UNITED STATES





FORM 10-QSB

(Mark One)

[X]

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




[   ]

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT




Commission file number  000-49626

CORTELCO SYSTEMS PUERTO RICO, INC.



PUERTO RICO
    66-0567491(State of incorporation)
    (IRS Employer Identification No.)


Parque Ind. Caguas Oeste Road 156 km 58.2, Caguas, Puerto Rico, 00725-0137



(787) 758-0000



Check whether the issuer
(1) filed all reports required to be filed by Section 13 or 15(d) of the 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 [  ]

State the number of shares outstanding of each of the
issuers classes of common equity, as of the latest practicable date:

1,604,557 shares of Common Stock, $0.01 par value, as of January 31, 2005.

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



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CORTELCO SYSTEMS PUERTO RICO, INC.

FORM 10-QSB


QUARTER ENDED JANUARY 31, 2005


INDEX

PART I - FINANCIAL INFORMATION
    1ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
    1Condensed Balance Sheet (Unaudited)
    1Condensed Income (Loss) Statements (Unaudited)
    2Condensed Statements of Cash Flows (Unaudited)
    3Notes to Condensed Financial Statements (Unaudited)
    4ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS
    7ITEM 3. CONTROLS AND PROCEDURES
    11PART II - OTHER INFORMATION
    11ITEM 1. LEGAL PROCEEDINGS
    11ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
    11ITEM 3. DEFAULTS UPON SENIOR SECURITIES
    11ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    11ITEM 5. OTHER INFORMATION
    11ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
    11SIGNATURES
    13




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PART I - FINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)




CORTELCO SYSTEMS PUERTO RICO, INC.




Condensed Balance Sheet (Unaudited)



(Dollars in thousands)

ASSETSCurrent assets:Cash and cash equivalents
    
    $
    352Trade accounts receivable, net
    
    
    1,771Inventories, net
    
    
    215Prepaid expenses
    
    
    148Total current assets
    
    
    2,486Property and equipment, net
    
    
    277Total
    
    $
    2,763LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Trade accounts payable
    
    $
    562Due to affiliated entities
    
    
    399Other accrued liabilities
    
    
    280Deferred revenue
    
    
    279Total current liabilities
    
    
    1,520Stockholders equity:Preferred stock, par value $0.01 per share;  authorized, 10,000,000 shares, no shares issued
    
    
    Common stock, par value $0.01 per share,  5,000,000 shares authorized; 1,604,557 shares issued   and outstanding
    
    
    16Capital in excess of par value
    
    
    6,969Accumulated deficit
    
    
    (5,742
    )Total stockholders equity
    
    
    1,243Total
    
    $
    2,763


See notes to condensed financial statements.

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CORTELCO SYSTEMS PUERTO RICO, INC.




Condensed Income (Loss) Statements (Unaudited)



(Dollars in thousands, except per share data)

Three Months Ended
    
    Six Months EndedJanuary 31
    
    January 312005
    
    2004
    
    2005
    
    2004Net revenues:Products
    
    $
    864
    
    
    $
    894
    
    
    $
    2,091
    
    
    
    2,109Services
    
    
    756
    
    
    
    799
    
    
    
    1,529
    
    
    
    1,610Total net revenues
    
    
    1,620
    
    
    
    1,693
    
    
    
    3,620
    
    
    
    3,719Cost of revenues:Products
    
    
    694
    
    
    
    973
    
    
    
    1,690
    
    
    
    1,962Services
    
    
    409
    
    
    
    797
    
    
    
    859
    
    
    
    1,266Total cost of revenues
    
    
    1,103
    
    
    
    1,770
    
    
    
    2,549
    
    
    
    3,228Gross profit (loss)
    
    
    517
    
    
    
    (77
    )
    
    
    1,071
    
    
    
    491Operating expenses:Selling, general, & administrative
    
    
    537
    
    
    
    649
    
    
    
    1,095
    
    
    
    1,247Total operating expenses
    
    
    537
    
    
    
    649
    
    
    
    1,095
    
    
    
    1,247Loss from operations
    
    
    (20
    )
    
    
    (726
    )
    
    
    (24
    )
    
    
    (756
    )Other income, net:
    
    
    3
    
    
    
    6
    
    
    
    27
    
    
    
    10Income (loss) before income taxes
    
    
    (17
    )
    
    
    (720
    )
    
    
    3
    
    
    
    (746
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    (17
    )
    
    $
    (720
    )
    
    $
    3
    
    
    $
    (746
    )Basic and diluted net income (loss) per common share
    
    $
    0.01
    
    
    $
    (0.60
    )
    
    $
    0.00
    
    
    $
    (0.62
    )


See notes to condensed financial statements.

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CORTELCO SYSTEMS PUERTO RICO, INC.

Condensed Statements of Cash Flows (Unaudited)



(Dollars in thousands)

Three Months Ended,
    
    Six Months Ended,January 31
    
    January 312005
    
    2004
    
    2005
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    (17
    )
    
    
    (720
    )
    
    $
    3
    
    
    $
    (746
    )Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depreciation and amortization
    
    
    33
    
    
    
    37
    
    
    
    66
    
    
    
    74Provision for doubtful accounts receivable
    
    
    
    
    
    
    200
    
    
    
    
    
    
    
    200Inventories write-downs
    
    
    
    
    
    
    600
    
    
    
    
    
    
    
    600Changes in operating assets and liabilities:Decrease (increase) in:Trade accounts receivable
    
    
    476
    
    
    
    293
    
    
    
    370
    
    
    
    195Due to affiliated entities
    
    
    
    
    
    
    (7
    )
    
    
    
    
    
    
    (14
    )Inventories
    
    
    (29
    )
    
    
    87
    
    
    
    229
    
    
    
    53Prepaid expenses
    
    
    4
    
    
    
    (10
    )
    
    
    (32
    )
    
    
    (85
    )Increase (decrease) in:Trade accounts payable
    
    
    (193
    )
    
    
    (346
    )
    
    
    (392
    )
    
    
    (157
    )Due to affiliated entities
    
    
    176
    
    
    
    (12
    )
    
    
    235
    
    
    
    (46
    )Accrued liabilities
    
    
    (84
    )
    
    
    (97
    )
    
    
    (278
    )
    
    
    (60
    )Deferred revenue
    
    
    (40
    )
    
    
    (44
    )
    
    
    48
    
    
    
    (28
    )Total adjustments
    
    
    343
    
    
    
    701
    
    
    
    246
    
    
    
    732Net cash provided by (used in) operating activities
    
    
    326
    
    
    
    (19
    )
    
    
    249
    
    
    
    (14
    )CASH FLOWS FROM INVESTING ACTIVITIES:Capital expenditures
    
    
    (11
    )
    
    
    (8
    )
    
    
    (23
    )
    
    
    (9
    )Net decrease in investment in sales type leases
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    Net cash (used in) investing activities
    
    
    (11
    )
    
    
    (13
    )
    
    
    (23
    )
    
    
    (9
    )NET CHANGE IN CASH
    
    
    315
    
    
    
    (32
    )
    
    
    226
    
    
    
    (23
    )CASH, BEGINNING OF PERIOD
    
    
    37
    
    
    
    72
    
    
    
    126
    
    
    
    63CASH, END OF THE PERIOD
    
    $
    352
    
    
    $
    40
    
    
    $
    352
    
    
    $
    40


See notes to condensed financial statements.

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Cortelco Systems Puerto Rico, Inc.




Notes to Condensed Financial Statements (Unaudited)



Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared by Cortelco Systems Puerto Rico, Inc. (CSPR or the Company).  It is managements opinion that these statements include all adjustments necessary to present fairly the financial position, results of operations, and cash flows as of January 31, 2005 and for all periods presented.

Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted.  These condensed financial statements should be read in conjunction with the financial statements and notes as of July 31, 2004 and for the periods then ended, which are included in the Annual Report on Form 10-KSB for the year ended July 31, 2004 filed with the Securities and Exchange Commission.

The accompanying unaudited condensed financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business.  However, our independent public accountants have expressed doubt about our ability to continue as a going concern in their report on our annual audited financial statements.  The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Significant Accounting Policies

Use of Estimates-The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent 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.

Fair value of financial instruments - The carrying amounts of cash is a reasonable estimate of its fair value.  The carrying amounts of accounts receivable, accounts payable (including to related parties), accrued expenses, and deposit liabilities approximate fair value due to their short-term maturities.

Revenue Recognition -The Company recognizes revenues for equipment shipped to customers only after completion of installation services and acceptance by the customer due to the customized nature of each installation.  Revenues from communications systems service contracts are recognized over the life of the individual contracts.  Currently, the Company sells and services communications systems purchased from various third-party vendors.  The Company allocates fees from multiple-element arrangement to the elements based on the relative fair value of each element.  The Company believes that its revenues recognition policies are compliant with Staff Accounting Bulleting No. 101, Revenue Recognition in Financial Statements.

Cash - Cash includes cash deposited in high?credit qualified financial institutions.

Allowance for Doubtful Accounts - The allowance for doubtful accounts is an amount that management believes will be adequate to absorb losses on existing accounts receivable that are considered uncollectible based on evaluations of collectibility of accounts receivable and prior credit experience.

Inventories - Inventories are stated at the lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method.  Returned equipment and inventory, mostly related to warranty claims and replacements of outdated communication systems, is accounted at no cost, unless repaired, as which time, it is valued at the lower of the repair cost or its net realizable value.

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Maintenance contracts - Maintenance contract revenues are recognized over the remaining life of each contract (usually one year) based on the straight-line method.

The following table summarizes the activity relating to the unexpired maintenance contracts during the second quarter of this fiscal year.

October 31, 2004
    
    
    
    
    
    January 31, 2005(Dollars in thousands)
    
    LiabilityBalance
    
    Additions
    
    Deductions
    
    Liability
BalanceMaintenance Contracts
    
    $
    244
    
    
    $
    53
    
    
    $
    80
    
    
    $
    217


Product Warranties  The Company gives a one-year warranty to certain products sold.  The Company recognizes an accrued warranty liability when it sells a product.  This amount is an estimate of the cost of labor to be performed if that warranty is exercised, based on experience.  If the Company is required to perform on its warranty, it sends the product to the manufacturer that normally warrants the product.  The Company only incurs the cost of labor of technicians and return freight.  The Company recognizes warranty revenue over the term of the warranty period.  The costs related to warranties exercised are recognized directly as cost of sales when incurred.

The following table summarizes the activity relating to the warranty reserve during the second quarter of this fiscal year.

(Dollars in thousands)
    
    October 31, 2004
Liability
Balance
    
    Additions
    
    Deductions
    
    January 31, 2005LiabilityBalanceWarranty Reserve
    
    $
    75
    
    
    $
    14
    
    
    $
    27
    
    
    $
    62


Accounting for income taxes-Deferred income taxes are accounted for using the asset and liability method of accounting.  Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases and operating loss and tax credit carryforwards.  Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

On August 4, 2003, the Company was granted certain tax exemption benefits under the Commonwealth of Puerto Rico Law 135 of December 2, 1997, as amended.  Under the ten?year decree, beginning on December 30, 2002, the Companys process of assembling communication equipment will enjoy preferential tax rates, as follows:

Tax
    
    BenefitIncome
    
    
    7% flat taxProperty
    
    
    90% exemptionMunicipal
    
    
    60% exemption


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Recent Accounting Pronouncements

In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets-an amendment of APB Opinion No. 29.  This Statement amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.  The future implementation of this Statement will have no significant effect on the Companys financial position or results of operations.

Other recently issued FASB Statements or Interpretations, SEC Staff Accounting Bulletins, and AICPA Emerging Issue Task Force Consensuses have either being implemented in prior periods or are not applicable to the Company.

Securities Authorized for Issuance Under the Companys Equity Compensation Plan

The following table summarizes the Company equity compensation plan as of January 31, 2005:

Plan category
    
    Number of securities to be issued upon exercise ofoutstanding options,warrants and rights
    
    Weighted-averageexercise price ofoutstanding options, warrants and rights
    
    Number of securities remaining availablefor future issuance under equitycompensation plans (excluding securities reflected in column (a)(a)

    

    (b)

    

    (c)Equity compensation plans approved by security holders
    
    
    
    
    
    
    
    
    
    
    350,000Equity compensation plans not approved by security holders
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    
    
    
    
    
    350,000


Inventories

Inventories consist of the following:

January 31, 2005(In thousand)Purchased components, net
    
    $
    144Components and materials related to installation in process
    
    
    24Parts and materials for sale, net
    
    
    47Total inventories
    
    $
    215


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Income (Loss) per Common Share

The Company reports its earnings per share (EPS) using Financial Accounting Standards Board (FASB) Statement No. 128, Earnings Per Share(SFAS 128).  SFAS 128 requires dual presentation of basic and diluted EPS.  Basic EPS is computed by dividing income (loss) attributable to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

The computations of basic and diluted loss per share were as follows:

Three Months Ended
January 31
    

    Six Months Ended
January 312005
    
    2004
    

    2005

    

    2004(In thousand, except per share data)
    
    (In thousand, except per share data)Basic and diluted loss per share:Net income (loss)
    
    $
    (17
    )
    
    $
    (720
    )
    
    $
    3
    
    
    $
    (746
    )Weighted average number of common shares outstanding
    
    
    1,604,557
    
    
    
    1,204,557
    
    
    
    1,604,557
    
    
    
    1,204,557Loss from operations per share
    
    $
    (0.01
    )
    
    $
    (0.60
    )
    
    $
    0.00
    
    
    $
    (0.62
    )


Contingencies

During this quarter, settlements for an amount substantially lower than the amounts originally requested were reached to close all related claims between CSPR and Envision, and one of the employment cases.  Both settlements were for a total amount of $53,000, without relevant impact in our financial statement during this quarter since the proper provision was made during a previous year.

CSPR is currently subject to three pending lawsuits.  One lawsuit regarding an alleged breach of contract, a second lawsuit regarding employment issues, and a third lawsuit in which the Company was included as a Third Party Defendant.  In the breach of contract case, the plaintiff alleges that CSPR breached the terms of the contract by ceasing to supply services to the plaintiff, and the plaintiff seeks damages of approximately $854,430.  In the employment lawsuit, the plaintiff is a former employee of the Company, who alleges under various theories of law that he was forced to resign therefore constituting an unlawful dismissal from employment.  With respect to the third lawsuit, the Company reached an agreement with the other party defendant, Ochoa Telecom, in which it was agreed that Ochoa would cover all of CSPRs legal fees and any judgment against CSPR that may result from this case.  CSPR has analyzed each lawsuit

with our legal advisors, and the Company does not believe that any of these cases will result in an unfavorable outcome that would have a material adverse effect upon our business.  However, in the event of one or more unfavorable determinations against us, such litigation could have a material adverse effect on our business by harming earnings if the Company is liable for a significant monetary judgment, by harming our reputation with our customers through any adverse publicity generated from an unfavorable determination, or by adversely affecting our relationship with current and prospective employees of our company.




ITEM 2.  MANAGEMENTS DISCUSSION AND ANALYSIS.

This report contains unaudited forward-looking statements within the meaning of the federal securities laws.  Unaudited forward-looking statements are those that express managements views of future events, developments, and trends.  In some cases, these statements may be identified by terminology such as may, will, should,

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expects, plans, intends, anticipates, believes, estimates, predicts, potential, or continue or the negative of such terms and other comparable expressions.  Unaudited forward-looking statements include statements regarding our anticipated or projected operating performance, financial results, liquidity and capital resources.  These statements are based on managements beliefs, assumptions, and expectations, which in turn are based on the information currently available to management.  Information contained in these unaudited forward-looking statements is inherently uncertain, and our actual operating performance, financial results, liquidity, and capital resources may differ materially due to a number of factors, most of which are beyond our ability to predict or control.  The Company also directs your attention to

the risk factors affecting our business that are discussed on this Item.  CSPR disclaims any obligation to update any of the unaudited forward-looking statements contained in this report to reflect any future events or developments.  The following discussions should be read in conjunction with our unaudited financial statements and the notes included thereto.

Financial Condition

Near term, the Companys cash position has improved as a result of lower receivables, however, our continuance as a going concern is still dependent upon our ability to improve profitability above the break-even point, generate cash from our receivables on a timely basis and to retain continued support from our suppliers.  Our independent public accountants have expressed doubt about our ability to continue as a going concern in their report on our annual audited financial statements.

CSPR achieved the budgeted sales in the quarter ended October 31, 2004.  However due to the postponement of large new system installations by three customers, the sales budget for the current quarter was narrowly missed.  While the sales outlook for the balance of the year is aligned with the annual budgeted sales, there remains the concern of obtaining additional sources of funds to be able to comply with our main equipment suppliers payment terms.  CSPR must continue to seek better payments terms from its suppliers or to obtain a line of credit from a Puerto Rican financial institution.

In October 2004, CSPR hired Juan Carlos Ramos to fill the position of General Manager.  As General Manager, he reports directly to the Companys President and is responsible for improving customer service, increasing installation and maintenance efficiencies, and attaining better sales results.

In January 2005, an agreement was reached between Cortelco, Inc. (CI) a related private company headquartered in Corinth, Mississippi, and CSPR whereby CSPR has been appointed as the Territory and Export Representative for all of CIs communications products for the defined territory.  The defined territory currently includes Argentina, Bolivia, Brazil, Chile, Colombia, Dominican Republic, Ecuador, El Salvador, Guyana, Haiti, Paraguay, Peru, Puerto Rico, Suriname, Uruguay, Venezuela, and the U.S. Virgin Islands.  As part of this agreement, CSPR in turn will provide assistance to CI to promote export sales in a total of fourteen separate and distinct countries that are located in the Caribbean and Latin American (CALA) or South America.  During the first month of this agreement, CSPR recognized sales covered under this agreement in the amount of approximately $166,000 and a profit of approximately $7,000.  Both companies a

re seeking to continue to find new sales opportunities due to this alliance.  The revenue for export is classified as part of Product in the Income Statement.

No assurance can be given that CSPR will be successful in achieving our near term goals necessary to raise sufficient cash and meet the Companys obligations with our customers and suppliers.  Ultimately, the Company must achieve profitable operations if the Company is to be a viable entity.

Results of Operations and Cash Flow for the Three Months Ended January 31, 2005 and 2004

The following discussion provides information about the Companys operations, for the three months ended January 31, 2005 and for the three months ended January 31, 2004.

Net revenues consist of sales of new product and additions (Products) and services (Services) related to revenues from maintenance contract and billable services.  Net revenues decreased 4.3%, or approximately $73,000 in the three months ended January 31, 2005 compared to the three months ended January 31, 2004.  The results primarily reflect decreased revenue of approximately $30,000 in Products due to customer purchase postponements, and a decrease of approximately $43,000 in Services due to market fluctuation in billable service calls and a decline in

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maintenance contracts due to changes in the main equipment for the Companys base customer.

Cost of revenues consists primarily of purchases from equipment manufacturers and other suppliers and costs incurred for final assembly, quality assurance, system installation and maintenance labor cost.  The gross margin for the three months ended January 31, 2005 was 31.9% and (4.5%) for the three months ended January 31, 2004.  In the quarter ended January 31, 2004, the Company made a $600,000 inventory valuation adjustment.  In the quarter ended January 31, 2005, no inventory adjustment was required.

Selling, general and administrative expenses consist primarily of salaries and benefit costs, advertising, and facilities and other overhead expenses incurred to support our business.  Selling, general and administrative expenses decreased 17.3% to approximately $537,000 in the three months ended January 31, 2005 from approximately $649,000 in the three months ended January 31, 2004.  The decrease was primarily due to decreased expenses and internal actions to reduce costs and improve productivity.

Interest income mostly from related parties, was nominal in last fiscal year 2004.  Interest income from related parties will not be accrued subsequent to July 31, 2004.  Other income in the three months ended January 31, 2005 was a nonrecurring transaction of approximately $3,000.  In addition, the Company had no significant interest expense in either the three months ended January 31, 2005 or 2004.

The Company recognized no income tax benefit for the quarters ended January 31, 2005 and 2004, because CSPR cannot conclude whether or not deferred tax assets will be realized in the future.

Cash flow provided by operating activities was approximately $326,000 in the three months ended January 31, 2005 and cash flow used in operating activities was approximately ($19,000) in the three months ended January 31, 2004.  Cash provided by operating activities in the three months of this fiscal year resulted primarily from a decrease in trade accounts receivable and an increase in trade accounts payable to affiliates that was partially offset by a decrease in overall trade accounts payable.  Cash flows used in investing activities for the three months ended January 31, 2005 and 2004 was approximately ($11,000) and ($13,000), respectively.  The change in cash for investing activities is related to the acquisition of new technical equipment to improve the performance of our technician force.

Results of Operations and Cash Flow for the Six Months Ended January 31, 2005 and 2004

The following discussion provides information about the Companys operations, for the six months ended January 31, 2005 and for the six months ended January 31, 2004.

Net revenues consist of sales of new product and additions (Products) and services (Services) related to revenues from maintenance contract and billable services.  Net revenues decreased 2.7%, or approximately $99,000 in the six months ended January 31, 2005 compared to the six months ended January 31, 2004.  The results primarily reflect decreased revenue of approximately $18,000 in Products due to customer purchase postponements, and a decrease of approximately $81,000 in Services due to market fluctuation in billable service calls and a decline in maintenance contracts due to changes in the main equipment for the Companys base customers.

Cost of revenues consists primarily of purchases from equipment manufacturers and other suppliers and costs incurred for final assembly, quality assurance, system installation and maintenance labor cost.  The gross margin for the six months ended January 31, 2005 was 29.6% and 13.2% for the six months ended January 31, 2004.  The increase was primarily due to the $600,000 inventory valuation adjustment recorded in the quarter ended January 31, 2004.

Selling, general and administrative expenses consist primarily of salaries and benefit costs, advertising, and facilities and other overhead expenses incurred to support our business.  Selling, general and administrative expenses decreased 12.2% to approximately $1,095,000 in the six months ended January 31, 2005 from approximately $1,247,000 in the six months ended January 31, 2004.  The decrease was primarily due to internal actions to reduce costs and improve productivity.

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Interest income mostly from related parties, was nominal in last fiscal year 2004.  Interest income from related parties will not be accrued subsequent to July 31, 2004.  Other income in the six months ended January 31, 2005 was a nonrecurring transaction of approximately $27,000.  In addition, the Company had no significant interest expense in either of the six months ended January 31, 2005 or 2004.

The Company recognized no income tax expense for the six months ended January 31, 2005, because the same was absorbed by available carryforwards losses.  Also no income benefit was recognized from the results of the six months ended January 31, 2004 because CSPR cannot conclude whether or not deferred tax assets will be realized in the future.

Cash flow provided by operating activities was approximately $249,000 in the six months ended January 31, 2005 and cash flow used in operating activities was approximately ($14,000) in the six months ended January 31, 2004.  Cash provided by operating activities in the six months of this fiscal year resulted primarily from a decrease in trade accounts receivable and an increase in trade accounts payable to affiliates that was partially offset by a decrease in overall trade accounts payable.  Cash flows used in investing activities for the six months ended January 31, 2005 and 2004 was approximately ($23,000) and ($9,000), respectively.  The change in cash for investing activities is related to the acquisition of new technical equipment to improve the performance of our technician force.

Other Relevant Financial Information

The Companys Board of Directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the preferences, rights and privileges of those shares without any further vote or action by the stockholders.  The rights of the holders of any preferred stock that may be issued in the future may harm the rights of the holders of common stock.  Certain provisions of our certificate of incorporation and bylaws may make it more difficult for a third party to acquire control of CSPR without the consent of our Board of Directors, even if such changes were favored by a majority of the stockholders.  These include provisions that provide for a staggered board of directors, prohibit stockholders from taking action by written consent and restrict the ability of stockholders to call special meetings.

CSPRs officers, directors and five percent or greater stockholders beneficially own or control, directly or indirectly, approximately 860,334 shares, which in the aggregate represent approximately 54% voting interest in the outstanding shares of our common stock.  These stockholders have the ability to control all matters submitted to our stockholders for approval, including the election and removal of directors and the approval of any business combinations.

The Company believes our stock fits the definition of a penny stock.  The Securities Exchange Act of 1934 defines a penny stock as any equity security that is not traded on a national securities exchange or authorized for quotation on The Nasdaq Stock Market and that has a market price of less than $5.00 per share, with certain exceptions.  Penny stocks are subject to Rule 15g under the Securities Exchange Act of 1934, which imposes additional sales practice requirements on broker-dealers who sell such securities.  In general, a broker-dealer, prior to a transaction in a penny stock, must deliver a standardized risk disclosure document that provides information about penny stocks and the risks in the penny stock market.  The broker-dealer must provide the customer with current bid and offer quotations for the penny stock, information about the commission payable to the broker-dealer and its salesperson in the transaction and m

onthly statements that disclose recent price information for each penny stock in the customers account.  Finally, prior to any transaction in a penny stock, the broker-dealer must make a special written suitability determination for the purchaser and receive the purchasers written consent to the transaction prior to sale. All of these requirements may restrict your ability to sell our stock and could limit the trading volume of our stock and adversely affect the price investors are willing to pay for our stock.

Off-Balance Sheet Arrangements

CSPR was not involved in any significant off-balance sheet arrangements during the six months ended January 31, 2005 and for the six months ended January 31, 2004.

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ITEM 3.  CONTROLS AND PROCEDURES.

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e) as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedure are effective.  There were no changes in our internal control over financial reporting during the six months ended January 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.




PART II - OTHER INFORMATION




ITEM 1.  LEGAL PROCEEDINGS.

No new legal proceedings.




ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.




ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

None.




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

None.




ITEM 5.  OTHER INFORMATION.

None.




ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

(A)  Exhibits.



Exhibit Number
    
    Description of Document10.10
    
    
    Export Telephone Sales Agreement dated January 3, 2005 between Cortelco Inc. and CSPR.31.1
    
    
    Officers Certification pursuant to Rules 13a-14(a) of the Securities Exchange Act of 1934.32.1
    
    
    Officers Certification pursuant to 18 U.S.C ss1350.


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(B)  Reports On Form 8-K.

During the second quarter ended January 31, 2005, the Company reported the following event on Form 8-K:

Date Filed
    
    Item No.
    
    DescriptionJanuary 27, 2005
    
    
    5.02
    
    
    
    Announced the resignation of Lanny N. Lambert as a Director of the Company and formally appointed Walter D. Duffey to fill the vacant board position and the Audit and Compensation Committees of the Board.


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SIGNATURES

In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Cortelco Systems Puerto Rico, Inc.Date:   March 15, 2005
    /s/ Francisco SanchezFrancisco Sanchez, Vice PresidentChief Financial Officer, TreasurerDuly Authorized Officer(Principal Financial and Accounting Officer)


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