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                                  United States
                       Securities and Exchange Commission
                              Washington, DC 20549

                                   FORM 10-KSB

[X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934

         For fiscal year ended December 31, 2006

[ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934

                         Commission File Number: 0-31483

                               TERRA SYSTEMS, INC.
                               -------------------
             (Exact name of registrant as specified in its charter)

                                      UTAH
                                      ----
          (State or other jurisdiction of incorporation or organization

                                   87-0476073
                                   ----------
                      (I.R.S. Employer Identification No.)

                7001 South 900 East, Ste 260, Midvale, Utah 84047
                -------------------------------------------------
                    (Address of principal executive offices)

                                 (801) 208-1289
                                 --------------
              (Registrant's telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Act:   None.

Securities registered pursuant to section 12(g) of the Exchange Act: Common,
$0.001 par value

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

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

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. Class: Common Stock, $0.001 par
value Outstanding as of April 13, 2007: 44,403,056

Check whether there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]

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

State issuer's revenue for the fiscal year ended December 31, 2006: $45,897

<PAGE>

As of December 31, 2006, the registrant had 42,675,356 shares of common stock
outstanding. The aggregate market value of the 32,072,064 shares of voting stock
held by non-affiliates as of that date was approximately $12,828,826

As of April 13, 2007, when this report was prepared, the registrant had
44,403,056 shares of common stock outstanding. The aggregate market value of the
33,799,764 shares of voting stock held by non-affiliates as of that date was
approximately $10,477,927.

Documents incorporated by reference: None.

Transitional Small Business Disclosure Format (check one): Yes [ ] No [X]

























                                       2
<PAGE>

                                TABLE OF CONTENTS

                                     PART I

Item 1.    Description of Business                                            4
Item 2.    Description of Property                                           11
Item 3.    Legal Proceedings                                                 11
Item 4.    Submission of Matters to a Vote of Security Holders               11

                                     PART II

Item 5.    Market for Common Equity, Related Stockholder Matters
           and Issuer Purchase of Securities                                 11
Item 6.    Management's Discussion and Analysis                              13
Item 7.    Financial Statements                                              15
Item 8.    Changes in and Disagreements with Accountants on
           Accounting and Financial Disclosure                               15
Item 8A.   Controls and Procedures                                           15
Item 8B.   Other Information                                                 16

                                    PART III

Item 9.    Directors, Executive Officers, Promoters and Control
           Persons, Compliance with Section 16(a) of the
           Exchange Act                                                      16

Item 10.   Executive Compensation                                            18

Item 11.   Security Ownership of Certain Beneficial Owners
           and Management and Related Stockholder Matters                    20

Item 12.   Certain Relationships and Related Transactions                    21

Item 13.   Exhibits                                                          21

Item 14.   Principal Accountant Fees and Services                            22

Signatures                                                                   23







                                       3
<PAGE>

         PART I

Item 1.  Description of Business

         Business Overview

         The Company was formed as a Utah  corporation  on  February  17,  1996,
under the name Terra  Systems,  Inc., and is a  development-stage  company whose
primary business purpose is the development and commercialization of a pneumatic
conveyance system to handle materials in a bulk state.

         On May 1, 1996, we merged with Xullux, Inc., a Utah corporation. In the
merger,  our shareholders  received  48,000,000 shares of Xullux common stock in
exchange  for  their  shares  of  Terra  Systems  common  stock.  Following  the
reorganization,  Xullux changed its name to Terra Systems,  Inc. In this report,
reference to the terms  "Terra  Systems,"  "we," "us," "our," and "the  Company"
refer  collectively  to Terra Systems,  Inc., and its  predecessors,  unless the
context clearly indicates otherwise.

         Our common  stock began  trading in July 1996 and was quoted  under the
ticker symbol "TSYI" on the OTC Bulletin Board in 2001. On November 15, 2001 the
stock ceased to trade on the OTC Bulletin  Board,  and began trading on the Pink
Sheets  under the ticker  symbol  TSYI.PK.  In September  2006,  our stock began
trading again on the OTC Bulletin Board under the ticker symbol "TSYI".

         Products

         Our principal product is a low-pressure  pneumatic  conveyance  system.
Low-pressure  systems  such as our  system  are  used  in  connection  with  the
pulverization,  moisture control,  classification,  transport, and processing of
bulk materials in a number of basic industries.

         Our system  relies on a slow moving  laminar  flow gas bearing to allow
for the  transportation  of material through a carrying duct. A laminar flow gas
bearing is formed  when the air in the center of a pipeline is  surrounded  by a
slow moving  turbulent  flow  boundary  air layer next to the inside wall of the
pipe. It is referred to as a boundary  because it acts to insulate the pipe from
severe abrasive  contact with the transported  material.  The amount of wear and
tear or erosion on the inside of a pipe  caused by the flow of a given  material
is referred to in the industry as the abrasion  signature.  Our process  reduces
this abrasion  signature because the material being transported is caught up and
carried by the faster moving gas in the center of the pipe. Unlike high-pressure
conveyance systems, low-pressure systems do not allow for the build-up or caking
of material inside the containment pipe. In pneumatic conveyance,  caking occurs
when dust combines with moisture and starts to gradually  build up on the inside
wall of the pipe.

         High-pressure  pneumatic  conveyance systems rely on the compression of
air for operation. When the air is compressed, the moisture contained in the air
collects inside the pipe. These pressurized  systems have to be enclosed and can
only purge  moisture at the end of their  conveyance  cycle.  The material  they
carry becomes exposed to this moisture,  which may lead to caking.  On the other
hand, a  low-pressure  system like ours  operates in an open  environment.  This
allows the  material  being  transported  to breathe any moisture out during the
transportation process.

         Many of our components are pre-fabricated with final assembly occurring
at the client's site. In most cases,  we bill the client an hourly or daily rate
for  constructing  a system  that will vary in cost  based on the  customization
involved  for each  client and their  unique  requirements.  For  example,  some
applications may require only product drying before going to an existing milling
operation.  Thus our equipment  could provide  simply the product drying service
onsite.

         The prospective markets for our industrial particle accelerator include
power generation, mining, agriculture,  environmental,  ceramics,  construction,
and  materials  transportation.  We  believe  that  because  of the  nature  and
flexibility of our process,  many bulk materials used in basic industries can be
economically separated, classified, and otherwise processed.


                                       4
<PAGE>

         Distribution, Marketing, and Customer Relations

         Our marketing strategy is to promote,  advertise and increase our brand
visibility and attract new customers through multiple channels, including:

         *        Developing strategic alliances;
         *        Establishing our brand name; and
         *        Direct marketing to existing and potential customers.

         We believe that the use of multiple  marketing channels will reduce our
reliance  on any one source  for  obtaining  customers.  This in turn will lower
costs and maximize brand awareness.

         Strategic alliances

         We do not  currently  have any  strategic  alliances.  We do,  however,
believe that future joint venture relationships will allow us to gain additional
insight,  expertise and  penetration  into markets where joint venture  partners
already  operate and may serve to increase  our  revenue and income  growth.  We
expect to review  potential  strategic  alliance  candidates  and to enter  into
agreements  in the future  should we feel these  alliances  would be in the best
interest of the company.

         Establish our name brand

         We cannot  guarantee  that we will be able to  successfully  market and
distribute our services in either the United States or other countries,  and the
failure to do so could have an adverse effect on our operations. We believe that
building  awareness of the Terra Systems brand is important in establishing  and
expanding our customer  base. We currently  have a web site  (www.tsyi.com)  and
will use traditional media as our revenues permit, to attract new customers.  We
are providing an inactive textual  reference only to our website because it does
not constitute a part of this report.

         Direct marketing

         To  date  our  marketing   activity  has  been  largely   word-of-mouth
referrals,  on-site  demonstrations,  as well as contacts generated from our web
site. We plan to move forward with industrial and agricultural  clients entering
into  exclusive  licensing  agreements,  which we  expect to  generate  fees and
royalty revenues.

         We  believe  that our  ability  to  establish  and  maintain  long-term
relationships with our customers and encourage repeat business depends, in part,
on the strength of our customer  support and service  operations  and staff.  We
value frequent  communication  with and feedback from our clients to continually
improve our  services.  We focus on  designing  high  quality  applications  and
engineered  products  that are  designed  to address  specific  customer  needs.
Although our existing customer  relationships are strong,  our operating results
may  fluctuate  due to  factors  such as the  addition  or  loss of  significant
customers.

         Industry Background and Competitive Conditions

         Nearly  all  bulk  materials  used in basic  industries  can or must be
separated,  pulverized,  classified, or otherwise enhanced.  Opportunities exist
for many  applications  in both organic and  inorganic  materials in an array of
large   industries,    including   power   generation,    mining,   agriculture,
environmental,  ceramics,  construction, and materials transportation.  Our main
competition  consists of companies  providing or engaging in traditional methods
of pulverization and transport of bulk materials; these include manufacturers of
roller  mills and ball  mills.  We  believe  that we compete on the basis of the
unique nature of our technology.  Specific  competitors in our industry would be
Bechtel,  Babcock & Wilcox,  and Ecology & Environment.  These companies provide
coal pulverization,  mineral  processing,  and remediation of industrial wastes.
They are  larger,  better  funded  and  possess  greater  name  recognition  and
reputation in the market than Terra Systems.  There is no assurance that we will
be able to compete successfully against these larger players in the industry.



                                       5
<PAGE>

         Raw Materials and Suppliers

         We do not purchase or supply raw materials.  Numerous raw materials are
used to conduct on-site  demonstrations  on the effectiveness of our process and
equipment;  however,  our  prospective  clients provide these  materials.  These
materials  used  in  on-site   demonstrations  include  rice,  coal,  coal  ash,
limestone,  gypsum,  agricultural  waste and other materials  containing various
heavy minerals, such as gold, silver, and platinum.

         The  following  is  a  partial  list  of  major  industries  where  our
technology could be adopted or utilized.

         *        Coal
                  *        Reduce moisture
                  *        Reduce ash
                  *        Increased Btu value
                  *        Micropulverize (80% of coal throughput ground down
                           to 325 mesh)
                  *        Transport
                  *        Reclaim from gob piles

         *        Electric Power Generation With Coal
                  *        Reduce air pollution emissions, especially NOx
                  *        See "Coal" above
                  *        Contain fugitive dust

         *        Agriculture
                  *        Rice, coarse grains, sugar
                           *        Drying
                  *        Soil conditioning
                           *        Restore depleted trace minerals

         *        Environmental
                  *        Extract/dry/remove waste from
                           *        Food processing
                           *        Animals
                           *        Industry
                           *        Radioactive materials

         *        Mining
                  *        Precious metals
                           *        Classify and concentrate desired ores

         *        Construction
                  *        Cement and concrete

         *        Ceramics
                  *        Micropulverize

         *        Transportation
                  *        Waterways
                  *        Dredging
                  *        Loading/unloading/transloading



                                       6
<PAGE>

Patents

         We own one patent,  U.S. Patent No.  6,170,768,  covering our pneumatic
accelerator  and granted  January 9, 2001.  We expect that we will  upgrade this
patent  or file  additional  applications  as  developments  are  made  with our
technology. We rely upon a combination of patents,  copyright protection,  trade
secrets,   know-how,   continuing   technological   innovation   and   licensing
opportunities  to develop and  maintain  our  competitive  position.  Our future
prospects depend in part on our ability to obtain and maintain patent protection
for our  technology.  We also  need to  continue  to  preserve  our  copyrights,
trademarks  and  trade  secrets  and we  must  operate  without  infringing  the
proprietary rights of third parties.

         We cannot  guarantee  that any of our future patent  applications  will
result  in  issued  patents,  nor  can we  assure  that  we  will  develop  more
proprietary  technologies that are patentable.  Patents issued may not provide a
basis for  commercially  viable  products  or may not  provide  any  competitive
advantages.  Third  parties could  challenge our patents.  The patents of others
could limit our ability to use some of our  processes  or  technologies.  Any of
these  situations  could have a  material  adverse  effect on our  ability to do
business.  We cannot prevent  others from  independently  developing  similar or
alternative  technologies,  duplicating any of our technologies,  or, if patents
are issued to us,  designing  around our patented  technologies.  We could incur
substantial costs in litigation if we are required to defend ourselves in patent
suits  brought by third parties or if we initiate  these suits against  possible
infringers of our patent rights.

         Others  may have  filed and in the  future  are  likely to file  patent
applications that are similar or identical to ours. To determine the priority of
inventions,  we may have to participate in interference  proceedings declared by
the United States Patent and Trademark Office. Those proceedings could result in
substantial  cost to us.  We  cannot  ensure  that any such  third-party  patent
application  will not have  priority over ours.  Additionally,  the laws of some
foreign  countries  may not protect our patent and other  intellectual  property
rights to the same extent as the laws of the United States.

         Our future  prospects  also  depend in part on our  neither  infringing
patents or  proprietary  rights of third parties nor breaching any licenses that
may relate to our  technologies  and products.  We cannot guarantee that we will
not infringe the patents, licenses or other proprietary rights of third parties.
We could in the future receive notices claiming  infringement from third parties
as well as  invitations to take licenses under  third-party  patents.  Any legal
action  against  our  strategic  partners  or us that claim  damages and seek to
enjoin  commercial  activities  relating to the affected  products and processes
could subject us to potential  liability for damages.  Those legal actions could
also  require  our  strategic  partners  or us to obtain a  license  in order to
continue to manufacture or market the affected products and processes. We cannot
ensure that our strategic  partners or we would prevail in any action. We cannot
ensure that any license,  including licenses proposed by third parties, required
under any patent would be available on terms that are  commercially  acceptable,
if at all.  We have not  conducted  an  exhaustive  patent  search and we cannot
ensure  that  patents  do not  exist or could  not be filed  that  would  have a
material adverse effect on our ability to develop and market our products. If we
become involved in such  litigation,  it could consume a substantial  portion of
our  managerial  and financial  resources,  which would have a material  adverse
effect  on  our  business,  financial  condition,  results  of  operations,  and
relationships with corporate partners.

         We  attempt  to  control  the  disclosure  and  use of our  proprietary
technology,  know-how  and  trade  secrets  under  agreements  with the  parties
involved.  However,  we cannot ensure that others will honor all confidentiality
agreements.  We cannot prevent others from  independently  developing similar or
superior technology, nor can we prevent disputes that could arise concerning the
ownership of intellectual property.

         Government Regulation

         We are not  currently  subject to direct  regulation by any domestic or
foreign  governmental  agency,  other than  regulations  applicable  to business
generally,  export control laws, and laws or regulations  directly applicable to
the industry.  We will be required to ensure the enforcement of the Occupational
and Health Administration (OSHA) regulations.

         We believe that we will be able to comply in all material respects with
the laws and  regulations  governing the industry and that compliance with those
laws will not have a material effect on our operations. However, various federal

                                       7
<PAGE>

and state  agencies may propose new  legislation  that may adversely  affect our
business, financial condition and results of operations. We are not aware of any
probable government regulations that may adversely affect our business.

         Research and Development Activities

         Our  success and ability to compete  will be  dependent  in part on the
protection  of our  existing and  potential  patents,  trademarks,  trade names,
service marks, and other  proprietary  rights.  Thus, a majority of our research
and development efforts has been focused on product  development,  testing,  and
patent application

         We seek to continue developing our products internally through research
and development or if appropriate,  through strategic  partnerships.  We expect,
however, that if we can purchase or license products,  services, or technologies
from third  parties at a  reasonable  cost,  we will do so in order to avoid the
time  and  expense   involved  in  developing   such  products,   services,   or
technologies.

         Employees

         As of  December  31,  2006,  we  had  three  full-time  employees,  one
part-time employee, and three consultants and advisors.  There were no organized
labor  agreements  or union  agreements  between  Terra  Systems,  Inc.  and our
employees.  We believe  that  relations  with our  employees  have been and will
continue to be good.

RISK FACTORS

         We have a history of losses and an accumulated deficit of approximately
$19,190,814  as of  December  31,  2006,  and  approximately  $17,778,583  as of
December 31, 2005. If we do not become  profitable or maintain  profitability in
the future, we may not be able to continue to operate.

         We incurred net losses of approximately $19,190,814 for the period from
February  1996  through  December  31,  2006.  We  expect to  continue  to incur
substantial net losses in the foreseeable future. If we do not become profitable
within the time frame  expected  by  investors,  the market  price of our common
stock  likely will  decline.  If we continue to incur net losses,  we may not be
able to  maintain or  increase  our number of  employees  or our  investment  in
capital equipment,  sales, marketing,  and research and development programs. We
do  not  know  when  or  if  we  will  become  profitable.   If  we  do  achieve
profitability,  we may not sustain or increase profitability in the future. As a
result, we may not be able to continue to operate.

         Our limited  operating  history  makes it difficult  to predict  future
results.

         Our  business  model is still  emerging,  and the  revenue  and  income
potential of our business and market are unproven.  We have a limited  operating
history  on which to base  estimates  for  future  performance.  Our  technology
represents a new approach to the challenges  presented in our selected  markets,
which to date have been dominated by established companies with longer operating
histories.  Although we expect that ongoing  negotiations with potential clients
may result in the  finalization  of feasibility  study and licensing  agreements
that would result in revenues and cash flows, there is no assurance that we will
be successful in those negotiations. Key markets within our industry may fail to
adopt  our  proprietary  technologies  and  products,  or we may  not be able to
establish  distribution  channels.  Any  evaluation  of  our  business  and  our
prospects must be considered in light of our limited  operating  history and the
risks and uncertainties  often encountered by companies in their early stages of
development.

         Technological  and other  developments  in our  markets  may render our
technologies  and products  obsolete or limit our ability to  penetrate  our key
markets.

         Technological change,  continuing process development,  and new product
introductions may affect the markets for our products.  Our success will depend,
in part, upon our continued  ability to manufacture  products that meet changing
customer needs,  successfully  anticipate or respond to technological changes in
manufacturing  processes  on a  cost-effective  and timely basis and enhance and
expand  our  existing  product  offerings.  Current  competitors  or new  market
entrants may develop new products with features that could adversely  affect the
competitive  position of our  products.  We have invested and continue to invest
substantial  resources in research and  development in an effort to improve upon

                                       8
<PAGE>

our existing  processes.  However,  there can be no  assurance  that our process
development   efforts  will  be   successful   or  that  the  emergence  of  new
technologies,  industry standards,  or customer requirements will not render our
technology,  equipment,  or processes obsolete or uncompetitive.  Any failure or
delay in  accomplishing  these goals could have a material adverse effect on our
business,  results of operations,  and financial condition.  In addition, to the
extent that we determine  that new  manufacturing  equipment  or  processes  are
required  to remain  competitive,  the  acquisition  and  implementation  of the
technologies,   equipment,   and  processes   required  are  likely  to  require
significant capital investment.

         Our reliance  upon  intellectual  property  licenses from third parties
limits the  control we have over  aspects of our  business  development  and may
increase the expense of doing  business,  which would reduce  profitability.  In
addition, the possibility of infringing upon the intellectual property rights of
third  parties  may  result  in  litigation  and  divert  the  attention  of our
management, adversely affecting our business.

         We may rely on intellectual  property licenses from third parties,  and
may be required to license  additional  products or services in the future,  for
use in the general  operations of our business plan. We cannot assure that these
third party licenses will be available or will continue to be available to us on
acceptable  terms,  if at all.  The  inability to enter into and maintain any of
these licenses could have a material  adverse effect on our business,  financial
condition,  or operating results. In addition,  policing unauthorized use of our
proprietary  and other  intellectual  property  rights could be expensive if not
difficult or impossible.

         Additionally,  we cannot  guarantee  that third  parties will not bring
claims of copyright or trademark  infringement against us, or claim that aspects
of our processes or other features  violate a patent they may hold. There can be
no  assurance  that third  parties  will not claim that we have  misappropriated
their  creative ideas or formats or otherwise  infringed upon their  proprietary
rights.  Any  claims  of  infringement,  with or  without  merit,  could be time
consuming to defend,  result in costly litigation,  divert management attention,
or require us to enter into  costly  royalty or  licensing  arrangements.  These
potentialities  could have a material adverse effect on our business,  financial
condition, or operating results.

         Our audited  financial  statements have been prepared on the assumption
that we will  continue as a going  concern.  If we fail to continue in business,
you would lose your investment.

         Our independent registered public accounting firm has issued its report
dated April 13, 2007,  that includes an explanatory  paragraph  stating that our
deficit in working capital,  negative cash flows from  operations,  shareholders
deficit and  recurring net losses raise  substantial  doubt about our ability to
continue as a going concern.  If we are not successful in generating  additional
sales,  reducing  expenses,  or  obtaining  additional  financing  through  this
offering  or  otherwise,  we  may be  required  to  scale  back  or  discontinue
operations,  in which case our investors could lose all or substantially  all of
their investment.

         If we  are to be  competitive,  we  need  to  attract  and  retain  key
personnel.  Our  financial  resources  are  limited,  and it may be difficult to
attract and retain personnel who are or would be instrumental to our success.

         Our future success depends  significantly  on the continued  service of
our senior  management.  The familiarity of these  individuals with the industry
makes them especially  critical to our success.  The loss of the services of one
or more  of our key  employees  could  have a  material  adverse  effect  on our
business.  We do not currently  have key man insurance on any of our  employees,
but we do anticipate  obtaining that insurance in the future. Our future success
also  depends on our  ability to attract  and retain  highly  qualified  design,
technical,  sales,  marketing,   customer  service,  and  management  personnel.
Competition for these personnel is intense, and we cannot guarantee that we will
be able to attract or retain a sufficient  number of highly qualified  employees
in the  future.  The lack of  qualified  management  personnel  could  limit our
ability to grow our business and may limit our ability to effectively compete in
our markets.

         Our  inability to  effectively  manage  growth may increase the cost of
doing business or result in inefficiencies  that would reduce cash available for
growth and prevent us from becoming profitable.

                                       9
<PAGE>

         To execute our business plan, we must grow  significantly.  This growth
will  place a  significant  strain on our  personnel,  management  systems,  and
resources.   We   expect   that  the   number   of  our   employees,   including
management-level employees, will continue to increase in the foreseeable future,
and  that  we may  need  additional  office  space  and  expanded  technological
infrastructure.  Failure to manage growth effectively will materially  adversely
affect our business, results of operations, and financial condition.

         We may not be able to obtain sufficient patent protection,  which could
harm our competitive position and increase our expenses.

         Our success and ability to compete depends to a significant degree upon
the  protection  of our  proprietary  technology.  Currently,  one of our patent
applications  has been  allowed.  These legal  protections  afford only  limited
protection  for our  technology,  and the rights  that may be granted  under any
future patents that may be issued may not provide competitive  advantages to us.
Patent  protection in foreign  countries may be limited or unavailable  where we
need this protection. It is possible that:

         *        competitors may independently develop similar  technologies or
                  design around our patents;

         *        patents  issued to us  may not be  broad enough to protect our
                  proprietary rights; and

         *        any issued patent could be successfully challenged.

         The  occurrence of any of these factors could result in the  diminution
or loss of our  protected  intellectual  property,  which  could have a material
adverse impact on our business.

         Our stock is  considered  a penny  stock.  Penny  stocks are subject to
special  regulations,  which may make them more  difficult  to trade on the open
market.

         As of the date of this  report,  our common stock was traded on the OTC
Bulletin Board under the ticker symbol "TSYI."  Securities in the Bulletin Board
market are generally more  difficult to trade than those on the NASDAQ  National
Market,  the NASDAQ Small Cap Market or the major stock exchanges.  In addition,
accurate price quotations are more difficult to obtain. Additionally, our common
stock is subject to special regulations governing the sale of penny stock.

         A "penny  stock," is  defined  by  regulations  of the  Securities  and
Exchange Commission as an equity security with a market price of less than $5.00
per share.  However, an equity security with a market price under $5.00 will not
be considered a penny stock if it fits within any of the  following  exceptions,
which are not applicable to our securities:

         *        The  equity  security  is  listed  on  NASDAQ  or  a  national
                  securities exchange;

         *        The  issuer  of the  equity  security  has been in  continuous
                  operation  for less than three  years,  and either has (a) net
                  tangible assets of at least $5,000,000,  or (b) average annual
                  revenue of at least $6,000,000; or

         *        The  issuer  of the  equity  security  has been in  continuous
                  operation  for more than  three  years,  and has net  tangible
                  assets of at least $2,000,000.

         If you buy or sell a penny stock,  these  regulations  require that you
receive,  prior to the  transaction,  a  disclosure  explaining  the penny stock
market and associated risks.  Furthermore,  trading in our common stock would be
subject to Rule 15g-9 of the  Exchange  Act,  which  relates to  non-NASDAQ  and
non-exchange  listed securities.  Under this rule,  broker-dealers who recommend
our  securities  to persons  other than  established  customers  and  accredited
investors  must  make  a  special  written  suitability  determination  for  the
purchaser and receive the purchaser's  written  agreement to a transaction prior
to sale.

         Penny stock  regulations  will tend to reduce  market  liquidity of our
common stock,  because they limit the  broker-dealers'  ability to trade,  and a
purchaser's  ability to sell the stock in the secondary market. The low price of
our common  stock will have a negative  effect on the amount and  percentage  of
transaction costs paid by individual  shareholders.  The low price of our common
stock  may also  limit  our  ability  to raise  additional  capital  by  issuing

                                       10
<PAGE>

additional  shares.  There are several  reasons for these  effects.  First,  the
internal  policies of many  institutional  investors  prohibit  the  purchase of
low-priced stocks. Second, many brokerage houses do not permit low-priced stocks
to be used as  collateral  for margin  accounts  or to be  purchased  on margin.
Third, some brokerage house policies and practices tend to discourage individual
brokers from dealing in low-priced  stocks.  Finally,  broker's  commissions  on
low-priced  stocks usually represent a higher percentage of the stock price than
commissions  on higher priced stocks.  As a result,  our  shareholders  will pay
transaction  costs that are a higher  percentage of their total share value than
if our share price were substantially higher.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

         Some of the statements under "Risk Factors,"  "Management's  Discussion
and Analysis or Plan of  Operation,"  "Business,"  and  elsewhere in this report
constitute forward-looking  statements.  These statements involve risks known to
us,  significant  uncertainties,  and other  factors  which may cause our actual
results,  levels of activity,  performance,  or  achievements  to be  materially
different  from  any  future  results,  levels  of  activity,   performance,  or
achievements expressed or implied by those forward-looking statements.

         You can  identify  forward-looking  statements  by the use of the words
"may," "will," "should," "could," "expects," "plans," "anticipates," "believes,"
"estimates,"  "predicts," "intends,"  "potential,"  "proposed," or "continue" or
the negative of those terms.  Additionally,  statements relating to our business
plans,  financial  projections,  capital needs,  business  development,  capital
raising and business  strategies may also consist of or contain  forward-looking
statements.  Such forward-looking statements are only predictions. In evaluating
these statements,  you should specifically  consider various factors,  including
the risks outlined  above.  These factors may cause our actual results to differ
materially from any forward-looking statement.

         Although   we  believe   that  the   expectations   reflected   in  the
forward-looking  statements are reasonable,  we cannot guarantee future results,
levels of activity,  performance  or  achievements.  We  expressly  disclaim any
obligation or intention to update any forward-looking statement.

Item 2.  Description of Property

         Terra Systems,  Inc.,  occupies  office space located at 7001 South 900
East, Ste 260. Terra Systems, Inc., is renting approximately 2300 square feet of
space. The Company, through its wholly owned subsidiary, Mountain Island Energy,
LLC,  acquired  423  acres  of  land  near  Soda  Springs,  Idaho.  The  land is
strategically    located   near   existing   industrial   facilities   and   key
infrastructure.  We  believe  that  these  properties  and  facilities  will  be
sufficient for our needs for the foreseeable future.

Item 3.  Legal Proceedings

         Litigation  -- In March 2006,  a former  employee of the Company  filed
suit for back wages.  On April 21, 2006,  the suit was settled.  The  settlement
agreement  included  three  payments  of  $10,000  each to be paid May 1,  2006,
September 1, 2006,  and December 1, 2006.  The first payment of $10,000 was made
on May 1, 2006. As of December 31, 2006, all three payments were made.

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

         None.

                                     PART II

Item 5.  Market  for  Common  Equity, Related  Stockholder  Matters  and  Issuer
Purchase of Securities

         MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

         Market for Common Stock  continued on the OTC Bulletin  Board under the
symbol TSYI



                                       11
<PAGE>

                                          High                   Low
2006
1st Quarter                              $ 0.80                $ 0.64
2nd Quarter                              $ 0.80                $ 0.45
3rd Quarter(1)                           $ 0.65                $ 0.35
4th Quarter                              $ 0.50                $ 0.34

2005
1st Quarter                              $ 2.05                $ 0.30
2d Quarter                               $ 1.01                $ 0.65
3d Quarter                               $ 1.02                $ 0.81
4th Quarter                              $ 0.99                $ 0.60

2004
1st Quarter                              $ 0.40                $ 0.18
2d Quarter                               $ 0.35                $ 0.18
3d Quarter                               $ 0.45                $ 0.18
4th Quarter                              $ 0.40                $ 0.24

(1) In September 2006, our stock began trading  on the OTC bulletin  Board under
the ticker symbol "TSYI".

         The source of these  high and low  prices  was the Pink  Sheets and OTC
Bulletin Board. These quotations  reflect  inter-dealer  prices,  without retail
mark-up, mark-down or commission and may not represent actual transactions.  The
high and low prices  listed have been rounded up to the next highest two decimal
places.

         The  market  price  of the  common  stock  is  subject  to  significant
fluctuations in response to variations in the our quarterly  operating  results,
general trends in the market for our technologies,  and other factors, over many
of which we have little or no control. In addition,  broad market  fluctuations,
as well as general economic,  business and political  conditions,  may adversely
affect the market for our common  stock,  regardless  of our actual or projected
performance.  On December 31, 2006, the closing bid price of the common stock as
reported by the OTC Bulletin Board was $0.40 per share.

         Holders

         As of December 31, 2006, there were  approximately  288 shareholders of
record of our common stock.

         Dividend Policy

         We have not paid cash  dividends  on our common stock and do not intend
to pay any cash dividends in the foreseeable future.

Sales of Unregistered Securities

         The following sets forth certain information for all securities we sold
during the past three years without registration under the Securities Act.

2004
         During the twelve  months ending  December 31, 2004 the Company  issued
120,000  shares of common  stock at $0.14 per  share for  proceeds  of  $17,000;
84,210  shares of common  stock at a price of $0.19 per share for  proceeds of $
16,000;  30,000  shares of common  stock at $0.33  per  share  for  proceeds  of
$10,000;  2,713  shares  of  common  stock at a price of $0.30  per  share for a
financing  fee of $814;  900,000  shares of  common  stock at $0.30 per share or
$270,000  for legal  settlement;  635,966  shares of common  stock at a price of
$0.25 per share for  settlement of  liabilities  of $158,990;  375,000 shares of
common  stock at a price of $0.28  per  share for  services  rendered  valued at
$108,000;  204,546  shares  of common  stock at $0.22  per  share  for  services
rendered valued at $ 61,365.

                                       12
<PAGE>

2005
         During the twelve months ending  December 31, 2005,  the Company issued
2,350,000  shares of common  stock at $0.10 per share for  proceeds of $235,000;
600,000  shares of common  stock at a price of $0.08 per share for  proceeds  of
$50,000;  700,000  shares  of  common  stock at a price of $0.07  per  share for
proceeds  of  $50,000;  125,000  shares of common  stock at a price of $0.20 per
share for  proceeds of  $25,000;  700,000  shares of common  stock at a price of
$0.25 per share for  proceeds of  $175,000;  60,000  shares of common stock at a
price of $0.50 per share for proceeds of $30,000; 350,000 shares of common stock
at a price of $0.30 per share or  $105,000  for  satisfaction  of debt;  100,000
shares of common stock at a price of $0.85 per share or $85,000 for satisfaction
of debt;  543,091  shares  of  common  stock at a price  of $0.75  per  share or
$407,318 for financing fees;  508,936 shares of common stock at a price of $0.75
per share or $381,702 for settlement of debt;  1,302,743  shares of common stock
at a price of $0.80 per  share or  $1,042,194  for  settlement  of debt;  90,000
shares of common  stock at a price of $0.81 per share or  $72,900  for  services
rendered;  1,270,000  shares  of  common  stock at a price of $0.95 per share or
$1,206,500 for services rendered; 2,697,257 shares of common stock at a price of
$0.80 per share or  $2,157,806  for services  rendered;  25,000 shares of common
stock as a price of $0.86 per share or $21,500  for  services  rendered;  52,941
share of  common  stock at a price of $0.81 per share or  $42,882  for  services
rendered; 50,001 shares of common stock at a price of $0.84 per share or $41,999
for services  rendered;  200,000  shares of common stock at a price of $0.75 per
share or $150,000 for  services  rendered;  878,048  shares of common stock at a
price of $0.93 per share or $816,585 in connection with an acquisition;  255,812
shares of common  stock at a price of $0.86 per share or $220,000 in  connection
with an acquisition.

2006
         During the twelve months ending  December 31, 2006,  the Company issued
342,401  shares of common  stock at $0.30 per share for  proceeds  of  $102,720;
500,000  shares of common  stock at a price of $0.50 per share for  proceeds  of
$250,000;  28,572  shares  of  common  stock at a price of $0.35  per  share for
proceeds  of  $10,000;  312,500  shares of  common  stock at $0.20 per share for
proceeds of $62,500; 65,000 shares of common stock at a price of $0.65 per share
for financing fees and interest valued at $42,250; 70,311 shares of common stock
valued at $0.65 per share or $45,702 for satisfaction of debt;  64,284 shares of
common stock at a price of $0.75 per share or $48,213 for services rendered.

         The sales of shares to the buyers were made in reliance on Section 4(2)
of  the  1933  Act,  and  rules  and  regulations  promulgated  thereunder,   as
transactions  not  involving  any public  offering.  No  advertising  or general
solicitation was employed in the issuance of the securities.

         The Company did not purchase any shares of its securities during 2006.

Item 6.  Management's Discussion and Analysis

MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

         You should read the following  description  of our financial  condition
and results of operations in conjunction with the audited  financial  statements
and the  notes  thereto  included  elsewhere  in this  report.  This  discussion
contains forward-looking statements based upon current expectations that involve
risks and uncertainties. Any statements contained herein that are not statements
of historical fact may be deemed to be  forward-looking  statements.  Our actual
results  and the timing of  business  events may differ  significantly  from the
results discussed in the forward-looking statements.  Factors that might cause a
discrepancy  include, but are not limited to, those discussed in "Risk Factors,"
"Business," and elsewhere in this report.

General

         Terra Systems was  incorporated  in Utah on February 17, 1996, and is a
development-stage   company.   Our  primary  business  is  the  development  and
commercialization  of our patented pneumatic  accelerator.  This device is a gas
linear  particle  accelerator  that conveys and processes bulk materials at high
velocity in a particle isolate state,  using air as the medium of movement.  The
traditional and more costly medium for processing  bulk materials is water.  Our
technology operates efficiently at ambient temperatures and at low pressures and
does not use water. We believe that most if not all,  organic and inorganic bulk
materials used in basic industries  (such as coal,  gypsum,  black sands,  corn,
rice,  and wheat)  can be more  economically  separated  and  classified  by our
dry-process  technology.  This  capability  facilitates  a number of  associated

                                       13
<PAGE>

procedures, including: drying, micropulverizing, mixing, forming, conveying, and
loading.  In addition,  bulk  materials can be  beneficiated  in important  ways
including   moisture   reduction,   ash   reduction,   Btu   enhancement,    and
electro-customization.  Our  system  can  perform  multiple  tasks,  needs  less
maintenance,  requires no chemical  additives,  and can improve the  surrounding
environmental quality.

         Our  success and ability to compete  will be  dependent  in part on the
protection  of our  existing and  potential  patents,  trademarks,  trade names,
service marks, and other  proprietary  rights.  Thus, a majority of our research
and development efforts have been focused on product  development,  testing, and
patent application.

         We seek to continue developing our products internally through research
and development, or if appropriate,  through strategic partnerships.  We expect,
however, that if we can purchase or license products,  services, or technologies
from third  parties at a  reasonable  cost,  we will do so in order to avoid the
time  and  expense   involved  in  developing  these  products,   services,   or
technologies.

Results of Operations

Twelve months ended December 31, 2006  compared to twelve months  ended December
--------------------------------------------------------------------------------
31, 2005
--------

         From  inception  through  December 31, 2006,  we have  incurred  losses
totaling $19,190,814 and generated revenues of $618,142 from operations.  During
the years  ended  December  31,  2006 and 2005,  we had  $45,897  and zero sales
revenues  respectively.  This factor,  among others,  raises  substantial  doubt
concerning our ability to continue as a going concern.  We intend to use capital
and debt financing as needed to supplement the cash flows that we expect will be
provided by licensing agreements. Our primary source of capital historically has
been through the sale of our securities.

         Realization  of  sales  of  our  products  and  services  is  vital  to
operations.  We may not be able to continue as a going concern without realizing
additional sales or raising additional capital. We cannot guarantee that we will
be able to compete  successfully or that the  competitive  pressures we may face
will not have a material  adverse effect on our business,  results of operations
and financial  condition.  Additionally,  a superior  competitive  product could
force us out of business.

         Our net loss for the year ended  December  31,  2006 was  approximately
$1,412,231,  compared to a net loss for the year ended  December  31,  2005,  of
approximately  $6,487,246.  The net loss was attributable to lower than expected
revenues  from sales of our  products  and  services.  Our expenses for the year
ending December 31, 2006, were approximately  $1,424,476 of which  approximately
91% were general and  administrative  expenses.  Our expenses for the year ended
December 31, 2005, were  approximately  $6,702,276,  of which  approximately 91%
were  general and  administrative.  The  increase in general and  administrative
expenses in 2005 was due to the  issuance of  6,062,150  shares of common  stock
valued at $5,137,490  for services,  financing  fees and an  acquisition.  Also,
during 2005 the Company recognized $728,331 in expense relating to stock options
granted during the year. For the year ended December 31, 2006,  depreciation and
amortization  expense  was $8,532  compared  to  depreciation  and  amortization
expense of $5,097 for the year ended December 31, 2005.

         Future Business

         We see  opportunities  for our  technology  and business in an array of
large   industries,    including   power   generation,    agriculture,   mining,
environmental,   construction,   ceramics,  and  materials  transportation.   We
anticipate  that we will generate  revenues  through the sale of our proprietary
equipment, fees, royalties, and profit sharing from licensing of our technology.

         We are continuing discussions with PacifiCorp regarding pulverized coal
processing  for  the  utility  industry.  We  have  been  working  closely  with
management  and  engineering  personnel in the  preliminary  product  design and
development  stages.  A  major  objective  of the  proposed  strategic  business
alliance with these  entities will be to design a system that has the ability to
produce low ash, low moisture, and ultra fine coal, which enhance the combustion
process  and  reduce  unburned  carbon  and  NOx  emissions.  Our  research  and
development team has been actively engaged in the design of a demonstration unit
since the beginning of 2001.

                                       14
<PAGE>

         Liquidity and Capital Resources

         Given our current  negative cash flows,  it will be difficult for Terra
Systems to continue as a going  concern.  While the issuance of a patent  should
allow us to pursue revenue and cash generating  contracts and opportunities,  it
may be necessary to raise  additional funds or reduce cash  expenditures.  Funds
could be generated  through the issuance of additional stock or through the sale
of existing plant and office equipment. Cash expenditures could be eased through
a reduction in overhead costs, including but not limited to labor and associated
employee benefits.

         As mentioned in our audited financial statements included with our Form
10-KSB, our audited consolidated  financial statements have been prepared on the
assumption that we will continue as a going concern. Our product line is limited
and it has been  necessary  to rely upon  financing  from the sale of our equity
securities to sustain  operations.  Additional  financing will be required if we
are to continue as a going concern. If additional  financing cannot be obtained,
we may be required to scale back or discontinue  operations.  Even if additional
financing  is  available  there  can be no  assurance  that it will be on  terms
favorable  to us.  In any  event,  this  additional  financing  will  result  in
immediate and possible substantial dilution to existing shareholders.

Item 7.  Financial Statements

         Audited  financial   statements  for  the  twelve-month  period  ending
December 31, 2006, are attached.

         Report of Independent Registered Public Accounting Firm            F-1

         Consolidated Balance Sheets- December 31, 2006 and 2005            F-2

         Consolidated Statements of Operations for the Years Ended
            December 31, 2006 and 2005 and for the Cumulative Period
            February 17, 1996 (Date of Inception), through December
            31, 2006                                                        F-3

         Consolidated Statement of Changes in Stockholders' Deficit
            for the Period February 17, 1996(Date of Inception),
            through December 31, 2006                                       F-4

         Consolidated Statements of Cash Flows for the Years Ended
            December 31, 2006 and 2005, and for the Cumulative
            Period February 17, 1996 (Date of Inception), through
            December 31, 2006                                               F-8

         Notes to Consolidated Financial Statements                         F-9

Item 8.  Changes  in  and  Disagreements  with  Accountants  on  Accounting  and
         Financial Disclosure

         None.

Item 8A. Controls and Procedures

         The Company  maintains a set of disclosure  controls and procedures (as
defined  in the  Securities  Exchange  Act of 1934 (the  "Exchange  Act")  Rules
13a-15(e)  or  15d-15(e))  designed  to ensure that  information  required to be
disclosed by the Company in the reports filed under the Securities Exchange Act,
is  recorded,  processed,  summarized  and  reported  within  the  time  periods
specified by the SEC's rules and forms.  Disclosure  controls are also  designed
with the  objective  of  ensuring  that  this  information  is  accumulated  and
communicated  to  the  Company's  management,   including  the  Company's  chief
executive officer and a consultant  performing services for the Company commonly
performed  by a  chief  financial  officer,  as  appropriate,  to  allow  timely
decisions regarding required disclosure.

         Based upon their evaluation as of the end of the period covered by this
report,  the  Company's  chief  executive  officer and a  consultant  performing
services  for  the  Company  commonly  performed  by a chief  financial  officer
concluded  that  the  Company's  disclosure  controls  and  procedures  were not

                                       15
<PAGE>

effective to ensure that  information  required to be included in the  Company's
periodic SEC filings is recorded, processed, summarized, and reported within the
time periods specified in the SEC rules and forms.

         The  Company was advised by Hansen,  Barnett & Maxwell,  the  Company's
independent  registered  public accounting firm that during their performance of
audit procedures for fiscal year 2006,  Hansen,  Barnett & Maxwell  identified a
material  weakness  as  defined in Public  Company  Accounting  Oversight  Board
Standard No. 2 in the Company's internal control over financial reporting.

         This  deficiency   consisted   primarily  of  inadequate  staffing  and
supervision that led to the untimely identification and resolution of accounting
and  disclosure  matters and failure to perform  timely and  effective  reviews.
However,  the  size of the  Company  prevents  it  from  being  able  to  employ
sufficient  resources  to enable the  Company to have  adequate  segregation  of
duties within its internal  control system.  Management is required to apply its
judgment in evaluating the  cost-benefit  relationship of possible  controls and
procedures.  In order to address  the  deficiency,  management  has  implemented
tighter cash flow controls and set-up a centralized  computer system to maintain
the accounting records.

         Certifications  of the  Chief  Executive  Officer  and  the  consultant
performing  services for the Company  commonly  performed  by a chief  financial
officer  regarding,  among other items,  disclosure  controls and procedures are
included immediately after the signature section of this Form 10-KSB.

Item 8B. Other Information

         None.

                                    PART III

Item 9.  Directors, Executive Officers, Promoters and Control Persons,
         Compliance Section 16(a) of the Exchange Act

MANAGEMENT

         The following table sets forth information about our board of directors
and management team as of December 31, 2006.

Name                         Age         Position
-------------------          ---         ------------------------------------

Clayton D. Timothy           60          Chief Executive Officer and Director
George W. Ford               61          President and Director
L. Kent Harmon               52          Vice President and Director
Mitchell Hart                49          Vice President and Director
Robert Underwood(1)          63          Director

(1) Robert  Underwood  resigned  from  the board of directors as of December 31,
2006.

         Clayton D Timothy,  Director and Chief  Executive  Officer- Mr. Timothy
has an Associates  Degree in Mine  Maintenance from the College of Eastern Utah.
His career has evolved around coal mining, initially as a miner, subsequently as
a  foreman  and in more  recent  years  as  entrepreneur  and  executive  in the
development and  implementation  of  technological  innovations in the field. In
this span of experiences,  he has considerable experience in handling industrial
bulk materials. From 1990-1994, he was Executive Vice President of Environmental
Technologies Group, Inc. (ETGP) of Lehi, Utah, which pioneered and implemented a
patented technology,  which agglomerated coal fines. The process became patented
and qualified as a synthetic  fuel,  entitling it to Section 29  Investment  Tax
Credit status.  ETGP was eventually renamed Covol  Technologies,  Inc., and more
than two dozen plants were built to utilize the coal fines technology. From 1994
to 1996 he was Vice President of Industrial Management and Engineering,  also in
Lehi, UT. He was the founder of TSYI in 1996.

         George W. Ford,  Director and  President of Terra  Systems,  Inc. - Mr.
Ford served as Principal  Scientist/Vice President of Science and Technology for
Headwaters,  Inc., a publicly  traded company  (NYSE:  HW), from June 1998 until

                                       16
<PAGE>

joining Terra  Systems,  Inc., in May, 2005. He also served as Vice President of
Research and  Development of Headwaters  from August 1993 through June 1998. Mr.
Ford served as a director of Headwaters  from August 1993 until  resigning  from
the Board in February 1997 in favor of establishing an outside Board.  From 1982
to 1993, Mr. Ford was employed at Ballard  Medical  Products,  Inc., in research
and development,  principally in the biomedical  field. He holds 27 national and
international patents covering a wide variety of technologies. He has functioned
as an  independent  consultant  working on  projects  in  computer  programming,
medical  product  device  design and process  polymer  chemistry  design for the
energy  industry.  Mr.  Ford is a member  of the  American  Association  for the
Advancement of Science, and the Iron and Steel Society.

         L. Kent Harmon, Director and Vice President, Technical Development--Mr.
Harmon has a broad  background in the theory and practice of materials  science.
Immediately  prior to  joining  TSYI,  he was  President  of  Metredyne  Imaging
Services,  Buena Park,  CA, a private  company.  Metredyne  created and marketed
diagnostic  systems that quantified the extent of physical  impairment caused by
work-related injuries. Mr. Harmon was a founder of TSYI in 1996.

         Mitchell J. Hart, P.E., Director,  Vice President,  Operations of Terra
Systems,  Inc and President of Mountain  Island Energy,  LLC- Mr. Hart served as
Senior  Specialist/Project  Manager for Monsanto  Company from June,  1986 until
joining Terra  Systems,  Inc., in June 2005.  During that time, he managed large
capital projects, directed permitting teams, and provided raw material technical
support to Monsanto's plants in Soda Springs, Idaho, and Rock Springs,  Wyoming.
Prior to joining Monsanto, Mr. Hart worked as a Senior Mining Engineer for Shell
Oil Company,  developing new mining projects along the Gulf Coast,  the hills of
eastern Ohio and the Powder River Basin of Wyoming.  He also worked  underground
coal  in  central  Illinois  for  Turris  Coal  Company.   He  is  a  registered
Professional  Engineer and holds Professional  Miner  designation.  Mr. Hart was
granted  certification  as  a  Glass  Production  Technologist,  a  Refractories
Manufacturing  Technologist,  and a Ceramic Manufacturing  Technologist from the
American Ceramic Society.  Mr. Hart is the President of the Association of Idaho
Cities   (which   represents   176   member   cities   in   Idaho),   serves  as
Secretary/Treasurer of the Southeast Idaho Council of Governments, and is in his
third term as a member of the Soda Springs City Council. He previously served as
a member of the Board of Trustees of Joint School District #150 in Soda Springs.
He is a member of the Society of Mining  Engineers,  of AIME,  and the  National
Mining Association.

         Robert  Underwood,  Director-  Mr.  Underwood has a BA in Economics and
Languages  from  Brigham  Young  University  and  an  MBA in  Finance  from  the
University  of Utah.  Prior to  becoming  a Director  of TSYI,  he had a 28 year
career  in  commercial  banking.  He  rose to Vice  President/Manager  of  First
Security Bank of Utah, NA, in which he specialized in commercial lending and had
responsibility for multi-million dollar loan portfolios.  He also spent 11 years
as an  adjunct  instructor  of  economics  a Brigham  Young  University  and the
American Institute of Banking. As noted, Mr. Underwood resigned as a Director of
the Company on December 31, 2006.

Compliance with Section 16(a) of the Exchange Act

         None of the Company's executive officers or directors filed Forms 5 for
the year ended December 31, 2006.  During the twelve months ending  December 31,
2006 no securities were sold by executive officers or directors.

Code of Ethics

         The  Company  is in the  process  of  adopting a code of ethics for our
principal  executive and financial  officers.  In the meantime,  our  management
intends to promote honest and ethical  conduct,  full and fair disclosure in our
reports  to the  SEC,  and  compliance  with  applicable  governmental  laws and
regulations.

                                       17
<PAGE>


Item 10. Executive Compensation

EXECUTIVE COMPENSATION

         The  Company's  compensation  program is designed to encompass  several
factors  in  determining  the  compensation  of the  Company's  names  executive
officers.  The following are the main objectives of the compensation program for
the Company's named executive officers:

         *        Retain qualified officers
         *        Provide overall corporate  direction for the officers and also
                  to provide direction that is specific to officer's  respective
                  areas of  authority.  The level of  compensation  amongst  the
                  officer group, in relation to one another,  is also considered
                  in order to maintain a high level of  satisfaction  within the
                  leadership  group.  We  consider  the  relationship  that  the
                  officers maintain to be one of the most important  elements of
                  the leadership group.
         *        Provide a performance incentive for the officers.

         The Company's  compensation  program is designed to reward the officers
in the following areas:

         *        achievement of specific goals;
         *        professional education and development;
         *        creativity  in the form of  innovative  ideas and analysis for
                  new programs and projects;
         *        new program implementation;
         *        attainment of company goals, budgets, and objectives;
         *        results oriented determination and organization;
         *        positive and  supportive direction for  company personnel; and
         *        community involvement.

         As of the date of this Report,  there were three principal  elements of
named  executive  officer  compensation.  The Board of Directors  determines the
portion of  compensation  allocated  to each element for each  individual  named
executive officer. The discussions of compensation practices and policies are of
historical  practices  and  policies.  Our Board of  Directors  is  expected  to
continue  these policies and  practices,  but will  reevaluate the practices and
policies as it considers advisable.

     The elements of the compensation program include:

         *        Base salary;
         *        Stock options and stock awards
         *        Employee benefits in the form of:
                      *   Health and dental insurance
                      *   Life insurance
         *        Other de minimis benefits

     Base salary

         Base  salary is intended to provide  competitive  compensation  for job
performance and to attract and retain  qualified named executive  officers.  The
base salary level is determined by considering  several factors  inherent in the
market place such as: the size of the company;  the prevailing salary levels for
the  particular  office  or  position;  prevailing  salary  levels  in  a  given
geographic  locale; and the qualifications and experience of the named executive
officer.

     Stock options and stock awards

         Stock  ownership  is provided to enable  named  executive  officers and
directors to participate in the success of the Company.  The direct or potential
ownership of stock will also provide the incentive to expand the  involvement of
the named  executive  officer to  include,  and  therefore  be  mindful  of, the
perspective of stockholders of the Company.


                                       18
<PAGE>

     Employee benefits

         Several of the employee  benefits for the named executive  officers are
selected to provide  security for the named  executive  officers.  Most notably,
insurance  coverage for health,  life,  and  liability are intended to provide a
level of protection to that will enable the named executive officers to function
without  having  the  distraction  of having to manage  undue  risk.  The health
insurance also provides access to preventative  medical care which will help the
named executive  officers function at a high energy level, to manage job related
stress,  and  contribute  to the  overall  well  being  of the  named  executive
officers, all of which contribute to an enhanced job performance.

     Other de minimis benefits

         Other de minimis employee  benefits such as cell phones,  parking,  and
auto usage  reimbursements  are directly  related to job functions but contain a
personal  use  element  which  is  considered  to  be a  goodwill  gesture  that
contributes to enhanced job performance.

         As discussed  above,  the Board of Directors  determines the portion of
compensation  allocated  to each  element for each  individual  named  executive
officer.  As  a  general  rule,  salary  is  competitively  based  while  giving
consideration to employee retention,  qualifications,  performance,  and general
market  conditions.  Typically,  stock  options are based on the current  market
value of the option and how that will contribute to the overall  compensation of
the named executive  officer.  Consideration  is also given to the fact that the
option has the potential for an  appreciated  future value.  As such, the future
value  may be the most  significant  factor of the  option,  but it is also more
difficult to quantify as a benefit to the named executive officer.

         Accordingly,  in determining the compensation  program for the Company,
as well as setting the compensation for each named executive officer,  the Board
of  Directors  attempts to attract the interest of the named  executive  officer
within in the  constraints of a compensation  package that is fair and equitable
to all parties involved.

         This table provides summary information concerning  compensation earned
by or paid  to  each  named  executive  officer  for  services  rendered  in all
capacities to us during fiscal year 2006.
<TABLE>
<CAPTION>

                                                    SUMMARY COMPENSATION TABLE

-----------------------------------------------------------------------------------------------------------------------------------
                                                                                          Change in
                                                                      Non-Equity         Pesion Value
                                                   Stock    Option   Incentive Plan      and Deferred        All Other
  Name and                    Salary(1)   Bonus    Awards   Grants    Compensation   Compensation Earnings  Compensation    Total
  Position           Year        $         $        $        $            $                   $                  $            $
-----------------------------------------------------------------------------------------------------------------------------------
Clayton Timothy,
Chief Exective
<S>                  <C>      <C>             <C>      <C>      <C>        <C>                <C>                <C>       <C>
Officer              2006     120,000         -        -        -          -                  -                  -         120,000
-----------------------------------------------------------------------------------------------------------------------------------
George W. Ford,
President            2006     120,000         -        -        -          -                  -                  -         120,000
-----------------------------------------------------------------------------------------------------------------------------------
Mitchell J. Hart,
Vice President       2006     120,000         -        -        -          -                  -                  -         120,000
-----------------------------------------------------------------------------------------------------------------------------------

         (1) Actual  compensation  paid to each named  officer was $110,000  with $10,000 each being  accrued as a liability as of
December 31, 2006.
</TABLE>

                                       19
<PAGE>

         The following table provides summary information concerning outstanding
equity awards for named executive officers as of December 31, 2006.

<TABLE>
                                         OUTSTANDING EQUITY AWARDS AT FISCAL 2006 YEAR-END
<CAPTION>
                                     Option Awards                                           Stock Awards
                  ----------------------------------------------------- ---------------------------------------------------------
                                                                                                                    Equity
                                                                                                    Equity         Incentive
                                                                                                   Incentive      Plan Awards:
                                                    Equity                                        Plan Awards:      Market or
                                                   Incentive                         Market        Number of      payout value
                                                  Plan Awards:           Number of  value of       Unearned       of unearned
                    Number of     Number of        Number of             Shares or  Shares or     Shares, Units   Shares, Units
                    Securities    Securities      Securities             Units of    Units of      or other          or other
                    Underlying    Underlying      Underlying            Stock that  Stock that    rights that      rights  that
                    Unxercised    Unxercised      Unexercised   Option   Have not    have not      have not          have not
   Name and         Options (#)   Options (#)      Unearned    Exercise   vested      vested        vested            vested
   Position         Exercisable  Unexercisable     Options      Price      (#)         ($)           (#)                ($)
----------------------------------------------------------------------- ---------------------------------------------------------
<S>                   <C>            <C>               <C>       <C>         <C>        <C>            <C>               <C>
Clayton Timothy,
Chief Exective
Officer               800,000             -            -         0.10        -          -              -                 -
------------------------------------------------------------------------------------------------------------------------------
George W. Ford,
President             114,286       685,714            -         0.38        -          -              -                 -
------------------------------------------------------------------------------------------------------------------------------
Mitchell J. Hart,
Vice President        114,286       685,714            -         0.38        -          -              -                 -
------------------------------------------------------------------------------------------------------------------------------
</TABLE>

         Stock Options Granted In 2006

         No stock options were granted to the  Executive  officers and directors
during the twelve months ended December 31, 2006..

         Compensation of Directors

         Directors  who also serve as  executive  officers  do not  receive  any
additional compensation for their services as directors.  Non-employee directors
are not paid an annual fee for services as board members.

         Employment Agreements

         During May 2005 the Company  entered into  Memorandum  of  Affiliations
with three officers.  The affiliation will be for three years with a base pay of
$120,000 for each officer.  The  affiliation  stipulates  that if there is early
termination  for any  reason  that the  officers  will  receive  full and  usual
benefits for up to 52 weeks.

Item 11. Security  Ownership of  Certain  Beneficial  Owners and  Management and
         Related Stockholder Matters

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table provides information regarding beneficial ownership
of our common stock as of December 31, 2006, by:

         *        Each  person or entity  known to us to own  beneficially  more
                  than 5% of our common stock;

         *        Each of the named executive officers;

         *        Each of our directors; and

         *        All executive officers and directors as a group.

         The following  table  assumes the  applicable  percentage  ownership is
based on 42,675,356  shares of common stock  outstanding as of December 31, 2006
and 2,628,572 shares of common stock options that are exercisable.

         Beneficial  ownership is determined  based on the rules and regulations
of the  Securities  and Exchange  Commission.  In computing the number of shares
beneficially  owned by a person and the  percentage  ownership  of that  person,
shares  of  common  stock  subject  to  options  held by that  person  that  are
exercisable or exercisable within 60 days of the date of this report are counted
as outstanding.  These shares,  however,  are not counted as outstanding for the
purposes of computing the  percentage  ownership of any other person.  Except as
indicated in the  footnotes to this table and pursuant to  applicable  community
property  laws,  each  shareholder  named  in the  table  has  sole  voting  and
investment   power  with  respect  to  the  shares  set  forth   opposite   that
shareholder's name. Unless otherwise noted, the address of each beneficial owner
listed below is c/o Terra Systems,  7001 South 900 East, Ste 260, Midvale,  Utah
84047.

                                       20
<PAGE>

Shareholder                        Shares Beneficially          Percentage of
                                          Owned                   Ownership

Clayton Timothy
Chief Executive Officer,
Director                               4,576,465(1)                10.53%

George W. Ford
President, Director                      872,751(4)                 2.04%

L. Kent Harmon
Vice President, Director               3,350,000(1)                 7.70%

Mitchell Hart
Vice President, Director                 397,751(4)                 0.93%

Robert Underwood
Director(5)                            2,468,903(1)                 5.68%

CHT Holding Trust(2)
3037 Soma Place
Costa Mesa, CA 92626                   2,505,000                    5.87%

Reynold Roeder
805 SW Broadway, Suite 580
Portland, OR 97205                     5,000,000(6)                10.56%

All Executive Officers and
Directors as A group
(5 individuals)                       11,665,870(3)                25.75%

(1)   Shares  beneficially  owned  include  options  to  purchase  up to 800,000
      shares.
(2)   Shares held by CHT Holding Trust, of which Howard Hucks is the trustee and
      Wayne Hansen and Valgene Blackburn are beneficiaries.
(3)   Shares  beneficially  owned  include  options to purchase up to  2,628,572
      shares.
(4)   Shares  beneficially  owned  include  options  to  purchase  up to 114,286
      shares.
(5)   As noted above, Mr. Underwood resigned as a director on December 31, 2006.
(6)   Includes  312,500  shares and options to purchase an additional  4,687,500
      shares. Mr. Roeder owns the securities jointly with Wendy Roeder.

Securities Authorized Under Equity Compensation Plans

         As of December 31, 2006, the Company had no equity  compensation  plans
or option plans.

Item 12. Certain Relationships and Related Transactions

       None.

Item 13. Exhibits

Exhibit No.       Title of Document
-----------       -----------------

2                 Articles of Merger of Terra Systems, Inc., with and into Terra
                  Merger  Subsidiary,  Inc.,  incorporated by reference from the
                  Company's  Form 10-SB,  filed with the Commission on September
                  6, 2000.
3.1               Amended  and  Restated  Articles  of  Incorporation  of  Terra
                  Systems, Inc., formerly known as Xullux, Inc., incorporated by
                  reference  from  the  Company's  Form  10-SB,  filed  with the
                  Commission on September 6, 2000.
3.2               Articles of  Incorporation of Terra Merger  Subsidiary,  Inc.,
                  incorporated by reference from the Company's Form 10-SB, filed
                  with the Commission on September 6, 2000.
3.4               Revised  Bylaws  of Terra  Systems,  Inc.  (formerly  known as
                  Xullux,  Inc.),  incorporated  by reference from the Company's
                  Form 10-SB, filed with the Commission on September 6, 2000.
10.1              Agreement  Between Terra Systems,  Inc., and XCEL  Associates,
                  Inc.,  dated March 29, 2000,  incorporated  by reference  from
                  Amendment  No. 1 to the Company's  Form 10-SB,  filed with the
                  Commission on December 1, 2000.
10.2              Memorandum  of  Affiliation  between  the  Company and Clayton
                  Timothy, dated May 12, 2005 (filed herewith)
10.3              Memorandum  of  Affiliation  between the Company and George W.
                  Ford Jr., dated May 12, 2005 (filed herewith)

                                       21
<PAGE>

10.4              Memorandum of Affiliation  between the Company and Mitchell J.
                  Hart, dated May 12, 2005 (filed herewith)
31.1              Rule 13a-14(a)/15d-14(a) Certification
31.2              Rule 13a-14(a)/15d-14(a) Certification
32.1              Section 1350 Certification
32.2              Section 1350 Certification

99.1              Stock  Issuance  with A Call Option  Vesting  Schedule & Stock
                  Issued for Services - Non Employees, incorporated by reference
                  from Amendment No. 1 to the Company's  Form 10-SB,  filed with
                  the Commission on December 1, 2000.

Item 14. Principal Accountant Fees and Services

(1) AUDIT FEES

      Audit fees billed during 2006 were $52,000, which were paid during 2006.

(2) AUDIT-RELATED FEES

      Not applicable.

(3) TAX FEES

       Not applicable.

(4) ALL OTHER FEES

      Not applicable.

(5) AUDIT COMMITTEE POLICIES AND PROCEDURES

      Not applicable.

(6) If greater than 50 percent, disclose the percentage of hours expended on the
principal accountant's engagement to audit the registrant's financial statements
for the most  recent  fiscal  year that were  attributed  to work  performed  by
persons other than the principal accountant's full-time, permanent employees.

      Not applicable.








                                       22
<PAGE>

SIGNATURES

In accordance  with Section 13 or 15(d) of the Securities  Exchange Act of 1934,
the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.


Date: April 13, 2007

                TERRA SYSTEMS, INC.


                           By:  /s/ Clayton Timothy
                                -----------------------------------------------
                                Clayton Timothy
                                CEO
                                (Principal Executive Officer)



                           By:  /s/ Mark Faerber
                                -----------------------------------------------
                                Mark Faerber
                                Consultant performing services for the Company
                                commonly performed by a chief financial officer

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

Date: April  13, 2007

/s/ George W. Ford
------------------------------------

Name: George W. Ford
Director


/s/ Mitchell Hart
------------------------------------

Name: Mitchell Hart
Director


/s/ L. Kent Harmon
------------------------------------

Name:  L. Kent Harmon
Director



                                       23
<PAGE>






                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)






             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
                                       AND
                        CONSOLIDATED FINANCIAL STATEMENTS






                           December 31, 2006 and 2005






<PAGE>



                      TERRA SYSTEMS, INC. AND SUBSIDIARIES
                          (A Development Stage Company)


                                TABLE OF CONTENTS



    Report of Independent Registered Public Accounting Firm                 F-1

    Consolidated Balance Sheets - December 31, 2006 and 2005                F-2

    Consolidated Statements of Operations for the Years Ended
       December 31, 2006 and 2005, and for the Cumulative
       Period February 17, 1996 (Date of Inception), through
       December 31, 2006                                                    F-3

    Consolidated Statement of Changes in Stockholders'
       Deficit for the Period February 17, 1996 (Date of
       Inception), through December 31, 2006                                F-4

    Consolidated Statements of Cash Flows for the Years
       Ended December 31, 2006 and 2005, and for the
       Cumulative Period February 17, 1996 (Date of
       Inception), through December 31, 2006                                F-8

    Notes to Consolidated Financial Statements                              F-9




<PAGE>

HANSEN, BARNETT & MAXWELL, P.C.
  A Professional Corporation
 CERTIFIED PUBLIC ACCOUNTANTS                Registered with the Public Company
   5 Triad Center, Suite 750                    Accounting Oversight Board
 Salt Lake City, UT 84180-1128
     Phone: (801) 532-2200
      Fax: (801) 532-7944
        www.hbmcpas.com




             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Shareholders
Terra Systems, Inc. and Subsidiary


We have audited the accompanying  consolidated  balance sheets of Terra Systems,
Inc. and  Subsidiary (a  development  stage company) as of December 31, 2006 and
2005,  and the related  consolidated  statements  of  operations,  stockholders'
deficit,  and cash flows for the years ended  December 31, 2006 and 2005 and for
the  cumulative  period  from  February  17,  1996 (date of  inception)  through
December 31, 2006.  These  financial  statements are the  responsibility  of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material respects,  the financial position of Terra Systems, Inc.
and  Subsidiary  as of  December  31,  2006 and  2005,  and the  results  of its
operations  and its cash flows for the years then ended and for the period  from
February 17, 1996  through  December 31, 2006,  in  conformity  with  accounting
principles generally accepted in the United States.

The  accompanying  financial  statements  have been  prepared  assuming that the
Company will continue as a going  concern.  The Company has incurred  losses and
negative cash flows from  operations  during each of the two years in the period
ended  December 31, 2006 and from  inception  through  December 31, 2006.  As of
December 31, 2006,  the Company had an accumulated  deficit of  $19,190,814  and
negative working capital of $2,299,672.  These matters raise  substantial  doubt
about the Company's ability to continue as a going concern.  Management's  plans
concerning these matters are also described in Note 1. The financial  statements
do not  include  any  adjustments  that might  result  from the  outcome of this
uncertainty.

As  explained  in Note 1 and Note 6 to the  consolidated  financial  statements,
effective January 1, 2006, the Company adopted Statement of Financial Accounting
Standards123(R) "Share-Based Payment".





                                       HANSEN, BARNETT & MAXWELL, P.C.
Salt Lake City, Utah
April 13, 2007

                                       F-1

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                           CONSOLIDATED BALANCE SHEETS


                                                 December 31,     December 31,
                                                    2006              2005
                                                -------------    --------------
                                     ASSETS
Current Assets
     Cash                                       $      52,091    $      184,930
     Other current assets                               5,391             5,395
                                                -------------    --------------
         Total Current Assets                          57,482           190,325
                                                -------------    --------------

Property and Equipment
     Land and water rights                                  -           378,126
     Furniture and equipment                          582,407           487,256
     Software                                          10,380            10,380
     Less:  Accumulated depreciation                 (474,128)         (465,596)
                                                -------------    --------------
         Net Property and Equipment                   118,659           410,166
                                                -------------    --------------

Investment in joint venture                           392,251                 -
                                                -------------    --------------
Total Assets                                    $     568,392    $      600,491
                                                =============    ==============

                     LIABILITIES AND STOCKHOLDERS' DEFICIT

Current Liabilities
     Accounts payable                           $     531,087    $      427,502
     Accounts payable to related parties              197,445           122,445
     Accrued liabilities                              331,935           335,866
     Accrued interest to related parties              326,133           268,245
     Notes payable to stockholders                    970,554           850,554
                                                -------------    --------------
         Total Current Liabilities                  2,357,154         2,004,612
                                                --------------   --------------

Stockholders' Deficit
     Common stock - $0.001 par value;
       100,000,000 shares authorized;
     42,675,356 and 41,292,288 issued
       and outstanding, respectively                   42,672            41,292
     Additional paid-in capital                    17,359,380        16,333,170
     Deficit accumulated during
       development stage                          (19,190,814)      (17,778,583)
                                                -------------    --------------
         Total Stockholders' Deficit               (1,788,762)       (1,404,121)
                                                -------------    --------------

Total Liabilities and Stockholders'  Deficit    $     568,392    $      600,491
                                                =============    ==============


      See accompanying notes to condensed consolidated financial statements

                                      F-2
<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                                From Inception
                                                                    of the
                                                               Development Stage
                                      For the Year Ended        on February 17,
                                          December 31,           1996 Through
                                 -----------------------------   December 31,
                                     2006             2005           2006
                                 -------------   ------------- -----------------

Revenues                         $      45,897   $           -   $      618,142
Cost of Revenues                        44,968               -   $      450,245
                                 -------------   ------------- -----------------

   Gross Profit                            929               -          167,897
                                 -------------   ------------- -----------------

Operating Expenses
   Research and development                  -          16,225        2,063,996
   General and administrative        1,296,669       6,109,756       15,015,842
   Depreciation and amortization         8,532           5,097          795,101
                                 -------------   ------------- -----------------
       Total Operating Expenses      1,305,201       6,131,078       17,874,939
                                 -------------   ------------- -----------------

       Loss from Operations         (1,304,272)     (6,131,078)     (17,707,042)
                                 -------------   ------------- -----------------

Nonoperating Income/(Expenses)
   Other income                         12,245          62,003           74,248
   Interest expense                   (120,204)       (571,198)      (1,391,013)
   Interest income                           -               -            1,709
   Gain from settlement of debt              -               -           64,284
   Loss on sale of securities                -               -          (99,000)
   Gain (loss) on sale of assets             -         153,027         (134,000)
                                 -------------   ------------- -----------------

   Net Nonoperating Expenses          (107,959)       (356,168)      (1,483,772)
                                 -------------   ------------- -----------------

Net Loss                         $  (1,412,231)  $  (6,487,246)  $  (19,190,814)
                                 =============   ============= =================
Basic and Diluted Loss
 Per Share                       $       (0.03)  $       (0.18)
                                 =============   =============
Weighted Average Shares
 Outstanding                        42,072,927      35,726,714
                                 =============   =============




      See accompanying notes to condensed consolidated financial statements

                                      F-3
<PAGE>
<TABLE>
<CAPTION>
                                           TERRA SYSTEMS, INC. AND SUBSIDIARY
                                             (A Development Stage Company)
                               CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT

                                                                                             Deficit
                                                           Common                          Accumulated
                           Common Stock        Additional   Stock    Subscrip-  Deferred   During the       Total
                       ---------------------    Paid-In    Subscrip-   tion      Compen-   Development   Stockholders'
                        Shares      Amount      Capital     tions    Receivable  sation      Stage          Deficit
----------------------------------------------------------------------------------------------------------------------
<S>                    <C>         <C>        <C>          <C>       <C>       <C>        <C>            <C>
Balance - February 17,
  1996 (Inception)              -  $      -   $         -  $      -  $      -  $       -  $           -  $           -
Shares issued to
  founders
   March 1996 -
    $0.00 per share    48,000,000    48,000       (47,520)        -         -          -              -            480
Shares issued to
  acquire Xullux
   May 1996 - $0.00
    per share           2,955,100     2,955        (2,955)        -         -          -              -              -
Common stock
  subscriptions July
  1996 through
  September 1996                -         -             -   196,000         -          -              -        196,000
Shares issued for
  marketable
  securities
   September 1996 -
     $0.80 per share       19,000        19        15,181   174,800         -          -              -        190,000
Shares issued for cash
   September 1996 -
     $0.80  to $1.00
     per share            706,500       707       667,793    10,000         -          -              -        678,500
   October 1996 -
    $0.80 per share       350,000       350       279,650         -         -          -              -        280,000
   November 1996 -
    $1.75 per share        12,000        12        20,988         -         -          -              -         21,000
   December 1996 -
    $1.75 to $2.00
    per share              57,500        58       103,692         -         -          -              -        103,750
   January 1997 -
    $1.00 to $1.75
    per share             126,000       126       145,374         -         -          -              -        145,500
   February 1997 -
    $1.00 per share       100,000       100        99,900         -         -          -              -        100,000
   March 1997 - $1.75
    per share              25,413        25        44,448         -         -          -              -         44,473
   April 1997 - $2.00
    per share               7,500         8        14,992         -         -          -              -         15,000
   May 1997 - $1.00
    per share             100,000       100        99,900         -         -          -              -        100,000
   June 1997 - $1.00
    per share              90,000        90        89,910         -         -          -              -         90,000
   August 1997 - $0.50
    to $1.00 per share     70,000        70        44,930         -         -          -              -         45,000
   October 1997 -
    $1.00 per share        25,000        25        24,975         -         -          -              -         25,000
   November 1997 -
    $0.72 to $0.80 per
    share                 172,399       173       128,243         -         -          -              -        128,416
   December 1997 -
    $0.80 per share        84,375        84        67,416         -         -          -              -         67,500
   April 1998 - $0.50
    to $0.73 per share    239,502       240       146,671         -         -          -              -        146,911
   May 1998 - $0.75 to
    $0.80 per share        38,333        38        29,962         -         -          -              -         30,000
   June 1998 - $0.75
    per share              30,146        30        22,579         -         -          -              -         22,609
   July 1998 - $0.36
    to $0.73 per share    236,846       237       119,368         -         -          -              -        119,605
   August 1998 - $0.50
    per share              20,000        20         9,980         -         -          -              -         10,000
   November 1998 -
    $0.30 to $0.33 per
    share                  78,000        78        24,772         -         -          -              -         24,850
   December 1998 -
    $0.32 to $0.33 per
    share                  72,900        73        23,664         -         -          -              -         23,737
   January 1999 -
    $0.50 per share       100,000       100        49,900         -         -          -              -         50,000
   April 1999 - $0.25
    per share              20,000        20         4,980         -         -          -              -          5,000
   May 1999 - $0.50
    per share              20,000        20         9,980         -         -          -              -         10,000
   June 1999 - $0.50
    per share             100,000       100        49,900         -         -          -              -         50,000
   July 1999 - $0.25
    per share             200,000       200        50,260         -         -          -              -         50,460
   September 1999 -
    $0.40 and $0.50
    per share             145,000       145        59,855         -         -          -              -         60,000
   October 1999 -
    $0.50 per share        60,000        60        29,940         -         -          -              -         30,000
   December 1999 -
    $0.50 per share        60,000        60        29,940         -         -          -              -         30,000
   January 2000 -
    $0.25 per share        12,000        12         2,988         -         -          -              -          3,000
   February 2000 -
    $0.25 per share        40,000        40         9,960         -         -          -              -         10,000
   March 2000 -
    $0.25 per share       139,340       140        34,696         -         -          -              -         34,836


                         See accompanying notes to condensed consolidated financial statements

                                                          F-4
</TABLE>

<PAGE>
<TABLE>
<CAPTION>
                                           TERRA SYSTEMS, INC. AND SUBSIDIARY
                                             (A Development Stage Company)
                               CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT
                                                      (CONTINUED)


                                                                                             Deficit
                                                           Common                          Accumulated
                           Common Stock        Additional   Stock    Subscrip-  Deferred   During the       Total
                       ---------------------    Paid-In    Subscrip-   tion      Compen-   Development   Stockholders'
                        Shares      Amount      Capital     tions    Receivable  sation      Stage          Deficit
----------------------------------------------------------------------------------------------------------------------
<S>                    <C>         <C>        <C>          <C>       <C>       <C>        <C>            <C>
   April 2000 -
    $0.30 per share        33,333        33         9,967         -         -          -              -         10,000
   July 2000 -
    $0.25 per share        32,000        32         7,968         -         -          -              -          8,000
   August 2000 -
    $0.25 per share       120,000       120        29,880         -         -          -              -         30,000
   January 2001 -
    $0.20 per share       100,000       100        19,900         -         -          -              -         20,000
   May 2001 - $0.20 to
    $0.25 per share       150,000       150        30,350         -         -          -              -         30,500
   June 2001 - $0.25
    per share              10,000        10         2,490         -         -          -              -          2,500
   July 2001 - $0.19
    per share              32,000        32         6,014         -         -          -              -          6,046
   August 2001 - $0.10
    per share             500,000       500        49,500         -         -          -              -         50,000
   November 2001 -
    $0.20 to $0.23 per
    share                 680,434       680       139,320         -  (100,000)         -              -         40,000
   March 2002 - $0.15
    per share              75,000        75        11,175         -         -          -              -         11,250
   July 2003 - $0.10
    per share             175,000       175        17,325         -         -          -              -         17,500
   November 2003 -
    $0.20 per share       125,000       125        24,875         -         -          -              -         25,000
Shares issued in
  satisfaction of
  subscription
  agreements
   October - December
    1996 $0.80 to
    $1.00 per share       246,000       245       205,755  (206,000)        -          -              -              -
   December 1996 -
    $0.76 per share       231,000       231       174,569  (174,800)        -          -              -              -
Shares issued for
  current and future
  services
   May 1997 - $1.00
    per share              75,000        75        74,850         -         -    (74,925)             -              -
   March 1998 -
    $1.13 per share       350,000       350       393,400         -         -   (393,750)             -              -
   March 1999 -
    $0.50 per share       106,286       106        53,083         -         -          -              -         53,189
   June 1999 - $0.50
    per share              60,000        60        29,940         -         -          -              -         30,000
   September 1999 -
    $0.70 to $0.97 per
    share                  63,000        63        49,257         -         -    (19,320)             -         30,000
   December 1999 -
    $0.60 per share        50,000        50        29,950         -         -          -              -         30,000
   March 2000 - $0.50
    per share              60,000        60        29,940         -         -          -              -         30,000
   May 2000 - $0.48
    per share              62,920        63        29,937         -         -          -              -         30,000
   July 2000 - $1.00
    per share              15,000        15        14,985         -         -          -              -         15,000
   September 2000 -
    $0.25 per share       122,400       122        29,878         -         -          -              -         30,000
   October 2000 -
    $0.25 per share        75,000        75        18,675         -         -          -              -         18,750
   December 2000 -
    $0.39 per share        99,338        99        38,901         -         -          -              -         39,000
   January 2001 -
    $0.50 per share        12,500        13         6,238         -         -          -              -          6,251
   March 2001 -
    $0.50 per share        60,000        60        29,940         -         -          -              -         30,000
   June 2001 -
    $0.40 per share        97,500        98        38,902         -         -          -              -         39,000
   September 2001 -
    $0.20 per share       500,000       500        99,500         -         -          -              -        100,000
   October 2001 -
    $0.20 per share       530,000       530       105,470         -         -          -              -        106,000
   November 2001 -
    $0.15 per share       180,000       180        26,820         -         -          -              -         27,000
   July  2002- $0.18
    to $0.19 per share    504,529       505        92,195         -         -          -              -         92,700
   November 2002 -
    $0.16 to $0.17 per
    share                 501,766       501        82,799         -         -          -              -         83,300
   March 2003 - $0.14
    per share             314,287       314        43,686         -         -          -              -         44,000
   May 2003- $0.15 per
    share                  10,000        10         1,490         -         -          -              -          1,500
   October 2003- $0.19
    to $0.28 per share    982,141       982       265,476         -         -          -              -        266,458
Shares issued for
  financing fees
   March 2003 - $0.17
    to $0.20 per share     43,000        43         8,047         -         -          -              -          8,090
   July 2003 - $0.18
    per share              31,500        32         5,639         -         -          -              -          5,671
   August 2003 - $0.18
    per share               7,000         7         1,253         -         -          -              -          1,260
   September 2003 -
    $0.18 per share        10,000        10         1,790         -         -          -              -          1,800
   October 2003 -
    $0.18 per share        25,000        25         4,475         -         -          -              -          4,500
Shares issued for
  settlement of
  liabilities
   January 1999 -
    $0.25 per share       200,000       200        49,800         -         -          -              -         50,000
   February 2002-
    $0.51 per share        49,020        49        24,951         -         -          -              -         25,000

                         See accompanying notes to condensed consolidated financial statements
</TABLE>

                                                          F-5
<PAGE>
<TABLE>
<CAPTION>
                                           TERRA SYSTEMS, INC. AND SUBSIDIARY
                                             (A Development Stage Company)
                               CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT
                                                      (CONTINUED)


                                                                                             Deficit
                                                           Common                          Accumulated
                           Common Stock        Additional   Stock    Subscrip-  Deferred   During the       Total
                       ---------------------    Paid-In    Subscrip-   tion      Compen-   Development   Stockholders'
                        Shares      Amount      Capital     tions    Receivable  sation      Stage          Deficit
----------------------------------------------------------------------------------------------------------------------
<S>                    <C>         <C>        <C>          <C>       <C>       <C>        <C>            <C>
   June 2003 - $0.18
    per share             200,000       200        34,800         -         -          -              -         35,000
   December 2003 -
    $0.36 per share     1,326,216     1,326       476,112         -         -          -              -        477,438
   November 2003 -
    $0.25 per share        40,000        40         9,960         -         -          -              -         10,000
Exercise of share
  rights
   May 2000 - $0.25
    per share (cash)      400,000       400        99,600         -         -          -              -        100,000
   October 2000 -
    $0.25 per share
    (cash)                300,000       300        59,700         -         -          -              -         60,000
   November 2000 -
    $0.20 per share
    (services)            225,000       225        44,775         -         -          -              -         45,000
   December 2000 -
    $0.20 per share
    (cash)                 75,000        75        14,925         -         -          -              -         15,000
Exercise of stock
  options
   April 2000 - $0.20
    per share
    (conversion of
    debt)                 500,000       500        99,500         -         -          -              -        100,000
   December 2000 -
    $0.20 per share
    (cash)                 25,000        25         4,975         -         -          -              -          5,000
   January 2001 -
    $0.20-$0.25 per
    share                 825,000       825       166,675         -         -          -              -        167,500
Share redemptions
   September 1996 - no
    consideration      (3,000,000)   (3,000)        3,000         -         -          -              -              -
   December 1996 -
    $0.001 per share  (36,775,000)  (36,775)            -         -         -          -              -        (36,775)
   December 1999 -
    $1.13 per share      (100,000)     (100)     (112,300)        -         -    112,400              -              -
   March 2000 - $1.13
    per share             (50,000)      (50)      (56,150)        -         -     56,200              -              -
Payment on
 subscription
 receivable                     -         -             -         -    51,250          -              -         51,250
Return of shares in
 satisfaction of
 subscription
 receivable              (130,000)     (130)      (25,870)        -    26,000          -              -              -
Write off subscription
  receivable balance            -         -             -         -    22,750          -              -         22,750
Compensation from
  grant of stock
  rights and options            -         -     1,106,626         -         -          -              -      1,106,626
Consulting expense
  from grant of share
  right                         -         -       818,500         -         -          -              -        818,500
Amortization of
  deferred
  compensation                  -         -             -         -         -    319,395              -        319,395
Net loss from February
   17, 1996 through
   December 31, 2003            -         -             -         -         -          -    (10,679,545)   (10,679,545)
Shares issued for
  services
   April 2004 - $0.28
    per share             375,000       375       107,625         -         -          -              -        108,000
   August 2004 - $0.22
    per share             204,546       204        61,161         -         -          -              -         61,365
Shares issued in
  satisfaction of
  liabilities and
  interest
   May 2004 - $0.25
    per share             635,966       635       158,355         -         -          -              -        158,990
   December 2004 -
   $0.30 per share        900,000       900       269,100         -                    -              -        270,000
Shares issued for
  financing fees
   May 2004 - $0.30
    per share               2,713         3           811         -         -          -              -            814
Shares issued for cash
   April 2004 - $0.14
    per share              84,500        85        11,915         -         -          -              -         12,000
   June 2004 - $0.14
    per share              35,500        36         4,964         -         -          -              -          5,000
   June 2004 - $0.19
    per share              84,210        84        15,916         -         -          -              -         16,000
   December 2004 -
    $0.33 per share        30,000        30         9,970         -         -          -              -         10,000
Net loss for period             -         -             -         -         -          -       (611,792)      (611,792)
                      -----------  --------   -----------  --------  -------- ----------  -------------  -------------

Balance December 31,
  2004                 28,433,459  $ 28,433   $ 8,301,312  $      -  $      -  $       -  $ (11,291,337) $  (2,961,592)


                         See accompanying notes to condensed consolidated financial statements
</TABLE>

                                                          F-6
<PAGE>
<TABLE>
<CAPTION>
                                           TERRA SYSTEMS, INC. AND SUBSIDIARY
                                             (A Development Stage Company)
                               CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT
                                                      (CONTINUED)


                                                                                             Deficit
                                                           Common                          Accumulated
                                               Additional   Stock    Subscrip-  Deferred   During the       Total
                           Common Stock         Paid-In    Subscrip-   tion      Compen-   Development   Stockholders'
                        Shares      Amount      Capital     tions    Receivable  sation      Stage          Deficit
----------------------------------------------------------------------------------------------------------------------
<S>                    <C>         <C>        <C>          <C>       <C>       <C>        <C>            <C>
Shares issued for
  services
   April 2005 - $0.81
    per share              90,000        90        72,810         -         -          -              -         72,900
   May 2005 - $0.95
    per share           1,270,000     1,270     1,205,230         -         -          -              -      1,206,500
   May 2005 - $0.80
    per share           2,697,257     2,697     2,155,109         -         -          -              -      2,157,806
   July 2005 - $0.86
    per share              25,000        25        21,475         -         -          -              -         21,500
   July 2005 - $0.81
    per share              52,941        53        42,829         -         -          -              -         42,882
   October 2005 -
    $0.84 per share        50,001        50        41,949         -         -          -              -         41,999
   December 2005 -
    $0.75 per share       200,000       200       149,800         -         -          -              -        150,000
Shares issued in
  satisfaction of
  liabilities and
  interest
   February 2005 -
    $0.30 per share       350,000       350       104,650         -         -          -              -        105,000
   April 2005 - $0.85
    per share             100,000       100        84,900         -         -          -              -         85,000
   May 2005 - $0.80
    per share           1,302,743     1,303     1,040,891         -         -          -              -      1,042,194
   December 2005 -
    $0.75 per share       508,936       509       381,193         -         -          -              -        381,702
Shares issued for
  financing fees
   December 2005 -
    $0.75 per share       543,091       543       406,775         -         -          -              -        407,318
Shares issued as part
  of land acquisition
   August  2005 -
    $0.93 per share       878,048       878       815,707         -         -          -              -        816,585
   August 2005 - $0.86
    per share             255,812       256       219,744         -         -          -              -        220,000
Shares issued for cash
   February 2005 -
    $0.10 per share       100,000       100         9,900         -         -          -              -         10,000
   March 2005 - $0.10
    per share           2,250,000     2,250       222,750         -         -          -              -        225,000
   March 2005 - $0.20
    per share             125,000       125        24,875         -         -          -              -         25,000
   March 2005 - $0.08
    per share             600,000       600        49,400         -         -          -              -         50,000
   March 2005 - $0.07
    per share             700,000       700        49,300         -         -          -              -         50,000
   July 2005 - $0.25
    per share             400,000       400        99,600         -         -          -              -        100,000
   December 2005 -
    $0.25 per share       300,000       300        74,700         -         -          -              -         75,000
   December 2005 -
    $0.50 per share        60,000        60        29,940         -         -          -              -         30,000
Compensation relating
  to intrinsic value
  of stock options              -         -       728,331         -         -          -              -        728,331
Net loss for period             -         -             -         -         -          -     (6,487,246)    (6,487,246)
                      -----------  --------   -----------  --------  -------- ----------  -------------  -------------

Balance December 31,
  2005                 41,292,288    41,292    16,333,170         -         -          -    (17,778,583)    (1,404,121)


Shares issued for
  services
   March 2006 - $0.75
    per share              64,284        63        48,150         -         -          -              -         48,213
Shares issued in
  satisfaction of
  liabilities and
  interest
   January 2006 -
    $0.65 per share        70,311        70        45,632         -         -          -              -         45,702
Shares issued for
  financing fees
   January 2006 -
    $0.65 per share        65,000        65        42,185         -         -          -              -         42,250
Shares issued for cash
   March 2006 - $0.30
    per share             242,400       242        72,478         -         -          -              -         72,720
   June 2006 - $0.30
    per share              33,334        33         9,967         -         -          -              -         10,000
   June 2006 - $0.50
    per share             500,000       500       249,500         -         -          -              -        250,000
   July 2006 - $0.35
    per share              28,572        29         9,971         -         -          -              -         10,000
   July 2006 - $0.30
    per share              66,667        66        19,934         -         -          -              -         20,000
   September 2006 -
    $0.20 per share       312,500       312        62,188         -         -          -              -         62,500
Compensation relating
  to fair value of
  stock options                 -         -       466,205         -         -          -              -        466,205
Net loss for period             -         -             -         -         -          -     (1,412,231)    (1,412,231)
                      -----------  --------   -----------  --------  -------- ----------  -------------  -------------

Balance December 31,
  2006                 42,675,356  $ 42,672   $17,359,380  $      -  $      - $        -  $ (19,190,814) $  (1,788,762)
                      ===========  ========   ===========  ========  ======== ==========  =============  =============

                         See accompanying notes to condensed consolidated financial statements

                                                          F-7
</TABLE>
<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                  From Inception
                                                                      of the
                                                                   Development
                                                                     Stage on
                                          For the Year Ended       February 17,
                                             December 31,          1996 Through
                                      --------------------------   December 31,
                                          2006          2005           2006
                                      ------------  ------------  --------------
Cash Flows from Operating Activities:
 Net loss                             $ (1,412,231) $ (6,487,246) $ (19,190,814)
 Adjustments to reconcile net loss
  to net cash used in operating
  activities:
   Depreciation and amortization             8,532         5,097        795,101
   Gain from debt relief                         -             -        (64,284)
   Loss on sale of investment
   securities                                    -             -         99,000
   (Gain) loss on disposal of assets             -      (153,027)       139,000
   Stock compensation                      515,120     5,458,504      9,391,469
   Write off of stock subscription               -             -         22,750
   Common stock issued for financing
   fees                                     42,250       407,318        471,703
 Changes in current assets and
  liabilities:
   Other current assets                          4        (5,395)        (5,391)
   Accounts payable                        148,585       (41,432)       969,344
   Accounts payable - related party         75,000       (10,000)       608,330
   Accrued liabilities                      (3,931)       65,751      1,441,092
   Accrued legal settlement expense              -       (83,460)        44,967
   Accrued interest payable                 57,888       154,860        707,109
                                      ------------  ------------  --------------

   Net Cash Used in Operating
   Activities                             (568,783)     (689,030)    (4,570,624)
                                      ------------  ------------  --------------

Cash Flows from Investing Activities:
 Purchase of equipment                    (109,276)     (123,245)    (1,003,049)
 Advances to related party                       -      (290,328)      (290,328)
 Organization costs paid                         -             -         (4,755)
 Proceeds from sale of assets                    -       250,000        367,715
                                      ------------  ------------  --------------

 Net Cash Used in Investing
   Activities                             (109,276)     (163,573)      (930,417)
                                      ------------  ------------  --------------

Cash Flows from Financing Activities:
 Proceeds from borrowings -
   stockholders                            250,000       570,000      1,690,111
 Payments on borrowings -
   stockholders                           (130,000)     (105,980)      (385,730)
 Proceeds from stock issuance and
   subscriptions                           425,220       564,999      4,434,391
 Payments on capital leases                     -             -        (185,640)
                                      ------------  ------------  --------------

 Net Cash Provided by Financing
 Activities                                545,220     1,029,019      5,553,132
                                      ------------  ------------  --------------

Net Increase (Decrease) in Cash           (132,839)      176,416         52,091

Cash at Beginning of Year                  184,930         8,514              -
                                      ------------  ------------  --------------

Cash at End of Year                   $     52,091  $    184,930  $      52,091
                                      ============  ============  ==============

Supplemental Cash Flow Information:
 Cash paid for interest               $     20,000  $      9,021
Non Cash Investing and Financing
 Activities:
 Conversion of liabilities to
  common stock                        $     45,000  $  1,613,896
 Settlement of related party advances
  through acquisition of land         $          -  $    290,328
 Transfer of land to investment in
  joint venture                       $    392,251  $          -

      See accompanying notes to condensed consolidated financial statements

                                      F-8
<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         Organization--  Terra Systems,  Inc., was  incorporated on February 17,
1996,  pursuant  to the laws of the  State of  Utah.  It is a  development-stage
company whose primary business purpose is the development and  commercialization
of a  pneumatic  conveyance  system  to  handle  materials  in a bulk  state  in
industrial research and processing.

         Xullux,  Inc., was incorporated  under the laws of the State of Utah on
November 4, 1983, under the name of Bunker Research, Inc. It changed its name to
Diamond  Resources,  Inc. on May 15, 1984, and changed its name again to Xullux,
Inc., on August 6, 1988.  On May 1, 1996,  Xullux,  Inc.,  entered into a merger
agreement with Terra Systems, Inc., whereby Terra Systems, Inc., was merged into
a newly-formed subsidiary of Xullux, Inc., called Terra Merger Subsidiary,  Inc.
Following the reorganization,  Xullux,  Inc., changed its name to Terra Systems,
Inc.

         In September  2005 the Company  acquired the assets of Mountain  Island
Energy,   LLC.,  an  Idaho-based  company  (MIE).  At  the  time  of  the  asset
acquisition, MIE was not considered a business and consisted solely of land. The
prior  owners  of MIE  were  all  shareholders  and  officers  of  the  Company.
Therefore,  the land was valued at the original  owners'  basis.  See Note 5 for
details.

         Principles of  Consolidation--  The consolidated  financial  statements
include the accounts of Terra Systems,  Inc., and its wholly owned subsidiaries,
Terra Merger Subsidiary, Inc. and Mountain Island Energy, LLC. All inter-company
transactions  have been eliminated.  The consolidated  entities are collectively
referred to herein as the "Company" or "Terra Systems."

         Use  of  Estimates--  The   preparation  of  financial   statements  in
conformity with generally accepted accounting  principles requires management to
make estimates and  assumptions  that affect the reported  amounts of assets and
liabilities at the date of the financial  statements and the reported amounts of
revenues and expenses during the reporting  period.  Actual results could differ
from those estimates.

         Basis  of  Presentation--  The  accompanying   consolidated   financial
statements have been prepared on a going concern basis,  which  contemplates the
realization of assets and the  satisfaction  of liabilities in the normal course
of business.  As shown in the  consolidated  financial  statements for the years
ended December 31, 2006 and 2005, the Company  received  $45,897 and no revenue,
respectively and incurred net losses of $1,412,231 and $6,487,246, respectively.
As  of  December  31,  2006,  the  Company  had a  working  capital  deficit  of
$2,299,672. These factors raise substantial doubt about the Company's ability to
continue as a going concern for a reasonable  period of time.  The  consolidated
financial   statements   do  not  include  any   adjustments   relating  to  the
recoverability   and  classification  of  recorded  assets  or  the  amount  and
classification  of  liabilities  that might be  necessary  should the Company be
unable to continue as a going  concern.  The Company's  continuation  as a going
concern is dependent upon its ability to generate  sufficient cash flows to meet
its  obligations  on a timely basis,  to obtain  additional  financing as may be
required, and ultimately to attain successful operations.

         The  Company's  management  is in the  process of  negotiating  various
agreements to perform  research on and the  development of pneumatic  conveyance
systems  to  handle  materials  in a  bulk  state  in  industrial  research  and
processing.  Management also intends to use capital and debt financing as needed
to supplement  the cash flows that  potentially  could be generated  through the
successful negotiation of agreements.


                                      F-9
<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         Cash and Cash  Equivalents--  For  purposes  of the  statement  of cash
flows,  the Company  considers  all highly liquid debt  instruments  maturing in
three months or less to be cash equivalents.

         Property and  Equipment -- Property and  equipment are recorded at cost
and are depreciated using the straight-line  method based on the expected useful
lives of the assets that range from five to fifteen years.  Depreciation expense
for the  years  ended  December  31,  2006 and  2005,  was  $8,532  and  $5,097,
respectively.

         Long-Lived  Assets  -- The  carrying  value  of  long-lived  assets  is
evaluated   periodically  when  events  or  circumstances  indicate  a  possible
inability to recover the carrying amounts.  An impairment loss is recognized for
the excess of the carrying amount over the fair value of the assets.  Fair value
is  determined  based on  estimated  discounted  net future  cash flows or other
valuation  techniques  available in the  circumstances.  This analysis  involves
significant  management judgment to evaluate the capacity of an asset to perform
within  projections.  Based upon  these  analyses,  no  impairment  losses  were
recognized in the accompanying financial statements.

         Financial   Instruments  --  The  estimated  fair  value  of  financial
instruments  is not presented  because,  in  management's  opinion,  there is no
material  difference  between  carrying amounts and estimated fair values of the
financial instruments as presented in the accompanying balance sheets.

         Revenue Recognition -- The Company's revenues,  during 2006,  primarily
have come from the sale of coal to another corporation.

         Basic and  Diluted  Loss Per Share -- Basic  loss per  common  share is
computed by dividing net loss by the  weighted-average  number of common  shares
outstanding  during the period.  Diluted  loss per share is  calculated  to give
effect to  potentially  issuable  common  shares except during loss periods when
those  potentially  issuable common shares would decrease the loss per share. As
of December 31, 2006 and 2005,  there were  4,812,867 and 4,500,000  potentially
issuable common shares,  respectively,  which were excluded from the calculation
of diluted loss per common share as their effect would have been  anti-dilutive,
thereby decreasing the net loss per common share.

         Stock Based  Compensation  --  Effective  January 1, 2006,  the Company
adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS
123R), using the modified prospective method. SFAS 123R requires the recognition
of the cost of employee  services  received  in exchange  for an award of equity
instruments in the financial  statements and is measured based on the grant date
fair value of the award.  SFAS 123R also requires the stock option  compensation
expense to be recognized over the period during which an employee is required to
provide service in exchange for the award (the vesting  period).  See Note 6 for
details.

         Corrected  prior  year  financial  statements  -- During  the course of
preparing the financial  statements  for the year ending  December 31, 2006, the
Company  identified  certain  prior period  misstatements  whose impact were not
material to the Company's  financial  statements for the year ended December 31,
2005. As a result,  the Company corrected the financial  statements for the year
ended December 31, 2005. The corrected balance sheet as of December 31, 2005, is
included in these financial statements. This misstatement relates to the Company
incorrectly reporting cash received as an equity investment instead of as a note
payable. As a result of the misstatement,  the Company also incorrectly reported
the  issuance of stock for cash.  This  correction  increased  notes  payable to
related parties by $100,000 and decrease additional  paid-in-capital by the same
amount.

                                      F-10

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         Recent Accounting  Pronouncements -- In July 2006, the FASB issued FASB
Interpretation  (FIN) No. 48, Accounting for Uncertainty in Income Taxes,  which
provides  guidance on the accounting for uncertainty in income taxes  recognized
in financial  statements.  FIN 48 is effective for fiscal years  beginning after
December 15, 2006, with earlier adoption permitted.  We are currently evaluating
the impact, if any, the adoption of FIN 48 will have on its financial  reporting
and disclosures.

         In September  2006, the FASB issued  Statement of Financial  Accounting
Standards No. 157, Fair Value Measurements, which provides enhanced guidance for
using fair value to measure assets and  liabilities.  SFAS No. 157 establishes a
common  definition of fair value,  provides a framework for measuring fair value
under  generally  accepted   accounting   principles,   and  expands  disclosure
requirements  about  fair value  measurements.  SFAS No.  157 is  effective  for
financial  statements  issued in fiscal years beginning after November 15, 2007,
and for interim periods within those fiscal years.  We are currently  evaluating
the impact,  if any,  the  adoption  of SFAS No. 157 will have on its  financial
reporting and disclosures.

         In September 2006, the SEC staff published  Staff  Accounting  Bulletin
No. 108,  "Considering the Effects of Prior Year  Misstatements when Quantifying
Misstatements  in  Current  Year  Financial  Statements"  ("SAB  108").  SAB 108
addresses   quantifying  the  financial   statement  effects  of  misstatements,
specifically,  how  the  effects  of  prior  year  uncorrected  errors  must  be
considered  in   quantifying   misstatements   in  the  current  year  financial
statements.  This  statement is effective for fiscal years ending after November
15, 2006. We do not expect the adoption of SAB 108 to have a material  effect on
its financial statements.

NOTE 2 - RELATED PARTY TRANSACTIONS

         Certain officers and shareholders of the Company have from time to time
advanced  operating capital and / or settled operating expenses on behalf of the
Company.  As of December  31, 2006 and 2005,  the  Company  received  additional
advances of $115,000 and $0, respectively,  and made payments in satisfaction of
its obligations worth $40,000 and $20,000,  respectively,  resulting in payables
to related parties of $197,445 and $122,445,  respectively.  All amounts are due
on demand and bear no interest.

         As  further  discussed  in Note 4, the  Company  has notes  payable  to
shareholders and officers. During 2006, the Company received proceeds from these
individuals totaling $250,000.  During the year ended December 31, 2006 and 2005
the Company made payments of $130,000 and $344,713, respectively. As of December
31, 2006 and 2005, the amounts due were $970,554 and $850,554, respectively.

         During the years ended December 31, 2006 and 2005, the Company  accrued
interest on the notes of $77,888, and $154,860, (which includes the common stock
to be issued valued at $93,000) respectively. During the year ended December 31,
2006, the Company made interest payments totaling $20,000. During the year ended
December  31,  2005,  the  Company  made a payment of  $345,976  related to this
accrued  interest  through the issuance of common stock. As of December 31, 2006
and 2005, the accrued interest due was $326,133 and $268,245, respectively.

         As part of these notes payable,  during 2005 the Company issued 543,091
shares of common stock valued at $407,318 as further financing  incentives.  The
Company  also  committed  to issue  100,000  shares  of common  stock  valued at
$93,000,  in  financing  incentives.  The  shares  have yet to be issued and the
$93,000 is included in accrued liabilities.


                                      F-11

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         See Note 5 for a discussion of stock issued to related  parties as part
of a land acquisition.

NOTE 3 - OPERATING LEASE OBLIGATION

         In September  2005, the Company  entered into a lease agreement to rent
2,328 square feet of office space for a period of three years.  During the years
ended December 31, 2006 and 2005,  the Company  incurred rent expense of $32,131
and $10,476  respectively.  Minimum payments for the remaining term of the lease
are as follows:

                  Year Ended
                 December 31,
                 ------------
                     2007             32,688
                     2008             22,208
                                    ---------
                                      54,896
                                    =========

NOTE 4 - NOTES PAYABLE TO STOCKHOLDERS

         Notes payable to stockholders are as follows:

                                                              December 31,
                                                           2006          2005
                                                        ----------   -----------
Notes payable to stockholders, interest
 rate at 10% per annum payable monthly,
 notes are currently due                                $  369,009   $  369,009

Notes payable to stockholders, no
 stated interest; 145,000 shares of
 common stock valued at $108,750 was
 issued in lieu of interest, amounts are
 due on demand                                              50,000      130,000

Note payable to stockholder, interest
 rate at 10% per annum payable monthly,
 amounts are due on demand                                 300,000      100,000

Note payable to stockholder; interest
 rate at 10% per annum payable monthly,
 100,000 shares of common stock valued at
 $93,000 are accrued and to be issued as
 additional interest, note is due on demand                250,000      250,000

Notes payable to stockholders for
 redemption of stock interest is 10%
 per annum payable monthly, due on demand                    1,545        1,545
                                                        ----------   -----------

Notes Payable to Stockholders                           $  970,554   $  850,554
                                                        ==========   ===========


                                      F-12

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 5 - STOCKHOLDERS' DEFICIT

         Common Stock Issued for Cash -- During 2006, the Company issued 775,734
shares of common  stock and  812,867  warrants  to  purchase  common  stock with
exercise  prices ranging from $0.30 to $1.25 per share for proceeds of $332,720.
The warrants vest immediately  with 137,867 warrants  expiring in March 2008 and
675,000 warrants  expiring in May 2009. The proceeds were allocated  $160,817 to
common stock and $171,903, to the warrants,  based on their relative fair values
on the date of issuance.  The fair value of the warrants was $356,924 determined
by the  Black-Scholes  option  pricing  model using the  following  assumptions:
estimated  volatility  of 110.80%  estimated  risk-free  interest  rate of 5.17%
estimated yield of 0% and life of 2.83 years.

         During the year ended  December  21,  2006 the Company  issued  312,500
shares of common  stock at a price of $0.20 per share for  proceeds  of $62,500.
The Company  also has an  agreement to sell an  additional  4,687,500  shares of
common stock at a price of $0.20 per share to this individual.  The agreement to
sell the additional shares of common stock expires September 11, 2007.

         The Company also issued  95,239  shares of common stock for proceeds of
$30,000 or at prices ranging from $0.30 to $0.35 per share.

         During 2005,  the Company  issued  4,535,000  shares of common stock at
prices ranging from $0.10 to $0.50 for proceeds of $564,999.

         Common Stock Issued for Services -- During the years ended December 31,
2006 and 2005, the Company issued 64,284 and 4,385,199 shares, respectively,  of
common  stock for  consulting  services.  The common  stock was valued at prices
ranging from $0.75 to $0.95 per share. For the years ended December 31, 2006 and
2005,  the Company  charged  $48,213 and  $3,693,587  of  consulting  expense to
operations,  respectively. The shares were valued based on the fair value of the
Company's common stock on the date of issuance.

         Common Stock Issued for  Satisfaction of Debt -- During the years ended
December 31, 2006 and 2005,  the Company  issued  70,311 and  2,261,679  shares,
respectively,  of common stock for satisfaction of its  obligations.  The common
stock was valued at prices  ranging from $0.30 to $0.85 per share.  For the year
ended December 31, 2006, the Company paid accounts  payable of $45,000.  For the
year ended  December  31,  2005,  the Company  relieved  related  party  accrued
interest of $345,976,  accrued wages of $799,220,  notes payable to shareholders
of $238,733, legal settlements of $44,967, related party payables of $10,000 and
accounts payable of $175,000.

         Common  Stock  Issued  for  Financing  Fees -- During  the years  ended
December  31, 2006 and 2005,  the Company  issued  65,000 and 543,091  shares of
common stock for financing fees incurred during the period. The common stock was
valued at prices  ranging  from  $0.65 to $0.75 per share.  For the years  ended
December  31,  2006 and 2005,  the Company  charged the $42,250 and  $407,318 of
finance fee to interest expense.

         Common Stock Issued in  Connection  with  Acquisition - In August 2005,
the Company acquired the assets of Mountain Island Energy,  LLC., an Idaho-based
company  (MIE) for  $100,000  in cash,  forgiveness  of prior cash  advances  of
$290,328  and the  issuance  of  1,133,860  shares  of  common  stock  valued at
$1,036,585.  At the time of the  asset  acquisition,  MIE was not  considered  a
business  and  consisted  solely  of  land.  The  prior  owners  of MIE were all
shareholders and officers of the Company.  Therefore, the land was valued at the
original  owners'  basis.  The  value  paid for the  assets  of MIE in excess of
historical cost is considered  additional  compensation to the original  owners.
The Company charged $1,136,585 as additional expense to the original owners.


                                      F-13

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 6 - STOCK OPTIONS AND STOCK WARRANTS

STOCK OPTIONS

         Effective  January 1, 2006, the Company adopted  Statement of Financial
Accounting  Standards  No. 123 (revised  2004) (SFAS  123R),  using the modified
prospective  method.  SFAS 123R requires the recognition of the cost of employee
services  received  in  exchange  for an  award  of  equity  instruments  in the
financial  statements  and is measured based on the grant date fair value of the
award.  SFAS 123R also  requires  the stock  option  compensation  expense to be
recognized  over the period  during  which an  employee  is  required to provide
service in exchange for the award (the vesting  period).  Prior to adopting SFAS
123R, the Company accounted for stock-based  compensation plans under Accounting
Principles  Board  Opinion  ("APB")  No.  25,  "Accounting  for Stock  Issued to
Employees"  ("APB  25").  Under APB 25,  generally  no  compensation  expense is
recorded  when the terms of the award  are fixed and the  exercise  price of the
employee stock option equals or exceeds the fair value of the  underlying  stock
on the date of grant. The Company had adopted the  disclosure-only  provision of
SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123").

         For the year ended December 31, 2006 and 2005,  the Company  calculated
compensation  expense of $453,605 and  $728,332  related to stock  options.  The
overall  effect of adopting SFAS 123R was an increase of net loss by $218,954 or
$0.01 per share, during 2006.

         For options  granted  subsequent  to the adoption  date of SFAS 123R on
January 1, 2006,  the fair value of each stock option grant will be estimated on
the date of grant using the Black-Scholes  option-pricing model. The Company had
no stock option  grants  during the year ended  December  31, 2006,  and granted
2,500,000  stock options  during the year ended  December 31, 2005. The weighted
average  fair value of stock  options at the date of grant during the year ended
December 31, 2005, was $0.77 per share.

         A summary of stock  option  activity  for the year ended  December  31,
2006, is presented below:

                                                      Weighted
                                       Weighted        Average
                         Shares        Average        Remaining       Aggregate
                         Under         Exercise      Contractual      Intrinsic
                         Option         Price           Life            Value
                     -------------  -------------   -------------   ------------
Outstanding at
December 31, 2004       2,000,000       $  0.10
 Granted                2,500,000       $  0.28
 Exercised                      -
 Forfeited                      -
 Expired                        -
Outstanding at
December 31, 2005       4,500,000       $  0.20
                     ------------
 Granted                        -
 Exercised                      -
 Forfeited                      -
 Expired                 (500,000)      $ (0.10)
                     ------------

Outstanding at
December 31, 2006       4,000,000       $  0.21             *        $  752,000
                     ============

Exercisable at
December 31, 2006       2,628,572       $  0.12             *        $  724,571
                     ============
Exercisable at
December 31, 2005       2,900,000       $  0.10
                     ============

          * 1,600,000  of these  options,  with an  exercise  price of $0.38 per
            share do not have a stated expiration date; the remaining  2,400,000
            options, with an exercise  price of $0.10 per share have a remaining
            life of .86 years


                                      F-14

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         The expected life of stock options  represents  the period of time that
the stock  options  granted are expected to be  outstanding  based on historical
exercise  trends.  The  expected  volatility  is based on the  historical  price
volatility of our common stock. The risk-free  interest rate represents the U.S.
Treasury  bill rate for the  expected  life of the related  stock  options.  The
dividend yield  represents our anticipated  cash dividend over the expected life
of the stock options.

         The following  are the  weighted-average  assumptions  used for options
granted during the year ended December 31, 2006 and 2005:

                                              2006                2005
                                          -------------      -------------

        Risk free interest rate                N/A                4.2%
        Expected life                          N/A             7.5 Years
        Dividend yield                         N/A                 -
        Volatility                             N/A                136%


         As  of  December  31,  2006,  there  was   approximately   $670,822  of
unrecognized  compensation cost related to stock options that will be recognized
over a weighted average period of 3.42 years.

         In May 2006,  the Company  changed  the  expiration  date on  1,500,000
options  from July 2006 to July 2007.  Using the  Black-Scholes  option  pricing
model and a risk free  interest  rate of 4.99%,  volatility  of  114.74%  and an
expected  life of 1 year,  it was  determined  that and  additional  expense  of
$12,600 was incurred.

         Prior  to  January  1,  2006,  the  Company  determined  the  value  of
stock-based compensation arrangements under the provisions of APB Opinion No. 25
"Accounting  for Stock  Issued  to  Employees"  and made pro  forma  disclosures
required under SFAS No. 123,  "Accounting  for  Stock-Based  Compensation."  Had
compensation  expense for stock option grants been determined  based on the fair
value at the grant dates consistent with the method  prescribed in SFAS No. 123,
the  Company's  net loss and net loss per share would have been  adjusted to the
pro forma  amounts  below for the year ended  December  31,  2005,  as indicated
below:

                                                             For the Year Ended
                                                             December 31, 2005
                                                             ------------------
Net loss, as reported                                        $       (6,487,246)
Add: Stock-based employee compensation
expense included in reported net loss                                   728,332
Deduct:  Total stock-based employee compensation
expense determined under fair value based
method for all awards                                                  (811,852)
                                                             ------------------
Pro forma net loss                                           $       (6,570,766)
                                                             ------------------

Basic and diluted loss per share, as reported                $            (0.18)
                                                             ------------------
Basic and diluted loss per share, pro forma                  $            (0.18)
                                                             ------------------


                                      F-15

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Stock Warrants

         A summary of stock warrants at December 31, 2006 is presented below;

                                                    Remaining
                 Warrants         Exercise       weighted average
                outstanding        price         contractual life
                -----------       --------      -------------------
                  137,867           $0.30            1.24 years
                  500,000           $0.75            2.38 years
                  175,000           $1.25            2.38 years
                -----------
                  812,867
                ===========

NOTE 7 - INVESTMENT IN JOINT VENTURES

         On June 29, 2006 the Company  entered  into a joint  venture  agreement
with United Fund Advisors, L.L.C. (UFA) of Portland Oregon. Under the agreement,
a new entity,  Mountain Island Energy Holdings,  L.L.C.  (MIEH) was formed. MIEH
was formed for the purpose of applying to the US  Department of the Treasury and
US Department of Energy for an award of federal  advanced clean coal project tax
credits under Section 48A of the Internal Revenue Code. UFA and the Company each
own 50% of MIEH. Under the agreement, Reynold Roeder of UFA and Mitchell J. Hart
of the  Company  will  serve  as  managing  directors  of MIEH.  Under  the MIEH
operating agreement, UFA was required to make capital cash contributions to MIEH
totaling $1,000 along with agreed upon services.  During the year ended December
31, 2006, UFA contributed $31,000 in cash, and services valued at $170,000.  The
Company,  according to the operating agreement,  was required to contribute land
and certain  professional  service work related to the  development of the land.
During the year ended  December  31,  2006,  the  Company  contributed  land and
development costs valued at $392,251. MIEH had no substantial operations for the
year ended  December 31, 2006.  The Company will account for this joint  venture
interest under the equity method of accounting.

         Mountain  Island  Energy,  LLC  ('MIE'),  of  Soda  Springs,  Idaho,  a
subsidiary  of Terra Systems Inc.,  and United Fund  Advisors,  LLC of Portland,
Oregon,  formed Sage Island Energy,  LLC, a Delaware limited liability  company.
Sage Island Energy was formed to respond to the Wyoming Infrastructure Authority
Request for Proposal,  which seeks to establish a public-private  partnership to
develop a "clean coal"  demonstration  project (or projects).  It is anticipated
that this project will  demonstrate the production of energy from coal mined and
converted  to  electrical  power  in  the  State  of  Wyoming  using  integrated
gasification  combined cycle  technology.  Sage Island Energy had no substantial
operations for the year ended December 31, 2006

NOTE 8 - RESEARCH AND DEVELOPMENT EXPENSE

         Expenses in the accompanying financial statements include certain costs
which are directly associated with the Company's research and development. These
costs,  which  consist  primarily  of fees paid to  individuals,  materials  and
supplies,  amounted to $0 and $16,225 for the years ended  December 31, 2006 and
2005, respectively.

NOTE 9 - INCOME TAXES

         There was no benefit or provision for income taxes during 2006 or 2005.
The Company also did not pay any income  taxes  during the years ended  December

                                      F-16

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



31, 2006 and 2005. The following presents the components of the net deferred tax
asset as of December 31, 2006 and 2005:

                                                        December 31,
                                              --------------------------------
                                                    2006            2005
                                              -------------   ----------------
   Tax loss carry forward                     $   5,551,762   $      5,208,394
   Stock based compensation                         445,562            271,668
   Asset bases differences                          386,646            386,646
   Accrued and deferred compensation                116,815            116,815
   Other accruals                                    15,444              5,945
                                              -------------   ----------------

      Total Deferred Tax Assets                   6,516,229          5,989,468

      Less: valuation allowance                  (6,516,229)        (5,989,468)
                                              -------------   ----------------

      Net Deferred Tax Asset                  $           -   $              -
                                              =============   ================

         The  Company  has net  operating  loss carry  forward of  approximately
$14,900,000 which expire from 2011 through 2025.

         The  following is a  reconciliation  of the amount of tax that would be
result from applying the federal rate to pretax income with provision for income
taxes for the years ending December 31, 2006 and 2005:

                                                  For the Years Ended
                                                      December 31,
                                              ----------------------------
                                                  2006            2005
                                              -------------   ------------

  Benefit at US federal statutory rate (34%)  $    (480,159)  $ (2,205,664)
  Non deductible items                                    -            270
  Deferred tax asset valuation change               526,762      2,419,472
  State benefit, net of federal effect              (46,603)      (214,078)
                                              -------------   ------------

    Benefit from Income Taxes                 $           -   $          -
                                              =============   ============


NOTE 10 - CONTINGENCIES

         Litigation  -- In March 2006,  a former  employee of the Company  filed
suit for back wages.  On April 21,  2006 the suit was  settled.  The  settlement
agreement  included  three  payments  of  $10,000  each to be paid May 1,  2006,
September  1, 2006,  and  December  1, 2006.  The  amounts  were paid in full by
December 31, 2006.

NOTE 11 - SUBSEQUENT EVENTS (UNAUDITED)

         During  January 2007,  the Company  issued  1,727,700  shares of common
stock to a creditor for payment of approximately $744,222 in liabilities.


                                      F-17

--------------------------------------------------------------------------------