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UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

FORM 10-QSB



|(Mark   One)                                  
|----------------------------------------------
|x                                             
|For   the quarterly period ended June 30, 2006
|                                              
|o                                             
|                                              
|For   the Transition Period from    to        

Commission file number 000-32925

|AVATAR   SYSTEMS, INC.                                             
|-------------------------------------------------------------------
|(Exact   name of small business issuer as specified in its charter)

|Texas                                                               |  | 75-2796037                               
|------------------------------------------------------------------- |  | -----------------------------------------
|(State   or other jurisdiction of    incorporation or organization) |  | (I.R.S.   Employer    Identification No.)

|2801 Network Boulevard, Suite 210   Frisco, Texas 75034                             
|------------------------------------------------------------------------------------
|(Address   of principal executive offices)                                          
|                                                                                    
|972-720-1800                                                                        
|(Issuers   telephone number)                                                       
|                                                                                    
|N/A                                                                                 
|(Former   name, former address and former fiscal year, if changed since last report)

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

|Yes
x | No
o
|----- | ----

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
|----- | ----

State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date: Common Stock, $.001 par value, 8,838,152 shares outstanding as of August 11, 2006.

Transitional Small Business Disclosure Format (check one):

|Yes
o | No
x
|----- | ----

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|PART I. FINANCIAL   INFORMATION                                       | 1 
|--------------------------------------------------------------------- | --
|                                                                      |   
|Item   1. Financial Statements                                        | 1 
|Item   2. Managements Discussion and Analysis or Plan of Operation   | 5 
|Item   3. Controls and Procedures                                     | 8 
|                                                                      |   
|PART II. OTHER   INFORMATION                                          | 8 
|                                                                      |   
|Item   1. Legal Proceedings                                           | 8 
|Item   2. Unregistered Sales of Equity Securities and Use of Proceeds | 8 
|Item   3. Defaults Upon Senior Securities                             | 8 
|Item   4. Submission of Matters to a Vote of Security Holders         | 9 
|Item   5. Other Information                                           | 9 
|Item   6. Exhibits                                                    | 9 
|Signatures                                                            | 10

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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Avatar Systems, Inc.BALANCE SHEETS

|                                                                                                           |  | June 30,    2006 |           | December   31,   2005 |  
|---------------------------------------------------------------------------------------------------------- |  | ---------------- | --------- | --------------------- | -
|                                                                                                           |  |                  |           |                       |  
|                                                                                                           |  | (unaudited)      |           | (audited)             |  
|ASSETS                                                                                                     |  |                  |           |                       |  
|CURRENT   ASSETS                                                                                           |  |                  |           |                       |  
|Cash   and cash equivalents                                                                                |  | $                | 211,289   |                       | $
|Marketable   securities                                                                                    |  |                  | 730,068   |                       |  
|Accounts   receivable                                                                                      |  |                  | 133,876   |                       |  
|Prepaid   expenses and other current assets                                                                |  |                  | 29,181    |                       |  
|Deferred   income taxes                                                                                    |  |                  | 14,247    |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total current assets                                                                                       |  |                  | 1,118,661 |                       |  
|PROPERTY   AND EQUIPMENT,
net of accumulated depreciation of $367,780 and   $265,343, respectively         |  |                  | 446,894   |                       |  
|PURCHASED   SOFTWARE,
net of accumulated amortization of $860,399 and   $859,136, respectively             |  |                  | 1,263     |                       |  
|SOFTWARE DEVELOPMENT   COSTS,
net of accumulated amortization of $1,568,133 and $1,373,073,   respectively |  |                  | 2,493,254 |                       |  
|OTHER   ASSETS                                                                                             |  |                  | 12,228    |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total assets                                                                                               |  | $                | 4,072,300 |                       | $
|                                                                                                           |  |                  |           |                       |  
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                       |  |                  |           |                       |  
|CURRENT   LIABILITIES                                                                                      |  |                  |           |                       |  
|Accounts   payable                                                                                         |  | $                | 132,335   |                       | $
|Accrued   expenses                                                                                         |  |                  | 111,707   |                       |  
|Current   maturities of long-term debt                                                                     |  |                  | 8,159     |                       |  
|Current   maturities of capital lease obligations                                                          |  |                  | 35,045    |                       |  
|Deferred   revenue                                                                                         |  |                  | 347,806   |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total current liabilities                                                                                  |  |                  | 635,052   |                       |  
|DEFERRED   INCOME TAXES                                                                                    |  |                  | 517,987   |                       |  
|OTHER   LONG-TERM LIABILITIES                                                                              |  |                  | 77,507    |                       |  
|LONG-TERM   DEBT                                                                                           |  |                  |           |                       |  
|Long-term   debt                                                                                           |  |                  | 19,829    |                       |  
|Long-term   capital lease obligations                                                                      |  |                  | 34,791    |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total long-term debt                                                                                       |  |                  | 54,620    |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total liabilities                                                                                          |  |                  | 1,285,166 |                       |  
|COMMITMENTS  AND CONTINGENCIES                                                                             |  |                  |          |                       |  
|STOCKHOLDERS'   EQUITY                                                                                     |  |                  |           |                       |  
|Preferred   stock, $0.001 par value, 10,000,000 shares authorized; none issued                             |  |                  |          |                       |  
|Common   stock, $0.001 par value; 30,000,000 shares authorized;8,838,152 shares issued   and outstanding   |  |                  | 8,838     |                       |  
|Paid-in   capital                                                                                          |  |                  | 1,768,203 |                       |  
|Retained   earnings                                                                                        |  |                  | 995,275   |                       |  
|Accumulated other   comprehensive income                                                                   |  |                  | 14,818    |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total stockholders' equity                                                                                 |  |                  | 2,787,134 |                       |  
|                                                                                                           |  |                  |           |                       |  
|Total liabilities and stockholders' equity                                                                 |  | $                | 4,072,300 |                       | $
|                                                                                                           |  |                  |           |                       |  

See accompanying notes to financial statements.

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Avatar Systems, Inc.STATEMENTS OF INCOME(unaudited)

|                                              |  | Three   months ended   June 30, |           | Six months   ended   June 30, |  
|--------------------------------------------- |  | ------------------------------- | --------- | ----------------------------- | -
|                                              |  |                                 |           |                               |  
|                                              |  | 2006                            |           | 2005                          |  
|                                              |  |                                 |           |                               |  
|Revenue:                                      |  |                                 |           |                               |  
|Software                                      |  | $                               | 306,768   |                               | $
|Maintenance                                   |  |                                 | 374,685   |                               |  
|Professional   services                       |  |                                 | 153,628   |                               |  
|Hardware                                      |  |                                 | 91,207    |                               |  
|                                              |  |                                 |           |                               |  
|Total revenue                                 |  |                                 | 926,288   |                               |  
|Cost of   revenue:                            |  |                                 |           |                               |  
|Software                                      |  |                                 | 124,514   |                               |  
|Maintenance                                   |  |                                 | 69,334    |                               |  
|Professional   services                       |  |                                 | 28,186    |                               |  
|Hardware                                      |  |                                 | 77,654    |                               |  
|                                              |  |                                 |           |                               |  
|Total cost of revenue                         |  |                                 | 299,688   |                               |  
|                                              |  |                                 |           |                               |  
|Gross profit                                  |  |                                 | 626,600   |                               |  
|Operating   expenses:                         |  |                                 |           |                               |  
|Sales   and marketing                         |  |                                 | 63,348    |                               |  
|General   and administrative                  |  |                                 | 161,723   |                               |  
|Amortization                                  |  |                                 | 98,161    |                               |  
|Depreciation                                  |  |                                 | 51,913    |                               |  
|                                              |  |                                 |           |                               |  
|Total operating expenses                      |  |                                 | 375,145   |                               |  
|                                              |  |                                 |           |                               |  
|Operating income                              |  |                                 | 251,455   |                               |  
|Other   income (expense):                     |  |                                 |           |                               |  
|Investment   income                           |  |                                 | 6,689     |                               |  
|Loss   on sales of marketable securities      |  |                                 | (258      | )                             |  
|Interest   expense                            |  |                                 | (3,265    | )                             |  
|                                              |  |                                 |           |                               |  
|Total other income                            |  |                                 | 3,166     |                               |  
|                                              |  |                                 |           |                               |  
|Income before income taxes                    |  |                                 | 254,621   |                               |  
|Deferred income tax expense                   |  |                                 | 86,571    |                               |  
|                                              |  |                                 |           |                               |  
|NET INCOME                                    |  | $                               | 168,050   |                               | $
|                                              |  |                                 |           |                               |  
|Net   income  per share:                      |  |                                 |           |                               |  
|Basic and diluted                             |  | $                               | 0.02      |                               | $
|                                              |  |                                 |           |                               |  
|Weighted   average common shares outstanding: |  |                                 |           |                               |  
|Basic and diluted                             |  |                                 | 8,838,152 |                               |  
|                                              |  |                                 |           |                               |  

See accompanying notes to financial statements.

Comprehensive income for the three months ended June 30, 2006 and 2005 was $169,057 and $82,064, and for the six months ended June 30, 2006 and 2005 was $177,389 and $45,405, respectively.  This includes the changes in unrealized gains (losses) marketable securities, net of tax and net income.

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Avatar Systems, Inc.STATEMENTS OF CASH FLOWS(unaudited)

|                                                                                       |  | Six months   ended June 30, |         
|-------------------------------------------------------------------------------------- |  | --------------------------- | --------
|                                                                                       |  |                             |         
|                                                                                       |  | 2006                        |         
|                                                                                       |  |                             |         
|Cash flows   from operating activities                                                 |  |                             |         
|Net   income                                                                           |  | $                           | 171,026 
|Adjustments   to reconcile net income  to net cash   provided by operating activities: |  |                             |         
|Amortization                                                                           |  |                             | 196,323 
|Depreciation                                                                           |  |                             | 102,437 
|Loss   on sale of marketable securities                                                |  |                             | 258     
|Deferred   income taxes                                                                |  |                             | 88,104  
|Changes   in operating assets and liabilities:                                         |  |                             |         
|Accounts   receivable                                                                  |  |                             | (52,697 
|Prepaid   expenses and other current assets                                            |  |                             | 5,602   
|Other   assets                                                                         |  |                             | (1,659  
|Accounts   payable                                                                     |  |                             | 11,285  
|Accrued   expenses                                                                     |  |                             | (5,609  
|Deferred   revenue                                                                     |  |                             | 48,454  
|Other   long-term liabilities                                                          |  |                             | 58,130  
|                                                                                       |  |                             |         
|Net   cash provided by operating activities                                            |  |                             | 621,654 
|Cash flows   from investing activities                                                 |  |                             |         
|Software   development costs capitalized                                               |  |                             | (284,700
|Purchases   of property and equipment                                                  |  |                             | (81,399 
|Purchases   of marketable securities                                                   |  |                             | (430,671
|Proceeds   from sale of marketable securities                                          |  |                             | 150,506 
|                                                                                       |  |                             |         
|Net   cash used in investing activities                                                |  |                             | (646,264
|Cash flows   from financing activities                                                 |  |                             |         
|Principal   payments on capital lease obligations                                      |  |                             | (17,078 
|Principal   payments on long-term debt                                                 |  |                             | (4,079  
|                                                                                       |  |                             |         
|Net   cash used in financing activities                                                |  |                             | (21,157 
|                                                                                       |  |                             |         
|Net   decrease in cash and cash equivalents                                            |  |                             | (45,767 
|Cash and equivalents at   beginning of period                                          |  |                             | 257,056 
|                                                                                       |  |                             |         
|Cash and cash equivalents   at end of period                                           |  | $                           | 211,289 
|                                                                                       |  |                             |         
|Supplemental disclosure of   cash paid for:                                            |  |                             |         
|Interest                                                                               |  | $                           | 5,689   
|                                                                                       |  |                             |         
|Supplemental disclosure of   noncash investing and financing activities:               |  |                             |         
|Purchase   of equipment under capital lease obligation                                 |  | $                           | 29,800  
|                                                                                       |  |                             |         
|Change   in unrealized gain on marketable securities, net of tax                       |  | $                           | 6,363   
|                                                                                       |  |                             |         
|Purchase   of vehicle through issuance of note payable                                 |  | $                           |        
|                                                                                       |  |                             |         
|Debt   repayment through non-cash asset transfer                                       |  | $                           |        
|                                                                                       |  |                             |         

See accompanying notes to financial statements.

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AVATAR SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (Unaudited)

1. Basis of Presentation

The interim financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) applicable to interim financial information. Certain information and footnote disclosures included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in these interim statements pursuant to such SEC rules and regulations. The interim financial statements should be read in conjunction with the audited financial statements and related notes included in the Companys 2005 Annual Report on Form 10-KSB filed with the SEC. Interim results are not necessarily indicative of the results to be expected for the full year.

In the opinion of management, the interim financial statements include all adjustments necessary to present the financial position and results of operations for each interim period shown in conformity with accounting principles generally accepted in the United States of America.

Item 2. Managements Discussion and Analysis or Plan of Operation

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

You should read the following discussion in conjunction with our financial statements and related notes. Except for historical information, the following discussion contains forward-looking statements within the meaning of Section 27a of the Securities Act of 1933 and Section 21e of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including, among other things, statements about our gross margins and operating costs and expenses. Our actual results may differ significantly from those projected in the forward-looking statements.  Factors that might cause future results to differ materially from those discussed in the forward-looking statements include, but are not limited to, those discussed elsewhere in this document, Risk Factors and Other Trends and Uncertainties Affecting Future Operations set forth in our 2005 Annual Report on Form 10-KSB and other documents we file from time to time with
the SEC.

Results of Operations

Revenues

Our revenues include four components: software licensing fees, maintenance, professional services and hardware.  Our revenues for the second quarter ended June 30, 2006 increased 35.5% to $926,288 compared with revenues of $683,738 for the same period in 2005.  Revenues for the six months ended June 30, 2006 increased 36.9% to $1,421,878, compared with $1,038,648 from the same period last year.  Revenues were impacted primarily by higher software sales and maintenance revenue followed by an increase in professional services.  The increase in revenues is due to petroleum companies updating information systems while they experience economic growth as a result of higher crude oil prices.

Software.Software sales for the second quarter of 2006 increased 55.6% to $306,768 compared with software sales of $197,154 for the second quarter of 2005.  Software sales for the six months ended June 30, 2006 increased 61.5% to $383,468 compared with $237,368 from the same period last year.  Software sales were higher compared to 2005 primarily because of the previously noted strength in the energy sector. During the quarter ended June 30, 2006, we completed an engagement to one customer that included the installation of our AS400 software and a document imaging system.

Maintenance.Maintenance revenue for the second quarter of 2006 increased 22.1% to $374,685 compared with maintenance revenue of $306,810 for the second quarter of 2005.  Maintenance revenue for the six months ended June 30, 2006 increased 24.8% to $708,074 compared with maintenance revenue of $567,206 for the same period last year.  Our maintenance revenues have increased primarily due to strong demand for our software that we provide in an ASP format.  We increased maintenance prices during the third quarter of 2005 and higher sales of our licensed software products have also increased our maintenance revenue.

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AVATAR SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (Unaudited)

Professional services. Professional services revenue for the second quarter of 2006 increased 131.1% to $153,628 compared with professional service revenue of $66,490 for the second quarter of 2005.  Professional service revenue for the six months ended June 30, 2006 increased 91.4% to $215,860, compared with $112,760 for the same period last year.  Professional services revenues increased in relation to installations of our petroleum accounting systems which require training services and the iSynergy document management solution that requires professional implementation and training services.

Hardware.Hardware sales for the second quarter of 2006 decreased 19.5% to $91,207, compared with hardware sales of $113,284 for the second quarter of 2005.  Hardware sales for the six months ended June 30, 2006 decreased 5.6% to $114,476, compared with $121,314 from the same period last year.  Hardware sales for the first quarter of 2006 consisted of scanning equipment that we sell with our document management system and peripheral products for the IBM AS400.  Hardware sales during 2005 included a greater percentage of IBM AS400 products.

COST OF REVENUES

Our cost of revenues includes four components: cost of software, cost of maintenance, cost of professional services, and cost of hardware sales.  Our cost of revenues for the second quarter of 2006 increased 37.4% to $299,688 compared with cost of revenues of $218,157 for the second quarter of 2005.  Cost of revenues for the six months ended June 30, 2006 increased 50.2% to $430,499 compared with $286,546 for the same period last year.  Cost of revenues as a percentage of total revenues increased to 32.4% for the quarter ended June 30, 2006 from 31.9% for the same period in 2005.  Cost of revenues as a percentage of total revenues increased to 30.3% for the six months ended June 30, 2006, compared with 27.6% for the same period in 2005. Cost of revenues increased in relation to higher software sales and maintenance revenue.  Costs of sales was higher because of the cost of our Isynergy product which we purchase from an outside vendor,
higher sales commissions, labor costs associated with providing customer support and professional services, and utility costs related to operating our data center.

Cost of software.Cost of software increased 89.1% to $124,514 in the second quarter of 2006 from $65,830 in the second quarter of 2005. Cost of software increased 95.0% to $163,017 in the six months ended June 30, 2006, compared with $83,584 in the same period last year.  Cost of software as a percentage of the related revenue increased to 40.6% for the second quarter of 2006 compared to 33.4% for the same period in 2005.  Cost of software as a percentage of the related revenues increased to 42.5% for the six months ended June 30, 2006, compared with 35.2% for the for the same period last year.  The increase in cost of software as a percentage of revenue is due to higher commissions on increased software sales volume and sales of our Isynergy document management solution which has a higher cost component than our internally developed products.

Cost of maintenance.Cost of maintenance revenues increased 64.9% to $69,334 for the second quarter of 2006 from $42,058 for the second quarter of 2005.  Cost of maintenance revenues increased 69.0% to $129,001 for the six months ended June 30, 2006, compared with $76,312 for the same period last year.  Cost of maintenance revenues as a percentage of the related revenue increased to 18.5% for the second quarter 2006, compared to 13.7% for the same period last year.  Cost of maintenance revenues as a percentage of the related revenue increased to 18.2% for the six months ended June 30, 2006, compared with 13.5% for the same period last year. The increase in cost of maintenance revenues was due to increased personnel costs, the maintenance cost component of Isynergy document management software, higher utility and bandwidth costs.

Cost of professional services. Cost of professional services increased 42.1% to $28,186 for the three months ended June 30, 2006, compared with $19,833 for the same period last year.  Cost of professional services increased 33.2% to $46,854 for the six months ended June 30, 2006 from $35,169 for the same period last year.  Cost of professional services as a percentage of the related revenue decreased to 18.3% in the second quarter 2006, compared to 29.8% for the same period last year.  Cost of professional services as a percentage of the related revenue decreased to 21.7% for the six months ended June 30, 2006, compared with 31.2% for the same period last year.  The cost of professional services increased in relation to higher professional services revenue.

Cost of Hardware. Cost of hardware sold decreased 14.1% to $77,654 for the quarter ended June 30, 2006, compared with $90,436 for the same period last year.  Cost of hardware sold increased 0.2% to $91,627 for the six months ended June 30, 2006, compared with $91,481 for the same period last year.  Cost of hardware as a percentage of the related revenue increased to 85.1% for the quarter ended June 30, 2006, compared with 79.8% for the same period last year.  Cost of hardware as a percentage of the related revenue increased to 80.0% for the six months ended June 30, 2006, compared with 75.4% for the same period last year.  Hardware sales during 2006 include a higher percentage of scanning equipment that has a lower gross profit margin than AS400 products.

-6-

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AVATAR SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (Unaudited)

OPERATING EXPENSES

Sales and Marketing. Our sales and marketing expenses for the second quarter of 2006 decreased 35.9% to $63,348 compared with $98,775 for the second quarter of 2005.  Sales and marketing expenses for the six months ended June 30, 2006 decreased 5.8% to $139,037, compared with $147,525 in the same period last year.  Sales and marketing expenses as a percentage of total revenues decreased to 6.8% for the second quarter of 2006, compared with 14.4% for the same period last year.  Sales and marketing expenses as a percentage of total revenues decreased to 9.8% for the six months ended June 30, 2006, compared with 14.2% for the same period last year.  The decreases in cost and related percentages of revenue were due to the elimination of a sales position, sales personnel costs allocated to cost of professional services due to a large implementation, reduced trade show expenditures, and lower printing costs.

General and Administrative.General and administrative expenses for the second quarter of 2006 increased 63.0% to $161,723, compared with $99,212 for the second quarter of 2005.  General and administrative expenses increased 31.3% to $300,809 for the six months ended June 30, 2006, compared with $229,176 in the same period last year.  General and administrative expenses as a percentage of total revenues increased to 17.5% in the second quarter of 2005, compared with 14.5% in the second quarter of 2005.  General and administrative expenses as a percentage of total revenues decreased slightly to 21.2% in the six months ended June 30, 2006, compared with 22.1% in 2005.  The increase in general and administrative costs were related to higher accounting costs, higher personnel costs,  a one-time personnel agency fee, and occupancy costs.

Investment Income.Investment income was $6,689 in the second quarter of 2006 compared to $7,056 in 2005.  Investment income for the six months ended June 30, 2006 was $12,304 compared with $8,894 in 2005.  The increase in investment income is due to primarily to larger invested balances and higher yields.

Provision for Income Taxes.For the six months ended June 30, 2006, we recorded a deferred tax expense of $88,104 based on our pretax income of $259,130 using an effective tax rate of 34%, which is our anticipated effective tax rate for the fiscal year 2006.  The actual effective tax rate for the entire fiscal year could vary substantially depending on actual results achieved.

LIQUIDITY AND CAPITAL RESOURCES

Our cash and cash equivalents and marketable securities at June 30, 2006 were $941,357 compared with $518,716 at June 30, 2005.  Cash and cash equivalents and marketable securities at December 31, 2005 were $697,576.  Cash flows for the second quarter of 2006 were impacted positively by cash we collect from recurring maintenance agreements, software, and hardware sales.  These cash flows were offset by additions to software development costs and purchases of computer equipment.

Cash flows from Operating Activities. Our cash flows from operating activities represent the most significant source of funding for our operations.  Operating activities provided cash flows of $621,654 and $319,501 for the six months ended June 30, 2006 and 2005, respectively.

The major use of our operating cash is to fund obligations that flow through our accounts payable and accrued liabilities, such as funding of payroll and related benefits, rent, facilities costs, insurance, professional fees and other costs incurred in our normal operations.

We expect cash provided by operating activities to remain relatively stable in future periods due primarily to the stability of our recurring maintenance revenues, but it will be impacted by fluctuations in software and hardware sales.

-7-

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AVATAR SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (Unaudited)

Cash Flows from Investing Activities.Net cash used in investing activities for the six month period ended June 30, 2006 of $646,264 consisted of capitalized software development costs of $284,700, purchases of computer equipment of $81,399, and net marketable securities purchased of $280,165.

Net cash used in investing activities for the six month period ended June 30, 2005 of $546,039 included $289,296 in capitalized software development costs, purchases of computer equipment of $106,477, and net marketable securities purchased of $150,266.

Cash Flows from Financing Activities.Net cash used in financing activities for the six month period ended June 30, 2006 of $21,157 was for principal payments on capital lease obligations and notes payable of $17,078 and $4,079, respectively.

Net cash used in financing activities for the six month period ended June 30, 2005 of $16,761 was for principal payments on capital lease obligations and notes payable of $13,121 and $3,640, respectively.

Working Capital. At June 30, 2006 we had $483,609 in working capital, up from $255,446 at December 31, 2005.  The increase in working capital is attributable primarily to cash provided by operating activities of $621,654, offset by software development costs of $284,700, computer equipment purchases of $81,399, principal payments on capital lease obligations of $17,078 and principal payments on long-term debt of $4,079.  We currently have no significant capital commitments other than commitments under our capital lease obligations, notes payable and operating leases.

Based upon our past performance and current expectations, we believe that our cash and cash equivalents, marketable securities and cash generated from operations will be sufficient to satisfy our working capital needs, capital expenditures, investment requirements and financing activities for at least the next twelve months.

Item 3. Controls and Procedures

The Chief Executive Officer/Chief Financial Officer of the Company has established and is currently maintaining disclosure controls and procedures for the Company. The disclosure controls and procedures have been designed to ensure that material information relating to the Company is made known to him as soon as it is known by others within the Company. There have been no significant changes in these controls or in other factors that could significantly affect internal controls subsequent to the end of the period covered by this report.

As of the date of this report, the Chief Executive Officer/Chief Financial Officer has conducted an update and a review and evaluation of the effectiveness of the Company's disclosure controls and procedures. It is the Chief Executive Officer /Chief Financial Officers opinion that the controls and procedures currently being utilized by the Company are sufficiently effective to ensure that any material information relating to the Company would become known to him within a reasonable time.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

None.

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

None.

Item 3. Defaults Upon Senior Securities

None.

-8-

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AVATAR SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (Unaudited)

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

31.1 Section 302 Certification pursuant to Sarbanes Oxley Act. 32.1 Section 906 Certification pursuant to Sarbanes-Oxley Act

-9-

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Signatures

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

|                       | AVATAR SYSTEMS, INC.
|---------------------- | --------------------
|                       |                     
|                       |                     
|Dated: August 11, 2006 | By:                 
|                       |                     
|                       |                     

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