UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





**FORM
      10-KSB**


(mark
      one)





x
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934 FOR THE FISCAL YEAR ENDED JULY 31,
                2006





o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934
              FOR
                THE TRANSITION PERIOD FROM _______TO
                _________





Commission
      File Number: 1-15687





**ATSI
      COMMUNICATIONS, INC.**


(Name
      of
      Small Business Issuer as Specified in Its Charter)





**Nevada**
              (State
                or Other Jurisdiction of Incorporation or Organization)
            
            **74-2849995**
              (IRS
                Employer Identification No.)**3201
                Cherry Ridge, Building C, Suite 300**
              **San
                Antonio, Texas**
              (Address
                of Principal Executive Offices)
            
            **78230**
              (Zip
                Code)





**(210)
      614-7240**


(Issuer’s
      Telephone Number, Including Area Code)





Securities
      registered under Section 12(b) of the Exchange Act: NONE





Securities
      registered under Section 12(g) of the Exchange Act:





**Common
      Stock, Par Value $0.001 Per Share**


**Series
      H Convertible Preferred Stock, Par Value $0.001 Per Share**


(Title
      of
      Class)





Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act. o





Check
      whether the issuer: (1)
      filed
      all reports required to be filed by Section 13 or 15(d) of the Exchange Act
      of
      1934 during the past 12 months (or for such shorter period that the registrant
      was required to file such reports), and (2) has been subject to such filing
      requirements for the past 90 days. x Yes o
      No





Check
      if
      there is not disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained in this form, and l no disclosure will be
      contained, to the best of registrant’s knowledge, in definitive proxy or
      information statements incorporated by reference in Part III of this Form 10-KSB
      or any amendment to this Form 10-KSB. o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act) o Yes
x
      No





Registrant’s
      revenues for its recent fiscal year were $14,695,485





The
      aggregate market value of the voting common equity held by non-affiliates of
      the
      issuer was $5,963,504 based on
      the closing price of
      $0.32 per
      share on October
      26, 2006 as
      reported on the over-the-counter bulletin board.





There
      were 18,635,950 shares of issuer ’s Common Stock outstanding as of October 26,
      2006.





Transitional
      Small Business Disclosure Format (check one): o Yes x
      No














**TABLE
      OF CONTENTS**






**Page****PART
                  I**Item
                  1. Description of Business
              3Overview
              3History
              4Recent
                  Developments
              4Services
                  and Products
              4Carrier
                  Services
              5Network
                  Services
              5Communication
                  Services
              5Voice
                  over Internet Protocol Network
              7Strategy
                  and Competitive Conditions
              7Government
                  Regulations/ Concession License
              9Suppliers
              13Employees
              13Risk
                  Factors
              13Item
                  2. Description of Properties
              16Item
                  3. Legal Proceedings
              17Item
                  4. Submission of Matters to a Vote of Security Holders
              17**PART
                  II**Item
                  5. Market for Registrant’s Common Equity and Related Stockholder
                  Matters
              17Item
                  6. Management’s Discussion and Analysis or Plan of
                  Operations
              19Item
                  7. Financial Statements and Supplementary Data
              26Item
                  8. Changes in and Disagreements with Accountants on Accounting
                  andFinancial
                  Disclosures
              50Item
                  8A.Controls and Procedures
              50**PART
                  III**Item
                  9. Directors, Executive Officers, Promoters and Control Persons,
                  Compliancewith
                  Section 16(A) of the Exchange Act
              51Item
                  10. Executive Compensation
              53Item
                  11. Security Ownership of Certain Beneficial Owners and
                  Management
              54Item
                  12. Certain Relationships and Related Transactions
              55Item
                  13. Exhibits and Reports on Form 8-K
              56Item
                  14. Principal Accountant Fees and Services
              59













**Statement
      Regarding Restatement of prior periods**





ATSI
      has
      restated its 2006 and 2005 quarterly financial statements and the financial
      statements for the year ended July 31, 2005 from amounts previously reported.
      During the fourth quarter of fiscal 2006, in consultation with our legal
      counsel, we evaluated the liability for the provisions for liquidation
      preferences contained in our Series E Preferred Stock instruments. Based on
      our
      evaluation, we concluded that our obligation to the holders of the Series E
      Preferred Stock was incorrectly accounted for as dividends. Based on this
      assessment, we have reversed all accrued dividends in the aggregate amount
      of
      $340,000. The adjustments to reverse the accrued dividends in our Series E
      Preferred Stock has been recorded during the periods that it occurred and the
      accumulated impact of the adjustments are reflected in our current fiscal year
      financial statements in accordance with SFAS No. 154, Accounting for Changes
      and
      Error Corrections. See Note 15 to the consolidated financial
      statements.





In
      all
      other material respects, the previously reported financial statements are
      unchanged .







**PART
      I**





**ITEM
              I.**
            **BUSINESS.**





**Overview**





We
      are an
      international telecommunications carrier that utilizes the Internet to provide
      cost-efficient and economical international communication services. Our current
      operations consist primarily of providing digital voice communications over
      the
      Internet using Voice-over-Internet-Protocol ("VoIP"). We
      provide high quality voice and enhanced communication services to carriers,
      telephony resellers and other VoIP carriers through various agreements with
      service providers in the United States, Mexico, Asia, the Middle East and Latin
      America utilizing VoIP technology. Our services are as follows:





*Carrier
      Services:* We
      provide VoIP communication services to United States and foreign
      telecommunications companies who lack transmission facilities, require
      additional capacity or do not have the regulatory licenses to terminate traffic
      in Mexico, Asia, the Middle East and Latin America. Typically these
      telecommunications companies offer their services to the public for domestic
      and
      international long distance and VoIP services.





Network
      Services: We provide private communication links and VoIP gateway services
      to
      multi-national and Latin American carriers and enterprise customers who use
      a
      high volume of telecommunications services to communicate with their U.S.
      offices or businesses and need greater dependability than is currently available
      through their own telecommunication network. These services include data, voice
      and fax transmission between multiple international offices, as well as Internet
      and collocation services in the United States.





*Communication
      Services:* We
      provide retail local phone service and international VoIP long distance service
      to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley.
      Our local phone service includes access to a landline and value-added services
      such a caller ID and call waiting. These services are offered to our customers
      on both a prepaid and postpaid basis. Additionally, we provide prepaid domestic
      and long-distance services; under these services we allow our customers to
      access our prepaid VoIP network platform.





3


We
      have
      had operating losses for almost every quarter since we began operations in
      1994.
      Our operating losses from continuing operations were approximately $598,000
      and
      $1,795,000, for the years ended July 31, 2006, and 2005, respectively.
      Additionally, we had a working capital deficit of approximately $2,801,000
      at
      July 31, 2006 that includes accrued dividends of $1,743,000 for the outstanding
      shares of Series H Convertible Preferred Stock issued to our stockholders upon
      our merger and reincorporation into a wholly owned Nevada subsidiary in 2004.
      The accrued dividends for our Series H Preferred Stock convert to common stock
      as our shareholders convert their preferred stock to common stock. We produced
      positive operating income in our 4 th quarter
      ended July 31, 2006 and expect to pay our vendors and lenders on time in the
      future if this trend continues. In addition, we are currently pursuing various
      financing alternatives including an equity offering, accounts receivable
      factoring, and exchanging some portion or all of our debt for equity. However,
      we may not be successful in these efforts or circumstances currently unknown
      or
      unforeseen by us may arise that will result in us not being able to obtain
      additional funding.





Due
      to
      the recurring losses, negative cash flows generated from our operations prior
      to
      our 4 th quarter
      ended July 31, 2006 and our substantial working capital deficit, our auditor’s
      opinion on our financial statements as of July 31, 2006 calls attention to
      substantial doubts about our ability to continue as a going concern. This means
      that there is substantial doubt that we will be able to continue in business
      through July 31, 2007. In order to remain a going concern, we intend to continue
      generating positive cash flow from our operations and/or generate cash from
      debt
      or equity offerings. There is no assurance that we will be able to continue
      generating positive cash flow from our operations or obtain funding to remain
      as
      a going concern.





As
      a
      result of the recurring losses, negative cash flows from operations prior
      to
      our 4 th quarter
      ended July 31, 2006 and
      our
      working capital deficit, management continued to pursue different avenues for
      funding. During the year ended July 31, 2006 we received $54,000 from the
      exercise of 366,666 warrants. Additionally, o n
      November 4, 2005, we entered into a note payable with CSI Business Finance,
      Inc.
      for $50,000 and also signed an accounts receivable credit facility with CSI
      Business Finance, Inc. and as of the end of the second quarter we had drawn
      $150,000 of this facility. Additionally,
      on May 5, 2006, we entered into a note payable with a related party for
      $120,000. The proceeds from the exercise of warrants, various notes payable
      and accounts
      receivable credit facility have
      allowed the Company to pay those operating and corporate expenses that were
      not
      covered by our current cash inflows from operations. Although there is no
      assurance that we will be successful in securing additional funding,
      w e
      produced positive operating income in our 4 th quarter
      ended July 31, 2006 and expect to pay our operating and corporate expenses
      with
      cash inflows from operations in the future if this trend continues.





**History**





ATSI
      Communications, Inc., a Nevada corporation, was formed in 2004 as the successor
      to the business originally incorporated in 1994 as a Canadian holding company,
      Latcomm International, Inc., with a Texas operating subsidiary, Latin America
      Telecomm, Inc. Both corporations were renamed “American TeleSource
      International, Inc.” in 1994. In May 1998, the Canadian corporation completed a
      share exchange with a newly formed Delaware corporation, also called American
      TeleSource International, Inc., which resulted in the Canadian corporation
      becoming the wholly owned subsidiary of the Delaware Corporation. Our
      stockholders voted to change our name from American TeleSource International,
      Inc. to ATSI Communications, Inc. in 2003 and to reincorporate in the State
      of
      Nevada by merger into our wholly owned subsidiary in 2004. We own 49% of ATSI
      Comunicaciones S.A de C.V. (ATSICOM), a Mexican corporation, that holds a
      30-year concession, allowing for the sale of voice and data services, long
      distance transport, and the operation of a telecommunications network in
      Mexico.




**Recent
      Developments**





During
      our fiscal year ending July 31, 2006:





·
            We
                expanded our NexTone’Communications Session Controller (soft-switch) by 65% to enhance
                our
                Voice over Internet Protocol (VoIP) network. This network expansion
                has
                allowed us to route our traffic more efficiently, improve our call
                processing, monitor quality of service and share port resources with
                our
                customers. The NexTone technology has allowed us to be more competitive
                and to improve margins in our international VoIP carrier services.
                As a
                result of these enhancements to our VoIP Network our customer base
                has
                grown to approximately 75 customers and our revenue increased from
                $6,011,000 during the year ended July 31, 2005 to $14,696,000 for
                the year
                ended July 31,2006.




4




·
            On
                February 1, 2006 we announced the formation of a new wholly owned
                subsidiary, Digerati Networks, Inc., to showcase ATSI's growing VoIP
                business. Digerati Networks will market the Company's VoIP services
                with
                the goal of achieving a leadership position in the industry while
                building
                brand and name recognition. The new subsidiary will also allow the
                parent
                company to take full advantage of corporate development opportunities
                that
                may arise in the future.





**Services
      and Products**





We
      provide three types of services: Carrier Services, Network Services and
      Communication Services.




*Carrier
      Services*





We
      provide VoIP communication services to United States and Latin American
      telecommunications companies who lack transmission facilities, require
      additional capacity or do not have the regulatory licenses to terminate traffic
      in Mexico, Asia, the Middle East and Latin America. We also provide 800
      toll-free voice origination services from Mexico. ** Typically
      these telecommunications companies offer their services to the public for
      domestic and international long distance and VoIP services. Revenues from this
      service accounted for approximately 96% of our total revenue during the year
      ended July 31, 2005 (“fiscal 2005”) and 99% of our total revenue during the year
      ended July 31, 2006 (“fiscal 2006”). The percentage of our total volume of
      carrier services traffic sent by customers can fluctuate dramatically, on a
      quarterly, and sometimes, daily basis. During fiscal 2006, we entered into
      various reciprocal agreements with our customers that allow them to transport
      and terminate traffic over our network and allowed us to transmit and terminate
      traffic over their networks. These reciprocals agreements with our customers
      were not for a specific period of time or volume of minutes. Under the
      reciprocal agreements, both parties were given a set of rates for services
      and
      each party would decide the volume of minutes it would send to be processed.
      Therefore, on a month-to-month basis there was not a required volume commitment
      of minutes from each party and the parties were free to re-route their traffic
      away to a lower priced provider.




*Network
      Services*





We
      provide private communication links and VoIP gateway services to multi-national
      and Latin American carriers and enterprise customers who use a high volume
      of
      telecommunications services to communicate with their U.S. offices or businesses
      and need greater dependability than is currently available through the foreign
      telecommunication networks. These services include data, voice and fax
      transmission between multiple international offices and branches as well as
      Internet and collocation services in the United States. We
      currently provide network Services to World Data, a Mexican corporation on
      a
      month-to-month basis and generate approximately $1,500 per month in revenue.
      There is no assurance that we will continue to generate this level of revenue
      in
      the future or that we will be able to enter into a long-term contract with
      World
      Data or any other customer.





We
      compete with AT&T, as well as the former telecommunication monopolies in the
      Latin American countries, in providing network services. Factors contributing
      to
      our competitiveness include reliability, network quality, speed of installation,
      and in some cases, geography, network size, and hauling capacity. We are at
      a
      competitive disadvantage with respect to larger carriers who are able to provide
      networks for corporations that encompass more countries in Latin America, as
      well as Europe, Asia and other parts of the globe. As a result of these
      disadvantages we do not expect a significant increase in revenue from this
      source in the near future.





*Communication
      Services*




On
      August
      1, 2004, we acquired a
      Competitive Local Exchange Carrier (“CLEC”) based in South Texas. This
      acquisition served as a gateway to reach out to the Hispanic communities
      residing along the US and Mexico border. We provide local phone service and
      international VoIP long distance service to the U.S. Hispanic market in Texas,
      through our wholly owned subsidiary, Telefamilia Communications, Inc. Revenues
      from this service accounted for approximately 1% of our total revenue in the
      year ended July 31, 2006. Our
      local phone service includes value-added services such a caller ID and call
      waiting.




5


We
      have
      deployed various postpaid and prepaid retail services and generated
      approximately $125,000 in retail services revenue during the fiscal year ended
      July 31, 2006




**Voice
      over Internet Protocol Networks**





The
      basic
      technology of traditional telecommunications systems was designed for slow
      mechanical switches. Communications over the traditional telephone network
      are
      routed through circuits that must dedicate resources to each call from its
      inception until the call ends, regardless of whether anyone is actually talking
      on the circuit. This circuit-switching technology incurs a significant cost
      per
      call and does not efficiently support the integration of voice with data
      services. Data networks, however, were designed for electronic switching. They
      break the data stream into small, individually addressed packages of data
      (“packets”) that are routed independently of each other from the origin to the
      destination. Therefore, they do not require a fixed amount of bandwidth to
      be
      reserved between the origin and destination of each call and they do not waste
      bandwidth when it is not being used for actual transmission of information.
      This
      allows multiple voice or voice and data calls to be pooled, resulting in these
      networks being able to carry more calls with an equal amount of bandwidth.
      Moreover, they do not require the same complex switching methods required by
      traditional voice telephone networks, instead using a multiplicity of routers
      to
      direct each packet in the direction of its destination and they automatically
      route packets around blockages, congestion or outages.





Packet
      switching is a method of transmitting messages that can be used within a data
      network or across networks, including the public Internet. The Internet itself
      is not a single data network owned by any single entity, but rather a loose
      interconnection of networks belonging to many owners that communicate using
      the
      Internet Protocol (“IP”). By converting voice signals to digital data and
      handling the voice signals as data, it can be transmitted through the more
      efficient switching networks designed for data transmissions and through the
      Internet using the IP. The transmission of voice signals as digitalized data
      streams over the Internet is known as Voice over Internet Protocol or “VoIP”. A
      VoIP network has the following advantages over traditional networks:





·
            **Integration
                of Voice and Data:**VoIP networks allows for the integration of voice, data traffic and
                images
                into the same network.





·
            **Simplification:**An
                integrated infrastructure that supports all forms of communication
                allows
                more standardization and less equipment management. The result is
                a fault
                tolerant design.





·
            **Network
                Efficiency:**The integration of voice and data fills up the data communication
                channels
                efficiently, thus providing bandwidth consolidation and reduction
                of the
                costs associated with idle bandwidth. The sharing of equipment and
                operations costs across both data and voice users can also improve
                network
                efficiency since excess bandwidth on one network can be used by the
                other,
                thereby creating economies of scale for voice (especially given the
                rapid
                growth in data traffic). An integrated infrastructure that supports
                all
                forms of communication allows more standardization and reduces the
                total
                equipment complement. This combined infrastructure can support dynamic
                bandwidth optimization and a fault tolerant design. The differences
                between the traffic patterns of voice and data offer further opportunities
                for significant efficiency improvements.





·
            **Co-existence
                with traditional communication mediums:**IP
                telephony can be used in conjunction with existing PSTN switches,
                leased
                and dial-up lines, PBXs and other customer premise equipment (CPE),
                enterprise LANs, and Internet connections. IP telephony applications
                can
                be implemented through dedicated gateways, which in turn can be based
                on
                open standards platforms for reliability and scalability.




6




·
            **Cost
                reduction:**Under the VoIP network, the connection is directly to the Internet
                backbone and as a result the telephony access charges and settlement
                fees
                are avoided.





The
      growth of voice on the Internet was limited in the past due to poor sound
      quality caused by technical issues such as delays in packet transmission and
      by
      bandwidth limitations related to Internet network capacity and local access
      constraints. However, the continuing addition of data network infrastructure,
      recent improvements in packet switching and compression technology, new software
      algorithms and improved hardware have substantially reduced delays in packet
      transmissions and the effect of these delays. Nevertheless, certain VoIP routes
      into countries with limited or poor Internet infrastructure continue to lack
      the
      consistent quality required for voice transport and termination.





A
      number
      of large long distance carriers have announced Internet telephony service
      offerings. Smaller Internet telephony service providers have also begun to
      offer
      low-cost Internet telephony services from personal computers to telephones
      and
      from telephones to telephones. Traditional carriers have substantial investments
      in traditional telephone network technology, and therefore have been slow to
      embrace Internet technology.





We
      believe that the infrastructure required for a global network is too expensive
      for most companies to deploy on their own. This mandates that the network be
      a
      combination of gateways owned by different operators. For a network to achieve
      optimal functionality and quality, however, the gateways need to be
      interoperable, or able to communicate with one another. Interoperability
      continues to be a challenge for VoIP providers and recently, technological
      solutions have emerged that support interoperability between different protocols
      and/or gateways. Cisco appears to have emerged as a dominant supplier of VoIP
      gateways and other manufacturers often seek to make their equipment
      interoperable with Cisco.





Long
      distance telephone calls transported over the Internet are less expensive than
      similar calls carried over the traditional telephone network primarily because
      the cost of using the Internet is not determined by the distance those calls
      need to travel. Also, routing calls over the Internet is more cost-effective
      than routing calls over the traditional telephone network because the technology
      that enables Internet telephony is more efficient than traditional telephone
      network technology. The greater efficiency of the Internet creates cost savings
      that can be passed on to the consumer in the form of lower long distance rates
      or retained by the carrier as higher margins.





By
      using
      the public Internet, VoIP providers like ATSI are able to avoid direct payment
      for transport of communications, instead paying for large “pipes” into the
      public Internet, billed by bandwidth rather than usage, which transmits calls
      to
      a distant gateway. The Internet, which has its origins in programs devised
      by
      the Department of Defense to provide multiple routes and therefore redundancy
      which was largely immune from the failure of a single network element, provides
      great redundancy and can be “self healing” in the event of an outage in a
      particular network element or transmission path. Moreover, adding an additional
      entry or exit point (a Point of Presence or “PoP”) does not require any
      expensive or time consuming reconfiguration or reprogramming of existing network
      elements. The new element is simply installed with a specific IP address and
      it
      can send or receive information from any other IP address on the
      Internet.





**Strategy
      and Competitive Conditions**





The
      long
      distance telephony market and the Internet telephony market are highly
      competitive. There are several large and numerous small competitors, and we
      expect to face continuing competition based on price and service offerings
      from
      existing competitors and new market entrants in the future. The principal
      competitive factors in our market include price, quality of service, coverage,
      customer service, technical response times, reliability, and network
      size/capacity. Our competitors include major and emerging telecommunications
      carriers in the U.S. and foreign telecommunications carriers. The competitive
      landscape is rapidly altering the number, identity and competitiveness of the
      marketplace, and we are unable to determine with certainty the impact of
      potential consolidation in our industry.





7


During
      the past several years, a number of companies have introduced services that
      make
      Internet telephony or voice services over the Internet available to other
      carriers. All major telecommunications companies either presently do or could
      route traffic to destinations worldwide and compete directly with us. Other
      Internet telephony service providers focus on a retail customer base and may
      in
      the future compete with us in the carrier services business. In addition,
      companies currently in related markets have begun to provide voice over the
      Internet services or adapt their products to enable voice over the Internet
      services. These related companies may potentially migrate into the Internet
      telephony market as direct competitors.





Carriers
      buying wholesale termination into Mexico, while cost conscious, are increasingly
      demanding high reliability and quality in service delivery. Sustainability
      and
      growth in this segment depends on specific competitive advantages that companies
      may possess in specific markets. Competitive advantages like proper licenses,
      network redundancy, favorable termination agreements, or the presence of a
      business infrastructure and relationships in the specific terminating market.
      The Company competes with the dominant providers, such as Qwest, as well as
      other, smaller providers for international long distance services to Mexico.
      The
      Company believes that in contrast to the dominant providers, it has a much
      more
      focused and cost competitive strategy that targets select higher margin
      telecommunication niches utilizing VoIP technology. Certain carriers provide
      termination services in Mexico at lower prices, since they contract with other
      carriers that “leak” into the local network using unlicensed IP points of
      presence. These carriers, however, have several disadvantages including:
      (i) generally poor quality, (ii) limited capacity, and (iii) poor
      reliability, since Mexican authorities periodically shut down their operations.
      Additionally, there are a few market trends that affect our carrier product’s
      competitiveness in the market. First, unauthorized, non-conventional operators
      continue to have a major impact by offering prices below real costs. Second,
      network expansion by newly licensed carriers in Mexico continues to drive down
      costs. The result of this trend is a significant reduction in revenue per
      minute. The combination of non-conventional termination and the new settlement
      rates have reduced U.S to Mexico termination prices from an average price of
      $0.27 per minute in 1998 to a current rate of $0.03 per minute.





Many
      of
      our competitors have substantially greater financial, technical and marketing
      resources, larger customer bases, longer operating histories, greater name
      recognition and more established relationships in the industry than we have.
      As
      a result, certain of these competitors may be able to adopt more aggressive
      pricing policies that could hinder our ability to market our services. We
      believe that our key competitive advantages are our ability to deliver reliable,
      high quality voice service over the Internet in a cost-effective manner. We
      cannot provide assurances, however, that these advantages will enable us to
      succeed against comparable service offerings from our competitors. A large
      number of telecommunications companies, including AT&T and Qwest currently
      provide wholesale voice telecommunications service which competes with our
      business. These companies, which tend to be large entities with substantial
      resources, generally have large budgets available for research and development,
      and therefore may further enhance the quality and acceptance of the transmission
      of voice over the Internet.





Our
      strategy is to position ourselves to take advantage of the demonopolization
      of
      the Latin American telecommunications markets, as well as the increasing demand
      for international communications services between these markets and the United
      States. Historically, telecommunications services in Latin America have been
      provided by state-run companies, operating as a legal or *de
      facto* monopoly. Although these companies failed to satisfy the demand for services
      in
      their countries, the regulatory scheme effectively precluded competition by
      foreign carriers. Currently, there is a trend toward demonopolization of the
      telecommunications industry in Latin America, and many of these countries are
      in
      various stages of migration toward a competitive, multi-carrier market. Many
      Latin American countries produce a significant number of immigrants to the
      United States, or are becoming homes to U.S. based corporations seeking lower
      labor costs. At the same time that Latin American markets have been opening
      up,
      the demand for telecommunications services between the United States and Latin
      America (particularly Mexico) has been strengthened by:





8


·
            the
                rapid growth of the Latino segment of the United States population


·
            Mexico’s
                status as the top calling partner with the United States


·
            increase
                in trade and travel between Latin America and the United States


·
            the
                build-out of local networks and corresponding increase in the number
                of
                telephones in homes and businesses in Latin countries


·
            proliferation
                of communications devices such as faxes, mobile phones, pagers, and
                personal computers


·
            declining
                rates for services as a result of increased competition.





Our
      strengths include our knowledge of, and relationships within, the
      telecommunications industry in the United States and certain countries within
      Latin America, particularly Mexico. Our management and employees have in-depth
      knowledge of the Mexican culture, business environment and telecommunications
      industry. As a result, we have been able to obtain a key long distance
      concession through our 49% ownership in ATSICOM that allows us to both generate
      and carry traffic within Mexico and between Mexico and the United States.





**Government
      Regulation / Concession License**





**Regulation
      of Internet Telephony**





Our
      operations are subject to federal, state and foreign laws and regulations. The
      use
      of the Internet to provide telephone service is a fairly recent market
      development. At present, we are not aware of any domestic, and only aware of
      a
      few foreign, laws or regulations that prohibit voice communications over the
      Internet.





*United
      States.*





We
      believe that, under U.S. law, the Internet-related services that we provide
      constitute information services as opposed to regulated telecommunications
      services, and, as such, are not currently actively regulated by the Federal
      Communications Commission (FCC) or any state agencies charged with regulating
      telecommunications carriers. Nevertheless, aspects of our operations may be
      subject to state or federal regulation, including regulations governing
      universal service funding, disclosure of confidential communications and excise
      tax issues. We cannot provide assurances that Internet-related services will
      not
      be actively regulated in the future. Several efforts have been made in the
      U.S.
      to enact federal legislation that would either regulate or exempt from
      regulation services provided over the Internet. Increased regulation of the
      Internet may slow its growth, particularly if other countries also impose
      regulations. Such regulation may negatively impact the cost of doing business
      over the Internet and materially adversely affect our business, operating
      results, financial condition and future prospects *.*





While
      the
      FCC to date has maintained an informal policy that information service
      providers, including VoIP providers, are not telecommunications carriers for
      regulatory purposes, various entities have challenged this premise, both before
      the FCC and at various state government agencies.  However,
      the FCC has ruled that certain traffic carried in part utilizing the Internet
      protocol format was nonetheless regulated telecommunications for which certain
      regulatory obligations applied. The
      FCC
      has considered whether to impose surcharges or other common carrier regulations
      upon certain providers of Internet telephony, primarily those which, unlike
      us,
      provide Internet telephony services directly to end users. Recently,
      the FCC ruled that interconnected VoIP service providers must make
      contributions to the Universal Service Fund. Additionally, the FCC has expressed
      an intention to further examine the question of whether certain forms of
      phone-to-phone VoIP services are information services or telecommunications
      services. The two are treated differently in several respects, with certain
      information services being regulated to a lesser degree. The FCC has noted
      that
      certain forms of phone-to-phone VoIP services bear many of the same
      characteristics as more traditional voice telecommunications services and lack
      the characteristics that would render them information services. The FCC has
      indicated that the mechanisms for contributing to the Universal Service Fund,
      issues as to applicability of access charges and other matters will be
      considered in that context. Adverse
      rulings or rulemakings could subject us to licensing requirements and additional
      fees and subsidies.





9


If
      the
      FCC were to determine that certain Internet-related services including Internet
      telephony services are subject to FCC regulations as telecommunications
      services, the FCC could subject providers of such services to traditional common
      carrier regulation, including payment of access charges to local telephone
      companies. A decision to impose such charges could also have retroactive effect,
      which could materially adversely affect us. It is also possible that the FCC
      may
      adopt a regulatory framework other than traditional common carrier regulation
      that would apply to Internet telephony providers. Any such determinations could
      materially adversely affect our business, financial condition, operating results
      and future prospects to the extent that any such determinations negatively
      affect the cost of doing business over the Internet or otherwise slow the growth
      of the Internet. Congressional dissatisfaction with FCC conclusions could result
      in requirements that the FCC impose greater or lesser regulation, which in
      turn
      could materially adversely affect our business, financial condition, operating
      results and future prospects.





State
      regulatory authorities may also retain jurisdiction to regulate certain aspects
      of the provision of intrastate Internet telephony services. Several state
      regulatory authorities have initiated proceedings to examine the regulation
      of
      such services. Others could initiate proceedings to do so.





*Other
      regulations affecting the Internet in the United States.*





Congress
      has recently adopted legislation that regulates certain aspects of the Internet,
      including online content, user privacy and taxation. In addition, Congress
      and
      other federal entities are considering other legislative and regulatory
      proposals that would further regulate the Internet. Congress has; for example,
      considered legislation on a wide range of issues including Internet spamming,
      database privacy, gambling, pornography and child protection, Internet fraud,
      privacy and digital signatures. Various states have adopted and are considering
      Internet-related legislation. Increased U.S. regulation of the Internet may
      slow
      its growth, particularly if other governments follow suit, which may negatively
      impact the cost of doing business over the Internet and materially adversely
      affect our business, financial condition, results of operations and future
      prospects. Legislation has also been proposed that would clarify the regulatory
      status of VoIP service. The Company has no way of knowing whether legislation
      will pass or what form it might take.





R *egulations
      pertaining to our retail operations.*





In
      the
      United States, services provided through our retail operations are subject
      to
      the provisions of the Communications Act of 1934, as amended, the FCC
      regulations, and the applicable laws and regulations of the various states
      and
      state regulatory commissions.




As
      a
      carrier offering services to the public, we must comply with the requirements
      of
      common carriage under the Communications Act of 1934, including the offering
      of
      service on a nondiscriminatory basis at just and reasonable rates, and obtaining
      FCC approval prior to any assignment of authorizations or any transfer of legal
      or actual control of the company.




We
      are
      subject to various specific common carrier telecommunications requirements
      set
      forth in the FCC’s rules, including operating, reporting and fee requirements.
      Both federal and state regulatory agencies have broad authority to impose
      monetary and other penalties on us for violations of regulatory requirements.





Domestic
      Service Regulation. We are considered a non-dominant domestic interstate
      carrier subject to minimal regulation by the FCC. We are not required to obtain
      FCC authority to initiate or expand our domestic interstate operations, but
      we
      are required to obtain FCC approval to transfer control or discontinue service
      and to file various reports and pay various fees and assessments. Among other
      things, interstate common carriers must offer service on a nondiscriminatory
      basis at just and reasonable rates. In addition, as a non-dominant carrier,
      we
      are subject to the FCC’s complaint jurisdiction.




10


All
      interstate telecommunications carriers are required to contribute to the federal
      universal service programs. The FCC currently is considering revising its
      universal service funding mechanism. We cannot predict the outcome of these
      proceedings or their potential effect on us. Although we currently do not
      provide VoIP services
      to the end users or consumer, VoIP services that we may provide in the future
      are not currently subject to direct regulation by the FCC or state regulatory
      commissions to the extent that they qualify as “enhanced” or “information”
services. The FCC defines enhanced services as services that (1) employ computer
      processing applications that act on the format, content, code, protocol or
      similar aspects of the subscriber’s transmitted information, (2) provide the
      subscriber additional, different or restructured information, or (3) involve
      subscriber interaction with stored information. In 1998, in a non-binding
      report, the FCC observed that “computer-to-computer” VoIP may be appropriately
      considered to be unregulated but that “phone-to-phone” VoIP may lack the
      characteristics that would render them unregulated “information” services. In
      February 2004, the FCC ruled that free computer-to-computer VoIP service is
      not
“telecommunications service” and that it is an interstate “information service.”
Although this order clarifies some of the relevant VoIP issues, the FCC has
      not
      yet issued a formal decision as to whether other variations of VoIP services
      should be subject to traditional common carrier telecommunications service
      regulation or whether any of the VoIP services should be subject to universal
      service contribution and access charge obligations. In March 2004, the FCC
      released a Notice of Proposed Rulemaking (“NPRM”) regarding VoIP service. The
      NPRM specifically addresses the regulatory classification and jurisdiction
      of
      VoIP; the application of access charges; and how to preserve key public policy
      objectives such as universal service, 911/emergency services, law enforcement
      surveillance requirements, and the needs of persons with disabilities. In
      November 2004, the FCC ruled that services provided by a particular VoIP
      provider are interstate in nature, and not subject to entry regulations of
      the
      various state Public Service Commissions. The FCC, however, declined to rule
      on
      whether the service is a regulated telecommunications service or an unregulated
      information service. In addition, in December 2004, the United States Court
      of
      Appeals for the 8 th Circuit
      ruled that such VoIP provider’s service is an information service and not
      subject to state regulation. The FCC continues to examine the appropriate
      regulatory treatment of VoIP. While initial indications from the FCC suggest
      that any regulation of VoIP will be limited in nature, the future regulatory
      treatment of other variations of VoIP by the FCC and state regulatory bodies
      continues to be uncertain. Furthermore, Congressional dissatisfaction with
      the
      FCC’s treatment of IP telephony could result in legislation requiring the FCC to
      impose greater or lesser regulation. Changes to, and further clarifications
      of,
      the treatment of VoIP services could result in the imposition of burdensome
      regulation and fees on some of our services and/or increase certain of our
      operating costs.




State
      Regulation.  Our intrastate long distance operations are subject to
      various state laws and regulations, including, in most jurisdictions,
      certification and tariff filing requirements. Telefamilia Communications, Inc.
      (Telefamilia), a wholly owned subsidiary of ours, maintains the necessary
      certificate and tariff approvals, where approvals are necessary, to provide
      intrastate long distance service in Texas. Telefamilia also maintains the
      necessary certificate to provide local services in Texas. Texas requires prior
      approval or notification for certain stock or asset transfers or
      for
      the issuance of securities, debt or for name changes. As a certificated carrier,
      consumers may file complaints against us at the public service commissions.
      Certificates of authority can generally be conditioned, modified, canceled,
      terminated, or revoked by state regulatory authorities for failure to comply
      with state law and/or the rules, regulations and policies of the state
      regulatory authorities. Fines and other penalties also may be imposed for such
      violations. Public service commissions also regulate access charges and other
      pricing for telecommunications services within each state. The Regional Bell
      Operating Carriers and other Local Exchange Carriers have been seeking reduction
      of state regulatory requirements, including greater pricing flexibility, which,
      if granted, could subject us to increased price competition. We may also be
      required to contribute to universal service funds in Texas.





*International.*





**  The
      regulatory treatment of Internet telephony outside of the U.S. varies widely
      from country to country. A number of countries that currently prohibit
      competition in the provision of voice telephony also prohibit Internet
      telephony. Other countries permit but regulate Internet telephony. Some
      countries will evaluate proposed Internet telephony service on a case-by-case
      basis and determine whether it should be regulated as a voice service or as
      another telecommunications service. Finally, in many countries, Internet
      telephony has not yet been addressed by legislation or regulation. Increased
      regulation of the Internet and/or Internet telephony providers or the
      prohibition of Internet telephony in one or more countries could materially
      adversely affect our business, financial condition, operating results and future
      prospects.





11


*Other
      General regulations*





The
      Telecommunications Act of 1996 (the “Telecom Act”), which became law in February
      1996, was designed to dismantle the monopoly system and promote competition
      in
      all aspects of telecommunications. The FCC has promulgated and continues to
      promulgate major changes to their telecommunications regulations. One aspect
      of
      the Telecom Act that is of particular importance to us is that it allows Bell
      Operating Companies or BOCs to offer in-region long distance service once they
      have taken certain steps to open their local service monopoly to competition.
      Given their extensive resources and established customer bases, the entry of
      the
      BOCs into the long distance market, specifically the international market,
      will
      create increased competition for us.





Although
      we do not know of any other specific new or proposed regulations that will
      affect our business directly, the regulatory scheme for competitive
      telecommunications market is still evolving and there could be unanticipated
      changes in the competitive environment for communications in general. For
      example, the FCC is currently considering rules that govern how Internet
      providers share telephone lines with local telephone companies and compensate
      local telephone companies. These rules could affect the role that the Internet
      ultimately plays in the telecommunications market.





The
      International Settlements Policy governs settlements between top tier U.S.
      carriers’ and foreign carriers’ costs of terminating traffic over each other’s
      networks. The FCC recently enacted certain changes in our rules designed to
      allow U.S. carriers to propose methods to pay for international call termination
      that deviate from traditional accounting rates and the International Settlement
      Policy. The FCC has also established lower benchmarks for the rates that U.S.
      carriers can pay foreign carriers for the termination of international services
      and these benchmarks may continue to decline. These rule changes have lowered
      the costs of our top tier competitors to terminate traffic in the United States
      and are contributing to the downward pricing pressure facing us in the carrier
      market.





*Mexico*





The
      Secretaría de Comunicaciones y Transportes or the SCT and COFETEL (Comisión
      Federal de Telecomunicaciones or Federal Telecommunications Commission) have
      issued ATSICOM a 30-year license granted in June 1998 to install and operate
      a
      public network. Under this license, ATSI Comunicaciones S.A de C.V. is required
      to meet the following:




General
      requirements





·
            Maintain
                approximately $10 million in registered and subscribed capital.


·
            Install
                and operate a network in Mexico. The Mexican government will need
                to
                approve the operating plan before it is implemented; additionally
                the
                Mexican government will need to approve any future changes to the
                operating plan before it can be implemented.


·
            Continuously
                develop and conduct training programs for its staff.


·
            The
                Concessionaire at all times needs to have an assigned individual
                responsible for the technical functions to operate the concession.





Concession
      services requirements





·
            The
                Concessionaire is required to provide continuous and efficient services
                at
                all times to its customers.


·
            The
                Concessionaire must establish a complaint center and correction facilities
                center. We are required to report to the Mexican Government on a
                monthly
                basis the complaints received and the actions taken to resolve the
                problems.




12


Tariff
      Requirements





·
            The
                Concessionaire will only be authorized to invoice its customer’s tariffs
                rates that have been approved by the Mexican
                government.




Verification
      and Information requirements




·
            The
                Concessionaire is required to provide audited financial statements
                on a
                yearly basis that includes a detailed description of the fixed assets
                utilized in the network and accounting reporting by region and location
                of
                where the services are being provided.


·
            The
                Concessionaire is required to provide quarterly reports and updates
                on the
                expansion of the network in Mexico and a description of the training
                programs and research and development programs.


·
            The
                Concessionaire is required to provide statistic reports of traffic,
                switching capacity and other parameters in the
                network.





Guarantee
      requirements





The
      Concessionaire is required to have a bond/ insurance policy for approximately
      $500,000, where the Mexican Federal Treasury Department will be the beneficiary
      in the event the Mexican government revokes the concession license.





**Suppliers**





We
      rely
      on various suppliers to provide services in connection with our communication
      services. We depend on various Global VoIP companies to complete our voice
      over
      Internet (VoIP) traffic between US, Mexico,
      Asia, the Middle East and Latin America.





**Employees**





As
      of
      July 31, 2006, we had eight employees, all of whom performed operational,
      technical and administrative functions. We believe our future success will
      depend to a large extent on our continued ability to attract and retain highly
      skilled and qualified employees. We consider our employee relations to be good.
      None of these aforementioned employees belong to labor unions.





**Risk
      Factors**





*Any
      investment in our common stock involves a high degree of risk. You should
      carefully consider the risks described below, which we believe include all
      the
      material risks to our business, together with the information contained
      elsewhere in this report, before you make a decision to invest in our company.*





**Factors
      That May Affect Future Results and Financial Condition**




***Risks
      Related to Our Operations***




**Our
      results of operations may fluctuate and the market price of our common stock
      may
      fall.**




Our
      revenue and results of operations have fluctuated and will continue to fluctuate
      from quarter to quarter in the future due to a number of factors, some of which
      are not in our control, including, among others:




·
            the
                amount of traffic we are able to sell to our customers, and their
                decisions on whether to route traffic over our network;




13




·
            increased
                competitive pricing pressure in the international long distance market;


·
            our
                ability to negotiate lower termination fees charged by our suppliers;


·
            our
                continuing ability to negotiate competitive costs to connect our
                network
                with those of other carriers and Internet backbone providers;


·
            fraudulently
                sent or received traffic which is unbillable, for which we may be
                liable;


·
            changes
                in call volume among the countries to which we complete calls;


·
            the
                portion of our total traffic that we carry over more lucrative routes
                could decline, independent of route-specific price, cost or volume
                changes;


·
            technical
                difficulties or failures of our network systems or third party delays
                in
                expansion or provisioning system components;


·
            our
                ability to manage our traffic on a constant basis so that routes
                are
                profitable;


·
            our
                ability to collect from our customers; and




**We
      may never generate sufficient revenue and gross margin to become profitable
      if
      telecommunications carriers and other communications service providers or others
      are reluctant to use our services or do not use our services, including any
      new
      services, in sufficient volume.**




If
      the
      market for VoIP telephony and new services does not develop as we expect, or
      develops more slowly than expected, our business, financial condition and
      results of operations will be materially and adversely affected.




Our
      customers may be reluctant to use our VoIP services for a number of reasons,
      including:




·
            perceptions
                that the quality of voice transmitted over the Internet is low;


·
            perceptions
                that VoIP is unreliable;


·
            our
                inability to deliver traffic over the Internet with significant cost
                advantages;


·
            development
                of their own capacity on routes served by us; and


·
            an
                increase in termination costs of international calls.




**We
      may increase costs and risks in our business to the extent we rely on third
      parties.**




*Parties
      that Maintain Phone and Data Lines and Other Telecommunications Services.* Our
      business model depends on the availability of the Internet and traditional
      telephone networks to transmit voice and fax calls. Third parties maintain
      and
      own these networks, other components that comprise the Internet, and business
      relationships that allow telephone calls to be terminated over the public
      switched telephone network. Some of these third parties are telephone companies.
      They may increase their charges for using these lines at any time and thereby
      increase our expenses. They may also fail to maintain their lines properly,
      fail
      to maintain the ability to terminate calls, or otherwise disrupt our ability
      to
      provide service to our customers. Any such failure that leads to a material
      disruption of our ability to complete calls or provide other services could
      discourage our customers from using our network and negatively impact our
      revenues.




*Communications
      Service Providers.* We
      maintain relationships with communications service providers in many countries,
      some of whom own the equipment that translates calls from traditional voice
      networks to the Internet, and vice versa. We rely upon these third parties
      both
      to provide lines over which we complete calls and to increase their capacity
      when necessary as the volume of our traffic increases. There is a risk that
      these third parties may be slow, or may fail, to provide lines, which would
      affect our ability to complete calls to certain destinations. We may not be
      able
      to continue our relationships with these providers on acceptable terms, if
      at
      all. Because we rely upon entering into relationships with
      providers to expand into additional countries, we may not be able to increase
      the number of countries to which we provide service. Finally, any technical
      difficulties that these providers suffer, or difficulties in their relationships
      with companies that manage the public switched telephone network, could affect
      our ability to transmit calls to the countries that those providers help serve.




14


**We
      are subject to downward pricing pressures and a continuing need to renegotiate
      overseas rates.**




As
      a
      result of numerous factors, including increased competition and global
      deregulation of telecommunications services, prices for international long
      distance calls have been decreasing. This downward trend of prices to end-users
      has caused us to lower the prices we charge communication service providers
      for
      call completion on our network. If this downward pricing pressure continues,
      we
      may not be able to offer VoIP services at costs lower than, or competitive
      with,
      the traditional voice network services with which we compete. Moreover, in
      order
      for us to lower our prices, we have to renegotiate rates with our foreign
      service providers who complete calls for us. We may not be able to renegotiate
      these terms favorably enough, or fast enough, to allow us to continue to offer
      services in a particular country on a cost-effective basis. The continued
      downward pressure on prices and our
      failure to renegotiate favorable terms in a particular country could have a
      material adverse effect on our ability to operate our network and VoIP business
      profitably.





**A
      variety of risks associated with our international operations could materially
      adversely affect our business.**




Because
      we provide many of our services internationally, we are subject to additional
      risks related to providing services into foreign countries. In particular,
      in
      order to provide services in some countries, we have forged relationships with
      foreign operators. Associated risks include:




·
            unexpected
                changes in tariffs, trade barriers and regulatory requirements relating
                to
                Internet access or VoIP;


·
            economic
                weakness, including inflation, or political instability in particular
                foreign economies and markets;


·
            difficulty
                in collecting accounts receivable;


·
            tax,
                consumer protection, telecommunications, and other laws;


·
            foreign
                currency fluctuations, which could result in increased operating
                expenses
                and reduced revenues;


·
            unreliable
                government power to protect our rights;




These
      and
      other risks associated with our international services may materially adversely
      affect our ability to attain or maintain profitable operations.





**International
      governmental regulation and legal uncertainties and other laws could limit
      our
      ability to provide our services, make them more expensive, or subject us to
      legal liability.**




Many
      countries currently prohibit or limit competition in the provision of
      traditional voice telephony services. In some of those countries, licensed
      telephony carriers as well as government regulators and law enforcement
      authorities have questioned the legal authority of VoIP services. We
      may
      face similar issues in additional countries. Our failure to qualify as a
      properly licensed service provider, or to comply with other foreign laws and
      regulations, could materially adversely affect our business, financial
      condition, and results of operations.


It
      is
      also possible that countries may apply to our activities laws relating to
      services provided over the Internet, including laws governing:




·
            user
                privacy;


·
            pricing
                controls and termination costs;


·
            characteristics
                and quality of products and services;


·
            qualification
                to do business;


·
            consumer
                protection;


·
            cross-border
                commerce, including laws that would impose tariffs, duties and other
                import restrictions;


·
            copyright,
                trademark and patent infringement; and


·
            claims
                based on the nature and content of Internet materials, including
                defamation, negligence and the failure to meet necessary obligations.




If
      foreign governments or other bodies begin to impose related restrictions on
      VoIP
      or our other services or otherwise enforce other laws against us or our foreign
      suppliers, such actions could have a material adverse effect on our operations.





15


**If
      we are not able to keep up with rapid technological change in a cost-effective
      way, the relative quality of our services could suffer.**




The
      technology upon which our services depend is changing rapidly. Significant
      technological changes could render the hardware and software that we use
      obsolete, and competitors may begin to offer new services that we are unable
      to
      offer. If we are unable to respond successfully to these developments or do
      not
      respond in a cost-effective way, we may not be able to offer competitive
      services and our business results may suffer.




**We
      may not be able to expand and upgrade our network adequately and
      cost-effectively to accommodate any future growth.**




Our
      VoIP
      business requires that we handle a large number of international calls
      simultaneously. As we expand our operations, we expect to handle significantly
      more calls. If we do not expand and upgrade our hardware and software quickly
      enough, we will not have sufficient capacity to handle the increased traffic
      and
      growth in our operating performance would suffer as a result. Even with such
      expansion, we may be unable to manage new deployments or utilize them in a
      cost-effective manner. In addition to lost growth opportunities, any such
      failure could adversely affect customer confidence in our network and services.




**Single
      points of failure on our network may make our business vulnerable.**




We
      operate one network control center in San Antonio, Texas. We have not yet
      designed a redundant system, provided for excess capacity, or taken other
      precautions against platform and network failures as well as facility failures
      relating to power, air conditioning, destruction, or theft. We are vulnerable
      to
      a network failure that may prohibit us from offering services.




**We
      depend on our current personnel and may have difficulty attracting and retaining
      the skilled employees we need to execute our business plan.**




Our
      future success will depend, in large part, on the continued service of our
      key
      management and technical personnel. If any of these individuals or others we
      employ are unable or unwilling to continue in their present positions, our
      business, financial condition and results of operations could suffer.




**If
      the Internet infrastructure is not adequately maintained, we may be unable
      to
      maintain the quality of our services and provide them in a timely and consistent
      manner.**




Our
      future success will depend upon the maintenance of the Internet infrastructure,
      including a reliable network backbone with the necessary speed, data capacity
      and security for providing reliability and timely Internet access and services.
      To the extent that the Internet continues to experience increased numbers of
      users, frequency of use or bandwidth requirements, the Internet may become
      congested and be unable to support the demands placed on it and its performance
      or reliability may decline thereby impairing our ability to complete calls
      and
      provide other services using the Internet at consistently high quality. The
      Internet has experienced a variety of outages and other delays as a result
      of
      failures of portions of its infrastructure or otherwise. Future outages or
      delays could adversely affect our ability to complete calls and provide other
      services. Moreover, critical issues concerning the commercial use of the
      Internet, including security, cost, ease of use and access, intellectual
      property ownership and other legal liability issues, remain unresolved and
      could
      materially and adversely affect both the growth of Internet usage generally
      and
      our business in particular. Finally, important opportunities to increase traffic
      on our network will not be realized if the underlying infrastructure of the
      Internet does not continue to be expanded to more locations worldwide.





16


**ITEM
                2.**
            **DESCRIPTION
                OF PROPERTIES.**





Our
      executive office is located at 3201 Cherry Ridge, Building C, Suite 300, San
      Antonio, Texas, consisting of 3,618 square feet. The lease for this facility
      will expire on November 15, 2011. We pay annual rent of $47,450. Management
      believes that our leased facilities are suitable and adequate for their intended
      use.





**ITEM
              3.**
            **LEGAL
                PROCEEDINGS.**




On
      October 31, 2002, we filed a lawsuit in the United States District Court for
      the
      Southern District Court of New York against several individuals and financial
      institutions, including the holders of our Series D and E Redeemable Preferred
      Stock, for, among other things, stock fraud and manipulation. On July 9, 2004,
      we filed a separate but related lawsuit in the same court against Sam Levinson
      and Uri Wolfson. On February 25, 2005, Judge Lewis A. Kaplan issued a memorandum
      opinion and order dismissing the complaint in the first action as to all
      defendants with prejudice. A judgment was entered in that action on September
      8,
      2005. We appealed that judgment on September 20, 2005 to the United States
      Court
      of Appeals for the Second Circuit. On April 27, 2005, the court entered a final
      judgment dismissing the second action with prejudice based on the February
      25,
      2005 decision in the first action. On May 25, 2005, we appealed the dismissal
      of
      the second action to the United States Court of Appeals for the Second Circuit.
      The defendants' briefs were filed in both appeals on March 29, 2006, and our
      reply briefs were filed on May 12, 2006. Oral arguments have
      been
      scheduled for November 29, 2006.  .
      Currently we cannot predict the outcome of this litigation or the financial
      impact on our ongoing operations.





On
      June
      16, 2005, ATSI Communications, Inc. filed an arbitration claim against Ntera
      Holdings, Inc. involving a dispute in the range of approximately $100,000 and
      attorney's fees for which Ntera counterclaimed. As part of a settlement
      agreement, Ntera agreed to a lesser balance it alleged had been owed, after
      which ATSI provided Ntera approximately $78,000 in VoIP termination services
      over a 90-day period from June 10, 2006 through September 10, 2006 to fully
      discharge an alleged indebtedness. ATSI successfully met its commitment under
      the settlement agreement. The arbitration was dismissed in October 2006,
      following the execution and performance of a settlement agreement.




In
      October 2005, Richard Beckenforf filed a lawsuit in Travis County, Texas against
      ATSI asserting indebtedness allegedly owed to him, principally for unpaid fees
      and un-reimbursed expenses during such time he was a director of ATSI. Such
      claims were for approximately $96,000 and exceeded $100,000 with attorney’s
      fees. This claim was settled on March 21, 2006 for $1,500 and issuance of ATSI
      stock valued at approximately $46,000 over the course of 6 months. As of
      September 15, 2006, the lawsuit against ATSI has been dismissed and we have
      successfully met our commitment under the settlement agreement.




On
      April
      13, 2006 ATSI filed suit in Bexar County, Texas and obtained injunctive relief
      against former ATSI consultant Diane Huth and John Highland associated to a
      dispute relating to who has prior claim and rightful ownership of the trade
      name
      "Telefamilia," which Defendants had undertaken to trademark for their own
      purposes. Defendants have filed an answer denying any liability. Temporary
      Injunctive relief was granted preserving ATSI's claims to such trade name.
      Currently, the suit is pending and no depositions have been taken and no trial
      date has been set. Currently we cannot predict the outcome of this litigation
      or
      the financial impact on our ongoing operations.





**ITEM
              4.**
            **SUBMISSION
                OF MATTERS TO A VOTE OF SECURITY
                HOLDERS.**





NONE





**PART
      II.**





**ITEM
              5.**
            **MARKET
                FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                PURCHASES OF EQUITY
                SECURITIES.**





(a)
            Market
                for Common Equity




17


Our
      common stock is quoted on the OTC Bulletin Board under the symbol “ATSX”. Our
      Series H Preferred Stock is not traded on any market. The following table sets
      forth the high and low bid prices for our common stock from August 1, 2004
      through July 31, 2006 as reported by Bloomberg, LP. Price quotations on the
      OTC
      Bulletin Board reflect inter-dealer prices, without retail mark-up, markdown
      or
      commission, and may not necessarily represent actual transactions.


**Fiscal
                  2005**
              **High
                  Low****First
                  Quarter**
              $1.20
                  $0.56**Second
                  Quarter**
              $1.25
                  $0.48**Third
                  Quarter**
              $0.92
                  $0.21**Fourth
                  Quarter**
              $0.32
                  $0.16**Fiscal
                  2006**
              **High
                  Low****First
                  Quarter**
              $0.44
                  $0.14**Second
                  Quarter**
              $0.43
                  $0.21**Third
                  Quarter**
              $0.51
                  $0.25**Fourth
                  Quarter**
              $0.39
                  $0.19


(b)  Holders





As
      of
      July 31, 2006, we had approximately 8,169 common shareholders of record. This
      amount does not include shares held in street name.





(c)
            Dividends





We
      have
      not paid cash dividends on our common stock. Additionally, the terms of our
      Series A, and Series H Preferred Stock restrict us from paying dividends on
      our
      common stock until such time as all outstanding dividends have been fulfilled
      related to each series of preferred stock. There are presently a total of
      $2,223,000 in unpaid dividends payable on outstanding series of preferred stock.
      Consequently, we do not anticipate paying any cash dividends in the foreseeable
      future.





*Equity
      Compensation Plans*





The
      following table provides information regarding securities that have been or
      are
      authorized to be issued under our equity compensation plans as of July 31,
      2006:





**Number
                of Securities to be Issued Upon Exercise of Outstanding Options,
                Warrants
                and Rights**
            **Weighted-Average
                Exercise Price of Outstanding Options, Warrants and
                Rights**
            **Number
                of Securities Remaining Available for Future Issuance Under Equity
                Compensation Plans****Equity
                Compensation plans approved by security holders**
            -0-
            N/A
            -0-**Equity
                Compensation Plans not approved by security
                holders**
            -0-
            N/A
            1,923,000**Total**
            -0-
            N/A
            1,923,000





The
      material features of each equity compensation plan are described in Note 13
      of
      the Notes to the Financial Statements.





18


(d)
            Sales
                of Unregistered Securities





On
      October 25, 2005, we issued 180,272 shares of our common stock to Nextone
      Communications, Inc. as a payment of $58,000 on the principal balance associated
      with the Nextone soft Switch. Additionally, we issued 69,180 and 95,238 common
      shares to Vianet Communications, Inc. on August 23, 2005 and September 14,
      2005,
      respectively, as part of the settlement agreement for certain litigation. The
      shares issued to Nextone Communications, Inc. and Vianet Communications, Inc.
      were issued pursuant to an exemption from registration under Section 4(2) of
      the
      Securities Act because of the limited size of the group, the absence of public
      solicitation or advertising, and restrictions on resale of the
      shares.





Additionally,
      we issued 66,603 and 98,328 common shares to Franklin, Cardwell and Jones on
      November 1, 2005 and January 6, 2006, respectively, for a payment of $10,000
      of
      accrued interest and principal payment of $33,000 on the current note payable.
      The shares issued to Franklin, Cardwell and Jones were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act because
      of
      the limited size of the group, the absence of public solicitation or
      advertising, and restrictions on resale of the shares.





On
      December 2, 2005, we issued 50,000 shares of our common stock to Carlos
      Kauachi/Dean Witter Reynolds as a settlement of debt of $49,000 associated
      with
      the commissions incurred as part of the acquisition of the concession license
      in
      Mexico during fiscal 2000. The shares issued to Carlos Kauachi/Dean Witter
      Reynolds were issued pursuant to an exemption from registration under Section
      4(2) of the Securities Act because of the limited size of the group, the absence
      of public solicitation or advertising, and restrictions on resale of the
      shares.





On
      April
      14, 2006, we issued 25,380 shares of our common stock to Richard Benkendorf
      as a
      payment of $7,614 associated with the settlement agreement between ATSI and
      Mr.
      Benkendorf. The shares issued to Mr. Benkendorf were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act because
      of
      the limited size of the group, the absence of public solicitation or
      advertising, and restrictions on resale of the shares.





On
      April
      20, 2006, we issued 278,444 shares of our common stock to Franklin, Cardwell
      and
      Jones as a payment of $1,950 of accrued interest and principal payment of
      $70,000 on the current note payable. The shares issued to Franklin, Cardwell
      and
      Jones were issued pursuant to an exemption from registration under Section
      4(2)
      of the Securities Act because of the limited size of the group, the absence
      of
      public solicitation or advertising, and restrictions on resale of the
      shares.





On
      May
      12, 2006, we issued 29,285 shares of our common stock to Richard Benkendorf
      as a
      payment of $7,614 associated with the settlement agreement between ATSI and
      Mr.
      Benkendorf. The shares issued to Mr. Benkendorf were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act because
      of
      the limited size of the group, the absence of public solicitation or
      advertising, and restrictions on resale of the shares.





On
      June
      13, 2006, we issued 26,255 shares of our common stock to Richard Benkendorf
      as a
      payment of $7,614 associated with the settlement agreement between ATSI and
      Mr.
      Benkendorf. The shares issued to Mr. Benkendorf were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act because
      of
      the limited size of the group, the absence of public solicitation or
      advertising, and restrictions on resale of the shares.





On
      July
      12, 2006, we issued 30,456 shares of our common stock to Richard Benkendorf
      as a
      payment of $7,614 associated with the settlement agreement between ATSI and
      Mr.
      Benkendorf. The shares issued to Mr. Benkendorf were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act because
      of
      the limited size of the group, the absence of public solicitation or
      advertising, and restrictions on resale of the shares.





19


On
      July
      31, 2006, we issued 261,6635 shares of our common stock to the Convertible
      Debenture Holders as a payment of $83,200 associated with a principal payment
      on
      the Convertible Debenture. The shares issued to the Convertible Debenture
      Holders were issued pursuant to an exemption from registration under Section
      4(2) of the Securities Act because of the limited size of the group, the absence
      of public solicitation or advertising, and restrictions on resale of the
      shares.





**ITEM
              6.**
            **MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS.**





*SPECIAL
      NOTE: This Annual Report on Form 10-KSB contains “forward-looking statements”
within the meaning of Section 27A of the Securities Act of 1933, as amended
      and
      Section 21E of the Securities and Exchange Act of 1934, as amended. “Forward
      looking statements” are those statements that describe management’s beliefs and
      expectations about the future. We have identified forward-looking statements
      by
      using words such as “anticipate,” “believe,” “could,” “estimate,” “may,”
“expect,” and “intend.” Although we believe these expectations are reasonable,
      our operations involve a number of risks and uncertainties, including our
      ability to continue as a going concern.*




The
      following is a discussion of the consolidated financial condition and results
      of
      operations of ATSI Communications, Inc., for the fiscal years ended July 31,
      2006 and 2005. It should be read in conjunction with our Consolidated Financial
      Statements, the Notes thereto and the other financial information included
      elsewhere in this annual report on Form 10-KSB. For purposes of the following
      discussion, fiscal 2006 or 2006 refers to the year ended July 31, 2006 and
      fiscal 2005 or 2005 refers to the year ended July 31, 2005.





**Sources
      of revenue and direct cost** ****





*Sources
      of revenue:*





Carrier
      Services: **  We
      currently provide VoIP communication services to U.S. and Foreign
      telecommunications companies who lack transmission facilities, require
      additional capacity or do not have the regulatory licenses to terminate traffic
      in Mexico, Asia, the Middle East and Latin America. Typically,
      these telecommunications companies offer their services to the public for
      domestic and international long distance services.





Network
      Services:  We
      provide private communication links and VoIP gateway services to multi-national
      and Latin American carriers and enterprise customers who use a high volume
      of
      telecommunications services to communicate with their U.S. offices or businesses
      and need greater dependability than is currently available through the foreign
      telecommunication networks. These services include data, voice and fax
      transmission between multiple international offices and branches as well as
      Internet and co-location services in the United States. **




Communication
      Services *:* We
      provide retail local phone service and international VoIP long distance service
      to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley.
      Our local phone service includes access to a landline and value-added services
      such a caller ID and call waiting. These services are offered to our customers
      on both a prepaid and postpaid basis. Additionally, we provide prepaid domestic
      and long-distance services; under these services we allow our customers to
      access our prepaid VoIP network platform. The customer will access this platform
      and be able to complete the call by using their local phone number as a “PIN” or
      personal identification number.





*Direct
      Costs:*





Carrier
      Services: ** We
      incur
      transmission and termination charges from our suppliers and the providers of
      the
      infrastructure and network. The cost is based on a per minute rate and volume
      of
      minutes transported and terminated through the network. Additionally, we incur
      fixed Internet bandwidth charges and per minute billing charges. In some cases
      we incur installation charges from certain carriers. These installation costs
      are passed on to our customers for the connection to our VoIP network.





20


Network
      Services: Under
      the network services, we incur bandwidth and co-location charges. The bandwidth
      charges are incurred as part of the connection links between the customer’s
      different remote locations and sites to transmit data, voice and Internet
      services. We also incur co-location charges that are passed through to our
      customers.





Communication
      Services: We incur
      charges for local telephone service and related features from the local exchange
      carrier. Additionally, we incur a cost per minute and platform fees from our
      suppliers for long distance services and platform access based on the number
      of
      accounts and calls accessed by our customers.




**Results
      of Operations**





The
      following table sets forth certain items included in our results of operations
      in thousands of dollar amounts and variances between periods for the years
      ended
      July 31, 2006 and 2005.




Years
                ended July 31,2006
            
            2005
            
            Variances
            
            %OPERATING
                REVENUES:
            
            
            (Restated)Carrier
                services
            $14,674
            
            $5,782
            
            $8,892
            
            154%Network
                services
            22
            
            229
            
            (207)
            
            -90%Total
                operating revenues
            14,696
            
            6,011
            
            8,685
            
            144%Cost
                of services (exclusive of depreciation and amortization, shown
                below)
            13,869
            
            5,664
            
            (8,205)
            
            -145%GROSS
                MARGIN
            827
            
            347
            
            480
            
            138%Selling,
                general and administrative expense (exclusive of legal and professional
                fees,non-cash
                stock compensation to employees and warrants for services, shown
                below)
            695
            
            517
            
            (178)
            
            -34%Legal
                and professional fees
            195
            
            417
            
            222
            
            53%Non-cash
                issuance of common stock and warrants for services
            176
            
            618
            
            442
            
            72%Non-cash
                stock-based compensation, employees
            267
            
            474
            
            207
            
            44%Bad
                debt expense
            -
            
            4
            
            4
            
            100%Depreciation
                and amortization expense
            92
            
            112
            
            20
            
            18%OPERATING
                (LOSS)
            (598)
            
            (1,795)
            
            1,197
            
            67%OTHER
                INCOME (EXPENSE):Other
                income
            -
            
            27
            
            (27)
            
            -100%Gain
                on disposal of investment
            -
            
            12,104
            
            (12,104)
            
            -100%Loss
                on derivative instrument liabilities
            (6)
            
            (287)
            
            281
            
            98%Debt
                forgiveness income
            50
            
            460
            
            (410)
            
            -89%Interest
                expense
            (151)
            
            (102)
            
            (49)
            
            -48%Total
                other income (expense), net
            (107)
            
            12,202
            
            (12,309)
            
            -101%NET
                INCOME (LOSS) FROM CONTINUING OPERATIONS
            (705)
            
            10,407
            
            (11,112)
            
            -107%DISCONTINUED
                OPERATIONS (see Note 7)Gain
                on disposal of discontinued operations
            1,652
            
            -
            
            1,652
            
            100%NET
                INCOME FROM DISCONTINUED OPERATIONS
            1,652
            
            -
            
            1,652
            
            100%NET
                INCOME
            $
                947
            
            $
                10,407
            
            $
                (9,460)
            
            -91%LESS:
                PREFERRED DIVIDEND
            (959)
            
            (639)
            
            (320)
            
            -50%NET
                INCOME (LOSS) TO COMMON STOCKHOLDERS
            ($12)
            
            $9,768
            
            ($9,780)
            
            -100%





**Year
      Ended July 31, 2006 Compared to Year ended July 31, 2005**





*Operating
      revenues.* Consolidated operating revenues increased by 144% between periods from $6.0
      million for the year ended July 31, 2005 to $14.7 million for the year ended
      July 31, 2006.




21


Carrier
      Services revenues increased by approximately $8.9 million, or 154% from the
      year
      ended July 31, 2005 to the year ended July 31, 2006. Our VoIP carrier traffic
      increased from approximately 149 million
      minutes during the year ended July 31, 2005 to
      approximately 283 million minutes during the year ended July 31, 2006. The
      increase in revenue and carrier traffic can mainly be attributed to an increase
      in customers during fiscal 2006 compared to fiscal 2005.





Network
      Services revenues decreased by approximately 90% or $207,000 from the year
      ended
      July 31, 2005 to the year ended July 31, 2006. The decrease in network services
      revenue is primarily due to the decrease in network services customers.




*Cost
      of Services (Exclusive of depreciation and amortization).* The
      consolidated cost of services increased by approximately $8.2 million, or 145%
      from the year ended July 31, 2005 to the year ended July 31, 2006. The increase
      in cost of services is a direct result of the increase in carrier services
      revenue. As mentioned above, our carrier traffic increased from approximately
      149 million minutes during the year ended July 31, 2005 to approximately 283
      million minutes in the year ended July 31, 2006, thus increasing our cost of
      services between periods. However, as a result of the increase in total revenue
      our gross profits increased from $347,000 during the period ended July 31,
      2005
      to $827,000 during the period ended July 31, 2006





*Selling,
      General and Administrative (SG&A) Expenses*  *(exclusive
      of legal and professional fees, non-cash stock compensation to employees and
      common stock and warrants for services).* SG&A
      expenses increased by $178,000, or 34% from the year ended July 31, 2005 to
      the
      year ended July 31, 2006. The increase is primarily attributable to an
      adjustment of $92,000 in salaries and wages and a reversal of an over-accrual
      for services recognized during the second quarter of Fiscal 2005. Additionally,
      during the third quarter of fiscal 2006 we recognized an increase in salaries
      and wages and consulting fees of approximately $35,000 as a result of the hiring
      of two new employees and the increase in bank fees of approximately $29,000
      during the year ended July 31, 2006.





*Legal
      and professional fees* .
      Legal
      and professional fees decreased $222,000, or 53% from the year ended July 31,
      2005 to the year ended July 31, 2006. The decrease is attributable to the
      recognition of approximately $150,000 in professional fees associated with
      a
      marketing campaign that commenced during the year ended July 31, 2005.
      Additionally, during the year ended July 31, 2005 we recognized approximately
      $90,000 in legal fees associated with a lawsuit filed by the Company for stock
      fraud and manipulation by various institutions, as described in the legal
      proceeding section of this report. We did not incur these types of expenses
      during the year ended July 31, 2006.




*Non-cash
      issuance of common stock and warrants for services* .
      Non-cash issuance of common stock and warrants for services decreased by
      $442,000 from the year ended July 31, 2005 to the year ended July 31, 2006.
      The
      decrease is primarily due to recognition during the quarter ended January 31,
      2005 of approximately $400,000 in non-cash compensation expense associated
      with
      the consulting agreements entered into with certain individual affiliates of
      Recap Marketing & Consulting, LLP. We did not incur these types of expenses
      during the year ended July 31, 2006.




*Non-cash
      stock-based compensation, employees* .
      Non-cash compensation expense to employees decreased by $207,000 from the year
      ended July 31, 2005 to the year ended July 31, 2006. The decrease is attributed
      to the recognition during the year ended July 31, 2005 of approximately $474,000
      of non-cash compensation expense associated with the stock grants to our
      employees and board of directors. We incurred $267,000 of non-cash compensation
      expense associated with the stock grants to our employees and board of directors
      issued during the year ended July 31, 2006.





*Bad
      debt expense.* Bad
      debt
      expense decreased by $4,000 from the year ended July 31, 2005 to the year ended
      July 31, 2006. During the year ended July 31, 2005 we recognized $4,000 in
      bad
      debt expense associated with the write-off of a receivable from carrier services
      customer that ceased operations.





22


*Depreciation
      and Amortization* .
      Depreciation and amortization decreased by $20,000 or 18% from the year ended
      July 31, 2005 to the year ended July 31, 2006. The decrease is attributed to
      the
      full amortization during fiscal 2005 of the installation and maintenance
      associated with the initial acquisition of the Nextone Soft-switch. As a result,
      during fiscal 2006 we did not incur this type of expense.





*Operating
      Loss* .
      The
      Company’s operating loss improved by $1,197,000 or 67% from the year ended July
      31, 2005 to the year ended July 31, 2006. The reduction in operating loss
      between periods is attributed to the increase in gross profit of $480,000;
      the
      decrease between periods in non-cash issuance of common stock and warrants
      expense for services of $442,000 and the decrease in non-cash stock based
      compensation expense to employees of $207,000 and the decrease in legal and
      professional fees of $222,000.





*Gain
      on disposal of investment.* Gain
      on
      disposal of investment decreased to zero during the year ended July 31, 2006.
      During the year ended July 31, 2005 ATSI recognized a gain on disposal of
      investment of approximately $12,104,000. The gain on disposal of investment
      was
      associated with the disposal of ATSI’s subsidiaries, American TeleSource
      International, Inc. (ATSI Texas) and TeleSpan, Inc. (TeleSpan).





*Gain
      (loss) on derivative instruments liabilities, net.* The
      Company recognized a loss on derivative instruments of $6,000 during the year
      ended July 31, 2006 compared to a loss of $287,000 during the year ended July
      31, 2005, a decrease of $281,000. The decrease is as a result of the net
      unrealized (non-cash) change in the fair value of our derivative instrument
      liabilities related to certain warrants and embedded derivatives in our debt
      instruments.





*Debt
      forgiveness income.* Debt
      forgiveness income decreased by 89% from $460,000 during the year ended July
      31,
      2005 to $50,000 during the year ended July 31, 2006. The decrease is primarily
      due to the recognition during the year ended July 31, 2005 of $460,000 in debt
      forgiveness income associated with the settlement of various liabilities for
      the
      issuance of common stock. These transactions were related to the settlement
      of
      $859,500 liability with Alfonso Torres Roqueni, the former owner of the
      concession license that we acquired in July 2000, and the settlement of a
      $250,000 note payable with Infraestructura Espacial, S.A de C.V. and Tomas
      Revesz, a former ATSI director. The debt forgiveness income was based on the
      difference between the market price of ATSI equity at the time of issuance
      and
      the market price calculated at the time of the settlement of the
      debt.





*Interest
      expense* .
      Interest expense increased by $49,000 or 48% from the year ended July 31, 2005
      to the year ended July 31, 2006. The increase can be mainly attributed to the
      increase in interest expense of approximately $24,000 associated with the note
      payable and the accounts receivable credit facility with CSI Business Finance,
      Inc. During the year ended July 31, 2005 we did not incur any interest expense
      associated with the Note payable and the accounts receivable credit facility
      with CSI Business Finance, Inc.





*Net
      income (loss) from continuing operations* .
      Net
      income from continuing operations decreased by $11,112,000. The decrease in
      operating loss between periods is attributed to a decrease in gain on disposal
      of investment of approximately $12,104,000 and a decrease between periods of
      $442,000 in non-cash issuance of common stock and warrant expense for services
      and the decrease of $207,000 in non-cash stock based compensation expense to
      employees and the decrease between periods of $222,000 in legal and professional
      fees. The decrease in operating loss from continuing operations was slightly
      offset by the increase in gross profit margin of $480,000.





*Net
      income from discontinued operations.* During
      the year ended July 31, 2006 we recognized a gain on disposal of discontinued
      operations of $1,652,000. The
      gain
      on disposal of discontinued operations arose from the sale of ATSI’s ownership
      in ATSIMex Personal S.A de C.V. Under the share purchase agreement the buyer
      acquired the total ownership and assumed all related liabilities in this entity
      of $1,652,000 and as a result we recognized a gain of $1,652,000 .




23


*Preferred
      Stock Dividends* .
      Preferred stock dividends expense increased by $320,000 between periods, from
      $639,000 for the year ended July 31, 2005 to $959,000 during the year ended
      July
      31, 2006. The increase in preferred stock dividend expense can be attributed
      to
      the recognition of $1,371,000 of dividend expense associated with the Redeemable
      Preferred Series H Stock. The certificate of designation of the Redeemable
      Preferred Series H provides for a 50% premium after it has been held under
      the
      shareholders name for 2 years from the date of issuance.





*Net
      income (loss) to common stockholders.* During
      the year ended July 31, 2006 we recognized $12,000 in net loss to common
      stockholders. This represented a decrease of $9,780,000 from the year ended
      July
      31, 2005. The decrease in net income to common stockholders is primarily due
      to
      the decrease in gain on disposal of investment of approximately $12,104,000.
      The
      decrease in gain on disposal of investment was slightly offset by the
      recognition of $1,652,000 from the gain on disposal of discontinued operations
      associated with to the sale of ATSIMex Personal S.A de C.V.





**Liquidity
      and Capital Resources**




*Cash
      Position:* Net cash
      consumed by operating activities in 2006 was approximately $304,000, compared
      to
      $561,000 during fiscal 2005. Net cash consumed by operating activities in 2006
      was largely a result of an increase in accounts payable of $156,000 and accrued
      liabilities of $101,000. This increase was slightly offset by a gain on disposal
      of discontinued operations of $1,652,000, non-cash charges for depreciation
      of
      $93,000, stock and option-based compensation of $267,000 and issuance of common
      stock and warrants for services of $176,000.





Investing
      activities during the year ended July 31, 2006 consumed $4,000 associated with
      the acquisition of various computers and communications routers. Financing
      activities during the year ended July 31, 2006 generated $315,000 in cash.
      This
      cash was primarily generated from proceeds of an accounts receivable credit
      facility of $150,000 and cash proceeds from a note payable of $50,000 from
      CSI
      Business Finance, Inc. Additionally, we received $54,000 from the exercise
      of
      366,666 warrants and we received $120,000 from a Note Payable entered into
      with
      a related party. These cash proceeds were offset by the $26,000 paid to
      Corporate Strategies, Inc. for the factoring and processing fees; $3,000
      associated with the principal payments under the lease of certain equipment;
      and
      $30,000 associated with note payables principal payments. Overall, our net
      operating, investing and financing activities during the year ended July 31,
      2006 provided an increase of $7,000 in cash. We had a cash balance of $36,000
      as
      of July 31, 2006.





Our
      current cash expenses are expected to be approximately $70,000 per month,
      including wages, rent, utilities, litigation fees and corporate professional
      fees. We are currently generating sufficient cash from operations to cover
      all
      monthly cash expenses, but we cannot predict if, over the next twelve months,
      we
      will continue to generate sufficient cash from operations to cover all of our
      cash expenses. We intend to cover our initial monthly cash expenses with our
      available cash from operations and the factoring of our receivables. We expect
      to continue conserving cash resources by paying executive compensation, fees
      for
      certain consultants and professional services with shares of our common stock.
      Furthermore, we will continue to pursue additional debt and equity financings
      to
      increase our cash reserves. However, we presently do not have a definitive
      agreement in place to obtain such financing. Any additional debt or equity
      financing may not be available in sufficient amounts or on acceptable terms.
      If
      such financing is not available in sufficient amounts or on acceptable terms,
      the Company's operational results and financial condition may be adversely
      affected.





We
      are
      not presently paying quarterly interest and dividends on our outstanding
      convertible debentures. However, we have continued to accrue dividends and
      interest on such debentures. The increase in accrued liabilities related to
      the
      dividends and interest in arrears contributed approximately $1,640,500 in cash
      flow savings during the year ended July 31, 2006.





24


During
      the fourth quarter of fiscal 2006, in consultation with our legal counsel,
      we
      evaluated the liability for conversion and redemption of our Series D or Series
      E Preferred Stock. Based on our evaluation, we concluded that our obligation
      to
      the holders of the Series D and Series E Preferred Stock to convert or redeem
      such shares was barred by the applicable statute of limitations. Based on this
      assessment, we have reversed an aggregate of $850,000 in liabilities relating
      to
      accrued dividends and redemption obligations and reclassified $1,912,000
      relating to the stated value from current liabilities to stock holders equity.
      Since the accrual for the redemption of the Series D and Series E Preferred
      Stock was based on management’s assessment of potential liabilities based on the
      available facts at the time and applying management’s estimates of the possible
      outcomes of claims for redemption by the holders of the Preferred Stock, the
      adjustment to reverse the full redemption premium in the aggregate amount of
      $493,000 has been recorded in the current fiscal year as a change in accounting
      estimate pursuant to SFAS No. 154, Accounting for Changes and Error Corrections.





Further,
      the Series D and Series E Preferred Stock no longer contain attributes
      characteristic of debt instruments due to the nullification of the redemption
      and conversion features. Accordingly, these instruments have been reclassified
      to the equity section of the balance sheet.





ATSI
      has
      restated its 2006 and 2005 quarterly financial statements and the financial
      statements for the year ended July 31, 2005 from amounts previously reported.
      During the fourth quarter of fiscal 2006, in consultation with our legal
      counsel, we evaluated the liability for the provisions for liquidation
      preferences contained in our Series E Preferred Stock instruments. Based on
      our
      evaluation, we concluded that our obligation to the holders of the Series E
      Preferred Stock was incorrectly accounted for as dividends. Based on this
      assessment, we have reversed all accrued dividends in the aggregate amount
      of
      $340,000. The adjustments to reverse the accrued dividends in our Series E
      Preferred Stock has been recorded during the periods that it occurred and the
      accumulated impact of the adjustments are reflected in our current fiscal year
      financial statements in accordance with SFAS No. 154, Accounting for Changes
      and
      Error Corrections. See Note 15 to the consolidated financial statements. In
      all
      other material respects, the previously reported financial statements are
      unchanged.




Our
      working capital deficit was $2,800,000 as of July 31, 2006. This represents
      a
      decrease of approximately $2,745,000 from our working capital deficit at July
      31, 2005. The decrease can primarily be attributed to the reclassification
      of
      our Series D and Series E Preferred Stock to the equity section of the balance
      sheet in the amount of $1,912,000; a$732,000
      decrease resulting from the reversal of redemption and dividend obligations
      related to the Series D and Series E Preferred Stock; a $1,152,000 decrease
      in
      liabilities from discontinued operations due to the sale of the operation;an increase of $451,000 in accounts receivable associated with increased
      revenues; a corresponding increase in accounts payable of $109,000 for increased
      cost of sales; an increase of $1,356,000 in accrued expenses associated with
      the
      accrual of dividends for Series A and H Redeemable preferred stock; and
      increased short-term borrowings of $290,000.





**Ongoing
      operations**





We
      generated sufficient income from operations to cover our operating expenses
      during the 4 th quarter
      ended July 31, 2006. However, we believe that based on our limited access to
      capital resources and our current cash balances, financial resources may not
      be
      available to support our ongoing operations for the next twelve months. These
      matters raise doubt about our ability to continue as a going concern. Our
      ability to continue as a going concern is dependent upon the ongoing support
      of
      our stockholders and customers, our ability to continue generating sufficient
      income from operations to cover our operating expense and our ability to obtain
      capital resources to support expansion.





During
      the year ended July 31, 2006, we received $150,000
      from an accounts receivable credit facility, and $50,000 from a Note Payable
      with CSI Business Finance, Inc.; $120,000 from a Note Payable with a related
      party and $54,000
      from the exercise of warrants. These funds, along with funds generated from
      sales, allowed us to cover our operating expenses and other corporate expenses
      during the year ended July 31, 2006. Additionally, on February 20, 2006 we
      entered into a factoring agreement with CSI Business Finance, Inc. Under the
      agreement, CSI Business committed to purchase up to $400,000 of ATSI’s monthly
      receivables. As our ongoing operations require, we will factor our receivables
      under this new agreement. As of date of this filing, we did not have any
      outstanding factored receivables under this agreement.





25


We
      will
      continue to pursue cost cutting or expense deferral strategies in order to
      conserve working capital. These strategies will limit the implementation of
      our
      business plan and increase our future liabilities. We are dependent on our
      operations and the proceeds from future debt or equity investments to fully
      implement our business plan. If we are unable to continue producing positive
      cash flow from operations or raise sufficient capital, we will be required
      to
      delay or forego some portion of our business plan, which will have a material
      adverse effect on our anticipated results from operations and our financial
      condition. Alternatively, we may seek interim financing in the form of private
      placement of debt or equity securities. Such interim financing may not be
      available in the amounts or at the time when it is required.










26








**ITEM
              7.**
            **FINANCIAL
                STATEMENTS AND SUPPLEMENTARY
                DATA**






**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**





Page**Consolidated
                  Financial Statements of ATSI
                  Communications, Inc. and Subsidiaries**Report
                  of Independent Registered Public Accounting Firm
              28Consolidated
                  Balance Sheet for the Years Ended July 31, 2006 and 2005
              29Consolidated
                  Statements of Operations for the Years Ended July 31, 2006 and
                  2005
              30Consolidated
                  Statements of Comprehensive Income (loss) forthe
                  Years Ended July 31, 2006 and 2005
              31Consolidated
                  Statement of Changes in Stockholders’ Deficit forthe
                  Years Ended July 31, 2006 and 2005
              32Consolidated
                  Statements of Cash Flows for the Years Ended July 31, 2006 and
                  2005
              33Notes
                  to Consolidated Financial Statements
              34





27


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








To
      the
      Board of Directors and Stockholders


ATSI
      Communications, Inc.


San
      Antonio, Texas





We
      have
      audited the accompanying consolidated balance sheets of **** ATSI
      Communications, Inc. and subsidiaries (“ATSI”) as of July 31, 2006 and
      2005, and the related consolidated statements of operations, comprehensive
      income (loss), stockholders’ deficit and cash flows for each of the two
      years then ended. These consolidated financial statements are the responsibility
      of ATSI’s management. Our responsibility is to express an opinion on these
      consolidated financial statements based on our audits.





We
      conducted our audits in accordance with standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of
      ATSI **** as
      of
      July 31, 2006 and 2005 and the consolidated results of their operations and
      its
      cash flows for each of the two years then ended in conformity with accounting
      principles generally accepted in the United States of America.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      ATSI will continue as a going concern. As discussed in Note 2 to the
      consolidated financial statements, ATSI has a working capital deficit, has
      suffered recurring losses and has a stockholders’ deficit. These conditions
      raise substantial doubt about ATSI’s ability to continue as a going concern.
      Management's plans in regard to these matters are also described in Note 2.
      The
      consolidated financial statements do not include any adjustments that might
      result from the outcome of this uncertainty.





As
      described in Note 15, the financial statements for 2005 have been
      restated.





MALONE
      & BAILEY, PC


www.malone-bailey.com


Houston,
      Texas





September
      13, 2006




28





**PART
      1. FINANCIAL INFORMATION**




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


ATSI
        COMMUNICATIONS, INC. AND SUBSIDIARIES
 CONSOLIDATED
        BALANCE SHEETS
 (In
        thousands, except per share amounts)




July
                31,
            
            July
                31,2006
            
            2005(Restated)ASSETSCURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            36
            
            $
            29Accounts
                receivable
            
            
            621
            
            
            170Prepaid
                & other current assets
            
            
            33
            
            
            44Total
                current assets
            
            
            690
            
            
            243PROPERTY
                AND EQUIPMENT
            
            
            284
            
            
            228Less
                - accumulated depreciation
            
            
            (182
            )
            
            (90
            )Net
                property and equipment
            
            
            102
            
            
            138Total
                assets
            
            $
            792
            
            $
            381LIABILITIES
                AND STOCKHOLDERS' DEFICITCURRENT
                LIABILITIES:Accounts
                payable
            
            $
            676
            
            $
            567Accounts
                payable, related parties
            
            
            42
            
            
            42Line
                of credit, CSI Business Finance
            
            
            150
            
            
            -Accrued
                liabilities
            
            
            2,389
            
            
            1,033Current
                portion of obligation under capital leases
            
            
            3
            
            
            3Notes
                payable
            
            
            50
            
            
            -Notes
                payable, related party
            
            
            106
            
            
            16Notes
                payable, Franklin, Cardwell & Jones
            
            
            -
            
            
            77Convertible
                debentures
            
            
            74
            
            
            234Series
                D Cumulative Preferred Stock, 3,000 shares authorized, 742 shares
                issued
                and outstanding
            
            
            -
            
            
            1,182Series
                E Cumulative Preferred Stock, 10,000 shares authorized, 1,170 shares
                issued and outstanding
            
            
            -
            
            
            1,462Derivative
                financial instrument liabilities
            
            
            -
            
            
            24Liabilities
                from discontinued operations, net of assets
            
            
            -
            
            
            1,152Total
                current liabilities
            
            
            3,490
            
            
            5,792LONG-TERM
                LIABILITIES:Notes
                payable
            
            
            500
            
            
            500Convertible
                debentures
            
            
            234
            
            
            -Obligation
                under capital leases, less current portion
            
            
            6
            
            
            9Other
            
            
            4
            
            
            8Total
                long-term liabilities
            
            
            744
            
            
            517Total
                liabilities
            
            
            4,234
            
            
            6,309STOCKHOLDERS'
                DEFICIT:Series
                A Cumulative Convertible Preferred Stock, $0.001, 50,000 shares
                authorized, 2,750 sharesissued
                and outstanding
            
            
            -
            
            
            -Series
                D Cumulative Preferred Stock, 3,000 shares authorized, 742 shares
                issued
                and outstanding
            
            
            1
            
            
            -Series
                E Cumulative Preferred Stock, 10,000 shares authorized, 1,170 shares
                issued and outstanding
            
            
            1
            
            
            -Series
                H Convertible Preferred Stock, $0.001, 16,000,000 shares authorized,
                11,802,353 and 13,912,372 sharesissued
                and outstanding, respectively
            
            
            12
            
            
            14Common
                stock, $0.001 par value, 150,000,000 shares authorized, 16,444,768
                and
                10,397,222 sharesissued
                and outstanding, respectively
            
            
            16
            
            
            10Additional
                paid in capital
            
            
            68,775
            
            
            66,741Accumulated
                deficit
            
            
            (72,248
            )
            
            (73,195
            )Other
                comprehensive income
            
            
            1
            
            
            502Total
                stockholders' deficit
            
            
            (3,442
            )
            
            (5,928
            )Total
                liabilities and stockholders' deficit
            
            $
            792
            
            $
            381




See
      accompanying summary of accounting policies and notes to financial statements.




29


ATSI
                  COMMUNICATIONS, INC. AND SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF OPERATIONS(In
                  thousands, except per share
                  amounts)
  Years
                  ended July 31,2006
              
              2005OPERATING
                  REVENUES:
              
              
              
              (Restated)Carrier
                  services
              
              $
              14,674
              
              $
              5,782Network
                  services
              
              
              22
              
              
              229Total
                  operating revenues
              
              
              14,696
              
              
              6,011OPERATING
                  EXPENSES:Cost
                  of services (exclusive of depreciation and amortization, shown
                  below)
              
              
              13,869
              
              
              5,664Selling,
                  general and administrative expense (exclusive of legal and professional
                  fees,non-cash
                  stock compensation to employees and warrants for services, shown
                  below)
              
              
              695
              
              
              517Legal
                  and professional fees
              
              
              195
              
              
              417Non-cash
                  issuance of common stock and warrants for services
              
              
              176
              
              
              618Non-cash
                  stock-based compensation, employees
              
              
              267
              
              
              474Bad
                  debt expense
              
              
              -
              
              
              4Depreciation
                  and amortization expense
              
              
              92
              
              
              112Total
                  operating expenses
              
              
              15,294
              
              
              7,806OPERATING
                  (LOSS)
              
              
              (598
              )
              
              (1,795
              )OTHER
                  INCOME (EXPENSE):Other
                  income
              
              
              -
              
              
              27Gain
                  on disposal of investment
              
              
              -
              
              
              12,104Loss
                  on derivative instrument liabilities
              
              
              (6
              )
              
              (287
              )Debt
                  forgiveness income
              
              
              50
              
              
              460Interest
                  expense
              
              
              (151
              )
              
              (102
              )Total
                  other income (expense), net
              
              
              (107
              )
              
              12,202NET
                  INCOME (LOSS) FROM CONTINUING OPERATIONS
              
              
              (705
              )
              
              10,407DISCONTINUED
                  OPERATIONS(see
                  Note 7)Gain
                  on disposal of discontinued operations
              
              
              1,652
              
              
              -NET
                  INCOME FROM DISCONTINUED OPERATIONS
              
              
              1,652
              
              
              -NET
                  INCOME
              
              $
              947
              
              $
              10,407LESS:
                  PREFERRED DIVIDEND
              
              
              (959
              )
              
              (639
              )NET
                  INCOME (LOSS) TO COMMON STOCKHOLDERS
              
              $
              (12
              )
              $
              9,768BASIC
                  INCOME (LOSS) PER SHARE:From
                  continuing operations
              
              
              (0.12
              )
              
              1.37From
                  discontinued operations
              
              
              0.12
              
              
              -Total
              
              
              (0.00
              )
              
              1.37DILUTED
                  INCOME (LOSS) PER SHAREFrom
                  continuing operations
              
              
              (0.12
              )
              
              0.42From
                  discontinued operations
              
              
              0.12
              
              
              -Total
              
              
              0.00
              
              
              0.42WEIGHTED
                  AVERAGE COMMON SHARES OUTSTANDING
              
              
              13,516,342
              
              
              7,128,847DILUTED
                  COMMON SHARES OUTSTANDING
              
              
              13,516,342
              
              
              24,856,501




See
      accompanying summary of accounting policies and notes to financial
      statements.




30


ATSI
                  COMMUNICATIONS, INC. AND SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF COMPREHENSIVE INCOME (LOSS)(In
                  thousands, except per share
                  amounts)
  Years
                  ended July 31,2006
              
              2005(Restated)Net
                  income (loss) to common stockholders
              
              $
              (12
              )
              $
              9,768Foreign
                  currency translation adjustment
              
              
              (501
              )
              
              -Comprehensive
                  income (loss) to common stockholders
              
              $
              (513
              )
              $
              9,768




See
        accompanying summary of accounting policies and notes to financial statements.




31






ATSI
                  COMMUNICATIONS, INC.AND
                  SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF STOCKHOLDERS' DEFICIT(
                  in thousands)
  Preferred
                  Stock (A)
              
              Preferred
                  Stock (D)
              
              Preferred
                  Stock (E)
              
              Preferred
                  Stock (H)
              
              Common
                  Stock
              
              
              
              Accumulated
              
              Other
                  Comp.
              
              TotalStockholders'Shares
              
              Amount
              
              Shares
              
              Amount
              
              Shares
              
              Amount
              
              Shares
              
              Amount
              
              Shares
              
              Amount
              
              A-P-I-C
              
              Deficit
              
              Income/Loss
              
              (Deficit)**BALANCE,
                  JULY 31, 2004**
              
              
              4
              
              
              0
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              14,386
              
              
              14
              
              
              2,919
              
              $
              3
              
              $
              62,723
              
              $
              (83,602
              )
              $
              502
              
              $
              (20,360
              )Shares
                  issued for services
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,417
              
              
              1
              
              
              606
              
              
              
              
              
              
              
              
              607Shares
                  issued to Purchase Assets
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              119
              
              
              1
              
              
              68
              
              
              
              
              
              
              
              
              69Shares
                  issued for P/S Conversion
              
              
              
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              (474
              )
              
              
              
              
              474
              
              
              0
              
              
              0
              
              
              
              
              
              
              
              
              -Shares
                  issued for Debt Conversion
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,188
              
              
              1
              
              
              944
              
              
              
              
              
              
              
              
              945Exercise
                  of Warrants
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,280
              
              
              4
              
              
              914
              
              
              
              
              
              
              
              
              918Warrant
                  expense
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              445
              
              
              
              
              
              
              
              
              445Derivative
                  instrument (income) expense
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,638
              
              
              
              
              
              
              
              
              1,638Dividends
                  declared
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (639
              )
              
              
              
              
              
              
              
              (639
              )Option
                  Expense
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              42
              
              
              
              
              
              
              
              
              42Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              10,407
              
              
              
              
              
              10,407**BALANCE,
                  JULY 31, 2005 (Restated)**
              
              
              4
              
              
              0
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              13,912
              
              
              14
              
              
              10,397
              
              $
              10
              
              $
              66,741
              
              $
              (73,195
              )
              $
              502
              
              
              (5,928
              )Shares
                  issued for services
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              549
              
              
              1
              
              
              127
              
              
              -
              
              
              -
              
              
              128Shares
                  issued to purchase assets
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              180
              
              
              -
              
              
              58
              
              
              -
              
              
              -
              
              
              58Shares
                  issued for P/S conversion
              
              
              (1
              )
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              (2,310
              )
              
              ($2
              )
              
              2,960
              
              
              3
              
              
              167
              
              
              -
              
              
              -
              
              
              168Shares
                  issued for debt conversion
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              200
              
              
              
              
              
              866
              
              
              1
              
              
              255
              
              
              -
              
              
              -
              
              
              256Reclass
                  of Series D from debt
              
              
              -
              
              
              
              
              
              1
              
              
              1
              
              
              -
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              741
              
              
              
              
              
              
              
              
              742Reclass
                  of Series E from debt
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              1
              
              
              1
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,169
              
              
              
              
              
              
              
              
              1,170Exercise
                  of warrants
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              367
              
              
              -
              
              
              54
              
              
              -
              
              
              -
              
              
              54Warrant
                  expense
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              48
              
              
              -
              
              
              -
              
              
              48Preferred
                  stock dividend
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              (959
              )
              
              -
              
              
              -
              
              
              (959
              )Shares
                  issued for services, employees
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              1,125
              
              
              1
              
              
              179
              
              
              -
              
              
              -
              
              
              180Derivative
                  instruments (income) expense
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              82
              
              
              -
              
              
              -
              
              
              82Beneficial
                  conversion feature
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              26
              
              
              -
              
              
              -
              
              
              26Options
                  expense - 123R
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              87
              
              
              -
              
              
              -
              
              
              87Other
                  comp. income/loss
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              -
              
              
              (501
              )
              
              (501
              )Net
                  loss
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              947
              
              
              -
              
              
              947**BALANCE,
                  JULY 31, 2006**
              
              
              3
              
              
              0
              
              
              1
              
              $
              1
              
              
              1
              
              $
              1
              
              
              11,802
              
              $
              12
              
              
              16,444
              
              $
              16
              
              $
              68,775
              
              $
              (72,248
              )
              $
              1
              
              $
              (3,442
              )




See
        accompanying summary of accounting policies and notes to financial statements.




32




ATSI
                  COMMUNICATIONS, INC. AND SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF CASH FLOWS(In
                  thousands, except per share
                  amounts)
  Years
                  ended July 31,2006
              
              2005(Restated)CASH
                  FLOWS FROM OPERATING ACTIVITIES:NET
                  INCOME
              
              $
              947
              
              $
              10,407Adjustments
                  to reconcile net loss to cash used in operating
                  activities:Gain
                  in disposal of investment
              
              
              (1,652
              )
              
              (12,104
              )Debt
                  forgiveness income
              
              
              -
              
              
              (460
              )Depreciation
                  and amortization
              
              
              92
              
              
              112Issuance
                  of stock grants and options, employees for services
              
              
              267
              
              
              474Issuance
                  of common stock and warrants for services
              
              
              176
              
              
              618Provisions
                  for losses on accounts receivables
              
              
              -
              
              
              4Loss
                  on derivative instrument liabilities
              
              
              6
              
              
              287Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (451
              )
              
              (125
              )Prepaid
                  expenses and other
              
              
              10
              
              
              (18
              )Accounts
                  payable
              
              
              101
              
              
              79Accounts
                  payable - related parties
              
              
              43
              
              
              -Accrued
                  liabilities
              
              
              156
              
              
              165Net
                  cash used in operating activities
              
              
              (304
              )
              
              (561
              )CASH
                  FLOWS FROM INVESTING ACTIVITIES:Purchases
                  of property & equipment
              
              
              (4
              )
              
              (8
              )Acquisition
                  of business
              
              
              -
              
              
              (8
              )Net
                  cash used in investing activities
              
              
              (4
              )
              
              (16
              )CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from notes payable, related party
              
              
              120
              
              
              -Payments
                  on notes payable, related party
              
              
              (30
              )
              
              -Proceeds
                  from notes payable
              
              
              50
              
              
              918Payments
                  on notes payable
              
              
              -
              
              
              (918
              )Proceeds
                  from line of credit, net
              
              
              124
              
              
              -Proceeds
                  from the exercise of warrants
              
              
              54
              
              
              514Principal
                  payments on capital lease obligation
              
              
              (3
              )
              
              (2
              )Net
                  cash provided by financing activities
              
              
              315
              
              
              512INCREASE
                  (DECREASE) IN CASH
              
              
              7
              
              
              (65
              )CASH
                  AND CASH EQUIVALENTS, beginning of period
              
              
              29
              
              
              94CASH
                  AND CASH EQUIVALENTS, end of period
              
              $
              36
              
              $
              29SUPPLEMENTAL
                  DISCLOSURES:Cash
                  paid for interest
              
              $
              24
              
              $
              -Cash
                  paid for income tax
              
              
              -
              
              
              -NON-CASH
                  INVESTING AND FINANCING TRANSACTIONSIssuance
                  of common stock for conversion of debt
              
              $
              256
              
              $
              944Issuance
                  of common stock for purchase of fixed & intangible
                  assets
              
              
              58
              
              
              82Fair
                  value of the derivative instrument
              
              
              -
              
              
              26Conversion
                  of preferred stock to common stock
              
              
              167
              
              
              206Beneficial
                  conversion feature on convertible notes
              
              
              26
              
              
              -Fair
                  value of derivatives transferred to equity
              
              
              82
              
              
              1,638Reclass
                  preferred stock to equity
              
              
              1,912
              
              
              -Preferred
                  stock dividend
              
              
              956
              
              
              639
  See
        accompanying summary of accounting policies and notes to financial statements.




33


**ATSI
      COMMUNICATIONS, INC.**


**AND
      SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**








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





***Description
      of Business.*** ATSI
      Communications, Inc. (“ATSI”) was incorporated in Nevada on May 24, 2004. ATSI
      is an international telecommunications carrier that utilizes the Internet to
      provide economical international communication services to carriers and
      telephony resellers around the world. ATSI’s continuing operations consist of
      VoIP carrier services, network services, and retail communication services.
      ATSI’s primary business consists of providing VoIP communication services to
      U.S. and foreign telecommunications companies that lack transmission facilities,
      require additional capacity or do not have the regulatory licenses to terminate
      traffic in Mexico, Asia, the Middle East and Latin America.





***Principles
      of Consolidation.*** The
      consolidated financial statements have been prepared on the accrual basis of
      accounting under accounting principles generally accepted in the United States
      (GAAP). All significant inter-company balances and transactions have been
      eliminated in consolidation.





***Reclassifications.*** Certain
      amounts in the consolidated financial statements of the prior year have been
      reclassified to conform to the presentation of the current year for comparative
      purposes.





***Restatement.*** The
      financial statements for the year ended July 31, 2005 have been restated. See
      Note 15.





***Use
      of Estimates.*** In
      preparing financial statements, management makes estimates and assumptions
      that
      affect the reported amounts of assets and liabilities in the balance sheet
      and
      revenue and expenses in the statement of expenses. Actual results could differ
      from those estimates.





***Concentration
      of Credit Risk.*** Financial
      instruments that potentially subject ATSI to concentration of credit risk
      consist primarily of trade receivables. In the normal course of business, ATSI
      provides credit terms to its customers. Accordingly, ATSI performs ongoing
      credit evaluations of its customers and maintains allowances for possible
      losses, which, when realized, have been within the range of management’s
      expectations. ATSI maintains cash in bank deposits accounts, which, at times,
      may exceed federally insured limits. ATSI has not experienced any losses in
      such
      accounts and ATSI does not believe ATSI is exposed to any significant credit
      risk on cash and cash equivalents.





***Revenue
      Recognition.*** ATSI
      derives revenue from Carrier Services, Network Services, and Communication
      Services. Revenue
      is recognized when persuasive evidence of an arrangement exists, service or
      network capacity has been provided, the price is fixed or determinable,
      collectibility is reasonably assured and there are no significant obligations
      remaining. Management currently groups Communication Services revenue with
      Carrier Services revenue.





*Carrier
      Service* :
      ATSI
      provides VoIP communication services to U.S. and foreign telecommunications
      companies who lack transmission facilities, require additional capacity or
      do
      not have the regulatory licenses to terminate traffic in Mexico, Asia, the
      Middle East and Latin America. Typically
      these telecommunications companies offer their services to the public for
      domestic and international long distance services. Carrier
      service revenue is derived through transporting and terminating minutes of
      telecommunications traffic over ATSI’s owned or leased VoIP network (Voice over
      Internet Protocol). ATSI recognizes revenue in the period the service is
      provided, net of revenue reserves for potential billing credits. Such disputes
      can result from disagreements with customers regarding the duration, destination
      or rates charged for each call.





*Network
      Services:* ATSI provides
      private communication links and VoIP gateway services to multi-national and
      Latin American carriers and enterprise customers who use a high volume of
      telecommunications services to communicate with their U.S. offices or businesses
      and need greater dependability than is currently available through the foreign
      telecommunication networks. These services include data, voice and fax
      transmission between multiple international offices and branches as well as
      Internet and collocation services in the United States. ATSI
      recognizes network services revenue during the period the service is
      provided.





34


*Communication
      Services:* ATSI
      provides retail local phone service and international VoIP long distance service
      to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley.
      Our local phone service includes access to a landline and value-added services
      such a caller ID and call waiting. These services are offered to our customers
      in both prepaid and postpaid basis. Additionally, ATSI provides prepaid domestic
      and long-distance services; under these services ATSI allows our customers
      to
      access our prepaid VoIP network platform. The customer will access this platform
      and be able to complete the call by using their local phone number as their
      “PIN” or personal identification number. The revenues derived from prepaid local
      telephone and long-distance are billed monthly in advance and are recognized
      the
      following month when services are provided. Additionally, revenues derived
      from
      postpaid local telephone and long-distance services are recognized monthly
      as
      services are provided.





***Direct
      Cost of Revenue:***





*Carrier
      Services:* Under
      carrier services, ATSI incurs termination charges. These charges are related
      to
      the fees that ATSI is charged by carriers/vendors for the termination of phone
      calls into their infrastructure and network to
      terminate traffic in Mexico, Asia, the Middle East and Latin America. The
      cost
      is based on a per minute rate and volume. ATSI also incurs installation charges
      from various carriers; this cost is passed on to customers for the connection
      to
      the VoIP network from ATSI’s carriers.





*Network
      Services* :
      Under
      network services, ATSI incurs Internet, co-location, and fiber optic charges.
      The Internet and fiber optic charges are incurred as part of the connection
      links between the customer’s different remote locations and sites to transmit
      data, voice and Internet services. Co-location charges are incurred for space
      utilized to install gateways, servers, and other communications equipment.





*Communication
      Services* :
      ATSI
      incurs charges for local telephone service and related features from the
      dominant local exchange carrier. Additionally, ATSI incurs a cost per minute
      and
      platform fees from two suppliers for long distance services and platform
      access.





***Cash
      and Cash Equivalents.*** For
      purposes of the statement of cash flows, ATSI considers all highly liquid
      investments purchased with an original maturity of three months or less to
      be
      cash equivalents.





***Allowance
      for Doubtful Accounts.*** Bad debt
      expense is recognized based on management’s estimate of likely losses each year
      based on past experience and an estimate of current year uncollectible amounts.
      There was no allowance for doubtful accounts as of July 31, 2006 and July 31,
      2005.





***Investment
      in unconsolidated subsidiary.*** **** On
      May
      22, 2003 ATSI sold 51% of its interest in ATSI Comunicaciones S.A de C.V.,
      (ATSICOM) As of July 31, 2006, ATSI has a 49% interest in the profits and equity
      of ATSICOM, a Mexican Corporation engaged in providing telecommunications
      services. During fiscal 2003, ATSI recorded the investment in the unconsolidated
      subsidiary in conformity with the equity method of accounting. During the year
      ended July 31, 2004, ATSI determined that the estimated future cash flows
      expected from the concession license were less than its carrying value. As
      a
      result ATSI recorded an impairment loss of approximately $702,000 to reduce
      the
      recorded value of the concession license to zero. A lthough
      there is no assurance of future value appreciation, from time to time ATSI
      will
      conduct a valuation of its investment in the concession license and record
      the
      determined value, if any, in its financial statements.





***Property
      and equipment.*** Property
      and equipment is recorded at cost. Additions are capitalized and maintenance
      and
      repairs are charged to expense as incurred. Gains and losses on dispositions
      of
      equipment are reflected in operations. Depreciation is provided using the
      straight-line method over the estimated useful lives of the assets, which are
      one to five years.





***Impairment
      of Long-Lived Assets.*** ATSI
      reviews the carrying value of its long-lived assets annually or whenever events
      or changes in circumstances indicate that the value of an asset may no longer
      be
      appropriate. ATSI assesses recoverability of the carrying value of the asset
      by
      estimating the future net cash flows expected to result from the asset,
      including eventual disposition. If the future net cash flows are less than
      the
      carrying value of the asset, an impairment loss is recorded equal to the
      difference between the asset’s carrying value and fair value.





35


***Derivative
      financial instruments*** .
      ATSI
      does not use derivative instruments to hedge exposures to cash flow, market,
      or
      foreign currency risks.





Derivative
      financial instruments are initially measured at their fair value. For derivative
      financial instruments that are accounted for as liabilities, the derivative
      instrument is initially recorded at its fair value and is then re-valued at
      each
      reporting date, with changes in the fair value reported as charges or credits
      to
      income. For option-based derivative financial instruments, ATSI uses the
      Black-Scholes option-pricing model to value the derivative
      instruments.





The
      classification of derivative instruments, including whether such instruments
      should be recorded as liabilities or as equity, is re-assessed at the end of
      each reporting period. Derivative instrument liabilities are classified in
      the
      balance sheet as current or non-current based on whether or not net-cash
      settlement of the derivative instrument could be required within 12 months
      of
      the balance sheet date. There are no derivative instrument liabilities as of
      July 31, 2006.





***Income
      taxes.*** ATSI
      recognizes deferred tax assets and liabilities based on differences between
      the
      financial reporting and tax bases of assets and liabilities using the enacted
      tax rates and laws that are expected to be in effect when the differences are
      expected to be recovered. ATSI provides a valuation allowance for deferred
      tax
      assets for which it does not consider realization of such assets to be more
      likely than not.





***Stock
      based compensation.***  Effective
      February 1, 2006, ATSI began recording compensation expense associated with
      stock options and other forms of equity compensation in accordance with
      Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as
      interpreted by SEC Staff Accounting Bulletin No. 107. Prior to February 1,
      2006, ATSI had accounted for stock options according to the provisions of
      Accounting Principles Board (“APB”) Opinion No. 25; “Accounting
      for Stock Issued to Employees”, and
      related interpretations, and therefore no related compensation expense was
      recorded for awards granted with no intrinsic value. ATSI adopted the modified
      prospective transition method as permitted under SFAS No. 123R, and,
      consequently, has not retroactively adjusted results from prior periods. Under
      this modified prospective transition method, compensation cost associated with
      stock options recognized during fiscal 2006 includes the amortization related
      to
      the remaining service period of all stock option awards granted prior to
      February 1, 2006, based on the grant date fair value estimated in accordance
      with the original provisions of SFAS No. 123.





The
      following table illustrates the effect on net loss and net loss per share if
      ATSI had applied the fair value provisions of FASB Statement No. 123R, to
      stock-based employee compensation:


Twelve
                months ended July 31,2006
            
            2005Net
                income (loss) to commonshareholders,
                as reported
            
            ($12,000)
            
            $9,768,000Add:
            stock
                based compensation determinedunder
                intrinsic value based method
            
            -
            
            42,080Less:
                stock based compensation determinedunder
                fair value based method
            
            (23,590)
            
            (1,000,493)Pro
                forma net income (loss) to common stockholders
            
            ($35,590)
            
            $8,809,587Basic
                net income (loss) per common share:As
                reported
            
            ($0.00)
            
            $1.37Pro
                forma
            
            ($0.00)
            
            $1.24Diluted
                net income (loss) per common share:As
                reported
            
            $0.00
            
            $0.42Pro
                forma
            
            $0.00
            
            $0.38





36


The
      fair
      value of each option and warrant granted is estimated on the date of grant
      using
      the Black-Scholes option pricing model with the following
      assumptions:





For
                the Years Ended July 31,2006
            
            2005Expected
                dividends yield
            
            0.00%
            
            0.00%Expected
                stock price volatility
            
            50%
            
            50%Risk-free
                interest rate
            
            4.39%
            
            3.5%Expected
                life of options
            
            10
                years
            
            3
                years





***Basic
      and diluted net loss per share.*** The
      basic net loss per common share is computed by dividing the net loss by the
      weighted average number of common shares outstanding. Diluted net loss per
      common share is computed by dividing the net loss adjusted on an "as if
      converted" basis, by the weighted average number of common shares outstanding
      plus potential dilutive securities.





***Recently
      issued accounting pronouncements.*** ATSI
      does not expect the adoption of any other recently issued accounting
      pronouncements to have a significant impact on ATSI’s results of operations,
      financial position or cash flows.





**NOTE
      2 - GOING CONCERN**





As
      shown
      in the accompanying financial statements, ATSI incurred net income (loss) from
      operations of ($705,000) and $10,407,000 in fiscal 2006 and 2005, respectively,
      has an accumulated deficit of $72 million and a working capital deficit of
      $2,800,000 as of July 31, 2006. These conditions create substantial doubt as
      to
      ATSI’s ability to continue as a going concern. Management plans to continue to
      improve its financial position through the growth of its operations subject
      to
      its capital limitations. Management will also continue to pursue financings
      that
      may include raising additional capital through the issuance of debt and sales
      of
      common stock, preferred stock, or warrants. The financial statements do not
      include any adjustments that might be necessary if ATSI is unable to continue
      as
      a going concern.





**NOTE
      3 - PROPERTY AND EQUIPMENT**





Following
      is a summary of ATSI’s property and equipment at July 31, 2006 (in
      thousands):





Depreciable
                lives
            
            2006
            
            2005Telecom
                equipment & software
            
            
            1-5
                years
            
            $
            284
            
            $
            228Less:
                accumulated depreciation
            
            
            
            
            
            (182
            )
            
            (90
            )Net-property
                and equipment
            
            
            
            
            $
            102
            
            $
            138





For
      the
      years ended July 31, 2006 and 2005, depreciation and amortization totaled
      approximately $92,000 and $112,000, respectively.





**NOTE
      4 - SETTLEMENT OF NOTE RECEIVABLE**





On October
      31, 2005, ATSI Communications, Inc. and Telemarketing de Mexico S.A de C.V.
      reached a “Confidential Settlement Agreement and Mutual Release”. Under the
      settlement agreement the parties agreed to release all claims and liabilities
      between the parties. ATSI agreed to release Telemarketing de Mexico S.A de
      C.V.
      of a note receivable with a balance $598,000. ATSI
      previously recognized an allowance for this receivable and the balance reflected
      in our balance sheet was zero. No additional gain or loss was recognized upon
      settlement. Additionally,
      as part of the settlement ATSI agreed to release 10% of ATSI
      Communicaciones S.A de C.V. total outstanding common stock that was held as
      collateral on the note receivable.





37


**NOTE
      5 - DEBT**





On
      November 4, 2005 ATSI entered into a $150,000 credit facility agreement with
      CSI
      Business Finance, Inc. Under the agreement, ATSI borrowed $150,000 bearing
      interest at 18% per annum and maturing November 4, 2006. The credit facility
      is
      secured by ATSI’s accounts receivables. In connection with the transaction ATSI
      paid an application, legal and documentation fee of $6,000 and a brokerage
      fee
      of $20,000 to Corporate Strategies, Inc.





On
      November 4, 2005, ATSI entered into a note payable with CSI Business Finance,
      Inc. for $50,000. The promissory note payable has a maturity date of November
      6,
      2006 and an annual interest rate of 18%. The note provides for interest payments
      of $750 each month with the principal balance due at maturity. The note is
      secured by ATSI’s equipment, deposit accounts and accounts receivables. ATSI has
      the option of paying off the total outstanding principal balance at any time,
      subject to a $10,000 early termination fee.





On
      February 20, 2006, ATSI entered into a factoring agreement with CSI Business
      Finance, Inc. Under the agreement, CSI Business committed to purchase up to
      $400,000 of ATSI’s accounts receivables. The factoring agreement is for an
      indefinite period of time, the factor or ATSI can terminate this agreement
      at
      its sole discretion at any time without
      cause .
      The
      factoring rate ranges from 1.25%-2.25% per factored amount. The
      accounts receivable factoring agreement is secured by ATSI’s accounts
      receivables. As of
      the date of this filing ATSI did not have any outstanding factored receivables
      under this agreement.





On
      November 1, 2004, ATSI entered into a promissory note payable with Franklin,
      Cardwell & Jones, PC, for $103,454 associated with legal and professional
      services previously rendered. The note payable had a maturity date of December
      1, 2005 and an annual interest rate of 6%. On December 1, 2005 Franklin,
      Cardwell & Jones agreed to extend the maturity date on this note until
      December 1, 2006.





Under
      the
      terms of the note, the holder, at any time after November 1, 2005, can convert
      all or any part of the outstanding balance and accrued and unpaid interest
      to
      shares of ATSI’s common stock equal to the amount converted divided by the
      product of (a) 0.90 times (b) the five-day average of the last sales of the
      common stock prior to the conversion day. This conversion feature was determined
      to be an embedded derivative and, accordingly, the embedded derivative portion
      of the value of the note was attributed to the conversion feature.





On
      November 1, 2005, the holder of the note elected to convert $13,454 of the
      principal balance and $6,207 of the accrued interest into 66,603 common shares
      of ATSI. Furthermore,
      on January 6, 2006, the holder elected to convert $20,000 of the principal
      balance and $1,632 of accrued interest into 98,328 common shares of ATSI stock.
      On April 1, 2006, the holder elected to convert the remaining principal balance
      of $70,000 and $1,950 of accrued interest into 278,444 shares of ATSI stock. Accordingly,
      the embedded derivative liability at July 31, 2006, is zero. A corresponding
      gain on derivative instrument liabilities of $10,219 is reflected in the
      statement of operations for the year ended July 31, 2006.





In
      May
      2006, ATSI entered into a short-term note payable with Fiesta Communications,
      Inc. (“Fiesta”) in the amount of $120,000 as part of a joint management and
      marketing agreement. ATSI’s CEO and President, Arthur L Smith, is a shareholder
      of Fiesta. This note payable matured on October 5, 2006 and accrues interest
      at
      the rate of 8% annually. This note payable provided for payment of principal
      and
      accrued interest at maturity.





**NOTE
      6 - CONVERTIBLE SUBORDINATED DEBENTURES**





On
      June
      1, 2006, ATSI restructured it’s 9% Convertible Subordinated Debentures
      (“Original 9% debentures”) by issuing 416 9% Convertible Subordinated Debentures
      (“New Debentures”) with a face value of $1,000 each, due June 2011. The New
      Debentures were issued in exchange for all of the Original 9% Debentures in
      the
      aggregate principal amount of $275,000 and $141,000 of accrued interest through
      June 2006. Each New Debenture accrues interest at the rate of 9% per annum
      payable annually. The debentures and any accrued interest are subject to an
      election to convert into common stock by either ATSI or the holders at the
      higher of (a) $0.27 per share or (b) the average closing price of ATSI’s common
      stock for the 10 days immediately preceding the date of conversion. The maximum
      common shares that can be issued upon conversion of the debentures are 1,540,741
      common shares. On June 1, 2006, ATSI issued 261,635 restricted common shares
      as
      an initial payment on the debenture of $83,200. Additionally, as of July 31,
      2006, ATSI had approximately $5,000 in accrued interest associated with these
      debentures.





38


Based
      on
      the guidance in SFAS 133 and EITF 00-19, ATSI concluded that these instruments
      were not required to be accounted for as derivatives. Since ATSI, met the requirements
      for (a) having sufficient authorized shares available upon conversion and (b)
      an
      explicit limit on the number of shares required to be issued upon conversion.
      ATSI will continuously evaluate these requirements every quarter to confirm
      if
      the requirements are met under EITF 00-19.





The
      proceeds from the debentures have been discounted by $26,000 to reflect a
      beneficial conversion feature derived from the difference between the conversion
      price and the market price at the time of issuance. The discount will be
      amortized over the life of the debentures using the effective interest method.
      A
      summary of the debentures is as follows:




Principal
                  balance from old debentures:
              
              $
              275,000Add:Re-financed
                  accrued interest
              
              
              141,000Total
                  new debentures:
              
              $
              416,000Less:Re-payments
                  by issuance of stock
              
              
              (83,200
              )Less:beneficial
                  conversion feature
              
              
              (26,000
              )Add:
                  amortization of discounts
              
              
              770Carrying
                  amount of debentures at July 31, 2006
              
              $
              307,570


**NOTE
      7 - GAIN ON DISPOSAL OF DISCONTINUED OPERATIONS**





During
      the year ended July 31, 2006, ATSI recognized a gain on disposal of discontinued
      operations of $1,652,000. The gain on disposal of discontinued operations was
      associated with the sale in October 2005 of ATSI’s Mexican subsidiary, ATSIMex
      Personal S.A de C.V. This entity discontinued all operations in May 2003. The
      total liabilities of this entity, net of assets, were approximately $1,652,000
      and were assumed by the purchaser.





**NOTE
      8 - DERIVATIVES**





ATSI
      evaluates the application of SFAS 133 and EITF 00-19 for all of its
      financial instruments and identified the following financial instruments as
      derivatives during fiscal 2006 and 2005:


1)
              Note
                  Payable, Franklin, Cardwell and Jones2)
              “Old”
                  9% Convertible Debentures;
                Warrants
                  to purchase common stock associated with the 2003 Debentures the
                  ("2003
                  Debenture Warrants");3)
              Warrants
                  to purchase common stock in connection with consulting agreements
                  with two
                  individuals (“Consulting Warrants”)
 
 39





Based
      on
      the guidance in SFAS 133 and EITF 00-19, we concluded that all of these
      instruments were required to be accounted for as derivatives. SFAS 133 and
      EITF
      00-19 required ATSI to bifurcate and separately account for the conversion
      features of the Note Payable to Franklin, Cardwell & Jones, the 9%
      Convertible Debentures and warrants issued to consultants as embedded
      derivatives.





Pursuant
      to SFAS 133, ATSI bifurcated the conversion feature from the Note Payable to
      Franklin, Cardwell & Jones, because the conversion price was not fixed and
      was not convertible into a fixed number of shares. Accordingly, the embedded
      derivative was required to be bifurcated and accounted for
      separately.





In
      addition, ATSI bifurcated the conversion feature from the Original 9%
      Convertible Debenture and the associated warrants, since the conversion price
      was not fixed and was not convertible into a fixed number of
      shares.





Furthermore,
      ATSI concluded that the exercise price and the number of shares to be issued
      under the “Consulting Warrants” to two individuals are fixed. However, since the
      Original 9% Convertible Debenture were issued prior to these warrants and these
      debentures might result in issuing an indeterminate number of shares, it could
      not be concluded that the Company had a sufficient number of authorized shares
      to settle these warrants. As such, the warrants were accounted for as derivative
      instrument liabilities. ATSI is required to record the fair value of the
      conversion features and the warrants on its balance sheet at fair value with
      changes in the values of these derivatives reflected in the consolidated
      statement of operations as “Gain (loss) on embedded derivative liability.”





The
      impact of the application of SFAS 133 and EITF 00-19 on the balance sheets
      as of
      July 31, 2006 and 2005 is as follows:





Embedded
                derivative liability balance
            
            Net
                change2006
            
            2005
            
            in
                valueNote
                Payable, Franklin, Cardwell & Jones
            
            $
            -
            
            $
            18,851
            
            $
            (18,851
            )9%
                Convertible Debenture & Warrants
            
            
            -
            
            
            -
            
            
            -Consulting
                Warrants
            
            
            -
            
            
            5,353
            
            
            (5,353
            )Total:
            
            $
            -
            
            $
            24,204
            
            $
            (24,204
            )





And
      the
      impact on statements of operations as of the year July 31, 2006 and July 31,
      2005 is as follows:





**Gain
                (loss) on embedded derivative liabilities:**
            
            Twelve
                months ended July 31,2006
            
            2005Note
                Payable, Franklin Cardwell and Jones
            
            $
            10,219
            
            $
            7,4309%
                Convertible Debenture & warrants
            
            
            -
            
            
            10,487Consulting
                warrants
            
            
            (16,186
            )
            
            (305,135
            )**Total
                gain (loss) on embedded derivative
                liabilities:**
            
            $
            (5,967
            )
            $
            (287,218
            )





During
      fiscal 2006, Franklin, Cardwell and Jones converted its note payable to common
      stock and the Original 9% Debentures were restructured. The features that
      previously required bifurcation and valuation of the embedded derivatives were
      eliminated either through conversion or restructuring. Accordingly, ATSI
      evaluated its derivative liabilities at the date such features no longer were
      effective and recognized the gain/loss on embedded derivatives at such date.
      Upon determination that ATSI had no further derivative liabilities, the balance
      of the derivative liability was recorded to Additional Paid in Capital in
      accordance with EITF 06-07.





**NOTE
      9 - COMMITMENTS AND CONTINGENCIES**





Leases:





40


ATSI
      leases its office space with monthly payments of $4,085; the lease expires
      in
      November 2011. The annual rent expense under the operating lease was $41,420
      and
      $45,442 for 2005 and 2006, respectively. The future minimum lease payments
      under
      the operating lease are as follows:


FY2007
              $43,486FY2008
              $47,439FY2009
              $48,199FY2010
              $49,100FY2011
              $49,250




Litigation:





On
      October 31, 2002, ATSI filed a lawsuit in the United States District Court
      for
      the Southern District Court of New York against several individuals and
      financial institutions, including the holders of its Series D and E Redeemable
      Preferred Stock, for, among other things, stock fraud and manipulation. On
      July
      9, 2004, ATSI filed a separate but related lawsuit in the same court against
      Sam
      Levinson and Uri Wolfson. On February 25, 2005, Judge Lewis A. Kaplan issued
      a
      memorandum opinion and order dismissing the complaint in the first action as
      to
      all defendants with prejudice. A judgment was entered in that action on
      September 8, 2005. ATSI appealed that judgment on September 20, 2005 to the
      United States Court of Appeals for the Second Circuit. On April 27, 2005, the
      court entered a final judgment dismissing the second action with prejudice
      based
      on the February 25, 2005 decision in the first action. On May 25, 2005, ATSI
      appealed the dismissal of the second action to the United States Court of
      Appeals for the Second Circuit. The defendants' briefs were filed in both
      appeals on March 29, 2006, and our reply briefs were filed on May 12, 2006.
      Oral
      arguments have been scheduled for November 29, 2006. Currently ATSI cannot
      predict the outcome of this litigation or the financial impact on our ongoing
      operations.





On
      June
      16, 2005, ATSI Communications, Inc. filed an arbitration claim against Ntera
      Holdings, Inc. involving a dispute in the range of approximately $100,000 and
      attorney's fees for which Ntera counterclaimed. As part of a settlement
      agreement, Ntera agreed to a lesser balance it alleged had been owed, after
      which ATSI provided Ntera approximately $78,000 in VoIP termination services
      over a 90-day period from June 10, 2006 through September 10, 2006 to fully
      discharge the alleged indebtedness. ATSI successfully met its commitment under
      the settlement agreement. The arbitration was dismissed in October 2006,
      following the execution and performance of the settlement
      agreement.





In
      October 2005, Richard Beckenforf filed a lawsuit in Travis County, Texas against
      ATSI asserting indebtedness allegedly owed to him, principally for unpaid fees
      and un-reimbursed expenses during such time he was a director of ATSI. Such
      claims were for approximately $96,000 plus attorney’s fees. This claim was
      settled on March 21, 2006 for $1,500 and issuance of ATSI stock valued at
      approximately $46,000 over a period of 6 months. As of September 15, 2006,
      the
      lawsuit against ATSI has been dismissed and ATSI has successfully met its
      commitment under the settlement agreement.





On
      April
      13, 2006 ATSI filed suit in Bexar County, Texas and obtained injunctive relief
      against former ATSI consultants Diane Huth and John Highland associated with
      a
      dispute relating to a claim for rightful ownership of the trade name
      "Telefamilia," which Defendants had undertaken to trademark for their own
      purposes. Defendants have filed an answer denying any liability. Temporary
      injunctive relief was granted preserving ATSI's claims to such trade name.
      Currently, the suit is pending and no depositions have been taken and no trial
      date has been set. Currently ATSI cannot predict the outcome of this litigation
      or the financial impact on our ongoing operations.





ATSI
      may
      become a party to future claims and legal proceedings arising in the ordinary
      course of business. Due to the inherent uncertainty of litigation, the range
      of
      possible loss, if any, cannot be estimated with a reasonable degree of precision
      and there can be no assurance that the resolution of any particular claim or
      proceeding would not have an adverse effect on our results of operations in
      the
      period in which it occurred.





**NOTE
      10 - EQUITY**





***Common
      Stock***





During
      fiscal 2006, ATSI issued 549,456 shares of common stock valued at $127,352
      for
      legal and consulting services rendered during the year by various
      individuals.





41


On
      October 10, 2005, ATSI issued 180,272 shares of common stock valued at $57,687
      to upgrade its NexTone Soft Switch machine.





During
      the year ended July 31, 2006, ATSI issued 2,959,731 common shares associated
      with the conversion of 2,309,880 shares of Series H Convertible Preferred Stock
      and 1,000 shares of Series A Preferred Stock.





During
      the year ended July 31, 2006, ATSI issued 366,666 shares of common stock related
      to the exercise of warrants and received proceeds of $54,184.





During
      fiscal 2006, ATSI issued 518,755 shares of its common stock to several creditors
      to repay its outstanding loans. The shares were recorded as expense at their
      fair value of $148,614.





During
      fiscal 2006, ATSI issued 85,996 shares of its common stock to Richard Benkendorf
      as a payment of $22,842 associated with the settlement agreement between ATSI
      and Mr. Benkendorf.





On
      July
      31, 2006, ATSI issued 261,635 shares of common stock valued at $83,200 for
      a
      payment on the “New Debentures” dated June 1, 2006. .




During
      the year ended July 31, 2006, ATSI issued 1,125,000 shares of common stock
      to
      its employees and directors. ATSI recorded compensation expense of $180,000
      in
      its statement of operations for the aggregate market value of the stock at
      the
      date of issuance.





No
      dividends were declared on ATSI’s common stock during fiscal 2006 and
      2005.





***Preferred
      Stock***





The
      terms
      of ATSI’s Series A, Series D, Series E and Series H preferred stock restrict
      ATSI from declaring and paying dividends on ATSI’s common stock until such time
      as all outstanding dividends have been fulfilled related to the preferred stock.
      The outstanding Series A, Series D, Series E and Series H preferred stock have
      liquidation preference prior to common stock and ratably with each other. No
      dividends were declared on ATSI’s preferred stock during fiscal 2006 and 2005.





**Series
      A Preferred Stock**





During
      fiscal 2006, ATSI issued 31,243 common shares associated with the conversion
      of
      1,000 shares of Series A Convertible Preferred Stock. As of July 31, 2006,
      2,750
      shares of Series A Preferred Stock remain outstanding. Additionally, as of
      July
      31, 2006, ATSI has accrued approximately $215,000 for dividends associated
      with
      the Series A Convertible Preferred Stock.





The
      Series A Preferred Stock and any accumulated, unpaid dividends may be converted
      into Common Stock for up to one year at the average closing price of the Common
      Stock for twenty (20) trading days preceding the Date of Closing (the “Initial
      Conversion Price”). On each Anniversary Date up to and including the fifth
      Anniversary Date, the Conversion price on any unconverted Preferred Stock,
      will
      be reset to be equal to 75% of the average closing price of the stock for the
      then twenty (20) preceding days provided that the Conversion price can not
      be
      reset any lower than 75% of the Initial Conversion Price. As these conversion
      features were considered a “beneficial conversion feature” to the holder, ATSI
      allocated approximately $3.6 million of the approximately $5.0 million in
      proceeds to additional paid-in capital as a discount that has been fully
      amortized in prior periods. The Series A Preferred Stock is callable and
      redeemable by ATSI at 100% of its face value, plus any accumulated, unpaid
      dividends at ATSI’s option any time after the Common Stock of ATSI has traded at
      200% or more of the conversion price in effect for at least twenty (20)
      consecutive trading days.





42


**Series
      D Preferred Stock**





The
      Series D Preferred Stock accrues cumulative dividends at the rate of 6% per
      annum payable quarterly. As of July 31, 2006, 742 shares of Series D Preferred
      Stock remain outstanding, for which ATSI accrued approximately $285,000 for
      dividends. Additionally, on January 24, 2003 ATSI received a demand redemption
      letter from the Series D Preferred holders. ATSI has not issued these shares;
      it
      is the position of ATSI that the investor’s shares are not owed. Further ATSI
      has filed a lawsuit against one or more parties to whom the investors share
      are
      allegedly owed. ATSI is seeking damages from the parties involved for stock
      manipulation and fraud. ATSI believes that the holders of the Series D Preferred
      Stock can no longer enforce the conversion or redemption features of the
      Preferred Stock instruments due to, among other things, the expiration of the
      applicable statute of limitations. Accordingly,
      ATSI recorded a reduction in the accrued redemption obligation in the amount
      of
      $199,887 and a corresponding increase in additional paid-in capital. ATSI
      recorded this amount in the current period to reflect a change in accounting
      estimate.




**Series
      E Preferred Stock**





As
      of
      July 31, 2006, 1,170 shares of Series E Preferred Stock remain
      outstanding.





The
      Series E Preferred Stock contain certain conversion and redemption features
      which provide that (1) they may be converted into Common Stock for up to three
      years at the lesser of a) the market price - defined as the average of the
      closing bid price for the five lowest of the ten trading days prior to
      conversion or b) the fixed conversion price - defined as 120% of the lesser
      of
      the average closing bid price for the ten days prior to closing or the October
      12, 2000 closing bid price and (2) allow for mandatory redemption by the holder
      upon certain conditions.





The
      Series E Preferred Stock allows the holder to elect redemption at $1,250 per
      share plus 6% per annum if: 1) ATSI refuses conversion notice, 2) an effective
      registration statement was not obtained by prior to March 11, 2001, 3)
      bankruptcy proceedings are initiated against ATSI, 4) The Secretaría de
      Comunicaciones y Transportes of the SCT limits or terminates the scope of the
      concession or, 5) if ATSI fails to maintain a listing on NASDAQ, NYSE or AMEX.
      ATSI believes that the holders of the Series E Preferred Stock can no longer
      enforce the conversion or redemption features of the Preferred Stock instruments
      due to, among other things, the expiration of the applicable statute of
      limitations. Accordingly,
      ATSI recorded a reduction in the accrued redemption obligation in the amount
      of
      $292,500 and a corresponding increase in additional paid -in capital. ATSI
      recorded this amount in the current period to reflect a change in accounting
      estimate.





**Series
      H Preferred Stock**





During
      fiscal 2006, 2,309,880 shares of Series H Convertible Preferred Stock were
      converted to 2,928,488 shares of common stock. As of July 31, 2006, 11,802,353
      shares of Series H Convertible Preferred Stock remained outstanding and accrued
      dividends of $1,743,000.





On
      May 6,
      2004 ATSI’s stockholders approved the reincorporation of ATSI into a wholly
      owned subsidiary, ATSI Merger Corporation in Nevada. As a result of the merger,
      ATSI’s Stockholders of record as of May 24, 2004 received one (1) share of New
      ATSI Common Stock and ten (10) shares of New ATSI Series H Convertible Preferred
      Stock for each 100 shares of Old ATSI Common Stock surrendered. During fiscal
      2004, 14,385,000 shares of the New ATSI Series H Convertible Preferred Stock
      were issued.





Pursuant
      to ATSI’s Certificate of Incorporation, ATSI’s board of directors may issue, in
      series, 16,000,000 of the New ATSI Series H Convertible Preferred shares, with
      a
      par value of $0.001.





**NOTE
      11 - WARRANTS AND STOCK OPTIONS**





On
      January 1, 2006, ATSI entered into consulting agreements for 90 days with
      NetComm Services Corp. The consulting agreement automatically renews every
      90
      days unless either party notifies the other of the intent to cancel within
      15
      days prior to the renewal period. As of July 31, 2006, the consulting agreement
      has automatically renewed and is still effective. The consulting agreement
      with
      NetComm Services Corp. provided for the issuance of compensation warrants to
      purchase a total of 150,000 shares of ATSI’s common stock at price per warrant
      of $0. 23.
      These
      warrants expire on January 1, 2009. At
      issuance, ATSI recognized $29,477 of non-cash compensation expense associated
      with the issuance of these warrants.





43


In
      June
      2004, ATSI adopted the “2004 Stock Compensation Plan”. The “2004 Stock
      Compensation Plan” authorizes the grant of up to 7.5 million of warrants, stock
      options, restricted common stock, non-restricted common stock and other awards,
      or a combination, to employees, directors, consultants and certain other
      persons. The “2004 Stock Compensation Plan” is intended to permit ATSI to retain
      and attract qualified individuals who will contribute to ATSI’s overall success
      of ATSI. The exercise price of all of the warrants, stock options, restricted
      common stock, non-restricted common stock and other awards will vary based
      on
      the market price of the shares of common stock as of the date of grant. The
      warrants, stock options, restricted common stock, non-restricted common stock
      and other awards vest pursuant based in the individual security
      granted.





The
      following are the issuance of ATSI’s stock under the “2004 Stock Compensation
      Plan” during fiscal 2006.





·
            During
                fiscal 2006, ATSI issued 635,452 shares of common stock valued at
                $150,194
                for legal and consulting services rendered during the year by various
                individuals. The average exercise price of the common stock issued
                was
                $0.24 per share.





·
            During
                fiscal 2006, ATSI issued 350,000 warrants to consultants for services
                rendered, the warrants exercise price range from $0.23 to $0.25 per
                share.
                During fiscal 2006 200,000 warrants were exercised at a price of
                $0.23 per
                share.





In
      September 2005, ATSI adopted the “2005 Stock Compensation Plan”. The “2005 Stock
      Compensation Plan” authorizes the grant of up to 7.5 million of warrants, stock
      options, restricted common stock, non-restricted common stock and other awards,
      or a combination, to employees, directors, and certain other persons. The “2005
      Stock Compensation Plan” is intended to permit ATSI to retain and attract
      qualified individuals who will contribute to ATSI’s overall success of ATSI. The
      exercise price of all of the warrants, stock options, restricted common stock,
      non-restricted common stock and other awards will vary based on the market
      price
      of the shares of common stock as of the date of grant. The warrants, stock
      options, restricted common stock, non-restricted common stock and other awards
      vest pursuant based in the individual security granted.





The
      following are the issuance of ATSI’s stock under the “2005 Stock Compensation
      Plan” during fiscal 2006.





·
            During
                fiscal 2006, ATSI granted 2,450,000 options to purchase common stock
                to
                employees and members of the Board of Directors with an exercise
                price of
                $0.16 per share, the closing price of ATSI’s stock on the grant date,
                September 29, 2005. These options will vest over a period of three
                years.
                During the year ended July 31, 2006, ATSI recognized compensation
                expense
                of $53,930 associated with these options. Under the fair value option
                method, compensation expense for these options is $248,080 and will
                be
                amortized over the service period.





·
            Additionally,
                during fiscal 2006, ATSI granted 1,904,000 options to purchase common
                stock to employees and members of the Board of Directors with an
                exercise
                price of $0.16 per share, the closing price of ATSI’s stock on the grant
                date, September 29, 2005. Seventy three percent of these options
                vested
                immediately and the remaining balances vest over three years. During
                the
                year ended July 31, 2006, ATSI recognized compensation expense of
                $33,377
                associated with these options. Under the fair value option method,
                compensation expense for these options is $60,735 and will be amortized
                over the service period.


·
            During
                fiscal 2006, ATSI issued 1,125,000 shares of common stock to its
                employees
                and directors. ATSI recorded compensation expense of $180,000 in
                its
                statement of operations for the aggregate market value of the stock
                at the
                date of issuance.





44


A
      summary
      of the status of ATSI’s “2004 and 2005 Stock Compensation Plans” for fiscal 2006
      and 2005 are presented below:


Years
                  Ended July 31,2006
              
              2005Weighted
              
              
              
              WeightedAverage
              
              
              
              Average**2004
                  Stock Compensation Plan**
              
              Options
              
              Exercise
                  Price
              
              Options
              
              Exercise
                  PriceOutstanding,Beginning
                  of year
              
              
              2,104,000
              
              $
              0.46
              
              
              -
              
              $
              -Granted
              
              
              -
              
              
              -
              
              
              3,004,000
              
              
              0.46Exercised
              
              
              -
              
              
              -
              
              
              (900,000
              )
              
              (0.46
              )Forfeited
              
              
              (2,104,000
              )
              
              (0.46
              )
              
              -
              
              
              -Outstanding,
                  end of year
              
              
              -
              
              $
              -
              
              
              2,104,000
              
              $
              0.46Options
                  exercisable at end of year
              
              
              -
              
              $
              -
              
              
              1,328,000
              
              $
              0.46Weighted
                  average fair value of options granted during the year
              
              
              
              
              $
              -
              
              
              
              
              $
              0.46


Years
                Ended July 31,2006
            
            2005Weighted
            
            
            
            WeightedAverage
            
            
            
            Average**2004
                Stock Compensation Plan (WARRANTS)**
            
            Warrants
            
            Exercise
                Price
            
            Warrants
            
            Exercise
                PriceOutstanding,Beginning
                of year
            
            
            303,140
            
            $
            0.25
            
            
            3,333,426
            
            $
            0.25Granted
            
            
            350,000
            
            
            0.23
            
            
            2,183,500
            
            
            0.32Exercised
            
            
            (366,666
            )
            
            0.24
            
            
            (4,280,286
            )
            
            0.21Forfeited
            
            
            (136,474
            )
            
            0.25
            
            
            (933,500
            )
            
            0.56Outstanding,
                end of year
            
            
            150,000
            
            $
            0.23
            
            
            303,140
            
            $
            0.25Warrants
                exercisable at end of year
            
            
            150,000
            
            $
            0.23
            
            
            303,140
            
            $
            0.25Weighted
                average fair value of warrants granted during the year
            
            
            
            
            $
            0.23
            
            
            
            
            $
            0.32






Years
                Ended July 31,2006
            
            2005Weighted
            
            
            
            WeightedAverage
            
            
            
            Average**2005
                Stock Compensation Plan**
            
            Options
            
            Exercise
                Price
            
            Options
            
            Exercise
                PriceOutstanding,Beginning
                of year
            
            
            -
            
            $
            -
            
            
            -
            
            $
            -Granted
            
            
            4,354,000
            
            
            0.16
            
            
            -
            
            
            -Exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -Forfeited
            
            
            -
            
            
            -
            
            
            -
            
            
            -Outstanding,
                end of year
            
            
            4,354,000
            
            $
            0.16
            
            
            -
            
            $
            -Options
                exercisable at end of year
            
            
            1,440,000
            
            $
            0.16
            
            
            -
            
            $
            -Weighted
                average fair value of options granted during the year
            
            
            
            
            $
            0.16
            
            
            
            
            $
            -$
            -
            
            
            
            
            $
            -




45




The
      following table summarizes information about stock options and warrants
      outstanding for all plans at July 31, 2006:





Options
                and Warrants Outstanding
            
            Options
                and Warrants ExercisableWeighted
                AverageNumber
            Weighted
                Avg.
            Remaining
            Number
            Weighted
                Avg.Exercise
                Price
            Outstanding
            Exercise
                Price
            Contractual
                Life (Years)
            Exercisable
            Exercise
                PriceOptions$0.16
            4,354,000
            $0.16
            9
            1,440,000
            $0.16Warrants$0.23
            150,000
            $0.23
            1
            150,000
            $0.23




**NOTE
      12 - INCOME TAXES**





Deferred
      tax assets are comprised of the following as of July 31, 2006 and
      2005:


2006
              
              2005(Restated)Net
                  operating loss carry-forward
              
              $
              11,660,000
              
              $
              11,500,000Valuation
                  allowance
              
              
              (11,660,000
              )
              
              (11,500,000
              )Total
                  deferred tax asset
              
              $
              -
              
              $
              -





ATSI
      conducts a periodic examination of its valuation allowance. Factors considered
      in the evaluation include recent and expected future earnings and ATSI’s
      liquidity and equity positions. As of July 31, 2006, ATSI has determined that
      a
      valuation allowance is necessary for the entire amount of deferred tax
      assets.





At
      July
      31, 2006, ATSI had net operating loss carry-forwards related to U.S. operations
      of approximately $12 million with expiration dates ranging from 2009 through
      2026.




**NOTE
      13 - EARNINGS (LOSS) PER SHARE**





In
      accordance with SFAS No. 128, “Earnings Per Share,” basic earnings per share has
      been computed based upon the weighted average of common shares outstanding.
      Diluted earnings per share gives effect to outstanding convertible preferred
      shares, warrants and stock options, unless their effect is anti-dilutive.
      Earnings (loss) per common share has been computed as follows:





46


Year
                ended July 31,2006
            
            2005(In
                thousands, except share information)Net
                income (loss) to be used to compute income(loss)
                per share:Net
                income (loss)
            
            $
            947
            
            $
            10,407Less
                preferred dividends
            
            
            (959
            )
            
            (639
            )Net
                income (loss) attributable to commonShareholders
                - Basic
            
            
            (12
            )
            
            9,768Add
                back preferred dividends
            
            
            959
            
            
            639Net
                income (loss) attributable to commonshareholders
                -Diluted
            
            $
            947
            
            $
            10,407Weighted
                average number of shares:Weighted
                average common shares outstanding
            
            
            13,516,342
            
            
            7,128,847Effect
                of conversion of preferred shares
            
            
            —
            
            
            17,100,845Effect
                of warrants and options
            
            
            —
            
            
            626,809Weighted
                average common shares outstandingassuming
                dilution
            
            
            13,516,342
            
            
            24,856,501Basic
                income (loss) per common share
            
            $
            (0.00
            )
            $
            1.37Diluted
                income (loss) per common share
            
            $
            (0.00
            )
            $
            0.42





**NOTE
      14 - RELATED PARTY TRANSACTIONS**





In
      December 2002, ATSI entered into a note payable with a related party, a director
      of ATSI, Mr. John R. Fleming, in the amount of $25,000. This note called for
      12
      monthly payments of $2,163.17 including interest, commencing on February 1,
      2003. This note has an interest rate of 7% annually and a maturity date of
      January 1, 2004. During fiscal 2004, ATSI made payments towards this note in
      the
      amount of $9,000. The note is currently in default. No demand has been made
      for
      payment under this note and ATSI continues to accrue interest at a 7% annual
      rate until such time as payment is made. As of July 31, 2006, the principal
      balance was $16,000 and the accrued interest was $4,800. Additionally, as at
      July 31, 2006, ATSI had a payable of $47,352 for board member fees and related
      expenses to Mr. Fleming.





In
      May
      2006, ATSI entered into a short-term note payable with Fiesta Communications,
      Inc. (“Fiesta”) in the amount of $120,000 as part of a joint management and
      marketing agreement. ATSI’s CEO and President, Arthur L Smith, is a shareholder
      of Fiesta. This note payable matured on October 5, 2006 and accrues interest
      at
      the rate of 8% annually. This note payable provided for payment of principal
      and
      accrued interest at maturity. On October 13, 2006, ATSI had paid off the
      remaining balance of $90,000 and the accrued interest of $2,900.





**NOTE
      15 - RESTATEMENTS**





ATSI
      has
      restated its 2006 and 2005 quarterly financial statements and the financial
      statements for the year ended July 31, 2005 from amounts previously reported.
      During the fourth quarter of fiscal 2006, in consultation with our legal
      counsel, we evaluated the liability for the provisions for liquidation
      preferences contained in our Series E Preferred Stock instruments. Based on
      our
      evaluation, we concluded that our obligation to the holders of the Series E
      Preferred Stock was incorrectly accounted for as dividends. Based on this
      assessment, we have reversed all accrued dividends in the aggregate amount
      of
      $340,000. The adjustments to reverse the accrued dividends in our Series E
      Preferred Stock has been recorded during the periods that it occurred and the
      accumulated impact of the adjustments are reflected in our current fiscal year
      financial statements in accordance with SFAS No. 154, Accounting for Changes
      and
      Error Corrections.





In
      all
      other material respects, the financial statements are unchanged.  Following
      is a summary of the restatement adjustments for each of the
      periods:





47


**For
      the three and nine months ended April 30, 2006 and 2005**


For
                  the three months ended April 30, 2006
              
              
              For
                  the three months ended April 30, 2005(in
                  thousands, except share information)
              (in
                  thousands, except share information)As
                  Reported
              Adjustments
              As
                  Restated
              
              As
                  Reported
              Adjustments
              As
                  Restated**Summary
                  Balance Sheet**Total
                  assets
              
              $653
              
              $-
              
              $653
              
              
              $423
              
              $-
              
              $423Accounts
                  payable
              
              $953
              
              $-
              
              $953
              
              
              $506
              
              $-
              
              $506Accrued
                  liabilities
              
              915
              
              -
              
              915
              
              
              558
              
              -
              
              558Current
                  portion of obligation under capital leases
              3
              
              -
              
              3
              
              
              3
              
              -
              
              3Notes
                  payable
              
              50
              
              -
              
              50
              
              
              24
              
              -
              
              24Notes
                  payable, Franklin Cardwell & Jones
              16
              
              -
              
              16
              
              
              77
              
              -
              
              77Convertible
                  debentures
              
              234
              
              -
              
              234
              
              
              234
              
              -
              
              234Series
                  D Cumulative Preferred Stock
              
              1,215
              
              -
              
              1,215
              
              
              1,171
              
              -
              
              1,171Series
                  E Cumulative Preferred Stock
              
              1,802
              
              (340)
              ++
              1,462
              
              
              1,732
              
              (270)
              ++
              1,462Derivative
                  financial instrument liabilities
              2
              
              -
              
              2
              
              
              23
              
              -
              
              23Liabilities
                  from discontinued operations
              
              -
              
              -
              
              -
              
              
              1,152
              
              -
              
              1,152Total
                  current liabilities
              
              5,190
              
              (340)
              
              4,850
              
              
              5,480
              
              (270)
              
              5,210Total
                  long-term liabilities
              
              512
              
              -
              
              512
              
              
              517
              
              -
              
              517Series
                  A preferred stock
              
              -
              
              -
              
              -
              
              
              -
              
              -
              
              -Series
                  H preferred stock
              
              12
              
              -
              
              12
              
              
              14
              
              -
              
              14Common
                  stock
              
              15
              
              -
              
              15
              
              
              10
              
              -
              
              10Additional
                  paid in capital
              
              67,106
              
              340
              ++
              67,446
              
              
              66,771
              
              270
              ++
              67,041Accumulated
                  deficit
              
              (72,183)
              
              -
              
              (72,183)
              
              
              (72,871)
              
              -
              
              (72,871)Other
                  comprehensive income
              
              1
              
              -
              
              1
              
              
              502
              
              -
              
              502Total
                  Stockholder's deficit
              
              (5,049)
              
              340
              
              (4,709)
              
              
              (5,574)
              
              270
              
              (5,304)Total
                  liabilities and stockholder's deficit
              
              $653
              
              $-
              
              $653
              
              
              $423
              
              $-
              
              $423++
                  Aggregate adjustment in accrued dividends for Series E Preferred
                  Stock**Summary
                  statements of operations**Net
                  income (loss) from continuing operations
              $(39)
              
              $-
              
              $(39)
              
              
              $12,165
              
              $-
              
              $12,165Net
                  income from discontinued operations
              -
              
              
              
              -
              
              
              -
              
              
              
              -Preferred
                  Dividends
              
              (41)
              
              18
              *****
              (23)
              
              
              (38)
              
              18
              *****
              (20)Net
                  income (loss) to common stockholders
              ($80)
              
              $18
              
              ($62)
              
              
              $12,127
              
              $18
              
              $12,145Basic
                  Earnings (loss) per share
              
              ($0.01)
              
              $0.00
              
              ($0.01)
              
              
              $1.39
              
              $0.00
              
              $1.39Diluted
                  Earnings (loss) per share
              
              ($0.01)
              
              $0.00
              
              ($0.01)
              
              
              $0.44
              
              $0.00
              
              $0.44*
                  Adjustment in preferred dividends for Series E Preferred Stock,
                  recorded
                  during the period that it occurred.For
                  the nine months ended April 30, 2006
              
              
              For
                  the nine months ended April 30, 2005(in
                  thousands, except share information)
              (in
                  thousands, except share information)As
                  Reported
              Adjustments
              As
                  Restated
              
              As
                  Reported
              Adjustments
              As
                  Restated**Summary
                  statements of operations**Net
                  income (loss) from continuing operations
              $(639)
              
              $-
              
              $(639)
              
              
              $10,729
              
              $-
              
              $10,729Net
                  income from discontinued operations
              1,652
              
              
              
              1,652
              
              
              -
              
              
              
              -Preferred
                  Dividends
              
              (136)
              
              54
              *****
              (82)
              
              
              (114)
              
              54
              *****
              (60)Net
                  income (loss) to common stockholders
              $877
              
              $54
              
              $931
              
              
              $10,615
              
              $54
              
              $10,669Basic
                  Earnings (loss) per share
              
              $0.07
              
              $0.00
              
              $0.07
              
              
              $1.69
              
              $0.01
              
              $1.70Diluted
                  Earnings (loss) per share
              
              $0.04
              
              $0.00
              
              $0.04
              
              
              $0.43
              
              $0.00
              
              $0.43*
                  Adjustment in preferred dividends for Series E Preferred Stock,
                  recorded
                  during the period that it
                  occurred.
  48


**For
      the three and six months ended January 31, 2006 and 2005**





For
                the three months ended January 31, 2006
            
            
            For
                the three months ended January 31, 2005As
                Reported
            Adjustments
            
            As
                Restated
            
            As
                Reported
            Adjustments
            
            As
                Restated**Summary
                Balance Sheet**Total
                assets
            
            $631
            
            $-
            
            $631
            
            
            $373
            
            $-
            
            $373Pre-petition
                Liabilities of bankrupt subsidiaries, net of assets
            $-
            
            $-
            
            $-
            
            
            $12,104
            
            $-
            
            $12,104Accounts
                payable
            
            702
            
            -
            
            702
            
            
            542
            
            -
            
            542Accounts
                payable, CSI Business Finance
            
            150
            
            
            
            150
            
            
            -
            
            -
            
            -Accrued
                liabilities
            
            932
            
            -
            
            932
            
            
            620
            
            -
            
            620Current
                portion of obligation under capital leases
            3
            
            -
            
            3
            
            
            3
            
            -
            
            3Notes
                payable, related party
            
            16
            
            -
            
            16
            
            
            16
            
            -
            
            16Notes
                payable
            
            50
            
            -
            
            50
            
            
            -
            
            -
            
            -Notes
                payable, Franklin Cardwell & Jones
            
            69
            
            -
            
            69
            
            
            77
            
            -
            
            77Convertible
                debentures
            
            234
            
            -
            
            234
            
            
            234
            
            -
            
            234Series
                D Cumulative Preferred Stock
            
            1,204
            
            -
            
            1,204
            
            
            1,159
            
            -
            
            1,159Series
                E Cumulative Preferred Stock
            
            1,785
            
            (322)
            ++
            1,463
            
            
            1,714
            
            (252)
            ++
            1,462Derivative
                financial instrument liabilities
            
            90
            
            -
            
            90
            
            
            597
            
            -
            
            597Liabilities
                from discontinued operations
            
            -
            
            -
            
            -
            
            
            1,152
            
            -
            
            1,152Total
                current liabilities
            
            5,235
            
            (322)
            
            4,913
            
            
            18,218
            
            (252)
            
            17,966Total
                long-term liabilities
            
            514
            
            -
            
            514
            
            
            517
            
            -
            
            517Series
                A preferred stock
            
            -
            
            -
            
            -
            
            
            -
            
            -
            
            -Series
                H preferred stock
            
            12
            
            -
            
            12
            
            
            14
            
            -
            
            14Common
                stock
            
            15
            
            -
            
            15
            
            
            9
            
            -
            
            9Additional
                paid in capital
            
            66,996
            
            322
            ++
            67,318
            
            
            66,226
            
            252
            ++
            66,478Accumulated
                deficit
            
            (72,142)
            
            -
            
            (72,142)
            
            
            (85,113)
            
            -
            
            (85,113)Other
                comprehensive income
            
            1
            
            -
            
            1
            
            
            502
            
            -
            
            502-Total
                Stockholder's deficit
            
            (5,118)
            
            322
            
            (4,796)
            
            
            (18,362)
            
            252
            
            (18,110)Total
                liabilities and stockholder's deficit
            
            $631
            
            $-
            
            $631
            
            
            $373
            
            $-
            
            $373++
                Aggregate adjustment in accrued dividends for Series E Preferred
                Stock**Summary
                statements of operations**Net
                income (loss) from continuing operations
            
            (186)
            
            -
            
            (186)
            
            
            414
            
            -
            
            414Net
                income from discontinued operations
            
            -
            
            -
            
            -
            
            
            -
            
            -
            
            -Preferred
                Dividends
            
            (54)
            
            18
            *
            (36)
            
            
            (38)
            
            18
            *
            (20)Net
                income (loss) to common stockholders
            
            ($240)
            
            $18
            
            ($222)
            
            
            $376
            
            $18
            
            $394Basic
                Earnings (loss) per share
            
            ($0.02)
            
            $0.00
            
            ($0.02)
            
            
            $0.06
            
            $0.00
            
            $0.06From
                continuing operations
            
            ($0.02)
            
            $0.00
            
            ($0.02)
            
            
            $0.06
            
            $0.00
            
            $0.06From
                discontinued operations
            
            $0.00
            
            $0.00
            
            $0.00
            
            
            $0.00
            
            $0.00
            
            $0.00Diluted
                Earnings (loss) per share
            
            ($0.01)
            
            $0.00
            
            ($0.01)
            
            
            $0.02
            
            $0.00
            
            $0.02From
                continuing operations
            
            ($0.01)
            
            $0.00
            
            ($0.01)
            
            
            $0.02
            
            $0.00
            
            $0.02From
                discontinued operations
            
            $0.00
            
            $0.00
            
            $0.00
            
            
            $0.00
            
            $0.00
            
            $0.00*
                Adjustment in preferred dividends for Series E Preferred Stock, recorded
                during the period that it occurred.For
                the six months ended January 31, 2006
            
            
            For
                the six months ended January 31, 2005(in
                thousands, except share information)As
                Reported
            Adjustments
            
            As
                Restated
            
            As
                Reported
            Adjustments
            
            As
                Restated**Summary
                statements of operations**Net
                income (loss) from continuing operations
            
            (598)
            
            -
            
            (598)
            
            
            (1,432)
            
            -
            
            (1,432)Net
                income from discontinued operations
            
            1,652
            
            -
            
            1,652
            
            
            -
            
            -
            
            -Preferred
                Dividends
            
            (95)
            
            36
            *
            (59)
            
            
            (76)
            
            36
            *
            (40)Net
                income (loss) to common stockholders
            
            $959
            
            36
            
            $995
            
            
            ($1,508)
            
            36
            
            ($1,472)Basic
                Earnings (loss) per share
            
            $0.08
            
            $0.00
            
            $0.08
            
            
            ($0.30)
            
            $0.01
            
            ($0.29)From
                continuing operations
            
            ($0.06)
            
            $0.00
            
            ($0.06)
            
            
            ($0.30)
            
            $0.01
            
            ($0.29)From
                discontinued operations
            
            $0.14
            
            $0.00
            
            $0.14
            
            
            $0.00
            
            $0.00
            
            $0.00Diluted
                Earnings (loss) per share
            
            $0.04
            
            $0.00
            
            $0.04
            
            
            ($0.30)
            
            $0.01
            
            ($0.29)From
                continuing operations
            
            ($0.02)
            
            $0.00
            
            ($0.02)
            
            
            ($0.30)
            
            $0.01
            
            ($0.29)From
                discontinued operations
            
            $0.06
            
            $0.00
            
            $0.06
            
            
            $0.00
            
            $0.00
            
            $0.00*
                Adjustment in preferred dividends for Series E Preferred Stock, recorded
                during the period that it occurred.





49


**For
      the three months ended October 30, 2005 and 2004**





For
                the three months ended October 31, 2005
            
            
            For
                the three months ended October 31, 2004(in
                thousands, except share information)As
                Reported
            Adjustments
            As
                Restated
            
            As
                Reported
            Adjustments
            As
                Restated**Summary
                Balance Sheet**Total
                assets
            
            $379
            
            $-
            
            $379
            
            
            $369
            
            $-
            
            $369Pre-petition
                Liabilities of bankrupt subsidiaries, net of assets
            -
            
            -
            
            -
            
            
            12,104
            
            -
            
            12,104Accounts
                payable
            
            612
            
            -
            
            612
            
            
            595
            
            -
            
            595Accrued
                liabilities
            
            1,008
            
            -
            
            1,008
            
            
            680
            
            -
            
            680Current
                portion of obligation under capital leases
            
            3
            
            -
            
            3
            
            
            3
            
            -
            
            3Notes
                payable, related party
            
            16
            
            -
            
            16
            
            
            16
            
            -
            
            16Notes
                payable
            
            
            
            
            
            
            
            
            691
            
            -
            
            691Notes
                payable, Franklin Cardwell & Jones
            
            77
            
            -
            
            77
            
            
            -
            
            -
            
            -Convertible
                debentures
            
            234
            
            -
            
            234
            
            
            234
            
            -
            
            234Series
                D Cumulative Preferred Stock
            
            1,193
            
            -
            
            1,193
            
            
            1,149
            
            -
            
            1,149Series
                E Cumulative Preferred Stock
            
            1,767
            
            (305)
            **++**
            1,462
            
            
            1,697
            
            (234)
            ++
            1,463Derivative
                financial instrument liabilities
            
            29
            
            -
            
            29
            
            
            2,233
            
            -
            
            2,233Liabilities
                from discontinued operations
            
            -
            
            -
            
            -
            
            
            1,152
            
            -
            
            1,152Total
                current liabilities
            
            4,939
            
            (305)
            
            4,634
            
            
            20,554
            
            (234)
            
            20,320Total
                long-term liabilities
            
            515
            
            -
            
            515
            
            
            520
            
            -
            
            520Series
                A preferred stock
            
            -
            
            -
            
            -
            
            
            -
            
            -
            
            -Series
                H preferred stock
            
            14
            
            -
            
            14
            
            
            14
            
            -
            
            14Common
                stock
            
            12
            
            -
            
            12
            
            
            5
            
            -
            
            5Additional
                paid in capital
            
            66,854
            
            305
            **++**
            67,159
            
            
            64,224
            
            234
            ++
            64,458Accumulated
                deficit
            
            (71,956)
            
            -
            
            (71,956)
            
            
            (85,450)
            
            -
            
            (85,450)Other
                comprehensive income
            
            1
            
            -
            
            1
            
            
            502
            
            -
            
            502Total
                Stockholder's deficit
            
            (5,075)
            
            305
            
            (4,770)
            
            
            (20,705)
            
            234
            
            (20,471)Total
                liabilities and stockholder's deficit
            
            $379
            
            $-
            
            $379
            
            
            $369
            
            $-
            
            $369++
                Aggregate adjustment in accrued dividends for Series E Preferred
                Stock**Summary
                statements of operations**Net
                income (loss) from continuing operations
            
            $(412)
            
            $-
            
            $(412)
            
            
            $(1,846)
            
            $-
            
            (1,846)Net
                income from discontinued operations
            
            1,652
            
            
            
            1,652Preferred
                Dividends
            
            (41)
            
            18
            *****
            (23)
            
            
            (38)
            
            18
            *
            (20)Net
                income (loss) to common stockholders
            
            $1,199
            
            $18
            
            $1,217
            
            
            ($1,884)
            
            $18
            
            ($1,866)Basic
                Earnings (loss) per share
            
            $0.11
            
            $0.00
            
            $0.11
            
            
            ($0.52)
            
            $0.01
            
            ($0.52)From
                continuing operations
            
            ($0.04)
            
            $0.00
            
            ($0.04)
            
            
            ($0.52)
            
            $0.00
            
            ($0.52)From
                discontinued operations
            
            $0.15
            
            $0.00
            
            $0.15
            
            
            $0.00
            
            $0.00
            
            $0.00Diluted
                Earnings (loss) per share
            
            $0.04
            
            $0.00
            
            $0.05
            
            
            ($0.52)
            
            $0.01
            
            ($0.52)From
                continuing operations
            
            ($0.01)
            
            $0.00
            
            ($0.00)
            
            
            ($0.52)
            
            $0.00
            
            ($0.52)From
                discontinued operations
            
            $0.05
            
            $0.00
            
            $0.05
            
            
            $0.00
            
            $0.00
            
            $0.00*
                Adjustment in preferred dividends for Series E Preferred Stock, recorded
                during the period that it occurred.





50


**For
      the Year ended July 31, 2005**





For
                the Year ended July 31, 2005(in
                thousands, except share information)As
                Reported
            
            Adjustments
            
            As
                Restated**Summary
                Balance Sheet**Total
                assets
            
            $381
            
            -
            
            $381Pre-petition
                Liabilities of bankrupt subsidiaries, net of assets
            -
            
            -
            
            -Accounts
                payable
            
            606
            
            -
            
            606Accrued
                liabilities
            
            1,033
            
            -
            
            1,033Current
                portion of obligation under capital leases
            
            3
            
            -
            
            3Notes
                payable, related party
            
            16
            
            -
            
            16Notes
                payable
            
            -
            
            -
            
            -Notes
                payable, Franklin Cardwell & Jones
            
            77
            
            -
            
            77Convertible
                debentures
            
            234
            
            -
            
            234Series
                D Cumulative Preferred Stock
            
            1,182
            
            -
            
            1,182Series
                E Cumulative Preferred Stock
            
            1,749
            
            (287)
            ++
            1,462Derivative
                financial instrument liabilities
            
            24
            
            -
            
            24Liabilities
                from discontinued operations
            
            1,152
            
            -
            
            1,152Total
                current liabilities
            
            6,075
            
            (287)
            
            5,788Total
                long-term liabilities
            
            517
            
            -
            
            517Series
                A preferred stock
            
            -
            
            -
            
            -Series
                H preferred stock
            
            14
            
            -
            
            14Common
                stock
            
            10
            
            -
            
            10Additional
                paid in capital
            
            66,458
            
            287
            ++
            66,745Accumulated
                deficit
            
            (73,195)
            
            -
            
            (73,195)Other
                comprehensive income
            
            502
            
            -
            
            502Total
                Stockholder's deficit
            
            (6,211)
            
            287
            
            (5,924)Total
                liabilities and stockholder's deficit
            
            381
            
            -
            
            381++
                Aggregate adjustment in accrued dividends for Series E Preferred
                Stock**Summary
                statements of operations**Net
                income (loss)
            
            10,407
            
            -
            
            10,407Preferred
                Dividends
            
            (709)
            
            70
            *
            (639)Net
                income (loss) to common stockholders
            
            9,698
            
            70
            
            9,768Basic
                Earnings (loss) per share
            
            $1.36
            
            $0.01
            
            $1.37Diluted
                Earnings (loss) per share
            
            $0.42
            
            $0.00
            
            $0.42*
                Adjustment in preferred dividends for Series E Preferred Stock, recorded
                during the period that it
                occurred.





51


**NOTE
      16 - SUBSEQUENT EVENTS**


In
        August
        2006, ATSI initiated a private placement offering for the sale of Units.
        The
        Units are being offered at a unit price of $0.20 and each Unit is comprised
        of one share of common stock and one warrant. Through October 25,
        2006, ATSI has raised $250,000. Under the private offering, each unit of
        common
        stock is sold at a set price of $0.20 per share. The investors also received
        an
        additional warrant to purchase ATSI common stock for every unit of common
        stock
        acquired. In accordance with the warrant agreement, the warrants will expire
        in
        five years from the date of issuance and have an exercise price of $0.60.
        The
        common stock issued as a result of the private placement will not be registered
        under the Securities Act of 1933.





**ITEM
              8.**
            **CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                DISCLOSURE.**





NONE.





**ITEM
              8A.**
            **CONTROLS
                AND PROCEDURES.**





**Evaluation
      of Disclosure Controls and Procedures**





The
      Company has adopted and implemented disclosure controls and procedures designed
      to provide reasonable assurance that all reportable information will be
      recorded, processed, summarized and reported within the time period specified
      in
      the SEC’s rules and forms. Under the supervision and with the participation of
      the Company's management, including the Company's President and Chief Executive
      Officer and the Company’s Controller and Principal Financial Officer, the
      Company has evaluated the effectiveness of the design and operation of its
      disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e)
      as of
      the end of the period covered by this report. Based on that evaluation, the
      President and Chief Executive Officer and the Controller and Principal Financial
      Officer have concluded that these disclosure controls and procedures are not
      effective as of the end of the period covered by this report.





We
      identified deficiencies in our internal controls over financial reporting
      related to the accounting for convertible debt with conversion features
      contingent upon future prices of our stock and convertible debt with detachable
      warrants, primarily with respect to accounting for derivative liabilities in
      accordance with EITF 00-19 and SFAS 133. Further, we identified deficiencies
      related to the accounting for certain liquidation preferences in our Preferred
      Stock instruments. Since January 2006, we are: 1) implementing better
      controls and procedures over the accounting for debt and equity instruments
      and
      2) improving supervision and training of our accounting staff. We are continuing
      our efforts to improve and strengthen our control processes and procedures
      to
      fully remedy these deficiencies. Our management and directors will continue
      to
      work with our auditors and other outside advisors to ensure that our controls
      and procedures are adequate and effective.





**Changes
      in Internal Control Over Financial Reporting**





There
      were no changes in the Company's internal control over financial reporting
      during the fourth fiscal quarter covered by this report that have had a material
      effect or are reasonably likely to have a material effect on internal control
      over financial reporting.





**PART
      III**





**ITEM
              9.**
            **DIRECTORS,
                EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
                SECTION
                16(A) OF THE EXCHANGE ACT.**




**Business
      Experience**





52


The
      following table contains the name, age of our directors and executive
      officers.





**Name**
            **Age**
            **Position
                Held**Arthur
                L. Smith
            41
            President,
                Chief Executive Officer and DirectorRuben
                Caraveo
            38
            Sr.
                Vice President, Operations and TechnologyAntonio
                Estrada
            32
            Corporate
                ControllerJohn
                R. Fleming
            52
            Interim
                Executive Chairman of the BoardMurray
                R. Nye
            53
            Director





*Arthur
      L. Smith* has
      served as our Chief Executive Officer and Director since May 2003. Mr. Smith
      also served as the President of ATSI de Mexico S.A de C.V. from August 2002
      to
      April 2003, as our Chief Executive Officer and a Director from June 1996 to
      July
      2002 and as our President since our formation in June 1996 to July 1998. Mr.
      Smith also served as President, Chief Operating Officer and a director of
      ATSI-Canada since its formation in May 1994. From December 1993 until May 1994,
      Mr. Smith served in the same positions with Latcomm International Inc., which
      amalgamated with Willingdon Resources Ltd. to form ATSI-Canada in May 1994.
      From
      June 1989 to December 1993, Mr. Smith was employed as director of international
      sales by GeoComm Partners, a satellite-based telecommunications company located
      in San Antonio, providing telecommunications services to Latin America. Mr.
      Smith has over 16 years’ experience in the telecommunications industry.





*Ruben
      R. Caraveo* has
      served as our Sr. Vice
      President of Operations and Technology since
      August 2006, and is also our Cheif Operations Officer for Digerati Networks,
      Inc. Mr. Caraveo also served as Vice President of Sales and Operations from
      May
      2003 to July 2006. Mr. Caraveo is responsible for VoIP Carrier Sales, Network
      Operations, MIS, and the delivery of VoIP Carrier Services. Prior to joining
      ATSI, Mr. Caraveo served as Vice President of Operations and Engineering at
      Vycera Communications where he was responsible for overseeing all daily
      operations, including Network Operations, Engineering, Marketing, and the
      Network Trouble Reporting and Resolution departments. His prior experience
      also
      includes positions with Worldtel Interactive, Frontier, and WorldCom. Mr.
      Caraveo is armed with more than 17 years’ telecommunications industry
      experience, specializing in the areas of Carrier Sales, Network Operations,
      Engineering, Data and Systems Analysis, Product Marketing, and Systems
      Development. Mr. Caraveo attended California State University, Northridge,
      School of Engineering.





*Antonio
      Estrada* has ** served
      as
      our Corporate Controller since May 2003. From January 2002 through January
      2003,
      Mr. Estrada served as our Director of International Accounting and Treasurer.
      From January 2001 to January 2002, Mr. Estrada served in various roles within
      ATSI, including International Accounting Manager and general Accountant. Prior
      to joining ATSI in 1999 he served as a Senior Accountant for the Epilepsy
      Association of San Antonio and South Texas. Mr. Estrada has more than 9 years’
experience in the telecommunications industry, financial reporting, treasury
      management, internal audit and accounting. Mr. Estrada graduated from the
      University of Texas at San Antonio, with a Bachelors of Business Administration,
      with a concentration in Accounting.





*John
      R. Fleming* has
      served as our Interim Executive Chairman of the Board since August 2002 and
      as
      one of our Directors since January 2001. Mr. Fleming is the principal and
      founder of Vision Corporation, an early-stage investment company that focuses
      on
      communications technologies, service and hardware. Prior to forming Vision
      Corporation, Mr. Fleming served as President, International of IXC
      Communications, Inc. from April 1998 to December 1999. Immediately prior to
      that
      he served as IXC’s President of Emerging Markets from December 1997, as
      Executive Vice President of IXC from March 1996 through November 1997 and as
      Senior Vice President of IXC from October 1994 through March 1996. He served
      as
      Vice President of Sales and Marketing of IXC from its formation in July 1992
      until October 1994. Prior to that, Mr. Fleming served as Director of Business
      Development and Director of Carrier Sales of CTI from 1986 to March 1990 and
      as
      Vice President of Marketing and Sales of CTI from March 1990 to July 1992.
      Mr.
      Fleming was a Branch Manager for Satellite Business Systems from 1983 to 1986.





53


*Murray
      R. Nye* has
      served as one of our Directors since its formation in June 1996. Mr. Nye also
      served as of the Chief Executive Officer and a director of ATSI-Canada from
      its
      formation in May 1994. From December 1993 until May 1994, Mr. Nye served in
      the
      same positions with Latcomm International Inc., which company amalgamated with
      Willingdon Resources Ltd. to form ATSI-Canada in May 1994. From 1992 to 1995,
      Mr. Nye served as President of Kirriemuir Oil & Gas Ltd. From 1989 until
      1992, Mr. Nye was self-employed as a consultant and Mr. Nye is again currently
      self-employed as a consultant. Mr. Nye serves as a director of D.M.I.
      Technologies, Inc., an Alberta Stock Exchange-traded company.




**Audit
      Committee and Audit Committee Financial Expert**





The
      Company does not presently have an audit or compensation committee or other
      board committee performing equivalent functions. The Company’s Board of
      Directors performs all functions of the audit committee and compensation
      committee. The Company does not have an audit committee financial expert because
      none of its current directors have the necessary training or experience to
      qualify as a financial expert.





**Section
      16(a) Beneficial Ownership Reporting Compliance**





Section
      16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s
      directors and executive officers and persons who own more than 10% of a
      registered class of the Company’s equity securities to file various reports with
      the Securities and Exchange Commission concerning their holdings of, and
      transactions in, securities of the Company. Copies of these filings must be
      furnished to the Company. Based on a review of the copies of such forms
      furnished to the Company and other information, the Company believes that,
      during the fiscal year ended July 31, 2006, the following individuals failed
      to
      report transactions in the Company’s equity securities or reported transactions
      late:





**Name
                and Position**
            **Number
                of Transactions Not Reported**
            **Number
                of Reports Filed Late**
            **Number
                of Transactions Reported Late**Arthur
                L. Smith, President and Director
            0
            12
            8Ruben
                R. Caraveo, Sr. Vice President
            15
            0
            0Antonio
                Estrada, Controller
            0
            13
            11John
                R. Fleming
            5
            0
            0Murray
                R. Nye
            5
            0
            0




**Code
      of Ethics**





ATSI
      Communications, Inc. adopted an
      Executive Code of Ethics that applies to the Chief Executive Officer, Chief
      Financial Officer, Controller and other members of our management team. The
      Board of Directors approved the code of Ethics on December 7, 2004. The
      Executive Code of Ethics may be viewed on our Website, www.atsi.net .
      Upon
      request, a copy of the Executive Code of Ethics will be provided without charge
      upon written request to ATSI Communications, Inc., 3201 Cherry Ridge, Building
      C, Suite 300, San Antonio, Texas 78230





**ITEM
      10.**  **EXECUTIVE
      COMPENSATION.**





**Summary
      Compensation Table**





The
      following table sets forth information concerning the compensation earned during
      the Company’s last three fiscal years by the Company’s Chief Executive Officer
      and each of the Company’s four most highly compensated executive officers whose
      total cash compensation exceeded $100,000 for services rendered in all
      capacities for the fiscal year ended July 31, 2006 and 2005 (collectively,
      the
“Named Executive Officers”).




54





**Annual
                Compensation**
            
            **Long-Term
                Compensation****Awards**
            
            **Payouts****Name
                And Principal Position**
            
            **Fiscal**
              **Year**
            
            **Salary
                ($)**
            
            **Stock**
              **Grant
                ($)**
            
            **Other
                Annual Compensation****($)(1)**
            
            **Restricted
                Stock**
              **Awards
                ($)**
            
            **Securities**
              **Underlying**
              **Options/**
              **SARs
                (#)**
            
            **LTIP
                Payout**
              **($)**
            
            **All
                Other Compens-****ation
                ($)**Arthur
                L. Smith
              CEO
                & President
            
            2006
              2005
              2004
            
            $128,000
              $128,000
              $128,000
            
            $40,000
              $31,500
              -
            
            -
              -
              -
            
            -
              -
              -
            
            $84,000
                (2)
              $67,200
                (2)
              -
            
            -
              -
              -
            
            -
              -
              -Ruben
                Caraveo
              Sr.
                Vice President
            
            2006
              2005
              2004
            
            $115,000
              $115,000
              $115,000
            
            $32,000
              $26,250
              -
            
            -
              -
              -
            
            -
              -
              -
            
            $76,000
                (2)
              $60,000
                (2)
            
            -
              -
              -
            
            -
              -
              -Antonio
                Estrada
              Corporate
                Controller
            
            2006
              2005
              2004
            
            $87,000
              $80,000
              $65,000
            
            $32,000
              $26,250
              -
            
            -
              -
              -
            
            -
              -
              -
            
            $76,000
                (2)
              $55,520
                (2)
            
            -
              -
              -
            
            -
              -
              -





(1)
            Certain
                of the Company’s executive officers receive personal benefits in addition
                to salary. The Company has concluded that the aggregate amount of
                such
                personal benefits does not exceed the lesser of $5,000 or 10% of
                annual
                salary and bonus for any Named Executive Officer.





(2)
            Stock
                options granted during fiscal 2006 and fiscal 2005 have an exercise
                price
                of $0.16





**Option
      SAR Grants**





The
      following table contains information relating to options granted to each
      of ** the
      Name
      Executive Officers during the year ended July 31, 2006.





**OPTION/SAR
      GRANTS IN LAST FISCAL YEAR**





**Individual
                Grants****Name**
            **Number
                of Securities Underlying Options**
            **Percent
                of Total Options Granted to Employees in Fiscal
                Year**
            **Exercise
                Price**
            **Expiration
                Date**Arthur
                L. Smith
            525,000
            21%
            $0.16
            October
                3, 2015Ruben
                Caraveo
            475,000
            19%
            $0.16
            October
                3, 2015Antonio
                Estrada
            475,000
            19%
            $0.16
            October
                3, 2015




**Aggregate
      options exercisable and unexercisable during fiscal 2006**





The
      following table contains information relating to outstanding options held by
      the
      Named Executive Officers.





**AGGREGATED
      OPTION/SAR EXERCISES IN LAST FISCAL YEAR**


**AND
      FISCAL YEAR END OPTION/SAR VALUES**


**Shares**
              **Acquired**
              **On**
              **Exercise**
            
            **Value**
              **Realized**
            
            **Number
                of Securities Underlying Unexercised Options at
                FYE(#)**
            
            **Value
                of In-the-Money Options at FYE ($)****Name**
            
            **(#)**
            
            **($)**
            
            **Exercisable**
            
            **Unexercisable**
            
            **Exercisable**
            
            **Unexercisable**Arthur
                L. Smith
            
            -
            
            -
            
            321,333
            
            623,667
            
            $51,413
            
            $99,787Ruben
                Caraveo
            
            -
            
            -
            
            285,667
            
            564,333
            
            $45,707
            
            $90,294Antonio
                Estrada
            
            -
            
            -
            
            257,667
            
            564,333
            
            $41,227
            
            $90,294





55


**COMPENSATION
      OF DIRECTORS**





ATSI
      Directors are reimbursed their reasonable out-of-pocket expenses in connection
      with their travel to and attendance at meetings of the Board of Directors.
      In
      addition, each Director that is not an officer of the Company receives 1,500
      shares of Common Stock for each meeting of the Board attended in person and
      $250
      for each meeting attended by telephone. During fiscal 2006, ATSI issued a total
      of 350,000 shares of our common stock as part of a stock grant, valued at
      $56,000, to outside directors. Additionally, during Fiscal 2005, ATSI issued
      a
      total of 400,000 shares of our common stock as part of the stock grant, valued
      at $84,000, to outside directors.




** **Aggregate
      options exercisable and unexercisable during fiscal 2006**





The
      following table reflects the Company’s director’s shares covered by both
      exercisable and unexercisable stock options as of July 31, 2006.





**Shares**
              **Acquired**
              **On**
              **Exercise**
            
            **Value**
              **Realized**
            
            **Number
                of Securities Underlying Unexercised Options at
                FYE(#)**
            
            **Value
                of In-the-Money Options at FYE ($)****Name**
            
            **(#)**
            
            **($)**
            
            **Exercisable**
            
            **Unexercisable**
            
            **Exercisable**
            
            **Unexercisable**John
                Fleming
            
            -
            
            -
            
            208,333
            
            416,666
            
            $33,333
            
            $66,666Murray
                Nye
            
            -
            
            -
            
            208,333
            
            416,666
            
            $33,333
            
            $66,666










**ITEM
      11.**  **SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT** **





The
      following table lists the beneficial ownership of shares of our Common Stock
      and
      Series A Preferred Stock by (i) all persons and groups known by the Company
      to
      own beneficially more than 5% of the outstanding shares of our Common Stock
      or
      Series A Preferred Stock, (ii) each director and nominee, (iii) the Named
      Executive Officers, and (vi) all directors and officers as a group. Information
      with respect to officers, directors and their families as of July 31, 2006
      and
      is based on the books and records of the Company and information obtained from
      each individual. Information with respect to other stockholders is based upon
      the Schedule 13D or Schedule 13G filed by such stockholders with the Securities
      and Exchange Commission. Unless otherwise stated, the business address of each
      individual or group is the same as the address of the Company's principal
      executive office and solely the person indicated beneficially owns all
      shares *.*




56




**NAME
                OF**
            
            **COMMON**
            
            **%
                OF**
            
            **SERIES
                A**
            
            **%
                OF**
            
            **TOTAL
                VOTING**
            
            **%
                OF****INDIVIDUAL
                OR GROUP**
            
            **STOCK**
            
            **CLASS
                (1)**
            
            **PREFERRED
                STOCK**
            
            **CLASS
                (2)**
            
            **INTEREST**
            
            **CLASS
                (3)**5%
                STOCKHOLDERSEdward
                Corcoran
            
            0
            
            *
            
            500
            
            18.2%
            
            743
            
            *6006
                W. 159th StreetBldg.
                C 1-WOak
                Forest, IL 60452Gerald
                Corcoran
            
            0
            
            *
            
            500
            
            18.2%
            
            743
            
            *11611
                90th AvenueSt.
                John, IN 46373Joseph
                Migilio
            
            0
            
            *
            
            500
            
            18.2%
            
            743
            
            *13014
                Sandburg Ct.Palos
                Park, IL 60464Jeffrey
                Tessiatore
            
            0
            
            *
            
            500
            
            18.2%
            
            743
            
            *131
                Settlers Dr.Naperville,
                IL 60565Gary
                Wright
            
            0
            
            *
            
            750
            
            27.3%
            
            1,115
            
            *3404
                Royal Fox Dr.St.
                Charles, IL 60174**INDIVIDUAL
                OFFICERS,****DIRECTORS
                AND NOMINEES**Arthur
                L. Smith
            
            945,385
            (4)
            5.1%
            
            -
            
            *
            
            945,385
            (4)
            5.1%President,
                Chief Executive OfficerDirectorAntonio
                Estrada
            
            566,000
            (5)
            3.1%
            
            -
            
            *
            
            566,000
            (5)
            3.1%Corporate
                ControllerRuben
                R. Caraveo
            
            594,500
            (6)
            3.2%
            
            -
            
            *
            
            594,500
            (6)
            3.2%Sr.
                Vice PresidentJohn
                R. Fleming
            
            650,090
            (7)
            3.5%
            
            -
            
            *
            
            650,090
            (7)
            3.5%DirectorMurray
                R. Nye
            
            650,000
            (8)
            3.5%
            
            -
            
            *
            
            650,000
            (8)
            3.5%DirectorALL
                OFFICERS ANDDIRECTORS
                AS A GROUP
            
            3,405,975
            (9)
            18.5%
            
            -
            
            *
            
            3,405,975
            (9)
            18.5%




*
        Less
        than 1%




(1)
              Based
                  on 18,451,101 shares of Common Stock outstanding as of July 31,
                  2006. Any
                  shares represented by options exercisable within 60 daysAfter
                  July 31, 2006 are treated as being outstanding for the purpose
                  of
                  computing the percentage of class for such person but not for any
                  other
                  purpose.
  (2)
                Based
                    on 2,750 shares of Series A Preferred Stock outstanding as of
                    July 31,
                    2006.
 (3)
                Based
                    on 18,451,101 shares of Common Stock outstanding as of July 31,
                    2006. Any
                    shares represented by options exercisable within 60 days After
                    July 31, 2006 are treated as being outstanding for the purpose
                    of
                    computing the percentage of class for such person but not for
                    any other
                    purpose.
 (4)
                  Includes
                      321,333 shares subject to options exercisable at July 31,
                      2006.
 (5)
                  Includes
                      257,667 shares subject to options exercisable at July 31,
                      2006..
 (6)
                  Includes
                      285,667 shares subject to options exercisable at July 31,
                      2006.
 (7)
                    Includes
                        208,333 shares subject to options exercisable at July 31,
                        2006.
 (8)
                    Includes
                        208,333 shares subject to options exercisable at July 31,
                        2006.
 (9)
                      Includes
                          1,281,333 shares subject to options exercisable at July
                          31,
                          2006.


**ITEM
      12.**  **CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS.**





In
      December 2002, ATSI entered into a note payable with a related party, a director
      of ATSI, Mr. John R. Fleming, in the amount of $25,000. The note called for
      12
      monthly payments of $2,163.17 including interest, commencing on February 1,
      2003. The note has an interest rate of 7% annually and a maturity date of
      January 1, 2004. During fiscal 2004 ATSI made payments towards this note in
      the
      amount of $9,000. As of July 31, 2006 the principal balance is $16,000 and
      the
      accrued interest is $4,800. Additionally, at July 31, 2006, ATSI had a payable
      of approximately $47,352 for board fees and related expenses.





In
      May
      2006, ATSI entered into a short-term note payable with Fiesta Communications,
      Inc. as part of a joint management and marketing agreement. Arthur L Smith,
      ATSI’s CEO and President is a shareholder of Fiesta Communications, Inc. The
      note payable is for an amount of $120,000. The note payable has a maturity
      date
      of October 5, 2006 and accrues interest at the rate of 8% annually. The note
      payable calls for payment of principal and accrued interest at maturity. On
      October 13, 2006, ATSI paid off the total principal balance of $120,000 and
      accrued interest of $2,900.





57


**ITEM
      13.**  **EXHIBITS
      AND REPORTS ON FORM 8-K**





The
      following documents are exhibits to this report.





2.1
            Plan
                and Agreement of Merger of ATSI Communications, Inc. with and into
                ATSI
                Merger Corporation, dated as of March 24, 2004.*(Exhibit
                2.1 to Form 8-K of ATSI filed on May 24,
                2004)*




3.1
            Articles
                of Incorporation of ATSI Merger Corporation.*(Exhibit
                3.1 to Form 8-K of ATSI filed on May 24,
                2004)*





3.2
            Bylaws
                of ATSI Merger Corporation.*(Exhibit
                3.2 to Form 8-K of ATSI filed on May 24,
                2004)*





3.3
            Articles
                of Merger of ATSI Communications, Inc. with and into ATSI Merger
                Corporation.*(Exhibit
                3.3 to Form 8-K of ATSI filed on May 24,
                2004)*





4.1
            Securities
                Purchase Agreement between The Shaar Fund Ltd. and ATSI dated July
                2, 1999*(Exhibit
                10.33 to Registration statement on Form S-3 (No. 333-84115) filed
                August
                18, 1999)*





4.2
            Common
                Stock Purchase Warrant issued to The Shaar Fund Ltd. by ATSI dated
                July 2,
                1999*(Exhibit
                10.35 to Registration statement on Form S-3 (No. 333-84115) filed
                August
                18, 1999)*





4.3
            Registration
                Rights Agreement between The Shaar Fund Ltd. and ATSI dated July
                2, 1999*(Exhibit
                10.36 to Registration statement on Form S-3 (No. 333-84115) filed
                August
                18, 1999)*





4.4
            Securities
                Purchase Agreement between The Shaar Fund Ltd. and ATSI dated September
                24, 1999*(Exhibit
                10.39 to Registration statement on Form S-3 (No. 333-84115) filed
                October
                26, 1999)*





4.5
            Common
                Stock Purchase Warrant issued to The Shaar Fund Ltd. by ATSI dated
                September 24, 1999*(Exhibit
                10.41 to Registration statement on Form S-3 (No. 333-84115) filed
                October
                26, 1999)*





4.6
            Registration
                Rights Agreement between The Shaar Fund Ltd. and ATSI dated September
                24,
                1999*(Exhibit
                10.42 to Registration statement on Form S-3 (No. 333-84115) filed
                October
                26, 1999)*





4.7
              Formof
                  Modification of Convertible Note*(Exhibit
                  4.6 to Registration statement on Form S-3 (No. 333-35846) filed
                  April 28,
                  2000)*





4.8
            Securities
                Purchase Agreement between The Shaar Fund Ltd. and ATSI dated February
                22,
                2000*(Exhibit
                4.5 to Registration statement on Form S-3 (No. 333-89683) filed April
                13,
                2000)*





4.9
            Common
                Stock Purchase Warrant issued to The Shaar Fund Ltd. by ATSI dated
                February 22, 2000*(Exhibit
                4.7 to Registration statement on Form S-3 (No. 333-89683) filed April
                13,
                2000)*





4.10
            Registration
                Rights Agreement between The Shaar Fund Ltd. and ATSI dated February
                22,
                2000*(Exhibit 4.9 to Registration statement on Form S-3 (No. 333-89683)
                filed
                April 13, 2000)*





4.11
            Convertible
                Debenture Agreement*(Exhibit
                4.37 to Annual Report on Form 10-K for the year ended July 31, 2003
                filed
                November 12, 2003)*





4.12
            ConvertiblePromissory
                Notes issued to Recap Marketing & Consulting, LLP*.
                (Exhibit 4.1 to form 10-QSB for the period Ended January 31, 2005
                filed
                March 15, 2005)*





4.13
            ConvertiblePromissory
                Note issued to Franklin Cardwell and Jones, PC. dated November 1,
                2004*(Exhibit
                4.2 to form 10-QSB for the period Ended January 31, 2005 filed March
                15,
                2005)*





4.14
            ConvertiblePromissory
                Notes issued to Recap Marketing & Consulting, LLP.*(Exhibit
                4.1 to form 10-QSB for the period Ended April 30, 2005 filed June
                14,
                2005)*





58


4.15
            ConvertiblePromissory
                Notes issued to Recap Marketing & Consulting, LLP.*(Exhibit
                4.1 to form 10-QSB for the period Ended July 31, 2005 filed October
                24,
                2005)*





4.16
            Agreement
                to Extend Promissory Note dated December 1, 2005 between ATSI
                Communications, Inc. and Franklin, Cardwell & Jones, PC.*(Exhibit 4.1 to form 10-QSB for the period Ended October 31, 2005
                filed
                December 15, 2005)*





4.17
            Secured
                Promissory Note and Security Agreement dated November 4, 2005 between
                ATSI
                Communications, Inc. and CSI Business Finance, Inc.*(Exhibit
                4.2 to form 10-QSB for the period Ended October 31, 2005 filed December
                15, 2005)*





4.18
            Convertible
                Debenture Agreement*(Exhibit
                4.18 to Annual Report on Form 10-KSB for the year ended July 31,
                2006
                filed October 30, 2006)**





4.19
            Promissory
                Note dated May 5, 2006 between Telefamilia Communications, Inc. and
                Fiesta
                Communications, Inc.*(Exhibit
                4.19 to Annual Report on Form 10-KSB for the year ended July 31,
                2006
                filed October 30, 2006)**





10.1
                  StockPurchase
                      Agreement with Telemarketing (Sale of ATSICOM)*(Exhibit
                      10.1 to Form 8-K filed June 16, 2003)***





10.2
            Interconnection
                Agreement TELMEX and ATSICOM (English summary) (*Exhibit
                10.26 to Annual Report on Form 10-K for year ended July 31, 2003
                filed
                November 12, 2003)*





10.3
            Interconnection
                Agreement TELMEX and ATSICOM (English Translation)*(Exhibit
                10.27 to Amended Annual Report on Form 10-K/A for the year ended
                July 31,
                2003 filed March 2, 2004)*





10.4
            Confidential
                Settlement Agreement and Mutual Release, Note Payable and Lock out
                agreement between ATSI and Alfonso Torres Roqueni, dated October
                1, 2004.*(Exhibit
                10.1 to Form 10-QSB for the quarter ended October 31, 2004 filed
                December
                15, 2004)*





10.5
            Extension
                to consulting agreements with Hunter M. A. Carr and Donald W. Sapaugh
                dated November 1, 2004.*(Exhibit 10.1 to Form 10-QSB for the quarter ended January 31, 2005
                filed
                March 15, 2005)*





10.6
            Extension
                of consulting agreements (Amendment No: 1) with Hunter M. A. Carr
                and
                Donald W. Sapaugh dated March 1, 2005.*(Exhibit
                10.1 to Form 10-QSB for the quarter ended April 30, 2005 filed June
                14,
                2005)*





10.7
            Settlement
                Agreement (at mediation) with James C. Cuevas, Raymond G. Romero,
                Texas
                Workforce Commission and ATSI-Texas dated March 28, 2005.*(Exhibit
                10.2 to Form 10-QSB for the quarter ended April 30, 2005 filed June
                14,
                2005)*





10.8
            Order
                granting Joint Motion to dismiss all claims against ATSI Communications,
                Inc. (A Nevada Corp., formerly a Delaware Corp.) by Helen G. Schwartz,
                Chapter 7 Trustee for TeleSpan, Inc. dated August 29, 2005.*(Exhibit 10.18 to annual report Form 10-KSB for the year ended July
                31,
                2005 filed October 18, 2005)*





10.9
            Agreement
                of compromise, settlement and release between ATSI Communications,
                Inc.
                and Vianet, Inc. dated August 10, 2005.*(Exhibit
                10.19 to annual report Form 10-KSB for the year ended July 31, 2005
                filed
                October 18, 2005)*





10.10
            Mutual
                release and Termination Agreement betweenHunter
                M. A. Carr and Donald W. Sapaughand
                ATSI Communications, Inc. dated June 1, 2005.*(Exhibit
                10.20 to annual report Form 10-KSB for the year ended July 31, 2005
                filed
                October 18, 2005)*





10.11
            Confidential
                Settlement Agreement and Mutual release dated October 31, 2005 between
                ATSI Communications, Inc. and Telemarketing de Mexico S.A de
                C.V.*(Exhibit 10.1 to quarterly report Form 10QSB for the quarter ended
                October
                31, 2005 filed December 15,
                2005)*




59




10.12
            Stock
                Purchase Agreement dated October 15, 2005 between ATSI Communications,
                Inc. and Alejandro Sanchez Guzman (Sale of ATSIMex Personal S.A de
                C.V.)*(Exhibit 10.2 to quarterly report Form 10QSB for the quarter ended
                October
                31, 2005 filed December 15,
                2005)*





10.13
            Factoring
                Agreement dated November 4, 2005 between ATSI Communications, Inc.
                and CSI
                Business Finance, Inc.*(Exhibit
                10.3 to quarterly report Form 10QSB for the quarter ended October
                31, 2005
                filed December 15, 2005)*





10.14
            Confidential
                Settlement Agreement and Mutual release dated December 2, 2005 between
                ATSI Communications, Inc. and Carlos Kauachi/Dean Witter
                Reynolds.*(Exhibit 10.1 to quarterly report Form 10QSB for the quarter ended
                January
                31, 2006 filed March 23, 2006)*





10.15
            Factoring
                Agreement dated February 20, 2006 between ATSI Communications, Inc.
                and
                CSI Business Finance, Inc.*(Exhibit
                10.2 to quarterly report Form 10QSB for the quarter ended January
                31, 2006
                filed March 23, 2006)*





10.16
            Agreement
                of Compromise, Settlement and Release dated May 31, 2006 between
                ATSI
                Communications, Inc. and Ntera Holdings, Inc.*(Exhibit 10.1 to quarterly report Form 10QSB for the quarter ended
                April
                30, 2006 filed June 13, 2006)*





10.17
            Agreement
                of Compromise, Settlement and Release dated May 27, 2006 between
                ATSI
                Communications, Inc. and Richard C. Benkendorf.*(Exhibit
                10.2 to quarterly report Form 10QSB for the quarter ended April 30,
                2006
                filed June 13, 2006)*





21
            Subsidiaries
                of ATSI (*Exhibit
                21 to Annual Report on Form 10-K for year ended July 31, 2004 filed
                November 9, 2004)*





31.1
            Certification
                of our President and Chief Executive Officer, under Section 302 of
                the
                Sarbanes-Oxley Act of 2002.***





31.2
            Certification
                of our Corporate Controller and Principal Financial Officer, under
                Section
                302 of the Sarbanes-Oxley Act of 2002.
                *





32.1
            Certification
                of our President and Chief Executive Officer, under Section 906 of
                the
                Sarbanes-Oxley Act of 2002.***





32.2
            Certification
                of our Corporate Controller and Principal Financial Officer, under
                Section
                906 of the Sarbanes-Oxley Act of 2002.***





99.1
            FCC
                Radio Station Authorization - C Band*(Exhibit
                10.10 to Registration statement on Form S-4 (No. 333-05557) filed
                June 7,
                1996)*





99.2
            FCC
                Radio Station Authorization - Ku Band*(Exhibit
                10.11 to Registration statement on Form 10 (No. 333-05557) filed
                June 7,
                1996)*





99.3
            Section
                214 Certification from FCC (*Exhibit
                10.12 to Registration statement on Form 10 (No. 333-05557) filed
                June 7,
                1996)*





99.4
            Comercializadora
                License (Payphone License) issued to ATSI-Mexico*(Exhibit
                10.24 to Registration statement on Form 10 (No. 000-23007) filed
                August
                22, 1997)*




60




99.5
            Network
                Resale License issued to ATSI-Mexico*(Exhibit
                10.25 to Registration statement on Form 10 (No. 000-23007) filed
                August
                22, 1997)*





99.6
            Shared
                Teleport License issued to Sinfra (*Exhibit
                99.7 to Amended Annual Report on Form 10-K for year ended July 31,
                1999
                filed April 14, 2000)*





99.7
            Packet
                Switching Network License issued to SINFRA*(Exhibit
                10.26 to Registration statement on Form 10 (No. 000-23007) filed
                August
                22, 1997)*





99.8
            Value-Added
                Service License issued to SINFRA*(Exhibit 99.9 to Amended Annual Report on Form 10-K for year ended
                July
                31, 1999 filed April 13, 2000)*





99.9
            Public
                Utility Commission of Texas ("PUC") approval of transfer of the Service
                Provider Certificate of Authority ("SPCOA") from Hinotel, Inc. to
                ATSI's
                subsidiary, Telefamilia Communications, Inc. Dated October 25,
                2004.*(Exhibit 99.1 on Form 10-QSB for the quarter ended October 31, 2004
                filed
                December 15, 2004)*





**ITEM
              14.**
            **PRINCIPAL
                ACCOUNTANT FEES AND
                SERVICES.**





The
      Company paid the following fees to its principal independent accountants for
      services during the fiscal years ended July 31, 2006 and July 31,
      2005.





Year
                Ended July 31,Description
                of Fees
            
            2006
            
            2005Audit
                Fees
            
            $
            32,000
            
            $
            29,000Other
                Fees
            
            
            24,500
            
            
            -0-Tax
                Fees
            
            
            -0-
            
            
            -0-





The
      Audit
      Committee has instructed Malone and Bailey, PC that any fees for non-audit
      services must be approved before being incurred.





61




**SIGNATURES**





In
      accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
      this report to be signed on its behalf by the undersigned, thereunto duly
      authorized.





**ATSI
              COMMUNICATIONS, INC.**Date:****October
              30, 2006
            By:
            /s/
              Arthur L. SmithArthur
              L. SmithPresident
              and Chief Executive Officer





In
      accordance with the Exchange Act, this report has been signed below by the
      following persons on behalf of the registrant and in the capacities and on
      the
      dates indicated.








**Signature**
            
            **Title**
            
            **Date**/s/
              Arthur L. Smith
            
            Principal
              Executive Officer and Director
            
            October
              30, 2006Arthur L. Smith/s/
              Antonio Estrada
            
            Principal
              Accounting Officer
            
            October
              30, 2006Antonio Estrada
            
            Principal Finance Officer/s/
              John R. Fleming
            
            Director
            
            October
              30, 2006John R. Fleming/s/
              Murray R. Nye
            
            Director
            
            October
              30, 2006Murray
                R. Nye






62