****


**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**WASHINGTON,
D.C. 20549**





**FORM
10-QSB**




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


For the
quarterly period ended March 31, 2005





**OR**





o
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE****SECURITIES
      EXCHANGE ACT OF 1934**


****
 For the
Transition Period from ___________ to ___________





**Commission
File Number: 333-116255**





**VIVID
LEARNING SYSTEMS, INC.**


(Exact
name of Registrant as specified in its charter)





**Delaware**
      (State
      or other jurisdiction of
      incorporation
      or organization)
    **42-1623500**
      (I.R.S.
      Employer Identification No.)





**723
The Parkway**


**Richland,
Washington 99352**


(Address
of principal executive offices, including zip code)





**(509)
943-5319**


(Registrant's
telephone number, including area code)




Check
whether the Registrant (1) has filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12
months, and (2) has been subject to such filing requirements for the past 90
days. Yes o No x




The
number of shares of the Registrant's common stock issued and outstanding at
March 22, 2005, was 10,247,996.




Transitional
Small Business Disclosure Format:  Yes o  No x

















**VIVID
LEARNING SYSTEMS, INC.**


**MARCH
31, 2005** **QUARTERLY REPORT ON FORM 10-QSB**





**TABLE
OF CONTENTS**


****


**PAGE**Special
      Note Regarding Forward Looking Statements
    3**PART
      I**
      **FINANCIAL
      INFORMATION**Item
      1.
    Financial
      Statements
    4Item
      2.
    Management’s
      Discussion And AnalysisOf
      Financial Condition And Results Of Operations
    20Item
      3
    Controls
      and Procedures
    26**PART
      II**
      **OTHER
      INFORMATION**Item
      6.
    Exhibits
    27










2


****


**SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS**





To the
extent that the information presented in this Quarterly Report on Form 10-QSB
for the quarter ended March 31, 2005, discusses financial projections,
information or expectations about our products or markets, or otherwise makes
statements about future events, such statements are forward-looking. We are
making these forward-looking statements in reliance on the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. Although we
believe that the expectations reflected in these forward-looking statements are
based on reasonable assumptions, there are a number of risks and uncertainties
that could cause actual results to differ materially from such forward-looking
statements. These risks and uncertainties are described, among other places in
this Quarterly Report, in “Management’s Discussion And Analysis Of Financial
Condition And Results Of Operations.”





In
addition, we disclaim any obligations to update any forward-looking statements
to reflect events or circumstances after the date of this Quarterly Report. When
considering such forward-looking statements, you should keep in mind the risks
referenced above and the other cautionary statements in this Quarterly
Report.






3





**PART
I - FINANCIAL INFORMATION**





**ITEM
1.** **FINANCIAL
STATEMENTS**








**PAGE**Consolidated
      Balance Sheets
    5Consolidated
      Statements of Income
    6-7Consolidated
      Statements of Cash Flows
    8Notes
      to Financial Statements
    9-19


4









**VIVID
LEARNING SYSTEMS, INC.**
 **CONSOLIDATED
BALANCE SHEETS**


March
      31,
    
    September
      30,2005
    
    2004(Unaudited)**ASSETS**CURRENT
      ASSETSCash
    
    $
    343
    
    $
    49,451Accounts
      and contracts receivable
    
    
    1,121,877
    
    
    1,933,573Accounts
      and contracts receivable, Fluor Hanford
    
    
    5,522
    
    
    59,035Accounts
      receivable, related party
    
    
    4,252
    
    
    3,894Employee
      advances
    
    
    8,781
    
    
    22,222Prepaid
      expenses
    
    
    81,264
    
    
    68,813Other
      current assets
    
    
    302,101
    
    
    72,179TOTAL
      CURRENT ASSETS
    
    
    1,524,140
    
    
    2,209,167PROPERTY,
      PLANT AND EQUIPMENTProperty
      and equipment
    
    
    1,255,538
    
    
    1,135,030Less:
      Accumulated depreciation and amortization
    
    
    (861,001
    )
    
    (764,914
    )TOTAL
      PROPERTY, PLANT AND EQUIPMENT
    
    
    394,537
    
    
    370,116OTHER
      ASSETSSoftware,
      net of amortization
    
    
    1,667,274
    
    
    1,684,406Intangibles,
      net of amortization
    
    
    1,184,443
    
    
    763,160Goodwill
    
    
    375,000
    
    
    375,000Long-term
      contracts receivable
    
    
    441,042
    
    
    —TOTAL
      OTHER ASSETS
    
    
    3,667,759
    
    
    2,822,566**TOTAL
      ASSETS**
    
    $
    5,586,436
    
    $
    5,401,849**LIABILITIES
      AND STOCKHOLDERS' EQUITY**CURRENT
      LIABILITIESAccounts
      payable
    
    $
    174,335
    
    $
    189,588Payable
      to related party
    
    
    1,439,090
    
    
    823,430Accrued
      contract labor
    
    
    196,451
    
    
    159,450Other
      current liabilities
    
    
    186,735
    
    
    271,950Unearned
      revenue
    
    
    8,138
    
    
    30,286Notes
      payable, related parties
    
    
    125,000
    
    
    250,000Current
      portion of long-term liabilities
    
    
    80,000
    
    
    30,000TOTAL
      CURRENT LIABILITIES
    
    
    2,209,749
    
    
    1,754,704LONG-TERM
      LIABILITIESOther
      long-term liability
    
    
    615,000
    
    
    545,000Related
      party payable
    
    
    176,769
    
    
    299,634TOTAL
      LONG-TERM LIABILITIES
    
    
    791,769
    
    
    844,634TOTAL
      LIABILITIES
    
    
    3,001,518
    
    
    2,599,338COMMITMENTS
      AND CONTINGENCIES
    
    
    —
    
    
    —STOCKHOLDERS'
      EQUITYPreferred
      stock, $0.0001 par value;5,000,000
      shares authorized, no shares issued and outstanding
    
    
    —
    
    
    —Common
      stock, $0.0001 par value;200,000,000
      shares authorized, 10,197,996shares
      issued and outstanding
    
    
    1,020
    
    
    1,020Additional
      paid-in capital
    
    
    2,490,536
    
    
    2,469,626Retained
      earnings
    
    
    93,362
    
    
    331,865TOTAL
      STOCKHOLDERS' EQUITY
    
    
    2,584,918
    
    
    2,802,511**TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY**
    
    $
    5,586,436
    
    $
    5,401,849—
    
    
    —


See
accompanying condensed notes.








5


****
 ****
 **VIVID
LEARNING SYSTEMS, INC.**
 **CONSOLIDATED
STATEMENTS OF INCOME**


Three
      Months EndedMarch 31, 2005
    
    Three Months
      Ended March
      31, 2004(Unaudited)
    
    (Unaudited)REVENUESTraining
      subscriptions
    
    $
    517,523
    
    $
    742,252Training
      subscriptions, Fluor Hanford
    
    
    147,337
    
    
    142,363Custom
      products and services
    
    
    300,730
    
    
    182,919Custom
      products and services, Fluor Hanford
    
    
    44,958
    
    
    4,1941,010,548
    
    
    1,071,728COST
      OF REVENUESTraining
      subscriptions
    
    
    89,133
    
    
    73,284Custom
      products and services
    
    
    286,051
    
    
    167,732375,184
    
    
    241,016GROSS
      PROFIT
    
    
    635,364
    
    
    830,712EXPENSESMarketing
      and related labor expenses
    
    
    253,264
    
    
    306,597Reseller
      commissions
    
    
    63,750
    
    
    65,759Depreciation
      and amortization
    
    
    17,773
    
    
    20,545Wages
      and contract labor
    
    
    227,880
    
    
    128,430Other
      operating expenses
    
    
    280,060
    
    
    38,221TOTAL
      OPERATING EXPENSES
    
    
    842,727
    
    
    559,552INCOME
      (LOSS) FROM OPERATIONS
    
    
    (207,363
    )
    
    271,160OTHER
      INCOME (EXPENSE)Interest
      income
    
    
    161
    
    
    460Interest
      expense
    
    
    (12,518
    )
    
    (1,658
    )TOTAL
      OTHER INCOME (EXPENSE)
    
    
    (12,357
    )
    
    (1,198
    )INCOME
      (LOSS) BEFORE INCOME TAXES
    
    
    (219,720
    )
    
    269,962INCOME
      TAX BENEFIT (EXPENSE)
    
    
    74,705
    
    
    (92,025
    )NET
      INCOME (LOSS)
    
    $
    (145,015
    )
    $
    177,937BASIC
      AND DILUTED NET INCOME (LOSS) PER SHARE
    
    $
    (0.01
    )
    $
    0.02BASIC
      AND DILUTEDWEIGHTED
      AVERAGE NUMBER OF SHARES
    
    
    10,197,996
    
    
    8,100,000
See accompanying condensed notes.


6





**VIVID
LEARNING SYSTEMS, INC.**
 **CONSOLIDATED
STATEMENTS OF INCOME**
 
 Six
      Months EndedMarch 31, 2005
    
    Six Months EndedMarch
      31, 2004(Unaudited)
    
    (Unaudited)REVENUESTraining
      subscriptions
    
    $
    1,149,335
    
    $
    1,254,573Training
      subscriptions, Fluor Hanford
    
    
    294,675
    
    
    284,726Custom
      products and services
    
    
    640,404
    
    
    481,148Custom
      products and services, Fluor Hanford
    
    
    53,822
    
    
    36,5802,138,236
    
    
    2,057,027COST OF REVENUESTraining
      subscriptions
    
    
    171,605
    
    
    145,164Custom
      products and services
    
    
    602,767
    
    
    303,005774,372
    
    
    448,169GROSS
      PROFIT
    
    
    1,363,864
    
    
    1,608,858EXPENSESMarketing
      and related labor expenses
    
    
    490,508
    
    
    549,307Reseller
      commissions
    
    
    172,932
    
    
    215,472Depreciation
      and amortization
    
    
    37,111
    
    
    44,983Wages
      and contract labor
    
    
    440,547
    
    
    217,356Other
      operating expenses
    
    
    560,450
    
    
    222,372TOTAL
      OPERATING EXPENSES
    
    
    1,701,548
    
    
    1,249,490INCOME
      FROM OPERATIONS
    
    
    (337,684
    )
    
    359,368OTHER
      INCOME (EXPENSE)Interest
      income
    
    
    431
    
    
    460Interest
      expense
    
    
    (24,115
    )
    
    (3,846
    )TOTAL
      OTHER INCOME (EXPENSE)
    
    
    (23,684
    )
    
    (3,386
    )INCOME (LOSS) BEFORE INCOME
    TAXES
    
    
    (361,368
    )
    
    355,982INCOME TAX BENEFIT (EXPENSE)
    
    
    122,865
    
    
    (121,034
    )NET INCOME (LOSS)
    
    $
    (238,503
    )
    $
    234,948BASIC
      AND DILUTED NET INCOME (LOSS) PER SHARE
    
    $
    (0.02
    )
    $
    0.03BASIC AND DILUTEDWEIGHTED
      AVERAGE NUMBER OF SHARES
    
    
    10,197,996
    
    
    8,100,000
   See
accompanying condensed notes.


7




**VIVID
LEARNING SYSTEMS, INC.**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 
 Six
      Months EndedMarch 31,2005
    
    Six
      Months EndedMarch 31,2004(Unaudited)
    
    (Unaudited)**CASH
      FLOWS FROM OPERATING ACTIVITIES:**Net
      income (loss)
    
    $
    (238,503
    )
    $
    234,948Adjustments
      to reconcile net income (loss)to
      net cash provided by operating activities:Depreciation
      and amortization
    
    
    37,111
    
    
    44,983Amortization
      of capitalized software
    
    
    147,289
    
    
    111,122Options
      issued for services
    
    
    20,910
    
    
    —Changes
      in assets and liabilities:Accounts
      and contracts receivable
    
    
    864,851
    
    
    (237,975
    )Prepaid
      expenses
    
    
    (12,451
    )
    
    4,207Other
      current assets
    
    
    (216,481
    )
    
    170,512Accounts
      payable
    
    
    (15,253
    )
    
    48,950Accrued
      payroll and related expenses
    
    
    37,001
    
    
    165,699Related
      party payables, net of line of credit
    
    
    117,238
    
    
    (292,895
    )Long-term
      receivable contracts
    
    
    (441,042
    )
    
    —Other
      current liabilities
    
    
    (107,363
    )
    
    83,565Net
      cash provided by operating activities
    
    
    193,307
    
    
    333,116**CASH
      FLOWS FROM INVESTING ACTIVITIES:**Acquisition
      of property, equipment and intangible assets
    
    
    (147,940
    )
    
    (134,648
    )Acquisition
      of software
    
    
    (197,450
    )
    
    (150,885
    )Net
      cash used by investing activities
    
    
    (345,390
    )
    
    (285,533
    )**CASH
      FLOWS FROM FINANCING ACTIVITIES:**Proceeds
      from stock issuances
    
    
    —
    
    
    422,799Payments
      on notes payable, related party
    
    
    (125,000
    )
    
    —Proceeds
      from related party line of credit
    
    
    227,975
    
    
    18,150Net
      cash provided by financing activities
    
    
    102,975
    
    
    440,949Net
      increase (decrease) in cash
    
    
    (49,108
    )
    
    488,532Cash
      at beginning of period
    
    
    49,451
    
    
    11,612Cash
      at end of period
    
    $
    343
    
    $
    500,144SUPPLEMENTAL
      CASH FLOW INFORMATION:Interest
      paid
    
    $
    24,115
    
    $
    5,846Income
      taxes paid
    
    $
    —
    
    $
    —NON-CASH
      TRANSACTIONS:Options
      issued for services
    
    $
    20,910
    
    $
    —
   See accompanying condensed notes.


8







**VIVID
LEARNING SYSTEMS, INC.**
**CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
**March
31, 2005**


****


**NOTE
1** - **BUSINESS
ORGANIZATION**





Nature
of Operations


Vivid
Learning Systems, Inc. (hereinafter “Vivid Washington”) was incorporated in 1995
in the State of Washington under the name of Applied Tec *Knowledge* y, and
was shortly thereafter renamed Vivid Concepts, Inc. Prior to December 23, 2003,
Vivid Washington was a wholly owned subsidiary of Nuvotec, Inc., a technology
commercialization corporation based in Washington State. On December 23, 2003,
Nuvotec, Inc., exchanged all of its 7,000,000 common stock shares in Vivid
Washington for 8,100,000 shares of common stock with a par value of $0.0001 in a
newly formed Delaware corporation also named Vivid Learning Systems, Inc. The
Delaware company (“Company” or “Vivid Delaware”) serves as the holding company
and parent and sole shareholder of the operating entity (“Vivid Washington”).
The common stock of the Delaware company was held 100% by Nuvotec, Inc., until
an additional 1,987,996 of the Company’s common stock was issued in a private
placement to approximately seventy individual shareholders at September 30,
2004. Vivid Washington develops and provides computer-based training products
and services, which are marketed nationally. The reorganization caused no change
in the accounting in the financial statements of Vivid Washington as Vivid
Washington continues to be the operating company and the financial information
provided is the historical financial information of Vivid Washington. Vivid
Delaware and its subsidiaries have a year end of September 30.





Basis
of Presentation


The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and the instructions to Form 10-QSB and Rule 10-01 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States for
complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring adjustments) considered necessary for a fair
presentation of interim results have been included. Operating results for the
six months ended March 31, 2005 are not necessarily indicative of the results
that may be expected for the fiscal year ending September 30, 2005. For further
information, refer to the Company’s consolidated audited financial statements
and footnotes thereto.





Certain
prior year amounts may have been reclassified to conform to the current period’s
presentation.





**NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





This
summary of significant accounting policies is presented to assist in
understanding the financial statements. The financial statements and notes are
representations of the Company’s management, which is responsible for their
integrity and objectivity. These accounting policies conform to accounting
principles generally accepted in the United States and have been consistently
applied in the preparation of the financial statements.




9


**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**








Accounting
Methods and Consolidation


The
Company’s financial statements are prepared using the accrual method of
accounting.





The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries, after elimination of intercompany accounts and
transactions. The wholly owned subsidiaries of the Company are Vivid Washington,
Inc., and ImageWorks Media Group, Inc.





Earnings
Per Share


The
Company has adopted Statement of Financial Accounting Standards No. 128, which
provides for calculation of "basic" and "diluted" earnings per share. Basic
earnings per share for Vivid includes no dilution and is computed by dividing
net income available to common shareholders by the weighted average number of
common shares outstanding for the period. Diluted earnings per share reflect the
potential dilution of securities that could share in the earnings of an entity.
There were 716,834 and 882,353 common stock equivalents outstanding at March 31,
2005 and September 30, 2004, respectively. Earnings per share at March 31, 2005
and September 30, 2004 reflect the forward stock split which occurred on
November 25, 2003.





Management
Services Provided by Nuvotec


In
Vivid’s consolidated statements of income, “other operating expenses” contains
amounts that represent allocations from Nuvotec of central overhead expenses,
including rent, director fees, central office overhead expense accounts, legal
and contracts, finance (including accounting and reporting, receivables and
collection activities, payables and cash management, budgeting, etc.), executive
and administrative expenses that are applied to the Vivid operation. Most of the
allocated expenses represent labor related costs.





Provision
for Taxes


The
current tax provision represents the federal income tax which the Company would
have incurred on a separate, stand-alone basis. The Company receives the benefit
of losses resulting from the federal income tax returns filed on a consolidated
basis by its majority shareholder, Nuvotec, Inc. The consolidated tax returns
are filed on a calendar year basis.





Income
taxes are provided based upon the liability method of accounting pursuant to
Statement of Financial Accounting Standards No. 109, “Accounting for Income
Taxes.” Under this approach, deferred income taxes are recorded to reflect the
tax consequences in future years of differences between the tax basis of assets
and liabilities and their financial reporting amounts at each year end. A
valuation allowance is recorded against deferred tax assets if management does
not believe the Company has met the “more likely than not” standard imposed by
Statement of Financial Accounting Standard No. 109 to allow recognition of such
an asset.





10





**VIVID
LEARNING SYSTEMS, INC.**


**CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**


**March
31, 2005**










Recent
Accounting Pronouncements


In
December 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 153. This statement addresses the measurement
of exchanges of nonmonetary assets. The guidance in APB Opinion No. 29,
“Accounting for Nonmonetary Transactions,” is based on the principle that
exchanges of nonmonetary assets should be measured based on the fair value of
the assets exchanged. The guidance in that opinion, however, included certain
exceptions to that principle. This statement amends Opinion 29 to eliminate the
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. This statement is effective for financial statements for fiscal
years beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges incurred during fiscal years beginning after the
date of this statement is issued. Management believes the adoption of this
statement will have no impact on the financial statements of the Company.




In
December 2004, the Financial Accounting Standards Board issued a revision to
Statement of Financial Accounting Standards No. 123R, “Accounting for Stock
Based Compensations.” This statement supersedes APB Opinion No. 25, “Accounting
for Stock Issued to Employees,” and its related implementation guidance. This
statement establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or
services that are based on the fair value of the entity’s equity instruments or
that may be settled by the issuance of those equity instruments. This statement
focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. This statement does not
change the accounting guidance for share based payment transactions with parties
other than employees provided in Statement of Financial Accounting Standards No.
123. This statement does not address the accounting for employee share ownership
plans, which are subject to AICPA Statement of Position 93-6, “Employers’
Accounting for Employee Stock Ownership Plans.” The Company previously adopted
SFAS No. 123.




In
November 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 151, “Inventory Costs— an
amendment of ARB No. 43, Chapter 4. “This statement amends the
guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the
accounting for abnormal amounts of idle facility expense, freight, handling
costs, and wasted material (spoilage). Paragraph 5 of ARB 43,
Chapter 4, previously stated that “. . . under some circumstances, items
such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period
charges. . . .” This statement requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of “so
abnormal.” In addition, this statement requires that allocation of fixed
production overhead to the costs of conversion be based on the normal capacity
of the production facilities. This statement is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The Company
does not at present have inventory that would be affected by this
statement.




11


**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**





In May
2003, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity” (hereinafter “SFAS No. 150”).
SFAS No. 150 establishes standards for classifying and measuring certain
financial instruments with characteristics of both liabilities and equity and
requires that those instruments be classified as liabilities in statements of
financial position. Previously, many of those instruments were classified as
equity. SFAS No. 150 is effective for financial instruments entered into or
modified after May 31, 2003 and otherwise is effective at the beginning of the
first interim period beginning after September 15, 2003. The Company has adopted
SFAS No. 150 during the year ended September 30, 2004.







Reseller
Commissions


Reseller
commissions are recorded as an expense if the cumulative affirmative impact
of indicators of gross revenue reporting, as outlined in EITF
99-19, Indicators 7-14, are met by the Company in the
transaction. **** The
Company pays each of the channel partners a commission, or a referral fee,
recorded as a selling expense, strictly on a success basis as a result of
selling the Company’s products and services to third party customers. The
Company has contractual arrangements with each of these partners that range from
one to two years. The Company pays these partners a referral fee, or a
commission, of between five and fifty percent of net revenue depending upon
their annual sales levels and other criteria.





None of
these U.S.-based contracts is exclusive, or restricts the Company from selling
directly or through other channel partners into any markets. The Company does
have one contract in place with a European reseller that is country-specific,
exclusive, and has a duration of two years. Such expenses paid to resellers are
recorded as a reduction to the underlying selling price if the cumulative
affirmative impact of indicators of net revenue reporting, as outlined in EITF
99-19, Indicators 15-17 are present in the transaction. The Company does not
provide any consideration to end-users other than negotiated price discounts for
subscriptions based on the size of the contract. Contract size is defined by the
number of employees (seats), number of lessons and length of the
contract.





The
Company renewed, effective July 1, 2004 for two additional years, a material
reseller agreement with Element K of Rochester, New York.





Software
Development Costs


Costs
incurred for the internal development of software products and enhancements,
after technological feasibility has been established for the related product,
are capitalized and stated at the lower of cost or net realizable value.
Amortization is provided based on the greater of the amount computed using (a)
the ratio that current gross revenues for a product bears to the total of
current and anticipated future gross revenues for that product, or (b) the
straight-line method over the remaining estimated economic life of the product,
not to exceed five years.




12




**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**





Production
costs incurred subsequent to the establishment of technological feasibility are
capitalized. Also capitalized are the component costs incurred associated with
the development of product templates in accordance with Statement of Financial
Accounting Standards No. 86, which consist primarily of labor related costs. As
revenue generation commences on specific training content, additional costs
incurred are classified as maintenance expense, or customer marketing expense,
in the period they are incurred. Hours expended via time sheets, and costs
incurred by production personnel on lesson content development on a per lesson
basis are maintained so that cost efficiency in software content development can
be analyzed on a lesson content by lesson content basis. Net realizable value is
determined by comparing the unamortized cost of each developed software lesson
content and the remaining available market (quantified by dollars) for that
content in the industry in which Vivid is selling the content. The unamortized
software development cost is then aggregated by lesson content and a grand total
is compared to the total remaining available aggregate market for the content to
determine if a write-down is required. The Company’s amortization method assumes
that sales of the Company’s existing software products will continue for at
least the ensuing five years. For the three months ended March 31, 2005 and
2004, $74,483 and $67,268 of amortization expense were recorded, respectively.





Software
development costs consist of the following at the dates shown:





March
      31, 2005
    
    September
      30,
      2004Software
      development costs
    
    $
    3,231,321
    
    $
    3,101,164Accumulated
      amortization
    
    
    (1,564,047
    )
    
    (1,416,758
    )$
    1,667,274
    
    $
    1,684,406





In
November 2003, the Company purchased software and related materials from
FoodSafety.com, Inc. for $305,000, which is included in software on the balance
sheet.





The
amount charged to amortization expense for the six months ending March 31, 2005
was $147,289. The amount written down to net realizable value during this period
was zero. The amount charged to amortization expense for the six months ending
March 31, 2004 was $133,190. The amount written down to net realizable value
during this period was zero.





Use of
Estimates


The
process of preparing financial statements in conformity with accounting
principles generally accepted in the United States of America requires the use
of estimates and assumptions regarding certain types of assets, liabilities,
revenues, and expenses. Such estimates primarily relate to unsettled
transactions and events as of the date of the financial statements. Accordingly,
upon settlement, actual results may differ from estimated amounts.




13




**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**


Revenue
and Cost Recognition


The
Company’s revenues are recognized at the time of shipment of products or
performance of the contracted services. The Company sells its products and
services both directly, using in-house sales employees, and indirectly, using
channel sales partners. Channel sales partners are classified as independent
resellers, value-added resellers, industry consultants and industry
associations. Cost of goods is primarily made up of labor costs associated with
software development and training.





The
Company’s sales contracts are primarily on a time and material basis, with
hourly billing rates negotiated with the customer. Contract revenues are earned
as hours are expended and reimbursable costs are incurred.





Training
revenues are recognized at the time of shipment of products or performance of
contracted services. Products are shipped FOB shipping point and title passes
upon shipment. Training contracts may contain elements of both custom contract
work (contracted services) and subscription arrangements (delivery of training
products). Training subscription revenues are recorded when collection of the
subscription is highly probable and no significant Company obligations remain
after the product has been delivered. The Company defers revenue recognition on
training contracts related to payments received during the current period for
the portion of the subscription contract that extends into future periods. At
March 31, 2005 and September 30, 2004, no subscription contracts were paid in
advance. In accordance with EITF 01-14, the Company’s reimbursable costs are
recorded as gross revenue, with the actual costs recorded as a direct
cost.





The
Company’s internet sales are less than .5% of total revenue. Such internet
transactions are recorded as training subscriptions and training is delivered
via the hosted web sites of Vivid. The revenue is recorded when the training is
delivered, when evidence of a persuasive arrangement exists, and when collection
is reasonably assured.





The
Company does not offer warranties or returns.





Royalty
expenses


Reseller
commissions or royalty payments are recorded as an expense if the Company bears
the primary responsibility for the fulfillment of the underlying customer’s
order and for the acceptance by the customer of the training services sold. Such
costs paid to resellers are recorded as a reduction to the underlying selling
price if the reseller is the primary obligor to the customer in the
transaction.




14


****
 **VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**
  **NOTE
3 - RELATED PARTY TRANSACTIONS**





The
Company was awarded a three-year contract with a minimum value of $1,708,353
with Fluor Hanford, Inc., a Nuvotec, Inc. shareholder, for the period from
October 2002 to September 30, 2005. The Company provides computer-based training
monthly for the employees of Fluor Hanford, Inc. and its contractors. The
accounts receivable due from Fluor Hanford at March 31, 2005 and September 30,
2004, was $5,522 and $59,035 respectively. Revenue from Fluor Hanford for the
three months ended March 31, 2005 and September 30, 2004 was $192,297 and
$174,749, respectively.





The total
amount payable by Vivid on the line of credit at March 31, 2005 and September
30, 2004 was $1,000,000 and $772,025, respectively. The portion of drawing on
the line of credit attributed to Nuvotec as of March 31, 2005 and September 30,
2004 was $1,000,000 and $227,577 leaving $0 available for use by either company
at March 31, 2005.





At March
31, 2005 and September 30, 2004, the recorded related party payable consisted of
$1,000,000 and $772,025 of borrowing from the line of credit and $318,881 and
$51,405 of management fees allocated and expenses paid on behalf of Vivid, by
the majority shareholder, Nuvotec, Inc.





**NOTE
4 - STOCKHOLDERS’ EQUITY**





The
Company has authorized 5,000,000 shares of $0.0001 par value preferred stock,
which may be issued in one or more series. The Company’s board of directors is
also authorized to determine or alter the rights, preferences, privileges and
restrictions granted to or imposed upon any series of preferred stock. At March
31, 2005 and September 30, 2004, no preferred stock has been issued by the
Company.





During
the year ended September 30, 2004 the Company completed a private placement of
1,987,996 common stock shares at $0.25 per share for total proceeds of $496,999
less costs to issue of $74,200. In addition, the Company issued 10,000 shares of
common stock for $2,500 as a gift to an employee’s family member. The Company
has committed 100,000 shares of common stock with a value of $25,000 for the
acquisition of ImageWorks.





On
December 23, 2003, the Company’s board of directors authorized several
transactions. The maximum number of authorized common stock shares of the
Company was increased to 200,000,000. The Company authorized a forward split of
the Vivid Learning Systems, Inc. common stock, such that the major shareholder,
Nuvotec, Inc. had 8,100,000 (restated) shares at September 30, 2003. Finally, a
stock option plan was approved with an option pool of 2,400,000 common stock
shares. Those shares will be available to employees, consultants and others
under the plan. All references to authorized and issued common and preferred
stock have been changed to reflect these board actions. The stock option plan is
more fully described below.





15


****


**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**


****


**NOTE
5 - STOCK-BASED COMPENSATION**





During
2004, the Company issued to executives and employees a total of 816,334 common
stock options, exercisable at $0.25 per share for four years and vesting at a
rate of 25% per year. No expense was recorded at September 30, 2004 because none
of the options were vested and the benefit period begins October 1, 2004. In
October 2004, 191,583 options vested and the Company recorded compensation
expense of $13,410. In addition, the Company issued 50,000 options for legal
fees. The fair market value of these options is $7,500, which was recorded
October 1, 2004 when the benefit period begins.





The fair
value of each option granted under the Company’s 2003 Stock Option Plan is
estimated on the grant date using the Black-Scholes Option Price Calculation. The
following assumptions were made in estimating the fair value: risk-free interest
is 4%; volatility is 0.3; and expected life is 4 years or 3 years.





The
following is a summary of stock option activity:





Equity
      compensation plans not approved by shareholders
    
    Number
      of securities to be issued upon exercise of outstanding
      options
    
    Weighted-average
      exercise price of outstanding options
    
    Number
      of securities remaining available for future issuance under equity
      compensation plans
  2003
      Stock Option Plan
    
    
    716,834
    
    $
    0.25
    
    
    1,683,166Total
    
    
    716,834
    
    
    
    
    
    1,683,166





Number
      ofShares
    
    Weighted
      Average Exercise PriceOutstanding
      at September 2003
    
    
    —
    
    $
    —Granted
    
    
    866,334
    
    
    0.25Exercised
    
    
    —
    
    
    —Outstanding
      at September 30, 2004
    
    
    866,334
    
    $
    0.25Expired
      or terminated options outstanding
      at
      March 31, 2005
    
    
    149,500
    
    
    0.25Options
      exercisable at March 31, 2005
    
    
    —
    
    
    —




16


****


****VIVID
LEARNING SYSTEMS, INC.**
**CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
**March
31, 2005****


****


**NOTE
6** - **ECONOMIC
DEPENDENCY**





The
Company provides services in Washington State to a dozen large corporate
contractors within the framework of a diverse set of programs and tasks. Most of
the funding for these services originates from the Department of Energy/ Federal
Government. During the six months ended March 31, 2005 and 2004, services
provided to these contractors aggregated $342,106 and $475,557, **** representing16%
and 23% of total revenue, respectively. At March 31, 2005 and 2004, amounts due
from these contractors are included in accounts receivable in the amounts of
$11,019 and $8,588, respectively.





The
Company’s concentration risks for customer accounts receivable and revenues
greater than 10% of the total account balances for the respective periods are as
follows:





6
      Months EndingMarch
      31, 2005
    
    6
      MonthsEnding March 31, 2004Revenues—Fluor
      Hanford
    
    $
    337,297
    
    $
    321,306Revenues—ERG
      (State
      of PA)
    
    $
    31,104
    
    $
    262,700Accounts
      Receivable
      Fluor
      Hanford
    
    $
    5,522
    
    $
    2,503Accounts
      Receivable
      ERG
      (State of PA)
    
    $
    327,344
    
    $
    0





The
Company maintains cash in a money market account at a bank in Washington State.
The funds on deposit are not insured by the FDIC and, accordingly, a total of $2
and $111 is at risk at March 31, 2005 and September 30, 2004,
respectively.





**NOTE
7 - COMMITMENTS AND CONTINGENCIES**





Commitments


The
Company is obligated, under separate agreements, to make royalty payments based
on varying percentages (8% to 25%) of cash collections from the sale of specific
software applications. For the six months ending March 3, 2005 and 2004, the
Company incurred $12,882 and $15,204 in royalty obligations, respectively, which
are recorded in marketing expense. At March 31, 2005 and September 30, 2004 the
Company accrued $11,670 and $11,202, respectively, in royalty obligations which
are recorded in other current liabilities on the balance sheet.





**NOTE
8 -** **SEGMENT
INFORMATION**





The
Company adopted Statement of Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information,"
(hereinafter “SFAS No. 131”) **** during
the year ended September 30, 2002. SFAS No. 131 established standards for
reporting information about operating segments in annual financial statements
and requires selected information about operating segments in interim financial
reports issued to stockholders. It also established standards for related
disclosures about products and services and geographic areas. Operating segments
are defined as components of an enterprise about which separate financial
information is available, evaluated regularly by the chief operating decision
makers, or a decision making group, in deciding how to allocate resources and in
assessing performance. The Company has three operating segments at March 31,
2005 and September 30, 2004: corporate training subscriptions; custom products
and services; ImageWorks-related revenues.




17





**VIVID
LEARNING SYSTEMS, INC.**
**CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
**March
31, 2005**


Segment
information (after intercompany eliminations) for the six months ended March 31,
2005 and 2004 are as follows:





March
      31, 2005
    
    March
      31, 2004Revenues:Corporate
    
    $
    —
    
    $
    —Training
      subscriptions
    
    
    1,444,010
    
    
    1,539,299Custom
      products and services
    
    
    222,927
    
    
    517,728ImageWorks
    
    
    471,299
    
    
    —Total
      Revenues
    
    $
    2,138,236
    
    $
    2,057,027Operatingincome
      (loss):Corporate
    
    $
    (1,725,232
    )
    $
    (1,252,876
    )Training
      subscriptions
    
    
    1,272,405
    
    
    1,394,135Custom
      products and services
    
    
    (188,946
    )
    
    214,723ImageWorks
    
    
    280,405
    
    
    —Income
      before income taxes
    
    $
    (361,368
    )
    $
    355,982





March
      31, 2005
    
    March
      31, 2004Identifiable
      assets:Corporate
    
    $
    5,430,633
    
    $
    5,401,849Training
      subscriptions
    
    
    —
    
    
    —Custom
      products and services
    
    
    —
    
    
    —ImageWorks
    
    
    155,803
    
    
    —****Total
      Identifiable Assets
    
    $
    5,586,436
    
    $
    5,401,849Depreciation
      and amortization:Corporate
    
    $
    26,959
    
    $
    44,983Training
      subscriptions
    
    
    —
    
    
    —Custom
      products and services
    
    
    —
    
    
    —ImageWorks
    
    
    10,152
    
    
    —Total
      Depreciation and Amortization
    
    $
    37,111
    
    $
    44,983




18





**VIVID
LEARNING SYSTEMS, INC.**
 **CONDENSED
NOTES TO THE CONSOLIDATED FINANCIALS STATEMENTS**
 **March
31, 2005**


Separate
management of each segment is required because each business unit is subject to
different marketing, production, and technology strategies.





Training
subscriptions, the first reportable segment, derives revenues from the sale of
computer-based safety training products and services throughout the United
States. Custom products and services which is the second reportable segment,
expects to derive its revenue from custom products and services designed
specifically for the end user. ImageWorks, the third segment, derives its
revenues from custom media products and services.





**NOTE
9 - PURCHASE OF TRUEACTIVE SOFTWARE**





On March
14, 2005, Vivid Learning Systems, Inc. entered into an asset purchase agreement
with TrueActive Software, Inc., (“Seller”) a Washington corporation. Pursuant to
the agreement, the Company purchased from the Seller intellectual property with
respect to certain software and other assets including Seller’s customer
database, accounts receivable, inventory and marketing materials. The
consideration for the purchase of assets consists of $120,000 in cash, an
interest free $120,000 one year promissory note with principal payments payable
monthly beginning May, 2005, four year warrants to purchase 80,000 shares of the
Company’s common stock at an exercise price of $1.00 per share vesting over two
years, and a two year employment agreement with the president of the Seller. The
agreement also provides for royalties of 8% of net sales of certain software
products purchased and 4% of net sales on derivative software products for a
period of three years. The note balance of $120,000 is recorded in current and
long-term liabilities at March 31, 2005.




19





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





**Results
of Operations:**





**RESULTS
OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 2005 COMPARED WITH THREE MONTHS
ENDED MARCH 31, 2004**





**Revenues:**





Overall
revenues decreased 6% to $1,010,548 in the second quarter of fiscal year 2005
from $1,071,728 in the second quarter of fiscal year 2004. The decrease was due
to a reduction in training subscription revenues. Also, if the revenues
attributable to subsidiary, ImageWorks Media Group, Inc. (“ImageWorks”) of
$191,052 during the second quarter of fiscal 2005 are excluded for comparison
purposes, which revenue stream was not available to the Company during the same
quarter in 2004 because the subsidiary was not acquired until May, 2004, overall
revenues decreased by 24% due to a reduction in both training subscription and
custom products and services revenues.





Training
subscription revenues decreased by 25% to $664,860 in the second quarter of
fiscal year 2005 from $884,615 in the second quarter of fiscal year 2004 because
of a reduction of revenue earned from a large east coast customer.





Custom
products and services revenues increased overall by 85% to $345,688 in the
second quarter of fiscal year 2005 from $187,113 in the second quarter of fiscal
year 2004. However, custom products and services revenues decreased 17% to
154,636 during the second quarter of fiscal year 2005 if the revenues from
ImageWorks are excluded, because of the reduction of contracted federal custom
work on the Hanford Site in Richland, WA from the Department of Energy and their
subcontractors.





**Operating
Expenses**





Cost of
Revenues:





Overall,
cost of revenues increased by 56% to $375,184 in the second quarter of fiscal
year 2005 from $241,016 in the second quarter of fiscal year 2004. The increase
is primarily due to a larger proportionate share of lower margin custom products
and services revenues as compared to training subscription revenues in comparing
the second quarter of fiscal 2005 to the second quarter of fiscal year 2004.
Much of the increase in custom products and services direct expenses in the
second quarter of fiscal year 2005 is attributable to the custom type of the
revenues generated by the newly acquired subsidiary, ImageWorks, and technical
assistance support expenses incurred in the delivery of custom projects.





Training
subscription cost of revenues increased by 22% to $89,133 in the second quarter
of fiscal year 2005 from $73,284 in the second quarter of fiscal year 2004. This
increase is due to higher expenses incurred in the delivery of training
subscription contracts sold.




20


Custom
products and services cost of revenues increased by 71% to $286,051 in the
second quarter of fiscal year 2005 from $167,732 in the second quarter of fiscal
year 2004. The increase is partially due to the new costs of revenue
attributable to the ImageWorks operation of $94,865 in the second quarter of
fiscal 2005. Also, significant expenses were incurred in building the
infrastructure of the custom products and services operating segment, which had
the effect of increasing the direct costs attributable to custom products and
services revenues in the second quarter of fiscal year 2005. These
infrastructure expenses included increased salaries of newly acquired production
personnel and technical assistance support for custom projects.





Marketing/Reseller
Commissions:





Marketing
and reseller commission expenses decreased by 15% to $317,014 in the second
quarter of fiscal year 2005 from $372,356 in the second quarter of fiscal year
2004. The decrease is mainly attributable to a reduction in sales management
employment related expenses and internal commissions paid to sales employees due
to a restructuring of the commission compensation plan applicable to sales
employees.





Depreciation
and Amortization:





Depreciation
and amortization decreased by 14% to $17,773 in the second quarter of fiscal
year 2005 from $20,545 in the second quarter of fiscal year 2004 due to an
increase in fully depreciated assets in comparing the two quarters.





General
and Administrative Expenses:





General
and Administrative expenses increased by 205% to $507,940 in the second quarter
of fiscal year 2005 from $166,651 in the second quarter of fiscal year 2004. The
significant expense categories of increase in comparing the second quarters of
fiscal year 2005 to 2004 are labor, professional fees, rents, and insurance. The
labor increase ($228,509 in the second quarter of fiscal year 2005 compared to
$128,430 in the second quarter of fiscal year 2004) is due to additional
administrative labor support from newly acquired ImageWorks and the hiring of
new employees, especially in management, to meet the internal administrative
needs of a growing operation. The increase in professional fees ($84,923 in the
second quarter of fiscal year 2005 compared to $23,697 in the second quarter of
fiscal year 2004) is related to increasing auditing, board, and legal fees
associated with becoming a publicly traded entity. The increase in rents
($58,766 in the second quarter of fiscal year 2005 compared to $12,819 in the
second quarter of fiscal year 2004) is due to the expiration of rent abatement
from the landlord, Port of Benton, in the current fiscal year. The increase in
insurance (75% increase to $12,609 in the second quarter of fiscal year 2005
compared to $7,213 in the first quarter of fiscal year 2004) is due to new
premiums for directors and officers liability coverage and an overall increase
in liability coverage requirements for becoming a publicly traded
entity.




21





**Income
from Operations**





Income
from Operations decreased by $478,523 to ($207,363) in the second quarter of
fiscal year 2005 from $271,160 in the second quarter of fiscal year 2004.
Principally, the decrease is due to increased direct and general and
administrative expenses in the comparison of the two quarters.





**Other
Income (Expense)**





The main
increase in other expenses is attributable to interest expense on the line of
credit in the second quarter of fiscal year 2005 compared to 2004. Interest
expense on the line of credit was $12,518 in the quarter ended March 31, 2005
compared to $1,658 in the quarter ended March 31, 2004. The line of credit was
utilized more frequently to finance the timing of expenses incurred in the
expansion of the operation in the second quarter of fiscal year 2005 compared to
fiscal year 2004.





**Net
Income (Loss)**





The
operation sustained a loss of $145,015 in the second quarter of fiscal year 2005
compared to a profit of $177,937, or 17% of revenues, in the second quarter of
fiscal year 2004. The decrease in net income of $322,952 is due to increased
infrastructure expenses to meet the needs of an expanding operation partially
offset by a federal income tax benefit related to the quarterly
loss.





The
Company believes that equity/debt financing together with cash generated by
operations are required to achieve market objectives in terms of timeliness into
the market and market share. If cash generated from operations is insufficient
to satisfy our liquidity requirements and the Company is unable to raise needed
equity/debt funds on acceptable terms or at all the Company may not be able to
develop or enhance its products, take advantage of future opportunities, or
respond to competitive pressures. A material shortage of capital may require the
Company to take steps such as reducing its level of operations, disposing of
selected assets, or seeking an acquisition partner.





**Seasonality
and Other Factors Affecting Quarterly Results**





The
revenues of the Company normally fluctuate during the holiday season of the
year. The October through December quarter is typically lower in revenues than
the other quarters of the year due to less emphasis on training and fewer
training courses delivered during this period by many of our clients. We expect
quarterly fluctuations in operating results as a result of many factors
including acquisitions and roll-out of new product offerings. The operating
results for any quarter are not necessarily indicative of the results for any
future period.





**Liquidity
and Capital Resources**





Historically,
the Company has financed its cash flow requirements through the management of
its line of credit and cash generated from operations. As of March 31, 2005, the
Company had cash and cash equivalents of $343 as compared to $49,451 as of
September 30, 2004.




22


Cash
flows provided by operating activities amounted to $132,229 in the second
quarter of fiscal year 2005 compared to $184,412 in the same period of fiscal
year 2004. The main reason for the reduction is attributable to the net loss of
$145,015 sustained by the Company in the second quarter of fiscal year 2005
partially offset by increases in accounts and contracts receivable in the
comparison of the two quarters.





Cash
flows used in investing activities increased by $161,593 to $256,290 in the
second quarter of fiscal year 2005 from $94,697 in the second quarter of fiscal
year 2004. The increase is attributable to higher expenditures related to the
acquisition of software and internally developed software.





Cash
flows provided by financing activities decreased by $375,525 to $37,904 in the
second quarter of fiscal year 2005 compared to $410,429 in the second quarter of
fiscal year 2004. The decrease in the current year’s quarter ending March 31,
2005 is attributable to collections from the private placement in the previous
year’s quarter ending March 31, 2004.





**RESULTS
OF OPERATIONS - SIX MONTHS ENDED MARCH 31, 2005 COMPARED WITH SIX MONTHS ENDED
MARCH 31, 2004**





**Revenues:**





Overall
revenues increased 4% to $2,138,236 in the six months year to date of fiscal
year 2005 from $2,057,027 in the six months year to date of fiscal year 2004.
The increase was due to the revenues attributable to subsidiary, ImageWorks
Media Group, Inc. (“ImageWorks”) of $471,299 during the six months year to date
of fiscal 2005, which revenue stream was not available to the Company during the
same quarter in 2004 because the subsidiary was not acquired until May, 2004. If
the revenues from the subsidiary ImageWorks are excluded for comparison
purposes, overall revenues decreased by 19% in comparing the six months year to
date of the two fiscal years.





Training
subscription revenues decreased by 6% to $1,444,010 in the six months year to
date of fiscal year 2005 from $1,539,299 in the six months year to date of
fiscal year 2004 because of a slight decrease in subscription renewals in the
comparison of the year to date totals of the two fiscal years.





Custom
products and services revenues increased overall by 34% to $694,226 in the six
months year to date of fiscal year 2005 from $517,728 in the six months year to
date of fiscal year 2004. However, custom products and services revenues
decreased by 57% to $222,927 during the six months year to date of fiscal year
2005 compared to the same period in fiscal year 2004, if the revenues from
ImageWorks are excluded, because of reduced custom revenue earned from a large
east coast customer, and the reduction of contracted federal custom work on the
Hanford Site in Richland, WA from the Department of Energy and their
subcontractors.





23





**Operating
Expenses**





Cost of
Revenues:





Overall,
cost of revenues increased by 73% to $774,372 in the six months year to date of
fiscal year 2005 from $448,169 in the six months year to date of fiscal year
2004. The increase is due to a larger proportionate share of lower margin custom
products and services revenues as compared to training subscription revenues in
comparing the six months year to date of fiscal 2005 with the same period in
fiscal year 2004. Much of the proportionate increase in custom products and
services revenue in the six months year to date of fiscal year 2005 is
attributable to the newly acquired subsidiary, ImageWorks.





Training
subscription cost of revenues increased by 18% to $171,605 in the six months
year to date of fiscal year 2005 from $145,164 in the six months ended March 31,
2004. This increase is due to higher direct expenses incurred in the delivery of
training subscription contracts sold.





Custom
products and services cost of revenues increased by 99% to $602,767 in the six
months year to date of fiscal year 2005 from $303,005 in the six months ended
March 31, 2004. The increase is partially due to the new costs of revenue
attributable to the ImageWorks operation of $190,894 in the six months year to
date of fiscal 2005. Also, significant expenses were incurred in building the
infrastructure of the custom products and services operating segment, which had
the effect of increasing the direct costs attributable to custom products and
services revenues in the six months year to date of fiscal year 2005. These
infrastructure expenses included increased salaries of newly acquired production
personnel and technical assistance support for custom projects.





Marketing/Reseller
Commissions:





Marketing
and reseller commission expenses decreased by 13% to $663,440 in the six months
year to date of fiscal year 2005 from $764,779 in the six months year to date of
fiscal year 2004. The decrease is mainly attributable to a 20% reduction in
internal and external sales commissions to $258,486 in the six months year to
date of fiscal year 2005 from $321,237 in the same comparable period of fiscal
year 2004. Also, a reduction in sales management and staff employment related
expenses due to a restructuring of the commission compensation plan applicable
to sales employees contributed to the decrease in comparing the two
periods.





Depreciation
and Amortization:





Depreciation
and amortization decreased by 17% to $37,111 in the six months to date of fiscal
year 2005 from $44,983 in the comparable period of fiscal year 2004 due to an
increase in fully depreciated assets in comparing the two quarters.




24




General
and Administrative Expenses:





General
and Administrative expenses increased by 128% to $1,000,997 in the six months
year to date of fiscal year 2005 from $439,728 in the six months year to date of
fiscal year 2004. The significant expense categories of increase in comparing
the six months year to date of fiscal year 2005 to 2004 are labor, professional
fees, rents, and insurance. The labor increase ($440,547 in the six month year
to date of fiscal year 2005 compared to $217,356 in the same period of fiscal
year 2004) is due to additional administrative labor support from newly acquired
ImageWorks, and the hiring of new employees, especially in management, to meet
the internal administrative needs of a growing operation. The increase in
professional fees ($141,520 in the six months year to date of fiscal year 2005
compared to $41,463 in the same period of fiscal year 2004) is related to
increasing auditing, board, and legal fees associated with becoming a publicly
traded entity. The increase in rents ($116,011 in the six months year to date of
fiscal year 2005 compared to $26,962 in the same period of fiscal year 2004) is
due to the expiration of rent abatement from the landlord, Port of Benton, in
the current fiscal year. The increase in insurance (93% increase to $26,650 in
the six months year to date of fiscal year 2005 compared to $13,826 in the same
period of fiscal year 2004) is due to new premiums for directors and officers
liability coverage and an overall increase in liability coverage requirements
for becoming a publicly traded entity.





**Income
from Operations**





Income
from Operations decreased by $697,052 to ($337,684) in the six months year to
date of fiscal year 2005 from $359,368 in the six months year to date of fiscal
year 2004. Principally, the decrease is due to increased direct and general and
administrative expenses in the comparison of the six months year to date of the
two fiscal years.





**Other
Income (Expense)**





The main
increase in other expenses is attributable to interest expense on the line of
credit in the six months year to date of fiscal year 2005 compared to 2004.
Interest expense on the line of credit was $24,115 in the six months ended March
31, 2005 compared to $3,846 in the six months ended March 31, 2004. The line of
credit was utilized more frequently to finance the timing of expenses incurred
in the expansion of the operation in the first quarter of fiscal year 2005
compared to fiscal year 2004.





**Net
Income (Loss)**





The
operation sustained a loss of $238,503 in the six months year to date of fiscal
year 2005 compared to a profit of $234,948, or 11% of revenues, in the six
months year to date of fiscal year 2004. The decrease in net income of $473,451
is due to increased infrastructure expenses to meet the needs of an expanding
operation partially offset by a federal income tax benefit related to the six
months year to date loss.





The
Company believes that equity/debt financing together with cash generated by
operations are required to achieve market objectives in terms of timeliness into
the market and market share. If cash generated from operations is insufficient
to satisfy our liquidity requirements and the Company is unable to raise needed
equity/debt funds on acceptable terms or at all the Company may not be able to
develop or enhance its products, take advantage of future opportunities, or
respond to competitive pressures. A material shortage of capital may require the
Company to take steps such as reducing its level of operations, disposing of
selected assets, or seeking an acquisition partner.




25


**Liquidity
and Capital Resources**





Historically,
the Company has financed its cash flow requirements through the management of
its line of credit and cash generated from operations.





Cash
flows provided by operating activities amounted to $193,307 in the six months
year to date of fiscal year 2005 compared to $333,116 in the same period of
fiscal year 2004. The main reason for the reduction is attributable to the net
loss of $93,488 sustained by the Company in the first quarter of fiscal year
2005 partially offset by increases in accounts and contracts receivable in the
comparison of the same period of the two fiscal years.





Cash
flows used in investing activities increased by $59,857 to $345,390 in the six
months year to date of fiscal year 2005 from $285,533 in the six months year to
date of fiscal year 2004. The increase is mainly attributable to higher
expenditures related to the acquisition of software and internally developed
software.





Cash
flows provided by financing activities decreased by $337,974 to $102,975 in the
six months year to date of fiscal year 2005 compared to $440,949 in the six
months year to date of fiscal year 2004. The decrease in the current year’s six
month period ending March 31, 2005 is attributable to collections from the
private placement in the previous year’s six month period ending March 31,
2004.





The
Company believes that equity/debt financing together with cash generated by
operations are required to achieve market objectives in terms of timeliness into
the market and market share. If cash generated from operations is insufficient
to satisfy our liquidity requirements and the Company is unable to raise needed
equity/debt funds on acceptable terms or at all the Company may not be able to
develop or enhance its products, take advantage of future opportunities, or
respond to competitive pressures. A material shortage of capital may require the
Company to take steps such as reducing its level of operations, disposing of
selected assets, or seeking an acquisition partner. ****





**ITEM
3. CONTROLS AND PROCEDURES**





Our chief
executive officer and chief financial officer evaluated the effectiveness of our
disclosure controls and procedures (as defined in Rule 13a-14(c) under the
Securities Exchange Act of 1934) as of the end of the three month and six months
to date periods ended March 31, 2005. Based on this evaluation, our chief
executive officer and chief financial officer have concluded that our controls
and procedures are effective in providing reasonable assurance that the
information required to be disclosed in this report is accurate and complete and
has been recorded, processed, summarized and reported within the time period
required for the filing of this report. Subsequent to the date of this
evaluation, there have not been any significant changes in our internal controls
or, to our knowledge, in other factors that could significantly affect our
internal controls.





26


****


**PART
II - OTHER INFORMATION**





**ITEM
6.**  **EXHIBITS.**





(a)  Exhibits





The
following exhibits are filed as a part of this report on Form 10-QSB:





**Exhibit
      No.**
    **Description**31.1
    Rule
      13(a)-14(a)/15(d)-14(a) Certification of Chief Executive
      Officer31.2
    Rule
      13(a)-14(a)/15(d)-14(a) Certification of Chief Financial
      Officer32.1
    Rule
      1350 Certification of Chief Executive Officer32.2
    Rule
      1350 Certification of Chief Financial
Officer











27




**SIGNATURES**





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





Vivid
      Learning Systems, Inc.Dated:
      May 10, 2005
    By:
    /s/ Kevin A.
  SmithKevin
      A. SmithPresident
      and
      Chief
      Executive Officer