ITEM
      1: FINANCIAL STATEMENTS**





**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**Consolidated
      Balance Sheets**




**September
                  30,****2006**
            
            **December
                  31,****2005****(unaudited)****ASSETS****Current
                assets**Cash
                and cash equivalents
            
            $
            2,410,477
            
            $
            14,790,504Accounts
                receivable, net of allowance for doubtful accounts of approximately
                $587,000 and $414,000 at
              September
                30, 2006 and December 31, 2005, respectively
            
            
            4,017,183
            
            
            2,952,760Restricted
                cash
            
            
            365,000
            
            
            —Prepaid
                expenses and other current assets
            
            
            1,089,362
            
            
            1,242,266Assets
                held for sale
            
            
            258,465
            
            
            245,305**Total
                current assets**
            
            
            8,140,487
            
            
            19,230,835**Property
                and equipment, net**
            
            
            7,217,900
            
            
            4,270,966**Other
                assets**Security
                deposits
            
            
            173,368
            
            
            331,891Restricted
                cash
            
            
            416,566
            
            
            218,176Goodwill
            
            
            4,971,221
            
            
            5,118,640Intangible
                assets, net
            
            
            4,919,216
            
            
            4,861,012Other
                assets
            
            
            130,247
            
            
            354,259**Total
                other assets**
            
            
            10,610,618
            
            
            10,883,978**TOTAL
                ASSETS**
            
            $
            25,969,005
            
            $
            34,385,779**LIABILITIES
                AND STOCKHOLDERS’ EQUITY****Current
                liabilities**Long-term
                debt, current portion
            
            $
            150,000
            
            $
            150,000Capital
                lease/equipment financing obligations, current portion
            
            
            939,920
            
            
            1,419,965Accounts
                payable and accrued expenses
            
            
            10,898,771
            
            
            9,269,341Investment
                in Estel
            
            
            600,011
            
            
            771,182Liabilities
                of discontinued operations
            
            
            235,085
            
            
            620,809**Total
                current liabilities**
            
            
            12,823,787
            
            
            12,231,297**Long-term
                liabilities**Capital
                lease/equipment financing obligations, net of current portion
            
            
            39,404
            
            
            7,650Other
                long-term liabilities
            
            
            —
            
            
            4,357,497**Total
                long-term liabilities**
            
            
            39,404
            
            
            4,365,147**Commitments
                and contingencies****Minority
                interests**
            
            
            669
            
            
            67,694**Stockholders’
                equity**Common
                stock, $0.01 par value, 105,000,000 shares authorized, 26,971,465
                and
                11,114,962 shares issued, and26,946,465
                and 10,439,387 shares outstanding at September 30, 2006 and December
                31,
                2005, respectively
            
            
            269,465
            
            
            104,394Common
                stock, Class A $0.01 par value, 21,000,000 shares authorized, 0 and
                15,739,963 shares issuedand
                outstanding at September 30, 2006 and December 31, 2005,
                respectively
            
            
            —
            
            
            157,400Capital
                in excess of par value
            
            
            110,504,674
            
            
            105,447,041Accumulated
                deficit
            
            
            (97,668,994
            )
            
            (87,987,194
            )**Total
                stockholders’ equity**
            
            
            13,105,145
            
            
            17,721,641**TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY**
            
            $
            25,969,005
            
            $
            34,385,779





See
      accompanying condensed notes to consolidated financial statements.




3


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**Consolidated
      Statements of Operations**




**Three
                months ended**
            
            
            **Nine
                months ended****September
                30,**
            
            
            **September
                30,****2006**
            
            
            **2005**
            
            
            **2006**
            
            
            **2005****(unaudited)**
            
            
            **(unaudited)**
            
            
            **(unaudited)**
            
            
            **(unaudited)****Revenues**
            
            $
            11,728,524
            
            **$**
            9,123,742
            
            **$**
            31,793,793
            
            **$**
            40,312,685**Operating
                expenses:**Cost
                of revenues, exclusive of depreciation and amortization shown separately
                below
            
            
            10,635,840
            
            
            8,280,078
            
            
            28,623,555
            
            
            36,981,492Depreciation
                and amortization
            
            
            386,702
            
            
            358,669
            
            
            864,544
            
            
            1,228,080Loss
                on impairment
            
            
            147,419
            
            
            —
            
            
            147,419
            
            
            —Selling,
                general and administrative expenses (includes $134,311 and $633,976
                non-cash
              compensation
                for the three months and nine months ended September 30, 2006,
              respectively)
            
            
            3,630,624
            
            
            2,767,564
            
            
            11,245,347
            
            
            8,369,906Advertising
                and marketing
            
            
            683,392
            
            
            32,857
            
            
            1,008,142
            
            
            149,290Total
                operating expenses
            
            
            15,483,977
            
            
            11,439,168
            
            
            41,889,007
            
            
            46,728,768**Operating
                loss**
            
            
            (3,755,453
            )
            
            (2,315,426
            )
            
            (10,095,214
            )
            
            (6,416,083
            )**Other
                income (expense)**Interest
                income
            
            
            58,694
            
            
            139,733
            
            
            294,272
            
            
            322,603Interest
                expense
            
            
            (30,972
            )
            
            (32,457
            )
            
            (90,486
            )
            
            (399,750
            )Gain
                on settlements of debt
            
            
            —
            
            
            52,539
            
            
            465,854
            
            
            57,879Loss
                from investment in Estel
            
            
            (48,128
            )
            
            (192,566
            )
            
            (118,766
            )
            
            (492,026
            )Other
            
            
            25,305
            
            
            (10,731
            )
            
            63,616
            
            
            (4,774
            )Minority
                interests
            
            
            58,498
            
            
            71,073
            
            
            67,025
            
            
            119,157Total
                other income (expense)
            
            
            63,397
            
            
            27,591
            
            
            681,515
            
            
            (396,911
            )**Loss
                from continuing operations**
            
            
            (3,692,056
            )
            
            (2,287,835
            )
            
            (9,413,699
            )
            
            (6,812,994
            )**Discontinued
                operations:**Income
                (loss) from discontinued operations
            
            
            (233,993
            )
            
            (53,305
            )
            
            (268,101
            )
            
            105,382**Net
                loss**
            
            $
            (3,926,049
            )
            **$**
            (2,341,140
            )
            **$**
            (9,681,800
            )
            **$**
            (6,707,612
            )**Basic
                and diluted net loss per common share:**Loss
                from continuing operations
            
            $
            (0.14
            )
            **$**
            (0.09
            )
            **$**
            (0.35
            )
            **$**
            (0.28
            )Income
                (loss) from discontinued operations
            
            
            (0.01
            )
            
            —
            
            
            (0.01
            )
            
            0.01Net
                loss per common share
            
            $
            (0.15
            )
            **$**
            (0.09
            )
            **$**
            (0.36
            )
            **$**
            (0.27
            )**Weighted
                average shares outstanding**Basic
                and diluted
            
            
            26,894,779
            
            
            26,179,151
            
            
            26,664,096
            
            
            24,555,878




See
      accompanying condensed notes to consolidated financial statements.





4




**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**Consolidated
      Statements of Cash Flows**




**Nine
                months ended September 30,****2006**
            
            **2005****(unaudited)**
            
            **(unaudited)****Cash
                flows from operating activities**Net
                loss
            
            **$**
            (9,681,800
            )
            $
            (6,707,612
            )**Adjustments
                to reconcile net loss to net cash used in operating activities:**Gain
                from sale of assets
            
            
            (40,980
            )
            
            —Depreciation
                and amortization
            
            
            864,544
            
            
            1,228,080Loss
                on impairment - continuing operations
            
            
            147,419
            
            
            —Loss
                on impairment - discontinued operations
            
            
            211,426
            
            
            —Bad
                debt expense (recovery)
            
            
            (60,250
            )
            
            226,000Stock
                based compensation
            
            
            633,976
            
            
            —Gain
                on forgiveness of debt
            
            
            (465,854
            )
            
            (57,879
            )Gain
                on discontinued operations
            
            
            —
            
            
            (175,000
            )Accretion
                of Series C Preferred Stock
            
            
            —
            
            
            287,115Loss
                from investment in Estel
            
            
            118,766
            
            
            492,026Minority
                interests
            
            
            (67,025
            )
            
            (119,156
            )Increase
                (decrease) in cash attributable to changes in operating assets and
                liabilities:Accounts
                receivable
            
            
            (1,319,173
            )
            
            425,471Prepaid
                expenses and other current assets
            
            
            173,735
            
            
            339,831Other
                assets
            
            
            21,652
            
            
            (275,181
            )Accounts
                payable and accrued expenses
            
            
            1,511,396
            
            
            (1,408,683
            )Liabilities
                of discontinued operations
            
            
            (385,724
            )
            
            (158,371
            )**Net
                cash used in operating activities**
            
            
            (8,337,892
            )
            
            (5,903,359
            )**Cash
                flows from investing activities:**Purchase
                of property and equipment - continuing operations
            
            
            (2,901,253
            )
            
            (1,524,835
            )Purchase
                of property and equipment - discontinued operations
            
            
            —
            
            
            (6,993
            )Advances
                to Estel
            
            
            (58,696
            )
            
            (164,547
            )Payments
                from Estel
            
            
            83,759
            
            
            116,287Purchase
                of Jamaican joint venture, net of cash acquired
            
            
            —
            
            
            (146,486
            )Purchase
                of minority interest in Efonica joint venture, net of cash
                acquired
            
            
            —
            
            
            (480,555
            )Purchase
                of Turkey joint venture, net of cash acquired
            
            
            —
            
            
            (92,971
            )Return
                of security deposits
            
            
            158,523
            
            
            156,136Payments
                of restricted cash
            
            
            (563,390
            )
            
            137,100Payments
                for other intangible assets
            
            
            (84,497
            )
            
            —**Net
                cash used in investing activities**
            
            
            (3,365,544
            )
            
            (2,006,864
            )**Cash
                flows from financing activities**Proceeds
                from sale of common stock and redeemable common stock purchase warrants,
                net
            
            
            —
            
            
            23,884,533Proceeds
                from exercise of stock options
            
            
            —
            
            
            50,250Proceeds
                from exercise of warrants
            
            
            500
            
            
            85,144Payment
                of dividends on Series C preferred stock
            
            
            —
            
            
            (664,634
            )Payments
                of long-term debt and capital lease/equipment financing obligations
            
            
            (677,091
            )
            
            (2,286,706
            )Contributions
                to minority stockholders of joint ventures
            
            
            —
            
            
            (17,961
            )**Net
                cash provided by (used in) financing activities**
            
            
            (676,591
            )
            
            21,050,626**Net
                increase (decrease) in cash and cash equivalents**
            
            
            (12,380,027
            )
            
            13,140,403**Cash
                and cash equivalents, beginning of period**
            
            
            14,790,504
            
            
            4,368,726**Cash
                and cash equivalents, end of period**
            
            **$**
            2,410,477
            
            $
            17,509,129





See
      accompanying condensed notes to consolidated financial statements.





5




**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**Consolidated
      Statements of Cash Flows (continued)**




**Nine
                months ended September 30,****2006**
            
            **2005****(unaudited)**
            
            
            **(unaudited)****Supplemental
                disclosure of cash flow information:**Cash
                paid during the period for interest
            
            $
            47,121
            
            $
            608,839**Supplemental
                disclosure of non-cash investing and financing activities:**Acquisition
                of capital leases /equipment financing obligations
            
            $
            228,800
            
            $
            737,425Acquisition
                of short term financing agreement
            
            $
            553,888
            
            $
            —Conversion
                of convertible notes payable and related debt offering costs
            
            $
            —
            
            $
            2,444,395Conversion
                of Series C preferred stock to common stock
            
            $
            —
            
            $
            10,003,141Conversion
                of prepaid offering costs to additional paid in capital
            
            $
            —
            
            $
            614,008Release
                of Efonica shares from escrow
            
            $
            4,357,497
            
            $
            —Issuance
                of restricted stock for consulting services
            
            $
            66,250
            
            $
            50,000Issuance
                of Common Stock for attainment of certain earn outs in
                Intellectual
              Property
                Transfer Agreement
            
            $
            90,000
            
            $
            —Liability
                for acquisition of Intellectual Property Transfer
                Agreement
            
            $
            30,000
            
            $
            —**Supplemental
                disclosure of joint venture acquisition activities:**Fair
                value of tangible assets, net of cash acquired
            
            $
            —
            
            $
            654,791Fair
                value of identifiable intangible assets
            
            
            —
            
            
            4,877,900Goodwill
                acquired
            
            
            —
            
            
            761,143Liabilities
                acquired
            
            
            —
            
            
            (401,504
            )Minority
                interest acquired
            
            
            —
            
            
            (244,118
            )Common stock
                issued excluding shares in escrow
            
            
            —
            
            
            (4,928,200
            )Cash
                paid for acquisition of joint ventures, net of cash
                acquired
            
            $
            —
            
            **$**
            720,012




See
      accompanying condensed notes to consolidated financial statements.





6


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC.**


**AND
      SUBSIDIARIES**





**Condensed
      Notes to Consolidated Financial Statements**





**1.
      Basis of Presentation**





The
      accompanying condensed notes to consolidated financial statements should be
      read
      in conjunction with the 2005 Form 10-K for Fusion Telecommunications
      International, Inc. and its Subsidiaries (the “Company”). These financial
      statements have been prepared in accordance with instructions to Form 10-Q
      and
      Article 10 of Regulation S-X and, therefore, omit or condense certain footnotes
      and other information normally included in the financial statements prepared
      in
      accordance with accounting principles generally accepted in the United States.
      In the opinion of the Company’s management, all adjustments (consisting of
      normal recurring accruals) considered necessary for fair financial statement
      presentation have been made. The results of operations for an interim period
      may
      not give a true indication of the results for the year.





During
      the nine months ended September 30, 2006 and 2005, comprehensive loss was equal
      to the net loss amounts presented for the respective periods in the accompanying
      Consolidated Statements of Operations.





***Advertising
      and Marketing***





Advertising
      and marketing costs primarily relate to the Company’s on-line Efonica
      advertising campaign. In connection with this campaign, the costs of production
      are expensed as incurred. The costs of communicating this advertising are
      expensed when received by the on-line consumer (i.e., consumer receives a link
      to the Efonica website as a result of a search engine keyword search). The
      Company’s costs also include newspaper ads for its Efonica retail services,
      product press releases, and exhibitions the Company attends to promote these
      retail services.





***Earnings
      Per Share***





SFAS
      No.
      128, “Earnings Per Share,” requires dual presentation of basic and diluted
      income per share for all periods presented. Basic income per share excludes
      dilution and is computed by dividing earnings available to common stockholders
      by the weighted-average number of common shares outstanding during the period.
      Diluted earnings per share reflects the potential dilution that could occur
      if
      securities or other contracts to issue common stock were exercised or converted
      into common stock or resulted in the issuance of common stock that then shared
      in the earnings of the Company.





Unexercised
      stock options to purchase 2,791,479 and 1,602,426 shares of the Company’s common
      stock as of September 30, 2006 and 2005, respectively, were not included in
      the
      computation of diluted earnings per share because the exercise of the stock
      options would be anti-dilutive to earnings per share.





Unexercised
      warrants to purchase 7,788,505 and 7,436,172 shares of the Company’s common
      stock as of September 30, 2006 and 2005, respectively, were not included in
      the
      computation of diluted earnings per share because the exercise of the warrants
      would be anti-dilutive to earnings per share.





***Stock-based
      Compensation***





On
      January 1, 2006, the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R”), that
      addresses the accounting for share-based payment transactions in which an
      enterprise receives employee services in exchange for either equity instruments
      of the enterprise or liabilities that are based on the fair value of the
      enterprise’s equity instruments or that may be settled by the issuance of such
      equity instruments. SFAS No. 123R eliminates the ability to account for
      share-based compensation transactions, as the Company formerly did, using the
      intrinsic value method as prescribed by Accounting Principles Board (APB”),
      Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally
      requires that such transactions be accounted for using a fair-value-based method
      and recognized as an expense in the Company’s Consolidated Statements of
      Operations.





The
      Company adopted SFAS No. 123R using the modified prospective method, which
      required the application of the accounting standard as of January 1, 2006.
      The
      Company’s consolidated financial statements as of September 30, 2006, and for
      the three and nine months ended September 30, 2006, reflect the impact of
      adopting SFAS No. 123R. In accordance with the modified prospective method,
      the
      consolidated financial statements for prior periods have not been restated
      to
      reflect, and do not include, the impact of SFAS No. 123R.




7


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**1.
      Basis of Presentation (continued)**





Stock-Based
      compensation expense recognized during the period is based on the value of
      the
      portion of stock-based payment awards that is ultimately expected to vest.
      Stock-based compensation expense recognized in the Consolidated Statements
      of
      Operations during the three and nine months ended September 30, 2006, includes
      compensation expense for stock-based payment awards granted prior to, but not
      yet vested, as of December 31, 2005, based on the grant date fair value
      estimated in accordance with SFAS No. 123R. As stock-based compensation expense
      recognized in the Consolidated Statement of Operations for the three and nine
      months ended September 30, 2006, is based on awards ultimately expected to
      vest,
      it has been reduced for estimated forfeitures. SFAS No. 123R requires
      forfeitures to be estimated at the time of grant and revised, if necessary,
      in
      subsequent periods if actual forfeitures differ from those estimates. When
      estimating forfeitures, the Company considered termination behaviors as well
      as
      trends for actual option forfeiture. In the pro forma information required
      under
      SFAS No. 148 (“Accounting for Stock-Based Compensation - Transition and
      Disclosure - an amendment of FASB Statement No. 123”) for the periods prior to
      2006, the Company accounted for forfeitures as they occurred.





The
      Company has recognized compensation expense based on the estimated grant date
      fair value method using the Black-Scholes valuation model. For these awards,
      the
      Company has recognized compensation expense using a straight-line amortization
      method. The impact on the Company’s results of operations of recording employee
      stock-based compensation for the three and nine months ended September 30,
      2006,
      was an expense of $101,186 and $534,404, respectively, which is included in
      selling, general and administrative expenses in the Consolidated Statements
      of
      Operations.





The
      following table illustrates the effect on the net loss and loss per share as
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123R
      for the three and nine months ended September 30, 2005.





**For
                the Three Months Ended**
              **September
                30, 2005**
            
            **For
                the Nine Months Ended**
              **September
                30, 2005**Net
                loss applicable to common stockholders, as reported
            
            $
            (2,341,140
            )
            $
            (6,707,612
            )Deduct:
                total stock-based compensation expense under fair value method
              for
                awards, net of related tax effect
            
            
            (162,122
            )
            
            (446,186
            )Net
                loss applicable to common stockholders, pro forma
            
            $
            (2,503,262
            )
            $
            (7,153,798
            )Loss
                per share:Basic
                and diluted loss, as reported
            
            $
            (0.09
            )
            $
            (0.27
            )Basic
                and diluted loss, pro forma
            
            $
            (0.10
            )
            $
            (0.29
            )





***Use
      of Estimates***





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





***Reclassifications***





Certain
      reclassifications have been made to the 2005 amounts to conform to the 2006
      presentation.




8


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**




**2.
      Going Concern**




At
      September 30, 2006, the Company had a working capital deficit of $4,683,300
      and
      an accumulated deficit of $97,668,994. The Company has continued to sustain
      losses from operations, and for the nine months ended September 30, 2006 and
      2005 has incurred a net loss of $9,681,800 and $6,707,612, respectively. In
      addition, the Company has not generated positive cash flow from operations
      since
      inception. The Company is reviewing options to raise additional capital through
      debt and/or equity financing. While management believes that its current cash
      resources should be adequate to fund its operations for the remainder of the
      year, the Company’s long-term liquidity is dependent on its ability to
      successfully complete the rollout of its full suite of retail VoIP paid services
      and effectively market its paid services, in order to attain profitable
      operations in the future. The Company cannot make any guarantees if and when
      it
      will be able to attain profitability. These factors, among others, indicate
      that
      the Company may be unable to continue operations as a going concern. No
      adjustment has been made in the consolidated financial statements to the amounts
      and classification of assets and liabilities which could result, should the
      Company be unable to continue as a going concern.




**3.
      Acquisitions and Joint Ventures**





***Pakistan***





In
      July 2002, the Company acquired a 75% equity interest in a joint venture
      with Turner Hill Investments, L.P. (“Turner Hill”) to provide VoIP services for
      calls terminating in Pakistan by the Pakistan Telecommunications Company Limited
      (“PTCL”). Turner Hill subsequently assigned its interest to Braddon Corporate
      Holdings Limited (“Braddon”).





As
      of
      December 31, 2005, a rolling advance of $415,500 was owed to the Company by
      PTCL. During February 2006, PTCL returned $389,000 of the rolling advance,
      which
      was reflected in prepaid expenses and other current assets in the
      December 31, 2005 Consolidated Balance Sheet. The remaining rolling advance
      balance of $26,500 is currently being disputed (reflected in security deposits
      in the September 30, 2006 Balance Sheet) along with a $58,960 receivable balance
      from PTCL (reflected in prepaids and other current assets in the September
      30,
      2006 Balance Sheet).





***Turkey***





During
      the quarter ended September 30, 2006, the Company decided to begin winding
      up
      and liquidating its Turkey joint venture. This decision was a result of various
      challenges the Company encountered from an increasingly complicated and
      constantly changing regulatory environment in Turkey, which made it very
      difficult to enter the market. These regulatory difficulties included an
      unstable environment as well as the selling of Turk-Telecom, which was a
      government owned entity, to a private company. As a result of this decision,
      the
      operations of this subsidiary are being treated as a discontinued operation.
      See
      Note 5 for further discussion.





***Jamaica***





As
      the
      Company’s business plan for its Jamaican joint venture evolved, the Company
      found a business partner who is willing to purchase the subsidiary’s switching
      equipment and accept assignment of the leased premises. Although there is no
      guarantee the agreement will close, an agreement has been executed, whereby
      the
      Company will receive $425,000. Under this agreement, the Company will retain
      the
      license, as it hopes to enter into a business relationship with the entity
      acquiring the assets or other entities. The fixed assets being sold in this
      agreement, as of September 30, 2006, are reflected as Assets Held for Sale
      in
      the Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005.
      Although, the Company intends to do business in Jamaica in the future, the
      Company reviewed the $147,419 of recorded goodwill for impairment, and
      determined it was impaired as a result of the changes in the Company’s business
      plan, and consequently wrote off this goodwill during the quarter ended
      September 30, 2006.





***iFreedom***





On
      November 14, 2005, the Company entered into an agreement to acquire the assets
      of iFreedom Communications International Holdings Limited and a number of its
      subsidiaries, (“iFreedom”), an entity that markets monthly recurring
      international VoIP service plans geared to meet the needs of consumers and
      businesses in emerging markets. The agreement provided for a purchase price
      of
      $500,000 in cash, and 1,100,000 shares of restricted common stock, of which
      750,000 shares were to be held in escrow and were subject to a performance
      based
      earn out. Under the terms of the agreement, the Company would have acquired
      iFreedom’s customer base as well as operations in Hong Kong, the Philippines,
      Malaysia, the United Kingdom, and the United States. As certain closing
      conditions were not met by iFreedom, the parties tried to work in good faith
      to
      renegotiate the terms and conditions of the transaction, but were not
      successful. The Company no longer intends to pursue this
      transaction.




9





**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**








**3.
      Acquisitions and Joint Ventures (continued)**





Until
      early August 2006, the Company had been providing termination services to
      iFreedom, which have aggregated outstanding charges of approximately $594,108
      as
      of September 30, 2006. iFreedom has entered into a non interest-bearing Note
      with respect to these charges. iFreedom has executed a secured promissory note
      evidencing and securing their indebtedness to the Company, and has started
      repaying the balance due to the Company for the termination services the Company
      has provided to iFreedom.





**4.
      Prepaid expenses and other current assets**





Prepaid
      expenses and other current assets consist of the following at September 30,
      2006
      and December 31, 2005.





**September
                30, 2006**
            
            **December
                31, 2005****(unaudited)**Prepaid
                expenses
            
            $
            542,352
            
            $
            425,832Prepaid
                insurance
            
            
            117,624
            
            
            105,884Prepaid
                advertising/marketing
            
            
            171,191
            
            
            —Due
                from PTCL
            
            
            58,960
            
            
            447,505Other
                current assets
            
            
            199,235
            
            
            263,045$
            1,089,362
            
            $
            1,242,266





**5.
      Discontinued operations**





Prior
      to
      2006, the Company’s discontinued operations related to Management’s decision in
      2001 to cease the operations of its domestic retail telecommunication services
      business lines. The Company continues its efforts to settle certain of these
      remaining liabilities. As a result of these efforts, the Company recognized
      a
      gain of $175,000 during the nine months ended September 30, 2005. The remaining
      liability at December 31, 2005, of approximately $621,000, is related to trade
      payables and accrued expenses associated with the discontinued retail
      telecommunications services. During the nine months ended September 30, 2006,
      the Company paid approximately $386,000 of these outstanding
      liabilities.





As
      discussed in Note 3, the Company decided in the quarter ended September 30,
      2006, to dissolve its subsidiary in Turkey. The dissolution and liquidation
      should be completed during the fourth quarter. In accordance with SFAS No.
      144,
“Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company
      has classified the operating results of its Turkey joint venture as a
      discontinued operation in the accompanying Consolidated Financial Statements.
      All prior periods have been reclassified to conform to the current year
      presentation. These discontinued operations affect only the Company’s VoIP to
      Consumers and Corporations segment. The following is a summary of the operating
      results of the discontinued operations.


**Three
                  months ended**
              
              **Nine
                  months ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****(unaudited)**
              
              **(unaudited)**
              
              **(unaudited)**
              
              **(unaudited)**Depreciation
                  and amortization
              
              $
              350
              
              $
              —
              
              $
              1,049
              
              $
              —Loss
                  on impairment
              
              
              211,426
              
              
              —
              
              
              211,426
              
              
              —Selling,
                  general and administrative expenses
              
              
              22,217
              
              
              49,181
              
              
              55,626
              
              
              65,494Advertising
                  and marketing
              
              
              —
              
              
              4,464
              
              
              —
              
              
              4,464Other
              
              
              —
              
              
              (340
              )
              
              —
              
              
              (340
              )Gain
                  on settlement of debt
              
              
              —
              
              
              —
              
              
              —
              
              
              (175,000
              )(Income)
                  loss from discontinued operations
              
              $
              233,993
              
              $
              53,305
              
              $
              268,101
              
              $
              (105,382
              )




10




**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**6.
      Accounts payable and accrued expenses**





Accounts
      payable and accrued expenses consist of the following at September 30, 2006
      and
      December 31, 2005:





**September
                30, 2006**
            
            **December
                31, 2005****(unaudited)**Trade
                accounts payable
            
            $
            7,007,808
            
            $
            6,134,373Accrued
                expenses
            
            
            2,608,257
            
            
            1,892,216Interest
                payable
            
            
            378,234
            
            
            334,869Deferred
                revenue
            
            
            351,037
            
            
            810,837Short-term
                financing agreement
            
            
            404,407
            
            
            —Other
            
            
            149,028
            
            
            97,046$
            10,898,771
            
            $
            9,269,341





During
      the nine months ended September 30, 2006, the Company entered into a short-term
      financing agreement for $553,888 to purchase certain hardware, software and
      software support from an equipment vendor. The payments are due on a monthly
      basis over a 9-month period. The vendor is charging a 7% finance charge for
      the
      $241,000 hardware portion of the purchase.





**7.
      Long-term debt and capital lease/equipment financing obligations**





At
      September 30, 2006, and December 31, 2005, components of long-term debt and
      capital lease/equipment financing obligations of the Company are comprised
      of
      the following:





**September
                30,****2006**
            
            **December
                31,****2005****(unaudited)**Promissory
                notes payable
            
            $
            150,000
            
            $
            150,000Capital
                lease/equipment financing obligations
            
            
            979,325
            
            
            1,427,615Total
                long-term debt and capital lease/equipment financing
                obligations
            
            
            1,129,325
            
            
            1,577,615Less
                current portion
            
            
            (1,089,921
            )
            
            (1,569,965
            )$
            39,404
            
            $
            7,650





**** ***Promissory
      note payable***





During
      February 2004, the Company entered into a settlement agreement for $600,000.
      In
      the same month, the Company paid $450,000 and executed a promissory note wherein
      the Company agreed to make 12 monthly payments for the remaining $150,000.
      The
      promissory note has not been repaid as of September 30, 2006, as the other
      party
      in the settlement agreement has not complied with the terms of the
      agreement.





***Capital
      lease/equipment financing obligations***





The
      Company entered into several financing agreements for equipment purchases during
      2005 and prior. The Company has imputed an interest rate of 10.0% related to
      these agreements, which are payable every 90 days over a 12-18 month
      period.





During
      the nine months ended September 30, 2006, the Company entered into a capital
      lease agreement for $228,800 (balance is approximately $153,000 at September
      30,
      2006). The interest rate is 7.3% and payments are due every 90 days over a
      16-month period.





At
      September 30, 2006 and December 31, 2005, approximately $720,000 of the capital
      lease obligations was in default and accordingly has been classified as
      currently due. See Legal Matters section of Note 11 for further
      discussion.





Future
      aggregate principal payments for the Company’s debt and capital lease/equipment
      financing obligations as of September 30, 2006 are as follows:





Total
                minimum payments due during the period ending September 30,
                2007
            
            $
            1,507,435Less
                amount representing interest
            
            
            (378,111
            )Present
                value of minimum payments
            
            
            1,129,324Less
                current portion
            
            
            (1,089,920
            )$
            39,404




11




**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**8.
      Equity Transactions**





On
      February 17, 2005, the Company closed its initial public offering of 3,600,000
      shares of common stock at a price of $6.45 per share and 3,600,000 redeemable
      common stock purchase warrants at $0.05 per warrant. Gross proceeds of the
      offering were approximately $23,400,000. Total estimated offering costs were
      approximately $3,000,000, which resulted in net proceeds to the Company of
      $20,400,000. On March 30, 2005, the Company’s underwriters exercised their
      over-allotment option and purchased an additional 480,000 shares of common
      stock
      and 540,000 purchase warrants. The Company received an additional
      $2,900,000 in net proceeds from the closing on the over-allotment
      option.





Subsequent
      to the IPO, the Company had two classes of outstanding common stock. The holders
      of the Class A Common Stock had identical rights and privileges to the regular
      common stock, except that they were able to transfer shares of Class A Common
      Stock until February 11, 2006. On that date, the 15,739,963 shares of
      outstanding Class A Common Stock were automatically converted into shares of
      common stock.





Upon
      completion of the IPO, convertible debt with a balance of $2,508,333 was
      converted into 651,515 shares of common stock. In addition, 1,439,643 shares
      of
      common stock were issued in connection with the Company’s acquisition of the
      49.8% minority interest in Efonica. In addition, all outstanding Series C
      preferred stock was converted into common stock.





During
      March 2006, 14,286 shares of common stock were issued upon the exercise of
      a
      warrant to purchase the shares at a price of $0.035 per share.





On
      March
      28, 2006, the Company entered into a consulting service agreement. In connection
      with the agreement, the Company issued 50,000 shares of restricted common stock.
      Of these shares, 25,000 shares were given to the consultant upon the signing
      of
      the agreement. The other 25,000 shares are being held in escrow until the sixth
      (6 th )
      month
      anniversary, at which time 12,500 shares will be released. The remaining 12,500
      shares will be released upon the ninth (9 th )
      month
      anniversary, unless the agreement has been terminated, pursuant to the Company’s
      right to terminate. The $66,250 expense associated with the 25,000 shares given
      to the consultant was amortized over the six-month term. The Company has
      continued to use this consultant after the sixth (6 th )
      month
      anniversary and, consequently, released the (1 st )
      12,500
      shares subsequent to September 30, 2006.





**9.
      Gain on settlements of debt**





During
      December 2003, the Company entered into a debt settlement agreement with a
      domestic carrier. The provisions of the agreement provided that $555,000 due
      to
      the carrier would be resolved with a service agreement whereby the carrier
      received a reduced rate for certain minutes of traffic that passed through
      the
      Company’s network through December 2005. The Company and the carrier continued
      to comply with the terms of this agreement until it was settled as discussed
      below. Since the settlement agreement was entered into, approximately $89,000
      of
      deferred revenue was recognized in connection with this service
      agreement.





During
      June 2006, the service agreement was cancelled and the carrier released the
      Company of all remaining indebtedness under the December 2003 settlement
      agreement. Consequently, the remaining deferred revenue balance of approximately
      $466,000 was recorded as a gain on settlement of debt.





**10.** **New
      Accounting Pronouncements**





In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
      Financial Instruments - an amendment of FASB Statements No. 133 and 140,” which
      simplifies accounting for certain hybrid financial instruments by permitting
      fair value re-measurement for any hybrid instrument that contains an embedded
      derivative that otherwise would require bifurcation and eliminates a restriction
      on the passive derivative instruments that a qualifying special-purpose entity
      may hold. SFAS No. 155 is effective for all financial instruments acquired,
      issued or subject to a re-measurement (new basis) event occurring after the
      beginning of an entity’s first fiscal year that begins after September 15, 2006.
      The adoption of SFAS No. 155 is not expected to have an impact on the Company’s
      results of operations or financial position.





In
      March
      2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial
      Assets - an amendment of FASB Statement No. 140,” which establishes, among other
      things, the accounting for all separately recognized servicing assets and
      servicing liabilities by requiring that all separately recognized servicing
      assets and servicing liabilities be initially measured at fair value, if
      practicable. SFAS No. 156 is effective as of the beginning of an entity’s first
      fiscal year that begins after September 15, 2006. The adoption of SFAS No.
      156
      is not expected to have an impact on the Company’s results of operations or
      financial position.




12


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**10.** **New
      Accounting Pronouncements (continued)**





In
      June
      2006, the FASB issued Financial Interpretation No. 48, “Accounting for
      Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN
      No. 48”). FIN No. 48 clarifies the accounting for uncertainty in income taxes
      recognized in the financial statements in accordance with SFAS No. 109,
“Accounting for Income Taxes.” The interpretation is effective for fiscal years
      beginning after December 15, 2006. The Company does not expect the adoption
      of
      this FIN will have a material impact on its financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 clarifies the
      SEC staff’s beliefs regarding the process of quantifying financial statement
      misstatements and is effective for fiscal years ending after November 15, 2006.
      The Company does not expect SAB No. 108 to have a material impact on its
      financial statements.





In
      September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements”, which
      establishes a framework for measuring fair value and requires expended
      disclosure about the information used to measure fair value. The statement
      applies whenever other statements require, or permit, assets or liabilities
      to
      be used to measure fair value. The statement does not expand the use of fair
      value in any new circumstances and is effective for fiscal years beginning
      after
      November 15, 2007, and interim periods within those fiscal years, with early
      adoption encouraged. The Company does not expect the adoption of this statement
      to have a material impact on its financial condition or results of
      operations.





**11.
      Commitments and contingencies**





***Legal
      Matters*** ****





On
      May 28, 2003, Jack Grynberg, et al., an investor in one of the Company’s
      private offerings, filed a complaint with the Denver District Court, State
      of
      Colorado ( *Jack
      Grynberg, et al v. Fusion Telecommunications International, Inc., et
      al* ,
      03-CV-3912) seeking damages in the amount of $400,000 for the purchase of an
      interest in Fusion’s 1999 private placement offering of subordinated convertible
      notes through Joseph Stevens & Company, Inc., a registered broker dealer.
      This complaint asserted the following claims for relief against us: Breach
      of
      Fiduciary Duty, Civil Theft, Deceptive Trade Practices, Negligent
      Misrepresentation, Deceit Based on Fraud, Conversion, Exemplary Damages and
      Prejudgment Interest. On June 25, 2004, the Company filed with the Court a
      Motion to Dismiss, which was granted. The Company was awarded attorneys’ fees by
      the court. The plaintiffs have filed an appeal of the motion, which is still
      pending as of the date of this filing.




On
      March
      30, 2006, an equipment vendor filed a complaint with the Circuit Court in
      Broward County, State of Florida seeking damages in the amount of $1,379,502
      allegedly due on two promissory notes plus accrued interest through March 1,
      2006 and attorney costs. Management asserted a counterclaim against the vendor
      and an affiliated company and is vigorously prosecuting the counterclaim. The
      Company’s legal counsel has advised that, at this stage, they cannot accurately
      predict the likelihood of an unfavorable outcome or quantify the amount or
      range
      of potential loss, if any. Accordingly, with the exception of amounts previously
      accrued by the Company under the capital lease arrangement, no adjustment that
      may result from resolution of these uncertainties has been made in the Company’s
      accompanying financial statements.





Due
      to
      the regulatory nature of the industry, the Company is periodically involved
      in
      various correspondence and inquiries from state and federal regulatory agencies.
      Management does not expect the outcome of these inquiries to have a material
      impact on the Company’s operations or financial condition.





***Letters
      of Credit***





In
      connection with the Company’s relocation of its New York office during April
      2006, the lease amendment required the Company to provide a Letter of Credit
      in
      favor of the landlord in the amount of approximately $428,000. The Letter of
      Credit was obtained in January 2006, and is secured by $239,000 in money market
      funds. The Company also received an $189,000 line of credit that would be drawn
      down, should the Company default on the lease terms.





During
      July 2006, in connection with the Company’s 75% owned subsidiary in Turkey, the
      Company provided a Letter of Credit for 250,000 Euros (approximately $0.3
      million) to the Telekomunikasyon Kurumu Telecommunication Administrator. This
      Letter of Credit is to secure a license to do business as a long distance
      telecommunication services company in Turkey. The guarantee is effective until
      January 1, 2007. Since the Company has since discontinued these operations
      in
      Turkey (See Note 3), it is in the process of requesting authorization to cancel
      this Letter of Credit and secure the return of the funds.





***Intellectual
      Property Transfer Agreement***





On
      February 15, 2006, the Company entered into an Intellectual Property Transfer
      Agreement with Xtreme VoIP Corp. (“Xtreme”) pursuant to which the Company
      purchased a software application and other intellectual property rights (the
      “Intellectual Property”) relating to a VoIP software solution that will allow
      Directed Peer-to-Peer Internet phone connections between SIP-enabled devices
      without the need to route the calls through a network of third-party computers,
      as typically occurs in a peer-to-peer environment.




13




**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**11.
      Commitments and contingencies**  **(continued)**





The
      purchase price of the Intellectual Property is $600,000, of which $60,000 has
      been paid in cash. An additional $90,000 was paid with the issuance of 52,254
      shares of common stock, as a result of certain earn outs having been met during
      the quarter ended September 30, 2006. An additional $30,000 will be paid when
      the final earn out threshold is met. However, the $30,000 is recorded as a
      liability as of September 30, 2006, since the contract requires a minimum
      payment of $180,000. On the second anniversary of this agreement, the Company
      has the option of (i) reverting the agreement and the Intellectual Property
      back
      to Xtreme, while retaining a perpetual non-exclusive, paid-up, royalty free
      license to utilize and sub-license the Intellectual Property, or (ii) keeping
      the Intellectual Property and complying with the terms of the agreement, which
      provides for final payment of the balance due by the fourth anniversary. In
      the
      event that the Company does not revert the assets, and licenses the Intellectual
      Property as a product to third parties, but not a sale of the Intellectual
      Property in its entirety, until the sixth (6 th )
      anniversary of this agreement, Xtreme will be entitled to receive a royalty
      equal to 20% of software sales sold by the Company. Any royalties paid to Xtreme
      or gains in the market value of stock received by Xtreme based on the last
      closing price of an aggregate of 30 days during the four year period when Xtreme
      is free to sell such shares with the highest market value, shall be applied
      to
      the remaining consideration. In the event that the assets revert back to Xtreme
      and in the event that the Company sub-licenses the Intellectual Property as
      a
      product to third parties, Xtreme will be entitled to a royalty equal to 50%
      of
      the software sales.





During
      April 2006, the Company filed a patent application with the United States Patent
      and Trademark Office for this technology.





**12.
      Segment information**





The
      Company operates and manages three reportable segments, which are organized
      by
      products and services. The Company measures and evaluates its reportable
      segments based on revenues and cost of revenues. This segment income excludes
      unallocated corporate expenses and other adjustments arising during each period.
      The other adjustments include transactions that the chief operating decision
      makers exclude in assessing business unit performance due primarily to their
      non-operational and/or non-recurring nature. Although such transactions are
      excluded from the business segment results, they are included in reported
      consolidated earnings. Each segment is managed according to the products, which
      are provided to the respective customers, and information is reported on the
      basis of reporting to the Company’s Chief Operating Decision
      Makers.





The
      Company’s segments and their principal activities consist of the
      following:





Voice
      to
      Carriers — Voice to Carriers includes VoIP to Carriers, which is the termination
      of voice telephony minutes by the Internet rather than the circuit-switched
      technology. VoIP permits a less costly and more rapid interconnection between
      the Company and international telecommunications carriers. This segment also
      includes traditional voice (the termination of voice telephony minutes from
      or
      to the countries served by the Company utilizing Time Division Multiplexing
      (TDM) and “circuit-switched” technology). Typically, this segment will include
      interconnection with traditional telecommunications carriers either located
      internationally, or those carriers that interconnect with the Company at its
      U.S. Points of Presence (POP) and provide service to international destinations.
      These minutes are sold to carriers on a wholesale basis.





VoIP
      to
      Consumers and Corporations — The Company provides VoIP services targeted to
      end-users and corporations, primarily through its Efonica brand. The Company
      offers services that permit consumers or corporations to originate calls via
      IP
      telephones or telephone systems that use the Internet for completion to standard
      telephone lines anywhere in the world. The Company also provides PC-to-phone
      service that utilizes the Internet to allow consumers to use their personal
      computers to place calls to the telephone of their destination
      party.





Internet,
      Managed Private Networks & Other — The Company provides Internet
      connectivity to telecommunications carriers, Internet service providers,
      government entities, and multinational customers via its POPs in the U.S. and
      India, and through its partners elsewhere.




14





**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**12.
      Segment information (continued)**





Operating
      segment information for the three months ended September 30, 2006 and 2005
      is
      summarized as follows:





**Three
                months ended September 30, 2006**
            
            **Voice
                to Carriers**
            
            **VoIP
                to Consumers and Corporations**
            
            **Internet,
                Managed Private Networks & Other**
            
            **Corporate
                & Unallocated**
            
            **Consolidated**Net
                revenues
            
            $
            10,942,103
            
            $
            435,734
            
            $
            350,687
            
            $
            —
            
            $
            11,728,524Cost
                of revenues (exclusive of depreciation and amortization)
            
            $
            (10,053,527
            )
            $
            (462,880
            )
            $
            (119,433
            )
            $
            —
            
            $
            (10,635,840
            )Depreciation
                and amortization
            
            $
            (207,555
            )
            $
            (147,971
            )
            $
            (5,666
            )
            $
            (25,510
            )
            $
            (386,702
            )Loss
                on impairment
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            (147,419
            )
            $
            (147,419
            )Selling,
                general and administrative
            
            $
            (1,371,486
            )
            $
            (1,041,021
            )
            $
            (31,407
            )
            $
            (1,186,710
            )
            $
            (3,630,624
            )Advertising
                and marketing
            
            $
            —
            
            $
            (683,392
            )
            $
            —
            
            $
            —
            
            $
            (683,392
            )Other
                income (expense)
            
            $
            (22,856
            )
            $
            32,027
            
            $
            (4,085
            )
            $
            58,311
            
            $
            63,397Income
                (loss) from continuing operations
            
            $
            (713,321
            )
            $
            (1,867,503
            )
            $
            190,096
            
            $
            (1,301,328
            )
            $
            (3,692,056
            )Income
                (loss) from discontinued operations
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            (233,993
            )
            $
            (233,993
            )Net
                income (loss)
            
            $
            (713,321
            )
            $
            (1,867,503
            )
            $
            190,096
            
            $
            (1.535,321
            )
            $
            (3,926,049
            )Capital
                Expenditures
            
            $
            —
            
            $
            217,781
            
            $
            —
            
            $
            90,987
            
            $
            308,768




**Three
                  months ended September 30, 2005**
              
              **Voice
                  to Carriers**
              
              **VoIP
                  to Consumers and Corporations**
              
              **Internet,
                  Managed Private Networks & Other**
              
              **Corporate
                  & Unallocated**
              
              **Consolidated**Net
                  revenues
              
              $
              7,855,850
              
              $
              813,365
              
              $
              454,527
              
              $
              —
              
              $
              9,123,742Cost
                  of revenues (exclusive of depreciation and amortization)
              
              $
              (7,442,721
              )
              $
              (572,973
              )
              $
              (264,384
              )
              $
              —
              
              $
              (8,280,078
              )Depreciation
                  and amortization
              
              $
              (295,560
              )
              $
              (17,379
              )
              $
              (14,427
              )
              $
              (31,303
              )
              $
              (358,669
              )Selling,
                  general and administrative
              
              $
              (1,104,801
              )
              $
              (473,267
              )
              $
              (148,786
              )
              $
              (1,040,710
              )
              $
              (2,767,564
              )Advertising
                  and marketing
              
              $
              
              
              $
              —
              
              $
              
              
              $
              (32,857
              )
              $
              (32,857
              )Other
                  income (expense)
              
              $
              (58,031
              )
              $
              (5,410
              )
              $
              (4,289
              )
              $
              95,321
              
              $
              27,591Income
                  (loss) from continuing operations
              
              $
              (1,045,263
              )
              $
              (255,664
              )
              $
              22,641
              
              $
              (1,009,549
              )
              $
              (2,287,835
              )Income
                  (loss) from discontinued operations
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              (53,305
              )
              $
              (53,305
              )Net
                  income (loss)
              
              $
              (1,045,263
              )
              $
              (255,664
              )
              $
              22,641
              
              $
              (1,062,854
              )
              $
              (2,341,140
              )Capital
                  Expenditures
              
              $
              365,606
              
              $
              35,396
              
              $
              19,301
              
              $
              46,700
              
              $
              467,003
  15


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**12.
      Segment information (continued)**





Operating
      segment information for the nine months ended September 30, 2006 and 2005,
      is
      summarized as follows:





**Nine
                months ended September 30, 2006**
            
            **Voice
                to Carriers**
            
            **VoIP
                to Consumers and Corporations**
            
            **Internet,
                Managed Private Networks & Other**
            
            **Corporate
                & Unallocated**
            
            **Consolidated**Net
                revenues
            
            $
            28,835,850
            
            $
            1,766,776
            
            $
            1,191,167
            
            $
            —
            
            $
            31,793,793Cost
                of revenues (exclusive of depreciation and amortization)
            
            $
            (26,594,300
            )
            $
            (1,484,338
            )
            $
            (544,917
            )
            $
            —
            
            $
            (28,623,555
            )Depreciation
                and amortization
            
            $
            (592,817
            )
            $
            (177,846
            )
            $
            (23,453
            )
            $
            (70,428
            )
            $
            (864,544
            )Loss
                on impairment
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            (147,419
            )
            $
            (147,419
            )Selling,
                general and administrative
            
            $
            (4,252,905
            )
            $
            (2,128,898
            )
            $
            (194,488
            )
            $
            (4,669,056
            )
            $
            (11,245,347
            )Advertising
                and marketing
            
            $
            (13,500
            )
            $
            (994,642
            )
            $
            —
            
            $
            —
            
            $
            (1,008,142
            )Other
                income
            
            $
            558,838
            
            $
            33,851
            
            $
            22,772
            
            $
            66,054
            
            $
            681,515Income
                (loss) from continuing operations
            
            $
            (2,058,834
            )
            $
            (2,985,097
            )
            $
            451,081
            
            $
            (4,820,849
            )
            $
            (9,413,699
            )Income
                (loss) from discontinued operations
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            (268,101
            )
            $
            (268,101
            )Net
                income (loss)
            
            $
            (2,058,834
            )
            $
            (2,985,097
            )
            $
            451,081
            
            $
            (5,088,950
            )
            $
            (9,681,800
            )Capital
                Expenditures
            
            $
            140,602
            
            $
            1,694,669
            
            $
            —
            
            $
            1,065,972
            
            $
            2,901,243





**Nine
                months ended September 30, 2005**
            
            **Voice
                to Carriers**
            
            **VoIP
                to Consumers and Corporations**
            
            **Internet,
                Managed Private Networks & Other**
            
            **Corporate
                & Unallocated**
            
            **Consolidated**Net
                revenues
            
            $
            35,779,479
            
            $
            2,996,626
            
            $
            1,536,580
            
            $
            —
            
            $
            40,312,685Cost
                of revenues (exclusive of depreciation and amortization)
            
            $
            (33,858,805
            )
            $
            (2,225,558
            )
            $
            (897,129
            )
            $
            —
            
            $
            (36,981,492
            )Depreciation
                and amortization
            
            $
            (1,034,788
            )
            $
            (41,605
            )
            $
            (41,609
            )
            $
            (110,078
            )
            $
            (1,228,080
            )Selling,
                general and administrative
            
            $
            (3,937,588
            )
            $
            (1,127,333
            )
            $
            (432,980
            )
            $
            (2,872,005
            )
            $
            (8,369,906
            )Advertising
                and marketing
            
            $
            
            
            $
            —
            
            $
            
            
            $
            (149,290
            )
            $
            (149,290
            )Other
                income (expense)
            
            $
            (473,955
            )
            $
            (20,346
            )
            $
            (21,587
            )
            $
            118,977
            
            $
            (396,911
            )Income
                (loss) from continuing operations
            
            $
            (3,525,657
            )
            $
            (418,216
            )
            $
            143,275
            
            $
            (3,012,396
            )
            $
            (6,812,994
            )Income
                (loss) from discontinued operations
            
            $
            175,000
            
            $
            —
            
            $
            —
            
            $
            (69,618
            )
            $
            105,382Net
                income (loss)
            
            $
            (3,350,657
            )
            $
            (418,216
            )
            $
            143,275
            
            $
            (3,082,014
            )
            $
            (6,707,612
            )Capital
                Expenditures
            
            $
            1,223,615
            
            $
            102,481
            
            $
            52,549
            
            $
            153,183
            
            $
            1,531,828





16


**FUSION
      TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES**





**CONDENSED
      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**





**12.
      Segment information (continued)**





**Voice
                to Carriers**
            
            **VoIP
                to Consumers and Corporations**
            
            **Internet,
                Managed Private Networks & Other**
            
            **Corporate
                & Unallocated**
            
            **Consolidated****Assets**September
                30, 2006
            
            $
            8,061,771
            
            $
            14,640,613
            
            $
            293,639
            
            $
            2,972,982
            
            $
            25,969,005December
                31, 2005
            
            $
            7,516,881
            
            $
            10,453,247
            
            $
            322,176
            
            $
            16,093,475
            
            $
            34,385,779





The
      Company employs engineering and operations resources that service across
      multiple product lines. Depreciation and indirect operating expenses were
      allocated to each product line based upon their respective revenues. The amounts
      reflected as Corporate & Unallocated represent those expenses that were not
      appropriate to allocate to each product line.




17


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





*The
      following discussion of our financial condition and results of operations should
      be read together with our consolidated financial statements, and the related
      notes thereto included in another part of this Quarterly Report. This discussion
      contains certain forward-looking statements; within the meaning of the Private
      Securities Litigation Reform Act of 1995, that involve substantial risks and
      uncertainties. When used in this report the words “anticipate,” “believe,”
“estimate,” “expect” and similar expressions as they relate to our management or
      us are intended to identify such forward-looking statements. Our actual results,
      performance or achievements could differ materially from those expressed in,
      or
      implied by, these forward-looking statements. Historical operating results
      are
      not necessarily indicative of the trends in operating results for any future
      period. The forward looking statements are made as of the date of this Quarterly
      Report on Form 10-Q and we do not undertake to update the forward looking
      statements or to update the reasons that actual results could differ from those
      projected in the forward looking statements.*





**Overview**





We
      are an
      international communications carrier delivering VoIP services to, from, in
      and
      between emerging markets in Asia, the Middle East, Africa, Latin America, and
      the Caribbean. We also offer on a limited basis, private networks, Internet
      access, and other advanced services. Our corporate strategy focuses our
      resources on customizing VoIP services to meet the demands of international
      communities of interest in emerging markets around the world including use
      of
      the worldwide Internet area code TM we developed, which provides a simple and
      universal method for our customers to retain existing calling patters and place
      calls by simply adding “10” to the beginning of existing landline or mobile
      telephone numbers. We seek to gain early entry in high growth emerging markets,
      often in partnership with local organizations that have strong distribution
      channels, regulatory experience, and market intelligence. Additionally, we
      have
      worked over the last 18 months to build a carrier grade retail infrastructure
      to
      expand our VoIP service and feature options and to better support the growth
      of
      our VoIP services to consumers and corporations. We recently put into production
      the first phase of our retail infrastructure. As this retail usage terminates
      over our voice to carrier infrastructure, we are better able to recognize
      beneficial synergies, such as improved utilization of our available
      capacity.





The
      following table summarizes our results of operations for the periods indicated:




**Three
                Months**
              **Ended
                September 30,**
            
            **Nine
                  Months****Ended
                September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Revenues**
            
            $
            11,728,524
            
            $
            9,123,742
            
            $
            31,793,793
            
            $
            40,312,685**Operating
                expenses:**Cost
                of revenues
            
            
            10,635,840
            
            
            8,280,078
            
            
            28,623,555
            
            
            36,981,492Depreciation
                and amortization
            
            
            386,702
            
            
            358,669
            
            
            864,544
            
            
            1,228,080Loss
                on impairment
            
            
            147,419
            
            
            —
            
            
            147,419
            
            
            —Selling,
                general and administrative
            
            
            3,630,624
            
            
            2,767,564
            
            
            11,245,347
            
            
            8,369,906Advertising
                and marketing
            
            
            683,392
            
            
            32,857
            
            
            1,008,142
            
            
            149,290Total
                operating expenses
            
            
            15,483,977
            
            
            11,439,168
            
            
            41,889,007
            
            
            46,728,768**Operating
                Loss**
            
            
            (3,755,453
            )
            
            (2,315,426
            )
            
            (10,095,214
            )
            
            (6,416,083
            )Other
                income (expense):Interest
                income
            
            
            58,694
            
            
            139,733
            
            
            294,272
            
            
            322,603Interest
                expense
            
            
            (30,972
            )
            
            (32,457
            )
            
            (90,486
            )
            
            (399,750
            )Gain
                on settlements of debt
            
            
            —
            
            
            52,539
            
            
            465,854
            
            
            57,879Loss
                from investment in Estel
            
            
            (48,128
            )
            
            (192,566
            )
            
            (118,766
            )
            
            (492,026
            )Other
            
            
            25,305
            
            
            (10,731
            )
            
            63,616
            
            
            (4,774
            )Minority
                interests
            
            
            58,498
            
            
            71,073
            
            
            67,025
            
            
            119,157Total
                other income (expense)
            
            
            63,397
            
            
            27,591
            
            
            681,515
            
            
            (396,911
            )**Loss
                from continuing operations**
            
            
            (3,692,056
            )
            
            (2,287,835
            )
            
            (9,413,699
            )
            
            (6,812,994
            )**Discontinued
                operations:**Income
                (loss) from discontinued operations
            
            
            (233,993
            )
            
            (53,305
            )
            
            (268,101
            )
            
            105,382**Net
                loss**
            
            $
            (3,926,049
            )
            $
            (2,341,140
            )
            $
            (9,681,800
            )
            $
            (6,707,612
            )




18




The
      following table presents our historical operating results as a percentage of
      revenues for the periods indicated:




**Three
                  Months****Ended
                September 30,**
            
            **Nine
                  Months****Ended
                September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Revenues**
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %**Operating
                expenses:**Cost
                of revenues
            
            
            90.7
            %
            
            90.8
            %
            
            90.0
            %
            
            91.7
            %Depreciation
                and amortization
            
            
            3.2
            %
            
            3.9
            %
            
            2.7
            %
            
            3.0
            %Loss
                on impairment
            
            
            1.3
            %
            
            0.0
            %
            
            0.5
            %
            
            0.0
            %Selling,
                general and administrative
            
            
            31.0
            %
            
            30.3
            %
            
            35.4
            %
            
            20.8
            %Advertising
                and marketing
            
            
            5.8
            %
            
            0.4
            %
            
            3.2
            %
            
            0.4
            %Total
                operating expenses
            
            
            (132.0
            %)
            
            (125.4
            %)
            
            (131.8
            %)
            
            (115.9
            %)**Operating
                Loss**
            
            
            (32.0
            %)
            
            (25.4
            %)
            
            (31.8
            %)
            
            (15.9
            %)**Other
                income (expense):**Interest
                income
            
            
            0.5
            %
            
            1.5
            %
            
            0.9
            %
            
            0.8
            %Interest
                expense
            
            
            (0.3
            %)
            
            (0.4
            %)
            
            (0.3
            %)
            
            (1.0
            %)Gain
                on settlements of debt
            
            
            0.0
            %
            
            0.6
            %
            
            1.5
            %
            
            0.1
            %Loss
                from investment in Estel
            
            
            (0.4
            %)
            
            (2.1
            %)
            
            (0.4
            %)
            
            (1.2
            %)Other
            
            
            0.2
            %
            
            (0.1
            %)
            
            0.2
            %
            
            0.0
            %Minority
                interests
            
            
            0.5
            %
            
            0.8
            %
            
            0.2
            %
            
            0.3
            %Total
                other income (expense)
            
            
            0.5
            %
            
            0.3
            %
            
            2.1
            %
            
            (1.0
            %)**Loss
                from continuing operations**
            
            
            (31.5
            %)
            
            (25.1
            %)
            
            (29.7
            %)
            
            (16.9
            %)**Discontinued
              operations:**Income
                (loss) from discontinued operations
            
            
            (2.0
            %)
            
            (0.6
            %)
            
            (0.8
            %)
            
            0.3
            %**Net
                loss**
            
            
            (33.5
            %)
            
            (25.7
            %)
            
            (30.5
            %)
            
            (16.6
            %)





**Revenues**




Historically,
      we have generated the majority of our revenues from voice traffic sold to other
      carriers, with a primary focus in the last several years on VoIP termination
      to
      emerging markets. We have focused on growing our existing customer base, which
      is primarily U.S. based, as well as adding new customers, and establishing
      direct VoIP terminating arrangements with telecommunication carriers in emerging
      markets around the world. Although we believe that this business continues
      to be
      of value to our strategy, ongoing competitive and pricing pressures have caused
      us to increase our focus on higher margin, value-added services (primarily
      VoIP
      to consumers and businesses), and to market these services to, or in conjunction
      with, distribution partners on a direct, co-branded or private label
      basis.





In
      an
      effort to further increase margins, expand our retail customer base, and develop
      more stable revenue streams, we have begun to focus significant effort and
      resources on building our VoIP business to consumers and corporations. While
      this does not yet represent a significant portion of our revenue base, we are
      increasing our emphasis in this area. We believe that this will complement
      our
      carrier business with a higher margin and more stable base of retail
      customers.




In
      2002,
      we acquired a 50.2% equity interest in a joint venture with Karamco, Inc.,
      and
      established Efonica F-Z, LLC, as a retail services company marketing VoIP
      services to consumer and corporate customers in emerging markets. Beginning
      in
      the Middle East, Asia and Africa, then extending into Latin America, Efonica’s
      services are primarily sold through distribution channels on a pre-paid basis.
      Efonica’s customers can place calls from anywhere in the world to any
      destination using a personal computer, Internet protocol telephone or regular
      telephone when accompanied by a hardware device. In February 2005, we
      closed on the purchase of the 49.8% minority interest in Efonica.





On
      June
      19, 2006, we launched our Efonica VoIP service. This new service, coupled with
      the simultaneous introduction of our patent-pending Worldwide Internet Area
      Code, gives us the potential to change the way people throughout the world
      communicate. We believe that there is value to creating a worldwide Internet
      calling community, and since our launch, we have added over 750,000 subscribers,
      from over 100 countries and currently have more than 10,000 paid subscribers.
      We
      will continue to develop and launch a wide variety of paid services. We will
      market our paid services to our free subscribers and sell paid service packages
      through physical and online distribution partners. In addition to all of the
      basic features of our free service, our paid packages include a number of value
      added features.




19





We
      manage
      our carrier revenues by product and customer. We manage our carrier costs by
      provider (vendor). We track carrier revenue at the customer level because our
      sales force has to manage the revenue generation at the customer level, and
      invoices are billed to and collected at the customer level. We also have to
      track the same revenues by product, because different products have different
      billing and payment terms, and individual customers may have multiple billing
      and payment terms if they purchase multiple products from us.




We
      manage
      our revenue segments based on gross margin, which is net revenues less cost
      of
      revenues, rather than on net profitability, due to the fact that our
      infrastructure is built to support all products, rather than individual
      products. This applies both to the capital investments made (such as switching
      and transmission equipment), and to certain Selling, General and Administrative
      resources. For example, the majority of our operations personnel support all
      product lines and are not separately hired to support individual product
      segments. For segment reporting purposes, all expenses below cost of revenues
      are allocated based on use of resources or percentage of revenues.




**OPERATING
      EXPENSES**





Our
      operating expenses during the nine months ended September 30, 2006 and 2005,
      are
      categorized as cost of revenues; depreciation and amortization; loss on
      impairment; administrative; and advertising and marketing.





Cost
      of
      revenues includes costs incurred from the operation of our leased network
      facilities, and the purchase of voice termination and Internet protocol services
      from other telecommunications carriers and Internet service providers. We
      continue to work to lower the variable component of the cost of revenue through
      the use of least cost routing, and continual negotiation of usage-based and
      fixed costs with domestic and international service providers.





Depreciation
      and amortization includes depreciation of our communications network equipment,
      amortization of leasehold improvements of our switch locations and
      administrative facilities, and the depreciation of our office equipment and
      fixtures. It also includes amortization of our Efonica customer
      list.





Loss
      on
      impairment includes losses associated with our review of long-lived assets,
      including goodwill, on an annual basis as well as whenever events or
      circumstances may indicate that an asset’s carrying amount is not
      recoverable.





Selling,
      general and administrative expenses include salaries and benefits, insurance,
      occupancy costs, sales, marketing and advertising, professional fees and other
      administrative expenses.





Advertising
      and marketing expenses currently relate primarily to our on-line Efonica
      advertising campaign. They also include newspaper ads for our Efonica retail
      services, product press releases, and costs associated with exhibitions we
      attend to promote these retail services.





**COMPANY
      HIGHLIGHTS**





The
      following summary of significant events during the nine months ended September
      30, 2006, highlights the accomplishments and events that have influenced our
      performance during that time period. This nine-month period includes many
      significant accomplishments including the launch of our VoIP services under
      our
      global Efonica brand and the introduction of our patent-pending Worldwide
      Internet Area Code.




·
                Acquired
                    Proprietary Technology - Acquired proprietary directed SIP peer-to-peer
                    technology that avoids routing Internet phone calls through network
                    of
                    users’ computers;
 ·
                New
                    Partnership - Announced partnership with AnchorFree to market
                    VoIP
                    services to users of large WI-FI network;
 ·
                Licensed
                    Market-Leading Technology - Licensed Global IP Sound’s market-leading
                    technology to power its VoIP softphone;
 ·
                Filed
                    Patent Application - Filed patent application for our proprietary
                    VoIP
                    technology for SIP peer-to-peer VoIP
                    communication;
 ·
                Completion
                    of Softphone Development - Completed development of our proprietary
                    PC-based VoIP softphone, which allows us to differentiate our
                    Efonica®
                    VoIP offering;
 ·
                Launched
                    Free Internet Service - Launched new free Internet phone service,
                    which
                    allows Efonica® subscribers worldwide to make free calls without
                    computers. We also created the Worldwide Internet Area CodeTM which allows
                    subscribers to use their existing telephone numbers preceded
                    by a
                    “10”;
 ·
                Worldwide
                    Internet Area Code Patent - Filed patent application for Worldwide
                    Internet Area CodeTM;
 ·
                Introduction
                    of EFO Out - We introduced one of our new paid services, EFO
                    Out, which
                    allows users to call any landline or mobile telephone number
                    in the world
                    at extremely competitive prices;
 ·
                Jinti
                    Partnership - Entered into a strategic partnership with Jinti,
                    a rapidly
                    growing Chinese community services site that currently attracts
                    in excess
                    of 3 million unique visitors from China each
                    month;
 ·
                Marketing
                    Alliance with MasterCard worldwide - We entered into a retail
                    marketing
                    alliance with MasterCard Worldwide to offer our suite of premium
                    paid VoIP
                    communication services to MasterCard
                    cardholders;
 ·
                Efonica
                    subscribers exceed 750,000 - Since launching our new Efonica
                    VoIP service
                    on June 19, 2005, we have registered more than 750,000 subscribers
                    and
                    currently have more than 10,000 paid subscribers;
                    and
  20
  ·
                Efonica
                    Services in Jordan - Introduction of our Efonica VoIP services
                    in Jordan
                    to allow us to continue to connect communities worldwide, due
                    to our
                    securing exclusive rights to a Jordanian Telecommunications
                    License.





The
      information in our period-to-period comparisons below represents only our
      results from continuing operations.





**Three
      Months Ended September 30, 2006, Compared with Three Months Ended September
      30,
      2005.**





***Revenues***





Consolidated
      revenues were $11.7 million during the three months ended September 30, 2006,
      compared to $9.1 million during the three months ended September 30, 2005,
      an
      increase of $2.6 million or 28.5%. This increase in revenue was due to an
      increase in our voice services sold to carriers segment. We expect our revenue
      from our voice services sold to carriers to continue to increase in future
      quarters.





Voice
      services sold to carriers increased to $10.9 million from $7.9 million during
      the three months ended September 30, 2006 and 2005, respectively. This was
      the
      fourth consecutive quarter that carrier revenues have increased.





Revenues
      for VoIP services to consumers and corporations decreased to $0.4 million during
      the three months ended September 30, 2006, from $0.8 million during the three
      months ended September 30, 2005. As we had been focusing on our new suite of
      retail VoIP services, we had scaled back some existing customers and made a
      strategic decision to service a broader spectrum of customers once our new
      products are deployed. Since our launch in June, the majority of our efforts
      centered on enhancing our free Efonica service offerings. Now, we are focused
      on
      introducing additional premium services in the near term and driving revenue
      growth through upselling existing customers and marketing our services through
      our growing number of retail distribution partners worldwide.





Revenues
      from our Internet, private network & other services decreased to $0.4
      million during the three months ended September 30, 2006, from $0.5 million
      during the three months ended September 30, 2005, primarily due to the loss
      of
      two customers.





***Cost
      of Revenues***





Consolidated
      cost of revenues increased $2.3 million or 28.5% to $10.6 million during the
      three months ended September 30, 2006 from $8.3 million during the three months
      ended September 30, 2005. This percentage increase is consistent with the
      revenue percentage increase and relates primarily to the voice services to
      carriers.





The
      cost
      of revenues for voice services to carriers increased $2.6 million or 35.1%
      to
      $10.1 million during the three months ended September 30, 2006 from $7.5 million
      during the three months ended September 30, 2005. This increase is a result
      of
      the increase in revenues for our voice services to carriers.





The
      cost
      of revenues for VoIP services to consumers and corporations decreased $0.1
      million or 19.2%, to $0.5 million during the three months ended September 30,
      2006 from $0.6 million during the three months ended September 30, 2005, due
      to
      the reduction in volume mentioned above. The cost of revenues for VoIP services
      in 2006 also included $0.1 million in promotional expense for the third quarter
      related to our new retail VoIP service. This promotional expense resulted from
      our giving new customers a test account to try one of our premium service
      offerings for free.





Cost
      of
      revenues for Internet, private network & other decreased $0.1 million or
      54.8% to $0.1 million during the three months ended September 30, 2006, from
      $0.2 million during the three months ended September 30, 2005. This decrease
      is
      a result of the revenue decreases previously discussed. When the revenues
      ceased, the corresponding cost of revenues decreased as well.





The
      consolidated gross margin percentage was 9.3% during the three months ended
      September 30, 2006, which was consistent with the margin percentage of 9.2%
      during the three months ended September 30, 2005. Our gross margin for VoIP
      services to consumers and corporations of (6.2%) was negatively impacted by
      costs associated with the promotions we ran to introduce our new premium
      services during our recent Efonica launch. Without the promotional expense,
      our
      gross margin for this segment would have been 22.4%. Absolute consolidated
      gross
      margin dollars increased by $0.2 million, which was attributable to improved
      margin in the voice to carrier segment services sold.





***Operating
      Expenses***





***Depreciation
      and Amortization*** .
      Depreciation and amortization remained consistent at $0.4 million during the
      three months ended September 30, 2006 and 2005. Our depreciation expense
      remained consistent. Our depreciation expense decreased as a result of many
      of
      our assets being fully depreciated during the three months ended September
      30,
      2006, which were not fully depreciated during the three months ended September
      30, 2005. This decrease was net with an increase in our depreciation expense
      as
      a result of the amortization of fixed assets associated with our retail VoIP
      infrastructure and our relocated New York headquarters.




21





***Loss
      on Impairment.*** Loss on
      impairment during the three months ended September 30, 2006, relates to a $0.1
      million write-off of goodwill recorded in connection with our Jamaican joint
      venture. This write-off resulted from changes in our business plans for that
      entity including the future sale of switching equipment and a future lease
      assignment.





***Selling,
      General and Administrative*** *.* Selling,
      general and administrative expenses increased $0.8 million or 31.2% to $3.6
      million during the three months ended September 30, 2006, from $2.8 million
      during the three months ended September 30, 2005. This increase is primarily
      attributed to increased salaries and benefits of approximately $0.4 million,
      as
      more personnel have been required to support our growth and our retail VoIP
      infrastructure. In addition, contributing to the 2006 increase is approximately
      $0.1 million of employee compensation expense recorded in connection with our
      adoption of SFAS 123(R) on January 1, 2006. Also increasing as a result of
      our
      growth, our VoIP retail services infrastructure, and our becoming a public
      company in February 2005, have been our legal and professional fees, which
      increased by approximately $0.1 million and equipment operating/maintenance
      expenses which increased by approximately $0.1 million. We believe that as
      we
      execute our business strategies and complete our VoIP retail rollout, selling,
      general and administrative expenses as a percentage of revenues will begin
      to
      decline.





***Marketing
      and Advertising*** .
      Marketing and advertising expenses increased $0.7 million during the three
      months ended September 30, 2006, from $33,000 during the three months ended
      September 30, 2005. This increase is a result of our more aggressive marketing
      plan for our retail VoIP services.





***Operating
      Loss*** *.* Our
      operating loss increased $1.5 million or 62.2% to a loss of $3.8 million during
      the three months ended September 30, 2006, from a loss of $2.3 million during
      the three months ended September 30, 2005. The increase in operating loss was
      primarily attributable to the increase in our gross profit of $0.2 million
      net
      with the $0.9 million increase in our selling, general and administrative
      expenses due to Company growth, the implementation of SFAS 123 on January 1,
      2006 (which resulted in non-cash employee compensation expense of approximately
      $0.1 million), and public company compliance requirements and $0.7 million
      of
      advertising/marketing expenses associated with our retail VoIP
      infrastructure.





***Other
      Income (Expense)*** *.* Total
      other income (expense) remained fairly consistent increasing by $36,000 to
      other
      income of $63,000 during the three months ended September 30, 2006 from other
      income of $28,000 during the three months ended September 30, 2005. Contributing
      to this increase in other income is a reduction in the loss from our investment
      in Estel of approximately $0.1 million.





***Net
      Loss*** *.* The
      primary factors causing our increased net loss of $1.6 million, is the $0.9
      million increase in selling, general and administrative expenses, and $0.7
      million increase in advertising and marketing expenses.





**Nine
      Months Ended September 30, 2006, Compared with Nine Months Ended September
      30,
      2005.**





***Revenues***





Consolidated
      revenues were $31.8 million during the nine months ended September 30, 2006,
      compared to $40.3 million during the nine months ended September 30, 2005,
      a
      decrease of $8.5 million or 21.1%. This decrease can be attributed to the fact
      that the three months ended June 30, 2005 represented an unusually large peak
      period for the voice to carrier segment (included a one time revenue opportunity
      of approximately $9 million). Although our consolidated revenues for the nine
      months ended September 30, 2006 declined from the nine months ended September
      30, 2005, they have been increasing quarter over quarter since the fourth
      quarter of 2005. This quarter over quarter increase in revenue was primarily
      from our voice services sold to carriers segment.





The
      decrease in voice services sold to carriers represented the majority of the
      consolidated revenue reduction. Voice services sold to carriers decreased $7.0
      million or 19.4%, to $28.8 million during the nine months ended September 30,
      2006 from $35.8 million during the nine months ended September 30, 2005. As
      previously indicated, there was an unusually large peak period in the second
      quarter of 2005, but carrier revenues have continued to increase during the
      past
      four quarters.





Revenues
      for VoIP services to consumers and corporations represented $1.2 million of
      the
      consolidated revenue reduction, decreasing to $1.8 million during the nine
      months ended September 30, 2006, from $3.0 million during the nine months ended
      September 30, 2005. As we had been focusing on our new suite of retail VoIP
      services, we had scaled back some existing customers and made a strategic
      decision to service a broader spectrum of customers once our new products are
      deployed. Since our launch in June, the majority of our efforts centered on
      enhancing our free Efonica service offerings. Now, we are focused on introducing
      additional premium services in the near term and driving revenue growth through
      upselling existing customers and marketing our services through our growing
      number of retail distribution partners worldwide.





Revenues
      from our Internet, private network & other services decreased $0.3 million
      or 22.5% to $1.2 million during the nine months ended September 30, 2006, from
      $1.5 million during the nine months ended September 30, 2005 due to the loss
      of
      two customers.





***Cost
      of Revenues***





Consolidated
      cost of revenues decreased $8.4 million or 22.6% to $28.6 million during the
      nine months ended September 30, 2006 from $37.0 million during the nine months
      ended September 30, 2005. The decrease in consolidated cost of revenues is
      primarily a result of the volume decrease in voice to carrier revenues, which
      decreased $7.3 million or 21.5% to $26.6 million during the nine months ended
      September 30, 2006, from $33.9 million during the nine months ended September
      30, 2005.




22





The
      cost
      of revenues for voice services to carriers decreased $7.3 million or 21.5%
      to
      $26.6 million during the nine months ended September 30, 2006 from $33.9 million
      during the nine months ended September 30, 2005. This decrease is a result
      of
      the decrease in revenues for our voice services to carriers.





The
      cost
      of revenues for VoIP services to consumers and corporations decreased $0.7
      million or 33.3%, to $1.5 million during the nine months ended September 30,
      2006 from $2.2 million during the nine months ended September 30, 2005, due
      to
      the reduction in volume mentioned above. The cost of revenues for VoIP services
      in 2006 also included $0.1 million in promotional expense during the third
      quarter related to our new VoIP retail services. This promotional expense
      resulted from our giving new customers a test account to try one of our premium
      service offerings for free.





Cost
      of
      revenues for Internet, private network & other decreased 39.3% to $0.5
      million during the nine months ended September 30, 2006 from $0.9 million during
      the nine months ended September 30, 2005, due to the loss of two customers
      and
      other revenue reductions.





Consolidated
      gross margin decreased $0.1 million or 4.8% to $3.2 million during the nine
      months ended September 30, 2006 from $3.3 million during the nine months ended
      September 30, 2005. Gross margin for voice services to carriers increased by
      $0.3 million offset by a decline in gross margin for VoIP services to consumers
      and corporation of $0.5 million. Contributing to the decline in gross margin
      for
      VoIP services to consumers and corporations was the $0.1 million of promotional
      expense previously discussed.





The
      consolidated gross margin percentage increased to 10.0% during the nine months
      ended September 30, 2006 from 8.3% during the nine months ended September 30,
      2005. This increase relates primarily to the voice services to carriers segment
      due to improved routing management.





***Operating
      Expenses***





***Depreciation
      and Amortization*** .
      Depreciation and amortization decreased by $0.3 million or 29.6% to $0.9 million
      during the nine months ended September 30, 2006, from $1.2 million during the
      nine months ended September 30, 2005. Our depreciation expense decreased
      primarily as a result of many our assets being fully depreciated during 2006,
      which incurred depreciation expense during all or a portion of the first nine
      months of 2005. This decrease is not with an increase in depreciation expense
      due to amortization of fixed assets associated with our retail VoIP
      infrastructure and our relocated New York headquarters.





***Loss
      on Impairment.*** Loss on
      impairment during the nine months ended September 30, 2006, relates to a $0.1
      million write-off of goodwill recorded in connection with our Jamaican joint
      venture. This write-off resulted from changes in our business plans for that
      entity including the future sale of switching equipment and a future lease
      assignment.





***Selling,
      General and Administrative*** *.* Selling,
      general and administrative expenses increased $2.8 million or 34.4% to $11.2
      million during the nine months ended September 30, 2006, from $8.4 million
      during the nine months ended September 30, 2005. This increase is primarily
      attributed to increased salaries and benefits of approximately $1.4 million,
      as
      more personnel have been required to support our growth and our retail VoIP
      infrastructure. In addition, contributing to the 2006 increase is approximately
      $0.5 million of employee compensation expense recorded in connection with our
      adoption of SFAS123(R) on January 1, 2006. Our legal and professional fees
      increased by approximately $0.3 million. This increase along with increases
      in
      costs associated with travel, occupancy and our software/equipment are a result
      of our growth, public company requirements and our VoIP retail service
      infrastructure. We believe that as we execute our business strategies and
      complete our VoIP retail rollout, selling, general and administrative expenses
      as a percentage of revenues will begin to decline.





***Marketing
      and Advertising*** .
      Marketing and advertising expenses increased $0.9 million or 575.3% to $1.0
      million during the nine months ended September 30, 2006, from $0.1 million
      during the nine months ended September 30, 2005. This increase is a result
      of
      our more aggressive marketing plan for our retail VoIP services.





***Operating
      Loss*** *.* Our
      operating loss increased $3.7 million or 57.3% to a loss of $10.1 million during
      the nine months ended September 30, 2006, from a loss of $6.4 million during
      the
      nine months ended September 30, 2005. The increase in operating loss was
      primarily attributable to the increase of $2.9 million in our selling, general
      and administrative expenses due to company growth, the implementation of SFAS
      123 on January 1, 2006, (resulted in additional non-cash employee compensation
      expense during 2006 of approximately $0.5 million), and public company
      compliance requirements and $0.9 million in and advertising/marketing expenses
      associated with our retail VoIP infrastructure.





***Other
      Income (Expense)*** *.* Total
      other income (expense) changed to other income of approximately $0.7 million
      during the nine months ended September 30, 2006 from other expense of $0.4
      million during the nine months ended September 30, 2005.





Interest
      income remained fairly consistent at $0.3 million during the nine months ended
      September 30, 2006 and 2005. Interest expense decreased $0.3 million or 77.4%
      to
      $0.1 million during the nine months ended September 30, 2006 from $0.4 million
      during the nine months ended September 30, 2005. The $0.4 million of interest
      expense during the nine months ended September 30, 2005, consisted primarily
      of
      accretion on the Series C Preferred Stock which was converted to common stock
      in
      connection with our February 2005 IPO, at which point the accretion ceased.
      In
      addition, during 2005, interest expense included interest for debt outstanding
      between January 1, 2005 and February 17, 2005, at which point we used our IPO
      proceeds to repay a significant portion of our interest-bearing debt. Interest
      expense during the nine months ended September 30, 2006 and 2005 includes
      primarily interest on our capital lease/equipment financing leases.




23





Gain
      on
      settlements of debt increased to $0.5 million during the nine months ended
      September 30, 2006 from approximately $0.1 during the nine months ended
      September 30, 2005. The 2006 gain on settlement relates to a debt settlement
      agreement we entered into during 2003 with a domestic carrier. The provisions
      of
      the agreement provided that $555,000 due to the carrier would be resolved with
      a
      service agreement whereby the carrier received a reduced rate for certain
      minutes of traffic that passed through our network through December 2005. Both
      parties continued to comply with the terms of the agreement past December 2005.
      During June 2006, the service agreement was cancelled and the carrier released
      us of all remaining indebtedness under the settlement agreement. Consequently,
      we recorded the remaining deferred revenue balance of approximately $466,000
      as
      a gain on settlement of debt.





The
      loss
      from investment in Estel decreased $0.4 million to $0.1 million during the
      nine
      months ended September 30, 2006, from $0.5 million during the nine months ended
      September 30, 2005. This reduction is primarily due to a reduction in the Estel
      allowance for doubtful accounts.





***Net
      Loss*** *.* The
      primary factors impacting our net loss of $9.7 million for the nine months
      ended
      September 30, 2006, were the decrease in depreciation and amortization expense,
      increase in selling, general and administrative and marketing/advertising
      expenses, gain on debt settlement during 2006, and the decrease in the net
      loss
      from our investment in Estel during the nine months ended September 30, 2006.





**Liquidity
      and Capital Resources**





Since
      our
      inception, we have incurred significant operating and net losses. In addition,
      we are not generating positive cash flows from operations. As of September
      30,
      2006, we had stockholders’ equity of approximately $13.1 million and a working
      capital deficit of approximately $4.7 million. Our positive stockholders’ equity
      is a result of the February 2005 closing of our initial public offering. Our
      IPO
      included 3,600,000 shares of common stock at a price of $6.45 per share and
      3,600,000 redeemable common stock purchase warrants at $0.05 per warrant. Gross
      proceeds of the offering were approximately $23,400,000. Total estimated
      offering costs were approximately $3.0 million, which resulted in net proceeds
      of approximately $20.4 million. On March 30, 2005, our underwriters exercised
      their over-allotment option and purchased an additional 480,000 shares of common
      stock and 540,000 purchase warrants. We received an additional approximately
      $2.9 million in net proceeds from the closing on the over-allotment option.
      The
      net proceeds from the offering were immediately used to repay a significant
      portion of our debt that was outstanding. The proceeds have been and will
      continue to be used for working capital and general corporate purposes; to
      fund
      the purchase of equipment for expanded capacity, international deployment,
      expanded service offerings and consumer hardware; the payment of debt, capital
      leases and related interest; international expansion; and marketing and
      advertising.





We
      are
      currently reviewing options to raise additional capital through debt and/or
      equity financing. While management believes that our current cash resources
      should be adequate to fund our operations through the end of the year, our
      long-term liquidity is dependent on our ability to successfully complete the
      rollout of our full suite of retail VoIP paid services and effectively market
      our paid services, in order to attain future profitable operations. We cannot
      make any guarantees if and when we will be able to attain future profitability.
      These factors, among others, indicate that we may be unable to continue
      operations as a going concern.





Below
      is
      a summary of our cash flows for the periods indicated. These cash flow results
      are consistent with prior years in that we continue to use significant cash
      in
      connection with our operating and investing activities. In addition, during
      2006, we used cash in financing activities, in contrast to having cash being
      provided by financing activities, which has been the case in previous years.





A
      summary
      of our cash flows for the periods indicated is as follows:




**Nine
                months ended September 30,****2006**
            
            **2005**Cash
                used in operating activities
            
            $
            (8,377,892
            )
            $
            (5,903,359
            )Cash
                used in investing activities
            
            
            (3,365,544
            )
            
            (2,006,864
            )Cash
                provided by (used in) financing activities
            
            
            (676,591
            )
            
            21,050,626Increase
                (decrease) in cash and cash equivalents
            
            
            (12,380,027
            )
            
            13,140,403Cash
                and cash equivalents, beginning of period
            
            
            14,790,504
            
            
            4,368,726Cash
                and cash equivalents, end of period
            
            $
            2,410,477
            
            $
            17,509,129





Our
      cash
      flow results were and continue to be impacted by the costs associated with
      implementing our corporate strategy focusing our resources on VoIP and the
      emerging international markets, as we completed our exit from the more highly
      competitive, infrastructure dependent business that previously characterized
      our
      business. On June 19, 2006, we launched our new free Internet service which
      allows Efonica® subscribers worldwide to make free calls without computers. We
      have and plan to continue to develop and launch a wide variety of paid services
      such as voicemail and out of network calling. We will sell these paid services
      to existing free subscribers and through online and physical distribution
      channels. Because certain of our costs are fixed and because the VoIP to
      consumers and corporations segment of our business has a higher profit margin,
      we expect that as our revenues increase (especially in the VoIP to consumers
      and
      corporations segment), total expenses would represent a smaller percentage
      of
      our revenues.




24




**Source
      of Liquidity**





As
      of
      September 30, 2006, we had cash and cash equivalents of approximately $2.4
      million. In addition, as of September 30, 2006, we had approximately $0.8
      million of cash restricted from withdrawal and held by banks as certificates
      of
      deposits securing letters of credit (equal to the amount of the certificates
      of
      deposit). We are in the process of requesting authorization to cancel the Letter
      of Credit for 250,000 Euros (approximately $0.3 million) related to our Turkey
      Joint Venture, which is in the process of being liquidated.





From
      our
      inception through September 30, 2006, we financed our operations from cash
      provided from financing activities. These activities were primarily through
      net
      proceeds of approximately $23.3 million from our February 2005 IPO, including
      exercise of the over-allotment option, the private placement of approximately
      $50.7 million of equity securities, $1.6 million from the exercise of stock
      options and warrants, and $23.1 million from the issuance of notes. In addition,
      since inception we have financed the acquisition of $9.8 million of fixed assets
      through capital lease/equipment financing obligations.





As
      noted
      above, we are currently reviewing options to raise additional capital through
      debt and/or equity financing. We can make no assurances that we will be able
      to
      obtain such financing nor that such financing will be obtained on reasonable
      terms.





**Uses
      of Liquidity**





Our
      short-term and long-term liquidity needs arise primarily from principal and
      interest payments related to our capital lease/equipment financing obligations,
      capital expenditures, working capital requirements as may be needed to support
      the growth of our business, and any additional funds that may be required for
      business expansion opportunities.





Our
      cash
      capital expenditures were approximately $2.9 million and $1.5 million during
      the
      nine months ended September 30, 2006 and 2005, respectively. The spending during
      2006 relates primarily to our retail VoIP infrastructure as well as our
      relocated New York office. We expect our cash capital expenditures to be
      approximately $0.9 million during the fourth quarter of 2006. The 2006 estimated
      capital expenditures include network expansion, purchase of additional software
      for expanded product offerings and new international deployments.





Cash
      used
      in operations was approximately $8.3 million during the nine months ended
      September 30, 2006 and $5.9 million during the nine months ended September
      30,
      2005. The cash used in our operations is primarily a function of our net losses
      and changes in working capital as a result of the timing of receipts and
      disbursements. Cash used in operations has been and will continue to be impacted
      by the amount we have spent year to date and the over $0.5 million we plan
      to
      spend for advertising and marketing during the remainder of 2006. Now that
      we
      have paid and settled a significant amount of our older liabilities and our
      retail infrastructure has become operational and will have expanded paid service
      features in the future, we expect our net cash used in operating activities
      to
      improve in future periods. We intend to continue to use the remaining capital
      raised from the IPO for general corporate overhead purposes, including salaries,
      marketing, capital expenditures, international expansion, capital
      lease/equipment financing obligation payments, and other expenses associated
      with business needs.





In
      some
      situations, we may be required to guarantee payment or performance under
      agreements, and in these circumstances we would need to secure letters of credit
      or bonds to do so. In connection with the relocation of our New York office,
      the
      lease amendment required us to provide a Letter of Credit in favor of the
      landlord in the amount of approximately $428,000. The Letter of Credit was
      obtained in January 2006, and is secured by $239,000 in money market funds.
      We
      also received a line of credit for $189,000 that would be drawn down upon should
      we default on lease terms. Subsequent to June 30, 2006, in connection with
      our
      75% owned subsidiary in Turkey, we provided a Letter of Credit for 250,000
      Euros
      (approximately $0.3 million) to the Telekomunikasyon Kurumu Telecommunication
      Administrator. This Letter of Credit is to secure a license for us to do
      business as a long distance telecommunication services company in Turkey. The
      guarantee is effective until January 1, 2007. As mentioned earlier, we are
      in
      the process of requesting authorization to cancel this letter of
      credit.





**Debt
      Service Requirements**





As
      of
      September 30, 2006, we had approximately $1.1 million of debt comprised
      primarily of approximately $1.0 million in capital lease/equipment financing
      obligations. Other than approximately $39,000, all of this debt is due during
      the 12 months ending September 30, 2006. Subsequent to our IPO, at which point
      we repaid a significant portion of our then outstanding debt, we have not
      incurred any additional debt other than some new capital lease/equipment
      financing obligations.





Our
      interest expense has decreased significantly during the nine months ended
      September 30, 2006 compared to the nine months ended September 30, 2005 due
      to
      the following factors:





1.
            
            During
                the nine months ended September 30, 2005, we recorded $0.3 million
                of
                accretion to interest expense related to our Series C Preferred Stock.
                This Series C Preferred Stock was converted to common stock during
                February 2005 and consequently, accretion ceased on this date.2.
            
            As
                discussed above, subsequent to the IPO, the reduction in our debt
                balances
                during February 2005, resulted in a significant reduction in our
                subsequent interest expense.




25


**Capital
      Instruments**





At
      September 30, 2006, we had outstanding shares of one class of our Common Stock
      and we did not have any outstanding preferred stock.





**Critical
      Accounting Policies and Estimates**





We
      have
      identified the policies and significant estimation processes below as critical
      to our business operations and the understanding of our results of operations.
      The listing is not intended to be a comprehensive list. In many cases, the
      accounting treatment of a particular transaction is specifically dictated by
      accounting principles generally accepted in the United States, with no need
      for
      management’s judgment in their application. In other cases, management is
      required to exercise judgment in the application of accounting principles with
      respect to particular transactions. The impact and any associated risks related
      to these policies on our business operations is discussed throughout
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” where such policies affect reported and expected financial results.
      For a detailed discussion on the application of these and other accounting
      policies, see Note 2 in the Notes to Consolidated Financial Statements for
      the
      year ended December 31, 2005, included in our Annual Report on Form 10-K.
      Our preparation of our consolidated financial statements requires us to make
      estimates and assumptions that affect the reported amount of assets and
      liabilities, disclosure of contingent assets and liabilities at the date of
      our
      consolidated financial statements, and the reported amounts of revenue and
      expenses during the reporting periods. Management bases its estimates on
      historical experience and on various other assumptions that are believed to
      be
      reasonable under the circumstances. There can be no assurance that actual
      results will not differ from those estimates and such differences could be
      significant.





***Revenue
      Recognition*** - Our
      revenue is primarily derived from fees charged to terminate voice services
      over
      our network, retail sales to consumers and corporations through our Efonica
      brand, and from monthly recurring charges associated with Internet and private
      line services.





Variable
      revenue is earned based on the number of minutes during a call and is recognized
      upon completion of a call, adjusted for allowance for doubtful accounts
      receivable and billing adjustments. Revenue for each customer is calculated
      from
      information received through our network switches. Customized software has
      been
      designed to track the information from the switch and analyze the call detail
      records against stored detailed information about revenue rates. This software
      provides us the ability to do a timely and accurate analysis of revenue earned
      in a period. Consequently, the recorded amounts are generally accurate and
      the
      recorded amounts are unlikely to be revised in the future.





Fixed
      revenue is earned from monthly recurring services provided to the customer
      that
      are fixed and recurring in nature, and are contracted for over a specified
      period of time. The initial start of revenue recognition is after the
      provisioning, testing and acceptance of the service by the customer. The charges
      continue to bill until the expiration of the contract, or until cancellation
      of
      the service by the customer.





Additionally,
      the majority of our VoIP services to consumers and corporations are prepaid.
      The
      revenue received from the prepayments that is related to VoIP termination
      services in the current month is booked to the current month’s revenue, and the
      remainder of the prepayments is booked to deferred revenue, until usage
      occurs.





***Accounts
      Receivable*** -
      Accounts receivable are recorded net of an allowance for doubtful accounts.
      On a
      periodic basis, we evaluate our accounts receivable and record an allowance
      for
      doubtful accounts, based on our history of past write-offs and collections
      and
      current credit conditions. Specific customer accounts are written off as
      uncollectible if the probability of a future loss has been established and
      payments are not expected to be received.





***Cost
      of Revenues and Cost of Revenues Accrual*** - Cost
      of revenues is comprised primarily of costs incurred from other domestic and
      international communications carriers to originate, transport and terminate
      calls. The majority of our cost of revenue is variable, based upon the number
      of
      minutes of use, with transmission and termination costs being the most
      significant expense. Call activity is tracked and analyzed with customized
      software that analyzes the traffic flowing through our network switches. Each
      period the activity is analyzed and an accrual is recorded for minutes not
      invoiced. This cost accrual is calculated using minutes from the system and
      the
      variable cost of revenue based upon predetermined contractual
      rates.





In
      addition to the variable cost of revenue, there are also fixed expenses. One
      category of fixed expenses is that associated with the network backbone
      connectivity to our switch facilities. These would consist of hubbing charges
      at
      our New York switch facility that allow other carriers to send traffic to our
      switch, satellite or cable charges to connect to our international network,
      or
      Internet connectivity charges to connect customers or vendors to Fusion’s switch
      via the public Internet, a portion of which are variable costs. The other
      category of fixed expenses is associated with charges that are dedicated
      point-to-point connections to specific customers (both private line and Internet
      access).





***Intangible
      Assets and Goodwill Impairment Testing*** - Absent
      any circumstances that warrant testing at another time, we test for goodwill
      and
      non-amortizing intangible asset impairment as part of our year-end closing
      process. Impairment losses are recorded when indicators of impairment are
      present based primarily upon estimated future cash flows.





***Income
      Taxes*** - We
      account for income taxes in accordance with the provisions of SFAS No. 109,
      “Accounting for Income Taxes” (“SFAS 109”). SFAS 109 requires companies to
      recognize deferred tax liabilities and assets for the expected future income
      tax
      consequences of events that have been recognized in our consolidated financial
      statements. Deferred tax liabilities and assets are determined based on the
      temporary differences between the consolidated financial statements carrying
      amounts and the tax bases of assets and liabilities, using enacted tax rates
      in
      the years in which the temporary differences are expected to reverse. In
      assessing the likelihood of utilization of existing deferred tax assets and
      recording a full valuation allowance, we have considered historical results
      of
      operations and the current operating environment.




26





**Recently
      Issued Accounting Pronouncements**





In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
      Financial Instruments - an amendment of FASB Statements No. 133 and 140,” which
      simplifies accounting for certain hybrid financial instruments by permitting
      fair value re-measurement for any hybrid instrument that contains an embedded
      derivative that otherwise would require bifurcation and eliminates a restriction
      on the passive derivative instruments that a qualifying special-purpose entity
      may hold. SFAS No. 155 is effective for all financial instruments acquired,
      issued or subject to a re-measurement (new basis) event occurring after the
      beginning of an entity’s first fiscal year that begins after September 15, 2006.
      The adoption of SFAS No. 155 is not expected to have an impact on our results
      of
      operations or financial position.





In
      March
      2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial
      Assets - an amendment of FASB Statement No. 140,” which establishes, among other
      things, the accounting for all separately recognized servicing assets and
      servicing liabilities by requiring that all separately recognized servicing
      assets and servicing liabilities be initially measured at fair value, if
      practicable. SFAS No. 156 is effective as of the beginning of an entity’s first
      fiscal year that begins after September 15, 2006. The adoption of SFAS No.
      156
      is not expected to have an impact on our results of operations or financial
      position.





In
      June
      2006, the FASB issued Financial Interpretation 48, “Accounting for Uncertainty
      in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN No. 48”).
      FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized
      in the financial statements in accordance with SFAS No. 109, “Accounting for
      Income Taxes.” The interpretation is effective for fiscal years beginning after
      December 15, 2006. We do not expect the adoption of this FIN will have a
      material impact on our financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 clarifies the
      SEC staff’s beliefs regarding the process of quantifying financial statement
      misstatements and is effective for fiscal years ending after November 15, 2006.
      We do not expect SAB No. 108 to have a material impact on our financial
      statements.





In
      September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements”, which
      establishes a framework for measuring fair value and requires expended
      disclosure about the information used to measure fair value. The statement
      applies whenever other statements require, or permit, assets or liabilities
      to
      be used to measure fair value. The statement does not expand the use of fair
      value in any new circumstances and is effective for fiscal years beginning
      after
      November 15, 2007, and interim periods within those fiscal years, with early
      adoption encouraged. We do not expect the adoption of this statement to have
      a
      material impact on our financial condition or results of
      operations.





**Inflation**





We
      do not
      believe inflation has a significant effect on our operations at this
      time.





**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**





We
      are
      exposed to certain market risks that are inherent in our financial instruments.
      These instruments arise from transactions in the normal course of
      business.





At
      September 30, 2006, the majority of our cash balances were held primarily in
      the
      form of short-term highly liquid investment grade money market funds held in
      major financial institutions. Due to the short-term nature of our investments,
      we believe that we are not subject to any material interest or market rate
      risks.





At
      September 30, 2006, all of our outstanding debt has fixed interest rates. As
      such, we are not subject to interest rate risk on any of our debt. Consequently,
      we currently believe that our interest rate risk is very low.





We
      currently do not conduct any significant amount of business in currencies other
      than the United States Dollar. The reporting and functional currency for our
      Dubai international subsidiary is the United States dollar. Our Jamaican and
      Turkey subsidiaries currently do not have any significant operations that would
      provide foreign currency risk. However, in the future, we likely will conduct
      a
      larger percentage of our business in foreign currencies that could have an
      adverse impact on our future results of operations.




**ITEM
      4. CONTROLS AND PROCEDURES**





(a)  ***Evaluation
      of Disclosure Controls and Procedures*** .
      As of
      the end of the period covered by this report, our management, under the
      supervision and with the participation of our Chief Executive Officer and Chief
      Financial Officer, evaluated the effectiveness of the design and operation
      of
      our disclosure controls and procedures pursuant to Rule 13a-15(e) of the
      Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on that
      evaluation, the Chief Executive Officer and the Chief Financial Officer
      concluded that our disclosure controls and procedures as of the end of the
      period covered by this report have been designed and are functioning effectively
      to provide reasonable assurance that the information we (including our
      consolidated subsidiaries) are required to disclose in reports filed under
      the
      Exchange Act is recorded, processed, summarized and reported within the time
      periods specified in the Securities and Exchange Commission’s rules and
      forms.




27




(b)  ***Changes
      in Internal Controls*** .
      There
      were no changes in our internal control over financial reporting, that occurred
      during the quarter ended September 30, 2006, that has materially affected,
      or is
      reasonably likely to materially affect, our internal control over financial
      reporting.





(c)  ***Limitations*** .
      A
      control system, no matter how well designed and operated, can provide only
      reasonable, not absolute, assurances that the control system’s objectives will
      be met. Further, the design of a control system must reflect the fact that
      there
      are resource constraints, and the benefits of controls must be considered
      relative to their costs. Because of the inherent limitations in all control
      systems, no evaluation of controls can provide absolute assurance that all
      control issues and instances of fraud, if any, within the Company have been
      detected. These inherent limitations include the realities that judgments in
      decision-making can be faulty, and that breakdowns can occur because of simple
      errors or mistakes. Controls can also be circumvented by the individual acts
      of
      some persons, by collusion of two or more people, or by management override
      of
      the controls. The design of any system of controls is based in part upon certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions. Over time, controls may become inadequate because of changes
      in conditions or deterioration in the degree of compliance with its policies
      or
      procedures. Because of the inherent limitations in a cost-effective control
      system, misstatements due to error or fraud may occur and not be detected.
      We
      periodically evaluate our internal controls and make changes to improve
      them.




28


**Fusion
      Telecommunications International, Inc. and Subsidiaries**





**Part
      II: Other Information**





**Item
      1. Legal Proceedings**





On
      May 28, 2003, Jack Grynberg, et al., an investor in one of the Company’s
      private offerings, filed a complaint with the Denver District Court, State
      of
      Colorado ( *Jack
      Grynberg, et al v. Fusion Telecommunications International, Inc., et
      al* ,
      03-CV-3912) seeking damages in the amount of $400,000 for the purchase of an
      interest in Fusion’s 1999 private placement offering of subordinated convertible
      notes through Joseph Stevens & Company, Inc., a registered broker dealer.
      This complaint asserted the following claims for relief against us: Breach
      of
      Fiduciary Duty, Civil Theft, Deceptive Trade Practices, Negligent
      Misrepresentation, Deceit Based on Fraud, Conversion, Exemplary Damages and
      Prejudgment Interest. On June 25, 2004, the Company filed with the Court a
      Motion to Dismiss, which was granted. The Company was awarded attorneys’ fees by
      the court. The plaintiffs have filed an appeal of the motion, which is still
      pending as of the date of this filing.




On
      March
      30, 2006, an equipment vendor filed a complaint with the Circuit Court in
      Broward County, State of Florida seeking damages in the amount of $1,379,502
      allegedly due on two promissory notes plus accrued interest through March 1,
      2006 and attorney costs. We asserted a counterclaim against the vendor and
      an
      affiliated company and are vigorously prosecuting the counterclaim. Our legal
      counsel has advised that, at this stage, they cannot accurately predict the
      likelihood of an unfavorable outcome or quantify the amount or range of
      potential loss, if any. Accordingly, with the exception of amounts previously
      accrued by us under the capital lease arrangement, no adjustment that may result
      from resolution of these uncertainties has been made in the accompanying
      financial statements.




Due
      to
      the regulatory nature of the industry, the Company is periodically involved
      in
      various correspondence and inquiries from state and federal regulatory agencies.
      Management does not expect the outcome of these inquiries to have a material
      impact on the Company’s operations or financial condition.





**Item
      1A. Risk Factors**





**FORWARD-LOOKING
      STATEMENTS**




Certain
      statements contained herein may constitute forward-looking statements within
      the
      meaning of the Private Securities Litigation Reform Act of 1995. Because such
      statements include risks and uncertainties, actual results may differ materially
      from those expressed or implied by such forward-looking statements. Factors
      that
      could cause actual results to differ materially include, but are not limited
      to,
      risks associated with the integration of businesses following an acquisition,
      concentration of revenue from one source, competitors with broader product
      lines
      and greater resources, emergence into new markets, the termination of any of
      our
      significant contracts or partnerships, our inability to maintain working capital
      requirements to fund future operations or our inability to attract and retain
      highly qualified management, technical and sales personnel . **** All
      forward-looking statements included in this document are made as of the date
      hereof, based on information available to us as of the date thereof, and we
      assume no obligation to update any forward-looking statements.





Factors
      and risks, including certain of those described in greater detail herein, that
      could cause actual results or circumstances to differ materially from those
      set
      forth or contemplated in forward-looking statements include, without
      limitation:




·
            We
                have a history of operating and net losses. There can be no assurance
                that
                we will ever achieve profitability or have sufficient funds to execute
                our
                business strategies.·
            We
                have recently launched a new retail VoIP service that has experienced
                significant growth in subscribers. There can be no assurances that
                our
                infrastructure can effectively support our growing subscriber
                base.·
            Part
                of our business plan is to market our paid features to our free
                subscribers and sell paid packages through physical and online
                distribution partners. There can be no assurance that we will be
                able to
                successfully sell our paid suite of services and that our revenues
                will be
                significantly increased.·
            The
                success of our planned expansion is dependent upon market developments
                and
                traffic patterns, which may lead us to make expenditures that may
                not
                result in increased revenues.·
            We
                experienced certain technical difficulties during the recent launch
                of the
                Beta version of our retail services. Although these difficulties
                have been
                addressed, there can be no assurance as to what future technical
                difficulties we might encounter, including possible service outages,
                which
                could result in a loss of revenue and harm our
                reputation.·
            We
                may be unable to adapt to rapid technology trends and evolving industry
                standards, which could lead to our products becoming
                obsolete.·
            We
                are pursuing new lines of business, and introducing new services.
                In some
                cases, the technology for these services and/or the market for those
                services are untested. Thus, there can be no assurance of our ability
                to
                introduce these services on a timely basis or our ability to derive
                significant revenues from them.·
            Our
                new services are dependent upon multiple, complex service platforms,
                network elements, and back-office systems, as well as the successful
                integration of these items. There can be no assurance of the success
                of
                this development and integration.
                In addition**,**although
                we believe we can fully support these complex systems, if we have
                too many
                subscribers, there is a possibility we can have trouble effectively
                supporting them.




·
            There
                can be no assurance that the planned migration of existing VoIP service
                customers onto our new infrastructure will be successful.




29




·
            If
                our information and processing systems for billing and client service
                are
                not properly implemented, it could have a negative affect on our
                ability
                to collect revenues.·
            Some
                of our new services depend on proprietary technology. There can be
                no
                assurance that others will not develop similar or competing technology,
                or
                that we will be successful in protecting our intellectual property
                rights.·
            If
                we do not utilize our Softswitch technology effectively, many of
                the
                potential benefits of this technology may not be
                realized.·
            Breaches
                in our network security systems may hurt our ability to deliver services
                and our reputation, and result in liability and lost
                sales.·
            Our
                entry into new markets will rely upon our ability to obtain licenses
                to
                operate in those countries, and our ability to establish good working
                relationships with postal telephone and telegraph companies in order
                to
                interconnect to the telephone networks. There can be no assurance
                of our
                ability to accomplish either.·
            The
                communications services industry is highly competitive and many of
                our
                competitors have more resources available to them, accordingly we
                may be
                unable to compete effectively.·
            Industry
                consolidation could make it more difficult for us to
                compete.·
            Our
                ability to provide services is often dependent on our suppliers and
                other
                service providers who may not prove to be effective.·
            We
                rely on the cooperation of postal telephone and telegraph companies
                who
                may hinder our operations in certain markets.·
            We
                are dependent on third-party equipment providers who may not be able
                to
                provide us the equipment necessary to deliver the services that we
                seek to
                provide.·
            If
                we are unable to develop and maintain successful relationships with
                our
                joint venture partners, it could hinder our operations in an important
                market.·
            The
                success of our business depends on the acceptance of the Internet
                in
                emerging markets that may be slowed by limited bandwidth, high bandwidth
                costs, and other technical obstacles.·
            Additional
                taxation and the regulation of the communications industry may slow
                our
                growth, resulting in decreased demand for our products and services
                and
                increased costs of doing business.·
            In
                addition to new regulations being adopted, existing laws may be applied
                to
                the Internet, which could hamper our growth.·
            Because
                we do business on an international level we are subject to an increased
                risk of tariffs, sanctions and other uncertainties that may hurt
                our
                revenues. It is possible that changes in the regulatory environment
                in
                countries where we do business can adversely affect us, including
                the
                potential for blockage of our
                services.





**Item
      2. Unregistered Sales of Securities and Use of Proceeds**





(a)  Unregistered
      Sales of Securities





None.





(b)  Use
      of
      Proceeds





The
      Company’s Registration Statement filed with the Securities and Exchange
      Commission (333-120412) on Form S-1 to register 3,600,000 shares of common
      stock
      and 3,600,000 redeemable common stock purchase warrants convertible into shares
      of common stock was declared effective on February 8, 2005. The offering
      commenced on January 18, 2005, and terminated on February 12, 2005. Upon
      completion, the underwriters managed by Kirlin Securities, Inc., successfully
      sold 3,600,000 shares of common stock and 3,600,000 redeemable common stock
      purchase warrants at $6.45 and $0.05, respectively, for an aggregate offering
      price of $6.50. On March 30, 2005, the underwriters exercised their
      over-allotment and purchased an additional 480,000 shares of common stock and
      540,000 purchase warrants. The net proceeds of the offering, including the
      over-allotment, totaled $23,300,000 and is being utilized by the Company for
      the
      purchase of additional equipment for expanded capacity and service offerings,
      international deployment, marketing and advertising and working
      capital.





The
      Registration Statement also registered 3,141,838 redeemable common stock
      purchase warrants to be offered for sale by certain selling security holders.
      The Company will not receive any proceeds from the sales of such
      warrants.





As
      of
      September 30, 2006, approximately $3.2 million of the net proceeds received
      by
      the Company were used to repay outstanding debt and capital lease/equipment
      financing obligations, and $0.6 million was used to repay accrued interest.
      Approximately $4.8 million was used to purchase property and equipment, $0.9
      million was used in connection with the Company’s purchase of the minority
      interest in its Efonica joint venture, $0.1 million for the Company’s investment
      in a Turkey joint venture, and $10.1 million was used to fund
      operations.





Of
      these
      payments, principal and accrued interest in respect of indebtedness to the
      Company was repaid as follows: approximately $1.1 million to Marvin S. Rosen,
      Chairman of the Board, $0.8 million to Philip Turits, Secretary, Treasurer
      and
      Director, $0.2 million to Evelyn Langlieb Greer, Director.




30




Karamco,
      Inc., a corporation of which Roger Karam, our President of VoIP Division, is
      the
      sole shareholder, received $930,000 with respect to the Company’s purchase of
      the minority interest in Efonica.





**Item
      3. Defaults Upon Senior Securities**





None.





**Item
      4. Submission Of Matters to a Vote of Security Holders**





Previously
      reported in the Company’s quarterly report on Form 10-Q for the quarter ended
      June 30, 2006.





**Item
      5. Other Information**





None





**Item
      6. Exhibits**





**Exhibit
                No.**
            
            **Description**31.1
            
            Certification
                of the Chief Executive Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.31.2
            
            Certification
                of the Chief Financial Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.32
            
            Certification
                of the Chief Executive Officer and Chief Financial Officer pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to
              Section
                906 of the Sarbanes-Oxley Act of 2002.





31




**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 the undersigned thereunto
      duly authorized.




**FUSION
                TELECOMMUNICATION INTERNATIONAL, INC.**Dated: November 14, 2006
            By:
            /s/
              Matthew D. RosenMatthew
                D. Rosen
              President
                and Chief Executive Officer


Dated: November 14, 2006
              By:
              /s/
                Barbara HughesBarbara
                    Hughes
                  Chief
                    Financial Officer
  32