**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-KSB**

**x**                              ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe fiscal year ended June 30, 2006**

**o**                                 TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Commissionfile number 0-29478**

**PRECISION AUTO CARE, INC.**

(Name of small businessissuer in its charter)

| **Virginia**                                                     | ** ** | **54-1847851**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification Number) |

 

**748 Miller Drive, S.E.,Leesburg, Virginia 20175**

(Address of principalexecutive offices)(Zip Code)

**703-777-9095**

(Issuer’s telephonenumber, including area code)

Securities registered pursuant to Section 12(b) ofthe Act:

**None**

Securities registered pursuant to Section 12(g) ofthe Act:

**CommonStock, par value $.01 per share**

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

Check if no disclosure of delinquent filers inresponse to Item 405 of Regulation S-B is contained in this form, and nodisclosure will be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-KSB or any amendment to this Form 10-KSB.   o

The issuer’s revenues forits most recent fiscal year were: $11,719,267.

The aggregate market valueof Common Stock held by persons not “affiliated” with the issuer at August 11,2006 was $10,796,178 based on the closing price of $0.45 per share. As of August 11,2006, 28,993,752 of Common Stock were issued and outstanding.

Transitional SmallBusiness Disclosure Format:   o Yes   x No

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

**DOCUMENTSINCORPORATED BY REFERENCE:**

Certainportions of Registrant’s definitive proxy statement, to be filed with theSecurities and Exchange Commission pursuant to Regulation 14A not later than120 days after the close of the Corporation’s fiscal year, are incorporated byreference under Part III.

 

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**TABLEOF CONTENTS**
|               | ** ** | ** ** | ** ** | ** **                                                                                                                 | ** ** | **Page** | ** ** |
|---------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I   |       | Item 1.    |       | Business                                                                                                                   |       |     | 4          |   |   |
|          |       | Item 2.    |       | Properties                                                                                                                 |       |     | 11         |   |   |
|          |       | Item  3.   |       | Legal  Proceedings                                                                                                         |       |     | 11         |   |   |
|          |       | Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                        |       |     | 14         |   |   |
| PART II  |       | Item 5.    |       | Market for Common Equity and Related Stockholder  Matters                                                                  |       |     | 15         |   |   |
|          |       | Item 6.    |       | Management’s Discussion and Analysis or Plan of  Operation                                                            |       |     | 16         |   |   |
|          |       | Item  7.   |       | Financial  Statements                                                                                                      |       |     | 22         |   |   |
|          |       | Item 8.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                      |       |     | 41         |   |   |
|          |       | Item 8A.   |       | Controls and Procedures                                                                                                    |       |     | 41         |   |   |
|          |       | Item  8B.  |       | Other  Information                                                                                                         |       |     | 41         |   |   |
| PART III |       | Item 9.    |       | Directors, Executive Officers, Promoters and Control  Persons; Compliance With Section 16(a) of the Exchange Act |       |     | 42         |   |   |
|          |       | Item 10.   |       | Executive Compensation                                                                                                     |       |     | 42         |   |   |
|          |       | Item 11.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                            |       |     | 42         |   |   |
|          |       | Item 12.   |       | Certain Relationships and Related Transactions                                                                             |       |     | 42         |   |   |
|          |       | Item 13.   |       | Exhibits                                                                                                                   |       |     | 42         |   |   |
|          |       | Item 14.   |       | Principal Accountant Fees and Services                                                                                     |       |     | 44         |   |   |

 

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**FORWARD-LOOKINGSTATEMENTS**

This report includes forward-looking statements withinthe meaning of the Securities Act of 1933 (the ‘‘Securities Act’’) and theSecurities Exchange Act of 1934. When used in this report, the words ‘‘anticipate,’’‘‘believe,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘intend’’ and ‘‘plan’’ as they relateto Precision Auto Care, Inc. or its management are intended to identifysuch forward-looking statements. All statements regarding Precision Auto Care, Inc.or Precision Auto Care, Inc.’s expected future financial position,business strategy, cost savings and operating synergies, projected costs andplans, and objectives of management for future operations are forward-lookingstatements. Although Precision Auto Care, Inc. believes the expectationsreflected in such forward-looking statements are based on reasonableassumptions, no assurance can be given that such expectations will prove tohave been correct. Important factors that could cause actual results to differmaterially from the expectations reflected in the forward-looking statementsherein include, among others, the factors set forth under the caption ‘‘Business—RiskFactors,’’ general economic and business and market conditions, changes infederal and state laws, and increased competitive pressure in the automotiveaftermarket services business.

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**PART I**

**Item 1.**                        *Business*

**OVERVIEW**

Precision Auto Care, Inc. (“PACI” or the “Company”)is a franchisor of automotive service centers located in the United States andin certain foreign countries. At June 30, 2006, the Company had 27 totalemployees of which 25 were full time employees. Through its franchised centers,services are provided to automobile owners and focus on those high-frequencyitems required on a periodic basis to maintain the vehicle properly.

The Company was incorporated as a Virginia corporationin April 1997, but its predecessors have been in the automotivemaintenance services business since 1976. The first Precision Tune wasestablished in 1976 to provide quick, convenient and inexpensive enginetune-ups. Franchising of Precision Tune centers began the next year. Asautomotive technology changed, Precision Tune expanded its menu of offeredautomotive maintenance and repair services to include oil changes, fuelinjection service, air conditioning service, cooling system service, brakeservice and more diagnostic services. In September 1996, the PrecisionTune brand name was changed to Precision Tune Auto Care to reflect the shift inemphasis.

The Company is theresult of the November 1997 combination of WE JAC Corporation (the ownerof Precision Tune Auto Care) and nine other automotive maintenance servicescompanies in connection with its initial public offering. With the goal ofreturning focus on core operations, the Company disposed of ancillary businesssegments with the result the Company now has one business segment, AutomotiveCare Franchising. The Automotive Care Franchising business segment, which iscomprised of Precision Tune Auto Care (“PTAC”), provides automotive servicesprimarily through franchised operations located in the United States and incertain foreign countries.

·       Through its franchisees,PTAC provides automotive maintenance and repair services, such as engineperformance, oil change and lubrication and brake services, which requirerelatively short service times. At June 30, 2006, these services wereprovided at 416 domestic and international Precision Tune Auto Care centersowned and operated by franchisees.

**OPERATIONS**

*Precision Tune AutoCare*

Precision Tune Auto Care is a franchisor of automotiveservice centers that provide specialized quality maintenance and repairservices that require relatively short service times. The automotive careservices provided by Precision Tune Auto Care centers include the diagnosis,maintenance and repair of ignition systems, fuel systems, computerized enginecontrol systems, cooling systems, starting/charging systems, emissions controlsystems, engine drive train systems, electrical systems, air conditioningsystems, oil and other fluid systems, and brake systems. The Company has recentlymade the decision to sell tires and tire related services at the centers aswell.

*PrototypeCenter.**  *Thecurrent prototype Precision Tune Auto Care center is a free-standing buildingwith six to eight service bays, of which two to four are drive-through andinclude pits to facilitate fast oil change and lubrication services. Franchiseestypically develop Precision Tune Auto Care centers either by entering into abuild-to-suit lease, under which the landlord constructs the center and leasesit to the franchisee, or by purchasing land and building the facility. TheCompany typically seeks sites in commercial areas with a minimum population of50,000 people within a five mile radius.  Exclusive of real estate, the estimatedcapital required to open a prototype Precision Tune Auto Care center rangesfrom $123,000 to $208,075.

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*RetailMarketing.**  *PrecisionTune Auto Care’s marketing objectives at the retail level are to increasefranchisee sales, enhance first-time customers’ experiences, and bolster eachfranchisee’s customer retention efforts. To further these objectives, PrecisionTune Auto Care has developed and implemented a marketing plan containingprograms and materials for use by Precision Tune Auto Care centers. The planincludes targeted marketing programs designed to reach key market segments,in-store merchandising materials designed to enhance retail sales and firsttime customer trials, and other local marketing materials (e.g., second cardiscounts, service reminder cards, and ATM receipt coupons) designed togenerate customers and improve customer retention.

*Trainingand Operational Support.**  *Asignificant element of Precision Tune Auto Care’s commitment to service is itstraining program for franchisees. New franchisees are required to successfullycomplete over 40 hours of initial training at its national training center inLeesburg, Virginia. The Company also offers a full line of technical training,including courses on engine performance, fuel systems and emissions, automotiveelectronics, fuel injection, and brake certification. These courses, whichinclude both classroom and hands-on training, are designed to allow franchiseesand service center technicians to maintain and update their technicalcapability to service today’s more complex vehicles.

*FranchiseMarketing.**  *TheCompany (through a predecessor company) has marketed franchises for PrecisionTune Auto Care centers since 1977. Its franchise sales process includesadvertising in appropriate franchise and business publications, establishingrelationships and working with sales brokers, conducting franchise salesseminars, maintaining a home page on the Internet through which interestedparties may submit a franchise inquiry, and advertising on several franchisesales orientated web sites. Prospective franchisees are asked to complete aConfidential Qualifications Report, which serves as the initial screening todetermine whether a prospect is qualified. The Company seeks individuals withmanagement experience who will make a full-time commitment to the operation oftheir franchise and who have a minimum of $70,000 and $250,000 in liquid assetsand net worth, respectively.

Precision Tune Auto Care’s area-development system hasplayed a significant role in its franchise development efforts. Under thissystem, Precision Tune Auto Care has entered into area-development agreementsthat grant area developers the right and obligation to develop franchiseswithin specific geographic regions for stated periods of time. Franchiseagreements within the area are between the Company and the franchisee. The areadeveloper typically receives up to one-half of the initial franchise fee,one-half of the subsequent royalty revenues and one-half of franchise renewaland transfer fees. After the creation of a franchise, the area developer performsmany of Precision Tune Auto Care’s franchise support obligations. As of June 30,2006, 19 area developers and their affiliates had an ownership interest inapproximately 28% of the total number of Precision Tune Auto Care centers.

*Open Area Development.**  *Precision Tune Auto Care’s current strategy is alsoto pursue new area developers to develop open areas in which current areadevelopers have not been granted rights. To attract new area developers, thecompany employs strategies similar to those used in marketing unit franchises. However,the net worth requirements for prospective area developers are greater thanthose required for a unit franchisee. These requirements range from $250,000 to$1,000,000 net worth, depending upon the size of the particular area.

**FRANCHISINGACTIVITIES**

*PrecisionTune Auto Care.*   As of June 30, 2006, all ofPrecision Tune Auto Care domestic and international centers were owned andmanaged by franchisees. Precision Tune Auto Care’s domestic franchises havebeen sold during the preceding years under franchise agreements that vary indetail as the Precision Tune Auto Care’s franchise program has evolved. Royaltyrates in existing franchise agreements range from 6.0% to 7.5%. Currently,Precision Tune Auto Care’s standard franchise agreement requires payment to theCompany of an initial franchise fee of $25,000 and a continuing royalty of 6.0%to 7.5% of 

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weekly gross receipts. Inaddition, the franchisee is required to contribute to or expend up to 9% ofweekly gross receipts on advertising, of which 1.5% is currently paid into thenational marketing fund and up to 7.5% of which is spent locally. The currentstandard form franchise agreement has an initial term of ten years and providesfor five-year renewal options.

The Company has implemented a domestic program underwhich qualified franchisees are eligible to have their royalty rate reduced toas low as 6% if they satisfy certain criteria. Under the program, franchiseesare also provided with an incentive to purchase additional Precision Tune AutoCare franchises. Any franchisee that has owned and operated a center for atleast one year in accordance with this program will be charged an initialfranchise fee of $15,000 for a second franchise and $10,000 for each additionalfranchise purchased, provided certain conditions are met.

Under its current form of domestic franchiseagreement, the Company has a continuing obligation to make technical andadministrative support available, centralized marketing support, and trainingand related support available to its franchisees. In areas where there are areadevelopers, the Company has delegated most of these duties to area developersunder its area developer system.

Upon non-renewal and transfer, the Company has thefirst right to purchase the operating assets and obtain an assignment of leasedfacilities in certain cases. In certain situations, the Company will repurchasefranchise rights. The decision to repurchase is made solely at its discretionand is not a contractual obligation. The Company also periodically obtainspossession of some franchisees’ franchise rights by exchanging for such rightsnotes payable or other consideration, or by exercising rights outlined in thefranchise agreements.

The Company also entersinto master franchise agreements to develop international markets. At the presenttime, the Company has master franchise agreements in Taiwan, Oman, Indonesia,United Arab Emirates, the Dominican Republic, El Salvador, Saudi Arabia, China,Spain and Portugal. Generally, the master franchisee pays a license fee and isrequired to develop Precision Tune Auto Care centers in accordance with anagreed upon schedule within the defined area. Franchise agreements within thearea are between the master franchisee and the unit franchisee. The masterfranchisee is required to perform all of the obligations of the franchisorincluding training, administrative and operational support, and the Companygenerally receives 20% of the initial franchise fee and up to one-third ofongoing royalty fees.

**CO-BRANDING**

On March 20, 2000, the Company entered into anagreement with Petro USA, Inc., a subsidiary of Getty Petroleum Marketing, Inc.,to provide Getty’s dealers with the opportunity to host a Precision Tune AutoCare franchise. This co-branding program involves a planned association of twodistinct brands, which are typically associated with different businessconcepts. ** **AtJune 30, 2006, there were five Getty stores that were hosting PrecisionTune Auto Care centers.

The Company is seeking toenter into other similar alliance agreements or other related agreements, whereits franchised businesses will be the secondary tenant at the primary tenant’slocation. The co-branding program may have separate agreements with the primarytenant’s organization or its affiliates to assist Precision Tune Auto Care inthe offer of franchises to the primary tenants and the provision of services. TheCompany expects that these co-branding opportunities will be with otherproviders of automotive services not similar to its own, like gasolinestations, detail, paint and body work stations, tire shops, glass shops, andmuffler shops. Due to the nature of these co-branding relationships, theCompany expects to modify its standard form of franchise agreement to reflectthe differences or similarities between its businesses. Some of these primarytenants may be in direct competition with the Company and may choose not tofranchise their particular location. Additionally, the Company makes the finaldecision as to entering into a franchise agreement with a primary tenant.

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**COMPETITION**

The Company’s franchisees encounter competition in allaspects of their business, including the sale by Precision Tune Auto Carecenters of automotive maintenance and repair services and fast oil andlubrication services. The Company believes that automobile dealerships,including recently emerging national and regional new and used autodealerships, represent Precision Tune Auto Care’s principal competitors. OtherPrecision Tune Auto Care competitors include tire companies and regionalunder-the-hood service specialists. National competitors within Precision TuneAuto Care’s market include Sears Auto Center and the automotive maintenancecenters operated by Goodyear, Midas, Meineke, Jiffy Lube, and Firestone, amongothers.   The Company believes that thegreater technical complexity of today’s vehicles provides a substantial barrierto entry for competitors in the “under-the-hood” segment of the automotive careservices industry.

The Company believes thatthe Precision Tune Auto Care centers all compete on the basis of customerawareness through advertising, service, convenience and location and, to alesser extent, on price. The Company believes that the potential ability tooffer all of the services provided by each of the operations at one center orin centers in close proximity to one another will be a significant competitiveadvantage.

**GOVERNMENTREGULATION**

*FranchisingRegulation.*   The Company is subject to federal,international and state laws and regulations, including the regulations of theFederal Trade Commission as well as similar authorities in individual states,in connection with the offer, sale and termination of franchises and theregulation of the franchisor/franchisee relationship. From time to time, theCompany experiences periods during which sales are restricted while the Companyregisters updates of its disclosure material with various states. Such delaysmay have an adverse effect on its ability to offer and sell franchises. Inaddition, the Company may become subject to litigation with, or other claimsfiled with state, federal or international authorities by, franchisees or areadevelopers based on alleged unfair trade practices, implied covenants of goodfaith and fair dealing or express violations of agreements. The failure by theCompany to comply with these laws could subject the Company to liability tofranchisees and to fines or other penalties imposed by governmental authoritiesand could have a material adverse effect on its financial condition and resultsof operations.

*Environmental Regulation.*   PrecisionTune Auto Care centers store new oil and handle large quantities of usedautomotive oils and fluids. As a result of these activities, the Company, itsfranchisees and area developers are subject to various federal, state and localenvironmental laws and regulations dealing with the transportation, storage,presence, use, disposal and handling of hazardous materials and hazardouswastes, and underground fuel storage tanks. If any such substances wereimproperly released or improperly stored on the property of any franchisee,including leased properties, or if the Company were found to be in violation ofapplicable environmental laws and regulations, the Company could be responsiblefor clean-up costs, property damage and fines or other penalties, any one ofwhich could have a material adverse effect on its financial condition andresults of operations.

**TRADEMARKS**

The Company has registereda number of trademarks and service marks with the United States Patent andTrademark Office, including “Precision Tune Auto Care.”  Its failure to obtain and maintain trademarkand service mark registration could have a material adverse effect on itsoperations. The Company has also registered or made application to registertrademarks in foreign countries where master franchise licenses have beengranted.

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**SEASONALITY**

Seasonal changes mayimpact various sectors of the Company’s businesses and, accordingly, itsoperations may be adversely affected by seasonal trends in certain periods. Inparticular, severe weather in winter months may make it difficult for consumersin affected parts of the country to travel to Precision Tune Auto Care andobtain services.

**RISK FACTORS**

The Company’s business and investment in its CommonStock are subject to certain risks, including the following:

*StockListing.**  *TheCompany’s common stock trades on the National Association of Securities Dealers, Inc.’sOTC Bulletin Board. Like other stocks traded over this quotation system, itscommon stock is thinly traded, highly volatile and not followed by analysts.

*PennyStock Regulations.**  *TheCompany’s common stock is subject to the rules promulgated under theSecurities Exchange Act of 1934, as amended, relating to “penny stocks.”  These rules require brokers sellingsecurities subject to these rules to persons other than establishedcustomers and institutional accredited investors to complete certaindocumentation, make suitability inquiries of investors, and provide investorswith certain information concerning the risks of trading in the security. Theserules may restrict the ability of brokers to sell the Company’s commonstock and thus may have an adverse effect on the liquidity and market price ofits common stock.

*ResaleRestrictions on Common Stock.**  *Becauseof large broker-dealer spreads, investors may be unable to sell the stockimmediately back to the broker-dealer at the same price the broker-dealer soldthe stock to the investor. In some cases, the stock may fall quickly in value. Themarket among broker-dealers may not be active, making it more difficult forinvestors to sell this stock. Investors in a penny stock often are unable tosell stock back to the dealer that sold them the stock. The mark-ups orcommissions charged by the broker-dealers may be greater than any profit aseller may make.

*Penny Stock Market.**  *Shareholders should be aware that, according toSecurities and Exchange Commission Release No. 34-29093, the marketfor penny stocks has suffered in recent years from patterns of fraud and abusewhich could cause investors to lose their entire investment. Such patternsinclude:

·       controlof the market for the security by one or a few broker-dealers that are oftenrelated to the promoter or issuer;

·       manipulationof prices through prearranged matching of purchases and sales and false andmisleading press releases;

·       “boilerroom” practices involving high pressure sales tactics and unrealistic priceprojections by inexperienced sales persons;

·       excessiveand undisclosed bid-ask differentials and mark-ups by selling broker-dealers;and

·       thewholesale dumping of the same securities by promoters and broker-dealers afterprices have been manipulated to a desired level, along with the inevitablecollapse of those prices with consequent investor losses.

The Company’s management is aware of the abuses thathave occurred historically in the penny stock market. Although it does notexpect to be in a position to dictate the behavior of the market or ofbroker-dealers who participate in the market, it will strive within theconfines of practical limitations to prevent the described patterns from beingestablished with respect to its securities.

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*Competition.*   Theautomotive services industry is highly competitive. The Company believes thatautomobile dealerships, including recently emerging national and regional newand used auto dealerships, represent the principal competitors for PrecisionTune Auto Care service centers; however, these service centers also competewith national and regional fast oil change and lube companies, major oilmanufacturers, local service stations and local, regional and nationalautomobile maintenance and repair service providers.

The Company believes the principal competitive factorsin the markets serviced by each of its business units are location, namerecognition and reputation, and quality of service and price.

The Company also competes with some of those notedabove and with other parties in the sale of franchises. Competitive factorsinclude startup costs, royalty rates, franchisee support and the financialperformance of existing centers. With respect to the sales of supplies andequipment to franchisees, competition is based on availability, price, abilityto provide prompt delivery and the quality of support services.

Certain competitors discussed above have greaterfinancial resources than the Company. There can be no assurance that theCompany or individual Precision Tune Auto Care centers will be able to competeeffectively. *See “Business**3⁄4Competition.”*

*Relianceon Franchising.**  *Franchiseroyalties are a significant component of its revenue base. Therefore, theCompany depends upon the ability of its franchisees to promote and capitalizeupon the “Precision Tune Auto Care” brand and the reputation the Companybelieves it enjoys for quality and value. There can be no assurance that theCompany or our area developers will be able to recruit and retain franchiseeswith the business abilities or financial resources necessary to open PrecisionTune Auto Care centers on schedule or that the franchisees will conductoperations profitably. In addition, to the extent that franchisees financetheir operations with secured indebtedness, the Company’s rights to receivefranchise royalties would be effectively subordinated to the rights offranchisees’ lenders. *See “Business**3⁄4Operations.”*

*AutomotiveTechnology Advances.**  *Thedemand for the services offered by its Precision Tune Auto Care centers couldbe adversely affected by continuing developments in automotive technology. Automotivemanufacturers are producing cars that last longer and require service andmaintenance at less frequent intervals. For example, some manufacturers nowrecommend that consumers change oil at 10,000 mile intervals and replace sparkplugs and other engine components at 100,000 miles, a significant increase fromthe mileage intervals recommended for earlier models and those currentlyrecommended by most manufacturers. The demand for its services also could beadversely affected by longer and more comprehensive warranty programs offeredby automobile manufacturers and other third parties. The Company believes thata majority of new automobile owners have their cars serviced by a dealer duringthe period the car is under warranty. In addition, advances in automotivetechnology may require the Company to incur additional costs to update itstechnical training program and upgrade the diagnostic capabilities of itscenters.

*LaborAvailability.*   The provision of high qualitymaintenance services by Precision Tune Auto Care centers requires an adequatesupply of skilled labor. In addition, the operating costs and operatingrevenues of such centers may be adversely affected by high turnover in skilledtechnicians. Trained and experienced automotive technicians are in high demand.Accordingly, a center’s ability to increase productivity and revenues could beaffected by its inability to maintain the employment of skilled techniciansnecessary to provide the center’s services. There can be no assurance thatPrecision Tune Auto Care or its franchisees will be able to attract andmaintain an adequate skilled labor force necessary to operate these centersefficiently or that labor expenses will not increase as a result of a shortagein the supply of skilled technicians, thereby adversely impacting its financialperformance.

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*Dependenceon Management and Key Personnel.**  *TheCompany’s success depends to a significant extent on the performance andcontinued services of senior management and certain key personnel. The Companybelieves these individuals possess the necessary experience in financing,operating and managing a company intent on improving its financial performance.The loss of the services of one or more of these key employees could have amaterial adverse impact on its financial condition and results of operations.

*SeasonalNature of Portions of the Business.**  *Seasonal changes may impact various sectors of itsbusinesses and, accordingly, its operations may be adversely affected byseasonal trends in certain periods. In particular, severe weather in wintermonths may make it difficult for consumers in affected parts of the country totravel to Precision Tune Auto Care centers and obtain services.

*Controlby Management and Principal Shareholders.**  *As of August 11, 2006, the Company’s directors,executive officers and shareholders beneficially owning more than 5% of itsoutstanding common stock, in the aggregate, beneficially owned approximately83% of its outstanding common stock. Accordingly, these persons havesubstantial influence over its affairs, including the ability to influence theelection of directors and appointment of management, the outcome of votes byits shareholders on major corporate transactions, including mergers and thesales of substantial assets and other matters requiring shareholder approval.

*FranchisingRegulations.**  *TheCompany is subject to federal, international and state laws and regulations,including the regulations of the Federal Trade Commission as well as similarauthorities in individual states, in connection with the offer, sale andtermination of franchises and the regulation of the franchisor/franchiseerelationship. *See “Business**3⁄4GovernmentRegulation.”*  Its failure to complywith these laws could subject the Company to liability to franchisees and tofines or other penalties imposed by governmental authorities. From time totime, the Company experiences periods during which sales are restricted whilethe Company registers updates of its disclosure material with various states. Suchdelays may have an adverse effect on its ability to offer and sell franchises. Inaddition, the Company may become subject to litigation with, or other claimsfiled with state, federal or international authorities by, franchisees or areadevelopers based on alleged unfair trade practices, implied covenants of goodfaith and fair dealing or express violations of agreements. Accordingly, itsfailure to comply with applicable franchise laws and regulations could have amaterial adverse effect on its financial condition and results of operations.

*Environmental Regulation.**  *Precision Tune Auto Care centers store new lubricantsand handle large quantities of used automotive lubricants and fluids. As aresult of these activities, the Company, its franchisees and area developersare subject to various federal, state and local environmental laws andregulations dealing with the transportation, storage, presence, use, disposaland handling of hazardous materials and hazardous wastes, discharge of stormwater, and underground fuel storage tanks. If any such substances were improperlyreleased or improperly stored on its property or the property of anyfranchisee, including leased properties, or the Company were found to be inviolation of applicable environmental laws and regulations, the Company couldbe responsible for clean-up costs, property damage and fines or otherpenalties, any one of which could have a material adverse effect on itsfinancial condition and results of operations. *See “Business**3⁄4Government Regulation.”*

**EXECUTIVE OFFICERSOF PRECISION AUTO CARE, INC.**

*Louis M. Brown, Jr.*, age 63became Chairman of the Board in October 2003. From October 2003 to May 2006,he was Chairman of the Board and Chief Executive Officer. From August 2000until October 2003, he was the Company’s President and Chief ExecutiveOfficer. He is Vice Chairman of Micros Systems, Inc. since April 2003and was Chairman of the Board from January 1987 to April 2003.

*Robert R. Falconi,*age 52, becameChief Executive Officer in May 2006. He also remains President. From November 2003to April 2006, he was Chief Operating Officer and Chief Financial Officer.From March 2002 to October 2003, he was Executive Vice President andChief Operating Officer/Chief 

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Financial Officer. From September 2000to February 2002, he was the Company’s Vice President—Finance, Administrationand Chief Financial Officer. From August 1998 until September 2000,he was Chief Financial Officer of Apptis, Inc.

*Mark P. Francis,*age 40, becameChief Financial Officer in May 2006. From October 2004 to April 2006,he was Controller. From April 2004 until October 2004, Mr. Franciswas the Assistant Controller of the Company. From December 1999 until April 2004,he was an accounting manager of REHAU, Inc.

*Frederick F. Simmons*, age 44,became Senior Vice President, General Counsel and Secretary in March 2001.From December 1995 to February 2001, he was Assistant General Counseland Assistant Secretary of Advantica Restaurant Group, Inc.

*John T. Wiegand*, age 44, becameSenior Vice President—Operational Programs and Training in March 2002. FromAugust 2000 to March 2002, he was Senior Vice president of FranchiseOperations and from June 1998 to August 2000, he was Vice Presidentof North American Operations. Mr. Wiegand joined WE JAC Corporation, theCompany’s predecessor, as Director of Field Operations in August 1996.

*Kevin Bates*, age 44, becameSenior Vice President of Marketing in August 2004. From October 1999to August 2004, Mr. Bates was Vice President—Marketing andAdvertising. From January 1998 until October 1999, he was ourDirector of Field Operations.

*Joel Burrows*, age 49, became VicePresident—Training/Research and Development in September 1999. From December 1997until September 1999, he was the PTAC Director of Training/Research andDevelopment.

*Glyn D.Massingill*, age 60, became Vice President—Franchise Servicesin January 2000. From September 1990 through December 1999, Mr. Massingillwas Vice President and General Manager of Precision Automotive ComponentsManufacturing and Distribution (PAC), a division of the Company.

**Item 2.**                        *Properties*

The Company’s corporate headquarters are located inapproximately 18,000 square feet of leased office space in Leesburg, Virginiapursuant to a lease that expires in 2009.

In the opinion ofmanagement, the Company’s current space is adequate for its operating needs.

**Item 3.**                        *Legal Proceedings*

From time to time, the Company and its subsidiariesare subject to litigation in the ordinary course of business, includingcontract, franchisee and employment-related litigation. In the course ofenforcing its rights under existing and former franchisee agreements, theCompany is subject to complaints and letters threatening litigation concerningthe interpretation and applicability of these agreements, particularly in casesinvolving defaults and terminations of franchises.

The Company is currently subject to litigation thatcould have a material adverse impact on its liquidity as follows:

***Maureen Jones v. Precision TuneAuto Care, Inc. Precision Franchising LLC, Paul Blakeman, and Complete CarCare LLC***, United States District Court, Western Districtof Oklahoma, Case No.: 06-CV-506, filed July 26, 2006,served August 14, 2006.

Complete Car Care LLC, (CCC) and Precision FranchisingLLC (the “Franchisor”) are parties to a Precision Tune Auto Care FranchiseAgreement (the “Franchise Agreement”) for the operation of a Precision TuneAuto Care center (the “Center”) in Oklahoma City, Oklahoma.

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Plaintiff Maureen Jones, a former employee of CCC,alleges that agents of CCC engaged in discrimination against her on account ofher gender. Plaintiff also claims retaliatory behavior subsequent to herinitial complaint. Plaintiff is suing under Title VII of the Civil Rights Actof 1964, and is seeking to hold Precision Franchising LLC (“PFL”) and itsaffiliate Precision Tune Auto Care, Inc. (“PTAC”) (collectively “DefendantFranchisor”) vicariously liable. In her complaint, Plaintiff asks for damagesin excess of $75,000.

Under the terms of the Franchise Agreement, CCC andPaul Blakeman (pursuant to the terms of a guarantee agreement) are required toindemnify and hold harmless the Defendant Franchisor for all claims made inconnection with the operation of the Center. Accordingly, Defendant Franchisorsent to CCC on August 14, 2006 a letter demanding that CCC respond toPlaintiff’s complaint and hold Defendant Franchisor harmless.

To date, CCC and Paul Blakeman have retained counseland have provided assurances that they will seek to have the Defendant Franchisorremoved from the suit.

Defendant Franchisor has retained counsel and filed ananswer on September 5, 2006 denying the allegations of plaintiff. DefendantFranchisor believes that it is not a proper party to the suit and will take allappropriate steps to obtain a dismissal.

***Precision Franchising LLC v. IraA. Starr and Barbara Starr***, USDC ED VA (AlexandriaDistrict), 1:06cv505, Filed: May 2, 2006.

Defendants are Precision Tune Auto Care (“PTAC”)franchisees (“Franchisees”) whose Precision Tune Auto Care Franchise Agreement(the “Franchise Agreement”) expired in June 2006. Upon execution of theFranchise Agreement in 1995, the Franchisees and Franchisees’ landlord enteredinto an Agreement and Contingent Assignment of Lease (“ACAL”). Upon the expirationof the Franchise Agreement, the ACAL permits Precision Franchising LLC (“PFL”)to assume Franchisees’ lease to the premises (the “Premises”) on which theyoperate the franchised business. Unbeknownst to PFL, the Franchisees purchasedfrom their landlord the Premises.

Franchisees subsequently expressed their desire not torenew the Franchise Agreement upon expiration; in turn, PFL then stated itsintention to exercise its option under the ACAL. However, upon expiration ofthe Franchise Agreement, Franchisees refused to honor PFL’s rights under theACAL and commenced operating on the Premises a non-PTAC automobile maintenancebusiness. The operation of such a business violates a non-competition covenantwithin the Franchise Agreement.

On April 24, 2006, Ira Starr, Barbara Starr andAllStarr Car Care, Inc. filed a complaint in the Circuit Court of KanawhaCounty, West Virginia against Precision Tune, Inc., PFL, GrimaudEnterprises, Inc. and David Grimaud (“Franchisor”). The suit was notserved on Precision Tune Inc. until June 19, 2006 and was not served onPFL until June 20, 2006. Franchisees seek to enjoin the Franchisordefendants from (i) exercising the option under the ACAL, and (ii) enforcingthe non-competition covenant. To date, no monetary damages have been specified.In their complaint, Franchisees make a claim for promissory estoppel byalleging Franchisor’s misrepresentations induced Franchisees to sign theFranchise Agreement. Franchisees also allege Franchisor breached the FranchiseAgreement by failing to fulfill its obligations there under. PFL believesneither claim has merit and both are pretexts to obscure Franchisees’ violationof the ACAL and non-competition covenants.

On May 2, 2006, PFL filed a complaint in theFederal District Court for the Eastern District of Virginia against theFranchisees. PFL seeks to enforce the non-competition covenants and the ACAL,and prevent Franchisees from continuing to use PFL’s proprietary point-of-salesoftware. PFL seeks more than $75,000 in damages and seeks to enjoinFranchisees from operating an automotive maintenance business on the Premises.

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On July 10, 2006, Franchisees served PFL withtheir answer, moved to dismiss or, in the alternative, transfer venue, and madea counterclaim for breach of contract, declaration of rights and to quiet titleto real property. On July 24, 2006 PFL filed its opposition to Franchiseesmotion to dismiss or transfer venue.  On July 31,2006 Franchisees filed their rebuttal to opposition to dismiss or transfervenue. On August 11, 2006, a motion hearing was held in the US DistrictCourt in the Eastern District of Virginia regarding Franchisees’ motion totransfer the case and motion to dismiss. The judge took both motions underadvisement.

On August 21, 2006, the judge ruled in favor ofPFL and PFL successfully obtained removal and consolidation of all claims intoa single suit, *Precision Franchising LLC v.Ira A. Starr and Barbara Starr,* to be adjudicated in the FederalDistrict Court for the Eastern District of Virginia.

***Barras, et al. v. Precision TuneAuto Care, Inc.***, 16th Judicial District Court, St.Martin Parish, Louisiana, docket numbers 70616-F, 70629-B, 70628-B,70630-D, filed May 18, 2006 (Barras) and May 24, 2006(Escuriex, Berard-Linford, Bergeron). Served May 26, 2006 (Barras), May 30,2006 (Berard-Linford, Bergeron), May 31, 2006 (Escuriex).

On May 21, 2005, an automobile operated by StevenBerard (“Berard”), in which Andrew Barras, Jr. (“Barras”), Berard’s sisterStephanie Domingue (“Domingue”), and Windi Bergeron (“Bergeron”) werepassengers, crossed into oncoming traffic and struck an automobile driven byJennifer W. Escuriex (“Escuriex”). Domingue, Bergeron, and Escuriex were eachinjured (as well as four of Escuriex’s passengers), while Barras and Berard werekilled. The automobile operated by Berard was actually owned by Berard’sgrandmother, Jacqueline Berard.

On May 18, 2006, plaintiffs Andrew J. Barras, Sr.and Kathy T. Barras (the “Barrases”) filed a Petition for Damages againstPrecision Tune Auto Care, Inc. (“PTAC”) on behalf of the estate of theirson Barras. PTAC is one of more than a dozen defendants; co-defendants includethe State of Louisiana, Berard, Jacqueline A. Berard, Wal-Mart (as well asseveral subsidiaries thereof), Ford Motor Company, State Farm and TRWAutomotive. The Barrases claim that PTAC was negligent in servicing, modifying,repairing, and/or inspecting Jacqueline Berard’s automobile, thereby making theaccident and resulting death more likely. Although the exact amount sought is notspecified in the Petition for Damages, the Barrases seek compensation formedical treatment, funeral expenses, and pain and suffering.

On May 24, 2006, Escuriex, ClaudetteBerard-Linford (“Berard-Linford”) (mother of Berard) on behalf of her sonBerard and daughter Domingue, and Bergeron, each filed a Petition for Damagesagainst PTAC. As in the Barras Petition for Damages, PTAC is one of more thandozen co-defendants. Escuriex, Berard-Linford, and Bergeron each claim thatPTAC was negligent in servicing, testing and/or inspecting Jacqueline Berard’sautomobile, thereby making the accident and resulting injuries more likely.

Plaintiffs  seekcompensation for medical treatment, physical and mental pain and suffering,disability, loss of society, past and future loss of income and earningcapacity, and past and future loss of enjoyment of life (although no exactamount is specified in the Petition for Damages).

PTAC intends to vigorously defend the claims filedagainst it, and has filed answers to each of the Petitions. At this time, thereis no evidence that Jacqueline Berard had her vehicle serviced by a PrecisionTune Auto Care franchise and, if she did, PTAC and the franchisee have anindependent contractor relationship since PTAC does not in any way control thebusiness operations of its franchisees. Furthermore, the franchisee’s insurancecarrier has agreed to provide a defense and has retained counsel for thatpurpose. On July 13, 2006, PTAC filed its response to Bergeron andBerard-Linford’s respective Petitions for Damages; on July 14, 2006, PTACfiled its response to Barras’s Petition for Damages; On July 16, 2006,PTAC filed its response to Escuriex’s Petition for Damages. In each case, PTACdenied the allegations asserted against it.

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***Shaw v. Precision Tune Auto Careand Mark Hall***, State of South Carolina, County ofGreenville, Court of Common Pleas, 13th Judicial Circuit, Case No.: 2006-CP-23-3737,filed and served 6/19/2006.

Plaintiff Tammy Shaw claims that the employees ofWoodruff Road Tune, Inc. (“Woodruff”), a Precision Tune Auto Carefranchisee, caused damage to her vehicle.  The named defendant, Mark Hall, is an agent ofWoodruff. Plaintiff seeks actual damages not to exceed $9,999.99, attorney’sfees, and the costs of the action.

Because Woodruff is contractually obligated toindemnify PTAC and because PTAC and Woodruff are independent contractors, PTACdoes not expect to incur liability.  PTACsent to Woodruff on June 19, 2006 a letter demanding that Woodruff holdPTAC harmless for all claims asserted by Shaw. Accordingly, Woodruff’sinsurance carrier has retained counsel to defend both Woodruff and PTAC’sinterests. On August 18, 2006, defendants filed their answer; eachallegation was denied, and it was asserted that PTAC is not a proper defendantdue to: (i) the independent contractor relationship between PTAC andWoodruff; and (ii) the fact that “PTAC” is merely a trademarked brand nameand Precision Franchising LLC is the actual corporate entity.

***United Bank, NA v. C. EugeneDeal, Miracle Partners, Inc., Star Auto Center, Inc.***,Common Pleas Court of Cuyahoga County, Ohio, Case No. 01-CV0019,Filed January 11, 2001.

Miracle Partners, Inc., a wholly-owned subsidiaryof the Company, was party to a confessed judgment of approximately $1.3 million.The subsidiary is currently inactive and has no assets. As such, managementbelieves this judgment will have no material impact on the Company’sconsolidated results of operations. Furthermore, the Company believes that ithas a meritorious claim against Mr. Deal for misrepresentations made inconnection with PACI’s acquisition of Miracle Partners, Inc. in 1997 forall amounts covered by the judgment.

***Lumnivision, S.A. de C.V. v.Praxis Afinaciones, S.A. de C.V.***, Third Civil Court,First Judicial District, Monterrey, Nuevo Laredo, Mexico.

Lumnivision filed suit against Praxis Afinaciones, anindirect wholly owned subsidiary of PACI, seeking payment of 766,000 MexicanPesos, plus interest at the rate of 5% per month, for services under a contract.Praxis Afinaciones denies the allegations and is defending the allegations inthe lawsuit.

The Company does notbelieve that any of the above claims or proceedings will result in a materialjudgment against the Company or any of it’s subsidiaries. There can be noassurance, however, that these suits will ultimately be decided in its favor. Anyone of these claims or proceedings may result in a material judgment againstthe Company, which could cause material adverse consequences to its operations.

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

None.

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**PART II**

**Item 5.**                        *Market for Common Equity and Related Stockholder Matters*

The Company’s common stock, par value $.01 per share (‘‘CommonStock’’) is publicly traded on the National Association of Security DealersInc.’s OTC Bulletin Board and is quoted under the symbol “PACI.’’

The following table sets forth the high and low salesprices on NASD OTC Bulletin Board for the Common Stock during the fiscal yearsended June 30, 2006, and June 30, 2005, respectively. To date, theCompany has not paid any Common Stock dividends and does not anticipate payingany Common Stock dividends in the foreseeable future; however dividends arecurrently being paid on the Company’s Series A redeemable preferred stock(see “Management’s Discussion and Analysis or Plan of Operation—Liquidity andCapital Resources”).

These over the countermarket quotations reflect inter-dealer prices, without retail mark-up,markdown, or commission, and may not necessarily represent actual transactions.

**Fiscal Year Ended June 30, 2006**

| **Quarter** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------|------------|------------|------------|----------|------------|---------|------------|
| First       |       | $          | 1.10       |     | $          | 0.85    |       |
| Second      |       | 1.00       |       | 0.67     |       |
| Third       |       | 0.80       |       | 0.55     |       |
| Fourth      |       | 0.70       |       | 0.55     |       |
|             |            |            |            |          |            |         |            |  |  |

 

**Fiscal Year Ended June 30, 2005**

| **Quarter** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------|------------|------------|------------|----------|------------|---------|------------|
| First       |       | $          | 0.90       |     | $          | 0.55    |       |
| Second      |       | 1.17       |       | 0.62     |       |
| Third       |       | 1.30       |       | 0.95     |       |
| Fourth      |       | 1.10       |       | 0.90     |       |
|             |            |            |            |          |            |         |            |  |  |

 

As of August 11,2006, there were approximately 188 record holders of Common Stock andapproximately 1,200 beneficial owners of the Company’s Common Stock.

**Equity Compensation Plan Information**

| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted average exercise  price of outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                              | ** ** | **(c)**                                                                                                              | ** ** |
| Equity  compensation plans approved by security holders     |       |       | 1,491,700  |                                                                                                                                                 |       |                                                                                                                 | 0.89       |                                                                                        |       |   | 921,997 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                                                 |       |                                                                                                                 | —     |                                                                                        |       |   | — |   |   |
| Total                                                       |       |       | 1,491,700  |                                                                                                                                                 |       |                                                                                                                 | 0.89       |                                                                                        |       |   | 921,997 |   |   |

 

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

**Introduction**

The following discussionshould be read in conjunction with the consolidated Financial Statements of theCompany and related notes thereto included elsewhere herein.

**Overview**

Precision Auto Care is a global franchisor of autocare centers. Company revenues are derived from three primary areas: franchisedevelopment, royalties, and product sales. Franchise development revenuesinclude sales of franchises and master licenses. Royalty revenues are derivedfrom royalty fees paid by individual franchisees to the Company based onqualified retail sales by the franchisee. Product revenues are derived from thesale of automotive related supplies and equipment to individual franchisees.

Direct costs consist of fees paid to area developersfor the sale of new franchises and for supporting franchisees on an ongoingbasis, other costs associated with directly supporting the franchise system,and the cost of automotive related supplies. General and administrativeexpenses include all legal, accounting, general overhead, informationtechnology and corporate staff expenses. Other income and expense items includeinterest income and expense which are included within the non-operatingincome/expense category on the Statement of Operations.

The Company has one business segment, Automotive CareFranchising. The Automotive Care Franchising business segment providesautomotive services primarily through franchised operations located in theUnited States and in certain foreign countries.

The Company’s core autocare and franchising business continues to benefit from an improved focus onunit economics, offering certain product services to the franchisees such asequipment and other marketing related materials as well as in the fieldtraining programs. Additionally, the Company is seeking growth throughacquisitions.

**Critical AccountingPolicies**

The following is a summaryof the Company’s critical accounting policies. For a full description of theseand other accounting policies, see Note 1 of the Notes to the ConsolidatedFinancial Statements. These critical accounting policies require estimates andassumptions that affect the amounts of assets, liabilities, revenues andexpenses reported in the consolidated financial statements. Due to theirnature, estimates involve judgments based on available information. Actualresults or amounts could differ from estimates and the difference could have amaterial impact on the consolidated financial statements. Therefore,understanding these policies is important in understanding the reported resultsof operations and the financial position of the Company.

*Revenue Recognition*

The Company enters into domestic Area Developmentagreements and international Master License agreements which grant the areadeveloper and master licensor, respectively, the right to sell, on theCompany’s behalf, Precision Tune Auto Care franchises within a specificgeographic region. Revenue from the sale of Area Development agreements andinternational Master License agreements is recognized as all material servicesor conditions related to the agreements are satisfied.

Revenue from the sale of a franchise is recognizedwhen all material services and conditions have been satisfied, generally at theopening of the franchised center.

The Company’s royalty revenue is recognized as earnedin accordance with the specific terms of each agreement and to the extent noknown issues involving collection exist. In the case when revenues are not 

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likely to be collected,the Company establishes reserves for such amounts. Such reserves are based uponour historical collection experience with the various franchisees taking intoconsideration the financial stability of such franchisees.

Product services in theform of equipment and other marketing materials related sales are recognizedupon delivery to the franchisee.

*Goodwill andIntangible Assets*

Statement of FinancialAccounting Standards (SFAS) No. 142, “Goodwill and Intangible Assets”,requires that goodwill no longer be amortized, but instead be tested forimpairment at least annually. The Company engaged a valuation specialist infiscal year 2005 to assist management with its test for impairment. The fairvalue of franchising operations was estimated utilizing a discounted cash flowapproach that estimates revenue, driven by assumed market growth rates and appropriatediscount rates. These estimates are consistent with the plans and estimatesmanagement uses to manage the underlying business. The Company carried forwardthe valuation from fiscal year 2005 for the current year analysis since thefair value of the franchising operations exceeded its carrying value by asubstantial margin and the fact that there have been no events andcircumstances that have had a material impact on the franchising operationssince the most recent fair value determination. Impairment testing is performedin the first quarter of each fiscal year. Based upon the above analysis,management has concluded that the $8.7 million carrying value of goodwill wasnot impaired.

*Deferred TaxValuation Allowance*

The Company recognizes deferred income tax liabilitiesand assets for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns. Deferred tax liabilitiesand assets reflect the effects of tax losses and the future income tax effectsof temporary differences between the consolidated financial statement carryingamounts of existing assets and liabilities and their respective tax bases andare measured using enacted tax rates that apply to taxable income in the yearsin which those temporary differences are expected to be recovered or settled. TheCompany recognizes deferred tax assets if it is more likely than not that theasset will be realized in future years.

The Company regularlyreviews the recoverability of its deferred tax assets and establishes avaluation allowance as deemed appropriate. In assessing the need for avaluation allowance against the deferred tax asset, management considersfactors such as future reversals of existing taxable temporary differences, taxplanning strategies and future taxable income exclusive of reversing temporarydifferences and carryforwards. As of June 30, 2006, the Company had recordeddeferred tax assets totaling $3.1 million, net of a $2.9 millionvaluation allowance.

**New AccountingPronouncement**

In July 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes—an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN48 clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with FAS 109, “Accounting forIncome Taxes”. FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. The requirements of FIN 48 areeffective for our fiscal year beginning July 1, 2007. The Company is inthe process of evaluating this guidance and therefore has not yet determinedthe impact that FIN 48 will have on our financial statements upon adoption.

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**Results ofOperations**

**Comparison of theyear ended June 30, 2006 to the year ended June 30, 2005**

**Summary (in thousands)**

| ** **                                    | ** ** | **Twelve Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                             | ** ** | **%** | ** ** | **2005** | ** ** | **%** | ** ** |
| Automotive care  franchising revenue          |       | $                                                    | 11,385     |   | 97 |   | $ | 12,347 |   | 96 |   |
| Other                                         |       | 334                                                  |       | 3 |   | 456 |   | 4 |   |
| Total revenues                                |       | $                                                    | 11,719     |   | 100 | % | $ | 12,803 |   | 100 | % |
| Automotive care  franchising direct cost      |       | 7,188                                                |       | 61 |   | 7,181 |   | 57 |   |
| Other                                         |       | 286                                                  |       | 3 |   | 395 |   | 3 |   |
| Total direct cost                             |       | 7,474                                                |       | 64 |   | 7,576 |   | 60 |   |
| General and  administrative                   |       | 2,999                                                |       | 25 |   | 3,486 |   | 26 |   |
| Depreciation  expense                         |       | 67                                                   |       | 1 |   | 111 |   | 1 |   |
| Operating income                              |       | 1,179                                                |       | 10 |   | 1,630 |   | 13 |   |
| Other income                                  |       | 134                                                  |       | 1 |   | 58 |   | 0 |   |
| Earnings before  taxes                        |       | 1,313                                                |       | 11 |   | 1,688 |   | 13 |   |
| Income taxes                                  |       | 590                                                  |       | 5 |   | (2,967 | ) | (23 | ) |
| Net income                                    |       | 723                                                  |       | 6 |   | 4,655 |   | 36 |   |
| Preferred stock  dividends                    |       | 2                                                    |       | — |   | 30 |   | — |   |
| Net income applicable to  common shareholders |       | $                                                    | 721        |   | 6 | % | $ | 4,625 |   | 36 | % |

 

*Revenue.*   Totalrevenue for the year ended June 30, 2006 was $11.7 million, a decrease ofapproximately $1.1 million, or 8%, compared with total revenue of $12.8 millionfor the year ended June 30, 2005.

Automotive care franchising revenue for the year endedJune 30, 2006 was $11.4 million, a decrease of approximately $962,000, or8%, compared with automotive care revenue of $12.3 million for the year ended June 30,2005. The decrease was primarily due a decrease in franchise developmentrevenue of $894,000. In fiscal year 2005, the Company sold the Area Developmentrights to three markets which resulted in franchise development revenue ofapproximately $600,000. Specifically, during the first quarter of fiscal year2005, franchise development revenue increased due to the Company signing anarea development agreement with North Pacific Precision, Inc. for the arearights for the Seattle market. Under the agreement, North Pacific Precision, Inc.paid $500,000 for the area developer rights. Such fees were recognized uponexecution of the agreement since all significant obligations under theagreement were satisfied at that time. The Company also recognized revenue ofapproximately $59,000 and $40,000, respectively, for the sale of the arearights for the San Diego and Colorado markets. Additionally, during fiscal year2005, the Company signed two master franchise agreements. The Companyrecognized revenue of $53,000 and $193,000 in connection with the signing ofthe China master franchising agreement for the year ended June 30, 2006and 2005, respectively. The Company recognized revenue upon receipt of paymentfrom the international franchisee as all significant obligations were satisfiedupon execution of the agreement (see Note 3 of the Consolidated FinancialStatements). The Company also signed a master franchise agreement withPrecision—Sociedade Gestora de Franchising S.A. de C.V. giving that corporationa license to operate and open at least 180 Precision Tune Auto Care (PTAC) carcare centers in Spain. The Company recognized revenue of $150,000 in connectionwith the signing of the master franchise agreement for the twelve months ended June 30,2005 since all significant obligations under the agreement were satisfied atthat time (see Note 3 of the Consolidated Financial Statements). The additionaldecrease in automotive care franchising revenue of approximately $68,000 wasthe net impact of an increase in distribution sales and a decrease in domesticand international royalty revenue.

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The Company recognized revenue from foreign franchiseeoperations of $311,000 and $614,000 for the fiscal years ended June 30,2006 and 2005, respectively. This decrease was primarily due to the $193,000 ofrevenue recognized from the China master franchise agreement during the fiscalyear ended June 30, 2005 and only $53,000 during the fiscal year ended June 30,2006. The Company terminated the China master franchise agreement during thenine months ended March 31, 2006 (see Note 3 of the Consolidated FinancialStatements). Additionally, the Company recognized revenue of $150,000 from theSpain master franchise agreements in 2005, there was no comparable revenuerecognized in 2006.

Other revenue for the year ended June 30, 2006was $334,000, a decrease of approximately $122,000, or 27%, compared to$456,000 for the year ended June 30, 2005. The decrease in other revenuewas primarily due to the cessation of support revenue from the Shell-Mexicotransaction which occurred in December 2004, a decrease in trainingrevenue offset by an increase from support fees associated with the new “SoftWrench”point of sale system.

*DirectCost.*   Total direct cost for the year ended June 30,2006 totaled $7.5 million, a decrease of approximately $102,000 or 1%, comparedwith $7.6 million for the year ended June 30, 2005.

Automotive care franchising direct cost for the yearended June 30, 2006 totaled $7.2 million, which was comparable to the yearended June 30, 2005.

Other direct cost for the year ended June 30,2006 totaled $286,000, a decrease of $109,000 or 28%, compared with $395,000for the year ended June 30, 2005. This decrease was primarily attributedto the termination of the agreement to provide support to Shell-Mexico as thatagreement was completed as of December 31, 2004 offset by the net impactof an increase of approximately $55,000 from support costs associated with thenew point of sale system and a decrease in training expenses of $13,000.

*Generaland Administrative Expense.*   General andadministrative expense was $3.0 million for the year ended June 30, 2006,a decrease of approximately $487,000 or 14%, compared with $3.5 million for theyear ended June 30, 2005. For the year ended June 30, 2006, theCompany recorded a benefit of approximately $207,000 related to variableaccounting for certain outstanding stock options because the Company’s stockprice declined over the last twelve months. Conversely, in the year ended June 30,2005, the Company recorded compensation expense of approximately $97,000 as aresult of an increase in the Company’s stock price over the related twelvemonth period. The balance of this decrease was due to a decrease in legalexpense as well as the result of management’s on-going cost reductioninitiatives in general and administrative costs.

*OperatingIncome.**  *TheCompany recorded operating income for the year ended June 30, 2006 ofapproximately $1.2 million, a decrease of $451,000, or 28%, compared with anoperating income of $1.6 million for the year ended June 30, 2005. Asdiscussed previously, for the year ended June 30, 2005, the Companyrecognized revenue for the signing of various area development agreements aswell as the signing of the China and Spain master franchising agreements whichbolstered operating income. There were no comparable transactions for the yearended June 30, 2006.

*OtherIncome.**  *TheCompany recorded other income of $134,000 for the year ended June 30,2006, an increase of approximately $76,000 or 131% compared to $58,000 in otherincome for the year ended June 30, 2005. This increase is primarily due toan increase in interest income.

*IncomeTaxes.**  *TheCompany’s effective tax rate for the year ended June 30, 2006 was 45% ascompared to (176%) for the year ended June 30, 2005. The increase inthe effective tax rate is due to the discrete release of $3 million to thevaluation allowance that occurred during the year ended June 30, 2005 forwhich there was no comparable adjustment made in the year ended June 30,2006.

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*Net Income Applicable toCommon Shareholders and Earnings Per Share.*   TheCompany recorded Net Income Applicable to Common Shareholders of $721,000, or$0.02 per share, for the year ended June 30, 2006 compared to $4.6million, or $0.18 per share, for the year ended June 30, 2005.

**Liquidity andCapital Resources**

**Sources and Uses ofCash**

Cash at June 30, 2006 was $4.4 million. Duringthe period, cash provided by operations was $1.2 million.

Cash used in investing activities for the twelvemonths ended June 30, 2006 was $42,000 resulting primarily from thepurchase of property and equipment for use in the Company’s franchiseoperations.

Cash provided by financing activities for the twelvemonths ended June 30, 2006 was $7,000 and the financing activities duringthe period consisted primarily of the net impact of proceeds from the exerciseof stock options and warrants of $42,000 and the payments of dividends andnotes payable of $34,000.

Management believes thatthe Company’s current cash balance, cash generated from operations, and theavailable $250,000 credit line will be sufficient to meet the Company’s workingcapital needs, capital expenditures, and contractual obligations for fiscalyear 2007.  At June 30, 2006, theentire line of credit was available.

**Equity Transactions**

In March 2005, 4,472,270 warrants were exercisedpursuant to an agreement the Company reached with Precision Funding, L.L.C. andformer board members in October 2002. Upon the exercise of these warrantsat the previously agreed to exercise price of $0.44 per share, the holderspurchased 4,472,270 restricted shares of common stock by surrendering 189,942shares of Series A Preferred Stock to the Company, therefore, there wereno cash proceeds received by the Company from this transaction.

In March 2005, 36,380 warrants were exercisedpursuant to an agreement the Company reached to restructure the Board LLCsubordinated debt. Upon the exercise of these warrants at the previously agreedto exercise price of $0.44 per share, the holder purchased 36,380 restrictedshares of common stock by surrendering 1,545 shares of Series A PreferredStock to the Company, therefore, there were no cash proceeds received by theCompany from this transaction.

In March 2005, 10,000 warrants were exercisedpursuant to an agreement the Company reached to restructure the Board LLCsubordinated debt. Upon the exercise of these warrants at the previously agreedto exercise price of $0.44 per share, the holder purchased 10,000 restrictedshares of common stock for $4,400.

In August 2005,10,000 warrants were exercised pursuant to an agreement the Company reached torestructure the Board LLC subordinated debt. Upon the exercise of thesewarrants at the previously agreed to exercise price of $0.44 per share, theholder purchased 10,000 restricted shares of common stock for $4,400.

**Line-of-Credit**

In February 2006, theCompany renewed the $250,000 line of credit with Chevy Chase Bank. The interestrate on this line of credit is indexed to the Prime Rate as published in *The Wall Street Journal*(8.25% at June 30, 2006) andthe Company has pledged the assets of its wholly-owned subsidiaries ascollateral. The Company has not borrowed against this line of credit.

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**Seasonality andQuarterly Fluctuations**

Seasonal changes may impact various sectors of theCompany’s business differently and, accordingly, the Company’s operations maybe affected by seasonal trends in certain periods. In particular, severeweather in winter months can adversely affect the Company because such weathermakes it difficult for consumers in affected parts of the country to travel toPrecision Auto Care centers.

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**Item 7.**                        *Financial Statements*

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors andStockholders of Precision Auto Care, Inc. and Subsidiaries

We have audited the accompanying consolidated balancesheets of Precision Auto Care, Inc. (the Company) and subsidiaries as of June 30,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity and cash flows for the years then ended. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audits to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove, present fairly, in all material respects, the consolidated financialposition of Precision Auto Care, Inc. and subsidiaries as of June 30,2006 and 2005, and the consolidated results of its operations and its cashflows for the years then ended in conformity with accounting principlesgenerally accepted in the United States of America.

/s/ GRANT THORNTON LLP

McLean, VirginiaSeptember 13, 2006

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**PRECISION AUTO CARE, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                   | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                   | ** ** | ** **              | ** ** | ** **              | ** ** |
| Current assets:                                                                                                              |       |                    |       |                    |       |
| Cash and cash  equivalents                                                                                                   |       | $                       | 4,441,850  |                    | $          | 3,279,568 |   |
| Accounts receivable, net  of allowance of $228,642 and $60,971, respectively                                                 |       | 499,364                 |       | 640,271                 |       |
| Notes receivable, net of  allowance of $184,856 and $100,586, respectively                                              |       | 115,145                 |       | 207,314                 |       |
| Deferred tax asset                                                                                                           |       | 447,710                 |       | 479,824                 |       |
| Other assets                                                                                                                 |       | 395,737                 |       | 344,593                 |       |
| Total current assets                                                                                                         |       | 5,899,806               |       | 4,951,570               |       |
| Property and equipment,  net                                                                                                 |       | 121,681                 |       | 108,431                 |       |
| Goodwill                                                                                                                     |       | 8,711,744               |       | 8,711,744               |       |
| Notes receivable, net of  allowance of $269,222 and $311,542, respectively                                              |       | 140,385                 |       | 80,146                  |       |
| Deferred tax asset                                                                                                           |       | 2,667,970               |       | 3,143,968               |       |
| Deposits and other                                                                                                           |       | 23,685                  |       | 24,314                  |       |
| Total assets                                                                                                                 |       | $                       | 17,565,271 |                    | $          | 17,020,173 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                               | ** ** | ** **              | ** ** | ** **              | ** ** |
| Current liabilities:                                                                                                         |       |                    |       |                    |       |
| Line-of-credit                                                                                                               |       | $                       | —     |                    | $          | — |   |
| Notes payable and capital  lease obligation—current                                                                     |       | 7,853                   |       | 19,346                  |       |
| Accounts payable and  accrued liabilities                                                                                    |       | 255,138                 |       | 344,414                 |       |
| Taxes payable                                                                                                                |       | 565,541                 |       | 547,235                 |       |
| Accrued commission  payable                                                                                                  |       | 314,077                 |       | 421,524                 |       |
| Accrued salaries and  related expenses                                                                                       |       | 375,648                 |       | 368,181                 |       |
| Due to related party                                                                                                         |       | 167,053                 |       | 116,073                 |       |
| Deferred revenue                                                                                                             |       | 320,029                 |       | 253,322                 |       |
| Total current liabilities                                                                                                    |       | 2,005,339               |       | 2,070,095               |       |
| Notes payable and  capital lease obligation, net of current portion                                                          |       | 35,346                  |       | 7,991                   |       |
| Total liabilities                                                                                                            |       | 2,040,685               |       | 2,078,086               |       |
| Commitments and  contingencies                                                                                               |       | —                  |       | —                  |       |
| Series A redeemable  preferred stock, $.01par value; 1,000,000 shares authorized; 11,227 shares  issued and outstanding |       | 116,312                 |       | 116,312                 |       |
| Stockholders’ equity:                                                                                                   |       |                    |       |                    |       |
| Common stock, $.01 par  value; 39,000,000 shares authorized; 28,993,752 and 28,862,252 shares issued  and outstanding        |       | 289,938                 |       | 288,623                 |       |
| Additional paid-in  capital                                                                                                  |       | 67,809,836              |       | 67,949,970              |       |
| Accumulated deficit                                                                                                          |       | (52,691,500             | )          | (53,412,818             | )          |
| Total stockholders’  equity                                                                                             |       | 15,408,274              |       | 14,825,775              |       |
| Total liabilities and stockholders’ equity                                                                              |       | $                       | 17,565,271 |                    | $          | 17,020,173 |   |

 

See accompanying notes.

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**PRECISION AUTO CARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                           | ** ** | **For The Years Ended  June 30,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                              | ** ** | **2005** | ** ** |
| Revenue:                                                             | ** ** | ** **                                            | ** ** | ** ** | ** ** |
| Franchise royalties                                                  |       | $                                                     | 10,948,289 |   | $ | 11,015,897 |   |
| Franchise development                                                |       | 436,454                                               |       | 1,330,768 |   |
| Other                                                                |       | 334,524                                               |       | 456,314 |   |
| Total revenues                                                       |       | 11,719,267                                            |       | 12,802,979 |   |
| Direct cost:                                                         |       |                                                  |       |   |   |
| Franchise support and other                                          |       | 7,474,006                                             |       | 7,576,301 |   |
| Contribution margin                                                  |       | 4,245,261                                             |       | 5,226,678 |   |
| General and administrative expense                                   |       | 2,999,518                                             |       | 3,486,448 |   |
| Depreciation  expense                                                |       | 67,284                                                |       | 110,778 |   |
| Operating income                                                     |       | 1,178,459                                             |       | 1,629,452 |   |
| Interest expense                                                     |       | (8,171                                                | )          | (5,508 | ) |
| Other income                                                         |       | 143,000                                               |       | 63,337 |   |
| Total other income                                                   |       | 134,829                                               |       | 57,829 |   |
| Income before income tax expense                                     |       | 1,313,288                                             |       | 1,687,281 |   |
| (Provision)  benefit for income taxes                                |       | (589,644                                              | )          | 2,967,771 |   |
| Net income                                                           |       | 723,644                                               |       | 4,655,052 |   |
| Preferred stock  dividends                                           |       | 2,326                                                 |       | 29,737 |   |
| Net income  applicable to common shareholders                        |       | $                                                     | 721,318    |   | $ | 4,625,315 |   |
| Net income applicable to common stock per common  share—Basic   |       | $                                                     | 0.02       |   | $ | 0.18 |   |
| Net income  applicable to common stock per common share—Diluted |       | $                                                     | 0.02       |   | $ | 0.16 |   |
| Weighted average common shares outstanding—Basic                |       | 28,950,823                                            |       | 25,253,897 |   |
| Weighted average common  shares outstanding—Diluted             |       | 29,647,208                                            |       | 28,186,206 |   |

 

See accompanying notes.

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**PRECISION AUTO CARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

| ** **                                  | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** **  |
|---------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|-----------|-------------|
| Balance at  June 30, 2004              |       | 23,808,602         |       | $                 | 238,086    |                             | $          | 65,619,904               |       | $         | (58,038,133 | ) | $ | 7,819,857 |   |
| Issuance of  common stock                   |       | 5,053,650          |       | 50,537            |       | 2,113,648                        |       | —                   |       | 2,164,185 |        |
| Tax benefit from  exercise of stock options |       | —             |       | —            |       | 114,072                          |       | —                   |       | 114,072   |        |
| Stock based  compensation                   |       | —             |       | —            |       | 102,346                          |       | —                   |       | 102,346   |        |
| Net income                                  |       | —             |       | —            |       | —                           |       | 4,625,315                |       | 4,625,315 |        |
| Balance at  June 30, 2005              |       | 28,862,252         |       | $                 | 288,623    |                             | $          | 67,949,970               |       | $         | (53,412,818 | ) | $ | 14,825,775 |   |
| Issuance of  common stock                   |       | 131,500            |       | 1,315             |       | 40,415                           |       | —                   |       | 41,730    |        |
| Tax benefit from  exercise of stock options |       | —             |       | —            |       | 21,693                           |       | —                   |       | 21,693    |        |
| Stock based  compensation                   |       | —             |       | —            |       | (202,242                         | )          | —                   |       | (202,242  | )           |
| Net income                                  |       | —             |       | —            |       | —                           |       | 721,318                  |       | 721,318   |        |
| Balance at June 30,  2006              |       | 28,993,752         |       | $                 | 289,938    |                             | $          | 67,809,836               |       | $         | (52,691,500 | ) | $ | 15,408,274 |   |

 

See accompanying notes.

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**PRECISION AUTO CARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                         | ** ** | **For The Years Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                              | ** ** | **2005** | ** ** |
| Operating activities:                                                              |       |                                                  |       |   |   |
| Net income applicable  to common shareholders                                      |       | $                                                     | 721,318    |   | $ | 4,625,315 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                                  |       |   |   |
| Depreciation and amortization                                                      |       | 67,284                                                |       | 110,778 |   |
| Bad debt expense                                                                   |       | 133,816                                               |       | 147,296 |   |
| Loss on disposal of property and equipment                                         |       | 9,530                                                 |       | — |   |
| Decrease in valuation allowance                                                    |       | —                                                |       | (3,526,000 | ) |
| Deferred taxes                                                                     |       | 529,805                                               |       | 507,280 |   |
| Stock based (benefit) compensation                                                 |       | (202,242                                              | )          | 102,346 |   |
| Changes in assets  and liabilities:                                                |       |                                                  |       |   |   |
| Restricted cash                                                                    |       | —                                                |       | 50,200 |   |
| Accounts and notes receivable                                                      |       | 39,021                                                |       | (156,966 | ) |
| Prepaid expenses, deposits and other                                               |       | (50,515                                               | )          | (15,749 | ) |
| Accounts payable and accrued liabilities                                           |       | (168,626                                              | )          | 9,186 |   |
| Due to related party                                                               |       | 50,980                                                |       | 24,647 |   |
| Deferred revenue and other                                                         |       | 66,707                                                |       | (142,828 | ) |
| Net cash provided by operating activities                                          |       | 1,197,078                                             |       | 1,735,505 |   |
| Investing  activities:                                                             |       |                                                  |       |   |   |
| Purchases of property and equipment                                                |       | (42,188                                               | )          | (54,804 | ) |
| Net cash used in investing activities                                              |       | (42,188                                               | )          | (54,804 | ) |
| Financing activities:                                                              |       |                                                  |       |   |   |
| Proceeds from issuance of common stock                                             |       | 41,730                                                |       | 180,380 |   |
| Payment of preferred stock dividends                                               |       | (2,326                                                | )          | (33,208 | ) |
| Repayment of notes payable                                                         |       | (32,012                                               | )          | (121,673 | ) |
| Net cash provided by financing activities                                          |       | 7,392                                                 |       | 25,499 |   |
| Net change in cash and cash equivalents                                            |       | 1,162,282                                             |       | 1,706,200 |   |
| Cash and cash equivalents  at beginning of year                                    |       | 3,279,568                                             |       | 1,573,368 |   |
| Cash and cash equivalents at end of period                                         |       | $                                                     | 4,441,850  |   | $ | 3,279,568 |   |
| Cash paid for the  period for:                                                     |       |                                                  |       |   |   |
| Interest                                                                           |       | $                                                     | 8,171      |   | $ | 5,508 |   |
| Income taxes                                                                       |       | $                                                     | 73,748     |   | $ | 68,175 |   |
| Supplemental  schedule of non cash investing and financing activities:             |       |                                                  |       |   |   |
| Property and  equipment acquired under capital lease                               |       | $                                                     | 47,875     |   | — |   |
| Preferred stock exchanged  for issuance of common stock                            |       | $                                                     | —     |   | $ | 1,983,805 |   |

 

See accompanying notes.

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**Precision Auto Care, Inc. and SubsidiariesNotes to Consolidated Financial Statements**

**Note 1—BusinessDescription and Financial Statement Presentation**

Precision Auto Care, Inc.(the ‘‘Company’’) is headquartered in Leesburg, VA and is a franchisor of automotivemaintenance service centers which provide specialized automotive care services,and fast oil change and lube services. These franchisee owned centers operateprimarily under the Precision Tune Auto Care brand name.

**Note 2—Summary ofSignificant Accounting Policies**

*Principles ofConsolidation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated in consolidation.

*Revenue Recognition*

The Company enters into domestic Area Developmentagreements and international Master License agreements which grant the areadeveloper and master licensor, respectively, the right to sell, on theCompany’s behalf, Precision Tune Auto Care franchises within a specificgeographic region. Revenue from the sale of Area Development agreements andinternational Master License agreements is recognized as all material servicesor conditions related to the agreements are satisfied.

Revenue from the sale of a franchise is recognizedwhen all material services and conditions have been satisfied, generally at theopening of the franchised center.

The Company’s royalty revenue is recognized as earnedin accordance with the specific terms of each agreement and to the extent noknown issues involving collection exist. In the case when revenues are notlikely to be collected, the Company establishes reserves for such amounts. Suchreserves are based upon our historical collection experience with the variousfranchisees taking into consideration the financial stability of suchfranchisees.

Product services in theform of equipment and other marketing materials related sales are recognizedupon delivery to the franchisees.

*Cash and CashEquivalents*

Cash and cash equivalents,consisting of certificates of deposit of approximately $2.5 million, arecomprised of highly liquid debt instruments with original maturities of threemonths or less. Cash balances may exceed insured amounts.

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*Property andEquipment*

Propertyand equipment are stated at cost and depreciated on a straight-line basis forbook purposes and accelerated methods for tax purposes over the estimateduseful lives of the related assets. The estimated useful lives are as follows:

| ** **              | ** ** | **Years**     | ** ** |
|-------------------------|------------|---------------|------------|
| Furniture and  fixtures |       | 5-7           |       |
| Equipment               |       | 3-10          |       |
| Other items             |       | 3-7           |       |
| Leasehold improvements  |       | Life of lease |       |

 

*Income Taxes*

The Company recognizesdeferred income tax liabilities and assets for the expected future taxconsequences of events that have been included in the financial statements ortax returns. Deferred tax liabilities and assets reflect the effects of taxlosses and the future income tax effects of temporary differences between theconsolidated financial statement carrying amounts of existing assets andliabilities and their respective tax bases and are measured using enacted taxrates that apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. A valuation allowance isestablished when management is not able to conclude that it is more likely thannot that the assets will be realized in future years.

*Impairment ofLong-Lived Assets*

The Company evaluates thecarrying amount of long-lived assets to be held and used, including goodwilland other intangible assets, when events and circumstances warrant such areview. The carrying amount of a long lived asset is considered impaired whenthe estimated undiscounted cash flow from each asset is less than its carryingamount. In that event, the Company would record a loss equal to the amount bywhich the carrying amount exceeds the fair market value of the long-livedasset.

*Concentration ofCredit Risk*

Financial instruments thatpotentially subject the Company to significant concentrations of credit riskconsist primarily of cash, trade accounts receivable and notes receivable. TheCompany’s cash is held at FDIC insured financial institutions, however, cashbalances may exceed insured amounts. The trade receivable balances aredispersed among a wide customer and franchisee base. The Company routinelyassesses the financial strength of its franchises. The Company maintainsreserves for credit losses, and such losses have been within management’sexpectations.

*Fair Value ofFinancial Instruments*

The Company’s financialinstruments, as defined under SFAS No. 107, Disclosures about Fair Valueof Financial Instruments, include its cash, accounts receivable and accountspayable and line of credit debt. The fair value of cash, accountsreceivable, accounts payable and borrowings outstanding under our line ofcredit approximate their respective carrying values at June 30, 2006 and2005 based on the short-term maturities of these instruments. The Companyholds cash and cash equivalents primarily in one financial institution, whichoften exceed FDIC insured limits. Historically, the Company has not experiencedany losses due to such concentration of credit risk.

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*Advertising Costs*

The Company expenses alladvertising costs as incurred. The Company incurred $10,000 and $60,000 inadvertising costs for the years ended June 30, 2006 and 2005,respectively.

*Use of Estimates inthe Preparation of Financial Statements*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

*Goodwill andIntangible Assets*

Statement of FinancialAccounting Standards (SFAS) No. 142, “Goodwill and Intangible Assets”,requires that goodwill no longer be amortized, but instead be tested forimpairment at least annually. The Company engaged a valuation specialist infiscal year 2005 to assist management with its test for impairment. The fairvalue of franchising operations was estimated utilizing a discounted cash flowapproach that estimates revenue, driven by assumed market growth rates and appropriatediscount rates. These estimates are consistent with the plans and estimatesmanagement uses to manage the underlying business. The Company carried forwardthe valuation from fiscal year 2005 for the current year analysis since thefair value of the franchising operations exceeded its carrying value by asubstantial margin and the fact that there have been no events andcircumstances that have had a material impact on the franchising operationssince the most recent fair value determination. Impairment testing is performedin the first quarter of each fiscal year. Based upon the above, managementhas concluded that the $8.7 million carrying value of goodwill was notimpaired.

*Segment Reporting*

The Company operates inone business segment; Automotive Care Franchising.

*Stock Options*

The Company appliesAccounting Principles Board (APB) Opinion No. 25, ‘‘Accounting for StockIssued to Employees’’, and related interpretations in accounting for stockoptions issued to employees and presents pro forma net income and earnings pershare data as if the fair value method prescribed by Statement of FinancialAccounting Standards No. 123, ‘‘Accounting for Stock Based Compensation’’had been applied. Compensation expense is recorded when modifications and otherprovisions cause the application of variable accounting or require a newmeasurement date.

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Hadcompensation cost for all options been determined based on the fair value atthe grant dates during the years ending June 30, 2006 and 2005 consistentwith the method of SFAS No. 123, the pro forma net income and income pershare would have been as follows:

| ** **                                                                                                               | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Net income  applicable to common shareholders                                                                            |       | $                                      | 721,318    |   | $ | 4,625,315 |   |
| (Deduct) add:  Total stock-based compensation (benefit) expense reported in net income under  the intrinsic value method |       | (202,242                               | )          | 102,346 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards                 |       | 114,910                                |       | 163,407 |   |
| Pro forma net  income                                                                                                    |       | $                                      | 404,166    |   | $ | 4,564,254 |   |
| Earnings per share:                                                                                                      |       |                                   |       |   |   |
| Basic—as reported and pro forma                                                                                     |       | $                                      | 0.01       |   | $ | 0.18 |   |
| Diluted—as reported and pro forma                                                                                   |       | $                                      | 0.01       |   | $ | 0.16 |   |
| Weighted average shares:                                                                                                 |       |                                   |       |   |   |
| Weighted average  common shares outstanding—Basic                                                                   |       | 28,950,823                             |       | 25,253,897 |   |
| Weighted average common  shares outstanding—Diluted                                                                 |       | 29,647,208                             |       | 28,186,206 |   |

 

Certain outstanding stock options are subject tovariable accounting. In the year ended June 30, 2006, the Company recordeda benefit of approximately $207,000 as a result of a decline in the Company’sstock price over the previous twelve months. Conversely, in the year ended June 30,2005, the Company recorded compensation expense of approximately $97,000 as aresult of an increase in the Company’s stock price over the related twelve monthperiod.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialStands No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)), whichis a revision of SFAS 123. SFAS 123(R) supersedes APB 25. Generally, theapproach in SFAS 123(R) is similar to the approach described in SFAS 123.However, SFAS 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values. Pro forma disclosure is no longer analternative.  The Company will adopt thisstandard effective July 1, 2006 using the modified prospective applicationmethod. Under the modified prospective application method, the Company willrecognize compensation cost in its consolidated financial statements for allawards granted after June 30, 2006 and to awards modified, repurchased orcancelled after the effective dates. Additionally, compensation cost for theportion of awards for which the requisite service has not been rendered (suchas unvested options) that are outstanding as of the date of adoption shall berecognized as the remaining requisite services are rendered.  The compensation cost relating to unvestedawards at the date of adoption shall be based on the fair value at the date ofgrant of those awards as calculated for pro forma disclosures under theoriginal SFAS No. 123. The Company estimates the adoption of SFAS No. 123(R),using the modified prospective method, will result in an aggregate incremental pre-taxcompensation expense of approximately $53,000 based on the Company’sunvested  stock options.

*Earnings Per Share*

The Company reports earnings per share (“EPS”) inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 128,“Earnings per Share” which specifies the methods of computation, presentation,and disclosure. Basic EPS is calculated by dividing net income available tocommon shareholders by the weighted average number of shares outstanding duringthe period. Diluted EPS is calculated by dividing net income available tocommon shareholders by the weighted average number of shares outstanding duringthe period plus the dilutive effect of common stock equivalents. The number ofshares outstanding related to stock options and warrants at June 30, 2006and 2005 was 

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1,986,635 and 5,682,022,respectively. Only stock options and warrants with exercise prices lower thanthe average market price of the common shares were included in the diluted EPScalculation for fiscal year 2006 and 2005. For the years ended June 30,2006 and 2005, respectively 182,950 shares attributable to outstanding stockoptions were not included in the computation of diluted earnings per sharebecause their inclusion would have been anti-dilutive.

Thefollowing table sets forth the computation of basic and diluted earnings pershare:

| ** **                                                    | ** ** | **For The Years Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                  | ** ** | **2005** | ** ** |
| Numerator:                                                    |       |                                                      |       |   |   |
| Net income                                                    |       | $                                                         | 723,644    |   | $ | 4,655,052 |   |
| Preferred stock dividends                                     |       | (2,326                                                    | )          | (29,737 | ) |
| Net income applicable to common Shareholders                  |       | $                                                         | 721,318    |   | $ | 4,625,315 |   |
| Denominator:                                                  |       |                                                      |       |   |   |
| Denominator for basic EPS weighted-average-shares             |       | 28,950,823                                                |       | 25,253,897 |   |
| Common stock equivalents—stock options and warrants      |       | 696,385                                                   |       | 2,932,309 |   |
| Denominator for diluted EPS weighted-average-shares           |       | 29,647,208                                                |       | 28,186,206 |   |
| Basic earnings  per share applicable to common shareholders   |       | $                                                         | 0.02       |   | $ | 0.18 |   |
| Diluted earnings per  share applicable to common shareholders |       | $                                                         | 0.02       |   | $ | 0.16 |   |

 

*Reclassifications*

Certain amounts on theprior period financial statements have been reclassed to be in conformity withthe current period financial statements.

**Note 3—MasterLicense Agreements**

In August 2004, the Company signed a masterfranchise agreement with Hung Yue Holdings (Hong Kong) Co., Ltd. giving thatfirm’s affiliate, Precision Tune Auto Care (China) Company Limited, a licenseto open and operate at least 330 Precision Tune Auto Care (PTAC) car carecenters in China over the next seven years. Under the terms of the originalagreement, Hung Yue Holdings was obligated to pay the Company approximately$2.1 million over seven years. Approximately $246,000 was collected under theagreement and recognized as revenue as all substantial obligations under thatagreement were fulfilled. In March 2006, the Company sent a default letterto Hung Yue Holdings notifying them that their exclusive master franchiserights were terminated due to Hung Yue Holdings failure to develop therequisite number of PTAC car care centers by the first anniversary of theoriginal agreement as well as being in default of several payments.Additionally, franchisees in the People’s Republic of China have threatened tosue Hung Yue Holdings and the Company for non-performance. None of thefranchisees have paid any royalties to the Company as of June 30, 2006.Management believes that there is very little likelihood of any formal legalproceedings and does not believe that there will be any material judgmentagainst the Company.

In May 2005, theCompany signed a master franchise agreement with Precision—Sociedade Gestora deFranchising S.A. de C.V. giving that corporation a license to open and operateat least 180 Precision Tune Auto Care (PTAC) car care centers in Spain over thenext five years. Under the terms of the agreement, Precision—Sociedade Gestorade Franchising S.A. de C.V. is obligated to pay the Company $750,000. TheCompany received $150,000 upon the signing of the master franchising agreementand will receive the remaining $600,000 through 2010 in accordance with anagreed upon payment schedule. The Company recognized revenue of $150,000 forthe year ended June 30, 2005 as the Company had substantially fulfilledall required obligations. No comparable revenue was recognized for the yearended 

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June 30,2006. Additionally, future revenue will not be recognized until collection ofsuch amounts is probable.  One center wasopened as of June 30, 2006.

**Note 4—NewAccounting Pronouncement**

In July 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes—an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN48 clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with FAS 109, “Accounting forIncome Taxes”. FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 also providesguidance on derecognition, classification, interest and penalties, accounting ininterim periods, disclosure and transition. The requirements of FIN 48 areeffective for our fiscal year beginning July 1, 2007. The Company is inthe process of evaluating this guidance and therefore has not yet determinedthe impact that FIN 48 will have on our financial statements upon adoption.

**Note 5—Property andEquipment**

Thecomponents of property and equipment are as follows:

| ** **                   | ** ** | **June 30,** | ** ** |
|------------------------------|------------|-------------------|------------|
| ** **                   | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Furniture and  fixtures      |       | $                 | 1,066,753  |   | $ | 1,065,575 |   |
| Equipment                    |       | 2,676,386         |       | 2,652,799 |   |
| Capital leases               |       | 101,342           |       | 79,459 |   |
| Leasehold  improvements      |       | 64,461            |       | 61,590 |   |
| Other items                  |       | 338,411           |       | 342,710 |   |
|                         |       | 4,247,353         |       | 4,202,133 |   |
| Accumulated  depreciation    |       | (4,125,672        | )          | (4,093,702 | ) |
| Property and equipment,  net |       | $                 | 121,681    |   | $ | 108,431 |   |

 

**Note 6—Income Taxes**

Theprovision (benefit) for income taxes consisted of the following items:

| ** **                     | ** ** | **Years Ended June 30,** | ** ** |
|--------------------------------|------------|-----------------------------------------|------------|
| ** **                     | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Current tax expense:           |       |                                    |       |   |   |
| Federal                        |       | $                                       | 15,000     |   | $ | 51,000 |   |
| State                          |       | 45,000                                  |       | — |   |
| Total current tax  expense     |       | 60,000                                  |       | 51,000 |   |
| Deferred tax  expense:         |       |                                    |       |   |   |
| Federal                        |       | 434,000                                 |       | 415,000 |   |
| State                          |       | 96,000                                  |       | 92,000 |   |
| Total deferred  tax expense    |       | 530,000                                 |       | 507,000 |   |
| Change in  valuation allowance |       | (—                                 | )          | (3,526,000 | ) |
| Total income tax  (benefit)    |       | $                                       | 590,000    |   | $ | (2,968,000 | ) |

 

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Theeffective tax rate differed from the statutory rate as follows:

| ** **                         | ** ** | **Years Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|
| ** **                         | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Statutory federal  rate            |       |                                    | 34         | % |   | 34 | % |
| State taxes                        |       |                                    | 8          |   |   | 5 |   |
| Nondeductible  expenses            |       |                                    | 1          |   |   | — |   |
| Adjustment to  deferred tax assets |       |                                    | 2          |   |   | (7 | ) |
| Change in  valuation allowance     |       |                                    | —     |   |   | (209 | ) |
| Other                              |       |                                    | —     |   |   | 1 |   |
| Effective tax rate                 |       |                                    | 45         | % |   | (176 | )% |

 

Deferred tax assets and liabilities reflect theeffects of tax losses and the future income tax effects of temporarydifferences between the consolidated financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and are measuredusing enacted tax rates that apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. Duringfiscal year 2006 and 2005, the Company made an adjustment of $(29,000) and$115,000, respectively, to the deferred tax assets primarily to adjustcumulative temporary balances and the net operating loss carryforwards.

Significantcomponents of the Company’s deferred tax liabilities and assets are as follows:

| ** **                                   | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Deferred tax  assets:                        |       |              |       |   |   |
| Net operating loss                           |       | $                 | 5,277,000  |   | $ | 5,726,000 |   |
| Other                                        |       | 738,000           |       | 797,000 |   |
|                                         |       | 6,015,000         |       | 6,523,000 |   |
| Valuation  allowance for deferred tax assets |       | (2,899,000        | )          | (2,899,000 | ) |
| Net deferred taxes                           |       | $                 | 3,116,000  |   | $ | 3,624,000 |   |

 

As of June 30, 2006, the Company had netoperating loss carryforwards for federal tax purposes of approximately $13.7million, which expire from 2020 through 2025.

The Company regularlyreviews the recoverability of its tax deferred assets and establishes avaluation allowance as deemed appropriate. As of June 30, 2006, theCompany had a valuation allowance of $2.9 million against deferred tax assetsrelated to net operating loss carryforwards that are likely to expire unused.

**Note 7—Debt**

*Line of Credit*

On February 28, 2006,the Company renewed the $250,000 line of credit with Chevy Chase Bank. Theinterest rate on this line of credit is indexed to the Prime Rate as publishedin *The Wall Street Journal*(8.25% at June 30,2006) and the Company has pledged the assets of its wholly-owned subsidiariesas collateral. As of June 30, 2006, the Company has not borrowed againstthis line of credit. Under this agreement, the Company must meet financialcovenants relating to profitability, debt service coverage and a maximumleverage ratio. The Company was in compliance with all such covenants as of June 30,2006 and 2005, respectively.

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*Debt*

During the years ended June 30, 2006 and 2005,the Company incurred interest expense of approximately $8,000 and $6,000,respectively.

Long-termdebt consists of the following:

| ** **                                                     | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                     | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Various notes and  obligations payable in monthly installments |       | $                 | —     |   | $ | 13,567 |   |
| Lease obligations                                              |       | 43,199            |       | 13,770 |   |
|                                                           |       | 43,199            |       | 27,337 |   |
| Less: current  maturities                                      |       | (7,853            | )          | (19,346 | ) |
| Long-term portion                                              |       | $                 | 35,346     |   | $ | 7,991 |   |

 

Thefuture debt obligations with maturities in excess of one year as of June 30,2006 are as follows:

| ** ** | ** ** | **Future  Debt Maturities** | ** ** |
|------------|------------|----------------------------------|------------|
| 2007       |       |                             | $          | 7,853 |   |   |
| 2008       |       |                             | 8,989      |   |   |
| 2009       |       |                             | 10,289     |   |   |
| 2010       |       |                             | 11,776     |   |   |
| 2011       |       |                             | 4,292      |   |   |
|       |       |                             | $          | 43,199 |   |   |

 

**Note 8—LeaseCommitments**

At June 30, 2006, theCompany has lease commitments for office space, a training center, and a numberof service center locations as well as office equipment under operating andcapital leases. These leases expire between 2006 and 2009, with renewal optionsin certain of the leases. The monthly rent for the office space increases by 3%on February 1 of each year. Most of the service center location leases aresubleased to franchisees. The Company recognizes rent expenses on astraight-line basic for certain leases which contained fixed escalations. Rentexpense for office space and warehouse facilities of approximately $350,000 and$361,000 is included in operating expenses for the year ended June 30,2006 and 2005 respectively. Rent expense for service center locations ofapproximately $47,000 and $47,000 is recorded net of sublease income of $47,000and $6,000 for the years ended June 30, 2006 and 2005, respectively.

*Operating Leases*

Thefuture minimum lease payments and related sublease payments for operatingleases with terms in excess of one year as of June 30, 2006 are asfollows:

| ** ** | ** ** | **Future Minimum  Lease Payments** | ** ** | **Sublease  Income** | ** ** | **Net** | ** ** |
|------------|------------|----------------------------------------------|------------|----------------------|------------|---------|------------|
| 2007       |       |                                         | $          | 485,000              |       |    | $          | 161,000 |   | $ | 324,000 |   |
| 2008       |       |                                         | 491,000    |                 |       | 157,000 |       | 334,000 |   |
| 2009       |       |                                         | 245,000    |                 |       | 47,000  |       | 198,000 |   |
| Thereafter |       |                                         | —     |                 |       | —  |       | — |   |
|       |       |                                         | $          | 1,221,000            |       |    | $          | 365,000 |   | $ | 856,000 |   |

 

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*Capital Leases*

At June 30, 2006 and 2005, the Company hadrecorded capital assets of $101,342 and $79,459, respectively. Accumulatedamortization related to the leased assets was $60,649 and $53,344 at June 30,2006 and 2005, respectively.

Thefuture minimum lease payments for capital leases with terms in excess of oneyear as of June 30, 2006 are as follows:

| ** **                           | ** ** | **Future Minimum  Lease Payments** | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|
| 2007                                 |       |                                         | $          | 13,244 |   |   |
| 2008                                 |       |                                         | 13,244     |   |   |
| 2009                                 |       |                                         | 13,244     |   |   |
| 2010                                 |       |                                         | 13,244     |   |   |
| 2011                                 |       |                                         | 4,414      |   |   |
| Total lease  payments                |       |                                         | $          | 57,390 |   |   |
| Less amounts  representing interest  |       |                                         | 14,191     |   |   |
| Present value of net  lease payments |       |                                         | $          | 43,199 |   |   |

 

**Note 9—RelatedParty Transactions**

The Company manages the operation of PTAC  Marketing Fund, Inc. (‘‘PMF’’), thenational advertising fund for Precision Tune Auto Care Centers, pursuant to aManagement Agreement approved by the Board of Directors of PMF, which iscomprised of franchisee and Company personnel. The Company charged PMF $741,000for administrative and other expenses incurred on behalf of PMF, for the yearsended June 30, 2006 and 2005, respectively. Based on the timing ofreceipts and disbursements, it is common for amounts to be due to and from theCompany and PMF. At June 30, 2006 and 2005, the amount due from PMF was$61,250 and $61,417, respectively. This amount is included in accountsreceivable. At June 30, 2006 and 2005, the amount due to PMF was $167,053and $116,073, respectively. This amount is included in due to related party.

Bassam N. Ibrahim, adirector of the Company, is a shareholder in Buchanan Ingersoll PC, anAlexandria, Virginia law firm that performs legal services for the Companyrelated to intellectual property protection. Fees paid in the amount ofapproximately $44,000 and $46,000 to the firm by the Company in the fiscalyears ended June 30, 2006 and 2005, respectively, did not exceed fivepercent of the firm’s gross revenues.

**Note 10—Stockholders’Equity**

*Voting Rights andOutstanding Shares*

Each share of non-voting preferred stock is entitledto receive, when and as declared by the Board of Directors, cumulativepreferential cash dividends at the rate of 2% of the liquidation preference ofthe Series A redeemable preferred stock, $10.36 per share, per annumpayable quarterly in arrears in cash on the last day, or the next succeedingbusiness day, of January, April, July, and October in each year, beginningJanuary 31, 2003. Accrued dividends were approximately $233 at June 30,2006 and 2005, respectively.

Each share of common stockis entitled to one vote for each matter submitted to the shareholders forapproval.

36

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*Common Stock OptionPlan*

In 1999, the Company’s Board of Directors and theCompany’s stockholders approved the 1999 Employee Stock Option Plan (the ‘‘OptionPlan’’) and, as amended, reserved 2,600,000 shares of common stock for issuanceunder the Plan. Options available for future grants under this plan were307,000 at June 30, 2006.

Options reserved for issuance under predecessor plansconsist of 400,000 related to the 1997 Employee Stock Option Plan, 175,000related to the 1996 Employee Stock Option Plan, and 75,000 related to the 1998Director’s Stock Option Plan. Options available for future grant at June 30,2006, under these plans were 327,500, 175,000 and 75,000, respectively. TheCompensation Committee of the Company’s Board of Directors determines therecipients of the award to be granted, exercise price, vesting period, term andnumber of shares underlying the options.

Thefollowing is a summary of the Company’s stock option activity under all plans:

| ** **          | ** ** | **Shares  Under Option** | ** **   | **Weighted-Average  Exercise Price** | ** ** |
|---------------------|------------|-------------------------------|--------------|-------------------------------------------|------------|
| June 30,  2004 |       |                          | 1,939,200    |                                      |       |   | 0.74 |   |   |
| Options granted     |       |                          | 375,000      |                                      |       |   | 0.62 |   |   |
| Options exercised   |       |                          | (535,000     | )                                         |       |   | 0.33 |   |   |
| Options forfeited   |       |                          | (57,500      | )                                         |       |   | 0.44 |   |   |
| June 30,  2005 |       |                          | 1,721,700    |                                      |       |   | 0.85 |   |   |
| Options granted     |       |                          |  — |                                      |       |   | — |   |   |
| Options exercised   |       |                          | (120,000     | )                                         |       |   | 0.31 |   |   |
| Options forfeited   |       |                          | —       |                                      |       |   | — |   |   |
| June 30, 2006  |       |                          | 1,601,700    |                                      |       |   | 0.89 |   |   |

 

At June 30, 2006 and 2005, options for 1,330,000and 1,198,000 shares, respectively, were exercisable. No options were grantedin fiscal year 2006. The weighted average grant date fair value per option foroptions granted in 2005 was $0.62. The weighted average remaining contractualterm of the options was 5.00 years as of June 30, 2006. The exercise priceof options outstanding at June 30, 2006 ranged from $0.25 to $10.00 pershare.

The Company applies Accounting Principles Board (APB)Opinion No. 25, ‘‘Accounting for Stock Issued to Employees’’, and relatedinterpretations in accounting for stock based compensation and presents proforma net income and earnings per share data as if the accounting prescribed byStatement of Financial Accounting Standards No. 123, ‘‘Accounting forStock Based Compensation’’ had been applied (see Note 2).

Thefollowing table summarizes the assumptions used by the Company in determiningthe fair value of options that were granted during 2005 using a binomial model.

| ** **                                            | ** ** | **2005** | ** ** |
|-------------------------------------------------------|------------|----------|------------|
| Risk free  interest rate                              |       | 2.80     | %          |
| Volatility  factors                                   |       | 191.38   | %          |
| Weighted-average  expected life of the option (years) |       | 3        |       |
| Dividend yield                                        |       | 0.00     | %          |

 

Because option valuationmodels require the input of highly subjective assumptions, such as expectedvolatility, and because changes in these subjective input assumptions canmaterially affect the fair value estimate, the existing model may notnecessarily provide a reliable single measure of the fair value of its stockoptions.

37

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*Outside Director’sStock Plan*

In 2000, the Company’sBoard of Directors and the Company’s stockholders approved the 2000 OutsideDirectors’ Stock Plan and reserved 50,000 shares for issuance under the Plan. Sharesavailable for future grants at June 30, 2006, under this plan were 37,000.

*Warrants*

In 1998, a subordinateddebenture was executed with an LLC composed of certain members of the Company’sboard of directors (Board LLC). Terms of the agreement included issuance ofwarrants to purchase 400,000 shares of the Company’s common stock with anexercise price of $0.44 per share. The number of shares outstanding related towarrants at June 30, 2006 and 2005 was 343,620 and 353,620, respectively.

*Equity Transactions*

In March 2005, 4,472,270 warrants were exercisedpursuant to an agreement the Company reached with Precision Funding, L.L.C. andformer board members in October 2002. Upon the exercise of these warrantsat the previously agreed to exercise price of $0.44 per share, the holderspurchased 4,472,270 restricted shares of common stock by surrendering 189,942shares of Series A Preferred Stock to the Company, therefore, there wereno cash proceeds received by the Company from this transaction.

In March 2005, 36,380 warrants were exercisedpursuant to an agreement the Company reached to restructure the Board LLCsubordinated debt. Upon the exercise of these warrants at the previously agreedto exercise price of $0.44 per share, the holder purchased 36,380 restrictedshares of common stock by surrendering 1,545 shares of Series A PreferredStock to the Company, therefore, there were no cash proceeds received by theCompany from this transaction.

In March 2005, 10,000 warrants were exercisedpursuant to an agreement the Company reached to restructure the Board LLCsubordinated debt. Upon the exercise of these warrants at the previously agreedto exercise price of $0.44 per share, the holder purchased 10,000 restrictedshares of common stock for $4,400.

In August 2005,10,000 warrants were exercised pursuant to an agreement the Company reached torestructure the Board LLC subordinated debt. Upon the exercise of thesewarrants at the previously agreed to exercise price of $0.44 per share, theholder purchased 10,000 restricted shares of common stock for $4,400.

**Note 11—Employees’Savings Plan**

The Company maintains a401(k) plan under which the Company may contribute up to 25% of anemployee’s first 6% of compensation deferred under the plan. Employees becomeeligible after attaining the age of 21 and completing six months of employmentwith the Company. The employees may elect to have no contribution limitation ontheir annual compensation subject to limitations set forth in the InternalRevenue Code. Employees’ contributions vest immediately. The employee matchingcontribution is discretionary and vests 20% after one year and in increments of20% each additional year. The employee matching contributions for each of theyears ended June 30, 2006 and 2005 were $31,000 and $36,000, respectively.

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**Note 12—Contingencies**

The Company iscurrently subject to litigation that could have a material adverse impact onits liquidity as follows:

***Maureen Jones v. Precision TuneAuto Care, Inc. Precision Franchising LLC, Paul Blakeman, and Complete CarCare LLC***, United States District Court, Western Districtof Oklahoma, Case No.: 06-CV-506, filed July 26, 2006,served August 14, 2006.

Defendant Franchisor has retained counsel and filed ananswer on September 5, 2006 denying the allegations of plaintiff. DefendantFranchisor believes that it is not a proper party to the suit and will take allappropriate steps to obtain a dismissal.

***Precision Franchising LLC v. IraA. Starr and Barbara Starr***, USDC ED VA (AlexandriaDistrict), 1:06cv505, Filed: May 2, 2006.

On April 24, 2006, Ira Starr, Barbara Starr andAllStarr Car Care, Inc. filed a complaint in the Circuit Court of KanawhaCounty, West Virginia against Precision Tune, Inc., PFL, GrimaudEnterprises, Inc. and David Grimaud (“Franchisor”). To date, no monetarydamages have been specified.

On May 2, 2006, PFL filed a complaint in theFederal District Court for the Eastern District of Virginia against theFranchisees. PFL seeks to enforce the non-competition covenants and the ACAL,and prevent Franchisees from continuing to use PFL’s proprietary point-of-salesoftware. PFL seeks more than $75,000 in damages and seeks to enjoinFranchisees from operating an automotive maintenance business on the Premises.

On August 21, 2006, the judge ruled in favor ofPFL and PFL successfully obtained removal of this claim to the Federal DistrictCourt for the Eastern District of Virginia.

***Barras, et al. v. Precision TuneAuto Care, Inc.***, 16th Judicial District Court, St.Martin Parish, Louisiana, docket numbers 70616-F, 70629-B, 70628-B,70630-D, filed May 18, 2006 (Barras) and May 24, 2006(Escuriex, Berard-Linford, Bergeron). Served May 26, 2006 (Barras), May 30,2006 (Berard-Linford, Bergeron), May 31, 2006 (Escuriex) .

On July 13, 2006, PTAC filed its response toBergeron and Berard-Linford’s respective Petitions for Damages; on July 14,2006, PTAC filed its response to Barras’s Petition for Damages; On July 16,2006, PTAC filed its response to Escuriex’s Petition for Damages. In each case,PTAC denied the allegations asserted against it.

***Shaw v. Precision Tune Auto Careand Mark Hall***, State of South Carolina, County ofGreenville, Court of Common Pleas, 13th Judicial Circuit, Case No.: 2006-CP-23-3737,filed and served 6/19/2006.

PTAC sent to Woodruff on June 19, 2006 a letterdemanding that Woodruff hold PTAC harmless for all claims asserted by Shaw. Accordingly,Woodruff’s insurance carrier has retained counsel to defend both Woodruff andPTAC’s interests. On August 18, 2006, defendants filed their answer; eachallegation was denied, and it was asserted that PTAC is not a proper defendantdue to: (i) the independent contractor relationship between PTAC andWoodruff; and (ii) the fact that “PTAC” is merely a trademarked brand nameand Precision Franchising LLC is the actual corporate entity.

***United Bank, NA v. C. EugeneDeal, Miracle Partners, Inc., Star Auto Center, Inc.***,Common Pleas Court of Cuyahoga County, Ohio, Case No. 01-CV0019, FiledJanuary 11, 2001.

Miracle Partners, Inc., a wholly-owned subsidiaryof the Company, was party to a confessed judgment of approximately $1.3 million.The subsidiary is currently inactive and has no assets. As such, managementbelieves this judgment will have no material impact on the Company’sconsolidated results of operations. Furthermore, the Company believes that ithas a meritorious claim against Mr. Deal for 

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misrepresentations made inconnection with PACI’s acquisition of Miracle Partners, Inc. in 1997 forall amounts covered by the judgment.

***Lumnivision, S.A. de C.V. v.Praxis Afinaciones, S.A. de C.V.***, Third Civil Court,First Judicial District, Monterrey, Nuevo Laredo, Mexico.

Lumnivision filed suit against Praxis Afinaciones, anindirect wholly owned subsidiary of PACI, seeking payment of 766,000 MexicanPesos, plus interest at the rate of 5% per month, for services under a contract.Praxis Afinaciones denies the allegations and is defending the allegations inthe lawsuit.

The Company does not believethat any of the above claims or proceedings will result in a material judgmentagainst the Company or any of it’s subsidiaries. There can be no assurance,however, that these suits will ultimately be decided in its favor. Any one ofthese claims or proceedings may result in a material judgment against theCompany, which could cause material adverse consequences to its operations.

**Note 13—SubsequentEvent**

On July 15, 2006, the Company was party to alease amendment related to one of its franchise centers. Under the terms of theoriginal lease agreement which was executed in fiscal year 2001, the Companyagreed to guarantee the lessee performance. Under the terms of the amendment,the Company has agreed to continue its guarantor obligations in conjunctionwith the leasing of the facility to another non-related party. The terms of theamendment are in effect through April 30, 2009. In the event that the newlessee defaults, the Company could be required to perform resulting inadditional rental expense of approximately $147,400 through April 30, 2009.In accordance with the provisions of FIN 45; Guarantor’s Accounting andDisclosure Requirements for Guarantees, the Company will have to recognize, atthe inception of the lease amendment, a liability for the fair value of theobligation undertaken in issuing the guarantee. The Company is in the processof determining the amount of the liability for the fair value of the guaranteeobligation.

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**Item 8.**                        *Changes In And Disagreements With Accountants On Accounting AndFinancial Disclosures*

None.

**Item 8A.**                *Controls and Procedures*

Under the supervision andwith the participation of our management, including the Chief Executive Officerand Chief Financial Officer, we have evaluated the effectiveness of the designand operation of our disclosure controls and procedures pursuant to ExchangeAct Rule 13a-14(c) as of the end of the period covered by thisreport. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer have concluded that these disclosure controls and proceduresare effective. There were no changes in our internal control over financialreporting during the year ended June 30, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting.

**Item 8B.**               *Other Information*

None.

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**PART III**

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

The required information on directors will becontained in the Company’s Proxy Statement, and reference is expressly made tothe Proxy Statement for the specific information incorporated in the Form 10-KSB.The required information on executive officers is set forth in Part I ofthis Form 10-KSB under an unnumbered item captioned “Executive Officers ofPrecision Auto Care, Inc.”

The code of ethics thatapplies to the Company’s Chief Executive Officer, Chief Financial Officer,Corporate Controller and all other employees is attached as an exhibit in Item13 of this report. If the Company makes any substantive amendments to the codeof ethics or grant any waiver, including any implicit waiver, from a provisionof the code to our Chief Executive Officer, Chief Financial Officer orCorporate Controller, the Company will disclose the nature of such amendment orwaiver in a report on Form 8-K.

**Item10.****                 *Executive Compensation***

The required informationwill be set forth under “Executive Compensation” and  “Report of the Organization and CompensationCommittee on Executive Compensation” in the Company’s Proxy Statement, andreference is expressly made to the Proxy Statement for the specific informationincorporated in the Form 10-KSB.

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

The required informationwill be set forth under “Security Ownership of Certain Beneficial Owners andManagement” in the Company’s Proxy Statement, and reference is expressly madeto the Proxy Statement for the specific information incorporated in the Form 10-KSB.Except as otherwise stated in the Proxy Statement, the address of each of thepersons owning more than 5% of the Company’s Common Stock is 748 Miller Drive,S. E., Leesburg, VA 20175.

**Item 12.**                 *Certain Relationships and Related Transactions*

The required informationwill be set forth under “Certain Relationships and Related Transactions” in theCompany’s Proxy Statement, and reference is expressly made to the ProxyStatement for the specific information incorporated in the Form 10-KSB.

**Item 13.**                 *Exhibits*

(a)           The following documentsare filed as part of this report:

1.                FinancialStatements

The following financial statements appear in Part II,Item 7 of this report:

Reportof Independent AuditorsAudited Financial Statements

Consolidated Balance SheetsConsolidated Statements of OperationsConsolidated Statements of Stockholders’ EquityConsolidated Statements of Cash FlowsNotes to Consolidated Financial Statements

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(b)          Exhibits
| 2.1  | Plan of Reorganization and Agreement for Combination  of Business dated as of August 27, 1997, by and among the Company, WE  JAC Corporation, Miracle Industries, Inc., Lube Ventures, Inc.,  Rocky Mountain Ventures, Inc., Rocky Mountain Ventures II, Inc.,  Miracle Partners, Inc., Prema Properties, LLC, Ralston Car Wash, LLC and  KBG LLC, included as an Exhibit to the Company’s Registration Statement  on Form S-1 (No. 333-34439) filed August 27, 1997, is  incorporated herein by reference. |
|------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1  | Articles of  Incorporation of the Company included as an exhibit to the Company’s  Registration Statement on Form S-1 (No. 333-34439) filed  August 27, 1997, are incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                            |
| 3.2  | By-laws of the Company  as amended August 18, 2004 are incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.3  | Articles of Amendment to  the Articles of Incorporation of Precision Auto Care, Inc. dated  October 28, 2002 to create a new series of preferred stock designated as  Series A Cumulative Redeemable Preferred Stock, included as an exhibit  to the Company’s Quarterly Report on Form 10-QSB, filed November 14,  2002, is incorporated herein by reference.                                                                                                                                                                       |
| 3.4  | Articles of Amendment to  the Articles of Incorporation of Precision Auto Care, Inc. dated  January 15, 2003 to increase the number of authorized shares, amend the  required number of Board of Directors, and amend the terms of the Board of  Directors, included as an exhibit to the Company’s Quarterly Report on  Form 10-QSB, filed February 14, 2003, is incorporated herein by  reference.                                                                                                                                      |
| 4.1  | Warrant to Purchase  Shares of Common Stock of Precision Auto Care, Inc. dated  October 30, 2002 (Warrant No. 2002-01) between the Company and  Desarollo Integrado, S. A. de C. V., included as an exhibit to the Company’s  Quarterly Report on Form 10-QSB, filed November 14, 2002, is  incorporated herein by reference.                                                                                                                                                                                                        |
| 4.2  | Warrant to Purchase  Shares of Common Stock of Precision Auto Care, Inc. dated  October 30, 2002 (Warrant No. 2002-02) between the Company and  Arthur C. Kellar, included as an exhibit to the Company’s Quarterly Report on  Form 10-QSB, filed November 14, 2002, is incorporated herein by  reference.                                                                                                                                                                                                                           |
| 10.1 | Precision Auto  Care, Inc. 1998 Employee Stock Purchase Plan, included as an exhibit to  the Company’s Registration Statement on Form S-8 (No. 333-49097),  filed April 1, 1998, is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                     |
| 10.2 | Precision Auto Care Inc.  2000 Outside Directors’ Stock Plan, included as an exhibit to the Company’s  Registration Statement on Form S-8 (No. 333-39226), filed  June 14, 2000, is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                     |
| 10.3 | Precision Auto  Care, Inc. 1998 Outside Directors’ Stock Option Plan, included as an  exhibit to the Company’s Registration Statement on Form S-8  (No. 333-85877), filed August 25, 1999, is incorporated herein by  reference.                                                                                                                                                                                                                                                                                                     |
| 10.4 | Precision Auto  Care, Inc. 1999 Employee Stock Option and Restricted Stock Plan,  included as an exhibit to the Company’s Registration Statement on  Form S-8 (No. 333-85879), filed August 25, 1999, is  incorporated herein by reference.                                                                                                                                                                                                                                                                                               |
| 10.5 | Precision Tune Stock  Option Plan, included as an exhibit to the Company’s Registration Statement  on Form S-8 (No. 333-47165), filed March 2, 1998, is  incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                                     |

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| 10.6  | Precision Auto Care  Employee Stock Option Plan, included as an exhibit to the Company’s  Registration Statement on Form S-8 (No. 333-47169), filed  March 2, 1998, is incorporated herein by reference.                                     |
|-------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7  | Precision Auto  Care, Inc. Director Stock Option Plan, included as an exhibit to the  Company’s Registration Statement on Form S-8 (No. 333-47171), filed  March 2, 1998, is incorporated herein by reference.                          |
| 10.8  | Subordinated Debenture Agreement  with Board LLC, dated October 15, 1998, included as an exhibit to the  Company’s Amended Quarterly Report on Form 10-Q/A, filed  November 20, 1998, is incorporated herein by reference.                   |
| 10.9  | Agreement dated  August 3, 2000 between the Company and Louis M. Brown, Jr.,  included as an Exhibit to the Company’s Annual Report on Form 10-K,  filed October 13, 2000, is incorporated herein by reference.                    |
| 10.10 | Lease dated  December 3, 2001 between Leesburg Airpark III, LLC and Precision Tune  Auto Care, Inc., included as an Exhibit to the Company’s Annual Report  on Form 10-K, filed October 15, 2002, is incorporated herein by  reference. |
| 10.11 | Agreement dated  July 17, 2003 between the Company and Board L.L.C. terminating the  Subordinated Debenture dated October 15, 1998 between the Company and  Board L.L.C. is incorporated herein by reference.                                          |
| 10.12 | Renewal of Promissory  Note dated February 28, 2006 between Precision Auto Care, Inc. and  Chevy Chase Bank, F.S.B. is incorporated herein by reference.                                                                                               |
| 21*   | Significant Subsidiaries  of the Company.                                                                                                                                                                                                                        |
| 23.1* | Consent of Grant  Thornton LLP, Independent Auditors.                                                                                                                                                                                                            |
| 31.1* | Written statement of  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                   |
| 31.2* | Written statement of  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                   |
| 32.1* | Written statement of  Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                       |

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*                    Filedherewith

**Item 14.**                 *Principal Accountant Fees and Services*

The required information will be set forth under “PrincipalAccountant Fees and Services” in the Company’s Proxy Statement, and referenceis expressly made to the Proxy Statement for the specific informationincorporated in the Form 10-KSB.

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**SIGNATURES**

**Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized, on September 22,2006.**
|            | PRECISION AUTO  CARE, INC. |
|------------|---------------------------------|
|       | By:                             | /s/  ROBERT R. FALCONI |
| ** ** | ** **                      | **Robert  R. Falconi** |
|       |                            | ***President  and Chief Executive Officer  (Duly Authorized Officer)*** |

 

**Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.**
|                               | **Signature** | ** **                     | ** ** | ** **              | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------------|---------------|--------------------------------|------------|-------------------------|-----------|------------|------------|------------|----------|------------|
| /s/ LOUIS M.  BROWN, JR. |          | Chairman of the  Board         |       | September 22, 2006 |
| **Louis M. Brown, Jr.**  |          |                           |       |                    |
| /s/ ROBERT R.  FALCONI        |          | President and  Chief Executive |       | September 22, 2006 |
| **Robert R. Falconi**         |          | Officer                        |       |                    |
| /s/ WOODLEY A.  ALLEN         |          | Director                       |       | September 22, 2006 |
| **Woodley A. Allen**          |          |                           |       |                    |
| /s/ BASSAM N.  IBRAHIM        |          | Director                       |       | September 22, 2006 |
| **Bassam N. Ibrahim**         |          |                           |       |                    |
| /s/ JOHN D.  SANDERS          |          | Director                       |       | September 22, 2006 |
| **John D. Sanders**           |          |                           |       |                    |
| /s/ PETER C.  KEEFE           |          | Director                       |       | September 22, 2006 |
| **Peter C. Keefe**            |          |                           |       |                    |
| /s/ MARK P.  FRANCIS          |          | Chief Financial  Officer       |       | September 22, 2006 |
| **Mark P. Francis**           |          |                           |       |                    |

 

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