UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

(x)      Annual report under Section 13 or 15 (d) of the Securities Exchange Act
         of 1934 for the fiscal year ended December 31, 2000.

(  )     Transition report under Section 13 or 15 (d) of the Securities Exchange
         Act of 1934 for the transition period from ___ to ___

                               TERRA SYSTEMS, INC.
                 (Name of small business issuer in its charter)

            Utah                                          87-0476073
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

   5912 West 11600 South, Payson, Utah                                 84651
 (Address of principal executive offices)                            (Zip Code)

                                 (801) 465-4400
                           (Issuer's telephone number)


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

Securities  registered under Section 12(g) of the Act: Common Stock,  $0.001 par
value per share.

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

Check if 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  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. (X)

Issuer's revenues for the most recent fiscal year: $10,515

The aggregate  market value of common stock held by  non-affiliates  on February
27, 2001 was  $6,503,257  based on the average bid and asked price of the common
stock reported by the Electronic OTC Bulletin Board.

The number of shares outstanding of the issuer's common stock as of February 27,
2001 was 19,051,631.

                     Transitional Small Business Disclosure
                       Format (Check one): Yes ( ) No (X)

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<PAGE>



                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
Part I
<S>  <C>            <C>                                                                             <C>
     Item 1.        Description of Business                                                          3
     Item 2.        Description of Property                                                          8
     Item 3.        Legal Proceedings                                                                9
     Item 4.        Submission of Matters to a Vote of Security Holders                              9

Part II
     Item 5.        Market for Common Equity and Related Stockholder Matters                        10
     Item 6.        Management's Discussion and Analysis or Plan of Operation                       11
     Item 7.        Financial Statements                                                            15
     Item 8.        Changes In and Disagreements With Accountants on Accounting and Financial       15
                    Disclosures

Part III
     Item 9.        Directors, Executive Officers, Promoters and Control Persons; Compliance        15
                    With Section 16(a) of the Exchange Act
     Item 10.       Executive Compensation                                                          17
     Item 11.       Security Ownership of Certain Beneficial Owners and Management                  18
     Item 12.       Certain Relationships and Related Transactions                                  18
     Item 13.       Exhibits and Reports on Form 8-K                                                18
                    Signatures                                                                      19
                    Index to Exhibits                                                               20
</TABLE>


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<PAGE>




                                     Part I

Item 1.  Description of Business

         We were formed as a Utah  corporation  on  February  16, 1996 under the
name Terra  Systems,  Inc. Terra  Systems,  Inc. 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.

         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. and
the Terra Systems,  Inc.  stockholders  were issued 48,000,000 shares of Xullux,
Inc. common stock.  Following the reorganization,  Xullux, Inc. 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.

         Our common stock began  trading in  July  1996  and is quoted under the
ticker symbol "TSYI" on the Electronic OTC Bulletin Board.

Products

         We develop and commercialize low-pressure pneumatic conveyance systems.
These  low-pressure  systems  are used in  connection  with  the  pulverization,
moisture control, classification, transport, and processing of bulk materials.

         The 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.  Reference to the
"abrasion  signature" is the amount of wear and tear or erosion on the inside of
a pipe caused by the flow of a given material. 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 caking of material inside the
piping.  "Caking"  is a term used to  describe  the build up of  material on the
inside of its 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 components are pre-fabricated in our warehouse 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


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example,  some  applications  may require just product drying before going to an
existing  milling  operation.  Thus our equipment could provide just the product
drying  service  onsite.  We construct  and test each system with the use of our
technical and research staff.

         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,  virtually  all  bulk  materials  used  in  basic
industries can be economically separated, classified, and otherwise processed.

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:

        o        Developing strategic alliances;
        o        Establishing our brand name; and
        o        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.

         Direct marketing

         To  date  our  marketing   activity  has  been  largely   word-of-mouth
referrals, on-site demonstrations, as well 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  -
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.

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<PAGE>

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.

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.

Customers

         One  customer,  PacifiCorp,  accounts  for  approximately  95%  of  our
revenues at this time.

New Product Offerings

         We did not offer a new product in the past year and we do not expect to
introduce any new products in the year ending December 31, 2001.

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 to strategic 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 certain processes or technologies.  Any
of these  situations  could have a material  adverse effect on our ability to do
business.  Furthermore,  patent  law  relating  to the  scope of claims is still
evolving in the technology fields in which we operate.  As a result,  the degree
of future protection for our proprietary rights is uncertain.  We cannot prevent


                                       5
<PAGE>

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 such 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.  Such 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 certain
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.  Such 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 such action.  We
cannot ensure that any license,  including  licenses  proposed by third parties,
required under any such 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.

         The  enactment of  legislation  implementing  the General  Agreement on
Trade and Tariffs,  effective  June 8, 1995,  has changed  certain United States
patent laws. Most notably, the term of patent protection for patent applications
filed on or after  that date is no longer a period of 17 years  from the date of
grant.  The new term of United States patents begins on the date of issuance and
terminates 20 years after the effective  date of filing.  This change in the law
could  substantially  shorten  the  term of our  patent  protection,  which  may
adversely affect our patent position.

         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.


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<PAGE>

         We believe that we will be able to comply in all material respects with
the laws and  regulations  governing the  industry,  and that such laws will not
have a material  effect on our  operations.  However,  various federal 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, 2000, we had five full-time employees, one part-time
employee,  and three  consultants  and  advisors.  There are no organized  labor
agreements  or union  agreements  between Terra  Systems and our  employees.  We
believe that our relations with our employees are good.

Risk Factors

         Our  business  is subject to  specific  risk  factors  that  affect our
results of operations and financial condition. Many of these factors are outside
our control. These risks include the following:

         Our limited  operating  history  makes it difficult  to predict  future
results.  We have a limited  operating  history on which to base  estimates  for
future performance.  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.  On a long-term  basis,  we
expect to structure  licensing  agreements to result in up-front  licensing fees
with subsequent  revenues to be generated by royalties or similar  payments over
time. If these events do not generate  sufficient  cash flows to cover operating
expenditures, we may be required to scale back or cease our business activities.

         We will require  additional  funding to continue our  business.  We may
need to obtain  additional  financing  if we are unable to realize  sales of our
services or collect accounts  receivable.  We may incur additional  indebtedness
from time to time to  finance  acquisitions,  provide  for  working  capital  or
capital  expenditures,  or for other purposes.  Furthermore,  our ability to pay
cash  dividends  on, and to  satisfy  redemption  obligations  in respect of our
outstanding  common stock will be primarily  dependent upon the future financial
and operating  performance  of the company.  That  performance is dependent upon
financial,  business,  and other  general  economic  factors,  many of which are
beyond our control.  If we are unable to generate  sufficient  cash flow to meet
our future debt service obligations or provide adequate long-term liquidity,  we
will be  required  to  pursue  one or more  alternatives,  such as  reducing  or
delaying capital  expenditures,  refinancing debt, selling assets or operations,
or raising  equity  capital.  There can be no assurance  that such  alternatives
could be accomplished on satisfactory terms, if at all, or in a timely manner.


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<PAGE>

         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
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 certain aspects of our business 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.  Terra  Systems,  Inc.  may rely on certain
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
term, 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 certain
aspects of our  processes  or other  features  violates 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.

         We are dependent  upon the  experience  and expertise of our management
and the loss of any one of certain of our  executive  officers or key  employees
would  adversely  affect our  business  and results of  operations.  Our success
depends upon the efforts, abilities, and expertise of our executive officers and
other  key  employees,   including  our  Chief  Executive  Officer,   President,
Secretary/Treasurer,  Consultants,  and Research and Development personnel.  The
loss of the services of such individuals and/or other key individuals could have
a material adverse effect on our business,  results of operations,  or financial
condition.

Item 2.  Description of Property

         Our  corporate  headquarters  are  located  at 5912 West  11600  South,
Payson,  Utah 84651. We have use of this space through a lease  arrangement from
Spring Lake Company, a related party. The terms of this lease are for $4,120 per
month on a  month-to-month  basis.  The  lease  expires  on July 1,  2003.  This


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<PAGE>

facility  consists of  approximately  20,000 square feet of office and warehouse
space  in the  main  building,  and  approximately  10,000  feet  of  additional
warehouse and storage in an unattached  building on  approximately  3.2 acres of
land.  We do not have any  present  plans for the  renovation,  improvement,  or
development  of this  property.  We have entered into a capital lease  agreement
with Spring Lake Company to acquire plant equipment at a total of $423,594. This
lease expires March 2002. The monthly payment is approximately  $13,528. We also
have  acquired  office  equipment  at a cost of  $70,678  and  additional  plant
equipment at a cost of $193,152,  and we own an automobile valued at $22,000 and
software valued at $10,380.

Item 3.  Legal Proceedings

         Terra  Systems and certain of our  executive  officers or directors are
involved in a single litigation matter as discussed in this Item 3.

         This matter is Civil No. 97-0400506,  pending in the District Court for
the Fourth Judicial District in and for Utah County,  State Of Utah. The parties
to this  action  are Terra  Systems,  Inc.,  a Utah  corporation,  Terra  Merger
Subsidiary,  Inc., a Utah corporation;  Kent Harmon, an individual,  and Clayton
Timothy, an individual,  Plaintiffs,  v. Wayne Hanson, an individual,  Howard H.
Hucks,  an individual and Trustee of CHT Holding Trust;  Valgene  Blackburn,  an
individual,  and CHT Holding Trust,  Defendants.  We filed a complaint against a
former  director  and officer and other  stockholders  and alleged that they had
engaged  in   improper   conduct   and   misrepresentations   concerning   their
qualifications and intentions to obtain a significant number of shares of common
stock. We are seeking a declaration by the court that none of the defendants has
any right, title to, or ownership of the common stock originally issued to them.
The  defendants  claim that the company and certain of its officers have engaged
in fraudulent and  conspiratorial  conduct and  defendants  filed a counterclaim
seeking (1) dismissal of our  complaint,  (2) an  unspecified  amount of damages
resulting  from our refusal on March 1, 1997 to tender shares to the  defendants
that they  allege  that they had the right to sell,  (3) the  removal of certain
restrictions on the common stock,  (4) money damages of $60,000 for breach of an
employment contract and interest,  and compensatory damages and punitive damages
in unspecified amounts, and together with attorney fees.

         On  October  9,  1999,  the Court  entered a partial  summary  judgment
against one of the defendants in our favor on all of our claims. The Court found
that the issues of  damages  and an award of  reasonable  attorney's  fees,  and
expenses  incurred in  connection  with the case would be determined at a future
date.  The Court also found that Terra Systems is entitled to a partial  summary
judgment against the defendant for securities  fraud,  including  rescission and
restitution  of the issuance of 1,000,000  shares of common stock and additional
damages to be determined in further  proceedings before the Court. The amount of
damages to be awarded has not yet been determined.

         We have denied the allegations  raised in the counterclaim filed by the
defendants and we will vigorously  defend against the  counterclaim and continue
to pursue our claims and actions against all of the defendants.  This litigation
is still in the discovery  phase and the ultimate  outcome  cannot  presently be
determined.

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

         No matters  were  submitted to the  shareholders  for a vote during the
fourth quarter of the year ended December 31, 2000.


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<PAGE>

                                     Part II

Item 5.  Market For Common Equity And Related Stockholder Matters

Market For Common Stock

         Our common stock, par value $0.001 per share (the "Common  Stock"),  is
traded in the Electronic OTC Bulletin Board under the symbol "TSYI."

         The following  table contains  information  about the range of high and
low bid prices for the common stock for each full  quarterly  period  within the
two most  recent  fiscal  years,  based  upon  reports  of  transactions  on the
Electronic OTC Bulletin  Board (and giving effect to all stock splits  occurring
during that period or prior to the issuance of this report):

                               High            Low
        2000
        1st Quarter              $0.81        $0.38
        2nd Quarter              $0.60        $0.25
        3rd Quarter              $0.38        $0.17
        4th Quarter              $0.72        $0.22

        1999
        1st Quarter              $0.65        $0.63
        2nd Quarter              $0.88        $0.22
        3rd Quarter              $1.13        $0.50
        4th Quarter              $0.88        $0.38

         The source of these high and low prices was the Electronic 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 February 27, 2000, the closing bid price of the common stock as
reported by the Electronic OTC Bulletin Board was $0.52 per share.

Holders

         As of December 31, 2000 there were  approximately  242  stockholders 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.


                                       10


<PAGE>

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.

1998

         In 1998, we issued 33,000 shares of common stock at a price of $.30 per
share for proceeds of $10,000;  27,900 shares at a price of $.3185 per share for
proceeds of $8,887;  90,000  shares at a price of $.33 per share for proceeds of
$29,700;  89,739  shares at a price of $.36 per share for  proceeds  of $32,632;
160,000  shares at a price of $.50 per share for  proceeds of  $80,000;  125,000
shares at a price of $.60 per share for proceeds of $75,000; 121,609 shares at a
price of $.73 per share for  proceeds of $ 88,883;  43,479  shares at a price of
$.75 per share for proceeds of $32,609; and 25,000 shares at a price of $.80 per
share for  proceeds  of  $20,000.  In each  instance,  the  purchasers  of these
securities  were  accredited or  sophisticated  investors,  and each of them was
afforded  complete  access  to all of our  books  and  records  prior  to  their
investment.

1999

         In 1999,  we issued  220,000  shares of common stock at a price of $.25
per share for proceeds of $55,460;  125,000  shares at a price of $.40 per share
for  proceeds  of $50,000;  and 360,000  shares at a price of $.50 per share for
proceeds of $180,000. In each instance,  the purchasers of these securities were
accredited or sophisticated  investors,  and each of them was afforded  complete
access to all of our books and records prior to their investment. We also issued
200,000 shares for the retirement of accounts payable to a related party, valued
at $50,000 or $0.25 per share.  On January 12, 1999,  we issued stock options to
five  individual  shareholders  totaling  2,250,000  shares of common stock at a
price of $0.20 per share.  As of year-end  December 31, 1999, we issued  166,286
shares of common stock at a price of $.50; 50,000 shares at a price of $.60; and
43,000 shares at a price of $.70 for consulting  services.  In addition,  during
the twelve months ended  December 31, 2000, we issued  197,400 shares at a price
of $.25;  99,338  shares at a price of $.39,  62,920  shares at a price of $.48;
60,000  shares  at a price of $.50;  and  15,000  shares at a price of $1.00 for
consulting services.

2000

         During the twelve  months ended  December 31, 2000,  we issued  343,340
shares of common  stock at a price of $.25 per share for proceeds of $85,835 and
33,333 shares at a price of $.30 per share for proceeds of  $10,000.00.  In each
instance,  the purchasers of these  securities were accredited or  sophisticated
investors,  and each of them were afforded  complete  access to all of our books
and records prior to their investment.  During the same period we issued 500,000
shares of common stock upon  conversion  of notes  payable to a related party in
the amount of $100,000 or $0.20 per share.

Item 6.  Management's Discussion and Analysis or Plan of Operation

Forward-Looking Statements

         This  Annual  Report  contains  forward-looking  statements  about  our
business,  financial  condition and prospects that reflect our  assumptions  and
beliefs based on information currently available.  We can give no assurance that
the expectations indicated by these forward-looking statements will be realized.
If any of our  assumptions  should prove  incorrect,  or if any of the risks and
uncertainties  underlying  such  expectations  should  materialize,  our  actual
results  may differ  materially  from  those  indicated  by the  forward-looking
statements.


                                       11

<PAGE>

         The key  factors  that are not within our  control  and that may have a
direct bearing on operating results include,  but are not limited to, acceptance
of our services,  our ability to expand our customer  base, our ability to raise
capital  in the  future,  the  retention  of key  employees  and  change  in the
regulation of our industry.  You should also review the "Risk Factors" contained
in Item 1 of this Report.

         There  may be other  risks  and  circumstances  that we are  unable  to
predict. When used in this Annual Report, words such as, "believes,"  "expects,"
"intends,"  "plans,"  "anticipates,"  "estimates,"  and similar  expressions are
intended  to  identify  forward-looking   statements  not  accompanied  by  such
expressions.  All  forward-looking  statements are intended to be covered by the
safe harbor created by Section 21E of the Securities Exchange Act of 1934.

General

         Terra  Systems was  incorporated  in Utah on February 16, 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.  This
technology operates efficiently at ambient temperatures and at low pressures and
does not use water,  the  generally  more  costly  traditional  alternative  for
processing bulk materials. 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
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.

Results of Operations

         In the approximately 58 months ended December 31, 2000 we have incurred
$6,730,927 in net losses and $340,187 in revenues from operations.  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.  Currently,  the  primary  source of capital  has been  through  the
issuance of common stock and the exercise of stock  options to XCEL  Associates,
Inc.  under an  agreement  dated March 29,  2000.  XCEL has also been engaged to
provide business management and marketing consultation  services,  including the
review of our business plan, preparation of a company profile, recommendation of
the company to various retail brokers, analysts, and institutional investors and
bankers.

         During the year ended  December  31,  2000,  we had sales  revenues  of
$340,187.  During  the year then  ended we  devoted  our  efforts  primarily  to
developing  our products and services,  implementing  our business  strategy and
raising  working capital  through equity  financing.  Our revenues are primarily
dependent  upon our  ability to  cost-effectively  and  efficiently  develop and
market our products and services. Our priorities for the next year are to:

        o Continue marketing our services;
        o Develop strategic relationships;
        o Respond to competitive developments; and
        o Establish our brand identity.


                                       12


<PAGE>

         Realization  of sales of our  products  and  services  during  the year
ending December 31, 2001 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.

         While we have been able to generate  testing  and  product  development
revenues  during the year ended  December 31, 2000,  we have been limited in the
scope of potential clients that could be contacted until our patent  application
had been approved.  In January 2001, we received  notification  that we had been
awarded a patent on our Pneumatic Accelerator.  We expect that this will enhance
our ability to pursue and enter into project development contracts.

         A  substantial  percentage of our revenue in 2000 was derived from work
performed  for  PacifiCorp  /  Interwest  Mining.  The agreed  upon  testing was
completed by late 1999, and we began negotiating additional testing and contract
formulation  with  management  at  PacifiCorp.  Early  in 2000,  Scottish  Power
acquired PacifiCorp, and as a result discussions were temporarily halted. In the
late summer of 2000 discussions were resumed;  however, our management staff and
consultants   have  had  to  devote   considerable   time  and   effort  in  the
"reintroduction"  of themselves and our system to new  management  from Scottish
Power.  We  anticipate  that we will be able to  begin  pursuit  of a  licensing
agreement with PacifiCorp in the near future.

         Our net  loss  for the  twelve  months  ended  December  31,  2000  was
approximately  $1,520,209,  compared  to a net loss for the year ended  December
1999  of  approximately   $1,229,863.   The  net  loss  in  2000  was  primarily
attributable  to lower than  expected  revenues  from sales of our  products and
services.  Our  expenses  for the twelve  months  ended  December  31, 2000 were
approximately   $1,439,739,   of  which   approximately  81%  were  general  and
administrative.  Our  expenses  for  the  year  ended  December  31,  1999  were
approximately   $1,143,992,   of  which   approximately  79%  were  general  and
administrative.  For the twelve months ended December 31, 2000, the depreciation
and amortization  expense was $124,910 compared to depreciation and amortization
expense of $125,823 in 1999.

         Since 1997, we have realized  minimal  revenues while incurring  normal
fixed  overhead and debt service  costs.  This  operating  trend is projected to
continue  for at least the  remaining  period of fiscal 2001 if we are unable to
obtain a signed contract with a client.

         During the year ended  December  31,  2000,  all elements of income and
loss arose from continuing operations.

Future Business

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

         We are continuing  discussions  with  PacifiCorp  and General  Electric
regarding  pulverized  coal  processing for the utility  industry.  We have been
working  closely  with  management  and  engineering  personnel  from  these two
companies 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.


                                       13

<PAGE>

         In October 2000, we led a successful initial presentation to P.S.G. LLC
("Product Services Group"),  who contracts with  Morrison-Knudsen.  The proposed
project  would  involve the clean up of a low-level  radioactive  waste site. In
November  2000,  a  follow-up  presentation  was  made in  Denver,  Colorado  to
Morrison-Knudsen  Corp. In this presentation,  we proposed a total bulk handling
system that would extract, transport,  pulverize, treat, bind, and load-out into
containment the low-level  radioactive  material.  Originally it was anticipated
that  engineering  and  feasibility  funds  would be made  available  to us upon
project  approval in  November  of 2000.  However,  ongoing  litigation  between
Morrison-Knudsen   and  a  general   government   contractor   has  delayed  its
decision-making  capability for our  transaction.  At this time, we anticipate a
resolution to this lawsuit by the end of the second quarter, 2001.

Liquidity and Capital Resources

         Given our current  negative cash flows,  it will be difficult for Terra
Systems to continue as a going  concern.  While  recent  developments  regarding
patent issuance will allow us to more  aggressively  pursue  revenue,  and cash,
generating  contracts,  it may be necessary to raise  additional funds or reduce
cash  expenditures in the next 12 months.  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.

         Our audited consolidated financial statements have been prepared on the
assumption  that we will continue as a going  concern.  Our  independent  public
accountants  have issued  their  report  dated March 5, 2001,  that  includes an
explanatory paragraph stating that our recurring losses and accumulated deficit,
among other things,  raise  substantial doubt about our ability to 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,  such
financing will result in immediate and possibly substantial dilution to existing
shareholders.

New Accounting Standards

         The Financial  Accounting  Standards  Board has issued  standards  that
mandate the accounting for derivative financial instruments,  effective December
31,  2000.  These  standards  require  that  all  of  our  derivative  financial
instruments be recorded on our  consolidated  balance sheets at their fair value
as either assets or  liabilities.  Changes in the fair value of derivatives  are
recorded  each  period in  earnings  or other  comprehensive  earnings.  How the
derivative is recorded  depends upon whether it is  designated  and effective as
part of a hedge transaction and, if it is, the type of hedge transaction.  Gains
and losses on derivative  instruments  reported in other comprehensive  earnings
are  reclassified  as earnings in the periods during which earnings are affected
by the hedged  item.  Adoption  of these new  standards  as of the  fiscal  year
beginning  December  31,  2000  resulted in a  cumulative  effect of a change in
accounting  principle  that was not  significant.  The  adoption  did not have a
material adverse effect on our assets and liabilities and we do not expect it to
have a material effect on our results of operations in subsequent periods.

         During  2000,   the  EITF  issued  a   pronouncement   addressing   the
recognition,  measurement and statement of earnings  classification  for certain
sales incentives.  The pronouncement  will be effective in the second quarter of
2001.   As  a  result,   certain   items   previously   included  in  marketing,
administration  and research  costs on our  consolidated  statements of earnings
will be recorded as  reductions of operating  revenue.  Upon  adoption,  we will
reclassify  prior  period  amounts to conform  to the new  requirements.  Due to


                                       14

<PAGE>

anticipated  additional  consideration of this pronouncement by the EITF, we are
currently  unable to quantify the impact of adoption.  We presently  expect that
adoption  and  subsequent  application  of this  pronouncement  will  not have a
material  effect on our financial  position or results of  operations.  The EITF
also issued a pronouncement  addressing the statement of earnings classification
of shipping  and  handling  costs  billed to  vendors.  This  pronouncement  was
effective  for the  fourth  quarter  of 2000,  but did not have an impact on our
combined financial statements.

         In the first quarter of 2001, the Financial  Accounting Standards Board
issued an Exposure  Draft related to business  combinations.  If the final rules
are adopted as  proposed,  as of July 1, 2001,  we will no longer be required to
amortize our goodwill as a charge to earnings.  In addition, we will be required
to periodically review our goodwill for potential  impairment.  If an impairment
is found to exist,  a charge  will be taken  against  earnings  in our  combined
statement of earnings. We cannot currently determine the amount of an impairment
charge, if any that would be recorded upon adoption.

Item 7.  Financial Statements

         Our financial statements for the years ended December 31, 1999 and 2000
are attached and included as a part of this report.

Item 8.  Changes  In  and  Disagreements  with  Accountants  on  Accounting  and
         Financial Disclosures

         None.

                                    PART III

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

         At  December  31,  2000,  the names  and  positions  of our  directors,
executive officers, and significant employees were as follows:

<TABLE>
<CAPTION>
         Name                   Age               Position                          Term
<S>      <C>                    <C>   <C>                              <C>
         Clayton Timothy        53    Chief Executive Officer          Since October of 1996
         L. Kent Harmon         46    President                        Since February of 1996
         Lloyd McEwan           72    Secretary/Treasurer              Since October of 1996
         Leonard Howe           42    Technical Development            Since February of 1996
         Robert Underwood       57    Director and Consultant          Since January of 1999
</TABLE>

         Clayton Timothy, Chief Executive Officer- Mr. Timothy is the Chairman
of the Board of Directors and as our Chief Executive Officer.  He has held those
positions  since October 1996.  Prior to joining Terra Systems,  Mr. Timothy was
Vice President of Industrial  Management and  Engineering in Lehi,  Utah. He was


                                       15

<PAGE>

responsible for corporate marketing and coordination of all projects.  From 1990
to 1994,  he was  Executive  Vice  President  and Director of COVOL  Environment
Technologies of Lehi, Utah.

         L. Kent  Harmon,  President-  Mr.  Harmon  is a member  of the Board of
Directors and as our  President.  He has held these  positions  since October of
1996.  Prior to his employment  with Terra Systems he was President of Metredyne
Imaging  Services  in Buena Park,  California.  Metredyne  created and  marketed
diagnostic  systems that quantified the extent of physical  impairment caused by
work related injuries.

         Lloyd McEwan,  Secretary and  Treasurer-  Mr. McEwan is a member of the
Board of Directors and our Secretary and Treasurer. Prior to his employment with
Terra  Systems in 1996, he was the principal  owner of State,  Inc.,  which is a
construction  company  specializing in metals,  mining,  electrical  utility and
petroleum refinery industries.  He has over 40 years of management experience in
this field.

         Leonard  Howe,  Technical  Development  - Mr.  Howe  has  provided  our
technical  development  since  inception.  He has been actively  involved in the
research and  development  of our  technology,  patent filing,  and  feasibility
testing.  Before his employment with Terra Systems,  Mr. Howe worked in the gold
mining industry.

         Robert Underwood,  Consultant- Mr. Underwood has served on the Board of
Directors  since  January  1999.  He also serves as a Consultant to the company.
Prior  to  joining  Terra  Systems,  Mr.  Underwood  worked  for 27 years in the
commercial  banking  industry as Vice  President and Manager for First  Security
Bank of Utah, NA. He received his BA from Brigham Young  University in Economics
and Language and his MBA in Finance from the  University of Utah. In addition he
was an instructor of Economics at BYU and for the American  Institute of Banking
for eleven years.

Section 16(a) Beneficial Ownership Reporting Compliance

         Section  16(a) of the  Securities  Exchange  Act of 1934  requires  our
directors  and  executive  officers,  and  persons  who own more than 10% of our
common stock to file with the SEC initial  reports of  ownership  and reports of
changes in ownership of common stock and other equity securities of the company.
Officers,  directors and greater than  ten-percent  stockholders are required by
SEC  regulations to furnish us with copies of all Section 16(a) forms they file.
To our  knowledge,  based  solely  on  review  of the  copies  of those  reports
furnished to us and written  representations that no other reports were required
during the fiscal year ended  December 31, 2000,  our  officers,  directors  and
greater than  ten-percent  beneficial  owners  complied  with all Section  16(a)
filing requirements for the year ended December 31, 2000.


                                       16

<PAGE>


Item 10.  Executive Compensation

         The following  table  discloses  compensation  we during the year ended
December 31, 2000 to our Chief  Executive  Officer.  None of our other executive
officers were paid  compensation  for the year ended December 31, 2000 in excess
of $100,000.

Summary Compensation Table

<TABLE>
<CAPTION>

<S> <C>                                <C>                <C>                   <C>         <C>
    Name and Principal Position                           Salary                Bonus       All Other Compensation
                                       Years                ($)                  ($)                 ($)

  Clayton Timothy, Chief Executive     1998-
              Officer                  2000        $60,000 per annum (1)         $0                   $0
</TABLE>



(1)      Mr. Timothy's salary has been accrued as a liability of the company.
         Due to our limited revenues, no salary payment was made to Mr. Timothy
         during the period indicated.

Stock Options Granted In Last Fiscal Year

         There were no stock options granted in the last fiscal year.

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 paid an annual fee of $60,000 for service as a board member.

Employment Agreements

         We do not have employment agreements with our executive officers.


                                       17

<PAGE>


Item 11.  Security Ownership of Certain Beneficial Owners and Management

         The following  table sets forth certain  information as of December 31,
2000,  with respect to the beneficial  ownership of our common stock by: (i) all
persons known by us to be beneficial owners of more than 5% of the common stock,
(ii) each  director,  and (iii) by all  executive  officers  and  directors as a
group.

<TABLE>
<CAPTION>
   ---------------------------------- --------------------------------- ----------------- --------------------
                                                                             Shares
                                                                          Beneficially       Percentage of
              Shareholder                   Nature of Ownership              Owned             Ownership
   ---------------------------------- --------------------------------- ----------------- --------------------
<S>                                   <C>                                <C>                      <C>
   Clayton Timothy                    Chief Executive Officer,           1,600,000                8.83%
                                      Director, 5% Shareholder
   ---------------------------------- --------------------------------- ----------------- --------------------
   L. Kent Harmon                     President, Director                  550,000                3.04%

   ---------------------------------- --------------------------------- ----------------- --------------------
   Lloyd McEwan                       Secretary, Treasurer, Director,    1,525,000                8.42%
                                      5% Shareholder
   ---------------------------------- --------------------------------- ----------------- --------------------
   Robert Underwood                   Director                             267,367                1.48%
   ---------------------------------- --------------------------------- ----------------- --------------------
   CHT Holding Trust*                 5% Shareholder                     2,505,000               13.83
   ---------------------------------- --------------------------------- ----------------- --------------------
   All Executive Officers and                                            3,942,367               20.69%
   Directors as a Group (4 persons)
   ---------------------------------- --------------------------------- ----------------- --------------------
</TABLE>


Item 12.  Certain Relationships And Related Transactions

         In July 1996,  we entered  into an  operating  lease with  Spring  Lake
Company,  a company  under common  ownership.  This lease expires June 30, 2003.
Amounts paid under the lease totaled  approximately  $12,360 in 1999 and $20,600
in 2000.  In October  1996,  Terra entered into a capital lease with Spring Lake
Company. The lease runs through March 2002. Amounts paid under the lease in 1999
were $44,175,  and in 2000 the company paid $51,187 under this  obligation.  The
principals of Spring Lake Company are Clayton Timothy and Lloyd McEwan.  Both of
these  individuals  are also executive  officers and directors of Terra Systems.
For further discussion and analysis of these transactions, see Notes 2, 4, and 9
to Financial Statements included in this report.

Item 13.  Exhibits And Reports On Form 8-K

(a)       Exhibits:

     A list of exhibits  required  to be filed as part of this annual  report is
     set  forth in the  Index  to  Exhibits,  which  immediately  precedes  such
     exhibits and is incorporated herein by reference.

(b)      Reports on Form 8-K:

     We did not file any  reports  on Form 8-K  during  the last  quarter of the
fiscal year ended December 31, 2000.


                                       18

<PAGE>


                                   Signatures

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

                                                TERRA SYSTEMS, INC.


                                                By:    s/ Clayton Timothy
                                                    ----------------------------
                                                       Clayton Timothy, CEO


                                                Date:    3/29/01
                                                       -------------------------

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.



                           By:     /s/ L. Kent Harmon
                               -------------------------------------------------
                                  L. Kent Harmon, President and Director


                           Date:        3/29/01
                                  ----------------------------------------------



                           By:     /s/ Lloyd McEwan
                               -------------------------------------------------
                                   Lloyd McEwan, Secretary / Treasurer
                                   and Director


                           Date:        3/29/01
                                  ----------------------------------------------



                           By:     /s/ Robert Underwood
                                ------------------------------------------------
                                  Robert Underwood, Director


                           Date:         3/29/01
                                  ----------------------------------------------



<PAGE>


Index To Exhibits

Exhibit
Number   Name And/Or Identification Of Exhibit

  2    Merger Agreement                                         Rendered as
                                                                Previously Filed
  3    Articles of Incorporation & By-Laws
         (a)  Articles of Incorporation filed May 1, 1996
         (b)  By-Laws of the Company adopted October 7, 1997    Previously Filed

 10    Material Contracts
         Agreement between Terra Systems, Inc. & XCEL
         Associates, Inc.                                       Previously Filed

<PAGE>

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









               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
                                       AND
                        CONSOLIDATED FINANCIAL STATEMENTS









                           December 31, 2000 and 1999


                            HANSEN, BARNETT & MAXWELL
                           A Professional Corporation
                          CERTIFIED PUBLIC ACCOUNTANTS


<PAGE>






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


                                TABLE OF CONTENTS


                                                                            Page

Report of Independent Certified Public Accountants F-1

Financial Statements:

    Consolidated Balance Sheets - December 31, 2000 and 1999                F-2

    Consolidated  Statements  of  Operations  for the Years  Ended
     December 31, 2000 and 1999, and for the  Cumulative  Period
     February 17, 1996 (Date of Inception)
     through December 31, 2000                                              F-3

    Consolidated Statements of Stockholders' Equity (Deficit)
     for the Period February 17, 1996 (Date of Inception)
      through December 31, 2000                                             F-4

    Consolidated  Statements  of Cash  Flows for the  Years  Ended
     December 31, 2000 and 1999, and for the  Cumulative  Period
     February 17, 1996 (Date of Inception)
     through December 31, 2000                                              F-7

Notes to Consolidated Financial Statements                                  F-8





<PAGE>



HANSEN, BARNETT & MAXWELL
A Professional Corporation
CERTIFIED PUBLIC ACCOUNTANTS

                                                          (801) 532-2200
    Member of AICPA Division of Firms                    Fax (801) 532-7944
            Member of SECPS                        345 East Broadway, Suite 200
    Member of Summit International Associates    Salt Lake City, Utah 84111-2693



               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS


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  (collectively  a development  stage company) as of December
31,  2000  and 1999  and the  related  consolidated  statements  of  operations,
stockholders'  deficit, and cash flows for the years ended December 31, 2000 and
1999, and for the  cumulative  period from February 17, 1996 (date of inception)
through December 31, 2000. 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 auditing standards generally accepted
in the 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,  2000 and 1999,  and the  results of their
operations  and their cash flows for the years ended December 31, 2000 and 1999,
and for the cumulative period from February 17, 1996 (date of inception) through
December 31, 2000, 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 is a  development  stage
enterprise  engaged in the  development  and  commercialization  of a  pneumatic
conveyance system to handle materials in a bulk state. As discussed in Note 1 to
the  consolidated  financial  statements,  the Company's  operating losses since
inception  and the  deficit  accumulated  during  the  development  stage  raise
substantial doubt about its 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.



                                                       HANSEN, BARNETT & MAXWELL
Salt Lake City, Utah
March 5, 2001

                                       F-1

<PAGE>



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


                                                            December 31,
                                                     2000             1999
                                                 -------------    -------------
Current Assets
      Cash                                       $       4,839    $       1,429
      Receivables                                        7,440            5,075
                                                 -------------    -------------
           Total Current Assets                         12,279            6,504
                                                 -------------    -------------

Property and Equipment
      Leasehold improvements                           331,642          331,642
      Furniture and equipment                          687,424          687,424
      Trucks and automobiles                            22,000           22,000
      Software                                          10,380           10,380
      Less: Accumulated depreciation                  (534,910)        (410,000)
                                                 -------------    -------------
           Net Property and Equipment                  516,536          641,446
                                                 -------------    -------------

Total Assets                                     $     528,815    $     647,950
                                                 =============    =============

                      LIABILITIES AND STOCKHOLDERS' DEFICIT

<TABLE>
<CAPTION>
Current Liabilities
<S>                                                                               <C>              <C>
      Accounts payable                                                            $     355,015    $     316,183
      Accounts payable to related party                                                 304,627          200,175
      Accrued liabilities                                                               726,260          542,224
      Accrued interest payable                                                          267,256          192,946
      Notes payable to stockholders - current portion                                    79,088               -
      Capital lease obligation - current portion                                        248,432          178,210
                                                                                  -------------    -------------
           Total Current Liabilities                                                  1,980,678        1,429,738
                                                                                  -------------    -------------

Long-Term Liabilities
      Notes payable to stockholders - net of current portion                            577,429          756,517
      Capital lease obligation - net of current portion                                   3,331           95,580
                                                                                  -------------    -------------
           Total Long-Term Liabilities                                                  580,760          852,097
                                                                                  -------------    -------------

Stockholders' Deficit
      Common stock,  $0.001 par value;  100,000,000  shares  authorized;  shares
        outstanding:
           December 31, 2000 - 18,114,131 shares,
           December 31, 1999 - 15,827,800 shares                                         18,114           15,828
      Additional paid-in capital                                                      4,689,448        3,589,098
      Deficit accumulated during the development stage                               (6,730,927)      (5,210,718)
      Deferred compensation                                                              (9,258)         (28,093)
                                                                                  -------------    -------------
           Total Stockholders' Deficit                                               (2,032,623)      (1,633,885)
                                                                                  -------------    -------------

Total Liabilities and Stockholders' Deficit                                       $     528,815    $     647,950
                                                                                  =============    =============
</TABLE>

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


                                       F-2

<PAGE>



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


<TABLE>
<CAPTION>
                                                                                                   Cumulative
                                                                                                 For the Period
                                                                                                   February 17,
                                                                                                 1996 (Inception)
                                                        For the Year Ended                          Through
                                                            December 31,                         December 31,
                                         -----------------------------------------------
                                              2000                             1999                    2000
                                         ----------------               ----------------         ---------------

<S>                                      <C>                            <C>                      <C>
Revenues                                 $         10,515               $        159,705         $       340,187

Cost of Revenues                                    2,744                        144,950                 307,805
                                         ----------------               ----------------         ---------------

    Gross Profit                                    7,771                         14,755                  32,382
                                         ----------------               ----------------         ---------------

Expenses
    Research and development                      147,340                        122,518               1,339,652
    General and administrative                  1,167,489                        895,651               4,393,078
    Depreciation and amortization                 124,910                        125,823                 540,891
                                         ----------------               ----------------         ---------------

       Total Expenses                           1,439,739                      1,143,992               6,273,621
                                         ----------------               ----------------         ---------------

Loss from Operations                           (1,431,968)                    (1,129,237)             (6,241,239)
                                         ----------------               ----------------         ---------------

Nonoperating Income/(Expenses)
       Interest expense                           (88,241)                      (100,643)               (385,722)
       Interest income                                  -                              17                  1,705
       Loss on sale of security                         -                              -                 (99,000)
       Loss on sale of assets                           -                              -                  (6,671)
                                         ----------------               ----------------         ---------------

       Net Nonoperating Expenses                  (88,241)                      (100,626)               (489,688)
                                         ----------------               ----------------         ---------------

Net Loss                                 $     (1,520,209)              $     (1,229,863)        $    (6,730,927)
                                         ================               ================         ===============

Basic and Diluted Loss
   Per Share                             $          (0.09)              $          (0.08)
                                         ================               ================

Weighted Average Shares
   Outstanding                                 16,913,157                     15,342,540
                                         ================               ================
</TABLE>



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


                                       F-3

<PAGE>



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

<TABLE>
<CAPTION>

                                                                                                Deficit
                                                 Common Stock                                 Accumulated
                                            ------------------------   Additional   Common     During the    Deferred  Total
                                             Number of                  Paid-In    Stock Sub-  Development   Compen-   Stockholders'
                                              Shares        Amount      Capital    criptions     Stage         sation     Deficit
                                            ----------   -----------  ------------ ---------   -----------  ---------- -------------

<S>                                         <C>          <C>          <C>          <C>        <C>           <C>        <C>
Balance - February 17, 1996 (Inception)              -   $         -  $         -  $      -   $         -   $      -   $          -

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         2,955,000         2,955       (2,955)        -             -          -              -
Common stock subscriptions - July
   1996 through September 1996                       -             -            -   196,000             -          -        196,000
Stock 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
Stock issued in satisfaction of subscription
      agreements:
   October - December - $0.80 to $1.00 per
      share                                    246,000          245      205,755    (206,000)           -          -              -
   December - $0.76 per share                  231,000           231      174,569   (174,800)           -          -              -
Stock-based compensation for current and
   future services -
   May 1997 - $1.00 per share                   75,000            75       74,850         -             -     (74,925)            -
Stock issued for marketable securities -
   September 1996 - $0.80 per share             19,000            19       15,181   174,800             -          -        190,000
Stock redemptions:
Stock redemption from original investors -
   $0.001 per share                        (36,775,000)      (36,775)          -          -             -          -        (36,775)
Redemption of stock (no consideration)
   - September 1996                         (3,000,000)       (3,000)       3,000         -             -          -              -
Amortization of deferred compensation                -             -            -         -             -      44,955        44,955
Net loss from February 17, 1996 through
   December 31, 1997                                 -             -            -         -    (2,676,648)        -      (2,676,648)
                                            ----------   -----------  -----------  ---------  ------------  ---------  -------------

Balance - December 31, 1997                 13,677,687        13,678    2,255,091         -    (2,676,648)   (29,970)      (437,849)

Stock issued for cash:
   April - $0.50 to $0.73 per share            239,502           240      146,671         -             -          -        146,911
   May - $0.75 to $0.80 per share               38,333            38       29,962         -             -          -         30,000
   June - $0.75 per share                       30,146            30       22,579         -             -          -         22,609
   July - $0.36 to $0.73 per share             236,846           237      119,368         -             -          -        119,605
   August - $0.50 per share                     20,000            20        9,980         -             -          -         10,000
   November - $0.30 to $0.33 per share          78,000            78       24,772         -             -          -         24,850
   December - $0.32 to $0.33 per share          72,900            73       23,664         -             -          -         23,737
Stock-based compensation for current and
   future services March - $1.13               350,000           350      393,400         -             -    (393,750)            -

Amortization of deferred compensation                -             -            -         -             -     275,953       275,953
Net loss for the period                              -             -            -         -    (1,304,207)        -      (1,304,207)
                                            ----------   -----------  -----------  ---------  ------------  ---------  -------------

Balance December 31, 1998                   14,743,414        14,744    3,025,487         -    (3,980,855)  (147,767)    (1,088,391)
                                                                                                                         (Continued)
</TABLE>

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


                                       F-4

<PAGE>



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


<TABLE>
<CAPTION>
                                                                                                Deficit
                                                 Common Stock                                  Accumulated
                                            ------------------------  Additional   Common      During the    Deferred     Total
                                            Number of                   Paid-In   Stock Sub-   Development    Compen-  Stockholders'
                                             Shares         Amount      Capital   scriptions     Stage        sation      Deficit
                                            ----------   -----------  ----------- ----------  ------------  ---------- -------------

<S>                                        <C>           <C>          <C>          <C>        <C>           <C>        <C>
Balance December 31, 1998                  14,743,414    $   14,744   $3,025,487   $      -   $(3,980,855)  $(147,767) $ (1,088,391)

Stock issued for cash:
   January - $0.50 per share                  100,000           100       49,900          -             -          -         50,000
   April - $0.25 per share                     20,000            20        4,980          -             -          -          5,000
   May - $0.50 per share                       20,000            20        9,980          -             -          -         10,000
   June - $0.50 per share                     100,000           100       49,900          -             -          -         50,000
   July - $0.25 per share                     200,000           200       50,260          -             -          -         50,460
   September - $0.40 and $0.50 per share      145,000           145       59,855          -             -          -         60,000
   October - $0.50 per share                   60,000            60       29,940          -             -          -         30,000
   December - $0.50 per share                  60,000            60       29,940          -             -          -         30,000
Stock issued for retirement of debt
   January - $0.25 per share                  200,000           200       49,800          -             -          -         50,000
Stock issued for services
   March - $0.50 per share                    106,286           106       53,083          -             -          -         53,189
   June - $0.50 per share                      60,000            60       29,940          -             -          -         30,000
   September - $0.70 per share                 43,000            43       29,957          -             -          -         30,000
   December - $0.60 per share                  50,000            50       29,950          -             -          -         30,000
Outstanding stock from acquisition of
   Xullux not previously recorded                 100             -            -          -             -          -              -
Deferred compensation relating to grant
   of stock options                                 -             -      179,126          -             -          -        179,126
Stock-based compensation for current and
   future services
    September - $0.97 per share                20,000            20       19,300          -             -     (19,320)            -
Stock redemption from former officer
   December - $1.13 per share                (100,000)         (100)    (112,300)         -             -     112,400             -
Amortization of deferred compensation               -             -            -          -             -      26,594        26,594
Net loss for the period                             -             -            -          -    (1,229,863)        -      (1,229,863)
                                           -----------   -----------  -----------  ---------  ------------  ---------  -------------

Balance - December 31, 1999                15,827,800        15,828    3,589,098          -    (5,210,718)   (28,093)    (1,633,885)

Stock issued for cash:
   January - $0.25 per share                   12,000            12        2,988          -             -          -          3,000
   February - $0.25 per share                  40,000            40        9,960          -             -          -         10,000
   March - $0.25 per share                    139,340           139       34,696          -             -          -         34,835
   April - $0.30 per share                     33,333            33        9,967          -             -          -         10,000
   July - $0.25 per share                      32,000            32        7,968          -             -          -          8,000
   August - $0.25 per share                   120,000           120       29,880          -             -          -         30,000
Stock issued for services
   March - $0.50 per share                     60,000            60       29,940          -             -          -         30,000
   May - $0.48 per share                       62,920            63       29,937          -             -          -         30,000
   July - $1.00 per share                      15,000            15       14,985          -             -          -         15,000
   September - $0.25 per share                122,400           122       29,878          -             -          -         30,000
   October - $0.25 per share                   75,000            75       18,675          -             -          -         18,750
   December - $0.39 per share                  99,338            99       38,901          -             -          -         39,000
</TABLE>




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


                                       F-5

<PAGE>


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


<TABLE>
<CAPTION>
                                                                                                 Deficit
                                                 Common Stock                                  Accumulated
                                           -------------------------  Additional    Common     During the    Deferred     Total
                                            Number of                  Paid-In    Stock Sub-   Development    Compen-  Stockholders'
                                             Shares         Amount     Capital    scriptions      Stage       sation     Deficit
                                           -----------   -----------  ------------ -----------------------  ---------- -------------

Exercise of Stock Rights
<S>                                        <C>           <C>          <C>          <C>        <C>           <C>        <C>
   May - $0.25 per share (cash)               400,000           400       99,600          -             -           -       100,000
   October - $0.25 per share (cash)           300,000           300       59,700          -             -           -        60,000
   November - $0.20 per share (services)      225,000           225       44,775          -             -           -        45,000
   December - $0.20 per share (cash)           75,000            75       14,925          -             -           -        15,000
Exercise of Stock Options
   April - $0.20 per share (conversion
            of debt)                          500,000           500       99,500          -             -           -       100,000
   December - $0.20 per share (cash)           25,000            25        4,975          -             -           -         5,000
Stock redemption from former officer
   March - $1.13 per share                    (50,000)          (50)     (56,150)         -             -      56,200             -
Consulting expense relating to grant of
   stock right                                      -             -      575,250          -             -           -       575,250
Amortization of deferred compensation               -             -            -          -             -     (37,365)      (37,365)
Net loss for the period                             -             -            -          -    (1,520,209)          -    (1,520,209)
                                           -----------   -----------  -----------  ---------  ------------  ---------- -------------

Balance - December 31, 2000                18,114,131    $   18,114   $4,689,448   $      -   $(6,730,927) $  (9,258)  $ (2,032,623)
                                           ===========   ===========  ===========  =========  ============  =========  =============
</TABLE>

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


                                       F-6

<PAGE>

                       TERRA SYSTEMS, INC. AND SUBSIDIARY
                          (A Development Stage Company)
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                                                         Cumulative
                                                                                                       For the Period
                                                                                                        February 17,
                                                                                                      1996 (Inception)
                                                                         For the Year Ended              Through
                                                                            December 31,                December 31,
                                                                -----------------------------------
                                                                     2000                1999               2000
                                                                ----------------    ---------------   ----------------
Cash Flows From Operating Activities
<S>                                                             <C>                 <C>               <C>
     Net loss                                                   $    (1,520,209)    $   (1,229,863)   $    (6,730,927)
     Adjustments to reconcile net loss to net cash used by
       operating activities:
        Depreciation and amortization                                   124,910            125,823            540,891
        Loss on sale of investment securities                                --                 --             99,000
        Loss on sale of assets                                               --                 --              6,671
        Compensation paid with common stock and
           options net of forfeitures                                   745,635            205,720          1,272,263
        Changes in current assets and liabilities:
           Receivables                                                   (2,365)            17,236             (7,440)
           Prepaid expenses                                                                  1,259                 --
           Accounts payable                                              38,832            336,517            573,272
           Accounts payable - related party                             104,453             55,639            278,840
           Accrued liabilities                                          184,036            141,142            726,361
           Accrued interest payable                                      74,310             86,128            267,256
                                                                ----------------    ---------------   ----------------

        Net Cash Used by Operating Activities                          (250,398)          (260,399)        (2,973,813)
                                                                ----------------    ---------------   ----------------

Cash Flows From Investing Activities
     Purchase of equipment                                                   --               (106)          (662,464)
     Organization costs paid                                                 --                 --             (4,755)
     Proceeds from sale of assets                                            --                 --            117,715
                                                                ----------------    ---------------   ----------------

        Net Cash Used by Investing Activities                                --               (106)          (549,504)
                                                                ----------------    ---------------   ----------------

Cash Flows From Financing Activities
     Proceeds from borrowings - stockholders                                 --                 --            870,111
     Payments on borrowings -  stockholders                                  --             (5,000)          (149,750)
     Proceeds from stock issuance and  subscriptions                    275,835            285,460          2,979,626
     Payments on capital leases                                         (22,027)           (23,025)          (171,831)
                                                                ----------------    ---------------   ----------------

        Net Cash Provided by Financing  Activities                      253,808            257,435          3,528,156
                                                                ----------------    ---------------   ----------------

Net Increase (Decrease) in Cash                                           3,410             (3,070)             4,839

Cash at Beginning of Period                                               1,429              4,499                 --
                                                                ----------------    ---------------   ----------------

Cash at End of Period                                           $         4,839     $        1,429    $         4,839
                                                                ================    ===============   ================

Supplemental Cash Flow Information
     Cash paid for interest                                     $         5,893     $        7,124
     Conversion of notes payable to equity                              100,000            193,190
     Redemption of stock issued to officers                              56,200            112,400
</TABLE>


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


                                       F-7

<PAGE>


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


NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
            PRINCIPLES

         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. and
the Terra Systems,  Inc.  stockholders  were issued 48,000,000 shares of Xullux,
Inc. common stock.

         For financial  accounting purposes, the merger was accounted for by the
purchase method of accounting with Terra Systems,  Inc. considered the acquiring
corporation.  The historical  financial  statements of Terra Systems,  Inc. were
restated to reflect the shares issued to the Terra Systems, Inc. stockholders as
being outstanding for all periods presented,  similar to a stock split.  Xullux,
Inc.  had no  assets  at the  date  of the  merger  and was  considered  a shell
corporation;  accordingly,  the  2,955,100  shares  held  by  the  Xullux,  Inc.
stockholders  were  deemed  to  have  been  issued  for  no  consideration.  The
operations of Xullux,  Inc.  have been included in the  statements of operations
from the date of the merger.

         Following  the  reorganization, Xullux, Inc. changed  its name to Terra
Systems, Inc.

         Principles  of  Consolidation--The  consolidated  financial  statements
include the accounts of Terra  Systems,  Inc.  and its wholly  owned  subsidiary
Terra  Merger   Subsidiary,   Inc.  All  intercompany   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, 2000 and 1999, the Company has received  nominal  revenue and
incurred net losses of $1,520,209 and $1,229,863,  respectively. At December 31,
2000 and 1999,  the  Company had a working  capital  deficit of  $1,968,399  and
$1,423,234,  respectively.  These factors, among others, 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 which 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


                                       F-8

<PAGE>


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


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.  As  discussed  in Note 3, the  Company
entered into an  agreement  with a  corporation  for  consultation  and advisory
services  related to  business  management  and  marketing.  As a result of this
agreement,  the Company  received  $180,000 for the issuance of common stock and
options. This agreement allows for additional cash proceeds through the issuance
of additional common stock and options.  Aside from this agreement,  the Company
obtained  additional  cash  proceeds of $95,835  through the  issuance of common
stock.

         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 which range from five to fifteen years. Depreciation expense
for the years  ended  December  31,  2000 and 1999 was  $124,910  and  $125,823,
respectively.

         Long-Lived Assets --The realizability 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 analyses involves  significant
management  judgement  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 amounts  reported  as cash,  receivables,
accounts  payable,  accrued  liabilities,  notes  payable  to  stockholders  and
obligations under capital leases are considered to be reasonable  approximations
of their fair values.  The fair value estimates  presented  herein were based on
market  information  available to management as of December 31, 2000. The use of
different  market  assumptions  and/or  estimation  methodologies  could  have a
material effect on the estimated fair value amounts. The reported fair values do
not take into  consideration  potential  expenses  that would be  incurred in an
actual settlement.

         Revenue  Recognition  -- The  Company's  revenue  source  has come from
providing  research and  development on behalf of another  corporation.  Revenue
from research and  development  contracts is recognized on a cost  reimbursement
basis.  As tests are performed and costs  incurred,  the Company  recognizes the
proceeds  as revenue at the time of  billing.  All  contracts  are for  specific
research and development projects and are short term in nature.

         Basic and Diluted  Loss Per Share -- The Company  computes net loss per
share in accordance  with SFAS No. 128 Earnings Per Share ("SFAS 128"),  and SEC
Staff  Accounting  Bulletin No. 98 ("SAB 98").  Under the provisions of SFAS 128
and SAB 98,  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. At December 31, 2000 and 1999,  respectively,
there were 2,725,000 and 2,500,000 potentially issuable common shares 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.

NOTE 2 - RELATED PARTY TRANSACTIONS

         As  discussed  in Notes 4 and 9, the Company  entered  into capital and
operating lease obligations with a company under common ownership.  The Company

                                       F-9

<PAGE>


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


has violated its lease agreements by being delinquent in its payments  regarding
these leases. At December 31, 2000 and 1999, the Company owed this related party
$226,325 and $161,456,  respectively,  in delinquent rent,  executory fees, late
fees,  sales tax and cash  advances.  Certain  Officers of the Company have from
time to time advanced the Company funds used for operating expenses. At December
31,  2000 and 1999,  the  Company  owed  these  Officers  $78,302  and  $38,719,
respectively. Total amounts due to Related Parties as shown on the balance sheet
at December 31, 2000 and 1999 are: $304,627 and $200,175. All amounts are due on
demand with no interest.  See Note 9 for principal amounts due on capital leases
to related party.

As discussed in Note 3, the Company has notes  payable to officers in the amount
of $656,517.

NOTE 3-NOTES PAYABLE TO STOCKHOLDERS

    Notes payable to stockholders are as follows:
<TABLE>
<CAPTION>
                                                                                      December 31,
                                                                                  2000             1999
                                                                             -------------    -------------
    Notes payable to  stockholders,  interest  rates from 6% to 10% payable
    monthly, all such notes mature between December 2001
<S>                                                                          <C>              <C>
    and January 2010, unsecured                                              $     619,742    $     719,742

    Notes payable to stockholders for redemption
    of stock, 10% interest payable monthly, due
    April 2002                                                                      36,775           36,775
                                                                             -------------    -------------

    Total Notes Payable to Stockholders                                            656,517          756,517

         Less: Current portion                                                      79,088               --
                                                                             -------------    -------------

    Notes Payable to Stockholders -
      Long-Term                                                              $     577,429    $     756,517
                                                                             =============    =============
</TABLE>

    Annual maturities of long-term debt as of December 31, 2000 for each of
the next five years are as follows:

              Year Ending December 31:
              -----------------------
                     2001                           $      79,088
                     2002                                 362,696
                     2003                                 202,733
                     2004                                      --
                     2005                                      --
                     Thereafter                            12,000




NOTE 4 - CAPITAL LEASE OBLIGATION

         In October 1996,  the Company  entered into capital  lease  obligations
with a company  under  common  ownership.  The related  company  entered into an
equipment  lease with a financial  institution  and is  responsible  to make all
payments  regarding  the lease. The  Company is  currently paying to the related

                                      F-10

<PAGE>


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


company the amount of the lease payment plus various other executory fees. These
leases expire in March 2002. Equipment under capital leases of December 31, 2000
was as follows:

           Equipment                                             $     423,594
           Less: Accumulated depreciation                             (241,420)
                                                                 --------------

                                                                 $     182,174

         The following is a schedule by years of future  minimum lease  payments
under  capital  leases  together with the present value of the net minimum lease
payments as of December 31, 2000:

         Year Ending December 31,
                        2001                                     $     415,602
                        2002                                             8,232
                                                                 -------------

         Total Minimum Lease Payments                                  423,834
         Less: Amount representing executory costs                    (138,487)
                                                                 -------------
         Net Minimum Lease Payments                                    285,347
         Less: Amount representing interest                            (33,584)
                                                                 -------------
         Present Value of Net Minimum Lease Payments                   251,763
         Less: Current portion                                         248,432
                                                                 -------------
         Capital Lease Obligation - Long Term                    $       3,331
                                                                 =============

         At December 31, 2000, the Company owed $99,131 in delinquent  executory
fees to the related party.

         The Company has violated its lease agreement by being delinquent in its
payments  regarding these leases. At December 31, 2000, the Company was eighteen
and  twenty-two  months  behind in its lease  payments.  According  to the lease
agreement,  the lease could be called and all  principal  amounts  would be due.
However, the lessor has waived this alternative and is only requiring delinquent
payments to be made up during the current year.

NOTE 5 - STOCKHOLDERS' EQUITY

         Stock-Based  Compensation for Current and Future Services -- During the
year ended  December 31, 1999,  the Company issued 20,000 shares of common stock
at $0.001 per share to various  employees for current and future  services.  The
shares  had a  market  value  of  $19,320,  or $0.97  per  share,  on the day of
issuance.  Under the terms of the stock issuance,  the Company can reacquire all
the stock at $0.001 per share  within one year from the date of issuance and one
half of the shares within two years from the date of issuance.  These shares are
considered  non-vested  and have been  accounted for in  accordance  with APB 25
Accounting  for Stock Issued to  Employees,  whereby the Company is  recognizing
compensation  expense  over the vesting  period of the stock for the  difference
between the fair value of the stock on the day of issuance and the consideration
paid by the  employees.  In the  event  employment  should  be  terminated,  all
non-vested shares of stock shall be forfeited by the employee.

         During the year ended December 31, 2000, an officer of the Company, who
had been issued 150,000 shares of the above mentioned stock, which was issued in
1999,  forfeited  50,000  shares of  non-vested  common stock valued at $56,200.
During the year ended December 31, 1999, an officer of the Company, who had been
issued 200,000 shares of the above  mentioned  stock,  which was issued in 1999,


                                      F-11

<PAGE>


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


left  the  Company.   Accordingly,  the  officer  forfeited  100,000  shares  of
non-vested common stock which was valued at $112,400.

         The Company recognizes  compensation  expense for the above shares over
the period the shares  vest.  During the year ended  December 31, 2000 and 1999,
the  Company   recognized   compensation   expense  of  $(37,365)   and  $7,274,
respectively.  Deferred compensation was $9,258 and $28,093 at December 31, 2000
and 1999, respectively.

         Common  Stock  Issued for Cash -- During the year  ended  December  31,
2000,  the Company issued 376,673 shares of common stock for proceeds of $95,835
at prices ranging from $0.25 to $0.30 per share.  During the year ended December
31,  1999,  the Company  issued  705,000  shares of common stock for proceeds of
$285,460 at prices ranging from $0.25 to $0.50 per share.

         Common Stock Issued for Services -- During the years ended December 31,
2000 and 1999, the Company issued 434,658 and 259,286 shares,  respectively,  of
common  stock for  consulting  services.  The common  stock was valued at prices
ranging from $0.25 to $1.00 per share. For the years ended December 31, 2000 and
1999,  the  Company  charged  $162,750  and  $143,189 of  consulting  expense to
operations, respectively.

         Common Stock Issued for the Conversion of Debt -- During the year ended
December 31, 2000, a stockholder  exercised 500,000 options.  The Company issued
500,000  shares  of  common  stock  for  the  conversion  of  notes  payable  to
stockholders in the amount of $100,000 or $0.20 per share. During the year ended
December 31, 1999,  the Company  issued 200,000 common shares for the retirement
of accounts payable to a related party, valued at $50,000 or $0.25 per share.

         Stock Right  Exercised  -- During the year ended  December 31, 2000 (as
discussed  in Note 6) the Company  granted  stock  rights in  connection  with a
consulting  agreement.  The Company recognized consulting expense of $575,250 in
connection with the grant of these stock rights.  Upon grant of the rights,  the
corporation  exercised  its right and the  Company  issued  1,000,000  shares of
common  stock for  $175,000  cash or $0.23 per share and by  providing  services
valued  at  $45,000  or $0.20  per  share.  Also,  as  discussed  in Note 6, the
Corporation  exercised  25,000 options and purchased  25,000 shares of stock for
$5,000 or $0.20 per share.



                                      F-12

<PAGE>


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


NOTE 6 - STOCK RIGHTS

         On March  29,  2000,  the  Company  entered  into an  agreement  with a
corporation  for  consultation   and  advisory   services  related  to  business
management and marketing.  In consideration for the services to be provided, the
Company agreed to grant to the  corporation  the right to purchase 50,000 equity
units at a purchase  price of $5.00 per unit.  Each unit  consists  of 20 freely
tradable  common  shares and the option to purchase  five shares at $0.50,  five
shares at $0.75,  five  shares at $1.00,  and five  shares at $1.25 - all freely
tradeable shares.

         The Company  measured  compensation  under this  stock-based  agreement
using the fair value at the grant date consistent with SFAS No. 123,  Accounting
for  Stock-Based  Compensation.   Under  this  method,  the  Company  recognized
consulting  expense of  $560,000.  The fair value of $11.20 for each equity unit
granted  was  estimated  on the date of grant  using  the  Black-Scholes  option
pricing model with the following  assumptions:  dividend yield of 0.0%; expected
volatility  of 145.00%  risk-free  rate of 6.13% and expected life of options of
1.0 year.

         In November  2000,  the Company  modified the terms of the agreement by
reducing the  exercise  price of the rights from $5.00 to $4.00 per equity unit.
In December  2000,  the Company  again  modified  the terms of the  agreement by
reducing the exercise price of 25,000 options exercisable at $0.50 per option to
$0.20 per option.  In  accordance  with  Financial  Accounting  Standards  Board
Interpretation   44,  Accounting  for  Certain   Transactions   Involving  Stock
Compensation,  the rights and options  have been  accounted  for as variable and
were thus revalued at the dates of the modifications.  By modifying the exercise
prices of the equity units and the options, the Company recognized an additional
$15,250 of  consulting  expense.  The Company  recognized a total of $575,250 of
consulting expense at December 31, 2000.

         By December 31, 2000, the corporation exercised its right and purchased
20,000  equity units for $100,000 or $0.25 per share,  purchased  18,750  equity
units  for  $75,000  or $0.20 per share and  purchased  11,250  equity  units by
providing  services valued at $45,000 or $0.20 per share. In connection with the
exercise  of these  stock  rights,  the  Company  issued  options to purchase an
additional 250,000 shares at $0.50,  250,000 shares at $0.75,  250,000 shares at
$1.00 and 250,000 shares at $1.25.

         By December 31, 2000,  the  corporation  exercised  25,000  options and
purchased 25,000 shares of stock for $5,000 or $0.20 per share.

         In connection  with the  consulting  agreement,  the  corporation  will
recommend the Company to potential investors. A finder's fee will be paid to the
corporation as a percentage of funds obtained.  A finder's fee of $150,000 would
be paid on $5,000,000 obtained. An additional 1% would be owed on any additional
funds obtained over the  $5,000,000.  The corporation may elect to obtain all or
part of its fee in shares of the  Company's  stock.  The stock will be valued at
80% of its most recent bid price for purposes of conversion to cash value.

NOTE 7 - STOCK OPTIONS

         The  Company  accounts  for its  stock  options  issued  to  directors,
officers and  employees  under  Accounting  Principles  Board Opinion No. 25 and
related  interpretations  ("APB  25").  Under APB 25,  compensation  expense  is
recognized if an option's  exercise price on the  measurement  date is below the
fair value of the Company's  common stock.  The Company accounts for options and
warrants  issued to non- employees in accordance  with SFAS No. 123,  Accounting
for  Stock-Based  Compensation"  (SFAS 123) which  requires  these  options  and
warrants to be accounted for at their fair value.

                                      F-13

<PAGE>


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


         Employee Grants -- On January 12, 1999, the company  granted  2,500,000
stock  options to  employees  and  directors  of the  Company.  The  options are
exercisable  at $0.20 per share,  exercisable  immediately  and expire two years
from the date of grant.  The fair value was estimated on the date of grant using
the  Black-Scholes  option-pricing  model  with the  following  weighted-average
assumptions: dividend yield of 0.0%; expected volatility of 136%; risk-free rate
of 4.61% and expected life of options of 2.0 years.

         During the year ended  December 31, 2000,  the Company  issued  500,000
shares of common stock upon  conversion of notes payable to  stockholders in the
amount of  $100,000  or $0.20 per  share.  On March 2, 1999,  a Director  of the
Company resigned and forfeited 250,000 options.

         Non Employee  Options -- As  discussed  in Note 6, the Company  entered
into an agreement  with a corporation  for  consultation  and advisory  services
related to business management and marketing.  In consideration for the services
to be  provided,  the Company  agreed to grant to the  corporation  the right to
purchase all 50,000 equity units.  During the year ended  December 31, 2000, the
corporation   exercised  its  right  and  purchased  all  50,000  equity  units.
Accordingly,  the Company  issued  options to purchase  250,000 shares of common
stock at $0.50,  250,000  shares at $0.75,  250,000  shares at $1.00 and 250,000
shares at $1.25.

         Also discussed in Note 6, the Company recognized  consulting expense of
$575,250 in  connection  with the grant of the stock  rights.  Accordingly,  any
consulting  expense  associated  with the grant of the  1,000,000  stock options
mentioned above was previously recognized.

         During the year ended  December 31,  2000,  the Company  issued  25,000
shares for $5,000 or $0.20 per share cash.

         Outstanding Stock Options -- A summary of stock option activity for the
years ending December 31, 2000 and 1999 is as follows:
<TABLE>
<CAPTION>
                                                                                          Weighted
                                                                                           Average
                                                    Options            Price Range      Exercise Price

<S>                                               <C>                <C>                 <C>
      Balance, December 31, 1998                             --      $      --           $    --
          Granted                                     2,500,000           0.20              0.20
          Forfeited                                    (250,000)          0.20              0.20
                                                  --------------
      Balance, December 31, 1999                      2,250,000           0.20              0.20
          Granted                                     1,000,000        0.20 - 1.25          0.87
          Exercised                                    (525,000)          0.20              0.20
                                                  --------------
      Balance, December 31, 2000                      2,725,000        0.20 - 1.25          0.44
                                                  ==============
      Exercisable, December 31, 2000                  2,725,000           0.44              0.44
                                                  ==============
      Weighted-average fair value of
         options granted during year
         ended December 31, 2000                  $        0.21
                                                  ==============
</TABLE>




         A summary of stock options  outstanding  and exercisable as of December
                           31, 2000 and 1999 follows:

     December 31, 2000

                                      F-14

<PAGE>


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



<TABLE>
<CAPTION>                                    Options Outstanding                       Options Exercisable
                               -------------------------------------------------   ---------------------------------
                Range of         Number        Weighted-Average                       Number
                Exercise       Outstanding       Remaining        Weighted-Average  Exercisable     Weighted-Average
                 Prices        At 12/31/00     Contractual Life    Exercise Price   At 12/31/00      Exercise Price
              ------------    -------------    ----------------   ---------------- --------------   ----------------
<S>           <C>             <C>              <C>                <C>              <C>              <C>
              $       0.20        1,750,000       0.03 years      $           0.20      1,750,000   $           0.20
               0.50 - 1.25          975,000       0.22 years                  0.88        975,000               0.88
                              -------------                                        --------------
                                  2,725,000                                             2,725,000
                              =============                                        ==============
</TABLE>

     December 31, 1999

<TABLE>
<CAPTION>                                    Options Outstanding                       Options Exercisable
                                ------------------------------------------------   --------------------------------
                Range of           Number      Weighted-Average                       Number
                Exercise         Outstanding     Remaining       Weighted-Average   Exercisable    Weighted-Average
                 Prices          At 12/31/99   Contractual Life   Exercise Price    At 12/31/99     Exercise Price
              -------------    -------------   ----------------  ----------------   ------------   ----------------
<S>               <C>             <C>               <C>                <C>           <C>                <C>
                  $0.20           2,250,000         1 year             $0.20         2,250,000          $0.20
</TABLE>

Stock-based  compensation  charged to operations was $179,126 for the year ended
December  31,  1999  from  options  granted  to  employees  and  directors.  Had
compensation cost for the Company's options granted to employees been determined
based on the fair  value at the  grant  dates  consistent  with the  alternative
method set forth under Statement of Financial  Accounting Standards No. 123, net
loss and loss per share would have increased to the pro forma amounts  indicated
below:

                                               For the Year       For the Year
                                                      Ended              Ended
                                               December 31,       December 31,
                                                       2000               1999
                                              -------------    ---------------
     Net loss:
          As reported                         $  (1,520,209)   $    (1,229,863)
          Pro forma                              (1,520,209)        (1,545,101)

     Basic and diluted loss per share:
          As reported                                 (0.09)             (0.08)
          Pro forma                                   (0.09)             (0.10)

NOTE 8 - RESEARCH AND DEVELOPMENT EXPENSE

     Research and  development  and patent  development  have been the principal
function of the  Company.  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 $147,340 and $122,518 for the
year ended December 31, 2000 and 1999, respectively.






NOTE 9 - OPERATING LEASES

     The Company  conducts its  operations  in a building  leased from a related
party through common  ownership  which expires in June 2003.  Rent expense under
this lease was $44,496 and $45,396 for the periods ended December 31, 2000 and

                                      F-15

<PAGE>


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


1999,  respectively.  The Company also leased  vehicles under 36 month operating
leases from a bank,  which  expired in August  1999.  Rent  expense  under these
leases was $17,375 for the period ended December 31, 1999.

     Future minimum rental payments for the next three years are as follows:

                     2001                                    $      49,440
                     2002                                           49,440
                     2003                                           24,720
                                                             -------------

                                                             $     123,600

         In  addition,  the  Company  rents  several  pieces of office and plant
equipment  on a  month-to-  month  basis from a related  party  through a common
ownership.  Rent expense  under these leases was $4,944 and $5,044 for the years
ended December 31, 2000 and 1999.

         At December 31, 2000 and 1999,  the Company owed  $111,783 and $143,916
for lease/rental  payments as well as other operating  expenses.  These payables
are due on demand and bear no interest.

NOTE 10 - INCOME TAXES

         There was no benefit or provision for income taxes during 2000 or 1999.
The following  presents the components of the net deferred tax asset at December
31, 2000 and 1999:

                                                    2000             1999
                                              --------------    -------------
    Operating loss carryforwards              $    2,092,668    $   1,560,781
    Accrued and deferred compensation                190,230          145,470
    Capital loss carryforward                         36,927           36,927
                                              --------------    -------------

             Total Deferred Tax Assets             2,319,826        1,743,178

             Less: Valuation Allowance            (2,319,826)      (1,743,178)
                                              --------------    -------------

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

         The  valuation  allowance  increased  $576,648 and $378,044  during the
years ended  December 31, 2000 and 1999.  The Company has a net  operating  loss
carryforward of $5,610,371 which expires,  if unused,  in the years 2012 through
2020.

         The following is a reconciliation of the income tax benefit computed at
the  federal  statutory  tax rate with the  provision  for income  taxes for the
periods ended December 31, 2000 and 1999:


                                                             December 31,
                                                    ----------------------------
                                                        2000             1999
                                                  -------------    -------------
   Income tax benefit at statutory rate (34%)     $   (516,871)    $   (418,119)
   Change in valuation allowance                       576,648          378,044
   State tax, net of federal benefit                   (50,167)         (40,582)
   Non includible items                                 (9,610)          80,657
                                                  -------------    -------------
   Provision for Income Taxes                     $         --     $         --
                                                  =============    =============
                                      F-16

<PAGE>


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




NOTE 11 - CONTINGENCIES

         Terra  Systems,  Inc.  Versus  a  Former   Director/Officer  and  Other
Stockholders -- The Company has filed a complaint  against a former director and
officer and other stockholders of the Company (the defendants) for using various
forms of improper conduct and misrepresentations concerning their qualifications
and  intentions to obtain a  significant  number of the  Company's  shares.  The
Company is seeking a declaration by the court that none of the  defendants  have
any right, title to or ownership of the Company's stock originally issued to the
defendants.  The  defendants  claim the Company and certain of its officers have
engaged in fraudulent and  conspiratorial  conduct and have filed a counterclaim
seeking the  following:  a dismissal  of the  Company's  complaint,  unspecified
amount of  damages  resulting  from the  Company's  refusal  on March 1, 1997 to
tender shares to the defendants  that the defendants  were entitled to sell, the
removal of certain restrictions on the Company's stock, $60,000 for breach of an
employment contract and interest,  compensatory  damages and punitive damages in
unspecified amounts, and together with attorney fees.

         On  October  9,  1999,  the Court  entered a partial  summary  judgment
against one of the defendants in favor of the Company on all of its claims.  The
Court  found that the  damages  sought  against  the  defendant  and an award of
reasonable  attorney's  fees, and expenses  incurred in connection with the case
shall be determined  at a future date.  The Court also found that the Company is
entitled to a partial  summary  judgment  against the defendant  for  securities
fraud,  including recission and restitution of the issuance of one million Terra
Systems  shares and additional  damages to be determined in further  proceedings
before  the  Court.  The  amount  of  damages  to be  awarded  has not yet  been
determined.

         The Company  denies all  material  allegations  against the Company and
intends to fully defend the  counterclaim  of the  defendants  and prosecute the
Company's claims and actions against the defendants. This litigation is still in
the  discovery  phase and the ultimate  outcome  cannot  presently be determined
Accordingly,  no adjustments have been made to the Company's financial position,
results of operations or cash flows.

         Threatened Litigation -- The Company and certain Officers and Directors
of the Company  received  notice from a litigant's  legal  counsel of threatened
litigation.  The litigant  contends that certain current  Officers and Directors
held and sold a number of Xullux  shares  that  were free  trading  prior to the
merger of Xullux and Terra Systems. The alleged sale may have impacted the value
of the  litigant's  Terra  Systems  restricted  publicly  issued  shares  in the
company. The litigant claims that the defendant's  ownership and alleged sale of
Xullux  stock  was not  disclosed  to him at or during  the time he  contributed
certain  assets and other  equipment to Terra  Systems in exchange for the Terra
Systems  restricted  stock. The litigant seeks to return 125,000 shares to Terra
Systems for value and seeks other monetary and punitive  damages in an amount of
not less than $1,500,000  including  additional  costs and attorney's  fees. The
Company  denies all of the  material  allegations  and  claims of the  litigant.
Currently,   the  ultimate   outcome  of  this  situation  cannot  presently  be
determined.  Accordingly,  no  adjustments  have  been  made  to  the  Company's
financial position, results of operations or cash flows.

         Based on the uncertain outcome of these contingencies, no provision for
any  loss or gain  that  may  result  upon  adjudication  has  been  made in the
accompanying  financial  statements,  and the  possible  effect  it will have on
future financial statements is unknown.



                                      F-17

<PAGE>


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


NOTE 12 - SUBSEQUENT EVENTS (UNAUDITED)

         Issuance of Options -- During February 2001, the Company issued options
to purchase  2,250,000  shares of common  stock to  employees  of the Company at
$0.20 per share.  These options  vested on the date granted and are  exercisable
for two years.  The  options  have an  intrinsic  value of  $787,500 on the date
granted and will be recognized as compensation expense on that date. The options
had a fair value of $0.47 per share based on the  Black-Scholes  option  pricing
model with the  following  assumptions:  risk free interest rte of 4.75 percent,
volatility of 147.67 percent,  expected dividend yield of 0 percent, an expected
life of two years.

         Repricing  of Options -- As  discussed  in Note 6, the Company  entered
into an agreement with a corporation for consultation and advisory  services and
issued  options to purchase  250,000  shares of common  stock at $0.50,  250,000
shares at $0.75,  250,000 shares at $1.00 and 250,000 shares at $1.25.  On three
separate  occasions  in January  2001,  the  Company  modified  the terms of the
agreement by reducing the exercise price of 225,000 options exercisable at $0.50
per share to $0.20 per share,  250,000 options exercisable at $0.75 per share to
$0.20 per share,  250,000  options  exercisable  at $1.00 per share to $0.20 per
share and 100,000 options  exercisable at $1.25 per share to $0.20 per share. In
accordance  with  Financial   Accounting   Standards  Board  Interpretation  44,
Accounting for Certain  Transactions  Involving Stock Compensation,  the options
have been  accounted  for as variable and were thus revalued at the dates of the
modifications.  By  modifying  the exercise  prices of the options,  the Company
recognized an additional $243,250 of consulting expense in January 2001.

         Exercise of Options -- Subsequent to December 31, 2000, 825,000 options
were exercised for proceeds of $167,500.

                                      F-18