**U.S.
      SECURITIES AND EXCHANGE COMMISSION**


WASHINGTON,
      D.C. 20549




**FORM
      10-Q**




**[X]
      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT**


**OF
      1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006**




**[ 
      ] 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: 000-24985*









**PACIFICNET
      INC.**


(Exact
      name of registrant in its charter)





**Delaware**
            
            **91-2118007**(State
                or other jurisdiction of
              incorporation
                or organization)
            
            (I.R.S.
                Employer
              Identification
                Number)




23/F,
                TOWER A, TIMECOURT, NO.6 SHUGUANG XILI,CHAOYANG
                DISTRICT, BEIJING, CHINA 100028
            
            n/a(Address
                of principal executive offices)
            
            (Zip
                Code)




Registrant’s
      telephone number, including area code:  0086-10-59225000


Indicate
        by check mark whether the registrant (1) has filed all reports required by
        Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
        12 months (or for such shorter period that the registrant was required to
        file
        such reports), and (2) has been subject to such filing requirements for the
        past
        90 days.  YES ý NO o
  Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of
        the
        Exchange Act).
  Large
        Accelerated Filer o Accelerated
        Filer o Non-accelerated filer ý
  Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act). YES o NO ý
  As
        of
        October 31, 2006, there were 11,671,836 shares of the issuer’s common stock, par
        value $0.0001 per share, outstanding.
  1
 **PACIFICNET
        INC.**
 **Form 10-Q
        for the Quarterly Period Ended September 30, 2006**
  **TABLE
        OF CONTENTS**
 
 **PART I.**
              **FINANCIAL
                  INFORMATION**Item
                  1.
              Financial
                  Statements (Unaudited)
              3-4Condensed
                  Consolidated Balance Sheets
              5Condensed
                  Consolidated Statements of Operations
              6Condensed
                  Consolidated Statements of Cash Flows
              7-8Notes
                  to Condensed Consolidated Financial Statements
              9Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              25Item
                  3.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              37Item
                  4.
              Controls
                  and Procedures
              38**PART II.**
              **OTHER
                  INFORMATION**Item
                  1.
              Legal
                  Proceedings
              42Item
                  1A.
              Risk
                  Factors
              42Item
                  2.
              Unregistered
                  Sales of Equity Securities and Use of Proceeds
              42Item
                  3.
              Defaults
                  upon Senior Securities
              42Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              42Item
                  5.
              Other
                  Information
              42Item
                  6.
              Exhibits
              42Signatures
              
              43
  2
 **PART
        I - FINANCIAL INFORMATION**
  **ITEM
        1. FINANCIAL STATEMENTS**
  **PACIFICNET
        INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        BALANCE SHEETS**
 (In
        thousands of United States dollars, except par values and share
        numbers)
  **ASSETS**
              
              **September
                  30,**
                **2006**
                **(Unaudited)**
              
              **December
                  31,**
                **2005**
                **(Audited)***Current
                  Assets:*Cash
                  and cash equivalents
              
              $
              7,439
              
              $
              9,579Restricted
                  cash - pledged bank deposit
              
              
              232
              
              
              1,652Accounts
                  receivables, net of allowances for doubtful accounts of $622 and
                  $5
              
              
              13,116
              
              
              5,998Inventories
              
              
              2,039
              
              
              1,836Loan
                  receivable from related parties
              
              
              4,879
              
              
              2,520Loan
                  receivable from third parties
              
              
              1,219
              
              
              1,572Other
                  current assets
              
              
              8,782
              
              
              7,973Total
                  Current Assets
              
              
              37,706
              
              
              31,130Property
                  and equipment, net
              
              
              8,731
              
              
              4,300Investments
                  in affiliated companies and subsidiaries
              
              
              776
              
              
              410Marketable
                  equity securities - available for sale
              
              
              545
              
              
              539Goodwill
              
              
              18,385
              
              
              14,824Other
                  assets - debt issuance costs (net)
              
              
              927
              
              
              -**TOTAL
                  ASSETS**
              
              **$**
              67,070
              
              $
              51,203**LIABILITIES
                  AND STOCKHOLDERS' EQUITY**Current
                  Liabilities:Bank
                  line of Credit
              
              
              1,082
              
              
              1,060Bank
                  loans-current portion
              
              
              992
              
              
              188Capital
                  lease obligations - current portion
              
              
              133
              
              
              126Accounts
                  payable
              
              
              3,931
              
              
              3,186Accrued
                  expenses and other payables
              
              
              2,586
              
              
              4,620Income
                  tax payable
              
              
              113
              
              
              296Subscription
                  payable
              
              
              390
              
              
              775Loans
                  payable to related party
              
              
              373
              
              
              369Total
                  Current Liabilities
              
              
              9,600
              
              
              10,620
  3
 Long-term
                  liabilities:Bank
                  loans - non current portion
              
              
              1,436
              
              
              6Capital
                  lease obligations - non current portion
              
              
              148
              
              
              78Convertible
                  Debenture
              
              
              8,000
              
              
              -Warrant
                  Liability
              
              
              268
              
              
              -Compound
                  Embedded Derivatives Liability
              
              
              357
              
              
              -Interest
                  discount
              
              
              (1,530
              )
              
              -Liquidated
                  damages liability
              
              
              800
              
              
              -Total
                  long-term liabilities
              
              
              9,479
              
              
              84Total
                  liabilities
              
              
              19,079
              
              
              10,704Minority
                  interest in consolidated subsidiaries
              
              
              11,586
              
              
              8,714Commitments
                  and contingenciesStockholders'
                  Equity:Preferred
                  stock, par value $0.0001, Authorized - 5,000,000 sharesIssued
                  and outstanding - none
              
              
              --
              
              
              --Common
                  stock, par value $0.0001, Authorized - 125,000,000 shares;
                Issued
                  and outstanding:September
                  30, 2006 - 13,983,497 shares issued, 11,646,836
                  outstandingDecember
                  31, 2005 - 12,000,687 issued, 10,831,024 outstanding
              
              
              1
              
              
              1Treasury
                  stock, at cost (2006 Q3: 2,336,661 shares, 2005: 1,169,663 shares)
              
              
              (243
              )
              
              (119
              )Additional
                  paid-in capital
              
              
              62,201
              
              
              57,690Cumulative
                  other comprehensive income (loss)
              
              
              266
              
              
              247Accumulated
                  deficit
              
              
              (25,386
              )
              
              (25,990
              )Less
                  stock subscription receivable
              
              
              (434
              )
              
              (44
              )Total
                  Stockholders' Equity
              
              
              36,405
              
              
              31,785**TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY**
              
              **$**
              67,070
              
              $
              51,203
  
 The
        accompanying condensed notes are an integral part of these consolidated
        financial statements.
 4
 **PACIFICNET
        INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
 (Unaudited.
        In thousands of United States dollars, except loss per share and share
        amounts)
 
 THREE
                  MONTHS ENDED
                SEPTEMBER
                  30
              
              NINE
                  MONTHS ENDED
                SEPTEMBER
                  302006
              
              2005
                (as
                  restated)
              
              2006
              
              2005
                (as
                  restated)Revenues
              
              $
              12,875
              
              $
              11,047
              
              $
              47,239
              
              $
              32,539Services
              
              
              5,445
              
              
              4,908
              
              
              22,145
              
              
              14,232Product
                  sales
              
              
              7,430
              
              
              6,139
              
              
              25,094
              
              
              18,307Cost
                  of revenues
              
              
              (10,392
              )
              
              (8,852
              )
              
              (33,352
              )
              
              (25,979
              )Services
              
              
              (3,352
              )
              
              (3,113
              )
              
              (10,635
              )
              
              (9,314
              )Product
                  sales
              
              
              (7,040
              )
              
              (5,739
              )
              
              (22,717
              )
              
              (16,665
              )Gross
                  margin
              
              
              2,483
              
              
              2,195
              
              
              13,887
              
              
              6,560Selling,
                  general and administrative expenses
              
              
              (2,482
              )
              
              (1,004
              )
              
              (9,982
              )
              
              (3,261
              )Inventory
                  write-down charge
              
              
              (486
              )
              
              -
              
              
              (486
              )
              
              -Bad
                  debt expense
              
              
              (657
              )
              
              -
              
              
              (657
              )
              
              -Depreciation
                  and amortization
              
              
              (255
              )
              
              (133
              )
              
              (474
              )
              
              (275
              )Interest
                  expense
              
              
              (395
              )
              
              (182
              )
              
              (851
              )
              
              (182
              )**EARNINGS/(LOSS)
                  FROM OPERATIONS**
              
              
              (1,792
              )
              
              876
              
              
              1,437
              
              
              2,842Interest
                  income
              
              
              96
              
              
              155
              
              
              177
              
              
              155Gain
                  in change in fair value of derivatives
              
              
              1,004
              
              
              -
              
              
              1,212
              
              
              -Liquidated
                  damages expense
              
              
              (800
              )
              
              -
              
              
              (800
              )
              
              -Sundry
                  income, net
              
              
              (113
              )
              
              171
              
              
              173
              
              
              577**Earnings/(Loss)
                  before Income Taxes and Minority Interest**
              
              
              (1,605
              )
              
              1,202
              
              
              2,199
              
              
              3,574Provision
                  for income taxes
              
              
              (119
              )
              
              13
              
              
              (319
              )
              
              (51
              )Share
                  of earnings of associated companies
              
              
              80
              
              
              8
              
              
              129
              
              
              12Minority
                  interests
              
              
              529
              )
              
              (612
              )
              
              (1,405
              )
              
              (1,916
              )**Net
                  Earnings/(Loss) Available to Common Stockholders**
              
              $
              (1,115
              )
              $
              611
              
              $
              604
              
              $
              1,619**BASIC
                  EARNINGS PER SHARE**
              
              $
              (0.10
              )
              $
              0.06
              
              $
              0.05
              
              $
              0.16**DILUTED
                  EARNINGS PER SHARE**
              
              $
              (0.10
              )
              $
              0.05
              
              $
              0.05
              
              $
              0.15
  The
        accompanying condensed notes are an integral part of these consolidated
        financial statements.
  5
 **PACIFICNET
        INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY**
  
 **PREFERRED
                  STOCK**
              
              **COMMON
                  STOCK**
              
              **ADDITIONAL
                  PAID-IN CAPITAL**
              
              **STOCK
                  SUBSCRIPTION**
                **RECEIVABLE**
              
              **CUMULATIVE
                  OTHER COMPREHENSIVE INCOME**
              
              **ACCUMUL**
                **ATED**
                **DEFICIT**
              
              **TREASURY
                  STOCK**
              
              **TOTAL
                  STOCKHOLDERS' EQUITY****BALANCE
                  AT DECEMBER 31, 2005**
                **(10,831,024
                  SHARES)**
              
              
              **--**
              
              **$**
              **1**
              
              **$**
              **57,690**
              
              **$**
              **(44**
              **)**
              **$**
              **247**
              
              
              **($25,990**
              **)**
              
              **($119**
              **)**
              **$**
              **31,785**Net
                  earnings/(loss)
              
              
              --
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              604
              
              
              
              
              
              604Exercise
                  of stock options for cash and receivable (369,000 shares)
              
              
              --
              
              
              
              
              
              784
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              784Issuance
                  of common stock for acquisition of subsidiaries (471,012
                  shares)
              
              
              --
              
              
              
              
              
              3,578
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,578PIPE
                  related expenses
              
              
              --Repurchase
                  of common shares (less 24,200 shares)
              
              
              --
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (124
              )
              
              (124
              )Cumulative
                  foreign exchange gain/(loss)
              
              
              --
              
              
              
              
              
              
              
              
              
              
              
              19
              
              
              
              
              
              
              
              
              19Stock-based
                  compensation
              
              
              
              
              
              
              
              
              120
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              120Issuance
                  of warrants for fees of issuing convertible debt (16,000
                  warrants)
              
              
              
              
              
              
              
              
              29
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              29Less
                  stock subscription receivable
              
              
              --
              
              
              
              
              
              
              
              
              (390
              )
              
              
              
              
              
              
              
              
              
              
              (390
              )**BALANCE
                  AT SEPTEMBER 30, 2006**
                **(11,646,836
                  SHARES)**
              
              
              --
              
              **$**
              **1**
              
              **$**
              **62,201**
              
              **$**
              **(434**
              **)**
              **$**
              **266**
              
              **$**
              **(25,386**
              **)**
              **$**
              **(243**
              **)**
              **$**
              **36,405**
 
 
 
 The
        accompanying condensed notes are an integral part of these consolidated
        financial statements.
  6
 **PACIFICNET
        INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 (Unaudited.
        In thousands of United States dollars, except earnings per share and share
        amounts)
 NINE
                  MONTHS ENDED
                SEPTEMBER
                  30**2006**
              
              **2005****Cash
                  Flows from operating activities**Net
                  earnings / (loss)
              
              $
              604
              
              $
              1,619*Adjustment
                  to reconcile net earnings/(loss) to net cash provided by (used
                  in)
                  operating activities:*Equity
                  loss of associated company
              
              
              (129
              )
              
              (12
              )Provision
                  for income taxes
              
              
              (183
              )
              
              51Provision
                  for allowance for doubtful accounts
              
              
              657
              
              
              -Minority
                  Interest
              
              
              1,405
              
              
              1,916Depreciation
                  and amortization
              
              
              1,173
              
              
              274Inventory
                  write-down charge
              
              
              486
              
              
              -Stock-based
                  compensation
              
              
              120
              
              
              *-*Change
                  in fair value of derivatives
              
              
              (1,212
              )
              
              -Amortization
                  of interest discount
              
              
              307
              
              
              -Liquidated
                  damages expense
              
              
              800
              
              
              -*Changes
                  in current assets and liabilities net of effects from purchase
                  of
                  subsidiaries:*Accounts
                  receivable and other current assets**
              
              
              (8,281
              )
              
              (3,029
              )Inventories
              
              
              (572
              )
              
              (452
              )Accounts
                  payable and other accrued expenses
              
              
              (1,591
              )
              
              (234
              )***Net
                  cash provided by (used in) operating activities***
              
              
              **(6,416**
              **)**
              
              **133****Cash
                  flows from investing activities**Decrease
                  in restricted cash
              
              
              1,420
              
              
              3,132Increase
                  in purchase of marketable securities
              
              
              -
              
              
              (409
              )Acquisition
                  of property and equipment
              
              
              (3,806
              )
              
              (1,844
              )Acquisition
                  of subsidiaries and affiliated companies
              
              
              (419
              )
              
              (1,183
              )Loans
                  receivable from third parties
              
              
              353
              
              
              (1,597
              )Loans
                  receivable from related party
              
              
              (2,359
              )
              
              (1,349
              )***Net
                  cash used in investing activities***
              
              
              **(4,811**
              **)**
              
              **(3,250**
              **)****CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Loan
                  payable to related party
              
              
              4
              
              
              513Advances
                  (repayments) under bank line of credit
              
              
              22
              
              
              (7
              )Increase
                  (repayments) of amount borrowed under capital lease obligations
              
              
              77
              
              
              29Repurchase
                  of treasury shares
              
              
              (124
              )
              
              -Proceeds
                  from exercise of stock options and warrants
              
              
              174
              
              
              981Net
                  proceeds from issuance of convertible debenture
              
              
              7,500
              
              
              -Advances
                  under bank loans
              
              
              1,152
              
              
              5***Net
                  cash provided by financing activities***
              
              
              8,805
              
              
              1,521
  7
 **Effect
                  of exchange rate change on cash and cash
                  equivalents**
              
              
              282
              
              
              **-****NET
                  DECREASE IN CASH AND CASH EQUIVALENTS**
              
              
              (2,140
              )
              
              (1,596
              )**CASH
                  AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD**
              
              
              9,579
              
              
              6,764**CASH
                  AND CASH EQUIVALENTS, END OF THE PERIOD**
              
              **$**
              7,439
              
              **$**
              5,168**CASH
                  PAID FOR:**Interest
              
              $
              744
              
              $
              182Income
                  taxes
              
              $
              502
              
              $
              34**NON-CASH
                  INVESTING AND FINANCING ACTIVITIES:**Fixed
                  assets acquired under banking loan
              
              
              1,082
              
              
              -Options
                  exercised for shares receivable
              
              
              434
              
              
              -Investments
                  in subsidiaries acquired through the issuance of common stock
              
              $
              3,578
              
              $
              2,871
  The
        accompanying condensed notes are an integral part of these consolidated
        financial statements.
  8
 **PACIFICNET
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 (Amounts
        expressed in United States dollars unless otherwise stated)
 
  **1.
        BASIS OF PRESENTATION**
  ***Description
        of Operations*** - PacificNet
        Inc. (referred to herein as "PacificNet" or the "Company") a leading provider
        of
        CRM and telecom services, ecommerce and gaming technology in Hong Kong, Macao,
        and China. Through our subsidiaries, PacificNet provides outsourcing services,
        telecom (VAS) services, products (telecom & gaming) services and the design
        and distribution of entertainment kiosks and gaming machines. Our business
        process outsourcing (BPO) services include call centers, providing customer
        relationship management (CRM), mail order direct marketing and telemarketing
        services, and our information technology outsourcing (ITO) includes software
        programming and development. We are also a provider of value-added telecom
        services in China, which is comprised of interactive voice response (IVR)
        systems, call center management systems, and voice over Internet protocol
        (VOIP), short messaging services (SMS), multimedia messaging services (MMS),
        wireless application protocol (WAP), mobile internet and 3G services. The
        Company's operations are primarily based in China, including Hong Kong and
        Macau
        Special Administrative Region and Asian markets.
  ***Condensed
        Consolidated Financial Statements*** - The
        condensed consolidated financial statements have been prepared in accordance
        with U.S. generally accepted accounting principles (“GAAP”) for interim
        financial reporting consistent in all material respects with those applied
        in
        the Company’s Annual Report on Form 10-KSB, as amended, for the year ended
        December 31, 2005, but do not include all disclosures required by GAAP. You
        should read these interim condensed consolidated financial statements in
        conjunction with the audited financial statements, including the notes thereto,
        and the other information set forth in the Company’s Annual Report on Form
        10-KSB, as amended, for the year ended December 31, 2005. The condensed
        unaudited consolidated financial statements include the accounts of PacificNet
        Inc. and its subsidiaries and variable interest entities (“VIEs”) for which the
        Company is the primary beneficiary. All significant intercompany balances
        and
        transactions have been eliminated in consolidation. In the opinion of
        management, all material adjustments considered necessary for a fair
        presentation of the Company’s interim results have been reflected. PacificNet’s
        2005 Annual Report on Form 10-KSB includes certain definitions and a summary
        of
        significant accounting policies and should be read in conjunction with this
        report. The results for interim periods are not necessarily indicative of
        annual results.
  ***Use
        of Estimates*** - The
        preparation of the consolidated financial statements in conformity with GAAP
        requires management to make estimates and assumptions that affect the reported
        amounts of assets and liabilities and disclosure of contingent assets and
        liabilities at the date of the financial statements and reported amounts
        of
        revenues and expenses during the reporting period. Actual results could differ
        from those estimates, and such differences may be material to the financial
        statements. Certain prior year amounts have been reclassified to conform
        to the
        current year presentation.
  **2.
        RECENT ACCOUNTING PRONOUNCEMENTS**
  In
        December 2004, the Financial Accounting Standards Board (“FASB”) issued
        Statement of Financial Accounting Standards (“SFAS”) 123-R, *Share-Based
        Payment* (“SFAS
        123(R)”). SFAS 123(R) replaces SFAS 123, *Accounting
        for Stock-Based Compensation* ,
        and
        supersedes APB Opinion 25, *Accounting
        for Stock Issued to Employees* .
        SFAS
        123(R) requires, among other things, that all share-based payments to employees,
        including grants of stock options, be measured based on their grant-date
        fair
        value and recognized as expense. Effective January 1, 2006, PacificNet adopted
        the fair value recognition provisions of SFAS 123(R) using the modified
        prospective application method. Under this transition method, compensation
        expense recognized for the quarter September 30, 2006, includes the applicable
        amounts of: (a) compensation expense of all stock-based payments granted
        prior
        to, but not yet vested as of January 1, 2006 (based on the grant-date fair
        value
        estimated in accordance with the original provisions of SFAS 123 and previously
        presented in pro forma footnote disclosures), and (b) compensation expense
        for
        all stock-based payments granted subsequent to January 1, 2006 (based on
        the
        grant-date fair value estimated in accordance with the new provisions of
        SFAS
        123(R)). Results for periods prior to January 1, 2006, have not been restated.
        See Note 6 for further details.
  9
 In
        February 2006, the FASB issued SFAS No. 155, *Accounting
        for Certain Hybrid Financial Instruments—an amendment of FASB Statements
        No. 133 and 140* (“SFAS 155”). This statement amends *SFAS
        No. 133,*  *Accounting
        for Derivative Instruments and Hedging Activities* (“SFAS 133”), and SFAS No. 140, *Accounting
        for Transfers and Servicing of Financial Assets and Extinguishments of
        Liabilities* and
        resolves issues addressed in SFAS 133 Implementation Issue No. D1,
“Application of Statement 133 to Beneficial Interest in Securitized
        Financial Assets.” This Statement: (a) permits fair value re-measurement
        for any hybrid financial instrument that contains an embedded derivative
        that
        otherwise would require bifurcation; (b) clarifies which interest-only
        strips and principal-only strips are not subject to the requirements of
        SFAS 133; (c) establishes a requirement to evaluate beneficial
        interests in securitized financial assets to identify interests that are
        freestanding derivatives or that are hybrid financial instruments that contain
        an embedded derivative requiring bifurcation; (d) clarifies that
        concentrations of credit risk in the form of subordination are not embedded
        derivatives; and, (e) eliminates restrictions on a qualifying
        special-purpose entity’s ability to hold passive derivative financial
        instruments that pertain to beneficial interests that are or contain a
        derivative financial instrument. The standard also requires presentation
        within
        the financial statements that identifies those hybrid financial instruments
        for
        which the fair value election has been applied and information on the income
        statement impact of the changes in fair value of those instruments. The Company
        is required to apply SFAS 155 to all financial instruments acquired, issued
        or subject to a re-measurement event beginning January 1, 2007, although
        early adoption is permitted as of the beginning of an entity’s fiscal year. The
        Company is evaluating the provisions of SFAS 155. The effects of adopting
        of SFAS 155 on the Company’s financial statements are not known at this
        time.
  In
        June
        2006, the Financial Accounting Standards Board (“FASB”) issued FASB
        Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an
        Interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the
        accounting for uncertainty in tax positions. This Interpretation requires
        that
        the Company recognize in its financial statements the impact of a tax position
        if that position is more likely than not of being sustained on audit, based
        on
        the technical merits of the position. The provisions of FIN 48 are effective
        for
        the Company on January 1, 2007, with the cumulative effect of the change in
        accounting principle, if any, recorded as an adjustment to opening retained
        earnings. The Company is currently evaluating the impact of adopting FIN
        48 on
        its consolidated financial position, cash flows and results of operations.
  Other
        recent accounting pronouncements issued by the FASB (including its Emerging
        Issues Task Force (“EITF”), the American Institute of Certified Public
        Accountants (“AICPA”), and the SEC did not or are not believed by management to
        have a material impact on the Company's present or future financial
        statements.
  **3.
        EARNINGS PER SHARE**
  Basic
        and
        diluted earnings per share (EPS) amounts in the financial statements are
        computed in accordance with SFAS No. 128, "Earnings Per Share." Basic EPS
        is
        based on the weighted average number of common shares outstanding. Diluted
        EPS
        is based on the weighted average number of common shares outstanding plus
        dilutive common stock equivalents. Basic EPS is computed by dividing net
        earnings available to common stockholders (numerator) by the weighted average
        number of common shares outstanding (denominator) during the period. Diluted
        EPS
        is calculated by dividing net earnings by the weighted average number of
        common
        shares outstanding and other dilutive securities. Dilutive EPS for third
        quarter
        of 2006 exclude the potential dilutive effect of 889,456 warrants because
        their
        impact would be anti-dilutive based on current market prices. 800,000
        convertible debentures are tested by using if-converted method. The result
        shows
        when convertible debentures are included in the computation, diluted EPS
        increases. According to SFAS No.128, those convertible debentures are ignored
        in
        the computation of diluted EPS. All per share and per share information are
        adjusted retroactively to reflect stock splits and changes in par
        value.
  10
 The
        reconciliation of the numerators and denominators of the basic and diluted
        EPS
        calculations was as follows:
 
 Three
                  Months Ended September 30
              
              Nine
                  Months Ended September 302006
              
              2005
              
              2006
              
              2005(IN
                  THOUSANDS OF UNITED STATES DOLLARS, EXCEPT WEIGHTED SHARES AND
                  PER SHARE
                  AMOUNTS)
              
              (IN
                  THOUSANDS OF UNITED STATES DOLLARS, EXCEPT WEIGHTED SHARES AND
                  PER SHARE
                  AMOUNTS)Numerator:
                  earnings/(loss)
              
              $
              (1,115
              )
              $
              611.
              
              $
              604
              
              $
              1,619Denominator:Weighted-average
                  shares used to compute basic EPS
              
              
              11,619,010
              
              
              10,826,983
              
              
              11,171,608
              
              
              10,171,224Dilutive
                  potential from assumed exercise of stock options and
                  warrants
              
              
              -
              
              
              918,760
              
              
              648,881
              
              
              859,147Weighted-average
                  shares used to compute diluted EPS
              
              
              11,619,010
              
              
              11,745,743
              
              
              11,820,489
              
              
              11,030,371Basic
                  earnings per common share:
              
              $
              (0.10
              )
              $
              0.06
              
              $
              0.05
              
              $
              0.16Diluted
                  earnings per common share:
              
              $
              (0.10
              )
              $
              0.05
              
              $
              0.05
              
              $
              0.15
 
 
 **4.
        GOODWILL AND BUSINESS ACQUISITIONS**
  The
        changes in the carrying amount of goodwill for the following reporting periods
        are summarized below:
 
 (US$000s)
              
              Group
                  1.
                Outsourcing
                Services
              
              Group
                  2.
                Telecom
                  Value-Added
                Services
              
              Group
                  3.
                Products
                  (Gaming and Technology)
              
              TotalBalance
                  as of December 31, 2005
              
              $
              3,936
              
              $
              9,788
              
              $
              1,100
              
              $
              14,824Goodwill
                  acquired during the first quarter
              
              
              --
              
              
              461
              
              
              --
              
              
              461Impairment
                  losses
              
              
              --
              
              
              --
              
              
              --
              
              
              --Goodwill
                  written off related to sale of business unit
              
              
              --
              
              
              --
              
              
              --
              
              
              --Balance
                  as of March 31, 2006
              
              $
              3,936
              
              $
              10,249
              
              $
              1,100
              
              $
              15,285Goodwill
                  acquired during the second quarter
              
              
              --
              
              
              1,571
              
              
              429
              
              
              2,000Impairment
                  losses
              
              
              --
              
              
              --
              
              
              --
              
              
              --Goodwill
                  written off related to sale of business unit
              
              
              --
              
              
              --
              
              
              --
              
              
              --Balance
                  as of June 30, 2006
              
              $
              3,936
              
              $
              11,820
              
              $
              1,529
              
              $
              17,285Goodwill
                  acquired during the third quarter
              
              
              --
              
              
              1,100
              
              
              
              
              
              1,100Impairment
                  losses
              
              
              --
              
              
              --
              
              
              --
              
              
              --Goodwill
                  written off related to sale of business unit
              
              
              --
              
              
              --
              
              
              --
              
              
              --Balance
                  as of September 30, 2006
              
              $
              3,936
              
              $
              12,920
              
              $
              1,529
              
              $
              18,385
  11
 **Business
        Acquisitions during the three months ended September 30,
        2006**
 
 **Able
        Entertainment Technology Ltd by PacificNet Games Limited**
 
 On
        August
        3, 2006, PacificNet’s wholly owned subsidiary PacificNet Games Limited
        (“PacGames”, Chinese Company Name [ 太平洋网络游戏有榰公司 ])
        completed the acquisition of 100% of Able Entertainment Technology Ltd.,
        a
        leading gaming technology provider based in the Macau Special Administrative
        Region of China. Upon completion of this transaction, the Company owned 35%
        of
        PacificNet Games Limited. Under the purchase agreement, Able Entertainment
        Technology Ltd represented that is expects to generate an annual profit of
        USD$1,600,000 and will provide for an adjustment to the purchase price if
        PacGames does not achieve an annual net profit of USD$1,600,000 during the
        first
        12-month period ended June 30, 2007, and USD$3,000,000 during the second
        12-month period ended June 30, 2008.
 
 The
        purchase price consideration is 200,000 restricted PACT shares in exchange
        for
        100% of the issued and outstanding shares of Able Entertainment Technology
        Ltd.
        or a 35% ownership interest in PacGames. The company has valued the
        consideration at a price of $5.08, representing the closing market price
        on
        August 3, 2006, the date of acquisition. As of September 30, 2006, 40,000
        total
        restricted shares of PacificNet had been issued for the acquisition and 160,000
        shares were held back as contingent consideration payable upon completion
        of
        certain earnings criteria pursuant to the purchase agreement. The agreement
        also
        provides for a loan of up to $1,600,000 on an as-needed basis and as of
        September 30, 2006, $128,000 was advanced. (See Note 9)
  On
        September 22, 2006, PACT acquired another 10% of PacGames in exchange for
        57,100
        restricted shares of the Company’s common stock. These shares have not been
        issued as of September 30, 2006.
 
 
 **5.
        STOCKHOLDERS' EQUITY**
  a)
        COMMON
        STOCK
  For
        the
        quarter ended September 30, 2006, the Company had the following equity
        transactions: (i)100,000 shares of common stock were issued as a result of
        the
        exercise of stock options for cash and receivable consideration of $220,000
        in
        the aggregate; (ii) 177,500 shares of common stock were released from escrow
        (PACT treasury shares) for acquisition of Able Entertainment and contingent
        consideration for ChinaGoHi valued at $1,303,200 .
 
 Subscription
        receivable of approximately $434,000 represents funds receivable from the
        exercise of options and is presented as a contra equity account in the
        stockholders’ equity section of the consolidated balance sheet.
  12
 b)
        STOCK
        OPTION PLAN - See Note 6 for further details.
  The
        status of the Stock Option Plan as of September 30, 2006, is as
        follows:
 
 OPTIONS
              
              WEIGHTED
                AVERAGE
                EXERCISE
                  PRICEOUTSTANDING,
                  DECEMBER 31, 2005
              
              
              1,575,000
              
              $
              4.00Granted
              
              
              -
              
              
              -Cancelled
              
              
              -
              
              
              -Exercised
              
              
              (24,000
              )
              $
              1.75OUTSTANDING,
                  MARCH 31, 2006
              
              
              1,551,000
              
              $
              4.
                  04Granted
              
              
              -
              
              
              -Cancelled
              
              
              (680,000
              )
              $
              6.57Exercised
              
              
              (245,000
              )
              $
              2.13OUTSTANDING,
                  JUNE 30, 2006
              
              
              626,000
              
              $
              2.03Granted
              
              
              500,000
              
              $
              4.75Cancelled
              
              
              -
              
              $
              -Exercised
              
              
              (100,000
              )
              $
              2.2OUTSTANDING,
                  SEPTEMBER 30, 2006
              
              
              1,026,000
              
              $
              3.34
 
 On
        May
        28, 2006, the board of directors and management approved and authorized the
        cancellation of 680,000 stock options that were previously granted during
        fiscal
        year 2005 that were unvested and unexercised. The option cancellation was
        authorized by the board and the management in order to reduce stock compensation
        expense due to the implementation of FASB 123R.
 
 On
        September 21, 2006, the
        board
        of directors and management approved and authorized the grant to directors,
        officers, employees and consultants of the company (including its subsidiaries)
        of options to purchase up to an aggregate of 500,000 shares of Common Stock
        with
        a $4.75 exercise price. Those options will vest 20% per year commencing from
        January 1 st 2007.
        The contract life for those options is 5 years.
 
 c)
        WARRANTS
  At
        September 30, 2006, the Company had outstanding and exercisable warrants
        to
        purchase an aggregate of 1,007,138 shares of common stock. The weighted average
        remaining life is 3.59 years and the weighted average price per share is
        $10.61
        per share as follows:
  Shares
                  of common stock
              
              EXERCISE
                  PRICE
                PER
                  SHARE
              EXPIRATION
                  DATE OF
                WARRANTS123,456
              
              $7.15
              January
                  15, 2009117,682
              
              $3.89
              November
                  15, 2009350,000
              
              $12.21
              December
                  9, 2009400,000
              
              $12.20
              March
                  13, 201116,000
              
              $12.20
              March
                  13, 20111,007,138
  13
 On
        March
        13, 2006, we issued 400,000 warrants to several institutional investors in
        connection with a private placement of $8 million in convertible debentures.
        On
        the same day we issued 16,000 warrants to our placement agent for the
        transaction. See Note 7 for further details.
  d)
        TREASURY STOCK
  The
        following is a summary of the movement of the Company's shares held as treasury
        stock for the quarterly ended September 30 of 2006:


**Number
                  of**
                **shares**
              
              
              **Remarks**Escrowed
                  shares returned to treasury in 2003
              
              
              800,000Shares
                  purchased in the open market
              
              
              38,154Repurchase
                  of shares from Take 1
              
              
              149,459Cancellation
                  of former employee shares
              
              
              45,000Holdback
                  shares as contingent consideration due to performance targets not
                  yet
                  met
              
              
              1,304,048
              
              
              Includes
                  shares related to Clickcom (78,000); Yueshen (24,200), ChinaGoHi
                  (550,000), Guangzho(Wanrong (138,348); iMobile (153,500), Able
                  Entertainment (160,000), and Allink (200,000)Balance,
                  September 30, 2006
              
              
              **2,336,661**Shares
                  outstanding at September 30, 2006
              
              
              11,646,836Shares
                  issued at September 30, 2006
              
              
              13,983,497
  14
 On
        March
        13, 2006, we repurchased 24,200 restricted shares of our common stock from
        Yueshen, a subsidiary of Shanghai Classic for a repurchase price of RMB1,000,000
        (approximately USD$124,223 using exchange rate of 1USD= 8.05 RMB). The
        repurchase of the shares was proposed by Yueshen and was unanimously agreed
        by
        the both parties.
  **6.
        STOCK-BASED COMPENSATION**
  Prior
        to
        January 1, 2006, PacificNet accounted for awards granted under stock-based
        compensation plans following the recognition and measurement principles of
        APB
        25, *Accounting
        for Stock Issued to Employees* ,
        and
        related interpretations. Accordingly, compensation expense was recognized
        for
        awards granted at an exercise price less than fair market value of the
        underlying common stock on the date of grant. Effective January 1, 2006,
        PacificNet adopted the fair value recognition provisions of SFAS 123(R).
        See
        Note 2 for a description of the Company’s adoption of SFAS 123R. The fair value
        of stock options is determined using the Black-Scholes option pricing model,
        which is consistent with the valuation techniques previously utilized for
        options in footnote disclosures required under SFAS 123, as amended by FASB
        Statement No. 148, “Accounting for Stock-Based Compensation - Transition
        and Disclosure.” The determination of the fair value of stock-based compensation
        awards on the date of grant using an option-pricing model is affected by
        the
        Company’s stock price as well as assumptions regarding a number of complex and
        subjective variables, including the expected volatility of the Company’s stock
        price over the term of the awards, actual and projected employee stock option
        exercise behaviors, risk-free interest rate and expected dividends. The
        compensation costs, which approximated $120,000 for the nine months ended
        September 30, 2006, are recognized on a straight-line base over the option
        vesting term and the amortized cost is included in selling, general and
        administrative expenses. PacificNet elected the modified prospective method
        and
        therefore has not restated results for prior periods. The valuation provisions
        of SFAS 123(R) apply to new grants and unvested grants that were outstanding
        as
        of the effective date.
 
 During
        the quarter ended September 30, 2006, the Company granted 500,000 new stock
        options, 100,000 options were exercised, and zero options were cancelled.
        See
        note 5 b) for the status of the Company’s stock option plan.
  Additional
        information on options outstanding as of September 30, 2006 is as
        follows:
 
 WEIGHTED
                AVERAGE
                EXERCISE
                PRICE
              OPTIONS
              AVERAGE
                REMAINING
                CONTRACTUAL
                LIFEOptions
                  outstanding
              $3.34
              1,026,000
              2.84
                  yearsOptions
                  exercisable
              $2.00
              526,000
              0.82
                  year
   **7.
        CONVERTIBLE DEBENTURES**
  On
        March
        13, 2006, we completed a private placement in which we sold $8,000,000 in
        convertible debentures and issued warrants to purchase up to an aggregate
        of
        400,000 shares of common stock. The debentures are convertible at any time
        into
        shares of our common stock at an initial fixed conversion price of $10.00
        per
        share, subject to adjustments for certain dilutive events. The debentures
        are
        due March 13, 2009. The warrants are exercisable for a period of five years
        at
        an exercise price of $12.20 per share. At the closing of the private placement,
        we prepaid the first year's interest on debentures equal to 5% of the aggregate
        principal amount of debentures. We will pay interest in cash or shares, provided
        that certain conditions are met, at the rate of 6% for the second year the
        debentures are outstanding and then 7% for the third. Beginning January 1,
        2007,
        we are obligated to redeem up to $320,000 every month, plus accrued, but
        unpaid
        interest, liquidated damages and penalties. We also have the option to prepay
        the debentures at any time, provided that certain conditions have been met,
        after the 12 month anniversary of the effective date of the registration
        statement that has been filed with the Securities and Exchange Commission
        with
        respect to the common stock issuable upon conversion of the debentures, some
        or
        all of the outstanding debentures for cash in an amount equal to 120% of
        the
        principal amount outstanding, plus accrued, but unpaid interest, liquidated
        damages and penalties outstanding. At any time after the six month anniversary
        of the effective date of the registration statement, we may force the holders
        to
        convert up to 50% of the then outstanding principal amount of the debentures,
        subject to certain trading conditions being met. If any event of default
        occurs
        under the debentures or other related documents, the holders may elect to
        accelerate the payment of the outstanding principal amount of the
        debenture, plus accrued, but unpaid interest, liquidated damages and penalties,
        which shall become immediately due and payable.
  15
 The
        convertible debt obligates the Company to file a registration statement with
        respect to the shares issuable under the convertible debt note. Due to various
        factors, as of September 30, 2006, the Company had not filed such a registration
        statement. Accordingly, the terms of the convertible note obligate the Company
        to pay liquidated damages to the convertible debenture investors at the rate
        of
        2% of the principal amount of the convertible per month, or $160,000.
        A s
        of
        September 30, 2006, the Company has determined to accrue five months of
        liquidated damages or approximately $800,000, although it is possible that
        the
        Company may not ultimately need to pay the full amount of liquidated
        damages.  The amount has been reflected in the consolidated financial
        statements as a separate line item on the consolidated balance sheet as
“liquidated damages liability” and as a separate line item on the consolidated
        statement of operations as “liquidated damages expense”.
 
 C.E.
        Unterberg, Towbin L.L.C. acted as placement agent and received a negotiated
        cash
        fee in the amount of $449,500 and a warrant to purchase up to 16,000 shares
        at
        an exercise price of $12.20 per share, which expire five years from the date
        of
        issuance. The fair value of these warrants totaled $28,952 and such amount
        was
        charged to other assets, net, and will be amortized over the life of the
        debentures and credited to additional paid-in capital during the nine months
        ended September 30, 2006. Maxim Group also acted as Placement Agent and received
        a cash fee in the amount of $50,000.
  In
        connection with the issuance of the debentures, the Company incurred $1,106,000
        of issuance costs, which primarily consisted of investment banker fees, legal
        and other professional fees. These costs are being amortized and are recorded
        as
        additional expense through three years, the scheduled date on which holders
        have
        the option to require the Company to repurchase the debentures. Amortization
        expense related to the issuance costs during the three months and nine months
        ended September 30, 2006 was $93,000 and $179,000, respectively. At September
        30, 2006, net debt issuance costs associated with the debentures was $927,000
        and is recorded in Other assets, net.
 
 The
        gross
        proceeds of $8,000,000 are recorded as a debenture liability. In addition,
        fair
        values attributed to the Investors’ warrants and to the embedded conversion
        feature in accordance with EITF issue No. 00-19 “Accounting for Derivative
        Financial Instruments Indexed to and Potentially Settled in a Company’s Own
        Stock” are recorded as liabilities. The debt discount consisted of an initial
        $690,642 value related to the Investors’ warrants and a $1,145,640 value
        attributed to the compound embedded derivatives liability, as well as the
        warrants liability. An aggregate gain of $1,211,583 representing the change
        in
        fair value of these derivative liabilities was recognized during the nine
        months
        ended September 30, 2006.
  In
        accordance with recent FASB guidance, due to certain factors, including a
        liquidated damages provision in the registration rights agreement, the Company
        values and accounts for the embedded conversion feature and the warrants
        related
        to the debentures as derivatives. Accordingly, these derivative liabilities
        are
        measured at fair value with changes in fair value reported in earnings as
        long
        as they remain classified as liabilities. The Company reassesses the
        classification at each balance sheet date. If the classification required
        under
        EITF No. 00-19 changes as a result of events during the period, the contract
        should be reclassified as of the date of the event that caused the
        reclassification.
 
 16
 **8.
        SEGMENT INFORMATION**
  The
        Company determines and classified its operating segments in accordance with
        SFAS
        No. 131 “DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED
        INFORMATION.” The Company identifies and classifies its operating segments
        based on reporting entities that exhibit similar long-term financial performance
        based on the nature of the products and services with similar economic
        characteristics such as margins, business practices and target market. The
        operating segments are classified into four major segments which are summarized
        as follows:
  (1)
        Outsourcing Services - involves human voice services such as Business Process
        Outsourcing, CRM, call center, IT Outsourcing and software development services.
        These types of services are conducted through our subsidiaries EPRO,
        Smartime/Soluteck and PacificNet Solution Ltd.
  (2)
        Telecom Value-Added Services - primarily involves machine voice services
        such as
        Interactive Voice Response, SMS and related VAS, which are conducted through
        our
        subsidiaries such as ChinaGoHi (Lion Zone, aka ChinaGoHi), Linkhead, Clickcom
        and Guangzhou 3G.
  (3)
        Products (Telecom & Gaming) - primarily involves communication and gaming
        products, GSM/CDMA/3G Products, Multimedia Communication Kiosks. This Group
        includes the following subsidiaries: PacificNet Communications Limited, iMobile,
        Allink, Take1 and PacificNet Games. PacificNet Games Limited (PacGames) is
        a
        leading developer of Asian electronic gaming machines, multi-player electronic
        gaming technology solutions and gaming related maintenance, IT, and distribution
        services for the leading hotel and casino operators based in the Macau and
        other
        Asian gaming markets.
  (4)
        Other
        Business -other administrative, financial and investment services and non-core
        businesses such as PacificNet Power Limited (PacPower), Pacific Financial
        Services Limited, etc.
  The
        Company's reportable segments are operating units, which represent the
        operations of the Company's significant business operations. Summarized
        financial information concerning the Company's reportable segments is shown
        in
        the following table. The "Other" column includes the Company's other
        insignificant services and corporate related items, and, as it relates to
        segment earnings/(loss), income and expense not allocated to reportable
        segments.
 
 For
                  the three months ended
                September
                  30, 2006
              Group
                  1.
              Group
                  2.
              Group
                  3.
              Group
                  4.
              TotalOutsourcing
                Services
              Telecom
                  Value-Added Services
              Products
                (Telecom
                  & Gaming)
              Other
                  Business($)
              ($)
              ($)
              ($)
              ($)Revenues
              3,733,000
              2,350,000
              6,411,000
              381,000
              12,875,000(%
                  of Total Revenues)
              29%
              18%
              50%
              3%
              100%Earnings
                  / (Loss) from Operations
              113,000
              (833,000)
              (191,000)
              (881,000)
              (1,792,000)(%
                  of Total Earnings)
              -6%
              46%
              11%
              49%
              100%Total
                  Assets
              9,159,000
              18,939,000
              12,813,000
              26,159,000
              67,070,000(%
                  of Total Assets)
              14%
              28%
              19%
              39%
              100%Goodwill
              3,936,000
              12,920,000
              1,529,000
              -
              18,385,000Geographic
                  Area
              HK,
                  PRC
              PRC
              Macau,
                  HK, PRC
              HK,
                  PRC, USA
  17
 For
                  the three months ended September 30, 2005
              Group
                  1.
              Group
                  2.
              Group
                  3.
              Group
                  4.
              TotalOutsourcing
                Services
              Telecom
                  Value-Added Services
              Products
                (Telecom
                  & Gaming)
              Other
                  Business($)
              ($)
              ($)
              ($)Revenues
              3,368,000
              2,870,000
              4,677,000
              132,000
              11,047,000(%
                  of Total Revenues)
              31%
              26%
              42%
              1%
              100%Earnings
                  / (Loss) from Operations
              217,000
              824,000
              172,000
              (337,000)
              876,000(%
                  of Total Earnings)
              25%
              94%
              20%
              -39%
              100%Total
                  Assets
              4,939,000
              9,254,000
              189,000
              28,983,000
              43,365,000(%
                  of Total Assets)
              11%
              21%
              1%
              67%
              100%Goodwill
              3,542,000
              8,702,000
              979,000
              -
              13,223,000Geographic
                  Area
              HK,
                  PRC
              PRC
              Macau,
                  HK, PRC
              HK,
                  PRC, USA
 
 For
                  the nine months ended September 30, 2006
              Group
                  1.
              Group
                  2.
              Group
                  3.
              Group
                  4.
              TotalOutsourcing
                Services
              Telecom
                  Value-Added Services
              Products
                (Telecom
                  & Gaming)
              Other
                  Business($)
              ($)
              ($)
              ($)
              ($)Revenues
              10,312,000
              14,907,000
              18,262,000
              3,758,000
              47,239,000(%
                  of Total Revenues)
              22%
              31%
              39%
              8%
              100%Earnings
                  / (Loss) from Operations
              515,000
              2,011,000
              74,000
              (1,163,000)
              1,437,000(%
                  of Total Earnings)
              36%
              140%
              5%
              -81%
              100%Total
                  Assets
              9,159,000
              18,939,000
              12,813,000
              26,159,000
              67,070,000(%
                  of Total Assets)
              14%
              28%
              19%
              39%
              100%Goodwill
              3,936,000
              12,920,000
              1,529,000
              -
              18,385,000Geographic
                  Area
              HK,
                  PRC
              PRC
              Macau,
                  HK, PRC
              HK,
                  PRC, USA
 
 For
                  the nine months ended September 30, 2005
              Group
                  1.
              Group
                  2.
              Group
                  3.
              Group
                  4.
              TotalOutsourcing
                Services
              Telecom
                  Value-Added Services
              Products
                (Telecom
                  & Gaming)
              Other
                  Business($)
              ($)
              ($)
              ($)Revenues
              9,860,000
              9,024,000
              13,408,000
              247,000
              32,539,000(%
                  of Total Revenues)
              30%
              28%
              41%
              1%
              100%Earnings
                  / (Loss) from Operations
              866,000
              2,413,000
              408,000
              (845,000)
              2,842,000(%
                  of Total Earnings)
              31%
              85%
              14%
              -30%
              100%Total
                  Assets
              4,939,000
              9,254,000
              189,000
              28,983,000
              43,365,000(%
                  of Total Assets)
              11%
              21%
              1%
              67%
              100%Goodwill
              3,542,000
              8,702,000
              979,000
              -
              13,223,000Geographic
                  Area
              HK,
                  PRC
              PRC
              Macau,
                  HK, PRC
              HK,
                  PRC, USA
 
 18
 Product
        and service revenues classified by major geographic areas are as follows
        (in
        US$):
 
 For
                  the three months ended
                September
                  30, 2006
              Hong
                  Kong, Macau
              PRC
              United
                  States
              TotalProduct
                  revenues
              5,261,000
              2,169,000
              -
              7,430,000Service
                  revenues
              3,435,000
              2,010,000
              -
              5,445,000
 
 For
                  the three months ended
                September
                  30, 2005
              Hong
                  Kong, Macau
              PRC
              United
                  States
              TotalProduct
                  revenues
              4,776,000
              1,363,000
              -
              6,139,000Service
                  revenues
              2,305,000
              2,603,000
              -
              4,908,000
 
 For
                  the nine months ended
                September
                  30, 2006
              Hong
                  Kong
                Macau
              PRC
              United
                  States
              TotalProduct
                  revenues
              17,355,000
              7,739,000
              -
              25,094,000Service
                  revenues
              9,970,000
              12,175,000
              -
              22,145,000
 
 For
                  the nine months ended
                September
                  30, 2005
              Hong
                  Kong, Macau
              PRC
              United
                  States
              TotalProduct
                  revenues
              13,538,000
              4,769,000
              -
              18,307,000Service
                  revenues
              6,990,000
              7,242,000
              -
              14,232,000
 
  19
 **9.
        RELATED PARTY TRANSACTIONS**
  *LOAN
        DUE TO AND FROM RELATED PARTIES*
 
 As
        of
        September 30, 2006, there was a total loan receivable of approximately
        $4,879,000 due from related parties while the loan due to related party was
        $373,000.
  As
        of
        September 30, 2006, the related party loan receivables included $1,026,000
        due
        from Take 1, an affiliated company that is 20% owned by PacificNet, $128,000
        due
        from PacificNet Games, an affiliated company that is 45% owned by PacificNet,
        and $3,725,000 due from shareholders and directors of certain of the Company’s
        subsidiaries in connection with the acquisition of these subsidiaries. The
        loans
        receivable from shareholders and directors of these subsidiaries is comprised
        of
        $1,249,000 due from a shareholder of Yueshen, $192,000 due from a director
        of
        Soluteck, and $2,284,000 due from a company owned by a shareholder of Lion
        zone
        (ChinaGoHi). The terms of these related parties loan receivables and payables
        are summarized below:
  *LOAN
        TO TAKE 1 (Cheer Era)*
  Take
        1 is
        an affiliated company and is 20% owned by PacificNet as of September 30,
        2006. A
        convertible loan of $1,026,000 is outstanding from Take 1 as of September
        30,
        2006. Conversion terms of the convertible loan provide PacificNet an option
        at
        any time during the Term to convert in part or in whole of the then outstanding
        loan principle up to $1,026,000 (or HKD$8,000,000) into shares of Take 1
        to
        reach 51% ownership of Take 1. The loan was extended as a working capital
        loan
        to finance the expansion of Take 1's business in Europe and North America.
 
 *LOAN
        TO PACIFICNET GAMES*
  PacGames
        is an affiliated company that is 45% owned by PacificNet as of September
        30,
        2006. A loan of approximately $128,000 is outstanding as of September 30,
        2006
        and is due and payable on July 31, 2007. Payment is due in equal monthly
        installments of approximately $11,752 which include principal repayments
        and an
        implied interest rate of 10%.
 
 *LOAN
        TO YUESHEN'S SHAREHOLDER*
  As
        of
        September 30, 2006, there was a $1,249,000 loan receivable due from the
        shareholder of Yueshen, a subsidiary of the Company. The purpose of the loan
        was
        to repay the working capital loan owed by the predecessor of Yueshen prior
        to
        PacificNet's acquisition, and to finance Yueshen shareholder's other projects.
        This loan is collateralized with 106,240 PacificNet shares owned by the
        shareholder of Yueshen.
 
 The
        Company has been experiencing difficulty recovering the loan receivable due
        from
        Yueshen’s shareholder. Specifically, the Company and the shareholder disagree
        over the outstanding balance owed and are in ongoing discussions about
        recovering the loan amount. As the Company still believes that it has a high
        probability of recovering the debt, it has continued to record the amount
        of the
        loan receivable at the full historical cost. Nevertheless, the Company will
        continue to closely monitor the repayment of the loan.
  20
 *LOAN
        TO SOLUTEK'S DIRECTOR*
  As
        of
        September 30, 2006, there was a loan outstanding of $192,000 receivable from
        a
        director of Soluteck, payable in three equal installments of $72,314 each,
        which
        includes principal plus interest, due on December 14 for three consecutive
        years
        ending 2007. The interest rate for the loan is 8% per annum plus 5% penalty
        interest in case it has not been timely paid. The loan is collateralized
        with
        100,000 PacificNet's shares owned by the borrowing director and Ms Iris Lo,
        and
        the remaining assets of Smartime Holding Ltd.
  *LOAN
        TO A COMPANY OWNED BY A SHAREHOLDER OF LION ZONE
        (CHINAGOHI)*
  As
        of
        September 30, 2006, a loan of $2,284,000 was receivable from a company owned
        by
        a shareholder of Lion Zone (ChinaGoHi). The loan is collateralized with this
        company’s real estate.
  *LOAN
        PAYABLE TO RELATED PARTY*
  As
        of
        September 30, 2006, a loan of $373,000 was payable to a shareholder of EPRO.
        The
        loan was advanced to Epro for working capital purposes. The loan is due on
        August 4, 2010. Interest being charged per annum is at Hong Kong Prime lending
        rate, which was approximately 6.5% per annum in 2005 and 8% in
        2006.
  **10.
        COMMITMENTS AND CONTINGENCIES**
  *Operating
        leases* .
        The
        Company leases warehouse and office space under operating leases with fixed
        monthly rentals. None of the leases included contingent rentals. Lease expense
        charged to operations for 2006 Q3 amounted to $332,000 (2005 Q3: $136,000).
        Future minimum lease payments under non-cancelable operating leases are $463,000
        for Oct. 2006 through Sep. 2007 and $312,000 for Oct. 2007 through Sep.
        2012.
  *Restricted
        Cash* -
        The
        Company has a $232,000 pledged bank deposit for Epro which represents overdraft
        protections with certain financial institutions.
  *Bank
        Line of Credit* As of
        September 30, 2006, the Company’s outstanding bank lines of credit were as
        follows:
 
 (i)
              Epro
                  has an overdraft banking facility with certain major financial
                  institutions in the aggregate amount of $949,000, which is secured
                  by a
                  pledge of its fixed deposits of $232,000, pursuant to the following
                  terms:
                  interest will be charged at the Hong Kong Prime Rate per annum
                  and payable
                  at the end of each calendar month or the date of settlement, whichever
                  is
                  earlier.
 (ii)
              Smartime
                  has an overdraft banking facility with a large Hong Kong bank in
                  the
                  aggregate amount of $133,000. This overdraft facility is personally
                  pledged by the deposit account of a director of
                  Smartime.
 
 *Minimum
        Stated Capital Requirements* .
        Guangzhou Dianxun Co, Limited (DE) ("Dianxun"), a subsidiary of the Group,
        is
        carrying on business as a telecommunication value-added service provider
        in the
        People's Republic of China ("PRC"). Initially, Dianxun obtained a certificate
        (the "Certificate") from PRC authorities to transact business in accordance
        with
        PRC Telecommunication Rules which require that all telecommunication value-added
        service providers n conduct business if the Certificate is granted, and if
        the
        Company maintains a minimum capital requirement of at least
        RMB10,000,000.
  21
 In
        order
        to satisfy the capital requirement of RMB 10,000,000, the shareholders of
        Dianxun contributed relevant assets equivalent to RMB9,000,000 on behalf
        of
        Dianxun and such assets were verified by an independent professional accountant.
        Subsequently, such assets were returned back to the shareholders. In the
        opinion
        of management, even though the capital requirement is not currently fulfilled,
        Dianxun can continue to carry on business. No provision for any loss arising
        from the consequential actions that may be taken by the authority in the
        PRC and
        any potential penalties or claims for the Company not maintaining the minimum
        stated capital requirements of the PRC have been made in these financial
        statements.
  Dianxun's
        contribution to consolidated revenues and net earnings for 2006 was
        approximately 0.17% and -23% respectively. Pursuant to a request by the PRC
        authorities, PacificNet agreed to loan Clickcom the remaining balance of
        the
        registration capital to provide the stated capital in accordance with PRC
        laws.
  *Bank
        Loans.* Bank
        loans represent the following at September 30, 2006:
  Secured
                  [1]
              $1,200,000Unsecured
              1,228,000Less:
                  current portion
              992,000Non
                  current portion
              $1,436,000
  Bank
        Loans are generated by two of the Company's subsidiaries. One of the
        subsidiaries is Pacificnet Epro Holdings Limited, a company incorporated
        in the
        Hong Kong Special Administrative Region of the PRC, primarily engaged in
        the
        business of providing call center and customer relationship management (CRM)
        services as well as other business outsourcing services.
  [1]
        The
        loans were secured by the following: joint and several personal guarantees
        executed by certain directors of the subsidiary of the Company; corporate
        guarantee executed by a subsidiary of the Company; second legal charge over
        a
        property owned by a subsidiary of the Company; and pledged bank deposits
        of
        $232,000 of a subsidiary of the Company.
  (Aggregate
        future maturities of borrowing for the next five years are as follows: Oct.
        2006
        to Sep. 2007: $944,000, Oct. 2007 to Sep. 2008: $247,000 and Oct. 2008 to
        Sep.
        2009: $190,000, thereafter: none.)
  The
        remaining bank loans of $1,047,000 are generated by PacificNet Inc. relating
        to
        a fixed asset bought during the first quarter with total cost of $1,648,000.
        The
        repayment of the bank loan was $56,000. (Aggregate future maturities of
        borrowing for the following period are as follows: Less than 1 year: $48,000,
        1-5 year: $223,000 and after 5 years: $776,000)
 
 *Capital
        Lease Obligations* .
        The
        Company leases various equipments under capital leases expiring in various
        years
        through 2008. Aggregate minimum future lease payments under capital leases
        for
        each of the next five years are as follows:
  (2006:
        $133,000; 2007: $95,000; 2008: $53,000, and thereafter: none.)
 
 Liquidated
        damages: Refer to Note 7 re the details behind the liquidating damages
        commitment for the Company.
 
 22
 
 **11.
        OTHER CURRENT ASSETS**
  Other
        current assets consist of the following at September 30, 2006 (in
        thousands):
 
 September
                  30, 2006
                $
                  (in thousands)Deposit
              
              $
              1,814Prepayment
              
              
              1,274Other
                  receivables
              
              
              5,377Prepaid
                  Expense
              
              
              376Provision
                  for Bad Debt
              
              
              (59
              )Total
              
              $
              8,782
   **12.
        INVENTORY**
  Inventories
        of approximately $2 million consist primarily of finished goods and represent
        telecommunication products such as mobile phone, rechargeable phone cards,
        smart
        chip, and interactive voice response cards and are accounted for using the
        first-in, first out (FIFO) method. Most inventories are held by the Company’s
        Linkhead subsidiary.
 
 In
        the
        beginning of the third quarter of 2006, the Chinese government announced
        that it
        would implement several new policies regarding mobile phone value-added service
        providers effective July 10, 2006. These policies include a “double
        confirmation” policy and the requirement that value-added service providers
        provide one-month trial subscriptions. By requiring that mobile phone customers
        “double-confirm” their intention to purchase services, and by requiring free
        subscriptions, the Chinese government has negatively affected value-added
        service providers.
 
 Since
        the
        Company sells hardware to value-added service providers that have been
        negatively affected by the new mobile phone policies, during the three months
        ended September 30, 2006, we recorded an adjustment to inventory of $486,000. The
        write
        down was considered prudent after an assessment by the Company’s internal
        control team determined that the inventory was considered not readily saleable
        as a result of the recent government policy restrictions.
 
 Although
        the Chinese government appeared to lessen restrictions by the end of the
        third
        quarter, the effect of lesser demand already necessitated a write-down of
        inventory.
 
 **13.
        INCOME TAXES**
  The
        Company is registered in the state of Delaware and has operations in primarily
        three tax jurisdictions - the PRC, Hong Kong and the United States. For
        operations in the United States of America, Hong Kong and Taiwan, the Company
        has incurred net accumulated operating loss for income tax purposes. The
        Company
        believes that it is more likely than not that these net accumulated operating
        loss will not be utilized in the future. Therefore, the Company has provided
        full valuation allowance for the deferred tax assets arising from the losses
        at
        these locations as of September 30, 2006. Accordingly, the Company has no
        net
        deferred tax assets as of September 30, 2006.
 
 23
 **14.
        SUBSEQUENT EVENTS**
  **Stock
        Option Exercise**
  On
        October 1, 2006, PacificNet issued 25,000 shares of common stock as a result
        of
        stock option exercise in accordance to PacificNet’s stock option
        plan.
 
 **Allink
        Hong Kong Limited**
  On
        August
        11, 2006, PacificNet ’ s
        wholly
        owned subsidiary PacificNet Communications Limited ( “ PacCom ” )
        agreed
        to the acquisition of 80% of Allink Hong Kong Limited (Allink, Chinese name “瘺瑑濦晧港有榰公司” ),
        a
        leading provider of security and surveillance technology and services based
        in
        the Hong Kong Special Administrative Region of China, through the issuance
        of
        200,000 restricted shares of PacificNet Inc. If the transaction is completed,
        PacificNet Inc. will own 80% of Allink. Under the purchase agreement, Allink
        has
        committed to generate an annual profit of HKD$3,000,000 (approx USD$385,000)
        and
        will provide for an adjustment to the purchase price if the Allink does not
        achieve an annual net profit of HKD$3,000,000. Allink operates one of the
        leading CCTV communication and security surveillance technology and services
        provider utilizing extra low voltage technology for property management
        companies in Hong Kong and Macau, China. The transaction was originally expected
        to be completed in the third quarter of 2006, however since the necessary
        due
        diligence has not been completed, the Company has been unable to consummate
        the
        merger.
 
 The
        consideration to be paid follows:
  (1)
              The
                  purchase consideration for 80% of the equity interest of the Company
                  is
                  payable entirely (100%) in restricted shares of PACT, equivalent
                  to
                  200,000 restricted PACT shares.
  (2)
              The
                  purchase price is payable upon achievement of certain quarterly
                  earn-out
                  targets based on net profits.
 
 
 
 24
 **ITEM
        2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**
  THE
        FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE INFORMATION
        CONTAINED IN THE FINANCIAL STATEMENTS OF THE COMPANY AND THE NOTES THERETO
        APPEARING ELSEWHERE HEREIN AND IN CONJUNCTION WITH THE MANAGEMENT'S DISCUSSION
        AND ANALYSIS SET FORTH IN THE COMPANY'S ANNUAL REPORT ON FORM 10-KSB FOR
        THE
        YEAR ENDED DECEMBER 31, 2005, AS AMENDED.
 
  **PRELIMINARY
        NOTE REGARDING FORWARD-LOOKING STATEMENTS**
  The
        statements contained in this Form 10-Q that are not purely historical are
        forward-looking statements within the meaning of Section 27A of the Securities
        Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
        1934,
        as amended. These include statements about the Company's expectations, beliefs,
        intentions or strategies for the future, which are indicated by words or
        phrases
        such as "anticipate," "expect," "intend," "plan," "will," "the Company
        believes," "management believes" and similar words or phrases. The
        forward-looking statements are based on the Company's current expectations
        and
        are subject to certain risks, uncertainties and assumptions, including those
        set
        forth in the discussion under "Description of Business," including the "Risk
        Factors" described in that section, and "Management's Discussion and Analysis
        or
        Plan of Operation." The Company's actual results could differ materially
        from
        results anticipated in these forward-looking statements. All forward-looking
        statements included in this document are based on information available to
        the
        Company on the date hereof, and the Company assumes no obligation to update
        any
        such forward-looking statements.
 
  **FACTORS
        THAT COULD AFFECT FUTURE RESULTS**
  Factors
        that might cause actual results, performance or achievements to differ
        materially from those projected or implied in such forward-looking statements
        include, among other things:
  l
              the
                  impact of competitive products;l
              changes
                  in laws and regulations;
 l
              adequacy
                  and availability of insurance coverage;l
              limitations
                  on future financing;
 l
              increases
                  in the cost of borrowings and unavailability of debt or equity
                  capital;l
              the
                  inability of the Company to gain and/or hold market
                  share;
 l
              exposure
                  to and expense of resolving and defending liability claims and
                  other
                  litigation;l
              consumer
                  acceptance of the Company's
                  products;
 l
              managing
                  and maintaining growth;l
              customer
                  demands;
 l
              market
                  and industry conditions,l
              the
                  success of product development and new product introductions into
                  the
                  marketplace;
 l
              the
                  departure of key members of management, andl
              the
                  effect of the United States War on Terrorism, as well as other
                  risks and
                  uncertainties that are described from time to time in the Company's
                  filings with the Securities and Exchange
                  Commission.
  25
 Regarding
        one of our subsidiaries, for example, Epro is engaged in the business of
        providing outsourced call center services with over 15 years of field experience
        in Hong Kong and China. The factors that could affect current and future
        results
        are as follows:
  l
              insufficient
                  sales forces for business development & account
                  servicing;l
              lack
                  of PRC management team in
                  operation;
 l
              less
                  familiarity on partners' product knowledge;l
              deployment
                  costs of a new HR application and the costs to upgrade the call
                  center
                  computer system;
 l
              increasing
                  operations costs (cost of salaries, rent, interest rates & inflation)
                  under rising economy in Hong Kong;l
              insufficient
                  brand awareness initiatives in the
                  market;
 l
              salary
                  increases due to an active labor market in Hong Kong and GuangZhou;
                  andl
              increasing
                  competition of call center solutions in the Hong Kong and PRC
                  markets.
  **CRITICAL
        ACCOUNTING POLICIES AND ESTIMATES**
  Our
        discussion and analysis or plan of operations is based upon our consolidated
        financial statements, which have been prepared in accordance with accounting
        principles generally accepted in the United States. The preparation of these
        financial statements requires us to make estimates and judgments that affect
        the
        reported amounts of assets, liabilities, revenues and expenses, and related
        disclosure of contingent assets and liabilities.
  On
        an
        on-going basis, we evaluate our estimates, including those related to accounts
        receivable reserves, provisions for impairment losses of affiliated companies
        and other intangible assets, income taxes and contingencies. We base our
        estimates on historical experience and on various other assumptions that
        are
        believed to be reasonable under the circumstances, the results of which form
        the
        basis for making judgments about the carrying values of assets and liabilities
        that are not readily apparent from other sources. Actual results may differ
        from
        these estimates under different assumptions or conditions.
  Management
        believes the following critical accounting policies reflect our more significant
        estimates and assumptions used in the preparation of our consolidated financial
        statements:
  *Allowance
        For Doubtful Accounts*
  We
        evaluate the collectibility of our trade receivables based on a combination
        of
        factors. We regularly analyze our significant customer accounts, and, when
        we
        become aware of a specific customer's inability to meet its financial
        obligations to us, such as in the case of bankruptcy filings or deterioration
        in
        the customer's operating results or financial position, we record a specific
        reserve for bad debt to reduce the related receivable to the amount we
        reasonably believe is collectible. We also record reserves for bad debt for
        all
        other customers based on a variety of factors including the length of time
        the
        receivables are past due, the financial health of the customer, macroeconomic
        considerations and historical experience. If circumstances related to specific
        customers change, our estimates of the recoverability of receivables could
        be
        further adjusted. In the event that our trade receivables become uncollectible,
        we would be forced to record additional adjustments to receivables to reflect
        the amounts at net realizable value. The accounting effect of this entry
        would
        be a charge to earnings, thereby reducing our net earnings. Although we consider
        the likelihood of this occurrence to be remote based on past history and
        the
        current status of our accounts, there is a possibility of this
        occurrence.
 
 26
 In
        the
        beginning of the third quarter of 2006, the Chinese government announced
        that it
        would implement several new policies regarding mobile phone value-added service
        providers effective from July 10, 2006. These policies include a “double
        confirmation” policy and the requirement that value-added service providers
        provide one-month trial subscriptions. By requiring that mobile phone customers
        “double-confirm” their intention to purchase services, and by requiring free
        subscriptions, the Chinese government has negatively affected value-added
        service providers.
 
 Since
        the
        Company does business with several value-added service providers that have
        been
        negatively affected by the new mobile phone policies, during the three months
        ended September 30, 2006, the Company decided to incur a bad debt charge
        of
        approximately $657,000. This amount is listed as a separate line item in
        the
        consolidated statement of operations. The
        write
        down was considered prudent after an assessment by the Company’s internal
        control team that several customer accounts may be uncollectible as a result
        of
        Chinese government pressure on value-added service providers.
 
 Although
        the Chinese government appeared to lessen restrictions by the end of the
        third
        quarter, the negative affect on the ability of certain of the Company’s
        customers to pay on accounts receivable already necessitated a provision
        for
        uncollectible accounts.
 
 ***Inventory***
 
 Our
        inventory purchases and commitments are made in order to build inventory
        to meet
        forecasted demand for our products. We perform a detailed assessment of
        inventory for each period, which includes a review of, among other factors,
        demand requirements, product life cycle and development plans, component
        cost
        trends, product pricing and quality issues. Based on this analysis, we record
        adjustments to inventory for excess, obsolescence or impairment, when
        appropriate, to reflect inventory at net realizable value. Revisions to our
        inventory adjustments may be required if actual demand, component costs or
        product life cycles differ from our estimates. In the event we were unable
        to
        sell our products, the demand for our products diminished, and/or other
        competitors offered similar or better products, we would be forced to record
        an
        adjustment to inventory for impairment or obsolescence to reflect inventory
        at
        net realizable value. The accounting effect of this entry would be a charge
        to
        earnings, thereby reducing our net earnings.
 
 In
        the
        beginning of the third quarter of 2006, the Chinese government announced
        that it
        would implement several new policies regarding mobile phone value-added service
        providers effective July 10, 2006. These policies include a “double
        confirmation” policy and the requirement that value-added service providers
        provide one-month trial subscriptions. By requiring that mobile phone customers
        “double-confirm” their intention to purchase services, and by requiring free
        subscriptions, the Chinese government has negatively affected value-added
        service providers.
 
 Since
        the
        Company sells hardware to value-added service providers that have been
        negatively affected by the new mobile phone policies, during the three months
        ended September 30, 2006, we recorded an adjustment to inventory of $486,000. The
        write
        down was considered prudent after an assessment by the Company’s internal
        control team determined that the inventory was considered not readily saleable
        as a result of the recent government policy restrictions.
 
 Although
        the Chinese government appeared to lessen restrictions by the end of the
        third
        quarter, the effect of lesser demand already necessitated a write-down of
        inventory.
 
 *Income
        Taxes*
  We
        record
        a valuation allowance to reduce our deferred tax assets to the amount that
        is
        more likely than not to be realized. We have considered future market growth,
        forecasted earnings, future taxable income, and the mix of earnings in the
        jurisdictions in which we operate and prudent and feasible tax planning
        strategies in determining the need for a valuation allowance. We currently
        have
        recorded a full valuation allowance against net deferred tax assets as we
        currently believe it is more likely than not that the deferred tax assets
        will
        not be realized. In the event we determine that we would not be able to realize
        all or part of our net deferred tax assets in the future, an adjustment to
        the
        deferred tax assets would be charged to earnings in the period such
        determination is made. Likewise, if we later determine that it is more likely
        than not that the net deferred tax assets would be realized, the previously
        provided valuation allowance would be reversed.
 
 27
 *Contingencies*
  We
        may be
        subject to certain asserted and unasserted claims encountered in the normal
        course of business. It is our belief that the resolution of these matters
        will
        not have a material adverse effect on our financial position or results of
        operations, however, we cannot provide assurance that damages that result
        in a
        material adverse effect on our financial position or results of operations
        will
        not be imposed in these matters. We account for contingent liabilities when
        it
        is probable that future expenditures will be made and such expenditures can
        be
        reasonably estimated.
  *Valuation
        of Long-Lived Assets Including Goodwill and Purchased Intangible Assets*
  We
        review
        property, plant and equipment, goodwill and purchased intangible assets for
        impairment whenever events or changes in circumstances indicate the carrying
        value of an asset may not be recoverable. Our asset impairment review assesses
        the fair value of the assets based on the future cash flows the assets are
        expected to generate. An impairment loss is recognized when estimated
        undiscounted future cash flows expected to result from the use of the asset
        plus
        net proceeds expected from disposition of the asset (if any) are less than
        the
        carrying value of the asset. This approach uses our estimates of future market
        growth, forecasted revenue and costs, expected periods the assets will be
        utilized and appropriate discount rates. Such evaluations of impairment of
        long-lived assets including goodwill arising on a business combination and
        purchased intangible assets are an integral part of, but not limited to,
        our
        strategic reviews of our business and operations performed in conjunction
        with
        restructuring actions. When an impairment is identified, the carrying amount
        of
        the asset is reduced to its estimated fair value. Deterioration of our business
        in a geographic region or within a business segment in the future could also
        lead to impairment adjustments as such issues are identified. The accounting
        effect of an impairment loss would be a charge to earnings, thereby reducing
        our
        net earnings.
 
 *Convertible
        Debt*
  In
        accordance with recent FASB accounting guidance, due to certain factors,
        including a liquidated damages provision in the registration rights agreement
        and an indeterminate amount of shares to be issued upon conversion of the
        debentures, the Company values and accounts for the embedded conversion feature
        related to the Debentures, the Investors’ warrants, and the registration rights
        as derivative liabilities. Accordingly, these derivative liabilities are
        measured at fair value with changes in fair value reported in earnings as
        long
        as they remain classified as liabilities. The Company reassesses the
        classification at each balance sheet date. If the classification required
        under
        EITF No. 00-19 changes as a result of events during the period, the contract
        should be reclassified as of the date of the event that caused the
        reclassification.
  The
        fair
        value of these derivative instruments, as determined by applying the
        Black-Scholes valuation model, is adjusted quarterly. The Black-Scholes
        valuation model requires the input of highly subjective assumptions, including
        the expected stock price volatility. Additionally, although the Black-Scholes
        model meets the requirements of SFAS 133, the fair values generated by the
        model may not be indicative of the actual fair values as our derivative
        instruments have characteristics significantly different from traded options.
        Accordingly, the results obtained could be significantly different if other
        assumptions were used. The effect of this entry would be a charge to net
        earnings, thereby either increasing or reducing our net earnings based upon
        the
        assumptions used and the results obtained.
 
 28
 **NATURE
        OF THE OPERATIONS OF THE COMPANY**
 
 **NATURE
        OF BUSINESS.**
 
 PacificNet
        Inc. is a leading provider of CRM and telecom services, ecommerce and gaming
        technology in China. We were incorporated in the state of Delaware in 1987.
        Our
        business consists of three groups, all of which operate within the outsourcing
        and telecommunications industries in Asia, primarily greater China, which
        includes the People's Republic of China (PRC), or mainland China, Hong Kong
        Special Administrative Region (HKSAR), Macau Special Administrative Region,
        and
        Taiwan and one group that focuses on primarily administrative and corporate
        related matters. Through our subsidiaries we provide outsourcing services,
        telecom (VAS) services, and products (telecom & gaming) services. Our
        business process outsourcing (BPO) services include call centers providing
        customer relationship management (CRM) and telemarketing services, and our
        information technology outsourcing (ITO) includes software programming and
        development. We are value-added resellers and providers of telecom VAS, which
        comprises interactive voice response (IVR) systems, call center management
        systems, and VOIP, as well as mobile phone VAS, such as short messaging services
        (SMS) and multimedia messaging services (MMS). In 2004, we commenced our
        communication products distribution service, through wholesale and, to a
        lesser
        extent, retail sale and distribution of mobile phones, software and hardware,
        mobile accessories, and calling cards in Hong Kong and China. In 2005, we
        invested Take1Technologies (Cheer Era), a company that designs, manufactures,
        and distributes multimedia interactive self-service kiosks, bingo and gaming
        machines for the casino and slot machine operators Europe and Asia.
 In
        2006,
        we invested in PacificNet Games Limited (PacGames), a leading provider of
        Asian
        multi-player electronic gaming machines, gaming technology solutions and
        gaming
        related maintenance, IT and distribution services for the leading hotel,
        casino
        and slot hall operators based in Macau, China and other Asian gaming markets.
        Macau is expected to surpass Las Vegas in total revenues by 2006. Currently,
        table games make up the bulk of Macau casino revenues, which is in sharp
        contrast to other areas such as Las Vegas. PacGames is a leading developer
        of
        electronic versions of these popular table games which are less expensive
        to run
        resulting in higher casino profits with great appeal to the mass market players.
        Further, the growing market in Macau is for Asian table games such as Baccarat,
        Roulette, Fan Tan, Fish-Prawn-Crab and Sic-Bo Cussec as these games have
        wider
        acceptance in the Asian market than Western games such as poker or slots.
        The
        development, manufacturing, maintenance, and service of electronic Asian
        table
        games are underserved areas which are predicted to grow considerably as Macau's
        gaming market matures. PacGames products include multi-play electronic gaming
        machines such as Baccarat, Fish-Prawn-Crab, Sib-Bo Cussec, Roulette, and
        Video
        Lottery Terminals (VLT) such as Keno and Bingo, as well as other traditional
        slot machines. We intend to continue to grow our business by acquiring and
        managing growing technology and network communications businesses with
        established products and customers in Asia.
 
 Our
        business process outsourcing services generate revenue from call center
        services, call center management software sales, and training and consulting.
        We
        invoice our call center clients monthly at per seat monthly rates, a base
        price
        plus commission per call, or a per hour charge rate, depending on the client's
        preference. Our call center software clients pay per license, for which there
        is
        usually a one-time charge on sale of the software and annual maintenance
        fees
        for service. We charge per project for our consulting and training services
        and
        for our telecom VAS, which are invoiced throughout the project. Our telecom
        VAS
        often includes a post-sale service contract for systems integration and
        consulting services for which we bill separately. Our communication products
        such as calling cards, kiosks and cell phones are sold cash-on-delivery.
        Our gaming
        center operations generate revenue through the sale of gaming machines to
        casinos, or through resellers who sell to casinos. Currently we do not
        consolidate gaming operations as we do not currently hold a controlling interest
        in the gaming operations, but a 45% interest.
 
 Our
        clients include the leading telecom operators, banks, insurance, travel,
        marketing, and service companies, as well as telecom consumers, in Greater
        China. Clients include China Telecom, China Netcom, China Mobile, China Unicom,
        PCCW, Hutchison Telecom, CSL, SmarTone, Sunday, Swire Travel, Coca-Cola,
        SONY,
        Samsung, Motorola, Nokia, TNT Express, Huawei, TCL, Dun & Bradstreet,
        American Express, Bank of China, DBS, Hong Kong Government, and Hongkong
        Post.
        PacificNet employs over 2,300 staff in our various subsidiaries in China
        with
        offices in Hong Kong, Beijing, Shanghai, Shenzhen, and Guangzhou.
 
 29
 PacificNet's
        operations include the following four groups:
  (1)
        Outsourcing Services: including Business Process Outsourcing (BPO), call
        center,
        IT Outsourcing (ITO) and software development services.
 (2)
        Telecom Value-added Services: including Content Providing (CP), Interactive
        Voice Response (IVR), Platform Providing (PP) and Service Providing
        (SP).
 (3)
        Products (Telecom & Gaming): including communication and gaming products,
        GSM/CDMA/3G Products, Multimedia Communication Kiosks. This Group includes
        the
        following subsidiaries: PacificNet Communications Limited, iMobile, Allink,
        Take1 and PacificNet Games. PacificNet Games Limited (PacGames) is a leading
        developer of Asian electronic gaming machines, multi-player electronic gaming
        technology solutions and gaming related maintenance, IT, and distribution
        services for the leading hotel and casino operators based in the Macau and
        other
        Asian gaming markets.
 (4)
        Other
        Business: including internal administrative matters, other related corporate
        items, and other business such as PacificNet Power. PacifiNet Power Limited
        (PacPower) has enjoyed significant growth beginning in late 2005 and early
        2006.
        PacPower was founded in Hong Kong on January 10, 2005 as a subsidiary of
        PacificNet Limited with 51% ownership by PacificNet. Headquartered in Hong
        Kong,
        PacPower invests in, develops, markets, distributes, resells, and manufactures
        energy saving products for use in commercial, residential and industrial
        settings. PacPower also engages in energy management services (EMS), energy
        savings consultation, analysis and solutions implementation, outsourcing
        energy
        management services, energy savings performance contract (ESPC). PacPower’s
        energy management services include electrical power management for lighting,
        air
        conditioning, elevators and escalators, buildings and roads, and energy related
        engineering services.
 PacPower
        recognizes revenue from product sales under the following two types of
        contracts:
 1)
        Equipment sale contract - Under the Equipment sale contract, we recognize
        revenue when persuasive evidence of an arrangement exists, the sales price
        to
        the buyer is fixed or determinable, collectability is reasonably assured,
        delivery has occurred and accepted by the buyers.
 2)
        Energy
        Management Contract (EMC) or Energy Savings Sharing Contract - Under this
        contract, we grant customers extended payment terms under contracts of sale.
        These contracts are generally for a period of one to six years at prevailing
        interest rates and are collateralized by the related equipment, which if
        repossessed, may be less than the receivable balance outstanding. We recognize
        revenue under profit sharing agreements when the amounts are fixed and
        determinable and collectability is reasonably assured. Amounts received by
        us in
        excess of the original estimated cost savings on the contract is recorded
        as
        interest income.
 
 **RESULTS
        OF OPERATIONS**
  The
        following table sets forth selected consolidated income statement data as
        a
        percentage of revenues for the periods indicated.
 
 THREE
                  MONTHS ENDED
                SEPTEMBER
                  30,
              
              NINE
                  MONTHS ENDED
                SEPTEMBER
                  30,2006
                  (%)
              
              2005
                  (%)
              
              2006
                  (%)
              
              2005
                  (%)Revenues
              
              
              100
              
              
              100
              
              
              100
              
              
              100Cost
                  of Revenues
              
              
              (80.7
              )
              
              (80.1
              )
              
              (70.6
              )
              
              (79.8
              )Gross
                  Margin
              
              
              19.3
              
              
              19.9
              
              
              29.4
              
              
              20.2Selling,
                  general and administrative expense
              
              
              (19.3
              )
              
              (9.1
              )
              
              (21.1
              )
              
              (10.0
              )Earnings
                  / (Loss) from operations
              
              
              (13.9
              )
              
              (7.9
              )
              
              3.0
              
              
              8.7Earnings
                  / (Loss) before income taxes, minority interest
                and
                  discontinued operations
              
              
              (12.5
              )
              
              (10.9
              )
              
              4.7
              
              
              11.0NET
                  EARNINGS / (LOSS)
              
              
              (8.7
              )
              
              5.5
              
              
              1.3
              
              
              5.0
   30
 **THREE
        AND NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THREE AND NINE MONTHS
        ENDED
        SEPTEMBER 30, 2005**
  REVENUES.
        Revenues for the three and nine months ended September 30, 2006 were $12,875,000
        and $47,239,000, an increase of 17% and 45% from $11,047,000 and $32,539,000
        for
        the three and nine months ended September 30, 2005, respectively. During
        the
        third quarter and first nine months of 2006, revenues of $3,733,000, $2,350,000,
        $6,411,000 and $10,312,000, $14,907,000, $18,262,000 were derived from the
        services rendered by the Company's three operating units: Outsourcing Services,
        Telecom Value-Added Services, and Products (Telecom & Gaming), respectively.
        The revenues in product sales during the third quarter of 2006 increased
        by 21%
        and 37% compared to the same periods of 2005. The revenues in services sales
        during the third quarter of 2006 increased by 11% and 56% compared to the
        same
        periods of 2005.
  The
        increase in revenue was mainly due to the following:
  (1)
              Outsourcing
                  services:The
                  year-over-year increase in outsourcing services for the three and
                  nine
                  months ended September 30, 2006 was primarily due to 44% and 30%
                  growth in
                  Epro compared to the same period in 2005. During the first nine
                  months of
                  2006, the outsourcing contract center in Hong Kong was at nearly
                  full
                  utilization. Driven by strong gains in outbound services, insourcing
                  services and facilities management services, Epro recorded double
                  digit
                  gains in revenue. As salaries continue to rise in Hong Kong and
                  China,
                  companies are under greater pressure to manage their labor costs.
                  Outsourcing has become an attractive tool for companies in the
                  region to
                  manage these costs. Additionally, the Company signed deals with
                  several
                  new clients, including a deal to provide customer service operation
                  management training for NanJing Airlines. The McDonalds Corporation
                  selected the Company to provide web-based quality management services
                  and
                  supplier quality management
                  services.
 (2)
                Separately,
                      stricter guidelines established by the China Securities Regulatory
                      Commission (CSRC) led to a decrease in the Company’s ability to market its
                      investment consulting services to retail audiences, which resulted
                      in
                      revenue underperformance. Nevertheless, although barriers remain
                      on
                      marketing through television, the Company has successfully
                      expanded its
                      use of stored-value cards to maintain its market position.
                      Due to its
                      large and loyal retail following, the Company believes it can
                      work through
                      the current regulatory environment. Additionally, the Company
                      has shifted
                      its marketing emphasis to the internet and to magazines.
  (3)
              Products
                  (Telecom & Gaming): iMobile added approximately $863,000 and
                  $1,326,000, or accounted for 13% and 7% in this segments revenues
                  for the
                  three and nine months ended September 30, 2006, respectively, in
                  which its
                  major business included internet sales of mobile phone and accessories.
                  The revenues from the sales of Motorola and Nokia contributed 95%
                  of
                  iMobile’s total revenues during the third quarter of 2006. The Company’s
                  18900.com website has now become one of the leading Internet e-commerce
                  distributor of mobile products in China, covering 1,572 cities
                  throughout
                  the nation. Additionally, during the third quarter, PacificNet
                  iMobile
                  entered into a new agreement with Motorola to become a designated
                  after-sales service provider for Motorola’s mobile products and
                  accessories in China.
                
                Continued
                  strength in the Company’s Hong Kong mobile phone wholesaler subsidiary
                  drove sales gains. The Company believes its Hong Kong mobile phone
                  wholesale subsidiary is now one of the top five largest wholesalers
                  of
                  mobile phones in Hong Kong, and its position has attracted numerous
                  overseas wholesale buyers.
  (4)
              The
                  remaining incremental revenues for the three and nine months ended
                  September 30, 2006 as compared to respective period was derived
                  from
                  organic growth from existing subsidiaries, such as PacPower ($176,000
                  and
                  $2,650,000) and PacificNet Limited ($124,000 and
                  $949,000).
  31
 Acquisitions
        during the first nine month of 2006 expanded PacificNet’s position as a leading
        provider of e-commerce, customer services and CRM in China's mobile distribution
        market, and increased our e-commerce and VAS revenues and our nationwide
        CRM
        service coverage. Several of our businesses experienced fluctuations in
        quarterly performance.
  Summarized
        financial information concerning each of our main operating units is set
        forth
        in the following table. The "Other Business" column included our other
        insignificant subsidiaries and corporate related items.
  FOR
        THE
        THREE MONTHS ENDED
  Group
                  1
                Outsourcing
                Services
              
              Group
                  2.
                Telecom
                  Value-Added Services
              
              Group
                  3
                Products
                (Telecom
                  & Gaming)
              
              Group
                  4
                Other
                Business
              
              TOTALSEPTEMBER
                  30, 2006
              
              ($)
              
              ($)
              
              ($)
              
              ($)
              
              ($)Revenues
              
              
              3,733,000
              
              
              2,350,000
              
              
              6,411,000
              
              
              381,000
              
              
              12,875,000Earnings
                  / (Loss) from Operations
              
              
              113,000
              
              
              (833,000
              )
              
              (191,000
              )
              
              (881,000
              )
              
              (1,792,000
              )
  FOR
        THE
        NINE MONTHS ENDED
  Group
                  3Group
                  1
              
              Group
                  2
              
              Products
              
              Group
                  4Outsourcing
                  Services
              
              Telecom
                  Value-Added Services
              
              (Telecom
                  & Gaming)
              
              Other
                Business
              
              TOTALSEPTEMBER
                  30, 2006
              
              ($)
              
              ($)
              
              ($)
              
              ($)
              
              ($)Revenues
              
              
              10,312,000
              
              
              14,907,000
              
              
              18,262,000
              
              
              3,758,000
              
              
              47,239,000Earnings
                  / (Loss) from Operations
              
              
              515,000
              
              
              2,011,000
              
              
              74,000
              
              
              (1,163,000
              )
              
              1,437,000
  COST
        OF
        REVENUES. Cost of revenues for the three and nine months ended September
        30,
        2006 was $10,392,000 and $33,352,000, an increase of 17% and 28% from $8,852,000
        and $25,979,000 for the three and nine months ended September 30, 2005,
        respectively. The cost of revenues in services sales for the three and
        nine months ended September 30, 2006 increased by 8% and 14%, respectively,
        and  cost of revenues in product sales for the three and nine months ended
        September 30, 2006 increased by 23% and 36%, respectively, in each case compared
        with the respective period in 2005. The increase is directly associated with
        the
        corresponding increase in revenues. In comparison to the same period last
        year,
        the majority of the costs associated with revenues were from Shanghai Classic,
        PacCom and Epro. Cost of goods sold increased as sales at the Company’s mobile
        phone subsidiaries increased.
  32
 GROSS
        PROFIT. Gross profit for the three and nine months ended September 30, 2006
        was
        $2,483,000 and $13,887,000, a significant increase of 13% and 112% as compared
        to $2,195,000 and $6,560,000 for the three and nine months ended September
        30,
        2005, respectively. Gross margin was 19% and 29% of total revenues for the
        three
        and nine months ended September 30, 2006, compared to 20% and 20% for the
        three
        and nine months ended September 30, 2005, respectively. As explained above,
        the
        improvement in gross margin for three and nine months periods from the prior
        periods was primarily due to increased contributions from higher margin
        subsidiaries. As a result of the shift in operations, we had lower revenue
        and
        higher than normal profit margin for project outsourcing during the three
        and
        nine months ended September 30, 2006. We believe that our overall gross margins
        approximate the industry standards and we expect our gross margin percentage
        to
        increase gradually as a result of cost reduction and greater efficiencies
        in our
        utilization of assets.
 
 As
        part
        of its strategy of shifting to higher-margin businesses, the Company is
        increasingly focusing on the gaming businesses. Gross profit margins from
        the
        company’s new PacGames subsidiary are currently more than 50%.
 
 SELLING,
        GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative
        expenses totaled $2,482,000 and $9,982,000 for the three and nine months
        ended
        September 30, 2006, an increase of 147% and 206% from $1,004,000 and $3,261,000
        for the three and nine months ended September 30, 2005, respectively. Selling,
        general and administrative expenses consist primarily of staff salaries,
        rent,
        insurance and traveling costs. The year-over-year increase in total general
        and
        administrative expenses during the three and nine months ended September
        30,
        2006 was mainly due to the increase in staff costs as well as rent and
        electricity expenses for the expansion of its call center (Epro accounted
        for
        11% of total selling, general and administrative expenses). The marketing
        expenses and staff cost from the new 3G service and Wanrong’s services also
        significantly affected the total expenses during the third quarter of 2006
        accounting for approximately 9% of the total selling, general and administrative
        expenses. Additionally, Linkhead accounted for 9% of the total selling, general
        and administrative expenses.
 
 The
        significant increase for general and administrative expenses from PacificNet
        Inc. year-over-year for the first nine months of 2006 was also
        partly due to $120,043 of vesting option expense for compensation cost
        amortization, $92,740 amortization cost from $8 million convertible debt
        issuance cost (3 years amortization) and depreciation cost from Beijing Time
        court (USD1.6m depreciated through 40 years). Additionally, there is
        approximately $127,532 financial expense for PacificNet Inc. Such expense
        consists of (1) convertible debt interest, in which 5% is prepaid interest
        expense, $100,000 is expensed in Q3 2006 and the following three quarters
        (Q4
        2006 and Q1 2007); and (2) the bank loan interest for Beijing Time Court
        ($14,347) in which the total amount of its bank loan is
        $1,082,000.
 
 EARNINGS/
        (LOSS) FROM OPERATIONS. On a year-over-year basis, loss from operations
        decreased 304% and 49% for the three months and nine months ended September
        30,
        2006, respectively. Operating earnings/(loss) of $113,000, $(833,000), and
        $(191,000) for the three months ended September 30, 2006 were generated from
        the
        Company's three business units: (1) CRM Outsourcing Services, (2) Telecom
        Value-Added Services, and (3) Products (Telecom & Gaming) Services,
        respectively. This compares to operating earnings/(loss) of $217,000, $824,000
        and $172,000 for the three months ended September 30, 2005, respectively.
        Various factors affected operating earnings during the third quarter of 2006,
        including increased capital expenditures resulting in greater non-cash charges
        such as depreciation and amortization expenses. As the Company expanded its
        call
        center sites in Hong Kong, amortization and depreciation expenses related
        to the
        new leasehold improvement, furniture & fixtures, computer equipment and
        software incurred in the first nine months of 2006 also increased. The increase
        in fixed assets also included a recorder monitor system, DVCAM, computer
        equipment. We continued to shift our business from our traditional lower-margin
        distribution business (B2B services) to higher margin value-added telecom
        services and B2C e-commerce. We believe that the Company has made substantial
        progress in a relatively short period of time which has been demonstrated
        by our
        increase in both gross and operating margins in the third quarter. Furthermore,
        the acquisition of majority interests in both iMobile and Guangzhou Wanrong
        during the first quarter enhanced our position in the rapidly growing B2C
        market
        in China.
  33
 INCOME
        TAXES. Income tax provision was $(119,000) and $(319,000) for the three and
        nine
        months ended September 30, 2006, as compared to $13,000 and $(51,000) for
        the
        three and nine months ended September 30, 2005. Interim income tax provisions
        are based upon management’s estimate of taxable income and the resulting
        consolidated effective income tax rate for the full year. As a result, such
        interim estimates are subject to change as the year progresses and more
        information becomes available. We expect our income taxes to increase as
        our net
        earnings increase and the tax holidays we have benefited from in Hong Kong
        and
        the PRC expire.
  MINORITY
        INTERESTS. Minority interests for the three and nine months ended September
        30,
        2006 totaled $529,000 and $(1,405,000) compared with $(612,000) and $(1,916,000)
        for the same period in the prior year, representing outside ownership interests
        in subsidiaries that is consolidated with the parent for financial reporting
        purposes.
  NET
        EARNINGS / (LOSS). Overall net loss year-over-year increased 282% and 62%
        during
        the three and nine months ended September 30, 2006, respectively. The Company’s
        results for the nine months ended September 30, 2006 included a total of
        $2,400,000 in non-cash expenses, including depreciation and amortization
        expense
        of $994,000 and $179,000 non-cash stock-based compensation expense recognized
        during 2006 as a result of the implementation of SFAS 123(R), which we adopted
        effective on January 1, 2006, The Company’s quarterly results also included a
        total of $1,341,000 in non-cash expenses, including depreciation and
        amortization expense of $388,000. Each of our subsidiaries and investments,
        including Epro, Smartime, Guangzhou 3G, Clickcom, ChinaGoHi, iMobile, PacificNet
        Communications, PacificNet Limited and PacificNet Power were profitable.
 
 **LIQUIDITY
        AND CAPITAL RESOURCES**
  CASH
        AND
        CASH EQUIVALENTS.
  As
        of
        September 30, 2006, cash and cash equivalents were $7,439,000, compared to
        $9,579,000 at December 31, 2005 as a result of the decrease of cash and cash
        equivalents of more than $2.3million for Lion Zone. The significant reduction
        for Lion Zone was primarily attributed to a loan to a related party of
        approximately $2.3million, acquisition of property and equipment, and taxes
        paid. The loan for Lion Zone is a related party advance with no fixed maturity
        date and captioned under “Loans receivable from related Parties” in the
        consolidated balance sheet.
  WORKING
        CAPITAL.
  The
        Company’s working capital increased to $28,106,000 at September 30, 2006, as
        compared to $20,510,000 at December 31, 2005. When compared to balances at
        December 31, 2005, an increase of 37.04% in working capital at September
        30,
        2006 was primarily due to the increases in current assets and the decrease
        in
        current liabilities accounts. The increase of current assets was mainly the
        result of significant increase in accounts receivable which was attributable
        to
        our existing subsidiaries and a significant increase in loan receivable from
        related parties. The decrease of current liabilities was primarily due to
        the
        decrease of accrual expense and other payable. The increase of accounts
        receivable at September 30, 2006 was mainly driven from the increase of
        $2,020,000 from PacPower (due to the revenues from Light Eco and Pure Air
        projects), the increase of $2,224,000 from PacCom, and the increase of $523,000
        from Epro.
  34
 NET
        CASH
        FROM OPERATING ACTIVITIES.
  Net
        cash
        (used in) operating activities was $(6,416,000) for the nine months ended
        September 30, 2006 as compared to net cash provided by operating activities
        of
        $133,000 for the nine months ended September 30, 2005. Net cash used in
        operating activities in the nine months ended September 30, 2006 was primarily
        due to net earnings of $604,000 offset by noncash items such as minority
        interest of $1,405,000, depreciation and amortization of $1,173,000, decrease
        in
        charge in fair value of derivatives of 1,212,000, provision for allowance
        for
        doubtful accounts of $657,000, inventory write down of $486,000, equity profit
        of associated company of $129,000, provision for income tax of $(183,000),
        amortization of interest discount of $307,000, and liquidated damages expense
        of
        $800,000 offset by a net decrease in working capital items of $10,444,000.
        The
        decrease in working capital was mainly due to a decrease in accounts receivable
        and other current assets of $8,281,000 and a decrease in inventories of $572,000
        which mainly resulted from higher revenues and a net decrease in account
        payables and accrued expenses of $1,591,000 which was primarily due to the
        decrease in accrued expenses and income tax payable.
  NET
        CASH
        FROM INVESTING ACTIVITIES.
  Net
        cash
        used in investing activities was $(4,811,000) for the nine months ended
        September 30, 2006 compared to $(3,250,000) for the comparative prior period.
        Net cash used in investing activities in the nine months ended September
        30,
        2006 was primarily due to the acquisition of property and equipment from
        the
        company, PACT strategic and PACT Limited totaling $(3,806,000), and a decrease
        in acquisition of subsidiaries and affiliated companies of $419,000, offset
        by
        the release of the restricted cash of $1,420,000, an increase of $353,000
        for
        loan receivables from third parties and an decrease of $2,359,000 for loan
        receivables from related parties.
  NET
        CASH
        FROM FINANCING ACTIVITIES.
  Net
        cash
        provided by financing activities for the nine months ended September 30,
        2006
        was $8,805,000, which was mainly due to the proceeds from issuance of
        convertible debenture of $7,500,000 and the exercise of the share options
        and
        warrants of $174,000, an increase in bank loan of $1,152,000 and an increase
        in
        loans payable to related party of $4,000 and repurchase of treasury shares
        of
        $(124,000), an increase in amount borrowed under capital lease obligations
        of
        $77,000 and bank line of credit of $22,000. Net cash provided by financing
        activities for the nine months ended September 30, 2005 was $1,521,000 which
        was
        primarily a result of an increase in proceeds from exercise of stock options
        and
        warrants of $981,000, increase in loans from related party of $513,000, and
        an
        increase in amount borrowed under capital lease obligations of
        $29,000.
  INFLATION.
        Inflation has not had a material impact on the Company's business in recent
        years.
  CURRENCY
        EXCHANGE FLUCTUATIONS.
  All
        of
        the Company's revenues are denominated either in U.S. dollars or Hong Kong
        dollars, while its expenses are denominated primarily in Hong Kong dollars
        and
        Renminbi ("RMB"), the currency of the People's Republic of China. The value
        of
        the RMB-to-U.S. dollar or Hong Kong dollar-to-United States dollar and other
        currencies may fluctuate and is affected by, among other things, changes
        in
        political and economic conditions. Since 1994, the conversion of Renminbi
        into
        foreign currencies, including U.S. dollars, has been based on rates set by
        the
        People's Bank of China, which are set daily based on the previous day's
        interbank foreign exchange market rates and current exchange rates on the
        world
        financial markets. Since 1994, the official exchange rate generally has been
        stable. Recently there has been increased political pressure on the Chinese
        government to decouple the RMB from the United States dollar. Although a
        devaluation of the Hong Kong dollar or RMB relative to the United States
        dollar
        would likely reduce the Company's expenses (as expressed in United States
        dollars), any material increase in the value of the Hong Kong dollar or RMB
        relative to the United States dollar would increase the Company's expenses,
        and
        could have a material adverse effect on the Company's business, financial
        condition and results of operations. The Company has never engaged in currency
        hedging operations and has no present intention to do so.
  35
 OFF-BALANCE
        SHEET ARRANGEMENTS.
  We
        had no
        off-balance sheet guarantees, interest rate swap transactions or foreign
        currency forward contracts. We did not engage in trading activities involving
        non-exchange traded contracts during the second quarter of 2006.
 
 **CONTRACTUAL
        OBLIGATIONS**
 
 The
        Company has convertible debt which obligates the Company to file a registration
        statement with respect to the shares issuable under the convertible debt
        note.
        Due to various factors, as of September 30, 2006, the Company had filed the
        registration statement, but it has not gone effective. Accordingly, the terms
        of
        the convertible note obligate the Company to pay liquidated damages to the
        convertible debenture investors at the rate of 2% of the principal amount
        of the
        convertible per month, or $160,000. As of September 30, 2006, the Company
        has determined to accrue five months of liquidated damages or approximately
        $800,000, although it is possible that the Company may not ultimately need
        to
        pay the full amount of liquidated damages. The amount has been reflected
        in the
        consolidated financial statements as a separate line item on the consolidated
        balance sheet as “liquidated damages liability” and as a separate line item on
        the consolidated statement of operations as “liquidated damages
        expense”.
 
 We
        have
        significant cash resources to meet our contractual obligations as of September
        30, 2006, as detailed below:
  **Payments
        Due by Period**
 
 Contractual
                  Obligations
              
              Total
              
              Less
                  than 1 year
              
              1-5
                  years
              
              After
                  5 yearsLine
                  of credit
              
              $
              1,082,000
              
              $
              1,082,000
              
              
              0
              
              
              0Bank
                  Loans
              
              $
              2,428,000
              
              $
              992,000
              
              $
              470,000
              
              $
              966,000Operating
                  leases
              
              $
              775,000
              
              $
              463,000
              
              $
              312,000
              
              
              0Capital
                  leases
              
              $
              281,000
              
              $
              133,000
              
              $
              148,000
              
              
              0Total
                  cash contractual obligations
              
              $
              4,566,000
              
              $
              2,670,000
              
              $
              930,000
              
              $
              966,000
   **CONCENTRATION
        OF CREDIT RISK**
  All
        of
        the Company's revenues are derived in Asia and Greater China. The Company
        does
        not have any single customer that accounts for more than 10% of its revenues
        or
        10% of its purchases. If the Company was unable to derive any revenue from
        Asia
        and Greater China, it would have a significant, financially disruptive effect
        on
        the normal operations of the Company. The economic environment in China can
        often involve dealing with arbitrary regulations, especially with regard
        to the
        telecommunications sector.. With this exception, the Company does not expect
        any
        material adverse impact to its business, financial condition and results
        of
        operations.
  36
  **SEASONALITY
        AND QUARTERLY FLUCTUATIONS**
  Several
        of our businesses experience fluctuations in quarterly performance.
        Traditionally, the first quarter from January to March is a low season for
        our
        call center business due to the long Lunar New Year holidays in China. Revenues
        and income from operations for the call center and VAS tend to be higher
        in the
        fourth quarter due to special holiday promotions. Internet sales, telemarketing
        and direct marketing revenues also tend to be higher in the fourth quarter
        due
        to increased consumer spending during that period. Revenues from the VAS
        and IVR
        segment can vary from quarter to quarter due to new product launches and
        the
        seasonality of certain product lines.
   **ITEM
        3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK**
  We
        are
        exposed to various market risks arising from adverse changes in market rates
        and
        prices, such as foreign exchange fluctuations and interest rates, which could
        impact our results of operations and financial position. We do not currently
        engage in any hedging or other market risk management tools, and we do not
        enter
        into derivatives or other financial instruments for trading or speculative
        purposes.
 
 ***Foreign
        Currency Exchange Rate Risk.***
 Fluctuations
        in the rate of exchange between the U.S. dollar and foreign currencies,
        primarily the Hong Dollar and the Chinese Renminbi, could adversely affect
        our
        financial results. During the quarter ended June 30, 2006, approximately
        all of
        our sales are denominated in foreign currencies. We expect that foreign
        currencies will continue to represent a similarly significant percentage
        of our
        sales in the future. Selling, marketing and administrative costs related
        to
        these sales are largely denominated in the same respective currency, thereby
        mitigating our transaction risk exposure. We therefore believe that the risk
        of
        a significant impact on our operating income from foreign currency fluctuations
        is not substantial. However, for sales not denominated in U.S. dollars, if
        there
        is an increase in the rate at which a foreign currency is exchanged for U.S.
        dollars, it will require more of the foreign currency to equal a specified
        amount of U.S. dollars than before the rate increase. In such cases and if
        we
        price our products in the foreign currency, we will receive less in U.S.
        dollars
        than we did before the rate increase went into effect. If we price our products
        in U.S. dollars and competitors price their products in local currency, an
        increase in the relative strength of the U.S. dollar could result in our
        price
        not being competitive in a market where business is transacted in the local
        currency. All of our sales denominated in foreign currencies are denominated
        in
        the Hong Dollar and the Chinese Renminbi. Our principal exchange rate risk
        therefore exists between the U.S. dollar and these two currencies. Fluctuations
        from the beginning to the end of any given reporting period result in the
        re-measurement of our foreign currency-denominated receivables and payables,
        generating currency transaction gains or losses that impact our non-operating
        income/expense levels in the respective period and are reported in other
        (income) expense, net in our combined consolidated financial statements.
        We do
        not currently hedge our exposure to foreign currency exchange rate fluctuations.
        We may, however, hedge such exposure to foreign currency exchange rate
        fluctuations in the future.
 
 All
        of
        our sales denominated in foreign currencies are denominated in the Hong Dollar
        and the Chinese Renminbi. Our principal exchange rate risk therefore exists
        between the U.S. dollar and these two currencies. Fluctuations from the
        beginning to the end of any given reporting period result in the re-measurement
        of our foreign currency-denominated receivables and payables, generating
        currency transaction gains or losses that impact our non-operating
        income/expense levels in the respective period and are reported in other
        (income) expense, net in our combined consolidated financial statements.
        We do
        not currently hedge our exposure to foreign currency exchange rate fluctuations.
        We may, however, hedge such exposure to foreign currency exchange rate
        fluctuations in the future.
  37
 ***Interest
        Rate Risk.***
 Changes
        in interest rates may affect the interest paid (or earned) and therefore
        affect
        our cash flows and results of operations. We are exposed to interest rate
        change
        risk with respect to Epros' (one of our subsidiaries) credit facility with
        a
        commercial lender. However, we do not believe that this interest rate change
        risk is significant.
  **ITEM
        4. CONTROLS AND PROCEDURES**
 
 **Evaluation
        of Disclosure Controls and Procedures**
  PacificNet
        Inc. (the "Company") maintains disclosure controls and procedures that are
        designed to ensure that information required to be disclosed in the reports
        the
        Company files or submits under the Securities Exchange Act of 1934, as amended
        (the "Exchange Act"), is recorded, processed, summarized and reported within
        the
        time periods specified in the Securities and Exchange Commission's rules
        and
        forms, and that such information is accumulated and communicated to the
        Company's management, including its Chief Executive Officer ("CEO") and Interim
        Chief Financial Officer ("CFO"), as appropriate, to allow timely decisions
        regarding required financial disclosure.
  In
        connection with the preparation of this Quarterly Report on Form 10-Q, the
        Company carried out an evaluation under the supervision and with the
        participation of the Company's management, including the CEO and Interim
        CFO, as
        of end of the period covered by this report of the effectiveness of the design
        and operation of the Company's disclosure controls and procedures, as such
        term
        is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based
        upon
        this evaluation the CEO and CFO concluded that as of September 30, 2006,
        the
        Company's disclosure controls and procedures contained significant deficiencies
        and material weaknesses. Also, as previously reported in our Annual Report
        on
        Form 10-KSB for the year ended December 31, 2005 (the "2005 Form 10-KSB")
        and as
        of the end of the period covered by this report, significant deficiencies
        and
        material weaknesses with respect to the Company's internal controls over
        financial reporting were identified and communicated to us by our independent
        auditors.
  The
        Company implemented remediation initiatives and interim measures beginning
        in
        the second quarter and continues to implement such initiatives.
  In
        the
        absence of full implementation of the remediation initiatives in the second
        quarter of 2006, the Company has undertaken additional measures described
        below
        in the interim to ensure that the Company's consolidated financial statements
        included in this Quarterly Report on Form 10-Q were prepared in accordance
        with
        accounting principles generally accepted in the United States. Accordingly,
        the
        Company's management believes that the consolidated financial statements
        included in this Quarterly Report on Form 10-Q fairly present in all material
        respects the Company's financial condition, results of operations and cash
        flows
        for the periods presented and that this Quarterly Report on Form 10-Q does
        not
        contain any untrue statement of a material fact or omit to state a material
        fact
        necessary to make the statements made, in light of the circumstances under
        which
        such statements were made, not misleading with respect to the period covered
        by
        this report.
 
 38
 **Management’s
        Remediation Initiatives and Interim Measures**
  Management
        continues to reviewe and implement changes to the overall design of the
        Company's control environment, which includes formalizing the roles, duties
        and
        responsibilities of each functional group within the organization and putting
        in
        place a process by which each subsidiary's accounting staff must report and
        communicate required financial disclosures to the Company's primary accounting
        groups for review and oversight, as well as new procedures to monitor internal
        controls over financial reporting, which the CEO and Interim CFO believe
        will
        greatly improve the current process.
  The
        following is a description of the Company’s remediation initiatives with respect
        to each deficiency identified in the 2005 Form 10-KSB and at the end of the
        period covered by this report:
 
 ***1.***
              ***The
                  current organization of the accounting department does not provide
                  PacificNet with the adequate skills to accurately account for and
                  disclose
                  significant transactions or
                  disclosures.***
 
 ***Remediation
        Initiatives***
 
 Beginning
        in the first quarter of 2006, the Company streamlined its reporting procedures
        by requiring all accounting groups within each subsidiary, which includes
        tax,
        treasury, financial planning and analysis groups, to directly report information
        and communicate to their respective accounting group at the Company’s financial
        accounting headquarters in Shenzhen. Each accounting group at Shenzhen is
        now
        responsible for overseeing the reporting results delivered for each subsidiary
        within their group to ensure that the material transactions and financial
        disclosures provided by such group are accurate, complete and correct and
        do not
        contain any material misstatements or omit material information.
 
 The
        Company plans to retain the services of outside consultants, other than the
        Company’s independent registered public accounting firm, with relevant
        accounting experience, skills and knowledge, working under the supervision
        and
        direction of the Company’s management, to supplement the Company’s existing
        accounting personnel.
  The
        Company plans to expand the size of its internal audit group, and has determined
        to retain an outside independent consulting firm with relevant accounting
        experience. In connection with this expansion the Company will give the internal
        audit group the added responsibility to monitor its wholly owned subsidiaries
        and partially owned subsidiaries and joint venture operations through reviews
        and audits at such locations a minimum of three times a quarter.
 
 The
        Company believes that this new responsibility of the internal audit group
        is
        critical upon each new acquisition, as the newly acquired subsidiary must
        quickly become familiar with the Company's policies and procedures for
        processing, summarizing, reporting and disclosing material information and
        ensuring that financial information about the new subsidiary is properly
        accounted for and communicated to management.
  39
 ***2.***
              ***Certain
                  key managers in the accounting department do not appear to have
                  the
                  knowledge and experience required for their
                  responsibilities.***
 
 ***Remediation
        Initiatives***
 
 As
        indicated in the Company’s 10-K filed on April 28, 2006, PacificNet has greatly
        expanded its Finance and Accounting staff in China in the last six months.
        In
        January, the Company promoted Mary Ma to the new position of Vice President
        of
        Finance for China operations, a position which will be permanently stationed
        in
        China. Ms. Ma has the prior business experience required to act in a supervisory
        capacity for the Company, including experience with Chinese Accounting
        Standards, IAS and US GAAP, corporate finance, finance analysis and operation.
        Ms. Ma. with assistance from other senior members of the financial staff,
        have
        reviewed and will continue to review and adapt the overall design of the
        Company's financial reporting structure, including the roles and
        responsibilities of each functional group within the Company. In May 2006,
        the
        Company announced the resignation of Mr. ShaoJian Wang as the CFO effective
        May
        26, 2006, as a result of this new position at Hurray! Holding Co. Ltd.
        (Nasdaq:HRAY) as their President and Chief Operating Operator. Mr. Wang has
        remained as a director of PacificNet. In September 2006, the Company announced
        the hiring of its new CFO, Mr. Joseph Levinson, a former manager at Deloitte
        and
        Touche in New York.
 
 The
        Company has plans to hire managers experienced in several key areas of
        accounting, including primarily persons with experience in US GAAP consolidation
        requirements, SEC financial reporting requirements and international tax
        skills,
        who will include the following:
 
 ·
              a
                  consolidation manager with relevant accounting experience, skills
                  and
                  knowledge;·
              several
                  senior managers familiar with SEC financial reporting requirements
                  with
                  relevant accounting experience, skills and knowledge;
                  and
 ·
              a
                  senior manager with relevant PRC and international tax and accounting
                  skills, experience and knowledge.
 
 In
        September 2005, the Company implemented a formal training process to train
        its
        accounting and financial staff and plans to continue this process to ensure
        that
        personnel have the necessary competency, training and supervision for their
        assigned level of responsibility and the nature and complexity of the Company’s
        business. The Company plans to conduct a training seminar regarding revenue
        recognition, including identification of non-standard contracts in China.
  The
        Company has allocated resources to continue to hire additional accounting
        personnel in the U.S., Hong Kong and China, in the areas of tax, external
        financial reporting, revenue recognition, treasury, financial planning and
        analysis and corporate accounting with relevant accounting experience, skills
        and knowledge.
 
 ***3.***
              ***Substantive
                  matters are not being addressed appropriately by the Board and
                  Audit
                  Committee resulting in inadequate oversight from the Board and
                  Audit
                  Committee.***
 
 ***Remediation
        Initiatives***
  The
        Company has proposed to set forth a schedule and increase the frequency of
        Board
        of Director meetings and Audit Committee meetings. The Company, its Board
        of
        Directors and the Audit Committee have recognized that communication is required
        earlier and more frequently to ensure that substantive matters are addressed
        as
        early as possible in both the review and audit process and to allow for more
        detailed financial accounting reports and findings to be prepared and presented
        to the Audit Committee in a timely manner.
  40
 ***4.***
              ***The
                  process that PacificNet is currently using to monitor the ongoing
                  quality
                  of internal controls performance, identify deficiencies and trigger
                  timely
                  corrective action is not working
                  effectively.***
 
 ***Remediation
        Initiatives***
 
 Utilization
        of Computerized Automated Controls:
  Beginning
        in the third quarter of 2005, the Company started to deploy a company-wide
        unified financial accounting system using the Kingdee K/3 Financial Accounting
        & ERP Software, provided by Kingdee International Software Group Company
        Limited (www.Kingdee.com), one of the top two financial accounting and ERP
        system providers in China. From Q3 2005 through Q1 2006, the Company rolled
        out and successfully implemented the Kingdee K/3 Software for all its wholly
        owned subsidiaries. In the second quarter of 2006, the Company rolled out
        the Kingdee K/3 Software for its other partially owned subsidiaries and joint
        ventures in China.
  The
        Kingdee Software allows the Company and its subsidiaries to easily manage
        and
        monitor all financial and accounting processes within the group, which will
        assist the Company in collecting all material information necessary for its
        financial reports easily and accurately. During the first quarter of 2006,
        the
        Company implemented, and plans to continue to enhance, its month-end closing
        procedures, including reconciliations and controls over spreadsheets, and
        standardized checklists to ensure such procedures are consistently and
        effectively applied throughout the organization in order to improve the
        financial review time and quality to ensure that U.S. GAAP reviewers monitor
        financial information from non-U.S. locations in a consistent manner, through
        such measures as use of standardized reporting packages and review
        procedures.
  The
        Company plans to deploy a document management system with secured intranet
        access during the third quarter of 2006 to ensure that all material contracts
        are collected, retained and available for review by all at one
        site.
 
 ***5.***
                ***There
                  is no adequate means of accurately capturing and recording certain
                  significant and complex business
                  transactions:***
 ******
 ***Remediation
        Initiatives***
  In
        2006
        the Company began requiring centralized retention of documentation evidencing
        proof of delivery of products and services and final acceptance for revenue
        recognition purposes. The Company believes the document management system
        it
        plans to deploy as described above will be the primary tool to ensure that
        its
        business transactions are accurately recorded and evaluated for the purposes
        of
        legal and financial disclosure. The Company plans to design a contract review
        process in China requiring financial and legal staff to provide input during
        the
        contract negotiation process to ensure timely identification and accurate
        accounting treatment of non-standard contracts and to ensure proper revenue
        recognition with adequate documentation.
  41
 **PART
        II - OTHER INFORMATION**
 
 **ITEM
        1. LEGAL PROCEEDINGS.**
  None.
  **ITEM
        1A. RISK FACTORS.**
  In
        addition to the other information set forth in this report, you should carefully
        consider the factors discussed in “Risk Factors” in our Annual Report on Form
        10-KSB for the year ended December 31, 2005, and in Part II, Item IA Risk
        Factors in our Amendment to Quarterly Report on Form 10-Q for the period
        ended
        June 30, 2006 which could materially affect our business, financial condition
        or
        future results. The risks described in our Annual Report on Form 10-KSB and
        the
        Amendment to our Quarterly Report on Form 10-Q are not the only risks facing
        us.
        Additional risks and uncertainties not currently known to us or that we
        currently deem to be immaterial also may materially adversely affect our
        business, financial condition and/or operating results.
  **ITEM
        2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**
  None.
  **ITEM
        3. DEFAULTS UPON SENIOR SECURITIES.**
  None.
  **ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**
  None.
  **ITEM
        5. OTHER INFORMATION.**
  None.
  **ITEM
        6. EXHIBITS**
  The
        following exhibits are filed as part of this report:
  EXHIBIT
  NUMBER
              DESCRIPTION
  31.1
              Rule
                  13a-14(a) Certification of Chief Executive Officer (Principal Executive
                  Officer)
  31.2
              Rule
                  13a-14(a) Certification of Chief Financial Officer (Principal Financial
                  Officer)
  32.1
              18
                  U.S.C. Section 1350 Certifications
   42
 SIGNATURES
  In
        accordance with the requirements of the Securities Exchange Act of 1934,
        as
        amended, the Registrant has duly caused this report to be signed on its behalf
        by the undersigned, thereunto duly authorized.
 
 PACIFICNET
                  INC.Date: November
                  17, 2006
              By:
              /s/ TONY
                  TONGTony
                  Tong
                Chief
                  Executive Officer
                (Principal
                  Executive Officer)Date: November
                  17, 2006
              By:
              /s/ Joseph
                  LevinsonJoseph
                  Levinson
                Chief
                  Financial Officer
                (Principal
                  Financial Officer)
   43