**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

**FORM 10-KSB**

**x ANNUAL REPORTUNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

For the fiscal year ended June 30, 2005

**o TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

Commission file number 0-29478

**PRECISION AUTOCARE, INC.**

(Name of small businessissuer in its charter)

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

 

**748 Miller Drive, S.E., Leesburg,Virginia 20175**(Address of principal executive offices)(Zip Code)

**703-777-9095**(Issuer’s telephone number, including area code)

Securities registeredpursuant to Section 12(b) of the Act:**None**

Securities registeredpursuant to Section 12(g) of the Act:**Common Stock, 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 ofdelinquent filers in response to Item 405 of Regulation S-B is contained inthis form, and no disclosure will be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB. o

The issuer’s revenues forits most recent fiscal year were: $12,802,979.

The aggregate market valueof Common Stock held by persons not “affiliated” with the issuer at August 15,2005 was $21,627,005 based on the closing price of $0.90 per share. As of August 15,2005, 28,932,252 of Common Stock were issued and outstanding.

Transitional Small BusinessDisclosure Format:        o Yes   x No

**DOCUMENTSINCORPORATED BY REFERENCE:**

Certain portions ofRegistrant’s definitive proxy statement, to be filed with the Securities andExchange Commission pursuant to Regulation 14A not later than 120 days afterthe close of the Corporation’s fiscal year, are incorporated by reference underPart III.

 

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**TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                                  | **Page** |
|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------|----------|
| PART I   | Item 1.    | Business                                                                                                                    | 4        |
|          | Item 2.    | Properties                                                                                                                  | 11       |
|          | Item 3.    | Legal Proceedings                                                                                                           | 12       |
|          | Item 4.    | Submission of  Matters to a Vote of Security Holders                                                                        | 13       |
|          |       |                                                                                                                        |     |
| PART II  | Item 5.    | Market for Common Equity and Related Stockholder  Matters                                                                   | 14       |
|          | Item 6.    | Management’s Discussion and Analysis or Plan of  Operation                                                             | 15       |
|          | Item 7.    | Financial Statements                                                                                                        | 21       |
|          | 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-LOOKING STATEMENTS**

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, 2005, the Company had 29 totalemployees of which 26 are 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”) and Precision Lube Express,provides automotive services primarily through franchised operations located inthe United States and in certain foreign countries.

·       Throughits franchisees, PTAC provides automotive maintenance and repair services, suchas engine performance, oil change and lubrication and brake services, whichrequire relatively short service times. At June 30, 2005, these serviceswere provided at 425 Precision Tune Auto Care centers owned and operated byfranchisees.

·       Precision Lube Expressfranchisees and licensees provide convenient fast oil change and lube services.At June 30, 2005, there was 1 Precision Lube Express center owned andoperated by a franchisee. In the future, the Company does not plan to selladditional Precision Lube Express franchises.

**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 hasrecently made the decision to sell tires and tire related services at thecenters as well.

*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 

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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.

*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 developerperforms many of Precision Tune Auto Care’s franchise support obligations. Asof June 30, 2005, 15 area developers and their affiliates had an ownershipinterest in approximately 29% of the total number of Precision Tune Auto Carecenters.

*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.

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**FRANCHISING ACTIVITIES**

*PrecisionTune Auto Care*.   As of June 30, 2005, all ofPrecision Tune Auto Care domestic and international centers were owned andmanaged by franchisees. Precision Tune Auto Care’s franchises have been soldduring the preceding years under franchise agreements that vary in detail asthe Precision Tune Auto Care’s franchise program has evolved. Royalty rates inexisting franchise agreements are 7.5%. Currently, Precision Tune Auto Care’sstandard franchise agreement requires payment to the Company of an initialfranchise fee of $25,000 and a continuing royalty of 7.5% of weekly grossreceipts. In addition, the franchisee is required to contribute to or expend upto 9% of weekly gross receipts on advertising, of which 1.5% is currently paidinto the national marketing fund and up to 7.5% of which is spent locally. Thecurrent standard form franchise agreement has an initial term of ten years andprovides for five-year renewal options.

The Company has implemented a program under whichqualified franchisees are eligible to have their royalty rate reduced to as lowas 6% if they satisfy certain criteria. Under the program, franchisees are alsoprovided with an incentive to purchase additional Precision Tune Auto Carefranchises. Any franchisee that has owned and operated a center for at leastone year in accordance with this program will be charged an initial franchisefee of $15,000 for a second franchise and $10,000 for each additional franchisepurchased, provided certain conditions are met.

Under its current form of franchise agreement, theCompany has a continuing obligation to make technical and administrativesupport available, centralized marketing support, and training and relatedsupport available to its franchisees. In areas where there are area developers,the Company has delegated most of these duties to area developers under itsarea 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 thepresent time, the Company has master franchise agreements in Taiwan, Oman,Indonesia, United Arab Emirates, the Dominican Republic, Peru, Brazil, ElSalvador, Ecuador, Saudi Arabia, China, Spain and Portugal. Generally, themaster franchisee pays a license fee and is required to develop Precision TuneAuto Care centers in accordance with an agreed upon schedule within the definedarea. Franchise agreements within the area are between the master franchiseeand the unit franchisee. The master franchisee is required to perform all ofthe obligations of the franchisor including training, administrative andoperational support, and the Company generally receives 20% of the initialfranchise fee and up to one-third of ongoing 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, 2005, 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 

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co-brandingprogram may have separate agreements with the primary tenant’s organization orits affiliates to assist Precision Tune Auto Care in the offer of franchises tothe primary tenants and the provision of services. The Company expects thatthese co-branding opportunities will be with other providers of automotiveservices not similar to its own, like gasoline stations, detail, paint and bodywork stations, tire shops, glass shops, and muffler shops. Due to the nature ofthese co-branding relationships, the Company expects to modify its standardform of franchise agreement to reflect the differences or similarities betweenits businesses. Some of these primary tenants may be in direct competition withthe Company and may choose not to franchise their particular location. Additionally,the Company makes the final decision as to entering into a franchise agreementwith a primary tenant.

**COMPETITION**

The Company’s franchisees and licensees encountercompetition in all aspects of their business, including the sale by PrecisionTune Auto Care and Precision Lube Express centers of automotive maintenance andrepair services and fast oil and lubrication services. The Company believesthat automobile dealerships, including recently emerging national and regionalnew and used auto dealerships, represent Precision Tune Auto Care’s principalcompetitors. Other Precision Tune Auto Care competitors include tire companiesand regional under-the-hood service specialists. National competitors withinPrecision Tune Auto Care’s market include Sears Auto Center and the automotivemaintenance centers operated by Goodyear, Midas, Meineke 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.

**GOVERNMENT REGULATION**

*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 and Precision Lube Express centers store new oil and handlelarge quantities of used automotive oils and fluids. As a result of theseactivities, the Company, its franchisees and area developers are subject tovarious federal, state and local environmental laws and regulations dealingwith the transportation, storage, presence, use, disposal and handling ofhazardous materials and hazardous wastes, and underground fuel storage tanks. Ifany such substances were improperly released or improperly stored on theproperty of any franchisee, including leased properties, or if the Company werefound to be in violation of applicable environmental laws and 

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regulations, theCompany could be responsible for clean-up costs, property damage and fines orother penalties, any one of which could have a material adverse effect on itsfinancial condition and results 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.

**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 selling securitiessubject to these rules to persons other than established customers andinstitutional accredited investors to complete certain documentation, makesuitability inquiries of investors, and provide investors with certaininformation concerning the risks of trading in the security. These rules mayrestrict the ability of brokers to sell the Company’s common stock and thus mayhave an adverse effect on the liquidity and market price of its 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;

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·       “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.

*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 and Precision Lube Express service centers; however, theseservice centers also compete with national and regional fast oil change andlube companies, major oil manufacturers, local service stations and local,regional and national automobile 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 for 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 does. There can be no assurance that theCompany or individual Precision centers will be able to compete effectively. *See “Business**3⁄4Competition.”*

*Reliance onFranchising.*   Franchiseroyalties are a significant component of its revenue base. Therefore, theCompany depends upon the ability of its franchisees to promote and capitalizeupon the “Precision” brand and the reputation the Company believes the Companyenjoys for quality and value. There can be no assurance that the Company or ourarea developers will be able to recruit and retain franchisees with thebusiness abilities or financial resources necessary to open Precision Tune AutoCare centers on schedule or that the franchisees will conduct operations profitably.In addition, to the extent that franchisees finance their operations withsecured indebtedness, the Company’s rights to receive franchise royalties wouldbe effectively subordinated to the rights of franchisees’ lenders. See “Business3⁄4Operations.”

*AutomotiveTechnology Advances.**  *Thedemand for the services offered by its Precision Tune Auto Care and PrecisionLube Express centers could be adversely affected by continuing developments inautomotive technology. Automotive manufacturers are producing cars that lastlonger and require service and maintenance at less frequent intervals. Forexample, some manufacturers now recommend that consumers change oil at 10,000mile intervals and replace spark plugs and other engine components at 100,000miles, a significant increase from the mileage intervals recommended forearlier models and those currently recommended by most manufacturers. Thedemand for its services also could be adversely affected by longer and morecomprehensive warranty programs offered by automobile manufacturers and otherthird parties. The Company believes that a majority of new automobile ownershave their cars 

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serviced by a dealerduring the period the car is under warranty. In addition, advances inautomotive technology may require the Company to incur additional costs toupdate its technical training program and upgrade the diagnostic capabilitiesof its centers.

*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.

*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 and Precision Lube Express centers andobtain services.

*Controlby Management and Principal Shareholders.**  *As of August 15, 2005, the Company’s directors,executive officers and shareholders beneficially owning more than 5% of itsoutstanding common stock, in the aggregate, beneficially owned approximately81% 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 and Precision LubeExpress centers store new oil and handle large quantities of used automotiveoils and fluids. Precision Auto Wash centers (which were formerly franchiseoperations under the PACI umbrella) used chemicals in the washing process. Thesechemicals, along with oils, fluids and other chemicals washed off of thevehicle were collected with the waste water from the car wash process. As aresult of these activities, the Company, its franchisees and area developersare subject to various federal, state and local environmental laws andregulations dealing 

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*withthe transportation, storage, presence, use, disposal and handling of hazardousmaterials and hazardous wastes, discharge of storm water, and underground fuelstorage tanks. If any such substances were improperly released or improperlystored on its property or the property of any franchisee, including leasedproperties, or the Company were found to be in violation of applicableenvironmental laws and regulations, the Company could be responsible forclean-up costs, property damage and fines or other penalties, any one of whichcould have a material adverse effect on its financial condition and results ofoperations. See*“Business3⁄4GovernmentRegulation.”

**EXECUTIVEOFFICERS OF PRECISION AUTO CARE, INC.**

*LouisM. Brown, Jr.*, age 62, became Chairman of theBoard in October 2003. He also remains Chief Executive Officer. He is ViceChairman of Micros Systems, Inc. since April 2003 and was Chairman ofthe Board from January 1987 to April 2003.

*RobertR. Falconi,*age 51, became President in October 2003.He also remains Chief Operating Officer and Chief Financial Officer. From March 2002to October 2003, he was Executive Vice President and Chief OperatingOfficer/Chief Financial Officer.**From September 2000to February 2002, he was the Company’s Vice President—Finance,Administration and Chief Financial Officer. From August 1998 until September 2000,he was Chief Financial Officer of Apptis, Inc.

*FrederickF. Simmons*, age 43, became Senior Vice President,General Counsel and Secretary in March 2001. From December 1995 to February 2001,he was Assistant General Counsel and Assistant Secretary of AdvanticaRestaurant Group, Inc.

*JohnT. Wiegand*, age 43, became Senior Vice President—OperationalPrograms and Training in March 2002. From August 2000 to March 2002,he was Senior Vice president of Franchise Operations and from June 1998 toAugust 2000, he was Vice President of North American Operations. Mr. Wiegandjoined WE JAC Corporation, the Company’s predecessor, as Director of FieldOperations in August 1996.

*KevinBates*, age 43, became Senior Vice President ofMarketing in August 2004. From October 1999 to August 2004, Mr. Bateswas Vice President—Marketing and Advertising. From January 1998 until October 1999,he was our Director of Field Operations.

*JoelBurrows*, age 48, became Vice President—Training/Researchand Development in September 1999. From December 1997 until September 1999,he was the PTAC Director of Training/Research and Development.

*GlynD. Massingill*, age 59, became Vice President—FranchiseServices in January 2000. From September 1990 through December 1999,Mr. Massingill was Vice President and General Manager of PrecisionAutomotive Components Manufacturing and Distribution (PAC), a division of theCompany.

*Mark P. Francis,*age39, became Controller in October 2004. From April 2004 until October 2004,Mr. Francis was the Assistant Controller of the Company. From December 1999until April 2004, he was an accounting manager of REHAU, Inc.

**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.

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**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. As of the date hereof, thereare no such lawsuits pending against the Company.

Previously Reported Cases:

*PuyallupAuto Stop Associates v. PTW, Inc.*, Superior Courtof the State of Washington, County of Pierce, filed March 9, 2005

On March 9, 2005 PTW, Inc. (PTW), aPrecision Tune Auto Care, Inc. subsidiary, was served with a complaint inwhich Puyallup Auto Stop Associates (PASA) seeks an amount to be determined attrial and attorney’s fees. PASA claims PTW breached a real property leasebetween the parties and seeks to recover from PTW certain environmentalremediation costs. Beginning in 1994, PTW subleased the property in question toa Precision Tune Auto Care franchisee, Michael and Catherine Ertman (the “Ertmans”).  Under the terms of the sublease and aconsent judgment between PTW and the Ertmans, the Ertmans have an obligation toindemnify PTW in the event PTW incurs any liability in this matter. On March 30,2005, PASA amended its complaint to include two other, third-party, defendants.PTW has not yet filed an answer in this matter. However, on April 14, 2005PTW provided to PASA an offer to settle this matter for a lump-sum payment of$10,000. PASA has not responded to PTW’s settlement offer. Trial is scheduledfor March 20, 2006.

*Lumnivision,S.A. de C.V. v. Praxis Afinaciones, S.A. de C.V.,*ThirdCivil 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.

*UnitedBank, NA v. C. Eugene Deal, 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.

*DavisTune, Inc. v. Precision Franchising LLC*, CircuitCourt for Escambia County, Florida

*PrecisionFranchising LLC v. Davis Tune, Inc. et al.*, FederalDistrict Court for the Eastern District of Virginia

On February 15, 2005, PFL was served with acomplaint in which franchisee Davis Tune, Inc. sought damages in excess of$30,000. Davis Tune, Inc. and its two shareholders, Mr. Donald Roeand Ms. Shirley F. Roe, were also defendants in a related actionfiled by PFL on November 1, 2004.

On June 10, 2005, the parties entered into asettlement agreement resolving both matters. Under the terms of the settlement DavisTune, Inc. agreed to: (1) renew one of its Franchise Agreements thathad expired and to re-brand the associated location as a Precision Tune AutoCare center; (2) pay 

12

 

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approximately $11,000 indelinquent fees, and (3) pay PFL $75,000 in the event it fails to complywith all agreements between the parties.

The Company does notbelieve that any of the above claims or proceedings will result in a materialjudgment against the Company. There can be no assurance, however, that thesesuits will ultimately be decided in its favor. Any one of these claims orproceedings may result in a material judgment against the Company, which couldcause material adverse consequences to its operations.

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

None.

13

 

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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, 2005, and June 30, 2004, 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.

**FiscalYear 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     |       |
|             |            |            |            |          |            |         |            |  |  |

 

**FiscalYear Ended June 30, 2004**

| **Quarter** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------|------------|------------|------------|----------|------------|---------|------------|
| First       |       | $          | 0.85       |     | $          | 0.55    |       |
| Second      |       | 1.25       |       | 0.68     |       |
| Third       |       | 0.91       |       | 0.60     |       |
| Fourth      |       | 0.95       |       | 0.60     |       |
|             |            |            |            |          |            |         |            |  |  |

 

As of August 15,2005, there were approximately 189 record holders of Common Stock andapproximately 1,200 beneficial owners of the Company’s Common Stock.

**EquityCompensation 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     |                   |       | 1,541,700  |                                                                                                                                                 |       |                                                                                                                 | 0.85       |                                                                                        |       |   | 871,997 |   |   |
| Equity  compensation plans not approved by security holders |                   |       | 0          |                                                                                                                                                 |       |                                                                                                                 | 0          |                                                                                        |       |   | 0 |   |   |
| Total                                                       |                   |       | 1,541,700  |                                                                                                                                                 |       |                                                                                                                 | 0.85       |                                                                                        |       |   | 871,997 |   |   |

 

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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 Financial Statements of the Company andrelated 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 field trainingprograms. Additionally, the Company is seeking growth through co-branding. Thisstrategy is designed to permit the Company to partner with other retailers andservice providers who are also seeking to improve cash flows throughcomplementary brands.

**Critical Accounting Policies**

The following is a summary of the Company’s criticalaccounting policies. For a full description of these and other accountingpolicies, see Note 1 of the Notes to the Consolidated Financial Statements. Thesecritical accounting policies require estimates and assumptions that affect theamounts of assets, liabilities, revenues and expenses reported in theconsolidated financial statements. Due to their nature, estimates involvejudgments based on available information. Actual results or amounts coulddiffer from estimates and the difference could have a material impact on theconsolidated financial statements. Therefore, understanding these policies isimportant in understanding the reported results of operations and the financialposition of the Company.

*Revenue Recognition*

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 likelyto be collected, the Company provides for estimated losses. This estimate isbased upon our historical experience as well as a detailed review of ourreceivable balances.

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 enters into domestic Area Developmentagreements and international Master License agreements which grant the areadeveloper and master licensor, respectively, the right to sell, on the 

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Company’s behalf,Precision Tune Auto Care franchises within a specific geographic region. Revenuefrom the sale of Area Development agreements and international Master Licenseagreements is recognized as all material services or conditions related to thesale are satisfied.

Product services in the form of equipment and othermarketing materials related sales are recognized upon delivery to thefranchisee.

The Company recognizedrevenues from foreign franchisee operations of $614,000 and $204,000 for thefiscal years ended June 30, 2005 and 2004, respectively.

*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 engages a valuation expert to assistin estimating the fair value of franchising operations utilizing a discountedfuture cash flow approach that estimates revenue, driven by assumed marketgrowth rates and appropriate discount rates. These estimates are consistentwith the plans and estimates we use to manage the underlying business. Impairmenttesting is performed in the first quarter of each fiscal year. Based uponthe current year analysis, management concluded that the $8.7 million carryingvalue of goodwill was not 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 tax deferred assets and establishes avaluation allowance as deemed appropriate. As of June 30, 2005, theCompany had a valuation allowance of $2.9 million against deferred taxassets. Given the Company’s current operating performance, management releasedapproximately $3.5 million and 629,000 of the valuation allowance during 2005and 2004, respectively. This adjustment was based upon management’s assessmentof the recoverability of deferred taxes which included projections of futurepretax earnings.

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**Results of Operations**

**Comparisonof the year ended June 30, 2005 to the year ended June 30, 2004**

***Summary***

| ** **                                    | ** ** | **Twelve Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                             | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                              | ** ** |
| Automotive care  franchising revenue          |       | $                                                    | 12,347     |   | 96 |   | $ | 11,192 |   | 94 |   |
| Other                                         |       | 456                                                  |       | 4 |   | 658 |   | 6 |   |
| Total revenues                                |       | $                                                    | 12,803     |   | 100 | % | $ | 11,850 |   | 100 | % |
| Automotive care  franchising direct cost      |       | 7,181                                                |       | 57 |   | 6,616 |   | 56 |   |
| Other                                         |       | 395                                                  |       | 3 |   | 611 |   | 5 |   |
| Total direct cost                             |       | 7,576                                                |       | 60 |   | 7,227 |   | 61 |   |
| General and  administrative                   |       | 3,486                                                |       | 26 |   | 3,366 |   | 28 |   |
| Depreciation  expense                         |       | 111                                                  |       | 1 |   | 318 |   | 3 |   |
| Operating income                              |       | 1,630                                                |       | 13 |   | 939 |   | 8 |   |
| Gain on debt  restructuring                   |       | —                                               |       | — |   | 193 |   | 2 |   |
| Other income                                  |       | 58                                                   |       | 0 |   | 65 |   | 0 |   |
| Earnings before  taxes                        |       | 1,688                                                |       | 13 |   | 1,197 |   | 10 |   |
| Income taxes                                  |       | (2,967                                               | )          | (23 | ) | (473 | ) | (4 | ) |
| Net income                                    |       | 4,655                                                |       | 36 |   | 1,670 |   | 14 |   |
| Preferred stock  dividends                    |       | 30                                                   |       | — |   | 80 |   | — |   |
| Net income applicable to  common shareholders |       | $                                                    | 4,625      |   | 36 | % | $ | 1,590 |   | 14 | % |

 

*Revenue.*   Totalrevenue for the year ended June 30, 2005 was $12.8 million, an increase ofapproximately $953,000, or 8%, compared with total revenue of $11.9 million forthe year ended June 30, 2004.

Automotive care franchising revenue for the year endedJune 30, 2005 was $12.3 million, an increase of approximately $1.1million, or 10%, compared with automotive care revenues of $11.2 million forthe year ended June 30, 2004. This increase was primarily due to anincrease in franchise development revenue of approximately $833,000. Franchisedevelopment revenue increased due to the Company signing an area developmentagreement with North Pacific Precision, Inc. for the area rights for theSeattle market. Under the agreement, North Pacific Precision, Inc. paid$500,000 for the area developer rights for the Seattle market. Such fees wererecognized upon execution of the agreement since all significant obligationsunder the agreement were satisfied at that time. The Company will receive fiftypercent of the income from the sale of franchises and from royalty paymentsfrom franchisees in that region. Franchise development revenue also increaseddue to the Company signing two master franchise agreements. The Company alsosigned a master franchise agreement with Hung Yue Holdings (Hong Kong) Co.,Ltd. giving that firm’s affiliate, Precision Tune Auto Care (China) CompanyLimited, a license to open and operate at least 330 Precision Tune Auto Care(PTAC) car care centers in China over the next seven years. Under the terms ofthe agreement, Hung Yue Holdings is obligated to pay the Company approximately$2.1 million. The Company recognized revenue of $193,000 through June 30,2005 in connection with the signing of the master franchise agreement, and$13,000 was deferred for travel expenses. The revenue was recognized as theCompany had substantially fulfilled all required obligations (see Note 3 of theConsolidated Financial Statements). Additionally, the Company signed a masterfranchise agreement with Precision—Sociedade Gestora de Franchising S.A. deC.V. giving that corporation a license to operate and open at least 180Precision Tune Auto Care (PTAC) car care centers in Spain over the next fiveyears. Under the terms of the agreement, Precision—Sociedade Gestora deFranchising S.A. de C.V. is obligated to pay the 

17

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Company approximately$750,000. The Company recognized revenue of $150,000 in connection with thesigning of the master franchise agreement for the twelve months ended June 30,2005 (see Note 3 of the Consolidated Financial Statements). The automotive carefranchising revenue also increased approximately $200,000 due to equipmentsales for the year ended June 30, 2005. There were no comparable equipmentsales for the year ended June 30, 2004.

Other revenue for the year ended June 30, 2005was $456,000, a decrease of approximately $202,000, or 31%, compared to$658,000 for the year ended June 30, 2004. This decrease was due to thefact that the support revenue from the Shell-Mexico transaction ceased as of December 31,2004 as well as a decrease in revenue derived from training and rebateprograms.

*DirectCost.*   Total direct cost for the year ended June 30,2005 totaled $7.6 million, an increase of approximately $342,000 or 5%,compared with $7.2 million for the year ended June 30, 2004.

Automotive care franchising direct cost for the yearended June 30, 2005 totaled $7.2 million, an increase of $565,000 or 9%,compared with $6.6 million for the year ended June 30, 2004. This increaseis directly attributable to the fact that nine more centers opened duringfiscal year 2005 compared to fiscal year 2004. Also, the equipment revenuecomprised a greater percentage of the total revenue mix in fiscal year 2005. Theincreased equipment revenue had a lower margin compared to the revenueassociated with royalties.

Other direct cost for the year ended June 30,2005 totaled $395,000, a decrease of $216,000, compared with $611,000 for theyear ended June 30, 2004. This decrease is primarily due to thetermination of the agreement to provide support to Shell-Mexico as thatagreement was completed as of December 31, 2004.

*Generaland Administrative Expense.*   General andadministrative expense was $3.5 million for the year ended June 30, 2005,an increase of approximately $120,000 or 4%, compared with $3.4 million for theyear ended June 30, 2004. This increase was primarily the result ofincreased legal expenses associated with enforcing franchise agreements. Othergeneral and administrative expenses remained consistent with prior year. Thegeneral and administrative expenses also include a charge of $97,000 and$127,000, respectively, due to variable accounting for certain employee stockoptions in 2005 and 2004 (see Note 10 of the Consolidated FinancialStatements).

*Operating Income From Continuing Operations.  *TheCompany recorded operating income for the year ended June 30, 2005 ofapproximately $1.6 million, an increase of $691,000, or 74%, compared with anoperating income of $939,000 for the year ended June 30, 2004.

*Gain on Debt Restructuring.  *TheCompany recognized a gain from debt restructuring in the amount of $193,000 forthe year ended June 30, 2004, primarily as a result of restructuring theBoard LLC debt (see Note 7 of the Consolidated Financial Statements).

*Other Income.**  *The Company recorded Other Income of $58,000 for theyear ended June 30, 2005, compared with Other Income of $65,000 for theyear ended June 30, 2004.

*Income Taxes.**  *The Company recorded an income tax benefit of $3.0million for the year ended June 30, 2005, an increase of $2.5 million or527%, compared with $473,000 for the year ended June 30, 2004. Theseadjustments were based upon management’s assessment of the recoverability ofdeferred taxes which included projections of future pretax earnings.

*NetIncome Applicable to Common Shareholders and Earnings Per Share*.*  *The Company recorded Net Income Applicable to CommonShareholders of $4.6 million, or $0.18 per share, for the year ended June 30,2005 compared to $1.6 million, or $0.08 per share, for the year ended June 30,2004.

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*Liquidity and Capital Resources*

*Sources and Uses ofCash*

Cash at June 30, 2005 was $3.3 million. Duringthe period, cash provided by operations was $1.7 million.

Cash used in investing activities for the twelvemonths ended June 30, 2005 was $55,000 resulting primarily from thepurchase of property and equipment.

Cash provided by financing activities for the twelvemonths ended June 30, 2005 was $25,000. Cash provided by financingactivities during the period consisted of proceeds from issuance of the Company’sstock net of the payments of other notes payable and preferred stock dividends.

Management believes thatthe Company’s current cash balance, cash generated from operations, andavailable credit line will be sufficient to meet the Company’s working capitalneeds, capital expenditures, and contractual obligations for fiscal year 2006.

*Debt Transactions*

In October 1998,a subordinated debenture in the amount of $2.0 million was executed with an LLCcomposed of certain members of the Company’s board of directors (Board LLC). OnJuly 17, 2003, the Company reached an agreement to restructure theremaining $633,000 due to the Board LLC. The terms of the agreement called forthe following:

·       Paymentof $200,000 within 3 days of receipt of approval by the Company’s Board ofDirectors.

·       Issuanceof a non-interest bearing note payable in the amount of $50,000, payable in tenmonthly installments of $5,000 each, commencing one month after the date ofapproval by the Company’s Board of Directors.

·       Issuanceof warrants to purchase 400,000 shares of the Company’s common stock with anexercise price of $0.44 per share having a fair value of approximately$222,000.

The Company recognized a gain of approximately$160,000 from this debt restructuring in the first quarter of fiscal year 2004.

In December 2003, the Company paid approximately$169,000 in full satisfaction of the $201,000 of debt owed to Radiant Systems, Inc.The Company recognized a gain of approximately $32,000 from this transaction inthe second quarter of fiscal year 2004.

In January 2004, 2,469,600 warrants wereexercised pursuant to an agreement the Company reached with Precision Funding,L.L.C. and a former board member in October 2002. Upon the exercise ofthese warrants at the previously agreed to exercise price of $0.44 per share,the holder purchased 2,469,600 restricted shares of common stock in exchangefor surrendering 104,885 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

In February 2004, 4,530,169 warrants wereexercised pursuant to an agreement the Company reached with Precision Funding,L.L.C. and a former board member in October 2002. Upon the exercise ofthese warrants at the previously agreed to exercise price of $0.44 per share,the holder purchased 4,530,169 restricted shares of common stock in exchangefor surrendering 192,401 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

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 

19

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restricted shares ofcommon stock by surrendering 189,942 shares of Series A Preferred Stock tothe Company, therefore, there were no cash proceeds received by the Companyfrom 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, 10,000warrants 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.

*Seasonality andQuarterly Fluctuations*

Seasonalchanges may impact various sectors of the Company’s business differently and,accordingly, the Company’s operations may be affected by seasonal trends incertain periods. In particular, severe weather in winter months can adverselyaffect the Company because such weather makes it difficult for consumers inaffected parts of the country to travel to Precision Auto Care and PrecisionLube Express centers. 
20
**Item 7.   *Financial Statements***

21

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**Report of Independent Registered Public AccountingFirm**

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

We have audited the accompanying consolidated balancesheets of Precision Auto Care, Inc. (the Company) and subsidiaries as of June 30,2005 and 2004, 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, thefinancial statements referred to above, present fairly, in all materialrespects, the consolidated financial position of Precision Auto Care, Inc.and subsidiaries as of June 30, 2005 and 2004, and the consolidatedresults of its operations and its cash flows for the years then ended inconformity with accounting principles generally accepted in the United Statesof America.

/s/ GRANT THORNTON LLP

Vienna, VirginiaSeptember 7, 2005

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**PRECISION AUTOCARE, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                     | ** ** | **June 30,**                                                                                       | ** ** | **June 30,**                                                                                       | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**                                                                                                | ** ** | **2004**                                                                                                | ** ** |
| **ASSETS**                                                                                                                                     |       |                                                                                                    | ** ** | ** **                                                                                              | ** ** |
| Current assets:                                                                                                                                |       |                                                                                                    |       |                                                                                                    |       |
| Cash and cash equivalents                                                                                                                      |       | $  3,279,568                                                                                  |       | $  1,573,368                                                                                  |       |
| Restricted cash                                                                                                                                |       | —                                                                                                  |       | 50,200                                                                                                  |       |
| Accounts receivable, net of allowance of $60,971 and  $72,815, respectively                                                                    |       | 640,271                                                                                                 |       | 545,133                                                                                                 |       |
| Notes receivable                                                                                                                               |       | 251,301                                                                                                 |       | 211,243                                                                                                 |       |
| Deferred tax asset                                                                                                                             |       | 479,824                                                                                                 |       | 473,000                                                                                                 |       |
| Other assets                                                                                                                                   |       | 344,593                                                                                                 |       | 283,244                                                                                                 |       |
| Total current assets                                                                                                                           |       | 4,995,557                                                                                               |       | 3,136,188                                                                                               |       |
| Property and equipment, at cost                                                                                                                |       | 4,202,133                                                                                               |       | 4,147,329                                                                                               |       |
| Less: Accumulated depreciation                                                                                                                 |       | (4,093,702                                                                                              | )          | (3,982,924                                                                                              | )          |
|                                                                                                                                           |       | 108,431                                                                                                 |       | 164,405                                                                                                 |       |
| Goodwill                                                                                                                                       |       | 8,711,744                                                                                               |       | 8,711,744                                                                                               |       |
| Notes receivable,  net of allowance of $412,128 and $254,832, respectively.                                                                    |       | 36,159                                                                                                  |       | 161,685                                                                                                 |       |
| Deferred tax  asset                                                                                                                            |       | 3,143,968                                                                                               |       | —                                                                                                  |       |
| Deposits and  other                                                                                                                            |       | 24,314                                                                                                  |       | 27,914                                                                                                  |       |
| Total assets                                                                                                                                   |       | $ 17,020,173                                                                                       |       | $ 12,201,936                                                                                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                  | ** ** | ** **                                                                                              | ** ** | ** **                                                                                              | ** ** |
| Current liabilities:                                                                                                                           |       |                                                                                                    |       |                                                                                                    |       |
| Line-of-credit                                                                                                                                 |       | $                — |       | $                — |       |
| Notes payable—current                                                                                                                     |       | 19,346                                                                                                  |       | 75,240                                                                                                  |       |
| Accounts payable and accrued liabilities                                                                                                       |       | 1,681,354                                                                                               |       | 1,705,376                                                                                               |       |
| Due to related party                                                                                                                           |       | 116,073                                                                                                 |       | 91,426                                                                                                  |       |
| Deferred revenue                                                                                                                               |       | 253,322                                                                                                 |       | 396,150                                                                                                 |       |
| Total current liabilities                                                                                                                      |       | 2,070,095                                                                                               |       | 2,268,192                                                                                               |       |
| Notes payable, net of current portion                                                                                                          |       | 7,991                                                                                                   |       | 13,770                                                                                                  |       |
| Total liabilities                                                                                                                              |       | 2,078,086                                                                                               |       | 2,281,962                                                                                               |       |
| Commitments and contingencies                                                                                                                  |       | —                                                                                                  |       | —                                                                                                  |       |
| Series A redeemable preferred stock,  $.01 par value; 1,000,000 shares authorized; 11,227 and 202,714 shares  issued and outstanding |       | 116,312                                                                                                 |       | 2,100,117                                                                                               |       |
| Stockholders’  equity:                                                                                                                    |       |                                                                                                    |       |                                                                                                    |       |
| Common stock, $.01 par value; 39,000,000 shares  authorized; 28,862,252 and 23,808,602 shares issued and outstanding                           |       | 288,623                                                                                                 |       | 238,086                                                                                                 |       |
| Additional paid-in capital                                                                                                                     |       | 67,949,970                                                                                              |       | 65,619,904                                                                                              |       |
| Accumulated deficit                                                                                                                            |       | (53,412,818                                                                                             | )          | (58,038,133                                                                                             | )          |
| Total stockholders’ equity                                                                                                                |       | 14,825,775                                                                                              |       | 7,819,857                                                                                               |       |
| Total liabilities  and stockholders’ equity                                                                                               |       | $ 17,020,173                                                                                       |       | $ 12,201,936                                                                                       |       |

 

See accompanying notes.

23

----

**PRECISION AUTOCARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                           | ** ** | **For The Years Ended**                                  | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **June 30,**                                                       | ** ** |
|                                                                 |       | **2005**                                                                |       | **2004** |   |
| Revenues:                                                            | ** ** | ** **                                                              | ** ** | ** ** | ** ** |
| Franchise royalties                                                  |       | $ 11,015,897                                                       |       | $ 10,701,034 |   |
| Franchise development                                                |       | 1,330,768                                                               |       | 490,826 |   |
| Other                                                                |       | 456,314                                                                 |       | 658,029 |   |
| Total revenues                                                       |       | 12,802,979                                                              |       | 11,849,889 |   |
| Direct cost:                                                         |       |                                                                    |       |   |   |
| Franchise support and other                                          |       | 7,576,301                                                               |       | 7,227,399 |   |
| Contribution                                                         |       | 5,226,678                                                               |       | 4,622,490 |   |
| General and administrative expense                                   |       | 3,486,448                                                               |       | 3,365,833 |   |
| Depreciation  expense                                                |       | 110,778                                                                 |       | 318,101 |   |
| Operating income                                                     |       | 1,629,452                                                               |       | 938,556 |   |
| Gain on debt restructuring                                           |       | —                                                                  |       | 192,875 |   |
| Interest expense                                                     |       | (5,508                                                                  | )          | (19,611 | ) |
| Other income                                                         |       | 63,337                                                                  |       | 85,079 |   |
| Total other income                                                   |       | 57,829                                                                  |       | 258,343 |   |
| Income before income tax expense                                     |       | 1,687,281                                                               |       | 1,196,899 |   |
| Benefit for  income taxes                                            |       | 2,967,771                                                               |       | 473,000 |   |
| Net income                                                           |       | 4,655,052                                                               |       | 1,669,899 |   |
| Preferred stock  dividends                                           |       | 29,737                                                                  |       | 80,127 |   |
| Net income  applicable to common shareholders                        |       | $ 4,625,315                                                        |       | $ 1,589,772 |   |
| Net income applicable to common stock per common  share—Basic   |       | $           0.18 |       | $           0.08 |   |
| Net income  applicable to common stock per common share—Diluted |       | $           0.16 |       | $           0.07 |   |
| Weighted average common shares outstanding—Basic                |       | 25,253,897                                                              |       | 19,392,950 |   |
| Weighted average common  shares outstanding—Diluted             |       | 28,186,206                                                              |       | 22,549,311 |   |

 

See accompanying notes.

24

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

| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | ** **  | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|----------------|------------|-----------------|------------|-------------|------------|
| ** **                                  | ** ** | **Common** | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
| ** **                                  | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Total**   | ** ** |
| Balance at  June 30, 2003              |       | 16,558,833 |       | $165,588   |       | $62,126,581    |       | $(59,627,905    | )          | $2,664,264  |       |
| Issuance of  common stock                   |       | 6,999,769  |       | 69,998     |       | 3,009,885      |       | —          |       | 3,079,883   |       |
| Common stock  issued as compensation        |       | 250,000    |       | 2,500      |       | 130,000        |       | —          |       | 132,500     |       |
| Debt to equity  conversion                  |       | —     |       | —     |       | 222,175        |       | —          |       | 222,175     |       |
| Stock option  compensation                  |       | —     |       | —     |       | 131,263        |       | —          |       | 131,263     |       |
| Net income                                  |       | —     |       | —     |       | —         |       | 1,589,772       |       | 1,589,772   |       |
| 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 |       |

 

See accompanying notes.

25

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**PRECISION AUTOCARE, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                       | ** ** | **For The Years Ended** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                       | ** ** | **June 30,**                      | ** ** |
| ** **                                                                                       | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Operating activities:                                                                            |       |                                   |       |   |   |
| Net income  applicable to common shareholders                                                    |       | $                                      | 4,625,315  |   | $ | 1,589,772 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:               |       |                                   |       |   |   |
| Depreciation and amortization                                                                    |       | 110,778                                |       | 318,101 |   |
| Bad debt expense                                                                                 |       | 147,296                                |       | 76,036 |   |
| Decrease in valuation allowance                                                                  |       | (3,526,000                             | )          | (629,000 | ) |
| Gain on debt restructuring                                                                       |       | —                                 |       | (192,875 | ) |
| Gain on sale of assets                                                                           |       | —                                 |       | (25,000 | ) |
| Stock issued for compensation                                                                    |       | —                                 |       | 132,500 |   |
| Tax benefit from exercise of stock options                                                       |       | 114,072                                |       | — |   |
| Stock based compensation                                                                         |       | 102,346                                |       | 131,263 |   |
| Changes in assets  and liabilities:                                                              |       |                                   |       |   |   |
| Restricted cash                                                                                  |       | 50,200                                 |       | (50,200 | ) |
| Accounts and notes receivable                                                                    |       | (156,966                               | )          | (88,222 | ) |
| Prepaid expenses, deposits and other                                                             |       | 2,251                                  |       | 19,323 |   |
| Accounts payable and accrued liabilities                                                         |       | 9,186                                  |       | (570,961 | ) |
| Due to related party                                                                             |       | 24,647                                 |       | 91,426 |   |
| Deferred revenue and other                                                                       |       | (142,828                               | )          | (121,350 | ) |
| Deferred taxes                                                                                   |       | 375,208                                |       | 156,000 |   |
| Net cash provided  by operating activities                                                       |       | 1,735,505                              |       | 836,813 |   |
| Investing activities:                                                                            |       |                                   |       |   |   |
| Purchases of property and equipment                                                              |       | (54,804                                | )          | (100,107 | ) |
| Net cash used in investing  activities                                                           |       | (54,804                                | )          | (100,107 | ) |
| Financing activities:                                                                            |       |                                   |       |   |   |
| Proceeds from issuance of parent company stock                                                   |       | 180,380                                |       | — |   |
| Payment of preferred stock dividends                                                             |       | (33,208                                | )          | (85,560 | ) |
| Repayment of subordinated debt and other notes  payable                                          |       | (121,673                               | )          | (641,888 | ) |
| Net cash provided  by (used in) financing activities                                             |       | 25,499                                 |       | (727,448 | ) |
| Net change in  cash and cash equivalents                                                         |       | 1,706,200                              |       | 9,258 |   |
| Cash and cash  equivalents at beginning of year                                                  |       | 1,573,368                              |       | 1,564,110 |   |
| Cash and cash  equivalents at end of period                                                      |       | $                                      | 3,279,568  |   | $ | 1,573,368 |   |
| Supplemental schedule of  non cash investing and finance activities:                             |       |                                   |       |   |   |
| Fair value of  preferred stock exchanged for issuance of common stock                            |       | $                                      | 1,983,805  |   | $ | 3,079,883 |   |
| Fair value of common,  preferred stock, and warrants issued in exchange for cancellation of debt |       | $                                      | —     |   | $ | 272,175 |   |

 

See accompanying notes.

26

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

**Note 1—Business Description and Financial StatementPresentation**

Precision Auto Care, Inc.(the ‘‘Company’’) is a franchisor of automotive maintenance service centerswhich provide specialized automotive care services, and fast oil change andlube services. These franchisee owned centers operate primarily under thePrecision Tune Auto Care and Precision Lube Express brand names.

**Note 2—Summary of Significant Accounting Policies**

*Principles ofConsolidation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries.

*Revenue Recognition*

The Company’s royalty revenue is recognized as earnedin accordance with the specific terms of each agreement and to the extent noissues involving collection exist. In the case when revenues are not likely tobe collected, the Company provides for an estimate of bad debt expense. Thisestimate is based upon our historical experience as well as a detailed reviewof our receivable balances.

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 enters into domestic Area Developmentagreements and international Master License agreements which grant the areadeveloper and master licensor, respectively, the right to sell, on the Company’sbehalf, Precision Tune Auto Care franchises within a specific geographic region.Revenue from the sale of Area Development agreements and international Master Licenseagreements is recognized as all material services or conditions related to thesales are satisfied.

Product services in the form of equipment and othermarketing materials related sales are recognized upon delivery to the franchisees.

The Company recognizedrevenues from foreign franchisee operations of $614,000 and $204,000 for thefiscal years ended June 30, 2005 and 2004, respectively.

*Cash and CashEquivalents*

Cash and cash equivalentsare comprised of highly liquid debt instruments with original maturities ofthree months or less. Cash balances may exceed insured amounts.

27

----

**Precision Auto Care, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2—Summaryof Significant Accounting Policies (Continued)**

*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 more likely than not thatthe 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.

*Advertising Costs*

The Company expenses alladvertising costs as incurred. The Company incurred $60,000 and $85,000 inadvertising costs for the years ended June 30, 2005 and 2004,respectively.

28

----

**Precision Auto Care, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2—Summaryof Significant Accounting Policies (Continued)**

*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 and IntangibleAssets*

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 engages a valuation expert to assistin estimating the fair value of franchising operations utilizing a discountedfuture cash flow approach that estimates revenue, driven by assumed marketgrowth rates and appropriate discount rates. These estimates are consistentwith the plans and estimates we use to manage the underlying business. Impairmenttesting is performed in the first quarter of each fiscal year. Based uponthe current year analysis, management concluded that the $8.7 million carryingvalue of goodwill was not impaired.

*Segment Reporting*

The Company operates inone business segment; Automotive Care Franchising.

*Stock Options*

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. Compensation expense is recordedwhen modifications and other provisions cause the application of variableaccounting or require a new measurement date.

Generally, the Board of Directors has granted stockoptions with exercise prices equal to the fair market value o f the Company’scommon stock on the grant date. However, the Company issued 65,000 options on July 30,2003 which had an exercise price below the fair market value of the underlyingcommon stock on that date. As a result, approximately $15,000 of compensationexpense will be recognized over the option’s vesting period. The Companygranted stock to an officer with a fair value of $212,500 during fiscal year2003, and recognized compensation expense of $132,500 and $80,000 as of June 30,2004 and 2003, respectively. The Company also repurchased certain options fromemployees and issued new options exercisable at an exercise price of $0.44 infiscal year 2003, resulting in the newly issued options being treated as arepricing under FIN 44, which triggered variable accounting. As a result, theCompany recorded compensation expense of approximately $87,000 and $127,000associated with these options as of June 30, 2005 and 2004, respectively.In January of 2005, 15,000 shares of the repriced options were exercised andthe Company recorded compensation expense of approximately $11,000 in thatperiod.

29

----

**Precision Auto Care, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2—Summaryof Significant Accounting Policies (Continued)**

Had compensation expensefor all options been determined based on the fair value at the grant datesduring the years ending June 30, 2005 and 2004 consistent with the fairvalue method of SFAS No. 123, the pro forma net income and income pershare would have been as follows:

| ** **                                                                                                | ** ** | **Year ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net income  applicable to common shareholders                                                             |       | $                                      | 4,625,315  |   | $ | 1,589,772 |   |
| Add: Total  stock-based compensation expense reported in net income                                       |       | 102,346                                |       | 263,763 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards* |       | 163,407                                |       | 243,500 |   |
| Pro forma net  income                                                                                     |       | $                                      | 4,564,254  |   | $ | 1,610,035 |   |
| Earnings per share:                                                                                       |       |                                   |       |   |   |
| Basic—as reported and pro forma                                                                      |       | $                                      | 0.18       |   | $ | 0.08 |   |
| Diluted—as reported and pro forma                                                                    |       | $                                      | 0.16       |   | $ | 0.07 |   |
| Weighted average shares:                                                                                  |       |                                   |       |   |   |
| Weighted average  common shares outstanding—Basic                                                    |       | 25,253,897                             |       | 19,392,950 |   |
| Weighted average common  shares outstanding—Diluted                                                  |       | 28,186,206                             |       | 22,549,311 |   |

 

*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, 2005and 2004 was 5,682,022 and 11,142,095, respectively. Only stock options andwarrants with exercise prices lower than the average market price of the commonshares were included in the diluted EPS calculation for fiscal year 2005 and2004. For the years ended June 30, 2005 and 2004, respectively 182,950shares attributable to outstanding stock options were not included in thecomputation of diluted earnings per share because their inclusion would havebeen anti-dilutive.

30

----

**Precision Auto Care, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2—Summaryof Significant Accounting Policies (Continued)**

The following table setsforth the computation of basic and diluted earnings per share:

| ** **                                                    | ** ** | **For The Years Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| Numerator:                                                    |       |                                                      |       |   |   |
| Net income                                                    |       | $                                                         | 4,655,052  |   | $ | 1,669,899 |   |
| Preferred stock dividends                                     |       | (29,737                                                   | )          | (80,127 | ) |
| Net income applicable to common Shareholders                  |       | $                                                         | 4,625,315  |   | $ | 1,589,772 |   |
| Denominator:                                                  |       |                                                      |       |   |   |
| Denominator for basic EPS weighted- average-shares            |       | 25,253,897                                                |       | 19,392,950 |   |
| Common stock equivalents- stock options and warrants          |       | 2,932,309                                                 |       | 3,156,361 |   |
| Denominator for diluted EPS weighted- average-shares          |       | 28,186,206                                                |       | 22,549,311 |   |
| Basic earnings  per share applicable to common shareholders   |       | $                                                         | 0.18       |   | $ | 0.08 |   |
| Diluted earnings per  share applicable to common shareholders |       | $                                                         | 0.16       |   | $ | 0.07 |   |

 

*Reclassifications*

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

**Note 3—Master License 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 agreement,Hung Yue Holdings is obligated to pay the Company approximately $2.1 million. Adeposit payment of $50,000 was paid into escrow prior to executing theagreement and $100,000 was paid on August 31, 2004, upon execution. Additionalpayments of $50,000 were to be paid by November 30, 2004 and December 31,2004, respectively. However, due to unforeseen circumstances Hung Yue Holdingsrequested additional time to make these payments. The Company has received$56,000 of the remaining installment payments relating to the signing of themaster franchise agreement and recognized revenue of $193,000 in connectionwith the signing of the master franchising agreement for the year ended June 30,2005 and $13,000 was deferred for travel expenses for on-site training. Therevenue was recognized as the Company had substantially fulfilled all requiredobligations. The Company will also receive a $250,000 payment on the firstanniversary of signing the master franchise agreement, and a minimum of $1.6million payable in seven annual installments beginning on August 31, 2005,relating to the opening of car care centers in China. No future revenue will berecognized until collection of such amounts is probable. Additionally, revenuefrom future franchises under the master license agreement will be recognizedwhen the Company’s obligations have been satisfied and collection of thefranchise fee is probable. There was one center opened as of June 30,2005.

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 

31

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**Precision Auto Care, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 3—MasterLicense Agreements (Continued)**

receive$150,000 on January 1 for the subsequent four years. The Companyrecognized revenue of $150,000 for the year ended June 30, 2005 as theCompany had substantially fulfilled all required obligations. Additionally,future revenue will not be recognized until collection of such amounts isprobable.  No centers were opened as of June 30,2005.

**Note 4—New Accounting Pronouncements**

In December 2004, theFinancial Accounting Standards Board issued SFAS 123 (revised 2004)“Share-Based Payment”. This Statement requires that the cost resulting from allshare-based transactions be recorded in the financial statements. The Statementestablishes fair value as the measurement objective in accounting forshare-based payment arrangements and requires all entities to apply afair-value-based measurement in accounting for share-based payment transactionswith employees. The Statement also establishes fair value as the measurementobjective for transactions in which an entity acquires goods or services fromnon-employees in share-based payment transactions. The Statement replaces SFAS123 “Accounting for Stock-Based Compensation” and supersedes APB OpinionNo. 25 “Accounting for Stock Issued to Employees.”  The provisions of this Statement will beeffective for the Company beginning with its fiscal year 2007. The Company iscurrently evaluating the impact this revised Standard will have on its financialposition and results of operations.

**Note 5—Property and Equipment**

Thecomponents of property and equipment are as follows:

| ** **                     | ** ** | **June 30,** | ** ** |
|--------------------------------|------------|-------------------|------------|
| ** **                     | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Furniture and  fixtures        |       | $                 | 1,065,575  |   | $ | 1,052,854 |   |
| Equipment                      |       | 2,652,799         |       | 2,498,685 |   |
| Equipment under  capital lease |       | 79,459            |       | 79,459 |   |
| Leasehold  improvements        |       | 61,590            |       | 46,809 |   |
| Other items                    |       | 342,710           |       | 469,522 |   |
|                           |       | 4,202,133         |       | 4,147,329 |   |
| Accumulated  depreciation      |       | (4,093,702        | )          | (3,982,924 | ) |
| Property and equipment,  net   |       | $                 | 108,431    |   | $ | 164,405 |   |

 

32

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6—Income Taxes**

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

| ** **                     | ** ** | **Years Ended June 30,** | ** ** |
|--------------------------------|------------|-----------------------------------------|------------|
| ** **                     | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Current tax  expense:          |       |                                    |       |   |   |
| Federal                        |       | $                                       | 51,000     |   | $ | — |   |
| State                          |       | —                                  |       | — |   |
| Total current tax  expense     |       | 51,000                                  |       | — |   |
| Deferred tax  expense:         |       |                                    |       |   |   |
| Federal                        |       | 415,000                                 |       | 129,000 |   |
| State                          |       | 92,000                                  |       | 27,000 |   |
| Total deferred tax  expense    |       | 507,000                                 |       | 156,000 |   |
| Change in valuation  allowance |       | (3,526,000                              | )          | (629,000 | ) |
| Total income tax  (benefit)    |       | $(2,968,000                             | )          | $(473,000 | ) |
|                                |            |                                         |            |  |  |  |  |

 

Theeffective tax rate differed from the statutory rate as follows:

| ** **                         | ** ** | **Years Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|
| ** **                         | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Statutory federal  rate            |       | 34                                      | %          |   | 34 | % |   |
| State taxes                        |       | 5                                       |       |   | 5 |   |   |
| Nondeductible  expenses            |       | —                                  |       |   | 5 |   |   |
| Adjustment to  deferred tax assets |       | (7                                      | )          |   | (31 | ) |   |
| Change in  valuation allowance     |       | (209                                    | )          |   | (51 | ) |   |
| Other                              |       | 1                                       |       |   | — |   |   |
| Effective tax rate                 |       | (176                                    | )%         |   | (38 | )% |   |

 

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 2005 and 2004, the Company made an adjustment of $115,000 and$974,000, respectively, to the deferred tax assets primarily to adjustcumulative temporary balances and the net operating loss carryforwards. Thisadjustment had no effect on the income statement as the valuation allowance wasadjusted by the same amount.

33

----

**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6—IncomeTaxes (Continued)**

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

| ** **                                   | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Deferred tax assets:                         |       |              |       |   |   |
| Net operating loss                           |       | $                 | 5,726,000  |   | $ | 6,824,000 |   |
| Other                                        |       | 797,000           |       | 74,000 |   |
|                                         |       | 6,523,000         |       | 6,898,000 |   |
| Valuation  allowance for deferred tax assets |       | (2,899,000        | )          | (6,425,000 | ) |
| Net deferred taxes                           |       | $                 | 3,624,000  |   | $ | 473,000 |   |

 

As of June 30,2004, the Company had net operating loss carryforwards for federal tax purposesof approximately $14.8 million, which expire from 2019 through 2022. TheCompany regularly reviews the recoverability of its tax deferred assets andestablishes a valuation allowance as deemed appropriate. As of June 30,2005, the Company had a valuation allowance of $2.9 million against deferredtax assets. Given the Company’s current operating performance, managementreleased approximately $3.5 million of the valuation allowance during 2005. Thisadjustment was based upon management’s assessment of the recoverability ofdeferred taxes which included projections of future pretax earnings.

**Note7—Debt**

*Line of Credit*

On March 1, 2005, theCompany renewed the $250,000 line of credit with Chevy Chase Bank.  The interest rate on this line of credit isindexed to the Prime Rate as published in *The Wall Street Journal*(6.25%at June 30, 2005) and the Company has pledged all of its wholly-ownedsubsidiaries as collateral. As of June 30, 2005, the Company has notborrowed against this line of credit. Under this agreement, the Company mustmeet financial covenants relating to profitability, debt service coverage and amaximum leverage ratio. The Company was in compliance with all such covenantsas of June 30, 2005 and 2004, respectively.

*Debt Restructuring*

In October 1998,a subordinated debenture in the amount of $2.0 million was executed with an LLCcomposed of certain members of the Company’s board of directors (Board LLC). OnJuly 17, 2003, the Company reached an agreement to restructure theremaining $633,000 due to the Board LLC. The terms of the agreement called forthe following:

·       Paymentof $200,000 within 3 days of receipt of approval by the Company’s Board ofDirectors.

·       Issuanceof a non-interest bearing note payable in the amount of $50,000, payable in tenmonthly installments of $5,000 each, commencing one month after the date of approvalby the Company’s Board of Directors.

·       Issuanceof warrants to purchase 400,000 shares of the Company’s common stock with anexercise price of $0.44 per share having a fair value of approximately$222,000.

34

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 7—Debt(Continued)**

The Company recognized a gain of approximately$160,000 from this debt restructuring in the first quarter of fiscal year 2004.

In December 2003, the Company paid approximately$169,000 in full satisfaction of the $201,000 of debt owed to Radiant Systems, Inc.The Company recognized a gain of approximately $32,000 from this transaction inthe second quarter of fiscal year 2004.

In January 2004, 2,469,600 warrants wereexercised pursuant to an agreement the Company reached with Precision Funding,L.L.C. and a former board member in October 2002. Upon the exercise ofthese warrants at the previously agreed to exercise price of $0.44 per share,the holder purchased 2,469,600 restricted shares of common stock in exchangefor surrendering 104,885 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

In February 2004, 4,530,169 warrants wereexercised pursuant to an agreement the Company reached with Precision Funding,L.L.C. and a former board member in October 2002. Upon the exercise ofthese warrants at the previously agreed to exercise price of $0.44 per share,the holder purchased 4,530,169 restricted shares of common stock in exchangefor surrendering 192,401 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

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.

During the years ended June 30, 2005 and 2004,the Company incurred interest expense of approximately $6,000 and $20,000, respectively.

Long-termdebt consists of the following:

| ** **                                                     | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                     | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Various notes and  obligations payable in monthly installments |       | $                 | 13,567     |   | $ | 62,117 |   |
| Lease obligations                                              |       | 13,770            |       | 26,893 |   |
|                                                           |       | 27,337            |       | 89,010 |   |
| Less: current  maturities                                      |       | (19,346           | )          | (75,240 | ) |
| Long-term portion                                              |       | $                 | 7,991      |   | $ | 13,770 |   |

 

35

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 7—Debt(Continued)**

Thefuture debt obligations with maturities in excess of one year as of June 30,2005 are as follows:

| ** ** | ** ** | **Future**               | ** ** |
|------------|------------|--------------------------|------------|
| ** ** | ** ** | **Debt Maturities** | ** ** |
| 2006       |       |                     | 19,346     |   |   |
| 2007       |       |                     | 6,758      |   |   |
| 2008       |       |                     | 1,233      |   |   |
|       |       |                     | $          | 27,337 |   |   |
|            |            |                          |            |  |  |  |

 

**Note 8—Lease Commitments**

At June 30, 2005, the Company has leasecommitments for office space, a training center, and a number of service centerlocations as well as office equipment under operating and capital leases. Theseleases expire between 2006 and 2009, with renewal options in certain of theleases. Most of the service center location leases are subleased tofranchisees. Rent expense for office space and warehouse facilities ofapproximately $361,000 and $284,000 is included in operating expenses for theyear ended June 30, 2005 and 2004 respectively. Rent expense for servicecenter locations of approximately $47,000 and $6,000 is recorded net ofsublease income of $26,000 and $0 for the years ended June 30, 2005 and2004, respectively.

Thefuture minimum lease payments and related sublease payments for operatingleases with terms in excess of one year as of June 30, 2005, are asfollows:

| ** ** | ** ** | **Future Minimum** | ** ** | **Sublease** | ** ** | ** ** | ** ** |
|------------|------------|-------------------------|------------|--------------|------------|------------|------------|
| ** ** | ** ** | **Lease Payments** | ** ** | **Income**   | ** ** | **Net**    | ** ** |
| 2006       |       |                    | 499,000    |         |       | 154,000    |       | 344,000 |   |
| 2007       |       |                    | 485,000    |         |       | 161,000    |       | 325,000 |   |
| 2008       |       |                    | 491,000    |         |       | 156,000    |       | 335,000 |   |
| 2009       |       |                    | 245,000    |         |       | 47,000     |       | 198,000 |   |
| Thereafter |       |                    | —     |         |       | —     |       | — |   |
|       |       |                    | $          | 1,720,000    |       |       | $          | 518,000 |   | $ | 1,202,000 |   |
|            |            |                         |            |              |            |            |            |  |  |  |  |  |

 

Thefuture minimum lease payments for capital leases with terms in excess of oneyear as of June 30, 2005, are as follows:

| ** **                           | ** ** | **Future Minimum** | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **Lease Payments** | ** ** |
| 2006                                 |       |                    | 7,543      |   |   |
| 2007                                 |       |                    | 7,543      |   |   |
| 2008                                 |       |                    | 1,258      |   |   |
| Total lease  payments                |       |                    | $          | 16,344 |   |   |
| Less amounts  representing interest  |       |                    | 2,574      |   |   |
| Present value of net  lease payments |       |                    | $          | 13,770 |   |   |

 

36

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 9—Related Party 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, 2005 and 2004, 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, 2005 and 2004, the net amount due from PMFwas $61,417. This amount is included in accounts receivable.

Bassam N. Ibrahim, adirector of the Company, is a partner in Burns, Doane, Swecker &Mathis LLP, an Alexandria, Virginia law firm that performs legal services forthe Company related to intellectual property protection. Fees paid in theamount of approximately $46,000 and $23,000 to the firm by the Company in thefiscal years ended June 30, 2005 and 2004, respectively, did not exceedfive percent of the firm’s gross revenues.

**Note 10—Stockholders’ Equity**

During the year ended June 30,2004, 250,000 shares of common stock were issued to an officer of the Companyin September 2003. Compensation expense of $132,500 and $80,000 wasrecorded for the earned portion of these shares for the fiscal years ended June 30,2004 and June 30, 2003, respectively.

*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 reserved 600,000 shares for issuance under the Plan. On March 21,2001 the Company’s stockholders approved an amendment to increase theauthorized shares under this plan to 1,600,000. On January 15, 2003 theCompany’s stockholders approved an amendment to increase the authorized sharesunder this plan to 2,600,000. Options available for future grants under thisplan were 257,000 and 560,000 at June 30, 2005 and 2004, respectively.

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 30,2004, 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, andnumber of shares underlying the options.

The Company repurchased 704,000 shares of common stockoptions (exercise prices of these options range from $0.75 to $1.00 per share)for $0.001 per share in the first quarter of fiscal year 2003. The Company inturn granted the same participants options for the purchase of 704,000 shares. Theseoptions are exercisable at an exercise price of $0.44 per share at the samevesting schedule as the participant’s repurchased options. The repurchase ofsuch shares was deemed a repricing under FIN 44 and as such, the Companyapplies variable accounting during the remaining life of these options and indoing so, measures compensation expense periodically based upon the change inthe fair market value of the underlying common stock. As a result, the Companyrecorded compensation expense of approximately $97,000 and $127,000 associatedwith these options as of June 30, 2005 and 2004, respectively. In fiscalyear 2005, 15,000 shares of the repriced options were exercised and the Companyrecognized an expense of approximately $11,000 at that date.

37

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 10—Stockholders’Equity (Continued)**

A summary of the Company’sstock option activity for the years ended June 30, are as follows:

| ** **          | ** ** | **Shares**            | ** ** | **Weighted-Average**    | ** ** |
|---------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **          | ** ** | **Under Option** | ** ** | **Exercise Price** | ** ** |
| June 30,  2003 |       |                  | 1,874,200  |                    |       |   | 0.75 |   |   |
| Options granted     |       |                  | 65,000     |                    |       |   | 0.44 |   |   |
| Options exercised   |       |                  | —     |                    |       |   | — |   |   |
| Options forfeited   |       |                  | —     |                    |       |   | — |   |   |
| 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 |   |   |

 

At June 30, 2005 and2004, options for 1,198,000 and 1,438,000 shares, respectively, wereexercisable. The weighted average grant date fair value per option for optionsgranted in 2005 and 2004 was $0.62 and $0.66, respectively. The exercise priceof options outstanding at June 30, 2005 ranged from $0.22 to $10.00 pershare.

The Company appliesAccounting Principles Board (APB) Opinion No. 25, ‘‘Accounting for StockIssued to Employees’’, and related interpretations in accounting for stockbased compensation and presents pro forma net income and earnings per sharedata as if the accounting prescribed by Statement of Financial AccountingStandards No. 123, ‘‘Accounting for Stock Based Compensation’’ had beenapplied (see Note 2).

Thefollowing table summarizes the assumptions used by the Company in estimatingcompensation expense as of the date the options were granted using a binomialmodel.

| ** **                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|
| Risk free  interest rate                              |       | 2.80     | %          | 2.19     | %          |
| Volatility  factors                                   |       | 191.38   | %          | 283.52   | %          |
| Weighted-average  expected life of the option (years) |       | 3        |       | 3        |       |
| Dividend yield                                        |       | 0.00     | %          | 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.

*Outside Director’s Stock 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, 2005, under this plan were 37,000.

38

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note11—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, 2005 and 2004 were $36,000 and $28,500, respectively.

**Note 12—Contingencies**

The Company is currentlysubject to litigation that could have a material adverse impact on itsliquidity as follows:

Previously Reported Cases:

*PuyallupAuto Stop Associates v. PTW, Inc.*, SuperiorCourt of the State of Washington, County of Pierce, filed March 9, 2005

On March 9, 2005 PTW, Inc. (PTW), aPrecision Tune Auto Care, Inc. subsidiary, was served with a complaint inwhich Puyallup Auto Stop Associates (PASA) seeks an amount to be determined attrial and attorney’s fees. PASA claims PTW breached a real property leasebetween the parties and seeks to recover from PTW certain environmentalremediation costs. Beginning in 1994, PTW subleased the property in question toa Precision Tune Auto Care franchisee, Michael and Catherine Ertman (the “Ertmans”).  Under the terms of the sublease and aconsent judgment between PTW and the Ertmans, the Ertmans have an obligation toindemnify PTW in the event PTW incurs any liability in this matter. On March 30,2005, PASA amended its complaint to include two other, third-party, defendants.PTW has not yet filed an answer in this matter. However, on April 14, 2005PTW provided to PASA an offer to settle this matter for a lump-sum payment of$10,000. PASA has not responded to PTW’s settlement offer. Trial is scheduledfor March 20, 2006.

*Lumnivision,S.A. de C.V. v. Praxis Afinaciones, S.A. de C.V., *ThirdCivil 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.

*UnitedBank, NA v. C. Eugene Deal, Miracle Partners, Inc., Star Auto Center, Inc., *CommonPleas 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.

39

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**Precision Auto Care, Inc and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 12—Contingencies(Continued)**

*DavisTune, Inc. v. Precision Franchising LLC*, CircuitCourt for Escambia County, Florida

*PrecisionFranchising LLC v. Davis Tune, Inc. et al.*, FederalDistrict Court for the Eastern District of Virginia

On February 15, 2005, PFL was served with acomplaint in which franchisee Davis Tune, Inc. sought damages in excess of$30,000. Davis Tune, Inc. and its two shareholders, Mr. Donald Roeand Ms. Shirley F. Roe, were also defendants in a related actionfiled by PFL on November 1, 2004.

On June 10, 2005, the parties entered into asettlement agreement resolving both matters. Under the terms of the settlementDavis Tune, Inc. agreed to: (1) renew one of its Franchise Agreementsthat had expired and to re-brand the associated location as a Precision TuneAuto Care center; (2) pay approximately $11,000 in delinquent fees, and (3) payPFL $75,000 in the event it fails to comply with all agreements between theparties.

The Company does not believe that any of the aboveclaims or proceedings will result in a material judgment against the Company orany of it’s subsidiaries. There can be no assurance, however, that these suitswill ultimately be decided in its favor. Any one of these claims or proceedingsmay result in a material judgment against the Company, which could causematerial adverse consequences to its operations.

40

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**Item8.**                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosures

None.                                                                          

**Item 8A.**                Controlsand 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, 2005 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting.

**Item 8B.     OtherInformation**

None.

41

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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 be containedin the Company’s Proxy Statement, and reference is expressly made to the ProxyStatement 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 “ExecutiveOfficers of Precision 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.      *ExecutiveCompensation***

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 Auditors

AuditedFinancial Statements

ConsolidatedBalance Sheets

ConsolidatedStatements of Operations

ConsolidatedStatements of Stockholders’ Equity

ConsolidatedStatements of Cash Flows

Notes to Consolidated Financial Statements

42

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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  |   | Bylaws 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 March 1, 2005 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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*                    Filed herewith

**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.

44

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**SIGNATURES**

**Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on September 26,2005.**
|        | PRECISION AUTO  CARE, INC. |
|--------|---------------------------------|
|   | By:                             | /s/  LOUIS M. BROWN, JR. |
|   |                            | Louis M.  Brown, Jr. |
|   |                            | Chief Executive  Officer and |
|   |                            | Chairman of the  Board |
|   |                            | (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. |          | Chief Executive  Officer and Chairman of  |       | September 26,  2005 |
| Louis M. Brown, Jr.     |          | the Board                                 |       |                     |
| /s/ ROBERT R. FALCONI        |          | President and  Chief Operating Officer    |       | September 26,  2005 |
| Robert R. Falconi            |          | (Principal Financial  Accounting Officer) |       |                     |
| /s/ WOODLEY A. ALLEN         |          | Director                                  |       | September 26,  2005 |
| Woodley A. Allen             |          |                                      |       |                     |
| /s/ BASSAM N. IBRAHIM        |          | Director                                  |       | September 26,  2005 |
| Bassam N. Ibrahim            |          |                                      |       |                     |
| /s/ JOHN D. SANDERS          |          | Director                                  |       | September 26,  2005 |
| John D. Sanders              |          |                                      |       |                     |
| /s/ PETER C. KEEFE           |          | Director                                  |       | September 26,  2005 |
| Peter C. Keefe               |          |                                      |       |                     |

 

 

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