**U.S.SECURITIES AND EXCHANGE COMMISSION**Washington, D.C.  20549

**FORM 10-Q**
| **x**                                                                                                                                                                                                                                                |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                 |   |                                                                                          |
| **For the  Quarter ended September 30, 2006**                                                                                                                                                                                                        |
|                                                                                                                                                                                                                                                 |
| **OR**                                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                 |
| **o**                                                                                                                                                                                                                                                |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                 |   |                                                                                          |
| **For the  transition period from                   to                  ** |

 

Commission filenumber **1-11568**

**DYNTEK,INC.**(Exact Name of Registrant as Specified in its Charter)

| **Delaware**                     |   | **95-4228470**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S Employer      |
| incorporation or  organization)  |   | Identification  No.) |

 

**19700Fairchild Road, Suite 230Irvine, CA  92612**(Address of principal executive offices) (Zip code)

Registrant’stelephone number, including area code **(949) 271-6700**

Indicate by checkwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months, (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filings requirements for thepast 90 days.  Yes x  No o

Indicate by check whether the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o |   | Accelerated  filer o |   | Non-accelerated filer x |
|---------------------------|--------|----------------------|--------|-------------------------|

 

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o  No x

As of November 20,2006, the number of shares outstanding of the registrant’s Common Stock, $.0001par value, was 58,077,499.

 

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**DYNTEK,INC. AND SUBSIDIARIESINDEX**
| **PART I – FINANCIAL  INFORMATION**                                                                                                                    |       |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                                                                  |       |       |
| Item 1. Condensed Consolidated Financial Statements                                                                                                         |       |       |
| ** **                                                                                                                                                  | ** ** | ** ** |
| Condensed Consolidated Balance Sheets – as of  September 30, 2006 (unaudited) and June 30, 2006                                                        |       |       |
| ** **                                                                                                                                                  | ** ** | ** ** |
| Condensed Consolidated Statements of Operations and  Comprehensive Loss (unaudited) - For the Three Months Ended September 30,  2006 and September 30, 2005 |       |       |
|                                                                                                                                                        |       |       |
| Condensed Consolidated Statements of Cash Flows  (unaudited) - For the Three Months Ended September 30, 2006 and September 30,  2005                        |       |       |
|                                                                                                                                                        |       |       |
| Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                                           |       |       |
|                                                                                                                                                        |       |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                         |       |       |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                                                                         |       |       |
| Item 4. Controls and Procedures                                                                                                                             |       |       |
|                                                                                                                                                        |       |       |
| **PART  II - OTHER INFORMATION**                                                                                                                            |       |       |
| ** **                                                                                                                                                  |       |       |
| Item  1. Legal Proceedings                                                                                                                                  |       |       |
| Item 6.  Exhibits                                                                                                                                           |       |       |
| ** **                                                                                                                                                  | ** ** | ** ** |
| **SIGNATURE**                                                                                                                                               |       |       |

 

2

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**1.       PART1 – FINANCIAL INFORMATION**

**ITEM 1.CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**DYNTEK,INC. AND SUBSIDIARIES**

# **CONDENSED CONSOLIDATED BALANCE SHEETS**

# (in thousands, exceptshare data)

| ** **                                                                                                                                                                                 | ** ** | **September  30, 2006** | ** ** | **June 30, 2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                                     |       |                         |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                            |       |                         |       |                        |       |
| Cash                                                                                                                                                                                       |       | $                            | 3,115      |                        | $          | 546 |   |
| Cash -  Restricted                                                                                                                                                                         |       | 635                          |       | 644                         |       |
| Accounts  receivable, net                                                                                                                                                                  |       | 2,525                        |       | 1,881                       |       |
| Due from NETF                                                                                                                                                                              |       | 2,537                        |       | 2,817                       |       |
| Inventory                                                                                                                                                                                  |       | 43                           |       | 193                         |       |
| Prepaid expenses  and other current assets                                                                                                                                                 |       | 202                          |       | 101                         |       |
| Other  receivables                                                                                                                                                                         |       | 111                          |       | 118                         |       |
| TOTAL CURRENT  ASSETS                                                                                                                                                                      |       | 9,168                        |       | 6,300                       |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| RESTRICTED CASH – non  current portion                                                                                                                                                |       | 443                          |       | 559                         |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| PROPERTY AND EQUIPMENT,  net                                                                                                                                                               |       | 724                          |       | 763                         |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| GOODWILL                                                                                                                                                                                   |       | 18,767                       |       | 18,767                      |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| ACQUIRED CUSTOMER  LISTS, net                                                                                                                                                              |       | 2,248                        |       | 2,722                       |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| DEFERRED FINANCING  COSTS, net                                                                                                                                                             |       | 307                          |       | 304                         |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| DEPOSITS AND OTHER  ASSETS                                                                                                                                                                 |       | 242                          |       | 273                         |       |
|                                                                                                                                                                                       |       | $                            | 31,899     |                        | $          | 29,688 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                 |       |                         |       |                        |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                       |       |                         |       |                        |       |
| Cash overdraft                                                                                                                                                                             |       | $                            | 221        |                        | $          | 168 |   |
| Accounts payable                                                                                                                                                                           |       | 2,833                        |       | 2,090                       |       |
| Accrued expenses                                                                                                                                                                           |       | 2,354                        |       | 2,705                       |       |
| Deferred revenue                                                                                                                                                                           |       | 974                          |       | 1,036                       |       |
| Current  liabilities of discontinued operations                                                                                                                                            |       | 258                          |       | 258                         |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                 |       | 6,640                        |       | 6,257                       |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| DEFERRED REVENUE – non  current portion                                                                                                                                               |       | 383                          |       | 529                         |       |
| NOTES PAYABLE - non  current portion                                                                                                                                                       |       | 5,485                        |       | 2,021                       |       |
| TOTAL LIABILITIES                                                                                                                                                                          |       | 12,508                       |       | 8,807                       |       |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                             |       |                         |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                 |       |                         |       |                        |       |
| Preferred stock,  $.0001 par value, 10,000,000 shares authorized; 0 and 0 shares issued and  outstanding as of September 30, 2006 and June 30, 2006, respectively                          |       | —                       |       | —                      |       |
| Class A Common  stock, $.0001 par value, 450,000,000 shares authorized; 56,592,351 and  55,180,586 shares issued and outstanding as of September 30, 2006 and June  30, 2006, respectively |       | 6                            |       | 6                           |       |
| Additional  paid-in capital                                                                                                                                                                |       | 147,973                      |       | 146,783                     |       |
| Treasury stock,  (537,825 shares)                                                                                                                                                          |       | (108                         | )          | —                      |       |
| Other  comprehensive income - foreign currency translation                                                                                                                                 |       | 12                           |       | —                      |       |
| Accumulated  deficit                                                                                                                                                                       |       | (128,492                     | )          | (125,908                    | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                           |       | 19,391                       |       | 20,881                      |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                           |       | $                            | 31,899     |                        | $          | 29,688 |   |

 

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

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**DYNTEK,INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(LOSS)**(Unaudited)(in thousands, except per share data)
| ** **                                                               | ** ** | **Three months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| REVENUES                                                                 |       |                                                 |       |   |   |
| Product Revenues                                                         |       | $                                                    | 16,783     |   | $ | 16,155 |   |
| Service Revenues                                                         |       | 4,994                                                |       | 7,280 |   |
| TOTAL REVENUES                                                           |       | 21,777                                               |       | 23,435 |   |
|                                                                     |       |                                                 |       |   |   |
| COST OF REVENUES                                                         |       |                                                 |       |   |   |
| Cost of Products                                                         |       | 14,595                                               |       | 14,152 |   |
| Cost of Services                                                         |       | 3,566                                                |       | 5,169 |   |
| TOTAL COST OF REVENUES                                                   |       | 18,161                                               |       | 19,321 |   |
|                                                                     |       |                                                 |       |   |   |
| GROSS PROFIT                                                             |       | 3,616                                                |       | 4,114 |   |
|                                                                     |       |                                                 |       |   |   |
| OPERATING  EXPENSES:                                                     |       |                                                 |       |   |   |
| Selling                                                                  |       | 2,593                                                |       | 3,176 |   |
| General and administrative                                               |       | 1,343                                                |       | 1,434 |   |
| Depreciation and amortization                                            |       | 693                                                  |       | 730 |   |
| TOTAL OPERATING EXPENSES                                                 |       | 4,629                                                |       | 5,340 |   |
|                                                                     |       |                                                 |       |   |   |
| LOSS FROM  OPERATIONS                                                    |       | (1,013                                               | )          | (1,226 | ) |
|                                                                     |       |                                                 |       |   |   |
| OTHER INCOME  (EXPENSE)                                                  |       |                                                 |       |   |   |
| Interest expense                                                         |       | (1,554                                               | )          | (734 | ) |
| Interest income                                                          |       | 19                                                   |       | 9 |   |
| Gain of  marketable securities                                           |       | —                                               |       | 54 |   |
| Other expense                                                            |       | 2                                                    |       | (1 | ) |
| TOTAL OTHER EXPENSE                                                      |       | (1,533                                               | )          | (672 | ) |
| LOSS FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES                     |       | (2,546                                               | )          | (1,898 | ) |
| INCOME TAX                                                               |       | 38                                                   |       | — |   |
| LOSS FROM  CONTINUING OPERATIONS                                         |       | (2,584                                               | )          | (1,898 | ) |
|                                                                     |       |                                                 |       |   |   |
| DISCONTINUED  OPERATIONS                                                 |       |                                                 |       |   |   |
| Gain on disposal of discontinued operations                              |       | —                                               |       | 216 |   |
| TOTAL GAIN FROM  DISCONTINUED OPERATIONS                                 |       | —                                               |       | 216 |   |
|                                                                     |       |                                                 |       |   |   |
| NET LOSS                                                                 |       | $                                                    | (2,584     | ) | $ | (1,682 | ) |
|                                                                     |       |                                                 |       |   |   |
| NET LOSS PER  SHARE:                                                     |       |                                                 |       |   |   |
| Continuing operations                                                    |       | $                                                    | (0.05      | ) | $ | (0. 21) |   |
| Discontinued operations                                                  |       | —                                               |       | — |   |
| NET LOSS PER  SHARE – basic and diluted                             |       | $                                                    | (0.05      | ) | $ | (0.21 | ) |
|                                                                     |       |                                                 |       |   |   |
| WEIGHTED AVERAGE  NUMBER OF SHARES USED IN COMPUTATION-BASIC AND DILUTED |       | 56,592,351                                           |       | 7,848,267 |   |
|                                                                     |       |                                                 |       |   |   |
| NET LOSS                                                                 |       | $                                                    | (2,584     | ) | $ | (1,682 | ) |
|                                                                     |       |                                                 |       |   |   |
| OTHER  COMPREHENSIVE, NET OF TAX                                         |       |                                                 |       |   |   |
| Foreign currency translation gain                                        |       | 12                                                   |       | — |   |
|                                                                     |       |                                                 |       |   |   |
| COMPREHENSIVE LOSS                                                       |       | $                                                    | (2,572     | ) | $ | (1,682 | ) |

 

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

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**DYNTEK,INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(Unaudited)(in thousands)
| ** **                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                 |       |                                                 |       |   |   |
| Net loss-Continuing operations                                                                         |       | $                                                    | (2,584     | ) | $ | (1,898 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:                           |       |                                                 |       |   |   |
| Depreciation and amortization                                                                          |       | 693                                                  |       | 730 |   |
| Non-cash interest                                                                                      |       | 1,150                                                |       | 185 |   |
| Stock-based compensation                                                                               |       | 528                                                  |       | 205 |   |
| Gain in marketable securities                                                                          |       | —                                               |       | (54 | ) |
| Effects of exchange rate changes on monetary assets  and liabilities denominated in foreign currencies |       | 12                                                   |       | — |   |
| Changes in operating assets and liabilities:                                                           |       |                                                 |       |   |   |
| Accounts receivable                                                                                    |       | (645                                                 | )          | 97 |   |
| Due from NETF                                                                                          |       | 280                                                  |       | — |   |
| Inventory                                                                                              |       | 150                                                  |       | (1,144 | ) |
| Accrued interest on notes payable                                                                      |       | —                                               |       | 138 |   |
| Prepaid expenses and other current assets                                                              |       | (101                                                 | )          | (102 | ) |
| Other receivables                                                                                      |       | 7                                                    |       | (66 | ) |
| Deposits and other assets                                                                              |       | 31                                                   |       | 15 |   |
| Accounts payable                                                                                       |       | 742                                                  |       | 2,360 |   |
| Deferred revenue                                                                                       |       | (208                                                 | )          | 75 |   |
| Accrued expenses                                                                                       |       | (351                                                 | )          | (479 | ) |
| Restricted cash                                                                                        |       | 125                                                  |       | (698 | ) |
| Total adjustments                                                                                      |       | 2,413                                                |       | 1,262 |   |
| NET CASH USED IN CONTINUING OPERATIONS                                                                 |       | (171                                                 | )          | (636 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                 |       |                                                 |       |   |   |
| Proceeds from disposition of marketable securities                                                     |       | —                                               |       | 54 |   |
| Cash paid for acquisition earn-out                                                                     |       | (100                                                 | )          | (1,765 | ) |
| Capital expenditures                                                                                   |       | (80                                                  | )          | (75 | ) |
| NET CASH USED IN INVESTING ACTIVITIES                                                                  |       | (180                                                 | )          | (1,786 | ) |
|                                                                                                   |       |                                                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                 |       |                                                 |       |   |   |
| Cash overdraft                                                                                         |       | 53                                                   |       | (582 | ) |
| Proceeds from debt financing                                                                           |       | 3,000                                                |       | — |   |
| Deferred financing costs                                                                               |       | (26                                                  | )          | (29 | ) |
| Net proceeds under line of credit                                                                      |       | —                                               |       | 3,552 |   |
| Exercise of options and warrants                                                                       |       | 1                                                    |       | — |   |
| Purchase of Treasury stock, net                                                                        |       | (108                                                 | )          | (9 | ) |
| Principal payments                                                                                     |       | —                                               |       | (438 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                              |       | 2,920                                                |       | 2,494 |   |
| CASH FLOWS OF  DISCONTINUED OPERATIONS:                                                                |       |                                                 |       |   |   |
| Operating cash flows                                                                                   |       | —                                               |       | 145 |   |
| NET CASH PROVIDED BY DISCONTINUED OPERATIONS                                                           |       | —                                               |       | 145 |   |
| NET INCREASE IN  CASH                                                                                  |       | 2,569                                                |       | 217 |   |
| CASH AT  BEGINNING OF PERIOD                                                                           |       | 546                                                  |       | 963 |   |
| CASH AT END OF PERIOD                                                                                  |       | $                                                    | 3,115      |   | $ | 1,180 |   |

 

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

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**DYNTEK,INC. AND SUBSIDIARIES**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(UNAUDITED)

(in thousands, except share data)
| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION: |       |                                                 |       |   |   |
|                                               |       |                                                 |       |   |   |
| Cash paid for interest                             |       | $                                                    | 140        |   | $ | 431 |   |
|                                                    |            |                                                      |            |  |  |  |  |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

6

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**DYNTEK, INC. & SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**September 30, 2006(UNAUDITED)**

**1.****              BASISOF PRESENTATION**

The accompanyingunaudited condensed consolidated financial statements of DynTek, Inc. and itssubsidiaries (“DynTek”, “Company”, or “we”) have been prepared in accordancewith accounting principles generally accepted in the United States of America,for interim financial statements and pursuant to the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosuresrequired for annual financial statements. These condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and related footnotesfor the year ended June 30, 2006 included in the Form 10-K for the year thenended.

The accompanyingcondensed consolidated financial statements reflect all adjustments, which, inthe opinion of management consist of normal recurring items that are necessaryfor a fair presentation in conformity with accounting principles generallyaccepted in the United States of America.  Preparing condensed consolidated financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses. The results of operations for any interim period are not necessarilyindicative of the results attainable for a full fiscal year.

**2.****              LIQUIDITYAND FINANCIAL CONDITION**

The Company incurred a net loss of $2,585,000 for thethree months ended September 30, 2006, which includes $2,372,000 of non-cashcharges resulting from $693,000 of depreciation and amortization; $528,000 innon-cash stock based compensation expense; and $1,151,000 in non-cash interestcharges.  At September 30, 2006, theCompany had working capital of approximately $2,528,000.

As described in greater detail in Note 5, the Companyentered into a Second Amendment to Note Purchase Agreement (the “SecondAmendment”) on September 26, 2006 in which the Company issued to Trust A-4 –Lloyd I. Miller a Junior Secured Convertible Note in the aggregate principalamount of $3,000,000 (the “Third Junior Note”) on substantially the same termsset forth in the Junior Note and the Additional Junior Note (both of which aredefined herein) with the additional collateralization of 66% of the Company’sassets and stock of its wholly-owned Canadian subsidiary being assigned to theThird Junior Note.  The proceeds of theThird Junior Note shall be used to finance acquisitions and for generalcorporate purposes.

On October 6, 2006, the Company utilized a portion ofthe proceeds from the Third Junior Note to enter into Asset Purchase Agreementfor substantially all of the assets of TekConnect, Inc.  In consideration for the purchased assets,the Company agreed to pay a cash payment of $400,000 at closing.

The Company utilized another portion of the ThirdJunior Note on October 27, 2006, when the Company, DynTek Canada, an Ontariocorporation and wholly-owned subsidiary of the Company (“DynTek Canada”),Sensible Security Solutions, Inc., an Ontario corporation (“SSS”), and PaulSaucier, an individual and 100% owner of SSS, entered into an Asset PurchaseAgreement for substantially all of the assets of SSS.  In consideration for the purchased assets,the Company agreed to pay SSS at closing a cash payment of $1,200,000, subjectto a minimum of $250,000 in working capital, and 1,485,148 shares of theCompany’s common stock, based upon a per share value of $0.202.  Inaddition, the Company has agreed to make additional payments over a three-yearperiod based upon the achievement of certain EBITDA performance targets. Such payments will be paid using a combination of cash and the Company’ commonstock, at the Company’s election, provided that at least half of the paymentswill be in cash (see Note 12).

7

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The Company believes that its strategy of streamliningthe business around its core competency of providing IT solutions is enablingit to operate under a more efficient cost structure than it had in the past.The Company is also not required to make principal payments under any of itsnote obligations until June 2009 and its accounts receivable and productfinancing arrangement with NETF is providing it with timely working capitalresources. Accordingly, the Company believes that it will have sufficientliquidity to sustain the business through September 30, 2007.

The Company is continuing its financial andoperational restructuring initiatives and will continue to implement itsstrategic business plan. Although the Company believes that it has sufficientliquidity to sustain the business through September 30, 2007, there is noassurance that unforeseen circumstances will not have a material affect on thebusiness that could require it to raise additional capital or take othermeasures to sustain operations in the event outside sources of capital are notavailable. The Company has not secured any commitments for new financing atthis time nor can it provide any assurance that new capital will be available toit on acceptable terms, if at all.

**3.****                                      SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

A.           Principlesof Consolidation - The consolidated financial statements include the accountsof the Company and its wholly-owned subsidiaries. All significant inter-companytransactions have been eliminated.

B.             RevenueRecognition.  The Company applies therevenue recognition principles set forth under SOP 97-2 and SAB 104 withrespect to all revenue.  The Companyadheres strictly to the criteria set forth in paragraph .08 of SOP 97-2 andoutlined in SAB 104 which provides for revenue to be recognized when (i)persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii)the vendor’s fee is fixed or determinable, and (iv) collectability is probable.

*Computer Hardware ProductRevenues*

The Company requires itshardware product sales to be supported by a written contract or other evidenceof a sale transaction that clearly indicates the selling price to the customer,shipping terms, payment terms (generally 30 days) and refund policy, if any.Since the Company’s hardware sales are supported by a contract or otherdocument that clearly indicates the terms of the transaction, and the sellingprice is fixed at the time the sale is consummated, the Company records revenueon these sales at the time in which it receives a confirmation that the goodswere tendered at their destination when shipped “FOB destination,” or uponconfirmation that shipment has occurred when shipped “FOB shipping point.”

*Software Product Revenues*

The Company makessubstantially all of its software product sales as a reseller of licenses,which may include a post contract customer support arrangement and access toproduct and upgrades, and enhancements that are provided exclusively by themanufacturer following delivery and the customer’s acceptance of the softwareproduct. The Company does not presently sell any software that it developsinternally.  Any responsibility fortechnical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated.  With respect to delivery, the Company requiresthat the customer has received transfer of the software or, at a minimum, anauthorization code (“key”) to permit access to the product.  If a software license is delivered to thecustomer, but the license term has not begun, the Company does not record therevenue prior to inception of the license term.

The Company requires itssoftware product sales to be supported by a written contract or other evidenceof a sale transaction, which generally consists of a customer purchase order oron-line authorization.  These forms ofevidence clearly indicate the selling price to the customer, shipping terms,payment terms (generally 30 days) and refund policy, if any. The selling pricesof these products are fixed at the time the sale is consummated.

For product sales, theCompany applies the factors discussed in Emerging Issues Task Force Issue “EITF”99-19 in determining whether to recognize product revenues on a gross or netbasis.

8

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In a substantial majorityof transactions, the Company (i) acts as principal; (ii) takes title to theproducts; and (iii) has the risks and rewards of ownership, including the riskof loss for collection, delivery or returns. For these transactions, the Company recognizes revenues based on thegross amounts billed to customers.  Incertain circumstances, based on an analysis of the factors set forth in EITF99-19, the Company has determined that it was acting as an agent, and thereforerecognizes revenues on a net basis.  Forthe three months ended September 30, 2006, and the three months ended September30, 2005, no revenues were recognized on a net basis.

*IT Services Revenue*

The Company generallybills its customers for professional IT services based on hours of time spenton any given assignment at its hourly billing rates. As it relates to deliveryof these services, the Company recognizes revenue under these arrangements asthe work is completed and the customer has indicated acceptance of services byapproving a work order milestone or completion order.   For certain engagements, the Company entersfixed bid contracts, and recognizes revenue as phases of the project arecompleted and accepted by the client. For its seat management services, the Company enters unit-pricecontracts (e.g., price per user for seat management), and recognizes revenuebased on number of units multiplied by the agreed-upon contract unit price permonth.

C.             Cashand Cash Equivalents – The Company considers all highly liquid temporary cashinvestments with an original maturity of three months or less when purchased,to be cash equivalents.

D.            Allowance forDoubtful Accounts - The Company has a policy of reserving for uncollectibleaccounts based on its best estimate of the amount of probable credit losses inits existing accounts receivable. The Company periodically reviews its accountsreceivable to determine whether an allowance is necessary based on an analysisof past due accounts and other factors that may indicate that the realizationof an account may be in doubt. Account balances deemed to be uncollectible arecharged to the allowance after all means of collection have been exhausted andthe potential for recovery is considered remote.

The Company sells its eligible accounts receivable with limitedrecourse to NETF under each of an Asset Purchase and Liability AssumptionAgreement and an Asset Purchase Agreement that it entered into with NETF duringthe year ended June 30, 2006. The Company retains certain servicing rightsunder a related Master Servicing Agreement that provides for the Company tomanage collections and other ongoing interactions with customers for certaincontractual fees.

TheCompany accounts for its transfers of accounts receivable to NETF under each ofthese agreements in accordance with the provision of *SFAS 140*“Accounting for Transfers andServicing of Financial Assets and Extinguishment of Liabilities” assales of such accounts receivable balances. The gain or loss on sales ofreceivables to NETF is determined at the date of transfer based upon the amountat which they are transferred to NETF less any fees, discounts and othercharges provided under the agreements (see Note 6).

E.              Propertyand Equipment - Property and equipment is stated at cost and is depreciated ona straight-line basis over the estimated useful lives of the assets. Leaseholdimprovements are amortized over the term of their respective leases or servicelives of the improvements, whichever is shorter.

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F.              Income(loss) per Common Share - Basic earnings per share has been calculated basedupon the weighted average number of common shares outstanding. Convertiblepreferred stock, convertible debt, options and warrants have been excluded ascommon stock equivalents in the diluted earnings per share because they areanti-dilutive.  The aggregate number ofpotential common stock equivalents outstanding as of September 30, 2006 is asfollows:

|                  | ** ** | **As of September 30,** | ** ** |
|------------------|------------|----------------------------------------|------------|
| ** **       | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Common stock     |       | 56,592,351                             |       | 8,116,459 |   |
| Warrants         |       | 31,593,019                             |       | 2,536,997 |   |
| Options          |       | 2,305,521                              |       | 225,355 |   |
| Convertible debt |       | 36,437,585                             |       | 1,592,881 |   |
|             |       | 126,928,476                            |       | 12,471,692 |   |

 

G.             Estimates- The Company’s financial statements and accompanying notes are prepared inaccordance with accounting principles generally accepted in the United States.Preparing financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenue,and expenses. These estimates and assumptions are affected by management’sapplication of accounting policies. Critical accounting policies includerevenue recognition, impairment of goodwill, and accounting for discontinuedoperations.

H.            StockBased Compensation – Effective July 1, 2005, the Company adopted FASB Statementof Financial Accounting Standard (“SFAS”) No. 123R “Share Based Payment”.  This statement is a revision of SFASStatement No. 123, and supersedesAPB Opinion No. 25, and its related implementation guidance. SFAS 123Raddresses all forms of share based payment (“SBP”) awards including sharesissued under employee stock purchase plans, stock options, restricted stock andstock appreciation rights. Under SFAS 123R, SBP awards result in a cost thatwill be measured at fair value on the awards’ grant date, based on theestimated number of awards that are expected to vest that will result in acharge to operations.  Consequently,during the three months ended September 30, 2005, the Company recognized$205,000 in expenses, which represents the fair value of stock option awardsthat the Company elected to accelerate vesting during that period.  During the three months ended September 30,2006, the Company recognized $288,000 in expenses, which represents the fairvalue of stock option awarded to two non-employee board members, $40,000 ofstock grants awarded to two non-employee board members, and $200,000 in an employeestock grant.

I.                 FairValue of Financial Instruments - The carrying amounts reported in the balancesheet for cash, trade receivables, accounts payable and accrued expensesapproximate fair value based on the short-term maturity of these instruments.  The carrying amounts of notes receivableapproximate fair value as such instruments feature contractual interest ratesthat are consistent with current market rates of interest. The carrying amountsof notes payable approximate fair value because the effective yields of suchinstruments, which includes the effect of contractual interest rates takentogether with discounts resulting from the concurrent issuances of common stockpurchase warrants, are consistent with current market rates of interest.

J.                Goodwill- Goodwill represents the excess of the purchase price over the fair value ofnet assets acquired in business combinations (Note 4).  SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill betested for impairment at the reporting unit level (operating segment or onelevel below an operating segment) on an annual basis (June 30th for the Company) and between annual tests whencircumstances indicate that the recoverability of the carrying amount ofgoodwill may be in doubt. Application of the goodwill impairment test requiresjudgment, including the identification of reporting units, assigning assets andliabilities to reporting units, assigning goodwill to reporting units, anddetermining the fair value. Significant judgments required to estimate the fairvalue of reporting units include estimating future cash flows, determiningappropriate discount rates and other assumptions. Changes in these estimatesand assumptions could materially affect the determination of fair value and/orgoodwill impairment for each reporting unit.

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K.            ComprehensiveIncome (Loss) - Comprehensive income (loss) is comprised of net income (loss)and all changes to the statements of stockholders’ equity, except for changesthat relate to investments made by stockholders, changes in paid-in capital anddistributions.

L.              Inventory- Inventory consist primarily of finished goods in transit, which are recordedat the lower of cost or market.

M.         Advertising Costs - Costsrelated to advertising and promotions of services are charged to salesoperating expense as incurred. Advertising expense amounted to approximately$43,200 and $34,900 for the three months ended September 30, 2006 and 2005respectively. These expenses are included in selling expenses in theaccompanying statements of operations.

N.            Shippingand Handling Costs - The Company accounts for shipping and handling costs as acomponent of “Cost of Product Revenues.” These costs are primarily the directfreight costs related to the “drop shipment” of products to the Company’scustomers. Shipping and handling costs amounted to approximately $41,500 and$116,600 for the three months ended September 30, 2006 and 2005, respectively.

O.            ConvertibleNotes - The Company accounts for conversion options embedded in convertiblenotes in accordance with Statement of Financial Accounting Standard (“SFAS)No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS133”) and EITF 00-19 “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”).SFAS 133 generally requires Companies to bifurcate conversion options embeddedin convertible notes from their host instruments and to account for them asfree standing derivative financial instruments in accordance with EITF 00-19.SFAS 133 provides for an exception to this rule when convertible notes, ashost instruments, are deemed to be conventional as that term is described inthe implementation guidance under Appendix A to SFAS 133 and further clarifiedin EITF 05-2 “The Meaning of “Conventional Convertible Debt Instrument”in Issue No. 00-19.

The Companyaccounts for convertible notes (deemed conventional) in accordance with theprovisions of Emerging Issues Task Force Issue (“EITF”) 98-5 “Accountingfor Convertible Securities with Beneficial Conversion Features,” (“EITF 98-5”),EITF 00-27 “Application of EITF 98-5 to Certain ConvertibleInstruments,” Accordingly, the Company records, as a discount to convertiblenotes, the intrinsic value of such conversion options based upon thedifferences between the fair value of the underlying common stock at thecommitment date of the note transaction and the effective conversion priceembedded in the note. Debt discounts under these arrangements are amortized overthe term of the related debt to their earliest date of redemption.

P.              Registration Rights- The Company accounts for registration rights as separate derivativeinstruments in accordance with “View C” of EITF Issue No. 05-4, “TheEffect of a Liquidated Damages Clause on a Freestanding Financial InstrumentSubject to EITF Issue No. 00-19, ‘Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock. The Company is currently subject to registration rights agreementsentered into concurrently with the debt obligations described in Note 5, whichprovide for stock based liquidated damages to be paid to such note in the eventof the Company’s failure to comply with the registration rights agreements. Thepotential number of shares issuable as liquidated damages under this agreementis fixed and determinable. The fair value of the liquidated damage provision isinsignificant to the Company’s financial statements.

Q.            Foreign Currency - Theconsolidated financial statements are presented in United States dollars inaccordance with SFAS No. 52, “Foreign Currency Translation”. The functionalcurrency of DynTek Canada, Inc., the Company’s Canadian Subsidiary (which todate has minimal operations) is the Canadian dollar.  Foreign denominated monetary assets aretranslated to United States dollars using foreign exchange rates in effect atthe balance sheet date. Revenues and expenses are translated at the averagerate of exchange during the period. Gain or losses arising on foreign currencytransactions are included in the determination of operating results for theperiod and were insignificant for the periods presented.

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R.             New AccountingStandards

In February 2006,the FASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments—an amendment of FASB Statements No. 133 and 150.” SFASNo. 155 (a) permits fair value re-measurement for any hybridfinancial instrument that contains an embedded derivative that otherwise wouldrequire bifurcation, (b) clarifies that certain instruments are notsubject to the requirements of SFAS 133, (c) establishes a requirement toevaluate interests in securitized financial assets to identify interests thatmay contain an embedded derivative requiring bifurcation, (d) clarifieswhat may be an embedded derivative for certain concentrations of credit riskand (e) amends SFAS 140 to eliminate certain prohibitions related toderivatives on a qualifying special-purpose entity. SFAS 155 is applicable tonew or modified financial instruments in fiscal years beginning afterSeptember 15, 2006, though the provisions related to fair value accountingfor hybrid financial instruments can also be applied to existing instruments.Early adoption, as of the beginning of an entity’s fiscal year, is alsopermitted, provided interim financial statements have not yet been issued. TheCompany will apply the provisions of this statement prospectively to newinstruments.

In March 2006, theFASB issued Statement of Financial Accounting Standards (“SFAS”) No. 156, Accounting for Servicing of Financial Assets(SFAS No. 156). SFAS No. 156 amends SFAS No. 140 “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,” to require allseparately recognized servicing assets and servicing liabilities to beinitially measured at fair value, if practicable. SFAS No. 156 alsopermits servicers to subsequently measure each separate class of servicingassets and liabilities at fair value rather than at the lower of cost or market.For those companies that elect to measure their servicing assets andliabilities at fair value, SFAS No. 156 requires the difference betweenthe carrying value and fair value at the date of adoption to be recognized as acumulative effect adjustment to retained earnings as of the beginning of thefiscal year in which the election is made. SFAS No. 156 is effective forthe first fiscal year beginning after September 15, 2006. The Company isevaluating the potential impact, if any, that the adoption of SFAS 156 willhave on its consolidated financial statements.

In September 2006, theFASB issued Statement of Financial Accountings Standards No. 157, Fair ValueMeasurements (“SFAS 157”). This Standard defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. The adoption of SFAS 157 isnot expected to have a material impact on the Company’s financial position,results of operations or cash flows.

In July 2006, the FASB issuedFASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. ThisInterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. This Interpretation also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. The Interpretation is effectivefor fiscal years beginning after December 15, 2006. We have not yet completedour analysis of the impact this Interpretation will have on our financialcondition, results of operations, cash flows or disclosures.

Other accountingstandards that have been issued or proposed by the FASB or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the consolidated financial statementsupon adoption.

**4**.              **RESTRICTED CASH**

Restricted cashincludes cash received in connection with maintenance agreements that isrestricted until the related revenue is earned and recognized under the termsof the respective agreements, which are three years.  The Company classified $635,000 as a currentasset and $443,000 as a non-current asset, which represents the amount of cashthat will become available to the Company under portions of the contracts thatexpire during and subsequent to the next twelve months, respectively.

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**5.             NOTES PAYABLE**

**Senior Notes**

On March 8, 2006, the Company entered into a NotePurchase Agreement (the “Note Purchase Agreement”) with SACC Partners, L.P. andLloyd I. Miller, III (the “Senior Lenders”), pursuant to which the Companyissued Senior Secured Notes (the “Senior Notes”) in the aggregate principalamount of $6,700,000 with warrants (the “Senior Warrants”)  to purchase up to 19.9% of the Company’soutstanding common stock on a fully diluted basis at the time of exercise.  The Senior Notes bear interest at the rate 8%per annum if paid in cash, or 11% per annum if paid in kind, which forms ofpayment can be made at the Company’s discretion. Principal payments are due in36 monthly installments beginning March 31, 2009. Interest is payablequarterly in arrears beginning June 30, 2006, unless the Company choosesto make its payments in kind, in which case such interest is added to theprincipal amount of the Senior Notes. The Senior Warrants have an exerciseprice of $0.001 per share and expire on December 31, 2016.

The Company may prepay the Senior Notes at 105% of theaggregate unpaid principal and interest at any time prior to their maturity.The Senior Notes are also subject to mandatory prepayment at 105% of theaggregate unpaid principal and interest in the event of a change in control, asdefined. The Company is also required to prepay the Senior Notes upon theoccurrence of a substantial asset sale in an amount equal to 50% of the grossproceeds received in such asset sale plus a penalty equal to 2% of theprepayment amount. Pursuant to the terms of the note purchase agreement,substantial asset sales are defined as any single asset sale resulting in grossproceeds of $100,000 or any series of assets sales occurring during a twelvemonth period resulting in gross cumulative proceeds of $100,000 or more. Changein control events described in the notes purchase agreement require approval bythe Board of Directors prior to being submitted to a vote of the Company’sshareholders. Accordingly, the redemption provision is not within the controlof the Senior Note holders.

Inaccordance with APB 14, the Company allocated $2,982,071 of the proceeds to theSenior Notes and $3,717,929 of the proceeds to the Senior Warrants. Theaggregate fair value of the Senior Warrants was calculated using theBlack-Scholes option pricing model based on all outstanding shares of theCompany’s common stock, outstanding options, Senior Warrants and issuableshares of stock under the conversion and debt settlement agreements (excludingthe Bridge Notes) totaling 13,859,028 Senior Warrants issuable to the holdersof the Senior Notes at the commitment date of this financing transaction. Thedifference between the carrying amount of the Senior Notes and theircontractual redemption amount is being accreted as interest expense toFebruary 2010, their earliest date of redemption.

The numberof shares issuable upon exercise of the warrants is subject to increase eachtime the Company issues additional shares of common stock or common stockequivalents. The incremental number of shares under any increase is equal tothe amount needed to cause the Senior Warrants to be exercisable for 19.9% ofall outstanding common stock on a fully diluted basis.

On May 5, 2006, the Company completed a second closingof the March 8, 2006 private placement in which 5,729,520 shares of commonstock and warrants to purchase an aggregate of 1,145,904 shares of common stockat an exercise price of $0.20 per share were issued. The Company also issued tothe placement agent in this transaction, warrants to purchase 1,145,904 sharesof common stock as compensation for services rendered. Accordingly, the numberof shares issuable to the holder of the Senior Warrants upon its exercise wasincreased by 1,992,814 shares to 15,851,842 shares. The fair value of theadditional Senior Warrants, which amounted to $850,483, is being amortized overthe remaining term of the Senior Notes.

On June 6, 2006 the Company, immediatelyfollowing the completion of its 1 for 10 reverse stock split, issued 13,046,574shares to the Bridge Note holders. Accordingly, the number of shares issuableto the holder of the Senior Warrants upon its exercise was increased by3,241,284 shares to 19,093,126 shares. The fair value of the additional SeniorWarrants, which amounted to $1,286,480, is being amortized over the remainingterm of the Senior Notes.

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On June 15, 2006, the Company issued anadditional Junior Secured Convertible Note to Trust A-4 – Lloyd I. Miller (“theJunior Lender”) in the aggregate principal amount of $1,000,000 (the“Additional Junior Note”) with substantially identical terms to the Junior Noteissued on March 8, 2006 (see discussion regarding “Junior Notes”below).  The Additional Junior Note isconvertible into 5,000,000 shares of the Company’s common stock. Accordingly,the number of shares issuable to the holder of the Senior Warrants upon itsexercise was increased by 1,242,197 shares to 20,335,323 shares. The fair valueof the additional Senior Warrants, which amounted to $344,990, is beingamortized over the remaining term of the Senior Notes.

On June 30, 2006, the Company elected to pay interest onthe Junior Notes in kind and recorded an aggregate interest charge of $136,932for the period ended June 30, 2006 which was added to the principal amountof the Junior Notes, increasing the convertible shares of the notes by 684,658shares at a conversion price of $0.20 per share. Accordingly, the numberof shares issuable to the holder of the Senior Warrants upon its exercise wasincreased by 170,096 shares to 20,505,419 shares. The fair value of theadditional Senior Warrants, which amounted to $28,587, is being amortized overthe remaining term of the Senior Notes.  On June 30, 2006, the Company elected topay interest on the Senior Notes in kind and recorded an aggregate interestcharge of $230,186 for the period ended June 30, 2006 which was added tothe principal amount of the notes.

On July 1, 2006, each of the two non-employeedirectors of the Company received a stock grant for 117,647 shares of ourcommon stock, which is equal to $20,000 divided by the closing price of ourcommon stock as reported on the Over the Counter Bulletin Board onJune 30, 2006, which was equal to $0.17 per share. Also on July 1,2006, Mr. Ron Ben-Yishay received a stock grant for 1,176,471 shares ofour common stock, which is equal to $200,000 divided by $0.17 per share.  On July 1, 2006 the Company (under its2005 Plan) granted to two non-employee directors, options to purchase anaggregate of 2,100,000 shares of its common stock at $0.17 per share that havea five year term. Accordingly, the number of shares issuable to the holder ofthe Senior Warrants upon its exercise was increased by 872,461 shares to21,377,880 shares. The fair value of the additional Senior Warrants, whichamounted to $155,283 and $6,383,751 in the cumulative, is being amortized overthe remaining term of the Senior Notes.

On September 26, 2006, the Company issued anotherJunior Secured Convertible Note to the Junior Lender in the aggregate principalamount of $3,000,000 (the “Third Junior Note”) with substantially identicalterms to the Junior Note (as defined below) and the Additional JuniorNote.  The Third Junior Note isconvertible into 15,000,000 shares of the Company’s common stock. Accordingly,the net number of shares issuable to the holder of the Senior Warrants upon itsexercise was increased by 3,592,975 shares to 24,970,855 shares. The fair valueof the additional Senior Warrants amounted to $481,528; however the cumulativetotal of the debt discount per the issuable Senior Warrants connected with theSenior Notes is limited to the carrying value of the notes, therefore $316,249,or a cumulative of $6,700,000 is being amortized over the remaining term of theSenior Notes and $165,279 is a direct charge against non-cash interest expense.

On September 30, 2006, the Company elected to pay interest onthe Junior Notes in kind and recorded an aggregate interest charge of $150,585for the period ended September 30, 2006 which was added to the principalamount of the Junior Notes, increasing the convertible shares of the notes by752,927 shares at a conversion price of $0.20 per share. Accordingly,the number of shares issuable to the holder of the Senior Warrants upon itsexercise was increased by 187,057 shares to 25,157,912 shares. The fair valueof the additional Senior Warrants amounted to $26,923 and is being chargeddirectly to interest expense.

As ofSeptember 30, 2006, the fair value of the 19.9% Senior Warrants wasapproximately $6,892,000, however, such discount is limited to the carryingvalue of the note. Therefore, only $6,700,000 was recorded as a discount andapproximately $192,000 was charged directly as a component of interest expense.The amortization of the debt discount in connection with the Senior Note SeniorWarrants for the period ended September 30, 2006 amounted to $421,349 whichdiscount is a component of interest expense in the accompanying statement ofoperations.

OnSeptember 30, 2006, the Company elected to pay interest on the SeniorNotes in kind and recorded an aggregate interest charge of $192,147 for theperiod ended September 30, 2006 accreting the principal amount of thenotes to $7,122,333.

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The Note Purchase Agreement relating to the issuancesof the Junior and Senior Notes provide the note holders with demandregistration rights that require the Company, within 30 days of such demand, tofile a registration statement covering the resale of shares underlying theconvertible notes and senior note warrant and to cause such registration to bedeclared effective within 90 or 120 days (depending on the circumstances) thereafter.Such registration rights provide for the Company to pay a share based penaltyin an amount equal to 2% of the shares registrable under the agreement untilsuch time that the Company becomes compliant or the registrable shares may besold without registration or restriction under Rule 144. The fair value ofthe registration rights agreement is insignificant to the Company’s financialstatements. The amount of shares issuable under this penalty provision iscontractually limited to an amount that may not exceed the authorized butunissued shares of the Company’s common stock. No demand has been made forregistration to date. In addition, the Company has filed the requiredregistration statement.

In addition to the above, the Company is not precludedfrom issuing unregistered shares to the holder of the convertible notes orWarrants in the event the holder elects to exercise these instruments prior tothe time which registered shares become available. In addition, the warrants donot feature any cash settlement alternatives that are within the control of theholder. Accordingly, the Warrants are classified as equity instruments inaccordance with the provisions of EITF 00-19.

**Junior Notes**

Under the Note Purchase Agreement, the Company issueda Junior Secured Convertible Note to the Junior Lender (the Junior Lender andthe Senior Lenders are referred to collectively as the “Lenders”) in theaggregate principal amount of $3.0 million (the “Junior Note”). The interestrate for the Junior Note is 10% per annum if paid in cash, or 14% per annum ifpaid in kind, which forms of payment are at the Company’s election for thefirst three years. Principal will be payable at the maturity date ofMarch 1, 2011 and interest is payable quarterly in arrears beginning June 30,2006, unless the Company chooses to pay the interest in kind option, in whichcase the interest will be added to the principal amount of the Junior Noteduring the period in which the Company makes such election. The Junior Note isconvertible into common stock of the Company at any time at the election of theholder at a conversion price of $0.20 per share of common stock. The JuniorNote issued to the Junior Lender is convertible into 15,000,000 shares of theCompany’s common stock, assuming the interest thereon is paid in cash. TheCompany is restricted from prepaying any or all of the Junior Notes prior toMarch 1, 2010 without the consent of the holder of the Junior Notes, whichconsent is at the sole discretion of the note holder.

The Company evaluated the conversion feature embeddedin the Junior Note to determine whether, under SFAS 133, such conversionfeature should be bifurcated from its host instrument and accounted for as afree standing derivative. In performing this analysis the Company determinedthat the Junior Notes meet the definition of a conventional debt instrument;accordingly, the notes and related conversion option were accounted for inaccordance with the provisions of EITF 98-5 and EITF 00-27. Underthis method, the Company recorded a $3,000,000 discount against the entireprincipal amount of the note, based on the intrinsic value of the embeddedconversion option of $0.40 per share as of March 8, 2006 multiplied by15,000,000 shares issuable upon conversion; however, such discount was limitedto the carrying value of the note. The discount of $3,000,000 is beingamortized over the five year term of the note. Amortization of the discountamounted to $200,000 for the year ended June 30, 2006 and is included as acomponent of interest expense in the accompanying statement or operations.

On June 15, 2006, the Company entered into aFirst Amendment to Note Purchase Agreement (the “First Amendment”) with theLenders pursuant to which the Company issued an additional Junior Secured ConvertibleNote to the Junior Lender in the aggregate principal amount of $1,000,000 (the“Additional Junior Note”) on substantially similar terms set forth in theJunior Note. Thus, the interest rate for the Additional Junior Note is 10% perannum if paid in cash, or 14% per annum if paid in kind, which is at theCompany’s election for the first three years. Principal will be payable at thematurity date of March 1, 2011 and interest will be payable quarterly inarrears beginning June 30, 2006, unless the Company chooses its payment inkind option, in which case interest will be added to the principal amount ofthe Additional Junior Note during the period that the Company continues suchelection. The Additional Junior Note may be converted into common stock at anytime at the election of the holder at a conversion price of $0.20 per share ofcommon stock. A portion of the proceeds from the issuance of the AdditionalJunior Note were used to purchase certain assets primarily consisting of acustomer list from the Long Island Division of TekConnect Corporation,(“TekConnect”), and the remaining proceeds will be used for general corporatepurposes. The Junior Note issued to the Junior Lender is convertible into5,000,000 shares of common stock of the Company, assuming the interestthereunder is paid in cash. The Company recorded a $400,000 discount againstthe principal amount of the note, based on the intrinsic value of the embeddedconversion option of $0.08 per share as of June 15, 2006 multiplied by5,000,000 shares issuable upon conversion. The discount of $400,000 is beingamortized over the remaining term of the note. Amortization of the discountamounted to $7,143 for the year ended June 30, 2006 and is included as acomponent of interest expense in the accompanying statement or operations.

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OnJune 30, 2006, the Company elected to pay interest on the note in kind andrecorded an aggregate interest charge of $136,932 for the period endedJune 30, 2006 which was added to the respective principal amount of the notes.The interest added to the principal amount is convertible at $0.20 per shareinto 684,658 shares of the Company’s common stock. The Company did not recordan additional discount as the trading price as of June 30, 2006 was belowthe conversion price.

On September 26, 2006, the Company entered into aSecond Amendment to Note Purchase Agreement (the “Second Amendment”) with theLenders pursuant to which the Company issued an additional Junior SecuredConvertible Note to the Junior Lender in the aggregate principal amount of$3,000,000 (the “Third Junior Note”) on substantially similar terms set forthin the Junior Note and the Additional Junior Note. Thus, the interest rate forthe Third Junior Note is 10% per annum if paid in cash, or 14% per annum if paidin kind, which is at the Company’s election for the first three years.Principal will be payable at the maturity date of March 1, 2011 andinterest will be payable quarterly in arrears beginning September 30,2006, unless the Company chooses its payment in kind option, in which caseinterest will be added to the principal amount of the Third Junior Note duringthe period that the Company continues such election. The Third Junior Note maybe converted into common stock at any time at the election of the holder at aconversion price of $0.20 per share of common stock.   A portion of the proceeds from the ThirdJunior Note were used to purchase substantially all of the assets of SSS,pursuant to an Asset Purchase Agreement dated October 27.  The Third Junior Note issued to the JuniorLender is convertible into 15,000,000 shares of common stock of the Company,assuming the interest thereunder is paid in cash.

OnSeptember 30, 2006, the Company elected to pay interest on the note inkind and recorded an aggregate interest charge of $150,585 for the period endedSeptember 30, 2006 which was added to the respective principal amount ofthe notes. The interest added to the principal amount is convertible at $0.20per share into 752,927 shares of the Company’s common stock. The Company didnot record an additional discount as the trading price as of September 30,2006 was below the conversion price.

**Juniorand Senior Notes and Senior Warrants Registration Rights**

The Note Purchase Agreement relating to the issuancesof the Junior and Senior Notes provide the note holders with demandregistration rights that require the Company, within 30 days of such demand, to(i) file a registration statement covering the resale of shares underlying theconvertible notes and Senior Warrants and (ii) cause such registration to bedeclared effective within 90 or 120 days (depending on the circumstances)thereafter.  Such registration rightsprovide for the Company to pay a share based penalty in an amount equal to 2%of the shares registrable under the agreement until such time that the Companybecomes compliant or the registrable shares may be sold without registration orrestriction under Rule 144. The fair value of the registration rightsagreement is insignificant to the Company’s financial statements. The amount ofshares issuable under this penalty provision is also contractually limited toan amount that may not exceed the authorized but unissued shares of theCompany’s common stock. No demand has been made for registration to date. Inaddition, the Company has filed the required registration statement andanticipates causing such registration statement to become effective followingthe filing of its quarterly report for the period ended September 30, 2006 onform 10-Q and a related amendment to the registration statement.

In addition to the above, the Company is not precludedfrom issuing unregistered shares to the holder of the convertible note orSenior Warrants in the event the holder elects to exercise these instrumentsprior to the time in which registered shares become available. In addition, theSenior Warrants and any embedded derivatives do not feature any forms of cashsettlement alternatives that are within the control of the holder. Accordingly,the Senior Warrants are classified as an equity instrument in accordance withthe provisions of EITF 00-19.

**6.****              DUEFROM NETF**

On August 8, 2005, the Company entered into aseries of related three-year agreements with NETF providing for NETF topurchase, eligible accounts receivable balances and to finance qualifiedpurchases (as defined). This facility is comprised of three components:  (1) an Asset Purchase and LiabilityAssumption Agreement (the “APLA”), under which NETF finances certain of theCompany’s qualified product purchases in connection with consummating sales tocustomers and (2) an Asset Purchase Agreement (the “APA”), and (3) aMaster Servicing Agreement (“MSA”).

Qualified product purchases financed by NETF under theAPLA are repaid from collections of accounts receivable balances that theCompany generates from its sales of such products to customers. The Companytransfers title to the invoices to NETF at the time these sales are financedand delivery is made to the customer. The Company pays contractual financingand servicing fees to NETF for its financing of these purchases in an amountthat is equal to a percentage of the gross profit margin on such sales. Thepercentages fees vary based on the (a) amount of gross profit on suchsales and (b) number of days in which the receivables from such salesremain uncollected.

NETF remits periodically to the Company an amountequal to the monthly gross profit margin on the sales less the contractualfees. The APLA also provides for the Company to repurchase, after 150 days, anyamounts that remain unpaid by the customer for reasons other than the customer’sinability to pay as a result of its financial condition or possible insolvency.NETF pre-approves all product purchases and the credit worthiness of theCompany’s customers under this arrangement as a precondition to financing thesale.

Under the APA, the Company transfers eligible accountsreceivable to NETF in exchange for advances of up to 80% of their grossamount.  NEFT charges the Company fees(the “Discount Factor”) in an amount equal to the LIBOR rate plus 4% annum onadvances made at the time of the transfer. The Company also retains servicingrights under the (“MSA”). Under the terms of the MSA, the Company managescollections and other ongoing interactions with its customers in exchange forfees amounting to approximately 20% of the gross invoice amount. NEFT settlesfees payable to the Company under this arrangement net of the Discount Factor.

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The APA also provides for the Company to repurchase,after 150 days, any amounts that remain unpaid by the customer for reasonsother than the customers’ inability to pay as a result of its financialcondition or possible insolvency; however such repurchases are limited to 15%of all receivables transferred to NETF under this arrangement. In addition,NETF pre-approves the credit worthiness of the Company’s customers under thisarrangement as a precondition to purchasing any invoice.

This facilitycontains customary affirmative and negative covenants as well as specificprovisions related to the quality of the accounts receivables sold. The Companyhas also indemnified NETF for the risk of loss under any transferred balancesexcept for loss incurred as a result of customer credit risk.

 During the period ended September 30, 2006,the Company sold approximately $15,361,000 of its product revenue under theterms of the APLA agreement and approximately $6,219,000 of its service revenueunder the terms of the APA agreement and incurred an aggregate fee of $395,194which is included as a component of interest expense in the accompanyingstatement of operations.

**7.****              STOCKHOLDERS’EQUITY**

On July 1, 2006, the Company issued stock grantsin the aggregate of 1,411,765 shares of common stock.  Two non-employee directors of the Companyeach received a stock grant for 117,647 shares of our common stock, whichis equal to $20,000 divided by the closing price of our common stock asreported on the Over the Counter Bulletin Board on June 30, 2006, whichwas equal to $0.17 per share. Also on July 1, 2006, Mr. RonBen-Yishay received a stock grant for 1,176,471 shares of our common stock,which is equal to $200,000 divided by $0.17 per share.

On August 14, 2006, the Company repurchased treasurystock amounting to 537,825 shares of stock held by an investor at a price of$0.20 per share.

**8.****              SHARE-BASEDPAYMENT ARRANGEMENTS****

**1997 Plan**

In November 2097 the Company’s Board of Directorsauthorized the adoption of the 1997 Stock Option Plan for non-employeeDirectors. The 1997 Plan provided for the grant of up to 30,000 stock optionsat an exercise price of 100% of the fair value of the Company’s common stock onthe date of grant. During the three months ended September 30, 2006, allremaining options under this plan expired and no further grants will be made

**2000 Plan**

On August 14, 2000, the Company assumed the DataSystems Network Corp Stock Option Plan in connection with a businesscombination. Options granted under this Plan were either ISO’s or NSO’s. Nofurther options may be granted under the Data Systems Plan. Options grantedunder this plan expire at various times until 2010. During the three monthsended September 30, 2006, 20 options were cancelled and options to purchase5,921 shares of the Company’s Series A Preferred stock at an averageexercise  price of $23.77 per shareremain outstanding. Each share of Series A Preferred issuable upon the ofexercise of these option is convertible into 2.5 shares of the Company’s commonstock.

**2001 Plan**

In 2001, the Company’s Board of Directors authorized theadoption of the 2001 Employee Stock Option Plan. The 2001 plan, as amended,provides for the grant of up to an aggregate 400,000 ISO to employees and NSO’sto officers, directors, key employees or other individuals at the discretion ofthe compensation committee of the Board of Directors. As of September 30, 2006there were outstanding options to purchase 89,600 shares of the Company’scommon stock under this plan at an average price of $6.37 per share and 24,625options were cancelled during the same period.

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**2005 Plan**

In May 2005, the Company’s Board of Directorsauthorized the adoption of the 2005 Employee Stock Option Plan. The 2005 plan,as amended, provides for the grant of up to an aggregate 3,000,000 ISO toemployees and NSO’s to officers, directors, key employees or other individualsat the discretion of the compensation committee of the Board of Directors.

**2006 Plan(Subject to Stockholder Approval)**

On June 15, 2006, the Company’s Board of Directorsapproved the 2006 Nonqualified Stock Option Plan (the “2006 Plan”), whichprovides for the grant of nonqualified stock options to purchase up to anaggregate of 11,790,672 shares of our common stock to members of our Board,employees and consultants. Our Board of Directors, or a committee of two ormore members of our Board, will administer the 2006 Plan. The administratorwill have full authority to establish rules and regulations for the properadministration of the 2006 Plan, to select the employees, consultants and directorsto whom awards are granted, and to set the date of grant, the exercise priceand the other terms and conditions of the awards, consistent with the terms ofthe 2006 Plan. The administrator may modify outstanding awards as provided inthe 2006 Plan.

The terms of the awards are subject to the provisionsin an option agreement, consistent with the terms of the 2006 Plan. Theexercise price of a stock option shall not be less than the fair market valueof our common stock on the date of grant. No stock option shall be exercisablelater than ten (10) years after the date it is granted.

The administrator may amend the 2006 Plan at any time.No such amendment may be made by our Board of Directors without the consent ofan option holder if such amendment would substantially affect or impair therights of such option holder. In addition, the administrator may terminate the2006 Plan at any time. However, in no event may an award be granted pursuant tothe 2006 Plan on or after June 15, 2016.

On August 11, 2006 the Company granted 7,010,000shares at an exercise price of $0.145 per share to employees subject toshareholder approval pursuant to the 2006 Nonqualified Stock Option Plan (the “2006Plan”) approved by the Board of Directors (the “Board”) of DynTek, Inc. (the“Company”) on June 15, 2006. The 2006 Plan provides for the grant ofnonqualified stock options to members of the Board, employees and consultants.On September 12, 2006, the Company granted an additional 795,000 at anexercise price of $0.147 per shares to employee subject to shareholder approvalunder the 2006 Plan. Shares granted under the 2006 Plan are subject toshareholder approval at the Company’s annual meeting on December 14, 2006.

The 2006 Plan will be submitted to a vote of ourstockholders within twelve months of the adoption of the 2006 Plan. Theaffirmative vote of stockholders holding not less than a majority of our issuedand outstanding shares of common stock is required to approve the adoption ofthe 2006 Plan. In accordance with SFAS 123R, the Company has not yet recognizedcompensation costs because the plan is still subject to shareholder approvalfor which the Company can not assure it will obtain.

**ShareBased Payments**

On July 1, 2006 the Company (under its 2005 Plan)granted to two non-employee directors options to purchase an aggregate of2,100,000 shares of its common stock at $0.17 per share that have a five yearterm. The stock-based compensation expense for the fair value of the fullyvested options granted to the two directors amounted to approximately $288,000during the three months ended September 30, 2006. Assumptions relating tothe estimated fair value of these stock options, which the Company isaccounting for in accordance with SFAS 123(R) are as follows: risk—freeinterest rate of 5.26%; expected dividend yield zero percent; expected optionlife of five years; and current volatility of 109.24%.  As of September 30, 2006, there are optionsto purchase 2,210,000 shares of common stock at an average price of $0.31 pershare.

The fair value of awards granted during the threemonth period ended September 30, 2006 was estimated at the date of grant usingthe Black-Scholes option pricing model. For purposes of performing thecalculation under the Black-Scholes model, the risk-free rate is based on theU.S. Treasury yield curve in effect at the time of grant. The Company has notpaid dividends to date and does not expect to pay dividends in the foreseeablefuture due to its substantial accumulated deficit and initiatives to conservecapital resources. Accordingly, expected dividend yields are currently zero.Expected volatility is principally based on the historical volatility of theCompany’s stock.

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The expensing of share based payments in futureperiods (expectations of vesting) will be based upon all available dataincluding historical cancellations and forfeitures of stock options and currentdata relating to employee turnover rates. The Company will prospectivelymonitor employee terminations, exercises and other factors that could affectthe development of its expectations of vesting of options in future periods.

A summary ofoption activity for the three months ended September 30, 2006 is asfollows:
| **Options**                             | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual   Term** | ** ** | **Aggregate   Intrinsic  Value** | ** ** |
|-----------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------------|------------|
| Outstanding at  June 30, 2006      |       | 231,166    |       | 5.26                                    |       |                                                       |       |                                  |       |
| Granted                                 |       | 2,100,000  |       | 0.17                                    |       |                                                       |       |                                  |       |
| Exercised                               |       | —     |       | —                                  |       |                                                       |       |                                  |       |
| Forfeited or  expired                   |       | (25,645    | )          | 7.63                                    |       |                                                       |       |                                  |       |
| Outstanding at  September 30, 2006 |       | 2,305,521  |       | 0.60                                    |       | 4.83                                                       |       | —                                |       |
| Exercisable at  September 30, 2006 |       | 2,268,021  |       | 0.56                                    |       | 4.85                                                       |       | —                                |       |

 

The weighted-average grant date fair value of optionsgranted during the three moths ended September 30, 2006 amounted to $0.17per share. The weighted average remaining contractual term of optionsoutstanding gives effect to employee terminations which, under the provisionsof the plans reduces the remaining life of such options to a period of 90 daysfollowing the respective dates of such terminations.

The Company did not modify any stock options grantedto employees or non employees under any of its share-based payments other thanaccelerating the vesting of options prior to July 1, 2005. In addition,the Company did not capitalize the cost associated with stock based compensationawards nor have optionees exercised any options during the three months endedSeptember 30, 2006. Unrecognized compensation costs which relates only tothe options granted to the Chief Executive Officer on July 13, 2005amounted to $58,136 and will be expensed in fiscal year 2007 as it is vested.

The Company did not modify any stock options grantedto employees or non employees under any of its share-based payment arrangementsother than accelerating (during the quarter ended September 30, 2005) the vestingof options granted prior to July 1, 2005. In addition, the Company did not capitalize the cost associated withstock based compensation awards nor have optionees exercised any options duringthe three months ended September 30, 2006. Unrecognized compensation costswhich relates only to the options granted to the Chief Executive Officer onJuly 13, 2005 amounted to $58,136 and will be expensed in fiscal year 2007as it is vested.

**9.****              COMMITMENTSAND CONTINGENCIES**

As described in Note 12, Pangaea Education Systemsfiled a claim against the Company for unspecified damages, but indicating ademand for payment in the amount of $2,500,000 during October 2006.

**10.****                     DISCONTINUEDOPERATIONS**

During 2003, theCompany disposed of its non-emergency transportation business.  At September 30, 2006, the total remainingliabilities of discontinued operations was $258,000.

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**11.****                     BUSINESSSEGMENTS**

The Company completed its transition out of its formerBusiness Process Outsourcing Services (“BPO”) Segment during the quarter endedJune 30, 2006.  Accordingly, the Company’  operated with a single segment, theInformation Technology (“IT”) Solutions Segment, during the three months endedSeptember 30, 2006.

Segmentinformation relating to the Company’s operations for the three months endedSeptember 30, 2005 and 2005, respectively, is as follows:
|                                        | ** ** | **Reportable Business Segments** | ** ** | ** **                             | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **Business  Process  Outsourcing**         | ** ** | **Information  Technology  Solutions** | ** ** | **Total** | ** ** |
| Three months  ended September 30, 2006 |       |                                       |       |                                   |       |   |   |
| Sales to external customers            |       | $                                          | —     |                                   | $          | 21,777 |   | $ | 21,777 |   |
| Depreciation and amortization expense  |       | —                                     |       | 693                                    |       | 693 |   |
| Net loss from operations               |       | —                                     |       | (1,013                                 | )          | (1,013 | ) |
| Interest expense                       |       | —                                     |       | (1,555                                 | )          | (1,555 | ) |
| Total assets                           |       | —                                     |       | 31,899                                 |       | 31,899 |   |
| Capital expenditures                   |       | —                                     |       | 80                                     |       | 80 |   |
|                                   |       |                                       |       |                                   |       |   |   |
| Three months  ended September 30, 2005 |       |                                       |       |                                   |       |   |   |
| Sales to external customers            |       | $                                          | 985        |                                   | $          | 22,450 |   | $ | 23,435 |   |
| Depreciation and amortization expense  |       | 35                                         |       | 695                                    |       | 730 |   |
| Net income (loss) from operations      |       | (11                                        | )          | (1,215                                 | )          | (1,226 | ) |
| Interest expense                       |       | -                                          |       | (734                                   | )          | (734 | ) |
| Total assets                           |       | 472                                        |       | 36,423                                 |       | 36,895 |   |
| Capital  expenditures                  |       | -                                          |       | 75                                     |       | 75 |   |

 

**12.****                     SUBSEQUENTEVENTS**

On August 11, 2006 the Company granted 7,010,000shares at an exercise price of $0.145 per share to employees, subject toshareholder approval, pursuant to the 2006 Nonqualified Stock Option Plan (the“2006 Plan”). The 2006 Plan provides for the grant of nonqualified stockoptions to members of the Board, employees and consultants. There are11,790,672 shares of Company common stock (the “Common Stock”) available forissuance under the 2006 Plan. On September 12, 2006, the Company grantedan additional 795,000 at an exercise price of $0.147 per shares to employeesubject to shareholder approval under the 2006 Plan. Shares granted under the2006 Plan are subject to shareholder approval at the Company’s annual meetingon December 14, 2006.

On October 6, 2006, the Company entered into an AssetPurchase Agreement with TekConnect, Inc pursuant to Section 363 of theUnited States Bankruptcy Code, for substantially all of its assets.  In consideration for the Purchased Assets,the Company agreed to a cash payment of $400,000 at closing.

On October 27, 2006, the Company, DynTek Canada Inc.,an Ontario corporation and wholly-owned subsidiary of DynTek (“DynTek Canada”),Sensible Security Solutions Inc., an Ontario corporation ( “SSS”), and PaulSaucier, an individual, entered into an Asset Purchase Agreement pursuant towhich DynTek Canada agreed to purchase from SSS substantially all of the assetsof SSS. In consideration for the purchased assets, DynTek Canada agreed to paySSS at closing a cash payment of $1,200,000, subject to a minimum of $250,000in working capital, and 1,485,148 shares of the Company’s common stock, basedupon a per share value of $0.202.  In addition, DynTek Canada has agreedto make additional payments over a three-year period based upon the achievementof certain EBITDA performance targets. The Company estimates payments based onforecasted EBITDA performance to be approximately $1,000,000 annually subjectto quarterly distributions over the first year and annually in the second andthird years. Such payments will be paid using a combination of cash and theCompany’s common stock, at the Company’s election, provided that at least halfof the payments will be in cash. On the date of closing, the Company reservedfor issuance and granted from its 2006 Nonqualified Stock Option Plan anaggregate of 300,000 options to purchase shares of the Company’s common stockto employees who were formerly employees of SSS.

The Company evaluated both the TekConnect and the SSSacquisitions to assess the level of significance under SEC reportingregulations and determined that the acquisitions, individually and in theaggregate were, insignificant in relation to the Company existing operations.

On or about October 30, 2006, Pangaea EducationSystems, LLC (“Pangaea”) filed a lawsuit against the Company alleging unfaircompetition, reverse passing off, misappropriation of trade secrets, copyrightinfringement and breach of contract arising out of services performed in 2003(the “Action”). Pangaea’s complaint does not specify the amount of damagessought, but Pangaea has demanded in excess of $2,500,000 in preliminarycommunications with the Company’s counsel. The Company contends that thisdemand is without factual or legal basis and that the Action has no merit. Aresponse to the complaint is due November 28, 2006. The Company intends tocontinue discussing an informal resolution. While the Company believes it has astrong position, it is not possible at this time to state the likelihood of anunfavorable outcome based on the early stage of the dispute, the positionstaken by Pangaea and the inherent uncertainties of litigation.

In October 2006, the Company's Board of Directorsauthorized stock-based compensation to an employee in the amount of $100,000 asa final payment per the earn-out provision from the 2004 acquisition of AMRNetworks and the original 30,000 shares of common stock still held in escrow bythe Company pursuant to the earn-out provision under the original acquisitionagreement will be returned to the Company. The number of shares will be determined on the actual date of the grant.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

The followingdiscussion and analysis of our results of operations and financial positionshould be read in conjunction with our audited consolidated financialstatements and related notes included in our Annual Report on Form 10-K for theyear ended June 30, 2006 and the unaudited consolidated financial statementsand related notes included in this Quarterly Report on Form 10-Q.  Depending upon the context, the terms DynTek,“we,” “our,” and “us,” refers to either DynTek alone, or DynTek and itssubsidiaries.

**Forward-LookingStatements**

This reportcontains “forward-looking statements” within the meaning of such term inSection 27A of the Securities Act of 1933, Section 21E of the SecuritiesExchange Act of 1934, and the Private Securities Litigation Reform Act of 1995.We wish to caution readers not to place undue reliance on any suchforward-looking statements, each of which speaks only as of the date made.  Forward-looking statements involve known andunknown risks, uncertainties and other factors which could cause actualfinancial or operating results, performance or achievements expressed orimplied by such forward-looking statements not to occur or be realized. Suchstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from historical results and those presentlyanticipated or projected.  See below, anda discussion of such risks and factors discussed in Item 1 (Business) of Part Iand Item 7 (Management’s Discussion and Analysis of Financial Condition andResults of Operations) of Part II of our Annual Report on Form 10-K for thefiscal year ended June 30, 2006 as filed with the Securities and ExchangeCommission.  Forward-looking statementsmade in this Form 10-Q generally are based on our best estimates of futureresults, performances or achievements, predicated upon current conditions andthe most recent results of the companies involved and their respectiveindustries. Forward-looking statements may be identified by the use offorward-looking terminology such as “may,” “will,” “could,” “should,” “project,”“expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” “potential,”“endeavor,”  “opportunity” or similarterms, variations of those terms or the negative of those terms or othervariations of those terms or comparable words or expressions. Readers shouldcarefully review those risks, as well as additional risks described in thisreport and other documents we file from time to time with the Securities andExchange Commission.  Potential risks anduncertainties include, among other things, such factors as:

·                  Our ability toreach target markets for services and products and our ability to retaincurrent and attract future customers;

·                  Our ability toattract and retain professional staff, successfully integrate acquiredcompanies into our operations, and our ability to acquire additional companies,if any;

·                  Marketacceptance, revenues and profitability of our current and future products andservices;

·                  Ourability to finance and sustain operations, including the ability to fund,maintain, replace and/or extend the Senior Notes and/or Junior Notes, when due,respectively, or to replace such instruments with alternative financing;

·                  Our ability toraise equity capital or debt in the future, despite historical losses fromoperations;

·                  General economicconditions in the United States and elsewhere, as well as the economicconditions affecting the industries in which we operate, our customers andsuppliers;

·                  The competitiveenvironment in the regions in which we compete, and the cost-effectiveness ofour products and services;

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·                  Political andregulatory matters that affect the industries in which we operate;

·                  Our continuedability to trade on the NASD bulletin board; and

·                  Other risksdetailed in our filings with the Securities and Exchange Commission.

The Company has no obligation to publicly release the results of anyrevisions to any forward-looking statements to reflect anticipated orunanticipated events or circumstances occurring after the date of suchstatements.

**Business Overview**

DynTek, Inc. provides professional informationtechnology (“IT”) services and sales of related products to mid-marketcommercial businesses, state and local government agencies, and educationalinstitutions. We operate our business primarily through our subsidiary, DynTekServices, Inc. and our Canadian subsidiary DynTek Canada, Inc.

We provide a broad range of multi-disciplinary ITsolutions that address the critical business needs of our clients, including ITsecurity, converged networking (including voice-over-internet-protocol “VOIP”),application infrastructure, and access infrastructure.  Our primary operations are located in four ofthe top ten largest IT spending states: California, New York, Florida, andMichigan.  We deliver complexinfrastructure technology solutions through teams of professional consultantsin close geographic proximity to our clients. Members of our technical and consulting services team have advancedcertifications with leading vendor-manufacturers, including Microsoft, Cisco, McAfeeand Citrix.   As a professional servicesfirm and value-added reseller of hardware and software from leadingmanufacturers, we help organizations assess, design, build, implement, manageand support their technology infrastructure.

We believe that our services-led approach, combined with expertise inmulti-disciplinary practice areas such as IT security, converged networking(VOIP), application infrastructure, and access infrastructure, will continue toprovide the platform we need to capture an increasing share of our targetmarkets.  Our strategy allows our clientsto rely on DynTek as their primary IT vendor. Additionally, we believe that our multi-disciplinary capabilities helpdifferentiate us from our competitors in the markets in which we compete.

We recognize revenue from sales of products andservices. Services are primarily provided to the client at hourly rates thatare established for each of our employees or third-party contractors based upontheir skill level, experience and the type of work performed. We also provideproject management and consulting work which are billed either by an agreedupon fixed fee or hourly rates, or a combination of both. The majority of ourservices are provided under purchase orders with commercial customers or bidcontracts with government entities.  (See“Revenue Recognition,” below)

Costs of services consist primarily of salaries ofservices personnel and related expenses incurred in providing such services,and the cost of outsourced service labor. Costs of products consist of our cost of products purchased and sold toour customers. Selling, general and administrative expenses consist primarilyof salaries and benefits of personnel responsible for administrative, finance,sales and marketing activities and all other corporate overhead expenses. Corporateoverhead expenses include rent, telephone and internet charges, insurancepremiums, accounting and legal fees, and other general administrativeexpenses.   Selling, general andadministrative costs also include a calculation of the fair value of employeestock options and other share-based payment awards calculated pursuant to SFASNo. 123R.

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**Results of Operations**

The following table setsforth, for the periods indicated, the relative percentages that certain incomeand expense items bear to net sales. 
|                                              | ** ** | **Three Months Ended Sept. 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Product Revenue                              |       | 77                                                   | %          | 69 | % |
| Service Revenue-Information Technology       |       | 23                                                   | %          | 27 | % |
| Service Revenue-Business Process Outsourcing |       | —                                               | %          | 4 | % |
|                                         |       |                                                 |       |   |   |
| Cost of Products                             |       | 87                                                   | %          | 88 | % |
| Cost of Service-Information Technology       |       | 71                                                   | %          | 69 | % |
| Cost of Service-Business Process Outsourcing |       | —                                               | %          | 18 | % |
|                                         |       |                                                 |       |   |   |
| Gross profit                                 |       | 17                                                   | %          | 18 | % |
|                                         |       |                                                 |       |   |   |
| SG & A                                   |       | 18                                                   | %          | 20 | % |
|                                         |       |                                                 |       |   |   |
| Loss from  continuing operations             |       | (12                                                  | )%         | (8 | )% |
| Gain (loss) from  discontinued operations    |       | —                                               | %          | 1 | % |
| Net income (loss)                            |       | (12                                                  | )%         | (7 | )% |

 

***Three months ended September 30, 2006 and September30, 2005***

**Revenues. **For the three months endedSeptember 30, 2006, our revenues decreased to approximately $21,777,000 fromapproximately $23,435,000 for the three months ended September 30, 2005. Thedecrease, which amounts to $1,658,000 or 7%, is principally attributable to thewinding down of activities in our former Business Process Outsourcing of$985,000 and a decline of $673,000 in our IT solutions business.

Our product salesincreased from $16,155,000 during the three months ended September 30, 2005 to$16,783,000 during the three months ended September 30, 2006.  This $628,000, or 4% increase resultedprimarily from the increase in product sales within our educational markets.

Our services revenuesdecreased from $7,280,000 during the three months ended September 30, 2005 to$4,994,000 during the same period in 2006. This $2,286,000, or 31% decline, is attributable to reduced services on commercialaccounts within our Southwest Region and curtailed government revenues withinthe Southeast region, while $985,000 of the decline is the loss of the BusinessProcess Outsourcing business.

Our customers are primarily state and local governmententities and mid-sized corporations in diversified industries.  For the three months ended September 30,2006, 38% of our revenues were derived from commercial clients, compared to 41%from government agencies and 21% from educational institutions.  For the three months ended September 30,2005, 50% of our revenues were derived from commercial clients, compared to 38%from government agencies and 12% from educational institutions.

**Gross profit. **Gross profit decreased from $4,114,000 in the quarterended September 30, 2005 to $3,616,000 in the quarter ended September 30, 2006,a decrease of 12%.  Gross margin declinedslightly from approximately 18% in the quarter ended September 30, 2005 toapproximately 17% for the same period in 2006. Despite the drop in gross profit and gross margin caused by reducedsales, our services margin remained approximately the same at 29% for the twocomparative periods while our product margins improved slightly from 12% to 13%as a result of qualifying for certain vendor rebate programs. We will continueto focus on improving our overall level of service utilization with respect toconsultants throughout the company, and a greater mix of higher-endservices.  We continue to expect productmargins to be subject to competitive pricing pressures and fluctuate fromquarter to quarter depending on the mix of products we provide.  We intend to meet the challenges ofaggressive price reductions and discount pricing by certain product suppliersby focusing our offerings around relatively higher margin practice areas,including security solutions, VOIP, and access infrastructure.  There can be no assurance, however, that wewill be able to improve profit margins, especially for our sale of products,and compete profitably in all areas, given the intense competition that existsin the IT industry.

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**Selling, general andadministrative expenses**. General and administrative expenses decreased to approximately$1,343,000 for the three months ended September 30, 2006, from approximately$1,434,000 for the three months ended September 30, 2005.  As a percent of revenues, general andadministrative expenses remained unchanged between the two periods atapproximately 6%; however, during the period ended September 30, 2006, two non-employeeboard members were provided in the aggregate $328,000 in non-cash stock basedcompensation expense comprised of $40,000 in stock grants and $288,000 in fullyvested, stock option grants, the value for which was calculated using a blackscholes pricing model on the fair value of the options on the date granted. Asimilar charge was not incurred during the same period in 2005 and thereforethe decrease in general and administrative expenses realized during theSeptember 2006 period compared to 2005 excluding the stock-based compensation expensewas approximately $419,000; a result of restructuring and cost reductionprograms implemented in fiscal year 2005.

Selling costs decreasedto approximately $2,593,000 for the three months ended September 30, 2006 from$3,176,000 in the three months ended September 30, 2005.  During the period ended September 30, 2006, a$200,000 stock based compensation expense was incurred for a stock grant issuedin July 2006.  During the period endedSeptember 30, 2005, a $205,000 charge was incurred for the accelerated vestingof employee stock options issued primarily to sales personnel. The 18% decreasein selling expenses realized during the September 2006 period compared to 2005is primarily the result of restructuring and personnel cost reductionimplementations made in 2005.

As a percentage of totalrevenues, the aggregate selling, general and administrative expenses were 17.9%during the three months ended September 30, 2006, compared to 19.7% for thesame period ended September 30, 2005.

**Depreciation and amortizationexpense.**  Depreciationand amortization expense decreased to approximately $693,000 for thethree-month period ended September 30, 2006, from approximately $730,000 duringthe same period in the prior year.  Thedecrease is primarily due to certain customer lists of prior acquisitionshaving been fully amortized.

**Interestexpense.**  Interestexpense for the three months ended September 30, 2006 increased to $1,554,000,as compared to $734,000 for the three months ended September 30, 2005.  The increase is primarily due tosignificantly higher non-cash interest for the period ended September 30, 2006approximately $1,150,000 compared to only $185,000 for the period endedSeptember 30, 2005. Amortization on the debt discounts on the Senior Notes wasapproximately $421,000 with approximately $191,000 of non-cash interest relatedto the fair value of the issuable Senior Note warrants in excess of thecarrying value of the Notes.  Thenon-cash interest amortization on the debt discounts on the Junior Notes wasapproximately $172,000. Fees incurred on the APA and APLA agreements wereapproximately $395,000. On September 30, 2006, the Company elected to pay inkind the interest on the Senior Notes of approximately $193,000 and $150,000 onthe Junior Notes. Amortization of deferred financing fees amounted toapproximately $23,000.

**Net loss.**  Our net loss for the three months endedSeptember 30, 2006 was $2,584,000 compared to a net loss of $1,682,000 for thethree months ended September 30, 2005. Loss from operations during the three months ended September 30, 2006includes depreciation and amortization expense of $693,000, non-cash stockbased compensation expense of $528,000, and interest expense of $1,554,000(including non-cash interest of $1,150,000). Loss from operations during the three months ended September 30, 2005includes depreciation and amortization expense of $730,000, non-cash stockbased compensation expense of $205,000, and interest expense of $734,000(including a non-cash portion of $185,000).

***Discontinued Operations. ***There was noincome from discontinued operations for the three months ended September 30,2005 compared to income of $216,000 for the three months ended September 30,2005.

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**Liquidity and Capital Resources**

We measure our liquidity in a number of ways, as summarized in thefollowing table:
| ** **                 | ** ** | **(Dollars in thousands)**           | ** ** |
|----------------------------|------------|------------------------------------------------|------------|
| ** **                 | ** ** | **As of   Sept. 30, 2006** | ** ** | **As of  June 30, 2006** | ** ** |
|                       |       |                                           |       |   |   |
| Cash and cash  equivalents |       | $                                              | 3,750      |   | $ | 1,190 |   |
|                       |       |                                           |       |   |   |
| Working capital            |       | $                                              | 2,528      |   | $ | 43 |   |
|                       |       |                                           |       |   |   |
| Current ratio              |       | 1.38:1                                         |       | 1.01:1 |   |

 

Cash and cash equivalents generally consist of cashand money market funds. We consider all highly liquid investments purchasedwith maturities of three months or less to be cash equivalents. Suchinvestments are stated at cost, which approximates fair value, and areconsidered cash equivalents for purposes of reporting cash flows.

During the three months ended September 30, 2006, weused approximately $171,000 of cash in our operating activities.

We incurred a net loss of $2,584,000 for the threemonths ended September 30, 2006, which includes $2,371,000 of non-cash chargesresulting from $693,000 of depreciation and amortization, $528,000 in non-cashstock compensation expense, and $1,150,000 in non-cash interest charges.

At September 30, 2006, the Company had working capitalof approximately $2,528,000 as a result of the Company entering into a SecondAmendment to Note Purchase Agreement (the “Second Amendment”) on September 26,2006 with the Lenders pursuant to which the Company issued an additional JuniorSecured Convertible Note to the Junior Lender in the aggregate principal amountof $3,000,000.  Proceeds from theadditional Junior Note were used to fund two acquisitions and for generalworking capital.

On October 6, 2006, the Company entered into an AssetPurchase Agreement with TekConnect, Inc pursuant to Section 363 of theUnited States Bankruptcy Code, for substantially all of its assets.  In consideration for the Purchased Assets,the Company agreed to pay the Seller at closing a cash payment of $400,000.

On October 27, 2006, the Company, through its wholly-ownedsubsidiary DynTek Canada, entered into an Asset Purchase Agreement with SSS andPaul Saucier whereby it agreed to purchase substantially all of the assets ofSSS. In consideration for the purchased assets, the Company agreed to pay SSSat closing a cash payment of $1,200,000 and 1,485,148 shares of the Company’scommon stock, based upon a per share value of $0.202.

In the future, we may continue to expand the scope ofour product and services offerings by pursuing acquisition candidates withcomplementary technologies, services or products.  Should we commence such acquisitions, webelieve that we would finance the transactions with a combination of ourworking capital, the issuance of additional equity securities, or the issuanceof additional debt instruments.    Therecan be no assurance, however, that we will be successful in identifying appropriateacquisition candidates or that, if appropriate candidates are identified, thatwe will be successful in obtaining the necessary financing to complete theacquisitions.

In the event of any additional financing, any equityfinancing would likely result in dilution to our existing stockholders and anydebt financing may include restrictive covenants.

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**ContractualObligations**
|                                   | ** ** | **Payments due by period** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **(in thousands)**                   | ** ** |
| ** **                        | ** ** | **Total**                                 | ** ** | **Less  than 1  year** | ** ** | **1-3 years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** | ** ** |
| *Contractual  Obligations*        | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Non-Convertible  Debt Obligations |       | 7,123                                     |       | — |   | — |   | 7,123 |   | — |   |
| Convertible Debt  Obligations     |       | 7,287                                     |       | — |   | — |   | 7,287 |   | — |   |
| Operating Lease  Obligations      |       | 1,534                                     |       | 603 |   | 811 |   | 120 |   | — |   |
| Total                             |       | $                                         | 15,944     |   | $ | 603 |   | $ | 811 |   | $ | 14,530 |   | $ | — |   |
|                                   |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**CriticalAccounting Policies and Estimates**

Our financial statements and accompanying notes areprepared in accordance with accounting principles generally accepted in theUnited States. Preparing financial statements requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenue, and expenses. These estimates and assumptions areaffected by management’s application of accounting policies. Criticalaccounting policies for us include revenue recognition, impairment of goodwill,and accounting for discontinued operations.

***Revenue*******Recognition.******  **We apply therevenue recognition principles set forth under SOP 97-2 and SAB 104with respect to all of our revenue. We adhere strictly to the criteria setforth in paragraph .08 of SOP 97-2 and outlined in SAB 104 whichprovides for revenue to be recognized when (i) persuasive evidence of anarrangement exists, (ii) delivery has occurred, (iii) the vendor’sfee is fixed or determinable, and (iv) collectability is probable. Asummary of our revenue recognition policies, as they relate to our specificrevenue streams, is as follows:

*Computer HardwareProduct Revenues*

We require our hardware product sales to be supportedby a written contract or other evidence of a sale transaction that clearlyindicates the selling price to the customer, shipping terms, payment terms(generally 30 days) and refund policy, if any.

Since our hardware sales are supported by a contractor other document that clearly indicates the terms of the transaction, and ourselling price is fixed at the time the sale is consummated, we record revenueon these sales at the time in which we receive a confirmation that the goodswere tendered at their destination when shipped “FOB destination,” or uponconfirmation that shipment has occurred when shipped “FOB shipping point.”

*Software Product Revenues*

We make substantially all of our software productsales as a reseller of licenses, which may include a post contract customersupport arrangement and access to product and upgrades, and enhancements thatare provided exclusively by the manufacturer following delivery and thecustomer’s acceptance of the software product. We do not presently sell anysoftware that we develop internally. Any responsibility for technical supportand access to upgrades and enhancements to these software products are solelythe responsibility of the software manufacturer, which arrangement is known tothe customer at the time the sale is consummated. With respect to delivery, werequire that the customer has received transfer of the software or, at aminimum, an authorization code (“key”) to permit access to the product. If asoftware license is delivered to the customer, but the license term has notbegun, we do not record the revenue prior to inception of the license term.

We require our software product sales to be supportedby a written contract or other evidence of a sale transaction, which generallyconsists of a customer purchase order or on-line authorization. These forms ofevidence clearly indicate the selling price to the customer, shipping terms,payment terms (generally 30 days) and refund policy, if any. The selling pricesof these products are fixed at the time the sale is consummated.

For product sales, we apply the factors discussed inEITF 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent”in determining whether to recognize product revenues on a gross or net basis.In a substantial majority of our transactions, we (i) act as principal;(ii) take title to the products; and (iii) have the risks and rewardsof ownership, including the risk of loss for collection, delivery or returns.

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For these transactions,we recognize revenues based on the gross amounts billed to our customers. Incertain circumstances, based on an analysis of the factors set forth in EITF 99-19,we have determined that we were acting as an agent, and therefore recognizerevenues on a net basis. During the nine months ended December 31, 2005,no revenues were recognized on a net basis.

*IT ServicesRevenue*

We generally bill our customers for professional ITservices based on hours of time that we spend on any given assignment at ourhourly billing rates. As it relates to delivery of these services, we recognizerevenue under these arrangements as the work is completed and the customer hasindicated their acceptance of our services by approving a work order milestoneor completion order. For certain engagements, we enter fixed bid contracts, andwe recognize revenue as phases of the project are completed and accepted by ourclient. For our seat management services, we enter unit-price contracts (e.g.,price per user for seat management), and we recognize revenue based on numberof units multiplied by the agreed-upon contract unit price per month.

*BPO ServicesRevenue*

For our BPO services, which primarily included ourchild support service contracts in the states of Kansas and Nebraska, weprovided services under a fixed price (flat monthly fee) contract, andrecognized revenue as the services are provided and billed. In the state ofNorth Carolina, we had one contract subject to revenue-sharing related to childsupport services. Under that contract, a fee from amounts collected was sharedwith the county on a percentage basis, and revenue was recognized monthly inarrears as a percentage of the total amount of collections received.

***Collectability ofReceivables.*****  **A considerable amount of judgment isrequired to assess the ultimate realization of receivables, including assessingthe probability of collection and the current credit worthiness of our clients.Probability of collection is based upon the assessment of the client’sfinancial condition through the review of its current financial statements orcredit reports.

***Goodwill.*****  **SFAS 142,Goodwill and Other Intangible Assets, requires that goodwill be tested forimpairment at the reporting unit level (operating segment or one level below anoperating segment) on an annual basis (June 30th for the company) andbetween annual tests in certain circumstances. Application of the goodwillimpairment test requires judgment, including the identification of reportingunits, assigning assets and liabilities to reporting units, assigning goodwillto reporting units, and determining the fair value. Significant judgmentsrequired to estimate the fair value of reporting units include estimating futurecash flows, determining appropriate discount rates and other assumptions.Changes in these estimates and assumptions could materially affect thedetermination of fair value and/or goodwill impairment for each reporting unit.

***Convertible Notes.*****  **The companyaccounts for conversion options embedded in convertible notes in accordancewith Statement of Financial Accounting Standard (“SFAS) No. 133 “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS 133”) and EITF 00-19“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a company’s Own Stock” (“EITF 00-19”). SFAS 133 generallyrequires companies to bifurcate conversion options embedded in convertiblenotes from their host instruments and to account for them as free standingderivative financial instruments in accordance with EITF 00-19. SFAS 133provides for an exception to this rule when convertible notes, as hostinstruments, are deemed to be conventional as that term is described in theimplementation guidance under Appendix A to SFAS 133 and further clarified inEITF 05-2 “The Meaning of “Conventional Convertible Debt Instrument” inIssue No. 00-19. The company accounts for convertible notes (deemedconventional) in accordance with the provisions of EITF 98-5.

“Accounting for Convertible Securities with BeneficialConversion Features,” (“EITF 98-5”), EITF 00-27 “Applicationof EITF 98-5 to Certain Convertible Instruments.” Accordingly, thecompany records, as a discount to convertible notes, the intrinsic value ofsuch conversion options based upon the differences between the fair value ofthe underlying common stock at the commitment date of the note transaction andthe effective conversion price embedded in the note. Debt discounts under thesearrangements are amortized over the term of the related debt to their earliestdate of redemption.

**Recent Changes in AccountingStandards**

In February 2006, the FASB issued SFASNo. 155, “Accounting for Certain Hybrid Financial Instruments—an amendmentof FASB Statements No. 133 and 150.” SFAS No. 155(a) permits fair value re-measurement for any hybrid financial instrumentthat contains an embedded derivative that

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otherwise would requirebifurcation, (b) clarifies that certain instruments are not subject to therequirements of SFAS 133, (c) establishes a requirement to evaluateinterests in securitized financial assets to identify interests that maycontain an embedded derivative requiring bifurcation, (d) clarifies whatmay be an embedded derivative for certain concentrations of credit risk and(e) amends SFAS 140 to eliminate certain prohibitions related toderivatives on a qualifying special-purpose entity. SFAS 155 is applicable tonew or modified financial instruments in fiscal years beginning after September 15,2006, though the provisions related to fair value accounting for hybridfinancial instruments can also be applied to existing instruments. Earlyadoption, as of the beginning of an entity’s fiscal year, is also permitted,provided interim financial statements have not yet been issued. The Companywill apply the provisions of this statement prospectively to new instruments.

In March 2006, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 156, Accounting for Servicing of Financial Assets (SFASNo. 156). SFAS No. 156 amends SFAS No. 140 “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,” to require allseparately recognized servicing assets and servicing liabilities to beinitially measured at fair value, if practicable. SFAS No. 156 alsopermits servicers to subsequently measure each separate class of servicingassets and liabilities at fair value rather than at the lower of cost ormarket. For those companies that elect to measure their servicing assets andliabilities at fair value, SFAS No. 156 requires the difference betweenthe carrying value and fair value at the date of adoption to be recognized as acumulative effect adjustment to retained earnings as of the beginning of thefiscal year in which the election is made. SFAS No. 156 is effective forthe first fiscal year beginning after September 15, 2006. The Company isevaluating the potential impact, if any, that the adoption of SFAS 156 willhave on its consolidated financial statements.

In September 2006, the FASB issued Statement ofFinancial Accountings Standards No. 157, Fair Value Measurements (“SFAS 157”).This Standard defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles and expands disclosures aboutfair value measurements. SFAS 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007 and interim periods withinthose fiscal years. The adoption of SFAS 157 is not expected to have a materialimpact on the Company’s financial position, results of operations or cashflows.

In July 2006, the Financial Accounting Standards Boardissued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.This Interpretation prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. This Interpretationalso provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. TheInterpretation is effective for fiscal years beginning after December 15, 2006.We have not yet completed our analysis of the impact this Interpretation willhave on our financial condition, results of operations, cash flows ordisclosures.

Other accounting standards that have been issued orproposed by the FASB or other standards-setting bodies that do not requireadoption until a future date are not expected to have a material impact on theconsolidated financial statements upon adoption.

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**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

Market risk associated with adverse changes infinancial and commodity market prices and rates could impact our financial position,operating results or cash flows. We do not have any variable rate debtinstruments and we are not exposed to market risk due to changes in interestrates such as the prime rate and LIBOR.

Our acquisition of Sensible Security Solutions, Inc.in October of 2006 significantly increases our presence in the Canadian marketand creates greater exposure to foreign currency rate fluctuations.  We do not expect this exposure to besignificant.

**ITEM 4.  CONTROLS AND PROCEDURES**

As of September 30, 2006, the Company carried outan evaluation, under the supervision and with the participation of members ofour management, including the Company’s Chief Executive Officer and the Company’sChief Financial Officer, of the effectiveness and operation of the Company’s disclosurecontrols and procedures. Based upon that evaluation, the Company’s ChiefExecutive Officer and the Chief Financial Officer have concluded that theCompany’s disclosure controls and procedures were not effective as ofSeptember 30, 2006, based on their evaluation of these controls andprocedures required by paragraph (b) of Exchange Act Rules 13a-15and 15d-15.

**DISCLOSURECONTROLS AND INTERNAL CONTROLS**

Disclosure controls are procedures that are designedwith the objective of ensuring that information required to be disclosed in ourreports filed under the Securities Exchange Act of 1934, as amended, such asthis Report, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms. Disclosure controls arealso designed with the objective of ensuring that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. Internal controls are procedures which aredesigned with the objective of providing reasonable assurance that ourtransactions are properly authorized, recorded and reported and our assets aresafeguarded against unauthorized or improper use, to permit the preparation ofour financial statements in conformity with generally accepted accountingprinciples.

Our company is not an “accelerated filer” (as definedin the Securities Exchange Act) and is not required to deliver management’sreport on control over our financial reporting until our fiscal year endedJune 30, 2008. Nevertheless, we identified certain matters that constitutematerial weakness (as defined under the Public Company Accounting OversightBoard Auditing Standard No. 2) in our internal controls over financialreporting.

The material weaknesses that we have identified relateto the fact that that our overall financial reporting structure, internalaccounting information systems, and current staffing levels are not sufficientto support the complexity of our financial reporting requirements. We haveexperienced employee turnover in our accounting department including theposition of Chief Financial Officer. As a result, we have experienceddifficulty with respect to our ability to record, process and summarize all ofthe information that we need to close our books and records on a timely basisand deliver our reports to the Securities and Exchange Commission within thetime frames required under the Commission’s rules. We also need to increase thesize of our staff and review assignments within our accounting department toensure we have adequate segregation of duties.

We have also identified a specific material weaknessin our ability to ensure that the accounting for our equity-based transactionsis accurate and complete. Historically, we have entered into various forms ofcomplex equity transactions involving the application of specialized accountingprinciples. The equity based transactions that we consummated specificallyrelate to stock based compensation arrangements, issuances of complexinstruments in financing transactions, modifications to embedded and freestanding derivatives and settlements of debt for equity. We believe that equitytransactions we completed in connection with our financial restructuring areunique and occurred as a result of the fact that our liquidity was highlyconstrained. Although we believe that these events are unique and that ourequity based transactions in the future are likely to be reduced, we areevaluating certain corrective measures to provide us with the structure we needat such times that we may engage in equity based transactions. These measurescould include seeking the assistance of outside specialists with expertise inthese areas.

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We believe these material weaknesses have resultedfrom liquidity constraints that caused us to focus on using our resources toimplement a financial and operational restructuring plan. We have recently madesubstantial changes to our operating and capital structure and intend to takecorrective measures after we finish evaluating our existing capabilities, theresources we have and resources we may need to make available to effectuatecorrective measures.

We believe that any such risks that may have been createdas a result of these material weaknesses are partially mitigated by the factthat we have minimal assets that are subject to the risk of misappropriation.In addition, activities during our most recent reporting periods have beenregularly reviewed and approved by our Chief Executive and Chief FinancialOfficers. However, we acknowledge that additional control procedures arenecessary to ensure that our all of our transactions are properly recorded, ourassets are appropriately safeguarded and that we can close and report ourresults within the time frames required by the Securities and ExchangeCommission.

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**PART II - OTHER INFORMATION**

**ITEM1.  LEGAL PROCEEDINGS**

On or about October 30, 2006, Pangaea EducationSystems, LLC (“Pangaea”) filed a lawsuit against the Company alleging unfaircompetition, reverse passing off, misappropriation of trade secrets, copyrightinfringement and breach of contract arising out of services performed in 2003(the “Action”). Pangaea’s complaint does not specify the amount of damagessought, but Pangaea has demanded in excess of $2,500,000 in preliminarycommunications with the Company’s counsel. The Company contends that thisdemand is without factual or legal basis and that the Action has no merit. Aresponse to the complaint is due November 28, 2006. The Company intends tocontinue discussing an informal resolution. While the Company believes it has astrong position, it is not possible at this time to state the likelihood of anunfavorable outcome based on the early stage of the dispute, the positionstaken by Pangaea and the inherent uncertainties of litigation.

# **ITEM 6.  EXHIBITS**

| (a)    | Exhibits. |                                                                                                                                                 |
|--------|-----------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |      |                                                                                                                                                 |
|   | 10.1      | Asset Purchase Agreement,  dated October 27, 2006, by and among the Company, DynTek Canada, Sensible  Security Solutions Inc. and Paul Saucier.      |
|   |      |                                                                                                                                                 |
|   | 31.1      | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of the Securities  Exchange Act of 1934.                            |
|   |      |                                                                                                                                                 |
|   | 31.2      | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of the Securities  Exchange Act of 1934.                            |
|   |      |                                                                                                                                                 |
|   | 32.1      | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities  Exchange Act of 1934 and 18 U.S.C. Section 1350. |
|   |      |                                                                                                                                                 |
|   | 32.2      | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities  Exchange Act of 1934 and 18 U.S.C. Section 1350. |

 

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**SIGNATURE**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|        |   | DYNTEK, INC.             |
|--------|--------|--------------------------|
|   |   |                     |
|   |   |                     |
|   |   | By:                      | /s/ Casper W.  Zublin Jr. |   |
|   |   |                     | Casper W. Zublin  Jr. |   |
|   |   |                     | Chief Executive  Officer |
|   |   |                     |
|   |   | Date: November  20, 2006 |
|        |        |                          |  |  |  |  |

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**INDEX TO EXHIBITS**
| Exhibit  Number | ** ** | **Description**                                                                                                                                      |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            |       | Asset Purchase Agreement, dated October 27, 2006, by  and among the Company, DynTek Canada, Sensible Security Solutions Inc. and  Paul Saucier.      |
|            |       |                                                                                                                                                 |
| 31.1            |       | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(d) / 15d-14(a) of the Securities Exchange Act of 1934.                             |
|            |       |                                                                                                                                                 |
| 31.2            |       | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(d) / 15d-14(a) of the Securities Exchange Act of 1934.                             |
|            |       |                                                                                                                                                 |
| 32.1            |       | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350. |
|            |       |                                                                                                                                                 |
| 32.2            |       | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350. |

 

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