UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                   Quarterly Report Under Section 13 or 15(d)
                     of the Securities Exchange Act of 1934

                                  FORM 10-QSB/A

                  FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

                        Commission File Number: 333-46424

                           CYBER DEFENSE SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)

                FLORIDA                                          55-0610380
----------------------------------------                    -------------------
    (State or other jurisdiction of                           (I.R.S. Employer
     incorporation or organization)                         Identification No.)

 10901 ROOSEVELT BOULEVARD, SUITE 100D
        ST. PETERSBURG, FLORIDA                                     33716
----------------------------------------                    -------------------
(Address of principal executive offices)                         (Zip code)

                   Registrant's telephone number: 727-577-0878

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 twelve 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 |_|

Indicate by check mark whether the registrant is an accelerated Filer (as
defined in Rule 12-b-2 of the Exchange Act). YES |_| NO |X|

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the close of the latest practical date.

              Title of Class            Number of Shares Outstanding
       ----------------------------   --------------------------------
       Class A Common Stock
       (par value $0.001 per share)   60,984,630 as of August 14, 2006
       Class B Common Stock
       (Par Value $0.001 per share)      545,455 as of August 14, 2006
       Class C Common Stock
       Par value $0.001 per share)             2 as of August 14, 2006

<PAGE>

                                                                           Page
                                                                          Number
                                                                          ------
                          PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements
         Condensed Consolidated Balance Sheets as of
           June 30, 2006 and December 31, 2005 (unaudited) ............        1
         Condensed Consolidated Statements of Operations for the
           Three Months Ended June 30, 2006 and 2005 (unaudited).......        2
         Condensed Consolidated Statements of Operations for the
           Six Months Ended June 30, 2006 and 2005 (unaudited).........        3
         Condensed Consolidated Statements of Cash Flows for the
           Six Months Ended June 30, 2006 and 2005 (unaudited) ........        4
         Notes to the Condensed Consolidated Financial
           Statements (unaudited) .....................................     6-20

Item 2.  Management's Discussion and Analysis of
           Financial Condition or Plan of Operations ..................       21

Item 3.  Controls and procedures ......................................       26

                           PART II. OTHER INFORMATION

Item 1.  Legal Proceedings ............................................       27

Item 2.  Unregistered Sales of Equity Securities ......................       27

Item 3.  Defaults Upon Senior Securities ..............................       27

Item 4.  Submission of Matters to a Vote of Security Holders ..........       27

Item 5.  Other Information ............................................       27

Item 6.  Exhibits and Reports on Form 8-K .............................       28

Signatures ............................................................       30

<PAGE>

                   CYBER DEFENSE SYSTEMS, INC. AND SUBSIDIARY
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                            June 30, 2006   December 31, 2005
                                                            -------------   -----------------
                                    ASSETS
<S>                                                          <C>              <C>
CURRENT ASSETS:
Cash and cash equivalents                                    $      5,457     $        476
Accounts receivable                                                77,720          364,299
Inventory                                                         584,276          336,523
Prepaid interest                                                       --           32,580
                                                             ------------     ------------
    TOTAL CURRENT ASSETS                                          667,453          733,878
                                                             ------------     ------------
OTHER ASSETS:
Intangible assets, net of accumulated amortization
  of $77,781 and $61,113 respectively                              22,219           38,887
Property and equipment, net of accumulated depreciation
  of $19,069 and $10,173 respectively                              85,713           91,973
Deposits and costs of equipment                                   150,976          150,976
Airship manufacturing license, net of accumulated
  amortization of $626,981 and $230,993 respectively           13,628,668       14,024,656
Loan costs, net of accumulated amortization of $642,189
  and $364,697 respectively                                     1,085,695        1,228,897
Security deposits                                                   7,371            7,371
                                                             ------------     ------------
    TOTAL ASSETS                                             $ 15,648,095     $ 16,276,638
                                                             ============     ============

                      LIABILITIES AND SHAREHOLDERS' DEFICIT

CURRENT LIABILITIES:
Accounts payable and accrued liabilities                     $  3,051,428     $  2,996,827
Accrued interest                                                  617,196          329,626
Accounts payable related parties                                    5,407           53,337
Deferred revenue                                                1,133,333          450,000
Notes payable - related parties' net of discount of
  $625,676 and $0, respectively                                   871,359        1,562,315
Note payable - unrelated parties                                1,789,016        1,728,075
Embedded derivative liability                                   8,093,843       10,057,733
                                                             ------------     ------------
    TOTAL CURRENT LIABILITIES                                  15,561,582       17,177,913
                                                             ------------     ------------
NON-CURRENT LIABILITIES:
Notes payable, net of discount of $3,031,889 and
  $2,762,333, respectively                                      1,271,315          655,358
Deferred taxes                                                         --          217,325
                                                             ------------     ------------
    TOTAL LIABILITIES                                          16,832,897       18,050,596
                                                             ------------     ------------
Commitments and contingencies                                          --               --

SHAREHOLDERS' DEFICIT:
Class A preferred stock, $0.001 par value; 100,000,000
  Shares authorized; none issued and outstanding                       --               --
Common stock:
Class A, $0.001 par value; 200,000,000 shares authorized;
  60,321,964 and 56,912,893 shares issued and outstanding          60,322           56,913
Class B, $0.001 par value; 200,000,000 shares authorized;
  545,455 shares issued and outstanding                               545              545
Class C, $0.001 par value; 200,000,000 shares authorized;
  2 shares issued and outstanding                                      --               --
Additional paid-in capital                                     17,446,531       14,644,966
Accumulated deficit                                           (18,692,200)     (16,476,382)
                                                             ------------     ------------
Total shareholders' deficit                                    (1,184,802)      (1,773,958)
                                                             ------------     ------------
    TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT              $ 15,648,095     $ 16,276,638
                                                             ============     ============
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements


                                       1
<PAGE>

                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (Unaudited)

                               THREE MONTHS ENDED
                                    JUNE 30,

                                                     2006           2005
                                                 ------------   ------------
Revenues                                         $    136,223   $     65,765
Cost of Sales                                          63,730         35,391
                                                 ------------   ------------
Gross profit                                           72,493         30,374
                                                 ------------   ------------
Expenses:
General and administrative                          2,296,197        769,116
Stock option compensation                             350,584             --
Research and development                               70,875        543,191
                                                 ------------   ------------
Total expenses                                      2,717,656      1,312,307
                                                 ------------   ------------
Loss from operations                               (2,645,163)    (1,281,933)
Other Income (Expense)
Interest income                                            --         10,241
Interest expense                                     (862,770)      (308,635)
Derivative valuation gain (loss)                    4,485,171     (7,496,210)
                                                 ------------   ------------
Other Income (Expense), net                         3,622,401     (7,794,604)
                                                 ------------   ------------
Net income (loss) before income tax                   977,238     (9,076,537)
                                                 ------------   ------------
Provision for income tax                                   --             --
                                                 ------------   ------------
Net income (loss)                                $    977,238   $ (9,076,537)
                                                 ============   ============
Basic and diluted income (loss) per share        $       0.02   $      (0.32)
                                                 ============   ============
Weighted average number of Class A
  common shares outstanding                        58,843,504     28,094,183
                                                 ============   ============

The accompanying notes are an integral part of these condensed consolidated
financial statements.


                                       2
<PAGE>

                           CYBER DEFENSE SYSTEMS, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

                                   (Unaudited)

                                SIX MONTHS ENDED
                                    JUNE 30,

                                                2006           2005
                                            ------------   ------------
Revenues                                    $    301,894   $     65,765
Cost of Sales                                    144,271         35,391
                                            ------------   ------------
Gross profit                                     157,623         30,374
                                            ------------   ------------
Expenses
General and administrative expenses            3,616,255      1,330,744
Stock option compensation                        984,279             --
Research and development                          99,261        543,191
Impairment of goodwill                                --      4,577,069
                                            ------------   ------------
Total expenses                                 4,699,795      6,451,004
                                            ------------   ------------
Loss from operations                          (4,542,172)    (6,420,630)
Other income (expense)
Interest income                                       --         10,241
Interest expense                              (1,385,670)      (861,085)
Derivative valuation gain (loss)               3,494,700     (7,496,210)
                                            ------------   ------------
Other income (expense), net                    2,109,030     (8,347,054)
                                            ------------   ------------
Net loss before income tax                    (2,433,142)   (14,767,684)
                                            ------------   ------------
Provision for income tax                         217,325             --
                                            ------------   ------------
Net loss                                    $ (2,215,817)  $(14,767,684)
                                            ============   ============
Basic and diluted loss per share            $      (0.04)  $      (0.55)
                                            ============   ============
Weighted average number of Class A
  common shares outstanding                   57,883,532     27,040,107
                                            ============   ============

The accompanying notes are an integral part of these condensed consolidated
financial statements


                                       3
<PAGE>

                           CYBER DEFENSE SYSTEMS, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

                                   (Unaudited)

                                SIX MONTHS ENDED
                                    JUNE 30,

                                                        2006          2005
                                                    -----------   ------------
CASH FLOWS FROM OPERATING ACTIVITIES
  Net loss                                          $(2,215,817)  $(14,767,684)
  Adjustments to reconcile net loss
  to net cash from operating activities:
    Interest expense from amortization of
      loan discount                                     980,917        678,228
    Derivative valuation (gain) loss                 (3,494,700)     7,496,210
    Stock option compensation                           984,279             --
    Issuance of stock for services                      140,578         94,125
    Issuance of warrant for services                    419,760             --
    Issuance of note for services                       351,192             --
    Depreciation and amortization                       699,044        137,668
    Income tax benefit                                 (217,325)            --
    Impairment of goodwill                                   --      4,577,069
    Write-off of intangible assets                           --          5,543
  Changes in assets and liabilities:
    Accounts receivable                                 286,579       (116,765)
    Inventory                                          (247,753)      (211,048)
    Prepaid expenses                                     32,580       (157,136)
    Security deposits                                        --           (215)
    Accounts payable and accrued liabilities            384,670        196,818
    Accrued interest                                    333,174             --
    Accounts payable - related party                         --        (76,163)
    Deferred revenue                                    683,333             --
                                                    -----------   ------------
NET CASH FROM OPERATING ACTIVITIES                     (879,489)    (2,143,350)
                                                    -----------   ------------
CASH FLOWS FROM INVESTING ACTIVITIES
   Loan to Techsphere                                        --     (1,007,397)
   Purchase of equipment                                 (2,636)       (12,000)
                                                    -----------   ------------
NET CASH FROM INVESTING ACTIVITIES                       (2,636)    (1,019,397)
                                                    -----------   ------------
CASH FLOWS FROM FINANCING ACTIVITIES
  Proceeds from convertible note payable                 82,000             --
  Gross Proceeds from sale of secured convertible
    Notes payable                                     1,000,000      2,800,000
  Proceeds from notes payable, related parties          187,289        286,871
  Issuance of common stock                                   --        255,209
  Payments of loan costs                                (85,000)      (133,136)
  Principal payments on notes payable
    unrelated parties                                  (247,183)            --
  Principal payments on notes payable
    related parties                                     (50,000)       (34,900)
  Payments on debt assumed from subsidiary                   --        (33,337)
                                                    -----------   ------------
NET CASH FROM FINANCING ACTIVITIES                      887,106      3,140,707
                                                    -----------   ------------
Net increase (decrease) in cash                           4,981        (22,040)
Cash and cash equivalents, beginning                        476        206,270
                                                    -----------   ------------
Cash and cash equivalents, ending                   $     5,457   $    184,230
                                                    ===========   ============

The accompanying notes are an integral part of these condensed consolidated
financial statements.


                                       4
<PAGE>

                           CYBER DEFENSE SYSTEMS, INC.
           CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

                                   (Unaudited)

                                SIX MONTHS ENDED
                                    JUNE 30,

                                                      2006        2005
                                                    --------   ----------
Supplemental disclosure of cash flow information:
Cash paid for interest                              $ 13,161   $   86,443
Cash paid for income taxes                                --           --

Supplemental disclosure of non-cash investing and
  financing information:
Partial payment of purchase cost of a license
  with a note payable                                     --      250,000
Partial payment of note payable by Mr. Robinson
  on behalf of the Company                                --      124,957
Conversion of notes payable into common stock        547,300      267,000
Conversion of notes payable - related party into
  common stock                                       289,333           --
Conversion of accounts payable - related party
  to a note payable                                   47,930      350,000
Issuance of warrants for discount on notes
  and loan costs                                     542,190    9,536,472
Common Stock issued for loan costs                    35,000      200,000
Common Stock issued for shares of Cyber Aerospace         --    4,603,650

The accompanying notes are an integral part of these condensed consolidated
financial statements


                                       5
<PAGE>

                   CYBER DEFENSE SYSTEMS, INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION, ACQUISITIONS AND MERGERS AND CONTROLLING SHAREHOLDERS --Cyber
Defense Systems, Inc. ("the Registrant" or "Cyber Defense" or "the Company") was
incorporated on August 19, 2004 in Florida. E-City Software, Inc. ("E-City") was
organized in Nevada on May 12, 2000. On Alert Systems, Inc. ("On Alert") was
incorporated on March 17, 2003 in Nevada and acquired a control position in
E-City in May of 2003 and in Cyber Aerospace Corp. ("Cyber Aerospace") in March
2004. On Alert was merged with and into Cyber Defense on September 1, 2004. On
September 1, 2004 E-City was also merged with and into Cyber Defense following
the On Alert merger. As a result of the aforementioned, Cyber Defense became the
successor to E-City and its shares of class A common stock began trading on the
Over the Counter Bulletin Board ("OTC:BB") under the symbol CYDF on September 7,
2004. Due to the nature of the mergers, the fiscal year end of the Company was
changed to December 31 effective for Fiscal 2003 and the historical financial
statements of the Company are now those of On Alert and include results of
operations for Cyber Aerospace from its date of inception in March 2004, as it
was previously a subsidiary of On Alert, and includes the results of operations
of E-City from it's date of merger, September 1, 2004. Cyber Aerospace was
merged with and into Cyber Defense effective March 31, 2005 with the acquisition
of the 6.19% minority interest in Cyber Aerospace for 1,650,000 shares of class
A common stock and 150,000 shares of class B common stock. In addition, on
September 19, 2005, the Company acquired its wholly owned subsidiary Techsphere
Systems International, Inc. ("TSI") for 23,076,923 Class A common shares and
245,455 Class B common shares.

The controlling shareholders of the company are Proxity, Inc. ("Proxity"), a
publicly traded company ("PRXT") and Cherokee Raiders, a partnership,
("Cherokee") owning approximately 27.5% and 16.3% of the Class A common shares
of the Company, respectively as of June 30, 2006. In addition, the former
shareholders of TSI also own 245,455 or 45%, of the issued and outstanding
shares of Class B common stock and Cherokee owns 300,000 or 55% of such class B
shares which allow for 1,000 votes per share and as a result, Cherokee is the
controlling shareholder of the Company. Cherokee and Proxity each own one share
of the two shares of Class C common stock issued and outstanding which have
certain liquidation preference rights. The Chief Executive Officer of both
Proxity and Cherokee is Mr. Robinson, the Chief Executive Officer of the
Company.

Consolidation - The accompanying condensed consolidated financial statements
include the accounts and transactions of Cyber Defense Systems, Inc. for all
periods presented and the accounts and transactions of Cyber Defense, and its
TSI wholly owned subsidiary from its date of acquisition on September 19, 2005,
(collectively the "Company"). Intercompany accounts and transactions have been
eliminated in consolidation.

Basis of Presentation -- The unaudited financial statements included in this
Form 10-QSB have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form
10-QSB and Item 310(b) of Regulation SB of the Securities and Exchange Act of
1934, as amended. The financial information furnished herein reflects all
adjustments, which, in the opinion of management, are necessary for a fair
presentation of the Company's financial position, the results of operations and
cash flows for the periods presented.


                                       6
<PAGE>

                   CYBER DEFENSE SYSTEMS, INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

Certain information and footnote disclosures normally contained in financial
statements prepared in accordance with generally accepted accounting principles
have been omitted, pursuant to such rules and regulations.

Condensed Interim Financial Statements -- The accompanying unaudited condensed
consolidated financial statements include the accounts of Cyber Defense Systems,
Inc. and its subsidiary, collectively ("Cyber" or the "Company"). These
financial statements are condensed and, therefore, do not include all
disclosures normally required by accounting principles generally accepted in the
United States of America. In the opinion of management, all adjustments
necessary for a fair presentation have been included in the accompanying
condensed consolidated financial statements and consist of only normal recurring
adjustments. The results of operations presented in the accompanying condensed
consolidated financial statements are not necessarily indicative of the results
that may be expected for the full year ending December 31, 2006 and such
financial statements should be read in conjunction with the Company's Form
10-KSB for the year ended December 31, 2005 and other filings made with the
Securities and Exchange Commission.

Use of Estimates - The preparation of 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, disclosure of contingent assets and
liabilities and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Business Condition - The accompanying financial statements have been prepared on
a going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. For the six months
ended June 30, 2006 the Company recorded revenues of $301,894 and incurred a net
loss of $2,215,817. For the year ended December 31, 2005, the Company recorded
revenues of $461,244 and incurred a net loss of $15,579,024. As of June 30, 2006
and December 31, 2005 the net working capital deficit was $14,894,129 and
$16,444,035, respectively. The lack of sufficient revenues and the loss from
operations raise substantial doubt about the Company's ability to continue as a
going concern for a reasonable period of time. The financial statements do not
include any adjustments relating to the recoverability and classification of
recorded assets or the amount and classification of liabilities which might be
necessary should the Company be unable to continue as a going concern. The
Company's continuation as a going concern is dependent upon its ability to
generate sufficient cash flows to meet its obligations on a timely basis, to
obtain additional financing as further discussed in Notes 5, 6 and 10 as may be
required, and ultimately to attain successful operations.

Cash and Cash Equivalents -- Cash equivalents include highly liquid short-term
investments with original maturities of three months or less, readily
convertible to known amounts of cash. At June 30, 2006 and December 31, 2005 the
Company had $0 and $0 of cash, respectively, in excess of federally insured
limits.

Inventory -- At June 30, 2006 and December 31, 2005, inventory of $584,276 and
$336,523, respectively primarily consists of parts for the Unmanned Aerial
Vehicles ("UAV's") and airships that the Company sells, leases and services.

Property and Equipment -- Property and equipment is recorded at cost.
Depreciation is computed using the straight-line method over the estimated
useful lives of the assets ranging from 3 to 5 years. Expenditures for
maintenance, repairs, and renewals are charged to expense as incurred.
Expenditures for major renewals and betterments that extend the useful lives of
existing equipment are capitalized and depreciated. On retirement or disposition
of property and equipment, the cost and accumulated depreciation are removed and
any resulting gain or loss is recognized in the statement of operations.


                                       7
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

Long-lived assets are reviewed for impairment when events or changes in
circumstances indicate that the carrying amount may not be recoverable.
Recoverability of assets to be held and used is measured by comparison of the
carrying amount of an asset to future net cash flows expected to be generated by
the asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount that the carrying amount of the assets
exceeds the fair value of the assets. Assets to be disposed of are reported at
the lower of the carrying amount or fair value less costs to sell. For the
quarter ended June 30, 2006, management has determined that no impairment of its
long lived assets was required. For the quarter ended June 30, 2005, goodwill of
$4,577,069 relating to the acquisition of the 6.19% minority interest in Cyber
Aerospace as of March 31, 2005 was impaired.

Manufacturing License -- The Company acquired an exclusive manufacturing license
valued at $14,255,649 with the acquisition of TSI in September, 2005.
Accumulated amortization relating to the license was $626,981 at June 30, 2006.
The Company evaluated the carrying value of the license to determine if the
carrying amount warranted revision or may not be recoverable. In management's
opinion, an adjustment is not required at June 30, 2006.

Fair Values of Financial Instruments -- The carrying amounts reported in the
balance sheet for notes payable approximate their fair values because the
interest rates approximate current interest rates to be charged on similar
borrowings.

Revenue Recognition - The Company recognizes service revenues when the services,
as specified by the customer and agreed to by the Company, have been performed
and the customer accepts the services, and the services are billed. Airship and
UAV sales are recognized when contract specifications are met, the price is
determined, title passes to the customer and the customer is billed. Lease
revenue on airships is recognized over the term of the lease. Reasonableness of
collectibility of all revenue transactions is a key element before the
transactions are recorded.

Share Based Payments - In December 2004, the Financial Accounting Standards
Board issued Statement Number 123 ("FAS 123 (R)"), Share-Based Payments, which
was adopted by the Company on January 1, 2006. The Company recognizes
compensation expense in an amount equal to the fair value of share based
payments such as stock options granted to employees. The Company has elected to
apply FAS 123 (R) using the modified prospective method. Under this method, the
Company records compensation expense as awards that were outstanding at the date
of adoption continue to vest for the unvested portion of the awards. For the six
months ended June 30, 2006 the Company recorded $984,279 in stock compensation
expense within general and administrative expenses in the accompanying statement
of operations. If the Company had accounted for share based payments under the
provisions of FAS 123(R) for the six months ended June 30, 2005 no expense would
have been recorded as there were no stock options issued.

Prior to January 1, 2006 the Company used Statement of Financial Accounting
Standards No. 148 "Accounting for Stock-Based Compensation - Transition and
Disclosure" (SFAS No. 148) to account for our stock based compensation
arrangements. This statement amended the disclosure provision of FASB statement
No. 123 to require prominent disclosure about the effects on reported net income
of an entity's accounting policy decisions with respect to stock-based employee
compensation. As permitted by SFAS No. 123 and amended by SFAS No. 148, we
continued to apply the intrinsic value method under Accounting Principles Board
("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," to account
for our stock-based employee compensation arrangements.


                                       8
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

Derivative Instruments - The Company does not hold or issue derivative
instruments for trading purposes. However, the Company has convertible notes
payable that contain embedded derivatives that require separate valuation from
the convertible notes under Emerging Issues Task Force Abstract (EITF) 00-19,
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock". The Company recognizes these derivatives as
liabilities in the accompanying balance sheet and measures them at estimated
fair value each quarter, and recognizes changes in estimated fair value in the
statement of operations in the respective period. The Company has estimated the
fair value of these embedded derivatives using the Black-Scholes model.

Income Taxes -- No income taxes have been paid or accrued because the Company
has had no net taxable income since inception. The Company recognizes the amount
of income taxes payable or refundable for the current year and recognizes
deferred tax assets and liabilities for the future tax consequences attributable
to differences between the financial statement amounts of certain assets and
liabilities and their respective tax bases. Deferred tax assets and deferred
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years those temporary differences are expected to be recovered or
settled. Deferred tax assets are reduced by a valuation allowance to the extent
that uncertainty exists as to whether the deferred tax assets will ultimately be
realized.

Earnings (Loss) Per Share --Basic earnings (loss) per share is calculated by
dividing earnings (loss) available to Class A common shareholders by the
weighted-average number of Class A common shares outstanding during each period.
Fully diluted income (loss) per share for the three and six months ended June
30, 2006 is the same as basic due to losses for the six months ended June 30,
2006 and due to being anti-dilutive for the three months ended June 30, 2006.

As of June 30, 2006, potentially dilutive securities in the future include an
aggregate of 41,875,752 shares issuable upon the conversion of the AJW Notes, an
aggregate of 7,730,428 shares issuable upon the conversion of Convertible Notes
at $0.30 per share, an aggregate of 11,379,900 Class A common shares subject to
stock options granted under the 2005 Option Plan and Class A common shares
issuable upon exercise of 6,100,000 warrants issued and outstanding, since the
exercise prices exceed the average market price of the Class A Common Stock for
the six months ending June 30, 2006. Fully diluted loss per share for the three
and six months ended June 30, 2005 is anti dilutive due to net losses incurred
by the Company. For the three and six months ended June 30, 2005, potentially
dilutive securities in the future include 88,000 shares subject to a stock
option held by All- Stars Marketing since August 9, 2004.

Recent Accounting Pronouncements -- In February 2006, the FASB issued Statement
of Financial Accounting Standards No. 155, "Accounting for Certain Hybrid
Financial Instruments," referred to as SFAS No. 155. This statement amends SFAS
No. 133 "Accounting for Derivative Instruments and Hedging Activities" and SFAS
No. 140 "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities." SFAS No. 155 permits fair value remeasurement
for hybrid financial instruments that contain embedded derivatives that would
require separate accounting. In addition, the statement establishes a
requirement to evaluate interests in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain embedded derivatives. SFAS No. 155 is effective for all
financial instruments acquired or issued beginning after an entity's fiscal year
beginning on or after September 15, 2006 with earlier adoption permitted.
Management believes this Statement will have no impact on the financial
statements of the Company once adopted.


                                       9
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

In March 2006, the FASB issued FASB Statement No. 156, which amends FASB
Statement No. 140. This Statement establishes, among other things, the
accounting for all separately recognized servicing assets and servicing
liabilities. This Statement amends Statement 140 to require that all separately
recognized servicing assets and servicing liabilities be initially measured at
fair value, if practicable. This Statement permits, but does not require, the
subsequent measurement of separately recognized servicing assets and servicing
liabilities at fair value. An entity that uses derivative instruments to
mitigate the risks inherent in servicing assets and servicing liabilities is
required to account for those derivative instruments at fair value. Under this
Statement, an entity can elect subsequent fair value measurement to account for
its separately recognized servicing assets and servicing liabilities. By
electing that option, an entity may simplify its accounting because this
Statement permits income statement recognition of the potential offsetting
changes in fair value of those servicing assets and servicing liabilities and
derivative instruments in the same accounting period. This Statement is
effective for financial statements for fiscal years beginning after September
15, 2006. Earlier adoption of this Statement is permitted as of the beginning of
an entity's fiscal year, provided the entity has not yet issued any financial
statements for that fiscal year. Management believes this Statement will have no
impact on the financial statements of the Company once adopted.

In June, 2006 the FASB issued FIN 48, "Accounting for Uncertainty in Income
Taxes--an interpretation of FASB Statement No. 109". This Interpretation
clarifies, among other things, the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return. This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition and is effective for fiscal years beginning after
December 15, 2006. Earlier application is encouraged if the enterprise has not
yet issued financial statements, including interim financial statements, in the
period the Interpretation is adopted. FIN 48, Accounting for Uncertainty in
Income Taxes--an interpretation of FASB Statement No. 109, is effective for
fiscal years beginning after December 15, 2006. Earlier application is
encouraged if the enterprise has not yet issued financial statements, including
interim financial statements, in the period the Interpretation is adopted.
Management believes this Statement will have no impact on the financial
statements of the Company once adopted.

NOTE 2 - RELATED PARTY TRANSACTIONS

Cyber Aerospace - Prior to March 31, 2005, Cyber Aerospace ("Aerospace") had
previously been consolidated with the Company as it was a 93.8% owned
subsidiary. All transactions and account balances between the Company and
Aerospace were eliminated during consolidation. On March 31, 2005, the Company
purchased the minority interest so that Aerospace became a wholly owned
subsidiary and was then merged with and into the Company.

Cherokee Raiders - Cherokee's general partner is William C. Robinson. Cherokee
also owns 300,000 Class B common shares, each of which entitles the holder to
1,000 votes. As a result, Cherokee is the controlling shareholder of the
Company.

William C. Robinson - Mr. Robinson is President, CEO and Chairman of the Company
and has significant ownership and control in Proxity and Cherokee Raiders.

During the six months ended June 30 2006, Mr. Robinson advanced an additional
$179,698 under his $1,000,000 line of credit to the Company and Mr. Frank
Lively, a director of the Company advanced an additional $16,722.

On April 20, 2006 David Barnes, the Company's Chief Financial Officer utilized
$11,000 of fees due him to exercise options for 55,000 shares of the Company's
Class A common stock at the exercise price of $0.20 per share. On July 21, 2006
the Board approved Mr. Barnes conversion of an additional $7,000 in fees into
46,666 shares of Class A common stock at a price of $0.15. The price was
determined based on the market pricing as of the date of conversion.

See Note 6 - Related Party Notes for additional related party disclosure.


                                       10
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

NOTE 3 - ACQUISITION OF TSI

On September 19, 2005, Cyber Defense Systems, Inc. acquired all 100,000 common
shares of the outstanding stock of TSI in exchange for 23,076,923 shares of
Cyber Class A common stock and 245,455 shares of Cyber Class B common stock
valued at $5,340,226 collectively, and TSI became a subsidiary of Cyber. The
transaction was accounted for as a purchase business combination in accordance
with FAS 141, "Business Combinations". An independent valuation was obtained for
both the Cyber stock and TSI's exclusive manufacturing license. In connection
with the acquisition by Cyber, TSI underwent a reorganization intended to
qualify as a reorganization within the meaning of Section 368(a)(1)(A) and
(a)(1)(D) of the Internal Revenue Code of 1986, as amended resulting in TSI
becoming a regular corporation from a limited liability corporation. The 100,000
shares of TSI stock were then exchanged for the Cyber stock mentioned above.
Negative goodwill was not recognized in connection with the acquisition of
Techsphere. Instead, the excess of the fair value of the net assets over the
purchase price was allocated as a pro rata reduction of the amounts that
otherwise would have been assigned to the long-term assets.

The unaudited consolidated pro forma results of operations assuming consummation
of the purchase of TSI as of January 1, 2005, are summarized as follows:

                                                Unaudited Pro Forma
                                       -------------------------------------
                                       Three Months Ended   Six Months Ended
                                              2005                2005
                                       ------------------   ----------------
Total revenue                             $   466,232         $  1,451,477
Net earnings                              $(9,737,417)        $(15,438,694)
Basic and diluted earnings per share      $     (0.19)        $      (0.31)

NOTE 4- INTANGIBLE ASSETS AND MANUFACTURING LICENSE

With the acquisition of TSI in September, 2005 the Company acquired an
exclusive, worldwide license with 21st Century Airships, Inc. for the
manufacture of its airships. The value recorded for the license was $14,255,649
pursuant to an independent valuation which is being amortized over the 18 year
life of the license, resulting in monthly amortization of $65,998. Amortization
expense for the six months ended June 30, 2006 was $395,988. The license
agreement stipulates royalty payments relating to the sales of airships ranging
from $450,000 for a low altitude airship, $600,000 for a medium altitude
airship, 10% of the gross sales price of a high altitude airship and $400,000
for the manufacture of a low altitude airship used for commercial advertising
purposes. Payments are to be made on any royalties due upon receipt of payment
from the customer on a proportionate basis as defined in the agreement and in
full within 120 days of completion of the manufacturing process.

The license agreement calls for a minimum annual royalty payment of $1,000,000
for the period of January 17, 2005 through January 16, 2006 and each annual
period thereafter ending January 16. The Company has accrued $1,250,000 related
to this royalty in the balance sheet as of June 30, 2006. The Company has
executed an amendment to the license agreement in April, 2006 providing payment
terms with respect to the $1,000,000 royalty through January 16, 2006 of
$200,000 each on May 15 and July 15, 2006, and $150,000 each for four months on
the fifteenth of each month ending November 15, 2006. The Company has made the
payment of $200,000 relating to May 15, 2006. The July and August 15, 2006
payments have not been made, but the Company has obtained a waiver until August
24, 2006. Should payment not be made on that date, the Company will be in
default and subject to potential termination of the license agreement.

In 2004, the Company purchased designs and plans for unmanned air vehicles
(UAV's) which have a useful life of 3 years. The cost was $100,000 and the
monthly amortization is $2,778. Amortization expense was $16,668 for the six
months ended June 30, 2006 and 2005.


                                       11
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

NOTE 5- NOTES PAYABLE

On March 15, 2006, the Company entered into a Securities Purchase Agreement,
dated as of March 14, 2006 with AJW Partners, LLC, AJW Offshore, Ltd., AJW
Qualified Partners, LLC, and New Millennium Capital Partners II, LLC ("AJW")
whereby the Company authorized the sale of an aggregate of $2,000,000 of 6%
Callable Secured Convertible Notes and warrants to purchase 2,000,000 shares of
common stock for a total offering price of $2,000,000. The $2,000,000 is to be
funded in three tranches ($1,000,000 on March 15, 2006, $500,000 upon filing a
Registration Statement and $500,000 upon effectiveness of the Registration
Statement). The conversion price is the lesser of $3.00 or 55% of the average of
the lowest three intra-day trading prices for the Company's common stock during
the 20 trading days immediately preceding the conversion date. The warrants to
purchase Class A common stock are priced at $1.25 per share. The warrants are
exercisable for a period of five years from the date of issuance. In connection
with the sale, the Company also entered into a Registration Rights Agreement
with AJW, requiring it to file a registration statement with the Securities and
Exchange Commission registering the shares of common stock issuable upon
conversion of the Notes and exercise of the Warrants. The Notes are secured by
all of the Company's assets, except for its accounts receivable and proceeds of
inventory. In addition, the lenders have agreed to subordinate to an
institutional lender. On March 15, 2006 the Company received $1,000,000 and
issued warrants for 1,100,000 shares of common stock valued at $542,190 on the
date of issuance which was recorded as a derivative liability. An aggregate of
$49,290 was recognized as loan costs and $492,900 was recognized as a derivative
valuation loss on issuance of the warrants. The beneficial conversion feature
was valued at $2,599,655 and was recorded as a derivative liability. An
aggregate of $1,000,000 was allocated to discounts on the individual notes,
representing 100% of the face value of the notes, with the remaining $1,599,655
recognized as a derivative valuation loss.

An analysis of the March 14, 2006 issuance and the significant assumptions used
to value the warrants and the beneficial conversion feature are contained in the
following table:

                                                           March 14, 2006
                                                              Agreement
                                                              Tranche 1
                                                           --------------
Issue date                                                   3/14/2006
Aggregate note amounts                                     $  1,000,000

Conversion price on issue dates                            $       0.19
Term of notes at issuance                                       3 years
Shares issuable upon conversion                               5,172,414
Warrants issued                                               1,100,000

Exercise price of warrants                                 $       1.25
Term of warrants at issuance                                    5 years

Market Price on issue dates                                $       0.51
Risk free interest rate on issuance date                           4.00%
Volatility on date of issuance                                   261.79%

Fair value per share of conversion shares                        0.5026
Beneficial conversion feature fair value                   $  2,599,655
Note discount amount                                       $  1,000,000
Warrant fair value per share at issuance                   $     0.4929
Fair values of warrants at issuance dates                  $    542,190
Value of warrants allocable to loan costs                  $     49,290
Fair value of derivative related to warrants               $    492,900
Fair value of derivative allocated to beneficial
conversion feature                                         $  1,599,655
Aggregate fair value allocated to derivative instruments   $  2,141,845


                                       12
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

The Company incurred loan costs totaling $134,290 which consisted of fees paid
in cash of $85,000 and a warrant to purchase 100,000 shares of Class A common
stock valued at $49,290 as described above which will be amortized over the
three year term of the notes.

On June 6, 2006 AJW converted an aggregate of $114,487 related to the 8%
Callable Secured Convertible Notes issued April 1, 2005 at $0.1879 representing
that note's conversion price of 60% of the average of the lowest three intra-day
trading prices for the Company's common stock during the 20 trading days
immediately preceding the conversion date. Accordingly, the Company issued an
aggregate of 609,300 shares of its Class A common stock to AJW.

An analysis of the conversion of the AJW Notes and the significant assumptions
used to value the beneficial conversion feature recognized upon conversion are
contained in the following table:

Conversion date                                             6/6/2006
                                                          -----------
Original proceeds from note                               $ 1,500,000
Note amount converted                                     $   114,487
Principal remaining after conversion                      $   802,996
Conversion price                                          $     0.188
Term of notes at December 31, 2005                         1.80 years
Shares issued on conversion                                   609,300
Potential remaining conversion shares                       4,273,528
Common Stock Price on conversion date                     $      0.40
Risk free interest rate at December 31, 2005                     4.99%
Volatility on conversion dates                                 241.68%
Fair value per share of conversion shares                      0.3736
Fair value of derivative                                  $ 1,596,590
Derivative liability reclassified to additional paid-in
   capital upon conversion                                $   227,634
Derivative valuation loss recognized
 on conversion                                            $   (13,184)

The carrying value of the March 14, 2006 AJW notes, as well as the notes issued
in 2005 to AJW as of June 30, 2006 and December 31, 2005 was $1,271,315 and
$655,358 net of discount, respectively. The carrying value will be increased
each quarter over the respective three year lives of the notes as the discount
related to the embedded derivatives is recorded until the carrying value equals
the face value of the notes.


                                       13
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

As of June 30, 2006 the derivative instruments related to AJW had a fair value
of $7,750,456. An analysis of the valuation of the individual tranches of the
AJW Notes as of June 30, 2006 and the significant assumptions used to value the
warrants and the beneficial conversion feature are contained in the following
table:

<TABLE>
<CAPTION>
                                              April 1, 2005    April 1, 2005     April 1, 2005    March 14, 2006
                                                Agreement        Agreement         Agreement         Agreement
                                                Tranche 1        Tranche 2         Tranche 3         Tranche 1
Revaluation date                                6/30/2006        6/30/2006         6/30/2006         6/30/2006          Total
                                              -------------   --------------   ---------------    --------------     ------------
<S>                                           <C>             <C>              <C>                <C>                <C>
Aggregate note amounts                        $     803,204   $    1,300,000   $     1,200,000    $    1,000,000     $  4,303,204
Aggregate interest amounts                    $      28,444   $       45,617   $        23,058    $       17,753
Conversion price                              $       0.105   $        0.105   $         0.105    $        0.105
Remaining term of notes                          1.75 years       1.90 years        2.10 years        2.70 years
Shares issuable upon conversion                   7,918,477       12,815,401        11,648,167        10,574,062       42,956,107
Warrants outstanding                              1,650,000        1,430,000         1,320,000         1,100,000        5,500,000
Exercise price of warrants                    $        4.25   $         4.25   $          4.25    $         1.25
Remaining term of warrants                       3.75 years       3.90 years        4.10 years         4.7 years
Common stock price                            $        0.17   $         0.17   $          0.17    $         0.17
Risk free interest rate                                5.10%            5.10%             5.10%             5.10%
Volatility                                           242.54%          242.54%           242.54%           242.54%
Fair value per share of conversion shares            0.1563           0.1582            0.1601            0.1643
Beneficial conversion feature fair value      $   1,237,658   $    2,027,396   $     1,864,872    $    1,737,318     $  6,867,244
Warrant fair value per share                  $      0.1577   $       0.1591   $        0.1607    $       0.1667
Fair value of derivative related to warrants  $     260,205   $      227,513   $       212,124    $      183,370     $   883,212
Fair value of derivative related to
  beneficial conversion feature               $   1,237,658   $    2,027,396   $     1,864,872    $    1,737,318     $  6,867,244
                                              -------------   --------------   ---------------    --------------     ------------

Aggregate fair value of derivative
instruments                                   $   1,497,863   $    2,254,909   $     2,076,996    $    1,920,688     $  7,750,456
                                              =============   ==============   ===============    ==============     ============
</TABLE>

The derivative liability is comprised of the following as of June 30, 2006 and
December 31, 2005:

<TABLE>
<CAPTION>
                                                   June 30, 2006  December 31, 2005
                                                   -------------     --------------
<S>                                                <C>               <C>
AJW Notes                                          $ 6,867,244       $ 1,515,756

AJW Warrants                                           883,212         8,541,977

James Gardiner Note (See below)                             --                --

William Robinson Note (See Note 5)                     300,728                --

Frank Lively Note (See Note 5)                          42,659                --
                                                   -----------       -----------
Total derivative liability                         $ 8,093,843       $10,057,733
                                                   ===========       ===========
</TABLE>


                                       14
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

As of December 31, 2005, the derivative instruments had a fair value of
$10,057,733. An analysis of the valuation of the individual tranches as of
December 31, 2005 and the significant assumptions used to value the warrants and
the beneficial conversion feature are contained in the following table:

<TABLE>
<CAPTION>
                                                    Tranche 1        Tranche 2          Tranche 3     Total
                                                 ---------------  ---------------  ---------------  -----------
<S>                                              <C>              <C>              <C>              <C>
Valuation date                                      12/31/2005      12/31/2005       12/31/2005
Aggregate note amounts                           $       917,691  $     1,300,000  $     1,200,000  $ 3,417,691
Conversion price                                 $         0.156  $         0.156  $         0.156
Term of notes                                         2.25 years        2.4 years        2.6 years
Shares issuable upon conversion                        5,957,684        8,333,333        7,692,308
Warrants outstanding                                   1,650,000        1,430,000        1,320,000    4,400,000
Exercise price of warrants                       $          4.25  $          4.25  $          4.25
Term of warrants                                      4.25 years        4.4 years        4.6 years
Stock Price                                      $          0.40  $          0.40  $          0.40
Risk free interest rate                                     4.37%            4.37%            4.37%
Volatility                                                252.54%          252.54%          252.54%
Fair value per share of conversion shares                 0.3867           0.3883           0.3903
Beneficial conversion feature fair value         $     2,303,836  $     3,235,833  $     3,002,308  $ 8,541,977
Warrant fair value per share                     $        0.3367  $        0.3447  $        0.3540
Fair value of derivative related to warrants     $       555,555  $       492,921  $       467,280  $ 1,515,756
Fair value of derivative related to
    beneficial conversion feature                $     2,303,836  $     3,235,833  $     3,002,308  $ 8,541,977
                                                 ---------------  ---------------  ---------------  -----------
Aggregate fair value of derivative instruments   $     2,859,391  $     3,728,754  $     3,469,588  $10,057,733
                                                 ===============  ===============  ===============  ===========
</TABLE>

The derivative valuation loss reported in the accompanying condensed
consolidated statements of operations results from the revaluation to fair value
of the beneficial conversion feature and attached warrants associated with the
above notes. As the fair value of the derivative changes, a gain or a loss is
recognized. The components of the derivative valuation loss for the three and
six months ended June 30, 2006 and 2005 consisted of the following:

<TABLE>
<CAPTION>
                                                                                Three months ended            Six months ended
                                                                          June 30, 2006  June 30, 2005  June 30, 2006  June 30, 2005
                                                                           -----------   ------------    -----------   ------------
<S>                                                                        <C>           <C>             <C>           <C>
Derivative valuation (loss) on issuance of notes - AJW                     $         -   $ (1,974,694)   $(1,599,655)  $ (1,974,694)
Derivative valuation (loss) on issuance of warrants -AJW                             -     (8,669,572)      (492,900)    (8,669,572)
Derivative valuation (loss) on conversion -AJW                                 (13,184)                      (13,184)
Derivative valuation (loss) on issuance of note - Gardiner                           -              -        (37,050)             -
Derivative valuation gain on conversion - Gardiner                                 840                           840
Derivative valuation (loss) on issuance of note - Robinson                      (7,076)             -       (368,608)             -
Derivative valuation (loss) - beneficial conversion revaluation - Robinson     742,612                       742,612
Derivative valuation (loss) on issuance of notes - Lively                            -              -        (58,306)             -
Derivative valuation (loss) - beneficial conversion revaluation - Lively       106,799                       106,799
Derivative valuation (loss) - beneficial conversion revaluation - Gardiner                          -        (20,520)             -
Derivative valuation gain (loss) - warrant revaluation AJW                   1,961,476      3,201,550      1,174,734      3,201,550
Derivative valuation gain (loss)- beneficial conversion revaluation - AJW    1,693,704        (53,494)     4,059,938        (53,494)
                                                                           -----------   ------------    -----------   ------------
                                                                           $ 4,485,171   $ (7,496,210)   $ 3,494,700   $ (7,496,210)
                                                                           ===========   ============    ===========   ============
</TABLE>


                                       15
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

On June 30, 2006 the Company filed a Registration Statement with the Securities
and Exchange Commission and, accordingly on July 6, 2006 the Company received
$500,000 representing the second tranche of the above referenced agreement in
exchange for 6% Callable Secured Convertible Notes and issued five year warrants
to purchase 550,000 shares of common stock priced at $1.25 valued at $81,180 on
the date of issuance which will be recorded as a derivative liability. An
aggregate of $7,380 was recognized as loan costs and $73,800 will be recognized
as a derivative valuation loss on issuance of the warrants. The beneficial
conversion feature was valued at $867,984 and will be recorded as a derivative
liability An aggregate of $500,000 was allocated to discounts on the individual
notes, representing 100% of the face value of the notes which will accrete over
the three year life of the notes, with the remaining $367,984 to be recognized
as a derivative valuation loss. The Company incurred loan costs totaling $32,380
which consists of fees to be paid in cash of $25,000 and a five year warrant to
purchase 50,000 shares of common stock priced at $1.25 valued at $7,380 on the
date of issuance which will be amortized over the three year term of the notes.
The Company will record these transactions in the quarter ending September 30,
2006.

An analysis of the July 6, 2006 issuance under the March 14, 2006 Securities
Purchase Agreement and the significant assumptions used to value the warrants
and the beneficial conversion feature are contained in the following table:

                                                          March 14, 2006
                                                            Agreement
                                                             Tranche 2
                                                          --------------
Issue date                                                  7/6/2006
Aggregate note amounts                                     $   500,000
Conversion price                                           $      0.08
Term of notes                                                  3 years
Shares issuable upon conversion                              5,928,854
Warrants issued                                                550,000
Exercise price of warrants                                 $      1.25
Term of warrants                                               5 years
Stock price                                                $      0.15
Risk free interest rate                                           5.17%
Volatility                                                      242.90%
Fair value per share of conversion shares                       0.1464
Beneficial conversion feature fair value                   $   867,984
Note discount amount                                       $   500,000
Warrant fair value per share                               $    0.1476
Fair values of warrants                                    $    81,180
Value of warrants allocable to loan costs                  $     7,380
Fair value of derivative related to warrants               $    73,800
Fair value of derivative allocated to beneficial
conversion feature                                         $   367,984
Aggregate fair value allocated to derivative instruments   $   449,164


                                       16
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

On January 15, 2006 the Company issued an unsecured note to James Gardiner in
the amount of $90,000 in exchange for cash of $82,000 and fees of $8,000. The
note is due December 31, 2007, is unsecured and bears interest at the rate of
12% and is convertible into Class A common stock at $0.30 per share at any time.
The note contains a beneficial conversion feature due to the conversion price of
$0.30 being lower than the market price of $0.53 on the date of issuance. The
beneficial conversion feature was valued at $127,050 using the Black Scholes
method on the date of issuance, and was recorded as a derivative liability on
the date of issuance. The Company allocated $90,000 of the beneficial conversion
feature as a discount on the note, which will accrete over the life of the note.
As of March 31, 2006, the derivative liability was valued at $147,570, which
resulted in an additional $20,520 of derivative valuation loss recorded in the
three month period ended March 31, 2006. On April 20, 2006 the holder converted
the note into 300,000 shares of the Company's Class A common stock. The
derivative on the date of conversion was valued at $146,730. As a result of the
conversion, the Company will recognize a derivative valuation gain of $840
representing the change of the value from the March 31, 2006 valuation date to
the date of conversion and as a result, reclassified $146,730 to additional paid
in capital and expensed the remaining discount on the note in the amount of
$85,000 to interest expense during the quarter ending June 30, 2006.

An analysis of the valuation of the beneficial conversion feature and the
significant assumptions used are contained in the following table:

<TABLE>
<CAPTION>
                                                         Issuance date              Report date          Conversion date
Valuation date                                          January 15, 2006           March 31, 2006         April 20, 2006
                                                       -----------------          ---------------       ----------------
<S>                                                    <C>                        <C>                   <C>
Aggregate note amounts                                 $          90,000          $        90,000       $         90,000
Conversion price                                       $            0.30          $          0.30       $           0.30
Remaining Term of note                                        1.95 years               1.75 years             1.70 years
Shares issuable upon conversion                                  300,000                  300,000                300,000
Market Price                                           $            0.45          $          0.53       $           0.53
Risk free interest rate                                             4.39%                    4.80%                  4.89%
Volatility                                                        253.76%                  247.96%                246.20%
Fair value per share of conversion shares                         0.4235                   0.4919                 0.4891
Beneficial conversion feature fair value               $         127,050          $       147,570       $        146,730
Note discount amount                                   $          90,000          $        85,000       $             --
Fair value of derivative related to
  beneficial conversion feature                        $          37,050          $        57,570       $         56,730
Derivative valuation gain (loss) recognized                                       $       (20,520)      $            840
</TABLE>

On January 17, 2006 the Company issued an unsecured note in the amount of
$88,637 bearing interest at the rate of 5.0% to a vendor in exchange for
services previously rendered. The note was originally due in full on April 19,
2006. The Company and the vendor have agreed to amend the payment terms of the
note. Payments of $15,000 were made during the three months ended June 30, 2006
and monthly payments remain of $25,000 on July 20, 2006 with the remaining
balance of principal and accrued interest due August 30, 2006. The note is
personally guaranteed by Mr. Robinson who has pledged certain of his personal
assets as collateral.

On March 20, 2006 the Company issued an unsecured note in the amount of $57,052
to a vendor in exchange for services previously rendered. The note was
originally due in three equal monthly installments of $19,024 beginning March
25, 2006. No interest is due if payments are paid by the due dates. If any
monthly installment is past due, the note bears interest at the rate of 10% per
annum. The note is in default as of June 30, 2006. On July 27, 2006 the Company
renegotiated the terms of the note. The revised terms provide for twelve equal
installments of $4,756 payable beginning August 1, 2006 through July 1, 2007.
The note is non interest bearing, except in the event of default.

                                       17
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

On April 20, 2006 Mayo Hadden converted $200,000 of his outstanding Convertible
Note into 666,667 shares of common stock at the conversion price of $0.30 per
share. On June 28, 2006, he converted the remaining balance of $131,250 plus
$11,563 of accrued interest at the conversion price of $0.30 into 476,043 shares
of Class A Common Stock.

On April 25, 2006 the Company issued a note to Sierra Nevada Corporation
pursuant to an agreement as more fully described in Note 9 dated April 25, 2006
due August 25, 2006 under certain conditions in the amount of $500,000. The note
is non-interest bearing until August 25, 2006, at which time it will bear
interest at the rate of 8.5% and is secured by certain inventory of the Company.
The Company recorded the initial net present value of $486,192 related to the
note using an 8.5% interest rate. The note is being accreted to the face value
at 8.5% using the effective interest method and accordingly, recognized
accretion of the note of $7,473 as interest expense, bringing the face value to
$493,665 as of June 30, 2006. (See Note 9)

Subsequent to June 30, 2006, Equipment Depot agreed to convert their $25,000
note and $1,500 of accrued interest into 106,000 shares of Company Class A
common stock. The conversion price exceeded the market price on the conversion
date of July 21, 2006 of $0.18 thus no beneficial conversion will be recognized
in the quarter ended September 30, 2006.

The Company is currently in discussions with Charles McClure to amend his note
agreement which continues to be in default.


                                       18
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                                    June 30,    December 31,
                                                                                      2006          2005
                                                                                   ----------   ------------
<S>                                                                                <C>           <C>
Current - Unrelated parties

Convertible Note payable - Mayo Hadden, unsecured, interest accrues
 at 10.0% per annum due February 25, 2007                                          $       --   $  331,250

Convertible Notes payable C.M.G. Tech., unsecured, interest accrues
 at 10% per annum due February 25, 2007                                               822,094      822,094

Note payable Charles McClure, secured by an airship, interest accrues
 at 25.0% per annum and was due December 31, 2005, currently in default               250,000      250,000

Notes payable to Vendors - unsecured, interest accrues at 12% per annum due in
 4 equal payments from March 5, 2006 to June 5, 2006
 in default at June 30, 2006 paid in full subsequent to June 30, 2006                  66,662      154,887

Commercial Promissory Note, - Equipment Depot, Inc., interest at 9.0%
 per annum, secured, due June 19, 2006, in default at June 30, 2006                    25,000       25,000

Note payable to vendor - unsecured, interest accrues at 5%
 per annum, monthly payments, due August 30, 2006                                      74,523           --

Note payable - 21st Century Airship, Inc. - interest accrues at 12%
 per annum, the Note was due on August 24, 2005, paid in full
 in March, 2006                                                                            --      144,844

Note payable to vendor - unsecured, interest accrues at 10% per annum due in
 three monthly installments from March 25, 2006
 to May 25, 2006, in default at June 30, 2006                                          57,072           --

Note payable - Sierra Nevada Corporation - non interest bearing secured by
 certain inventory due August 25, 2006 net of unamortized discount of $6,335          493,665           --
                                                                                   ----------   ----------
TOTAL CURRENT UNRELATED PARTIES                                                    $1,789,016   $1,728,075
                                                                                   ==========   ==========
Long-term - unrelated parties

Notes payable - AJW Partners, LLP and affiliates, callable secured convertible
 notes bearing interest at 8.0% per annum, $802,997 due April 4, 2008;
 $1,300,000 due May 25, 2008 and $1,200,000 due August 4, 2008 less total
 discount of $2,130,519
 and $2,762,333, respectively                                                       1,172,685      655,358

Notes payable - AJW Partners, LLP and affiliates, callable secured convertible
notes bearing interest at 6.0% per annum,
due March 13, 2009 less total discount of $901,370                                     98,630           --
                                                                                   ----------   ----------
TOTAL LONG TERM NOTES PAYABLE                                                      $1,271,315   $  655,358
                                                                                   ==========   ==========
</TABLE>


                                       19
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

NOTE 6 - NOTES PAYABLE - RELATED PARTIES

On April 19th, 2006, the Board approved a $1,000,000 line of credit with Mr.
Robinson. On April 19, 2006 pursuant to the line of Credit, the Company entered
into a convertible variable promissory note in the principal amount as of March
31, 2006 of $565,188 including all related accrued interest. The note bears
interest at the rate of 12% per annum, is unsecured and is convertible into
Class A common stock at $0.30 per share. The note is due on December 31, 2007.
The note contains a beneficial conversion due to the conversion price of $0.30
being lower than the market price of $0.53 on the date of issuance. The
beneficial conversion feature was valued at $926,720 on the date of issuance and
recorded as a derivative liability. The Company has allocated $565,188 of the
beneficial conversion feature as a discount on the note, which represents 100%
of the face value of the note, which will accrete over the life of the note. In
addition, the Company recognized a derivative valuation loss on the issuance of
the note in the amount of $361,533.

Mr. Robinson advanced an additional $75,272 during the three months ended June
30, 2006, resulting in additional discount being recorded by the Company of
$65,796. In addition, Mr. Robinson converted an aggregate of $52,123 of accounts
payable to the line of credit. An analysis of the valuation upon issuance and
the revaluation as of June 30, 2006 of the beneficial conversion feature related
to Mr. Robinson's note and the significant assumptions used are contained in the
following table:

<TABLE>
<CAPTION>
                                                                    Issuances
                                              Issuance date        from April 1 to        Report date
                                              March 31, 2006         June 30, 2006      June 30, 2006

<S>                                         <C>                 <C>                   <C>
Aggregate note amounts                      $        565,188    $          127,395    $       642,583

Conversion price                            $           0.30    $             0.30    $          0.30
Term of notes at issuance                         1.75 years      1.55 - 1.7 years         1.50 years
Shares issuable upon conversion                    1,883,960               424,649          2,141,942

Market Price                                $           0.53    $     0.29 - $0.50    $          0.17
Risk free interest rate on issue date                   4.80%         4.96% - 5.14%              5.16%
Volatility on issue date                              247.96%     240.51% - 246.75%            242.54%

Fair value per share of conversion shares             0.4919    $     0.25 - $0.46             0.1404

Beneficial conversion feature fair value    $        926,720    $          116,620    $       300,729

Note discount amount                        $        565,188    $          109,545    $       547,512
Fair value of derivative related to

  beneficial conversion feature             $        361,532    $            7,075    $       300,729
</TABLE>

                                       20
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

On April 20, 2006, Mr. Robinson converted $50,000 of the balance at the stated
conversion rate into 166,667 shares of Class A common stock. An analysis of the
valuation of the beneficial conversion feature related to Mr. Robinson's note
and the significant assumptions used are contained in the following table:

Conversion date                                               4/20/2006
                                                           ------------------
Original proceeds from note                                $          565,188
Note amount converted                                      $           50,000
Principal remaining after conversion                       $          515,188
Conversion price                                           $             0.30
Term of notes at December 31, 2005                            1.70 years
Shares issued on conversion                                           166,667
Potential remaining conversion shares                               1,717,293
Common Stock Price on conversion date                      $             0.53
Risk free interest rate at December 31, 2005                            4.89%
Volatility on conversion dates                                        246.20%
Fair value per share of conversion shares                              0.4891
Fair value of derivative                                   $          839,928
Derivative liability reclassified to additional
paid-in
capital upon conversion                                    $           81,517
Derivative valuation loss recognized
on conversion                                              $                -

The Company has allocated an aggregate of $674,733 of the beneficial conversion
feature as a discount on the note which will accrete over the life of the note.
Total accretion of $127,221 was recorded during the three months ended June 30,
2006. The carrying value of the note is $95,671, net of discount of $547,512 and
is recorded in Notes Payable - related parties in the accompanying balance sheet
as of June 30, 2006.

On April 19, 2006, the Board approved two convertible promissory notes for
amounts as of April 17th, 2006, of $83,726 and $13,056, respectively with Frank
Lively for cash advanced for working capital plus fees and interest. The notes
bear interest at the rate of 12% per annum, are unsecured and are convertible
into Class A common stock at $0.30 per share. The notes are due on December 31,
2007. The notes contain a beneficial conversion feature due to the conversion
price of $0.30 being lower than the market price of $0.53 on the date of
issuance. The beneficial conversion feature was valued at $149,457 on the date
of issuance and recorded as a derivative liability. The Company has allocated
$91,151 of the beneficial conversion feature as a discount on the balance of the
notes as of March 31, 2006 which will accrete over the life of the notes. In
addition, the Company recognized a derivative valuation loss on the issuance of
the note in the amount of $58,306. Total accretion of $12,986 was recorded
during the three months ended June 30, 2006.The carrying value of the notes as
of June 30, 2006 was $12,986 net of discount of $78,165 and is recorded in Notes
Payable - related parties in the accompanying balance sheet as of June 30, 2006.
The Company paid $15,000 of principal and accrued interest in July 2006 to Mr.
Lively.


                                       21
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

An analysis of the valuation upon issuance and the revaluation as of June 30,
2006 of the beneficial conversion feature related to Mr. Lively's note and the
significant assumptions used are contained in the following table:

<TABLE>
<CAPTION>
                                                            Issuance date              Report date
                                                            March 31, 2006             June 30, 2006
                                                         ----------------------     -------------------
<S>                                                      <C>                        <C>
Aggregate note amounts                                   $               91,151     $            91,151
Conversion price at March 31, 2006                       $                 0.30     $              0.30
Term of notes at March 31, 2006                             1.75 years                 1.50 years
Shares issuable upon conversion                                         303,837                 303,836
Market Price                                             $                 0.53     $              0.17
Risk free interest rate on issue date                                      4.80%                   5.16%
Volatility on issue date                                                 247.96%                 242.54%
Fair value per share of conversion shares                                0.4919                  0.1404
Beneficial conversion feature fair value                 $              149,457     $            42,659
Note discount amount                                     $               91,151     $            78,165
Fair value of derivative related to
beneficial conversion feature                            $               58,306     $            42,659
</TABLE>


On April 19, 2006, the Board approved a convertible promissory note for an
aggregate amount as of April 17, 2006 in the amount of $312,255 plus accrued
interest with Cherokee Raiders, LP, by way of cash advanced for working capital
plus fees and interest. The note bears interest at the rate of 12% per annum, is
unsecured and is convertible into Class A common stock at $0.30 per share. The
note is due on December 31, 2007. This note replaces the note dated December 31,
2005 on identical terms.

The three notes discussed above provide for acceleration of payment from amounts
in excess of a minimum of $7,000,000 that are raised in any type of financing.
Such prepayments would be made on a pro rata basis among certain note holders.
As a result of this acceleration provision, the notes have all been treated as
current liabilities.

On April 20, 2006 the Company issued an aggregate of 964,443 shares upon
exercise of the conversion rights to Class A common stock at a conversion price
of $0.30 per share associated with Convertible Notes in the aggregate amount of
$289,333. The four executive employees converted an aggregate of $139,419, Frank
Lively converted one of his notes representing deferred salary in the amount of
$49,914, and Mr. Robinson and Cherokee each converted $50,000.

During the three months ended June 30, 2006 the Company paid $25,000 of the
principal balance of the Convertible Note payable to Proxity, Inc.


                                       22
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                                    June 30,    December 31,
                                                                                      2006          2005
                                                                                   ----------   ------------
<S>                                                                                 <C>            <C>
Convertible Promissory Note - Cherokee Raiders, interest at 12%
  per annum, due December 31, 2007, unsecured ..................................     262,255        312,255

Convertible Promissory Note - Proxity Inc., interest at 12% per annum,
  due July 31, 2008, unsecured .................................................     326,600        351,600

Convertible Promissory Note - William Robinson, interest at 12% per annum, due
  December 31, 2007, unsecured, net of discount of
  $547,512 and $0, respectively ................................................      95,671        460,851

Convertible Promissory Note - Jim Alman - interest at 12% per
  annum, due December 31, 2007, unsecured ......................................      50,000         50,000

Convertible Promissory Notes - executive employees - interest at
  12% per annum, unsecured, due December 31, 2007 ..............................     123,847        263,266

Convertible Promissory Notes - Frank Lively - interest at 12% per annum,
  unsecured, due December 31, 2007 net of discount of
  $78,165 and $0, respectively .................................................      12,986        124,343
                                                                                    --------     ----------
                                                                                    $871,359     $1,562,315
                                                                                    ========     ==========
</TABLE>

NOTE 7- STOCKHOLDERS' DEFICIT

COMMON STOCK - At June 30, 2006 and December 31, 2005, the Company had
60,321,964 and 56,912,893 shares of Class A Common Stock outstanding,
respectively, 545,455 shares of Class B Common Stock, and 2 shares of Class C
Common Stock issued and outstanding with 200,000,000 shares of Class A and Class
B Common Stock authorized, par value $.001, and 200,000,000 shares of Class C
Common Stock authorized, par value $.001. In addition, the Company had
100,000,000 shares of Class A Preferred Stock authorized, par value $.001, with
no shares issued and outstanding. Class B Common Stock allows for 1,000 votes
per share. Class C Common Stock allows for one vote per share and entitles the
holder to receive the net assets of the Company upon dissolution. Additional
paid in capital at June 30, 2006 and December 31, 2005 was $17,446,531 and
$14,644,966, respectively. The accumulated deficit as at June 30, 2006 and
December 31, 2005 was $18,692,200 and $16,476,382, respectively.


                                       23
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (unaudited)

NOTE 8- INCOME TAXES

The Company has paid no federal or state income taxes since its
incorporation. As of June 30, 2006 and December 31, 2005, the Company had net
operating loss carry forwards for federal income tax reporting purposes of
approximately $8,495,000 and $6,154,864 respectively, which if unused, will
expire through 2026. Deferred tax assets are reduced by a valuation allowance to
the extent that uncertainty exists as to whether the deferred tax assets will
ultimately be realized.

NOTE 9- COMMITMENTS AND CONTINGENCIES

On January 1, 2006 we entered into a new employment agreement with Mr. Robinson,
the CEO, Chairman and President of the Company. The term of this agreement is
for a period of one year subject to renewal for successive one year periods,
unless 14 days prior written notice is provided by either party. Mr. Robinson
will receive an annual salary of not less than $250,000. The agreement provides
for standard benefits, vacation and participation in the Company's bonus pool as
defined in the agreement. In addition, the Company shall issue to Employee
options to purchase shares of Company stock (Shares) in accordance with the
Company's Stock Option Plan. The agreement may be terminated for due cause, upon
death, upon disability, voluntary termination by him, or the Company, without
due cause by providing 14 days prior written notice. Mr. Robinson is subject to
a non-compete and non-solicitation provision during the employment term and
during a specified Post-Employment Period (as defined in the employment
agreement).

On January 1, 2006, we entered into a new employment agreement with our Vice
President, James D. Alman. The term of this agreement is for a period of one
year, subject to renewal for successive one year periods, unless 14 days prior
written notice is provided by either party. Mr. Alman will receive an annual
salary of not less than $135,000. The agreement provides for standard benefits,
vacation and participation in the Company's bonus pool as defined in the
agreement. In addition, the Company shall issue to Employee options to purchase
shares of Company stock (Shares) in accordance with the Company's Stock Option
Plan. The Agreement may be terminated for due cause, upon death, upon
disability, voluntary termination by him, or the Company without due cause by
providing 14 days prior written notice. Mr. Alman is subject to a non-compete
and non-solicitation provision during the employment term and during a specified
Post-Employment Period.

On January 1, 2006, The Company entered into a new employment agreement with
Keith Vierela as Chief Operating Officer. The term of this agreement is one
year, subject to renewal for successive one year periods, unless 14 days prior
written notice is provided by either party. Mr. Vierela will receive an annual
salary of not less than $150,000. The agreement provides for standard benefits,
vacation and participation in the Company's bonus pool as defined in the
agreement. In addition, the Company shall issue to Employee options to purchase
shares of Company stock (Shares) in accordance with the Company's Stock Option
Plan. The Agreement may be terminated for due cause, upon death, upon
disability, voluntary termination by him, or the Company without due cause by
providing 14 days prior written notice. Mr. Vierela is subject to a non-compete
and non-solicitation provision during the employment term and during a specified
Post-Employment Period.


                                       24
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

On January 1, 2006, TSI entered into a new employment agreement with John
Youngbeck as Executive Vice President. The term of this agreement is one year,
subject to renewal for successive one year periods, unless 14 days prior written
notice is provided by either party. Mr. Youngbeck will receive an annual salary
of not less than $100,000. The agreement provides for standard benefits,
vacation and participation in the Company's bonus pool as defined in the
agreement. In addition, the Company shall issue to Employee options to purchase
shares of Company stock (Shares) in accordance with the Company's Stock Option
Plan. The Agreement may be terminated for due cause, upon death, upon
disability, voluntary termination by him, or the Company without due cause by
providing 14 days prior written notice. Mr. Youngbeck is subject to a
non-compete and non-solicitation provision during the employment term and during
a specified Post-Employment Period.

On January 1, 2006, TSI entered into a new employment agreement with Michael
Lawson as Corporate Marketing Officer. The term of this agreement is one year,
subject to renewal for successive one year periods, unless 14 days prior written
notice is provided by either party. Mr. Lawson will receive an annual salary of
not less than $100,000. The agreement provides for standard benefits,
commissions of 2% of all gross sales less costs registered by the employee,
vacation and participation in the Company's bonus pool as defined in the
agreement. In addition, the Company shall issue to Employee options to purchase
shares of Company stock (Shares) in accordance with the Company's Stock Option
Plan. The Agreement may be terminated for due cause, upon death, upon
disability, voluntary termination by him, or the Company without due cause by
providing 14 days prior written notice. Mr. Lawson is subject to a non-compete
and non-solicitation provision during the employment term and during a specified
Post-Employment Period.

On January 1, 2006, the Company entered into an hourly consulting agreement with
Frank Lively. The consulting agreement provides for the cancellation of Mr.
Lively's prior employment agreement. Fees due under the consulting agreement are
convertible into Class A common shares of the Company by Mr. Lively at the
lesser of $0.30 per share or the closing price on the date of conversion.

On January 1, 2006, the Company entered into an hourly consulting agreement with
Steve Johnson. Fees due under the consulting agreement are convertible into
Class A common shares of the Company by Mr. Johnson at the lesser of $0.30 per
share or the closing price on the date of conversion.

In January, 2006 the Company entered into a Strategic Consulting Agreement for
finance consulting services. The agreement calls for a minimum term of 90 days
and the payment of the equivalent of $120,000 of the Company's Class A common
stock at a 30% discount to the closing price and 150,000 warrants at a price to
be determined upon the close of a financing transaction as defined in the
agreement. The agreement was cancelled effective April 19, 2006 and the Company
issued an aggregate of 114,285 shares of Class A Common stock valued at $60,571
pursuant to the terms of a cancellation agreement. The warrants potentially
issuable in the agreement were not issued.


                                       25
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

In February, 2006, the Company entered into an Investor Relations Agreement for
a term of one year with Osprey Partners to provide investor and shareholder
relations services to the Company. The agreement calls for a monthly retainer of
$6,000 and the issuance of warrants to purchase 600,000 shares of the Company's
Class A common stock at a strike price of $0.45 per share with a value of
$419,760 on the date of grant using the Black Scholes method. The warrants
expire 7 years after the anniversary date. The warrants vest monthly over one
year, with 50,000 warrants vesting at the signing of the agreement, subject to
immediate vesting of all remaining warrants should the retainer become 30 days
past due. During June, 2006 the retainer became 30 days past due and
accordingly, the Company recognized compensation expense of $419,760 within
general and administrative expenses in the accompanying statement of operations
for the six months ended June 30, 2006.

In March, 2006 the Company executed a Due Diligence Agreement with GreenHills
Ventures, LLC. ("GreenHills"). Under the agreement, the Company paid GreenHills
$10,750 plus expenses for GreenHills to perform due diligence on behalf of
potential investors as a due diligence fee. In addition, the Company agreed to
compensate GreenHills for any financing transaction (debt, equity, hybrid
security, merger and acquisition or other similar arrangement financing) with
any qualified purchaser as defined in the agreement. The compensation consists
of the payment of cash of 10% of the aggregate value of any equity or non-loan
financing and 7% of the value to be paid in Class A common stock of the Company.
In the event of a non-equity financing, the compensation consists of payment of
cash of 3% of the aggregate value of the transaction and 7% of the value to be
paid in Class A common stock of the Company.

The agreement calls for the payment of a breakup fee to be paid under certain
conditions as defined in the agreement of 2.5% of the first $5,000,000 of a
financing plus 1% of any amount greater than $5,000,000.

On April 27, 2006 the "Company entered into an Agreement, (the "Agreement")
dated as of April 25, 2006, by and among the Company, Sierra Nevada Corporation
"Sierra" and TSI. The Agreement is intended to clarify the relationship and
obligations of the parties, which arise from three prior agreements (the
Exclusive Agreement to Provide Integration Services, dated June 30, 2004, the
Memorandum of Agreement dated November 4, 2004 and the Subcontract Agreement
dated May 11, 2005) which were entered into prior to Techsphere becoming a
wholly-owned subsidiary of the Company. The Agreement provides that SNC will
serve as the prime contractor to Government End-Users for all Techsphere
Airships and provided that Sierra will give Techsphere the right of first
refusal to lease or sell other non-Techsphere manufactured airships to Sierra on
competitive terms. The Agreement also is intended to arrive at an understanding
with respect to amounts claimed by Sierra as owed, which arose from certain
expenditures made by Sierra for which they are seeking reimbursement. The
Agreement provides that if all other conditions of the Agreement are fulfilled
that (i) Sierra will reduce its claim from $780,000 to $500,000; (ii) the
Company will within 90 days deliver four MAA-90 airship pods to Techsphere free
and clear of any liens and encumbrances and (iii) if a demonstration contract is
awarded and Techsphere delivers the completed MAA-90 airship to Sierra, Sierra
will set-off the $500,000 payment due from the Company. If the demonstration
contract is not awarded and Techsphere does not deliver to Sierra the completed
airship within 120 days of the date of award of the demonstration contract, the
Company's promissory note to Sierra will become due and payable in accordance
with its terms.

Pursuant to the Agreement, the Company issued a note to Sierra dated April 25,
2006 in the amount of $500,000 which bears interest at the rate of 8.5%
beginning August 25, 2006 secured by the above referenced airship pods. The
Company recognized the net present value of the note as Selling, General and
Administrative expenses in the accompanying statements of operations. (See Note
5)


                                       26
<PAGE>

                    CYBER DEFENSE SYSTEMS INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

During the quarter ended June 30, 2006, the Company executed an Airship
Advertising Agreement with a fortune 100 publicly traded company for the lease
and operation of two of its SA-60A spherical airships. The lease term will
commence on January 1, 2007 and provides for an initial six-month term which can
be extended at the discretion of the lessee. Future minimum lease payments to be
received by the Company are as follows:

Payment at fabric & material review   $  700,000
Due at launch of first airship           700,000
Due at launch of second airship          700,000
Due three months from launch             700,000
Due at end of initial term               700,000
                                      ----------
  Total                               $3,500,000
                                      ==========

The Company is responsible for all operating, maintenance, insurance, permits,
taxes and related costs. Certain travel related costs incurred will be
reimbursed by the lessee.

In addition, the lessee granted a non-exclusive, non-transferable personal
license to the Company to make and distribute airship related merchandise in
exchange for a royalty of four percent (4.0%) of all net sales of merchandise as
defined in the agreement.

The Company received $700,000 during the quarter ended June 30, 2006 and has
classified the amount as deferred revenue in the accompanying balance sheet as
of June 30, 2006. An additional $686,000, net of vendor discounts of $14,000 was
received August, 2006. Revenue from the lease will be recognized over the six
month term of the lease which commences on January 1, 2007.

NOTE 10- SUBSEQUENT EVENTS

On April 17, 2006 the Company entered into agreements with Equipment Depot,
Inc., to acquire approximately $4,100,000, as valued, of aerospace R & D and
production equipment to further the fulfillment of the Company's anticipated
contracts and purchase orders. The Company would pay approximately $2.7 million,
in a combination of $700,000 in cash and the exchange of 1,700,000 newly issued
common stock of the Company, valued at $1.00 a share for the purposes of the
transactions, to complete the purchase. As of August, 2006, Equipment Depot,
Inc. has indicated to the Company that it is aware of at least one financing
source for completing this transaction.

Pursuant to a letter of proposal with Tatonka Capital Corporation ("Tatonka")
dated April 28, 2006, whereby Tatonka was to provide construction and
transaction financing up to a total of $1,600,000 based on 80% of the
acquisition cost for equipment related to certain airships. All subsequent
proposals were deemed not economically feasible and in August 2006 the company
ceased all related discussions. In August, 2006, the Company ceased discussions
with Tatonka.

On July 21, 2006 the Company issued 46,666 shares of its Class A common stock
upon the conversion of $7,000 of accounts payable by its Chief Financial
Officer, David M. Barnes at a price of $0.15 per share, representing the market
value on the date of issuance.

On July 21, 2006 the Company issued 116,000 shares of its Class A common stock
to a vendor for services rendered relating to the financings with AJW. The stock
was valued at $0.18 per share, representing the closing price on the date of
issuance. The Company will record this transaction in the quarterly period
ending September 30, 2006 as additional loan costs in the amount of $20,880
related to the AJW loans and will amortize them over the remaining term of the
loan to which they pertain of three years.

On July 21, 2006, the Company agreed to issue an aggregate of 500,000 shares of
its Class A common stock to Crescent Fund an investor relations firm for
services to be rendered to the Company. The stock was valued at $0.18 per share,
representing the closing price on the date of issuance. The Company will record
this transaction in the quarterly period ending September 30, 2006 as $90,000 of
additional general and administrative expense for investor relations.


                                       27
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
LIQUIDITY AND CAPITAL RESOURCES

GENERAL

The following discussion and analysis should be read in conjunction with the
Condensed Consolidated Financial Statements and Notes thereto appearing
elsewhere in this Form 10-QSB.

This management's discussion and analysis of financial conditions and results of
operations contains certain "forward-looking statements" as defined in the
Private Securities Litigation Reform Act of 1995. Such statements relating to
future events and financial performance are forward-looking statements that
involve risks and uncertainties, detailed from time to time in the Company's
various SEC filings. No assurance can be given that any such matters will be
realized.

RESULTS OF OPERATIONS

The Three Months Ended June 30, 2006 Compared to the Three Months Ended June 30,
2005

General and administrative expenses totaled $2,296,197 for the three months
ended June 30, 2006 as compared to $769,116 for the three months ended June 30,
2005, a net increase of $1,527,081. The increase is primarily due to
compensation expense relative to warrants of $353,616 as well as increased
payroll, marketing related activities, specialized consulting and legal fees and
a general increase in overheads. Also included in the three months ended June
30, 2006 is an aggregate of $721,277 pertaining to TSI for which no prior year
comparable expense exists. The TSI expenses for the three months ended June 30,
2006 are comprised of $250,000 of royalty expense and $197,994 of amortization
related to the Century 21 Airships license and $273,283 related to general
overheads.

Stock option compensation expense for the three months ended June 30, 2006
totaled $350,584 relating to the fair value of stock options that vested during
the period. There was no comparable prior year period expense.

Research and development expense totaled $70,785 for the three months ending
June 30, 2006 as compared to $543,191 for the three months ended June 30, 2005,
a net decrease of $472,406. The expense for the 2006 period pertains to
development of the Company's UAV's while the comparable 2005 period pertains to
the airship propulsion systems for which no current period comparable expense
exists.

Other income and expense for the three months ended June 30, 2006 and 2005 was
comprised of interest expense, interest income and derivative valuation gains
and losses. Interest expense for the three months ended June 30, 2006 was
$862,770, of which $662,210 represents amortization of discounts on notes to
AJW, Mr. Robinson, Mr. Lively and James Gardiner. Interest expense for the three
months ended June 30, 2005 was $308,635, of which $161,228 represented
amortization of loan discount. Interest income for the three months ended June
30, 2005 was $10,241 for which no amount exists for the three months ended June
30, 2006.

Derivative valuation gains for the three months ended June 30, 2006 in the
amount of $4,485,171 relate to the issuance, conversion and revaluation of Notes
and Warrants to AJW and various notes issued to Mr. Robinson, Mr. Lively and
James Gardiner treated as derivative securities. Derivative valuation loss for
the three months ended June 30, 2005 in the amount of $7,496,210 relate to the
losses on issuance and revaluation of Notes and Warrants to AJW.

                                       28
<PAGE>

The components of the derivative valuation gains (losses) for the three months
ended June 30, 2006 and 2005 are presented in the following table.

<TABLE>
<CAPTION>
                                                                                     Three months ended
                                                                              June 30, 2006       June 30, 2005
                                                                            ----------------    ----------------
<S>                                                                         <C>                 <C>
Derivative valuation (loss) on issuance of notes - AJW                      $             --    $     (1,974,694)
Derivative valuation (loss) on issuance of warrants -AJW                                  --          (8,669,572)
Derivative valuation (loss) on conversion -AJW                                       (13,184)
Derivative valuation (loss) on issuance of note James Gardiner                            --                  --
Derivative valuation (loss) on issuance of note- William Robinson                     (7,076)                 --
Derivative valuation gain - beneficial conversion revaluation - William
Robinson                                                                             742,612
Derivative valuation (loss) on issuance of notes - Frank Lively                           --                  --
Derivative valuation (loss) - beneficial conversion revaluation - Frank
Lively                                                                               106,799
Derivative valuation (loss) - beneficial conversion revaluation - James
Gardiner                                                                                 840                  --
Derivative valuation gain (loss) - warrant revaluation AJW                         1,961,476           3,201,550
Derivative valuation gain (loss)- beneficial conversion revaluation - AJW          1,693,704             (53,494)
                                                                            ----------------    ----------------
                                                                            $      4,485,171    $     (7,496,210)
                                                                            ================    ================
</TABLE>

The Company uses the Black Scholes method to value the derivatives contained in
the securities it has issued. The assumptions used in the valuation of the
derivatives have been detailed in Note 5 and 6 of the financial statements. The
most significant valuation assumption components in the valuation calculations
are the closing stock price on the date of the valuation and the number of
shares issuable upon conversion, which is based upon a discount applied to the
average of the lowest three intra-day trading prices for the Company's common
stock during the 20 trading days immediately preceding the valuation date.

The primary assumption change in the valuation of the derivative securities has
been the change in the market price of the common stock as of the valuation
dates. There was a decrease in the price of the Company's common stock during
the quarter ended June 30, 2006. The stock price was $0.53 as of March 31, 2006
as compared to $0.17 as of June 30, 2006. As a result of the decrease of the
stock price, the valuation of the underlying derivatives decreased. The
derivative gains for the three months ended June 30, 2006 are also due to the
fact that there were no issuances of new derivative securities to AJW during the
three months ended June 30, 2006, which have historically resulted in the
recognition of losses upon issuance. As a result, since the Company recognizes a
gain or loss dependant upon the change in valuation at each reporting date, the
decrease in value as of June 30, 2006 when compared to the March 31, 2006
resulted in gains upon the revaluation of the derivatives.

The derivative losses for the three month period ended June 30, 2005 result
primarily from the price of the stock on the date of issuance of the AJW
securities on April 1, 2005 of $3.60 and the price on May 25, 2005 of $2.75
resulted in significant losses upon issuance when using the Black Scholes
method. The price of the stock at the valuation date of June 30, 2005 decreased
to $2.00, .resulting in a decrease in the value of the warrants and the
recognition of a derivative valuation gain related to the decreased value of the
warrants that partially offset the issuance losses.

The Six Months Ended June 30, 2006 Compared to the Six Months Ended June 30,
2005

General and administrative expenses totaled $3,616,255 for the six months ended
June 30, 2006 as compared to $1,330,744 for the six months ended June 30, 2005,
a net increase of $2,285,511. The increase is primarily due to share based
compensation expense relative to warrants of $419,760 as well as increased
payroll, marketing related activities, specialized consulting and legal fees and
a general increase in overheads. Also included in the six months ended June 30,
2006 is an aggregate of $1,349,956 pertaining to TSI for which no prior year
comparable expense exists. The TSI expenses for the three months ended June 30,
2006 are comprised of $494,122 of royalty expense and $395,988 of amortization
related to the Century 21 Airships license and $459,846 related to salaries,
rents and general overheads.

                                       29
<PAGE>

Stock option compensation expense for the six months ended June 30, 2006 totaled
$984,279 relating to the fair value of stock options that vested during the
period. There was no comparable prior year period expense.

Research and development expense totaled $99,261 for the six months ending June
30, 2006 as compared to $543,191 for the six months ended June 30, 2005 a net
decrease of $443,930. The expense for the 2006 period pertains to development of
the Company's UAV's while the comparable 2005 period pertains to the airship
propulsion systems for which no current period comparable expense exists.

The impairment of goodwill in the amount of $4,577,069 for the six months ended
June 30, 2005 pertains to goodwill associated with the acquisition of Cyber
Aerospace for which no current year comparable amount exists.

Other income and expense for the six months ended June 30, 2006 and 2005 was
comprised of interest expense, interest income and derivative valuation gains
and losses. Interest expense for the six months ended June 30, 2006 was
$1,385,670, of which $976,124 represents amortization of discounts on notes to
AJW, Mr. Robinson, Mr. Lively and James Gardiner. Interest expense for the six
months ended June 30, 2005 was $861,085, of which $678,228 represented
amortization of loan discount. Interest income for the six months ended June 30,
2005 was $10,241 for which no amount exists for the three months ended June 30,
2006.

Derivative valuation gains for the six months ended June 30, 2006 in the amount
of $3,494,700 relate to the issuance, conversion and revaluation of Notes and
Warrants to AJW and various notes issued to Mr. Robinson, Mr. Lively and James
Gardiner treated as derivative securities. Derivative valuation losses for the
six months ended June 30, 2005 in the amount of $7,496,210 relate to the losses
on issuance and revaluation of Notes and Warrants to AJW.

The components of the derivative valuation gains (losses) for the six months
ended June 30, 2006 and 2005 are presented in the following table:

<TABLE>
<CAPTION>
                                                                                             Six months ended
                                                                                     June 30, 2006      June 30, 2005
                                                                                   ----------------    ----------------
<S>                                                                                <C>                 <C>
Derivative valuation (loss) on issuance of notes - AJW                             $     (1,599,655)   $     (1,974,694)
Derivative valuation (loss) on issuance of warrants -AJW                                   (492,900)         (8,669,572)
Derivative valuation (loss) on conversion -AJW                                              (13,184)

Derivative valuation (loss) on issuance of note James Gardiner                              (37,050)                 --

Derivative valuation (loss) on issuance of note- William Robinson                          (368,608)                 --
Derivative valuation gain - beneficial conversion revaluation - William Robinson            742,612

Derivative valuation (loss) on issuance of notes - Frank Lively                             (58,306)                 --
Derivative valuation gain - beneficial conversion revaluation - Frank Lively                106,799

Derivative valuation (loss) - beneficial conversion revaluation - James Gardiner            (19,680)                 --
Derivative valuation gain  - warrant revaluation AJW                                      1,174,734           3,201,550
Derivative valuation gain (loss)- beneficial conversion revaluation - AJW                 4,059,938             (53,494)
                                                                                   ----------------    ----------------
                                                                                   $      3,494,700    $     (7,496,210)
                                                                                   ================    ================
</TABLE>

                                       30
<PAGE>

The derivative gain for the six months ended June 30, 2006 relates primarily to
the decrease in the value of the common stock for the six months ended June 30,
2006. The stock price was $0.40 as of December 31, 2005 as compared to $0.17 as
of June 30, 2006. As a result of the decrease of the stock price, the valuation
of the underlying derivatives decreased significantly. As a result, since the
Company recognizes a gain or loss dependant upon the change in valuation at each
reporting date, the decrease in the liability related to this value as of June
30, 2006 when compared to the December 31, 2005 resulted in gains, most notably
in the AJW beneficial conversion valuation. In addition, the issuance of notes
of $1,000,000 to AJW and related warrants for the purchase of 1,100,000 shares
of common stock for the six months ended June 30, 2006 decreased from the
$2,500,000 issuance of notes to AJW and related warrants for the purchase of
2,750,000 shares of common stock related to issuances of new convertible notes
treated as derivative securities in the six months ended June 30, 2005.

The derivative losses for the six month period ended June 30, 2005 result
primarily from the price of the stock on the date of issuance of the AJW
securities on April 1, 2005 of $3.60 and the price on May 25, 2005 of $2.75
resulted in significant losses upon issuance. The price of the stock at the
valuation date of June 30, 2005 decreased to $2.00, .resulting in a decrease in
the value of the warrants and the recognition of a derivative valuation gain
that partially offset the issuance losses.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary needs for liquidity and capital resources are the funding
of salaries and other administrative expenses related to the management of the
Company as well as for payment of the cost of products sold and inventory.

The Company's cash and cash equivalents of $5,457 as of June 30, 2006 is not
sufficient to support current levels of operations for the next twelve months
and it is therefore necessary for the Company to seek additional financing.

Pursuant to such need, on March 15, 2006, the Company entered into a Securities
Purchase Agreement, whereby the Company agreed to issue and sell an aggregate of
$2,000,000 of 6% Callable Secured Convertible Notes and warrants to purchase
2,000,000 shares of common stock at a price of $1.25 per share for a total
offering price of $2,000,000. The $2,000,000 is to be funded in three tranches
of which $1,000,000 was funded on March 15, 2006, $500,000 upon filing the
Registration Statement and $500,000 upon effectiveness of the Registration
Statement. On June 30, 2006 the Company filed a Registration Statement with the
Securities and Exchange Commission and, accordingly on July 6, 2006 the Company
received $500,000 representing the second tranche of the above referenced
agreement in exchange for 6% Callable Secured Convertible Notes and issued five
year warrants to purchase 500,000 shares of common stock priced at $1.25. There
can be no assurances that the Company's Registration Statement will be declared
effective by the Securities and Exchange Commission.


                                       31
<PAGE>

On April 20, 2006 Mayo Hadden converted $200,000 of his outstanding Convertible
Note into 666,667 shares of common stock. On June 28, 2006, he converted the
remaining balance of $131,250 plus $11,563 of accrued interest into 476,043
shares of Class A Common Stock. The conversions were at the price of $0.30 per
share. There was no beneficial conversion feature associated with this note.

On April 21, 2006 the Company issued an aggregate of 964,443 shares to related
parties upon exercise of the conversion rights to Class A common stock at a
conversion price of $0.30 per share associated with Convertible Notes in the
aggregate amount of $289,333. Four executive employees converted an aggregate of
$139,419, Frank Lively converted his note representing deferred salary in the
amount of $49,914, and Mr. Robinson and Cherokee each converted $50,000. The
conversion of Mr. Robinson's note resulted in the reclassification of a
derivative liability in the amount of $81,617 to additional paid in capital. No
gain or loss was recognized on the conversion as the value did not change since
the last revaluation date.

On June 6, 2006, AJW converted $114,487 of the Notes for 609,300 Shares of Class
A common stock of the Company. The conversions were made at a 40% discount to
market pursuant to the terms of the Secured Convertible Note agreements. The
conversion resulted in the reclassification of a derivative liability in the
amount of $227,634 to additional paid in capital and the recognition of a loss
on conversion of $13,184.

On January 15, 2006 the Company issued an unsecured note in the amount of
$90,000 in exchange for cash of $82,000 and fees of $8,000. The note is due
December 31, 2007, is unsecured and bears interest at the rate of 12% and is
convertible into Class A common stock at $0.30 per share at any time. On April
20, 2006, the holder converted the note into 300,000 shares of the Company's
Class A common stock. The conversion resulted in the reclassification of a
derivative liability in the amount of $56,730 to additional paid in capital and
the recognition of a gain on conversion of $840.

On April 17, 2006 the Company entered into agreements with Equipment Depot,
Inc., to acquire approximately $4,100,000, as valued, of aerospace R & D and
production equipment to further the fulfillment of the Company's anticipated
contracts and purchase orders. The Company would pay approximately $2.7 million,
in a combination of $700,000 in cash and the exchange of 1,700,000 newly issued
common stock of the Company, valued at $1.00 a share for the purposes of the
transactions, to complete the purchase. As of August, 2006, Equipment Depot,
Inc. has indicated to the Company that it is aware of at least one financing
source for completing this transaction.

On April 19th, 2006, the Board approved a $1,000,000 line of credit with Mr.
Robinson. On April 19, 2006 pursuant to the line of Credit, the Company entered
into a convertible variable promissory note in the principal amount as of March
31, 2006 of $565,188 under the line of credit including all related accrued
interest. The note bears interest at the rate of 12% per annum, is unsecured and
is convertible into Class A common stock at $0.30 per share. The note is due on
December 31, 2007. During the six months ended June 30, 2006, Mr. Robinson
advanced an additional $179,698 under the line of credit during the six months
ended June 30, 2006.

On April 19, 2006, the Board approved two convertible promissory notes for
amounts as of April 17th, 2006, of $83,726 and $13,056, respectively with Frank
Lively, a director of the Company for cash advanced for working capital plus
fees and interest. The notes bear interest at the rate of 12% per annum, is
unsecured and is convertible into Class A common stock at $0.30 per share. The
notes are due on December 31, 2007. Mr. Lively has advanced an aggregate of
$16,722 for the six months ended June 30, 2006.

On May 22, 2006, Techsphere Systems International, Inc., ("TSI") closed on a
lease contract for two of its SA-60A Spherical Airships to a fortune 100
publicly held company at an estimated initial contract value of approximately
$4.2 million. The Company received an initial down payment of $700,000 with the
closing and an additional $686,000 in August, 2006.


                                       32
<PAGE>

The Company is utilizing its working capital financing agreement with Commerce
Funding Corporation (CFC) for secured financing of up to $3,000,000 for a two
year term ending March 31, 2007 unless earlier terminated. All borrowings under
this potential financing are collateralized by a first security UCC-1 filing on
all assets related to accounts receivable and a Cross Corporate Guaranty by
Proxity, Inc., the Company's largest shareholder. In addition, CFC requires a
Limited Guaranty of certain provisions in the loan agreement by the Company's
Chief Executive Officer. The interest rate on borrowings is Prime plus 1/2 %.
All borrowings are subject to eligibility of accounts receivable as defined and
determined by CFC and the advance rate on eligible receivables, as defined, is
90% for direct Government accounts and 80% for Commercial Accounts.

The Company is in discussions with several other potential lending sources, but
there can be no assurance that these discussions will be successful or that the
Company will obtain sufficient financing or that financing(s) will be structured
on agreeable terms.

Subject to the realization of certain financings as described above and the
financing available from Commerce Funding Corporation, if we generate sufficient
eligible receivables to finance, we should be in a position to fund the
anticipated level of operations for at least one year. However, there can be no
assurances that this will be the case. If the Company does not obtain such
additional financing, the level of operations may have to be curtailed.

CRITICAL ACCOUNTING POLICIES

The Company's discussion and analysis of its financial condition and results of
operations are based upon Cyber Defense's financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires the use of
estimates that affect the reported amounts of assets, liabilities and expenses.
The Company evaluates its estimates on an ongoing basis, including estimates for
Income tax assets and liabilities and the impairment of the value of
investments. The Company bases its estimates on historical experience and on
actual information and assumptions that are believed to be reasonable under the
circumstances at that time. Actual results may differ from these estimates under
different assumptions or conditions. The Company believes that the following
critical accounting policies affect its more significant estimates used in the
preparation of its financial statements.

REVENUE RECOGNITION

The Company recognizes service revenues when the services, as specified by the
customer and agreed to by the Company, have been performed and the customer
accepts the services, and the services are billed. Airship sales are recognized
when contract specifications are met, the price is determined, title passes to
the customer and the customer is billed. Lease revenue on airships is recognized
over the term of the lease. Reasonableness of collectibility of all revenue
transactions is a key element before the transactions are recorded.


                                       33
<PAGE>

DERIVATIVE INSTRUMENTS

The Company does not hold or issue derivative instruments for trading purposes.
However, the Company has convertible notes payable that contain embedded
derivatives that require separate valuation from the convertible notes under
Emerging Issues Task Force Abstract (EITF) 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock." The Company recognizes these derivatives as liabilities in the
accompanying balance sheet and measures them at estimated fair value each
quarter, and recognizes changes in estimated fair value in the statement of
operations in the respective period. The Company has estimated the fair value of
these embedded derivatives using the Black-Scholes model.

SHARE BASED PAYMENTS

In December 2004, the Financial Accounting Standards Board issued Statement
Number 123 ("FAS 123 (R)"), Share-Based Payments, which was adopted by the
Company on January 1, 2006. The Company recognizes compensation expense in an
amount equal to the fair value of share-based payments such as stock options
granted to employees. The Company has elected to apply FAS 123 (R) on a modified
prospective method. Under this method, the Company records compensation expense
as awards that were outstanding at the date of adoption continue to vest for the
unvested portion of the awards.

ACCOUNTING FOR INCOME TAXES

No income taxes have been paid or accrued because the Company had no net income
for the fiscal year ended December 31, 2005 or 2004. The Company recognizes the
amount of income taxes payable or refundable for the current year and recognizes
deferred tax assets and liabilities for the future tax consequences attributable
to differences between the financial statement amounts of certain assets and
liabilities and their respective tax bases. Deferred tax assets and deferred tax
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years those temporary differences are expected to be recovered or
settled. Deferred tax assets are reduced by a valuation allowance to the extent
that uncertainty exists as to whether the deferred tax assets will ultimately be
realized.

LONG LIVED ASSETS

Long-lived assets are reviewed for impairment quarterly or when events or
changes in circumstances indicate that the carrying amount may not be
recoverable. Recoverability of assets to be held and used is measured by
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount that the carrying amount
of the assets exceeds the fair value of the assets.

RECENT ACCOUNTING PRONOUNCEMENTS

In February 2006, the FASB issued Statement of Financial Accounting Standards
No. 155, "Accounting for Certain Hybrid Financial Instruments," referred to as
SFAS No. 155. This statement amends SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities" and SFAS No. 140 "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No.
155 permits fair value remeasurement for hybrid financial instruments that
contain embedded derivatives that would require separate accounting. In
addition, the statement establishes a requirement to evaluate interests in
securitized financial assets to identify interests that are freestanding
derivatives or that are hybrid financial instruments that contain embedded
derivatives. SFAS No. 155 is effective for all financial instruments acquired or
issued beginning after an entity's fiscal year beginning on September 15, 2006
with earlier adoption permitted.


                                       34
<PAGE>

In March 2006, the FASB issued FASB Statement No. 156, which amends FASB
Statement No. 140. This Statement establishes, among other things, the
accounting for all separately recognized servicing assets and servicing
liabilities. This Statement amends Statement 140 to require that all separately
recognized servicing assets and servicing liabilities be initially measured at
fair value, if practicable. This Statement permits, but does not require, the
subsequent measurement of separately recognized servicing assets and servicing
liabilities at fair value. An entity that uses derivative instruments to
mitigate the risks inherent in servicing assets and servicing liabilities is
required to account for those derivative instruments at fair value. Under this
Statement, an entity can elect subsequent fair value measurement to account for
its separately recognized servicing assets and servicing liabilities. By
electing that option, an entity may simplify its accounting because this
Statement permits income statement recognition of the potential offsetting
changes in fair value of those servicing assets and servicing liabilities and
derivative instruments in the same accounting period. This Statement is
effective for financial statements for fiscal years beginning after September
15, 2006. Earlier adoption of this Statement is permitted as of the beginning of
an entity's fiscal year, provided the entity has not yet issued any financial
statements for that fiscal year. Management believes this Statement will have no
impact on the financial statements of the Company once adopted.

In June, 2006 the FASB issued FIN 48, "Accounting for Uncertainty in Income
Taxes--an interpretation of FASB Statement No. 109". This Interpretation
clarifies, among other things the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return. This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. is effective for fiscal years beginning after
December 15, 2006. Earlier application is encouraged if the enterprise has not
yet issued financial statements, including interim financial statements, in the
period the Interpretation is adopted. FIN 48, Accounting for Uncertainty in
Income Taxes--an interpretation of FASB Statement No. 109, is effective for
fiscal years beginning after December 15, 2006. Earlier application is
encouraged if the enterprise has not yet issued financial statements, including
interim financial statements, in the period the Interpretation is adopted.
Management believes this Statement will have no impact on the financial
statements of the Company once adopted.

ITEM 3. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

The Company's principal executive officer and principal financial officer, after
evaluating our "disclosure controls and procedures" (as defined in the
Securities Exchange Act of 1934 (the "Exchange Act") Rules 13a-14(c) and
15d-14(c) have concluded that as of a date within 90 days of the filing date of
this report (the "Evaluation Date") our disclosure controls and procedures are
effective to ensure that information we are required to disclose in reports that
we file or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commission
rules and forms.

Changes in internal controls

Subsequent to the Evaluation Date, there were no significant changes in our
internal controls or in other factors that could significantly affect our
disclosure controls and procedures, nor were there any significant deficiencies
or material weaknesses in our internal controls. As a result, no corrective
actions were required or undertaken.


                                       35
<PAGE>

                            PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None

ITEM 2. CHANGES IN SECURITIES INCLUDING UNREGISTERED SALES OF EQUITY SECURITIES

On April 20, 2006 the Company issued an aggregate of 797,776 shares of its Class
A common stock pursuant to the conversion of certain convertible notes payable
to certain officers, directors and executive employees of the Company. In
addition, the Company issued 166,667 shares to Cherokee Raiders, LLP pursuant to
conversion of a portion of its note payable from the Company.

On April 20, 2006 the Company issued an aggregate of 966,667 shares of its Class
A common stock pursuant to the conversion of convertible notes from 2 unrelated
parties.

On April 20, 2006 the Company issued an aggregate of 337,617 shares of its Class
A common stock for services rendered by certain vendors of the Company and in
settlement of certain obligations of the Company.

On April 20, 2006 the Company issued 55,000 shares of its Class A common stock
upon the exercise of stock options by its Chief Financial Officer, David M.
Barnes.

On June 6, 2006, the Company issued 609,300 shares of its Class A common stock
to AJW et al pursuant to their exercise of conversion rights at a 40% discount
to market of $114,487 of secured convertible notes.

On June 28, 2006 the Company issued 476,043 shares of its Class A common stock
to Mayo Hadden upon conversion of his convertible note payable and related
accrued interest.

On July 21, 2006 the Company issued 46,666 shares of its Class A common stock
upon the conversion of accounts payable by its Chief Financial Officer, David M.
Barnes.

On July 21, 2006 the Company issued 116,000 shares of its Class A common stock
to a vendor for services rendered.

All securities described above were issued in reliance upon the exemption set
forth of Section 4(2) of the Securities Act of 1933.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

None

ITEM 5. OTHER INFORMATION

None


                                       36
<PAGE>

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

All references to the Company's Forms 8-K include reference to File No.
333-46424.

4.18 Form of Stock Purchase Warrant dated March 14, 2006 by and among the
Company and AJW Partners, LLC. ("Partners"), AJW Offshore, Ltd. ("Offshore"),
AJW Qualified Partners ("Qualified") and New Millenium Capital Partners, II, LLC
("Millenium") (incorporated by reference to Exhibit 4.1 filed with the March 20,
2006 Form 8-K).

10.25 Form of Secured Convertible Note dated March 14, 2006 by and among the
Company and AJW Partners, LLC.("Partners"), AJW Offshore, Ltd. ("Offshore"), AJW
Qualified Partners ("Qualified") and New Millenium Capital Partners, II, LLC
("Millenium") (incorporated by reference to Exhibit 10.1 filed with the March
20, 2006 Form 8-K).

10.26 Securities Purchase Agreement dated March 14, 2006 (without schedules) by
and among the Company and AJW Partners, LLC. ("Partners"), AJW Offshore, Ltd.
("Offshore"), AJW Qualified Partners ("Qualified") and New Millenium Capital
Partners, II, LLC ("Millenium") (incorporated by reference to Exhibit 10.2 filed
with the March 20, 2006 Form 8-K).

10.27 Security Agreement dated March 14, 2006 by and among the Company and AJW
Partners, LLC. ("Partners"), AJW Offshore, Ltd. ("Offshore"), AJW Qualified
Partners ("Qualified") and New Millenium Capital Partners, II, LLC ("Millenium")
(incorporated by reference to Exhibit 10.3 filed with the March 20, 2006 Form
8-K).

10.28 Intellectual Property Security Agreement dated March 14, 2006 by and among
the Company and AJW Partners, LLC. ("Partners"), AJW Offshore, Ltd.
("Offshore"), AJW Qualified Partners ("Qualified") and New Millenium Capital
Partners, II, LLC ("Millenium") (incorporated by reference to Exhibit 10.4 filed
with the March 20, 2006 Form 8-K).

10.29 Registration Rights Agreement dated March 14, 2006 by and among the
Company and AJW Partners, LLC. ("Partners"), AJW Offshore, Ltd. ("Offshore"),
AJW Qualified Partners ("Qualified") and New Millenium Capital Partners, II, LLC
("Millenium") (incorporated by reference to Exhibit 10.4 filed with the March
20, 2006 Form 8-K).

10.30 Convertible Variable Promissory Note Under A Line Of Credit Not To Exceed
$1,000,000 by and among the Company and William C. Robinson dated April 24, 2006
(incorporated by reference to exhibit 10.1 filed with the April 24, 2006 8-K).

10.31 Convertible Promissory Note by and among the Company and Harvey Frank
Lively dated April 24, 2006 (incorporated by reference to exhibit 10.2 filed
with the April 24, 2006 8-K).

10.32 Convertible Promissory Note by and among the Company and Cherokee Raiders,
LP dated April 24, 2006 (incorporated by reference to exhibit 10.3 filed with
the April 24, 2006 8-K).

10.33 Agreement by and among the Company, TSI and Sierra Nevada Corporation
dated April 25, 2006 (incorporated by reference to exhibit 10.1 filed with the
May 2, 2006 8-K).


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<PAGE>

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

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

32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

(b) - Reports on Form 8-K

The Company filed a Current Report on Form 8-K on April 11, 2006 regarding it's
April 5, 2006 press release relating to its preliminary results of operations
for its fiscal year ended December 31, 2005.

The Company filed a Current Report on Form 8-K on April 24, 2006 regarding
the approval of certain Convertible Notes to William Robinson, Frank Lively and
Cherokee Raiders, LLP. In addition, the Company reported the issuance of
unregistered equity securities in conversion of certain officer, director and
affiliate notes and issuances to lenders and vendors and the related April 24,
2006 press release.

The Company filed a Current Report on Form 8-K on May 2, 2006 regarding the
Company's entry into an Agreement dated as of April 25, 2006, by and among the
Company, Sierra Nevada Corporation and Techsphere Systems International Inc.

The Company filed a Current Report on Form 8-K on May 23, 2006 regarding the May
22, 2006 lease contract by Techsphere Systems International, Inc, a subsidiary
of the Company, for two of its SA-60A Spherical Airships to a fortune 100
publicly held company at an estimated initial contract value of approximately
$4.2 million.

The Company filed a Current Report on Form 8-K/A-2 on June 22, 2006 amending the
Form 8-K/A filed on December 7, 2005 regarding the acquisition of TSI including
changes to their audited financial statements and the audited notes thereto.


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<PAGE>

                                   SIGNATURES

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

                                           CYBER DEFENSE SYSTEMS, INC.

                                                 February 7, 2007

                                           By: /s/ William C. Robinson
                                               -----------------------------
                                               William C. Robinson
                                               Chief Executive Officer,
                                               President and Chairman

                                           By: /s/ David M. Barnes
                                               -----------------------------
                                               David M. Barnes
                                               Chief Financial Officer


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