UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549









FORM 10-KSB


| |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
| |  | ------------------------------------------------------------------------------------



For the fiscal year ended July 31, 2005 or


| |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
| |  | ----------------------------------------------------------------------------------------



For the transition period from
                         to




Commission File Number 000-49626




CORTELCO SYSTEMS PUERTO RICO, INC.




(Name of small business issuer in its
charter)







|PUERTO
RICO              |  | 66-0567491                           | 
|------------------------ |  | ------------------------------------ | 
|(State
of incorporation) |  | (I.R.S.
Employer Identification No.) | 



Parque Industrial Caguas Oeste, Road 156 Km 58.2, Valle
Tolima, Caguas PR 00727-0137(Address of principal executive offices)




(787) 758-000(Telephone number)




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




Securities registered pursuant to Section 12(g) of the
Act:




Common Stock, $0.01 par value per share(Title of each class)




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




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




Indicate by check mark whether
the registrant is a shell company (as defined in Rule 12-b-2 of the Exchange Act)  YES  
NO Revenues for the
Registrants most recent fiscal year: $7,414,000




The aggregate market value of the
voting and non-voting common equity held by non-affiliates of the registrant was approximately $562,000 based upon the closing sale price as quoted on
the OTC Bulletin Board on 09/30/05. The number of outstanding shares of the registrants $0.01 par value common stock was 1,604,557 shares as of
that date.




DOCUMENTS INCORPORATED BY REFERENCE




Certain portions of the
registrants Proxy Statement for the 2005 Annual Meeting of Shareholders are incorporated by reference in Part III.




Transitional Small Business
Disclosure Format (Check one):  YES   NO







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TABLE OF CONTENTS







|           |  |  |    |                                                                                                                 |  | Page
|---------- |  |  | -- | --------------------------------------------------------------------------------------------------------------- |  | ----
|PART I     |  |  | 1 
|ITEM
1     |  |  |    | DESCRIPTION OF BUSINESS                                                                                         |  |     
|ITEM
2     |  |  |    | DESCRIPTION OF PROPERTY                                                                                         |  |     
|ITEM
3     |  |  |    | LEGAL
PROCEEDINGS                                                                                               |  |     
|ITEM
4     |  |  |    | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                             |  |     
|          
|PART II    |  |  | 4 
|ITEM
5     |  |  |    | MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                                                        |  |     
|ITEM
6     |  |  |    | MANAGEMENTS DISCUSSION AND ANALYSIS                                                                            |  |     
|ITEM
7     |  |  |    | FINANCIAL STATEMENTS                                                                                            |  |     
|ITEM
8     |  |  |    | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                            |  |     
|ITEM
8A    |  |  |    | CONTROLS AND PROCEDURES                                                                                         |  |     
|ITEM
8B    |  |  |    | OTHER
INFORMATION                                                                                               |  |     
|          
|PART III   |  |  | 23
|ITEM
9     |  |  |    | DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT |  |     
|ITEM
10    |  |  |    | EXECUTIVE COMPENSATION                                                                                          |  |     
|ITEM
11    |  |  |    | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS                 |  |     
|ITEM
12    |  |  |    | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                  |  |     
|ITEM
13    |  |  |    | EXHIBITS                                                                                                        |  |     
|ITEM
14    |  |  |    | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                          |  |     
|          
|SIGNATURES |  |  | 25

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PART I




FORWARD-LOOKING STATEMENTS




This report contains forward-looking statements within the
meaning of the federal securities laws. Forward-looking statements are those that express managements views of future events, developments, and
trends. In some cases, these statements may be identified by terminology such as may, will, should,
expects, plans, intends, anticipates, believes, estimates,
predicts, potential, or continue or the negative of such terms and other comparable expressions. Forward-looking
statements include statements regarding our anticipated or projected operating performance, financial results, liquidity and capital resources. These
statements are based on managements beliefs, assumptions, and expectations, which in turn are based on the information currently available to
management. Information contained in these forward-looking statements is inherently uncertain, and our actual operating performance, financial results,
liquidity, and capital resources may differ materially due to a number of factors, most of which are beyond our ability to predict or control. We also
direct your attention to the risk factors affecting our business that are discussed elsewhere in this report. We disclaim any obligation to update any
of the forward-looking statements contained in this report to reflect any future events or developments. The following discussions should be read in
conjunction with our financial statements and the notes included thereto in Item 7.


|ITEM
1 |  | DESCRIPTION OF BUSINESS
|------ |  | -----------------------



Introduction




Cortelco Systems Puerto Rico, Inc. (the
Company, CSPR) is a value-added reseller of third-party brands of voice and data communication systems. The Companys
products help enterprises communicate more effectively with customers and increase their customer satisfaction and loyalty. The rapid technological
change from traditional to voice-over IP systems has necessitated the need for the Company to become more focused on fewer brands and on increased
efficiency in its core business. The Companys revenues are comprised mostly of sales of PBX customer premise new equipment and additions,
including the newer IP based voice and data communication as well as maintenance contracts and services. On July 31, 2003, CSPR substantially
discontinued the cellular operation in order to focus all efforts in its core business. Accordingly, there are no significant revenues reflected for
this segment in fiscal years 2005 and 2004. The Company conducts most of its business in Puerto Rico, and also sells telephone equipment in the
Caribbean, Latin America or South America.




CSPR was incorporated in July 1998 under the laws of the
Commonwealth of Puerto Rico. At the time of incorporation, our sole stockholder was Cortelco Puerto Rico, Inc. (CPR). Prior to becoming a
wholly-owned subsidiary of eOn Communications Corporations (eOn) in April 1999, CPR contributed substantially all of its operations and
certain assets and liabilities to us. On July 31, 2002, the Company was spun-off from eOn as a separate entity to the stockholders of
eOn.




Products and Services




The Company installs, programs, and services voice and
data communications systems such as customer premise PBXs, call centers, voice over IP systems, interactive voice switches and CTI applications,
as well as reselling computers and local area networks to enterprises and businesses of all sizes. PBXs are private telephone switching systems,
usually located on a customers premises, which provide telephone services within the customers premises, as well as access to the public
switched network.




Sales and Marketing




The Company sells our voice and data communications
systems through a direct sales force. Most of the voice and data communications systems CSPR sells are installed directly by us. CSPR advertises our
voice and data communications products primarily through trade shows and hosted marketing presentations.




Customer Service and Support




The Company earned approximately $3.0 million of our
revenue in fiscal year 2005 and approximately $3.2 million in fiscal year 2004 from the servicing of voice and data communications systems previously
installed. Customers generally sign maintenance agreements, which detail the services provided and the fees charged for delivering such services. The
equipments manufacturer trains our personnel in the products that the Company distributes through




1


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training courses. A key factor in assessing whether to
distribute additional equipment brands or acquire assets of other distributors is the size of an installed base of customers in the market and the
technical expertise required to service the equipment.




Industry Overview




Competitors that distribute many of the same products that
CSPR distributes generally characterize the Companys markets. Therefore, price competition is often intense for many of the products that CSPR
distributes. As other value-added resellers sometimes offer the same equipment as us, the quality of customer service provided is often the
differentiating factor in winning new customers.




Competition




The business communications market is highly competitive.
Competitive factors include (1) market acceptance of the products, services and technology solutions that the Company provides, (2) pending and future
legislation affecting the communications industry, (3) name recognition and market share, (4) our ability to provide integrated communication and data
solutions for customers in a dynamic industry, and (5) the introduction of new technologies.




The dominant competitor in the Puerto Rico market is
Puerto Rico Telephone Company (PRTC), which is significantly larger than any other competitor in the market. However, recently PRTC has
begun to reduce its voice equipment installation and service business in order to apply its resources to other markets that it deems more attractive.
PRTC has traditionally been the reseller, installer, and a service company in Puerto Rico for Nortel Networks, the largest voice communications
equipment provider in Puerto Rico. As PRTC exits the reseller and service business for customer premise voice products, the Company will compete with
other resellers in the attempt to acquire the maintenance contracts from PRTCs customers. Buyers of enterprise voice communications systems are
generally very sensitive to price and, to a lesser degree, customer service; therefore, having the lowest sales price is often the key to winning a
customer initially. Resellers will often compete aggressively on price in order to win customers for maintenance purposes. CSPR is one of the largest
resellers in the Puerto Rico market. The Company believes that its size offers a competitive advantage in continuing to grow the communications systems
segment as the large resellers are better able to compete on sales price due to discounts received from equipment manufacturers for larger volume
purchases and other special discounts for obtaining certification required by some of CSPRs suppliers.




Some of our competitors in the communications business are
small, owner-operated companies typically located and operated in a single geographic area. Certain of these smaller competitors may have lower
overhead cost structures and, consequently, may be able to charge lower rates for their services. Therefore, CSPRs relative size may be a
competitive disadvantage for small customers, but the Company is beginning to pursue the medium to large systems for which the overhead of our major
competitors is higher than ours. Strategic alliances between CSPR, as the systems provider, and major network providers allow presentation of a full
solution to large accounts.




There are also a number of large, integrated national
companies, which also manufacture and sell directly the products that the Company services and sells. Some of our larger competitors may have greater
financial resources to finance acquisition and internal growth opportunities and may be willing to pay higher prices than us for acquisition
opportunities. As a result, CSPR has a competitive disadvantage compared to these larger competitors but the Company is working to find an
institutional line of credit to compete in this type of situation.




Future competition may be encountered from other newly
formed or existing public or private service companies with aggressive acquisition and marketing programs. Certain products and services that the
Company offers are manufactured or supplied by others. This presents a competitive disadvantage to us since CSPR incurs the risk of reliance upon
third-party systems and services, as well as risks associated with the need to integrate services and solutions across networks, platforms and
equipment manufactured or supplied by various companies.




Principal suppliers




The Company sells, installs, and services the voice and
data communications of a number of equipment manufacturers, including Avaya, Mitel, Cortelco, eOn, Nortel, Lucent, Hitachi and Nec among others. CSPR
does




2


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not make any of the products that it sells but
assembles, integrates and programs the communication system equipment that the Company sells. The products that CSPR sells are not under exclusive
agreements from the manufacturers.




Customers




Our customers include mostly small and medium sized
businesses as well as a few larger ones. Thus, the Company does not derive a significant portion of our revenues from any single
customer.




Intellectual Property




The Company does not own any patents, trademarks, or
licenses in the conduct of our business. The Company conducts most of the operations under the trade name Cortelco which is well known by
customers in Puerto Rico. Under Puerto Rican law, CSPR has a proprietary interest in this trade name for as long as the Company continues to actively
use it.




Governmental Regulation




The Company is not directly regulated by any governmental
agency. However, the Federal Communications Commission and Telecommunications Regulatory Board of Puerto Rico have regulations, which address consumer
products that connect to the public telephone network. The Companys business could be adversely affected if these agencies modify or adopt new
regulations. Such regulations could impact the cost of the products CSPR sells or limit the types of products that it may sell, thus reducing our
revenues.




Research and Development Activities




As the Company distributes the products of third parties
and does not sell any products that the Company designs or develops, CSPR does not incur any costs for research and development.




Employees




As of July 31, 2005, the Company had approximately 70
employees, including 15 in sales and marketing, 36 in customer service and support, and 19 in finance and administration, including both regular and
contract employees.


|ITEM
2 |  | DESCRIPTION OF PROPERTY
|------ |  | -----------------------



CSPR leases one building of approximately 8,200 square
feet for office space and assembly processing from Municipality of Caguas. The lease on this facility expires in November 2007. Adjacent to this
building, the Company leases another building of approximately 5,800 square feet for warehouse space from Puerto Rico Industrial Development Company
(PRIDCO). The lease on this facility expires in December 2012. Virtually all of our employees work at these facilities.


|ITEM
3 |  | LEGAL PROCEEDINGS
|------ |  | -----------------



From time to time, the Company may be a party to legal
proceedings incidental to our business. The Company does not believe that any of these proceedings will have a material adverse effect on our business
or financial condition.




In 1997, Cellu-Tel, Inc. filed a complaint in the Court of
First Instance, San Juan, Puerto Rico alleging that CSPR breached the terms of a contract by ceasing to supply services to the plaintiff. The plaintiff
seeks damages of approximately $854,430. Discovery proceedings are being conducted. As a result of the information obtained during discovery, the
Company filed a Third Party Complaint against City Cellular, Inc. and Edgardo Correa, who is the President of Cellu-Tel, Inc. and City Cellular, Inc.
CSPR alleged in the Third Party Complaint that City Cellular is a business conduit (an alter ego) of plaintiff Cellu-Tel, Inc. The Company
has also alleged that City Cellular has continued to conduct the business of the plaintiff. The Company also believes that City Cellular has received
the benefits and income that plaintiff would have received, if any. Therefore, CSPR believes that City Cellular is




3


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directly responsible to Cellu-Tel. City Cellular has
answered the Third Party Complaint and denied the allegations and raised several defenses. On January 12, 2005, the Court of First Instance issued a
Summary Judgment in favor of the third Party Defendants, City Cellular and Edgardo Correa. As a result, the lawsuit against the third party defendants
was dismissed. On February 18, 2005, the Company filed an Appeal with the Puerto Rico Court of Appeals. On August 30, 2005, the Court of Appeals held a
Judgment in favor of CSPRs position. The Company believes, based on the opinion of counsel, that if the Court does not accept the Companys
defense, a negative outcome is reasonably possible, although for a lower sum than the one claimed by plaintiff. Because the loss, if any, cannot be
classified as probable nor the amount determinable, an accrual for losses has not been recorded in the Companys financial
statements.




In 2001, Jorge Gonzalez-Nogueras filed a complaint in the
Court of First Instance, San Juan, Puerto Rico alleging that CSPR offered him employment in order to reduce competition from other enterprises and with
the ill intent to take advantage of his business. After accepting employment, Mr. Gonzalez-Nogueras resigned voluntarily alleging problems adjusting to
the corporate culture of CSPR. The plaintiffs seek $5,074,321 for alleged damages and loss of business. CSPR filed a Motion for Summary Judgment and
such motion is under the consideration of the court. Cortelco is strongly defending this case because all allegations of conspiracy are plainly false,
because plaintiff does not have a profitable competing business and his resignation was voluntary. The Company believes that this litigation is without
merit and will not have a material adverse effect on our business.




The Company is also a party in other claim incidental to
their business. The Company does not believe that this claim will have a material adverse effect on the Companys business or its financial
condition.


|ITEM
4 |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
|------ |  | ---------------------------------------------------



None.




PART II


|ITEM
5 |  | MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
|------ |  | --------------------------------------------------------



Market Information




There currently is no established public trading market
for any class of our capital stock. The Company is not currently offering any shares of our capital stock publicly, nor have we publicly proposed to
conduct such an offering. Shares of our common stock are reported on the OTC Bulletin Board under the symbol CPROF.




The OTC Bulletin Board is a quotation service that
displays quotes, last-sale prices and volume information regarding over-the-counter (OTC) equity securities. An OTC equity security generally is any
equity security that is not listed or traded on a national securities exchange nor is authorized for quotation on The NASDAQ Stock
Market.




The OTC Bulletin Board is only a quotation medium, not an
issuer listing services, and should not be confused with The NASDAQ Stock Market. Market makers for OTC Bulletin Board securities generally are
required only to match up willing buyers and sellers. Generally, market makers are not required to purchase securities directly from willing sellers or
sell securities directly to willing buyers. For this and other reasons, the trading markets for OTC equity securities are generally significantly less
liquid than the trading markets for securities listed on a national securities exchange or authorized for quotation on The NASDAQ Stock Market and,
therefore, there may be a substantial delay in execution of trades. In addition, an active trading market in the Company common stock may not
develop.




The following table sets forth the quarterly high and low
bid quotations per share of common stock on the OTC Bulletin Board as reported for the periods indicated. These prices also represent inter-dealer
quotations without retail mark-ups, markdowns, or commissions and may not necessarily represent actual transactions.




4


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|                                |  |  |  | HIGH |      | LOW
|------------------------------- |  |  |  | ---- | ---- | ---
|FISCAL YEAR
ENDED JULY 31, 2005 |  |  |  |      |      |    
|First
Quarter                   |  |  |  | $    | 0.17 |    
|Second
Quarter                  |  |  |  |      | 0.32 |    
|Third
Quarter                   |  |  |  |      | 0.30 |    
|Fourth
Quarter                  |  |  |  |      | 0.35 |    
|FISCAL YEAR
ENDED JULY 31, 2004 |  |  |  |      |      |    
|First
Quarter                   |  |  |  | $    | 0.25 |    
|Second
Quarter                  |  |  |  |      | 0.25 |    
|Third
Quarter                   |  |  |  |      | 0.25 |    
|Fourth
Quarter                  |  |  |  |      | 0.30 |    



Holders




As of September 30, 2005, there were 226 shareholders of
record of our common stock and, to the best of our knowledge, approximately 2,500 beneficial owners whose shares of common stock were held in the names
of brokers, dealers, and clearing agencies.




Dividends




During fiscal year 2005, the Company did not declare any
dividends on our capital stock. The Company currently intends to retain any earnings to finance the operation and expansion of our business and,
therefore, does not expect to pay cash dividends on the common stock in the foreseeable future.




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




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




Equity Compensation Plan Information







|Plan category                                                  |  |  |  | Number of securities to be issued upon exercise
of outstanding options, warrants and rights (a) |   | Weighted-average exercise price of outstanding
options, warrants and rights (b) |  | Number of securities remaining available for future
issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
|-------------------------------------------------------------- |  |  |  | ----------------------------------------------------------------------------------------------- | - | ------------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|Equity
compensation plans     approved by security holders     |  |  |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                
|Equity
compensation plans     not approved by security holders |  |  |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                
|Total                                                          |  |  |  |                                                                                                 |  |                                                                                 |  |                                                                                                                                                



5


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|ITEM
6 |  | MANAGEMENTS DISCUSSION AND ANALYSIS
|------ |  | ------------------------------------



Financial Condition




Near term, the Companys cash position has improved
from prior years. The cash at the end of the fiscal year 2005 was approximately $499,000 and for fiscal year 2004 was approximately $126,000, mostly
generated from a reduction in receivables.




Working capital increased to approximately $1.0 million in
fiscal year 2005 from approximately $920,000 in fiscal year 2004, mainly because the company had no significant investing or financing
outlays.




The Companys management has taken measures to
protect our future by narrowing product offerings. The current sales outlook for fiscal year 2006 is encouraging. Historically the second quarter of
each fiscal year is a low point for sales revenue, but CSPR has been receiving customer commitments for new system installations to achieve the current
budget for said quarter of fiscal year 2006. However to achieve the increased opportunities, CSPR will continue to seek a credit line from a Puerto
Rican financial institution, also the Company believes that they will be able to effectively increase the credit limit with our main suppliers as it
has successfully done so during fiscal year 2005. During fiscal year 2005, CSPR implemented a plan to accelerate payment terms during the installation
process to reduce accounts receivable. In the past, the customer was allowed to withhold up to 30% of the total contract until final customer
acceptance. New agreements are and will be negotiated to limit the amount subject to final customer acceptance to not more than 10% of the
total.




CSPR plans to continue to closely monitor our operating
costs and expenses, which have stabilized in 2005 and 2004 after significant reductions in prior years. This was done while striving for an increase
in sales profits. The Company will continually look for ways to increase our installed base of customers via improved service performance, and
increased maintenance sales efforts since our highest gross margins are from service revenues. To improve service performance, the Company will
continue its training program so as to develop more highly qualified technicians and salespersons. CSPR is obtaining the highest certifications in
three of its products, which the Company believes will improve our competitive position with customers and suppliers. To improve new installation and
maintenance sales results, the Company hired three new salespersons to support and increase our customer base. The Company is also pursuing
productivity improvements via implementing new technologies such as Web ticketing and the Project Management programs.




No assurance can be given that CSPR will be successful in
achieving all our near term goals.




Results of Operations and Cash Flows




The following discussion provides information about the
Companys operations, for the fiscal year ended July 31, 2005 and for the fiscal year ended July 31, 2004.




Net revenues consist of sales of new product and additions
(Product) and services related to revenues from maintenance contract and billable services (Services). Net revenues increased
1.4% to $7.4 million in fiscal year 2005 from $7.3 million in fiscal year 2004. The results primarily reflected increased revenues of approximately
$273,000 from the Product segment mainly due to an increase in equipment sales. In the Service segment the decrease of revenues was approximately
$198,000 as a result of maintenance contract decline due to customers decision to acquire new systems from the Company with a one-year of
warranty and a certain decrease in billable services calls due to market fluctuations.




Cost of revenues consists of the same two segments as
Revenues. The cost of revenues of Product segment includes primarily of purchases from equipment manufacturers and other suppliers and costs incurred
for final assembly, quality assurance and installations of the systems. The cost of revenues of Service segment includes primarily costs to replace or
repair equipment and labor related to the services and maintenances. The gross margin by segment remained stable in both years, however, the total
gross margin was 29% in fiscal year 2005 and 17% in fiscal year 2004 mainly due to the $950,000 inventory adjustment charged in fiscal year
2004.




CSPR reduced the inventory 37.8% from approximately
$444,000 in fiscal year 2004 to approximately $276,000 in fiscal year 2005. The Company will continue the plan to sell its excess written down
inventory in the secondary market.




6


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Selling, general and administrative expenses consist
primarily of salaries and benefit costs, advertising, and facilities and other overhead expenses incurred to support our business. Selling, general and
administrative expenses decrease 1.36% to approximately $2.17 million in fiscal year 2005 from approximately $2.20 million in fiscal year
2004.




For fiscal year 2005, there were no additional provisions
for doubtful accounts. In fiscal year 2004, CSPR increased the allowance by $200,000, thereby eliminating any credit risk associated with the remaining
old and disputed accounts receivable, mostly related to services no longer provided. The Company plans to continue its collections efforts by using
collection agencies and legal resources.




In fiscal year 2004, CSPR wrote off the $382,000 of
goodwill originally recorded in the acquisition of Ochoa Telecom. Based upon market values for the company stock, it was not practical to continue to
report this at the assigned value.




Other income in the fiscal year 2005 was a nonrecurring
transaction of approximately $31,000. In addition, the Company had no significant interest expense or interest income in either fiscal year 2005 or
2004.




The resulting income tax in fiscal year 2005 was offset by
the available carryforward losses, through a change in valuation allowance. There was no current income tax payable in fiscal year
2004.




Cash flow provided by operating activities was
approximately $419,000 in fiscal year 2005 and cash flow used in operating activities was approximately ($323,000) in fiscal year 2004. Cash provided
by operating activities in fiscal year 2005 resulted primarily from a decrease in accounts receivable and inventories that was partially offset by a
decrease in trade accounts payable and the accrued liabilities. Cash flow used in investing activities for the fiscal year 2005 and 2004 was
approximately ($46,000) and ($7,000), respectively. The change in cash for investing activities is related to the acquisition of new technical
equipment to improve the performance of our technician force. For the fiscal year 2005, there were no transactions related to financing activities.
Cash provided by financing activities for the fiscal year 2004 was approximately $393,000 due principally to transactions with a related
party.




During fiscal year 2005, CSPR was able to meet our cash
needs principally as a result of collection of trade accounts receivable.




Other Relevant Financial Information




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




CSPRs officers, directors and five percent or
greater stockholders beneficially own or control, directly or indirectly, approximately 980,431 shares, which in the aggregate represent approximately
62% voting interest in the outstanding shares of our common stock. These stockholders have the ability to control all matters submitted to our
stockholders for approval, including the election and removal of directors and the approval of any business combinations.




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




7


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




As a subsequent event, on September 16, 2005, the Board of
Directors authorized the Officers of the Company to accept a partial settlement related to a note receivable of $304,000 from a related party,
assigned to the Company upon the spin-off from eOn Communication Corporation, on July 31, 2002. The partial settlement consist of 43,104 shares of CSPR
stock valued at 60 days trailing average from 09/13/05, of $0.33 per share, and 175,983 shares of eOn stock valued at 60 days trailing average from
09/13/05, of $1.29 per share. This note is presented in this report in the financial statement as a reduction of stockholders
equity.




Off-Balance Sheet Arrangements




CSPR was not involved in any significant off-balance sheet
arrangement during the fiscal years ended July 31, 2005 and 2004.




8


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|ITEM
7 |  | FINANCIAL STATEMENTS
|------ |  | --------------------



INDEX TO FINANCIAL STATEMENTS







|                                                                                         |  |  |  | PAGE
|---------------------------------------------------------------------------------------- |  |  |  | ----
|Financial
Statements of Cortelco Systems Puerto Rico, Inc.:                              |  |  |  |     
|Independent
Auditors Report  Horwath Velez & Co. PSC                                   |  |  |  |     
|Balance
Sheet as of July 31, 2005                                                        |  |  |  |     
|Statements
of Operations for the Years Ended July 31, 2005 and 2004                      |  |  |  |     
|Statements
of Changes in Stockholders Equity for the Years Ended July 31, 2005 and 2004 |  |  |  |     
|Statements
of Cash Flows for the Years Ended July 31, 2005 and 2004                      |  |  |  |     
|Notes to the
Financial Statements                                                        |  |  |  |     



All other schedules have been omitted since the required
information is not presented or not present in an amount sufficient to require submission of the schedules, or because the information required is
included in the financial statements or notes thereto.




9


---



INDEPENDENT AUDITORS REPORT




To the Board of Directors and Stockholders of Cortelco Systems Puerto Rico, Inc. Caguas, Puerto Rico




We have audited the accompanying balance sheet of Cortelco Systems Puerto Rico, Inc. as of July 31, 2005, and the related statements of
operations, changes in stockholders equity and cash flows for each of the two years in the period ended July 31, 2005. These financial statements
are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our
audits.




We conducted our audits in accordance with the standards
of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial
reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.




In our opinion, the financial statements referred to above
present fairly, in all material respects, the financial position of Cortelco Systems Puerto Rico, Inc. at July 31, 2005, and the results of its
operations and its cash flows for each of the two years in the period ended July 31, 2005 in conformity with accounting principles generally accepted
in the United States of America.




The accompanying financial statements have been prepared
assuming that Cortelco Systems Puerto Rico, Inc. will continue as a going concern. As discussed in Note 2 to the financial statements, in prior years,
Cortelco Systems Puerto Rico, Inc.s suffered significant losses from operations that combined with a lack of financial resources raise doubt
about its ability to continue as a going concern. Managements plans concerning these matters are also described in Note 2. The financial
statements do not include any adjustments that might result from the outcome of this uncertainty.




/S/ HORWATH VÉLEZ & CO, PSC




Puerto Rico




October 20, 2005 Puerto Rico Society of Certified Public Accountants Stamp number 2097486 was affixed to the original of
this report.




10


---





CORTELCO SYSTEMS PUERTO RICO, INC. BALANCE SHEET
 JULY 31, 2005 (Dollars in Thousands)







|ASSETS                                                                                                       | 
|------------------------------------------------------------------------------------------------------------ | 
|Current
assets:                                                                                              | 
|                                                                                                            
|Cash                                                                                                         | 
|Trade accounts
receivable, net of allowance of uncollectible accounts of $214                                | 
|Account
receivable from affiliates                                                                           | 
|Inventories                                                                                                  | 
|Prepaid
expenses                                                                                             | 
|Total current
assets                                                                                         | 
|                                                                                                            
|Property
and equipment,net                                                                                   | 
|                                                                                                            
|Purchased
software, net of accumulated amortization of $71                                                   | 
|                                                                                                             | 
|                                                                                                            
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                        
|Current
liabilities:                                                                                         | 
|                                                                                                            
|Trade accounts
payable                                                                                       | 
|Due to
affiliated entities                                                                                   | 
|Other accrued
liabilities                                                                                    | 
|Deferred
revenue                                                                                             | 
|Total current
liabilities                                                                                    | 
|                                                                                                            
|Commitments
and contingencies                                                                                | 
|                                                                                                            
|Stockholders equity:                                                                                        | 
|                                                                                                            
|Preferred
stock, par value $.01 per share; authorized 10,000,000 shares, no shares issued                    | 
|Common stock,
par value $.01 per share; 5,000,000 shares authorized, 1,604,557 shares issued and outstanding | 
|Capital in
excess of par value, net of capital contribution note receivable from related party of $304       | 
|Accumulated
deficit                                                                                          | 
|Total
stockholders equity                                                                                   | 
|                                                                                                             | 



See notes to financial statements.




11


---



CORTELCO SYSTEMS PUERTO RICO, INC. STATEMENTS OF
OPERATIONS YEARS ENDED JULY 31, 2005 AND 2004 (Dollars and Share Data in Thousands Except Per Share Data)







|                                                |  |  |  | 2005 |       | 2004
|----------------------------------------------- |  |  |  | ---- | ----- | ----
|Net
revenues:                                   |  |  |  |      |       |     
|                                               
|Product                                         |  |  |  | $    | 4,392 |     
|Services                                        |  |  |  |      | 3,022 |     
|Total net
revenues                              |  |  |  |      | 7,414 |     
|                                               
|Cost of
revenues:                               |  |  |  |      |       |     
|                                               
|Product                                         |  |  |  |      | 3,480 |     
|Services                                        |  |  |  |      | 1,784 |     
|Inventory
write-down adjustments                |  |  |  |      |      |     
|Total cost of
revenues                          |  |  |  |      | 5,264 |     
|Gross
profit                                    |  |  |  |      | 2,150 |     
|                                               
|Operating
expenses:                             |  |  |  |      |       |     
|Selling,
general and administrative             |  |  |  |      | 2,170 |     
|Provision for
doubtful accounts                 |  |  |  |      |      |     
|Loss on
goodwill write-off                      |  |  |  |      |      |     
|Total
operating expenses                        |  |  |  |      | 2,170 |     
|                                               
|Loss from
operations                            |  |  |  |      | (20   | )   
|                                               
|Other
income, net                               |  |  |  |      | 31    |     
|                                               
|Income
(loss) before provision for income taxes |  |  |  |      | 11    |     
|                                               
|Provision
for income taxes                      |  |  |  |      |      |     
|                                               
|Net income
(loss)                               |  |  |  | $    | 11    |     
|                                               
|Basic and
diluted net income (loss) per share   |  |  |  | $    | 0.01  |     
|                                               
|Weighted-average number of shares outstanding   |  |  |  |      | 1,605 |     



See notes to financial statements.




12


---



CORTELCO SYSTEMS PUERTO RICO, INC. STATEMENTS OF
CHANGES IN STOCKHOLDERS EQUITY YEARS ENDED JULY 31, 2005 AND 2004 (Dollars in Thousands)







|                        |  |  |  | Common stock |    | Capital in excess of par value |  | Capital contribution note receivable from
related party |       | (Deficit) |  | Total
|----------------------- |  |  |  | ------------ | -- | ------------------------------ |  | ------------------------------------------------------- | ----- | --------- |  | -----
|Balance,
August 1, 2003 |  |  |  | $            | 12 |                                |  | $                                                       | 7,169 |           |  | $    
|Capital
contribution    |  |  |  |              | 4  |                                |  |                                                         | 104   |           |  |      
|Net
loss                |  |  |  |              |   |                                |  |                                                         |      |           |  |      
|Balance,
July 31, 2004  |  |  |  |              | 16 |                                |  |                                                         | 7,273 |           |  |      
|Net
income              |  |  |  |              |   |                                |  |                                                         |      |           |  |      
|Balance,
July 31, 2005  |  |  |  | $            | 16 |                                |  | $                                                       | 7,273 |           |  | $    



See notes to financial statements.




13


---



CORTELCO SYSTEMS PUERTO RICO, INC. STATEMENTS OF CASH
FLOWS YEARS ENDED JULY 31, 2005 AND 2004 (Dollars in Thousands)







|                                                                                                   |  |  |  | 2005 |      | 2004
|-------------------------------------------------------------------------------------------------- |  |  |  | ---- | ---- | ----
|Cash flows
from operating activities:                                                              |  |  |  |      |      |     
|Net income
(loss)                                                                                  |  |  |  | $    | 11   |     
|Adjustments to
reconcile net income (loss) to net cash provided by (used in) operating activities: |  |  |  |      |      |     
|Depreciation
and amortization                                                                      |  |  |  |      | 136  |     
|Provision for
doubtful accounts                                                                    |  |  |  |      |     |     
|Inventory
write-downs                                                                              |  |  |  |      |     |     
|Goodwill
write-down                                                                                |  |  |  |      |     |     
|Loss on
disposition of equipment                                                                   |  |  |  |      |     |     
|Changes in
operating assets and liabilities:                                                       |  |  |  |      |      |     
|Decrease
(increase) in:                                                                            |  |  |  |      |      |     
|Trade accounts
receivable                                                                          |  |  |  |      | 759  |     
|Due from
affiliated entities                                                                       |  |  |  |      | (2   | )   
|Inventories                                                                                        |  |  |  |      | 168  |     
|Prepaid
expenses                                                                                   |  |  |  |      | 21   |     
|Increase
(decrease) in:                                                                            |  |  |  |      |      |     
|Trade accounts
payable                                                                             |  |  |  |      | (455 | )   
|Due to
affiliated entities                                                                         |  |  |  |      | 5    |     
|Other accrued
liabilities                                                                          |  |  |  |      | (282 | )   
|Deferred
revenue                                                                                   |  |  |  |      | 58   |     
|Total
adjustments                                                                                  |  |  |  |      | 408  |     
|Net cash
provided by (used in) operating activities                                                |  |  |  |      | 419  |     
|                                                                                                  
|Cash flows
from investing activities:                                                              |  |  |  |      |      |     
|Capital
expenditures                                                                               |  |  |  |      | (46  | )   
|Net decrease
in investment in sales-type leases                                                    |  |  |  |      |     |     
|Net cash used
in investing activities                                                              |  |  |  |      | (46  | )   
|                                                                                                  
|Cash flows
from financing activities:                                                              |  |  |  |      |      |     
|Issuance of
common stocks                                                                          |  |  |  |      |     |     
|Proceeds from
related parties                                                                      |  |  |  |      |     |     
|Payments of
promissory note                                                                        |  |  |  |      |     |     
|Net cash
provided by financing activities                                                          |  |  |  |      |     |     
|                                                                                                  
|Net change
in cash                                                                                 |  |  |  |      | 373  |     
|                                                                                                  
|Cash,
beginning of year                                                                            |  |  |  |      | 126  |     
|                                                                                                  
|Cash,
end of year                                                                                  |  |  |  | $    | 499  |     



See notes to financial statements.




14


---





CORTELCO SYSTEMS PUERTO RICO, INC. NOTES TO FINANCIAL
STATEMENTS YEARS ENDED JULY 31, 2005 AND 2004 (Dollars in Tables in Thousands)


|1. |  | ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES:
|-- |  | ------------------------------------------------------------



Organization 
Cortelco Systems Puerto Rico, Inc. (the Company), a Puerto Rico corporation, was a wholly-owned subsidiary of eOn Communications
Corporation (eOn) through July 30, 2002. Effective July 31, 2002, the Company was spun-off from eOn to the eOn stockholders. After such
spin-off, the Company became an independent entity originally headquartered in San Juan, Puerto Rico that subsequently moved to Caguas, Puerto Rico.
The Companys operations include the sale and service of integrated communications and data equipment in Puerto Rico.




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




Credit risk concentration
 The Companys business activities primarily are with customers located in Puerto Rico and its trade accounts receivable reflects a
broad customer base in the local market. The Company routinely assesses the financial strength of its customers. As a consequence, concentration of
credit risk on an individual customer basis is limited.




Recent accounting
pronouncement  The following are recent accounting pronouncements:




In March 2005, the Financial
Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 47, Accounting for Conditional Asset Retirement Obligations. FIN 47,
which clarifies the accounting for conditional asset retirement obligations as used in Statement of Financial Accounting Standards (SFAS) No. 143,
Accounting for Asset Retirement Obligations. A conditional asset retirement obligation is an unconditional legal obligation to perform an
asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control
of the entity. Therefore, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation under SFAS No.
143 if the fair value of the liability can be reasonably estimated. The provisions of FIN 47 are effective for reporting periods ending after December
15, 2005. The Company does not anticipate that FIN 47 will have a material impact on the financial statements.




In May 2005, the FASB issued SFAS
No. 154, Accounting changes and Error Corrections  a replacement of APB Opinion No. 20 and FASB Statement No. 3. This statement replaces
APB Opinion 20, Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for a reporting of a change
in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to a changes required by an
accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes
specific transition provisions, those provisions should be followed. The future implementation of this Statement will have no significant effect on the
Companys financial statements.




As revised in 2004, the FASB
issued SFAS No. 123, Accounting for Stock-Based Compensation. This Statement requires that when an entity exchanges its own equity instruments
for goods or services, the transaction should be accounted at the fair value of the shares surrendered. The Company is required to implement SFAS No.
123, as amended, during the third quarter of fiscal year 2006. At present, the Company does not have any Stock-Based Compensation agreements in force,
even when there are 350,000 common stock shares segregated for such purposes in the future. The implementation of SFAS No. 123, as amended, is not
expected to have a material impact in the Companys financial statements.




15


---



Fair value of financial
instruments  The carrying amount of cash is a reasonable estimate of their fair value.




The carrying amounts of accounts
receivable, accounts payable trade (including related party), accrued expenses, and deposit liabilities approximate fair value due to their short-term
maturities.




Impairment of long-live assets
 The Company periodically reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable from the estimated future net cash flows expected to result from the use of the asset. Any indicated
impairment would be measured as the amount by which the carrying amount of the asset exceeds its fair value. Long-lived assets to be disposed of are
reported at the lower of carrying amount or fair value less cost to sell. No indications of impairment are evident as a result of such
review.




Communication systems and
maintenance services revenuesRevenues from communication systems and parts include the sales of integrated communications equipment and all
the related installation and implementation services. The Company recognizes revenues from the communications systems it installs upon completion of
the installation services and acceptance by the customer due to the customized nature of each installation. The Company recognizes service revenues for
maintenance contracts over the life of the service contracts on a straight-line basis, and for other services as the service is provided. The Company
allocates fees from multiple-element arrangements to the elements based on the relative fair value of each element. The Company believes that its
revenue recognition policies are compliant with Staff Accounting Bulleting No. 101, Revenue Recognition in Financial
Statements.




Cash  Cash is
deposited in high-credit qualified financial institutions.




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




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




Property and equipment
 Property and equipment is recorded at cost. Depreciation and amortization are provided using the straight-line method over the shorter of
the assets estimated useful life or lease term as follows:







|                                |  |  |  | Estimated useful life (years)                   
|------------------------------- |  |  |  | ------------------------------------------------
|Office and
production equipment |  |  |  | 35                                             
|Furniture
and fixtures          |  |  |  | 510                                            
|Internal use
software           |  |  |  | 35                                             
|Leasehold
improvements          |  |  |  | 5 or lesser of
lease life or asset category life



When assets are sold, retired or
otherwise disposed of, their cost and related accumulated depreciation are removed from the accounts, and any gain or loss is credited or charged to
income. Significant improvements to leased property are capitalized and amortized over the term of the lease. Maintenance and repairs are
expensed.




Purchased software 
Purchased software for internal use is recorded at cost, and amortized using the straight-line method over the estimated useful life of 3 to 5
years.




Product warranty 
The Company gives a one-year warranty to certain products and services sold. The Company recognizes an accrued warranty liability when it sells a
product or service. This amount is an




16


---



estimate of the cost of labor
to be performed if that warranty is exercised, based on experience. If the Company is required to perform on its warranty, it sends the product to the
manufacturer that normally warrants the product. The Company only incurs the cost of technicians labor and freight.




The Company recognizes warranty
revenue over the term of the warranty period. The costs related to warranties exercised are recognized directly as cost of sales when
incurred.




Accounting for legal costs
expected to be incurred in connection with a loss contingency  The Company policy to account for legal costs in relation to a loss
contingency is to account for such costs as incurred.




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




Advertising 
Advertising is charged to expense as incurred. Advertising expense was $5,272 for fiscal year 2005 and $37,413 for fiscal year 2004.




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


|2. |  | GOING CONCERN AND MANAGEMENT PLANS:
|-- |  | -----------------------------------



The accompanying financial
statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments
in the normal course of business. The Companys previous years recurring losses, reduced market share, and lack of financing resources raised
doubt about the Companys ability to continue as a going concern. The Companys current efforts to reorganize its core business has allowed
the Company to be in a break-even position in fiscal years 2005 and 2004 (prior to non-recurring charges), but efforts continue to return to
profitability. Accordingly, although management is optimistic about the projected outcome for fiscal year 2006, no assurances can be given that the
Company will be successful in maintain positive cash flows and profitability. The financial statements do not include any adjustments that might result
from the outcome of this uncertainty.


|3. |  | INVENTORIES:
|-- |  | ------------






|Purchased
components, net of slow moving inventory write-down of approximately $213,000        |  |  |  | $ | 125 | 
|---------------------------------------------------------------------------------------------- |  |  |  | - | --- | 
|Component
and materials related to installations in process                                    |  |  |  |   | 100 | 
|Service
parts and materials, net of slow moving inventory write-downs of approximately $89,000 |  |  |  |   | 51  | 
|                                                                                               |  |  |  | $ | 276 | 



17


---

|4. |  | PROPERTY AND EQUIPMENT:
|-- |  | -----------------------






|Furniture
and fixtures                         |  |  |  | $ | 247  |  
|---------------------------------------------- |  |  |  | - | ---- | -
|Leasehold
improvements                         |  |  |  |   | 88   |  
|Computer
equipment                             |  |  |  |   | 94   |  
|                                               |  |  |  |   | 429  |  
|Less
accumulated depreciation and amortization |  |  |  |   | (248 | )
|                                               |  |  |  | $ | 181  |  



The accumulated amortization of
leasehold improvements was $35,000.


|5. |  | OTHER ACCRUED LIABILITIES:
|-- |  | --------------------------






|Reorganization costs      |  |  |  | $ | 65  | 
|------------------------- |  |  |  | - | --- | 
|Payroll and
payroll taxes |  |  |  |   | 115 | 
|Commissions               |  |  |  |   | 30  | 
|Other                     |  |  |  |   | 66  | 
|                          |  |  |  | $ | 276 | 

|6. |  | RELATED PARTY TRANSACTIONS:
|-- |  | ---------------------------



During the years ended July 31,
2005 and 2004, the Company purchased approximately $567,000 and $466,000, respectively, in merchandise from Cortelco Inc., a related
party.




As of July 31, 2005, the balances
due to related parties are non-interest bearing, unsecured, and have no definite due date. Also, a $304,000 note receivable from a related party,
assigned to the Company upon the spin-off from eOn Communications Corporation, on July 31, 2002, is still outstanding. This note is presented in the
financial statements as a reduction of stockholders equity. See Note 12.


|7. |  | INCOME TAXES:
|-- |  | -------------



As a Puerto Rico corporation not
doing business in the United States, the Company is exempt from Federal taxes.




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







|Tax       |  |  |  | Benefit      
|--------- |  |  |  | -------------
|Income    |  |  |  | 7% flat
tax  
|Property  |  |  |  | 90%
exemption
|Municipal |  |  |  | 60%
exemption



18


---



Under the decree, the Company
will be required to comply with certain levels of employment. The tax decree did not result in any income tax benefit for the years ended July 31, 2005
and 2004.




The Company has available income
tax carry-forward losses to offset future taxable income that expire as follows:







|Year |  |  |  | Income covered by the decree |       | Other Income
|---- |  |  |  | ---------------------------- | ----- | ------------
|2009 |  |  |  | $                            |      |             
|2010 |  |  |  |                              | 1,508 |             
|2011 |  |  |  |                              | 918   |             
|2012 |  |  |  |                              | 858   |             
|     |  |  |  | $                            | 3,284 |             



Reconciliation between the income
tax expense recognized in the Companys statement of operations and the income tax expense (benefit) computed by applying the Puerto Rico
statutory income tax rate to income before income taxes for taxable income is as follows:







|                                                                                   |  |  |  | 2005 |      | 2004
|---------------------------------------------------------------------------------- |  |  |  | ---- | ---- | ----
|Current
income tax, assuming no carryforward benefit at Puerto Rico tax rate (39%) |  |  |  | $    | 99   |     
|Current
income tax benefit at Puerto Rico tax rate (39%)                           |  |  |  |      | (334 | )   
|Difference
in method in recognizing doubtful accounts receivable                   |  |  |  |      | (7   | )   
|Difference
in method in recognizing inventory write-downs                          |  |  |  |      | (236 | )   
|Differences
in accrued expenses                                                    |  |  |  |      | 2    |     
|Utilization
of carryforward benefit                                                |  |  |  |      | (99  | )   
|Other,
net                                                                         |  |  |  |      |     |     
|Effect of
decree on tax determination                                              |  |  |  |      | 467  |     
|Change in
valuation allowance                                                      |  |  |  |      | 108  |     
|Total income
tax expense                                                           |  |  |  | $    |     |     



19


---



The components of the net
deferred tax asset for taxable income at July 31, 2005 are as follows:







|                                    |  |  |  | 2005
|----------------------------------- |  |  |  | ----
|Deferred tax
assets resulting from: |  |  |  |     
|Allowance
for doubtful accounts     |  |  |  | $   
|Inventory
allowance                 |  |  |  |     
|Other
accrued liabilities           |  |  |  |     
|Net
operating loss carryforwards    |  |  |  |     
|                                    |  |  |  |     
|Less
valuation allowance            |  |  |  |     
|                                    |  |  |  | $   



The Company cannot conclude that
it is more likely than not that deferred tax assets will be realized in the future. Accordingly, a valuation allowance has been recorded for the total
amount of the deferred tax asset.


|8. |  | COMMITMENTS AND CONTINGENCIES:
|-- |  | ------------------------------



Claims:




The Company is currently subject
to one claim regarding an alleged breach of contract, and various claims regarding employment issues, as follows:




In the breach of contract case,
the plaintiff alleges that the Company breached the terms of contract by ceasing to supply services to the plaintiff, and the plaintiff seeks damages
of approximately $855,000. Although management is strongly contesting the claim, management believes, based on the opinion of counsel, that if the
Court does not accept the Companys defense, a negative outcome is reasonably possible, although for a lower sum than the one claimed by
plaintiff. Because the loss, if any, cannot be classified as probable nor the amount determinable, an accrual for losses has not been recorded in the
Companys financial statements.




The Company is also defendant in
one claim by former employee, totaling approximately $5 million. The Company has filed motion for summary judgment and such motion is under the
consideration of the court. The Companys management believes based on the opinion of counsel that the same is without merit and does not believe
that this case will result in a significant unfavorable outcome that would have a material adverse effect upon the Companys
business.




The Company is also a party in
other claim incidental to their business. The Company does not believe that this claim will have a material adverse effect on the Companys
business or its financial condition.




Leases:




The Company leases its principal
facilities from the Municipality of Caguas under an operating lease agreement that expires on November 30, 2007. Rent expense related to this agreement
for the year ended July 31, 2005 and 2004 amounted to $39,000 and $31,000, respectively. The Company also leases warehouse facilities from the Puerto
Rico Industrial Development Company (PRIDCO) under an operating




20


---



lease agreement that expires
on December 30, 2012. Rent expense related to this agreement for the year ended July 31, 2005 and 2004 amounted to $24,000 and $23,000,
respectively.




Future minimum lease payments
under these agreements for the next five years are as follows:







|Year ending July 31, |  |  |  | Amount
|-------------------- |  |  |  | ------
|2006                 |  |  |  | $     
|2007                 |  |  |  |       
|2008                 |  |  |  |       
|2009                 |  |  |  |       
|2010                 |  |  |  |       
|                     |  |  |  | $     



During the years ended July 31,
2005 and 2004, rent expense related to other operating leases amounted to approximately $19,000 and $85,000, respectively.


|9. |  | EMPLOYEE BENEFITS:
|-- |  | ------------------



The Company provides its
employees a savings plan (the plan). Under the terms of the plan, employees may contribute from 1% to 10% of pretax annual compensation, but cannot
exceed $8,000. However, effective January 2003, the Company no longer contributes to the plan. Previously the Company matched 50% of employees
contributions up to 6% of the employees compensation, as defined, with a maximum limitation of $2,000 for any one employee.


|10. |  | PREFERRED AND COMMON STOCK:
|--- |  | ---------------------------



The Board of Directors of the
Company is authorized from time to time to divide the preferred stock into series and to determine the number of shares of each series and the relative
designation, powers, rights and preferences of each such series. As of July 31, 2005, there were no outstanding shares of preferred
stock.




On June 9, 2003, the Board of
Directors approved the addition of 250,000 common stock shares to be reserved for an equity incentive plan. As of July 31, 2005, the equity incentive
plan has not been established.




On March 22, 2004, the Company
sold 400,000 shares of common stock for $0.27 per share under an agreement with Cortelco Inc., a related party. This sale was exempt from registration,
as it was a nonpublic offering. The shares were issued on September 29, 2004.


|11. |  | SUBSEQUENT EVENT:
|--- |  | -----------------



On September 16, 2005, the Board
of Directors authorized the Officers of the Company to accept a partial settlement related to a note receivable of $304,000 from a related party,
assigned to the Company upon the spin-off from eOn Communication Corporation, on July 31, 2002. The partial settlement consist of 43,104 shares of CSPR
stock valued at 60 days trailing average from 09/13/05, of $0.33 per share, and 175,983 shares of eOn stock valued at 60 days trailing average from
09/13/05, of $1.29 per share. This Note is presented in this report in the financial statement as a reduction of stockholders
equity.




21


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|ITEM
8 |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
|------ |  | ------------------------------------------------------------------------------------



None.


|ITEM
8A |  | CONTROLS AND PROCEDURES
|------- |  | -----------------------



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


|ITEM
8B |  | OTHER INFORMATION
|------- |  | -----------------



On March 15, 2005, CSPR accepted the resignation of James
Hopper as Director of the Company and formally appointed Alan L. Laffoon to fill the vacant board position. Mr. Laffoon was appointed to the Audit and
Compensation Committees of the Board.




Mr. Laffoon has been director of the Company since March
15, 2005. He has been Financial Manager for the City of Jackson, Tennessee since February 2004. Prior to entering the public sector in 2004, Mr.
Laffoon has was Vice President of Operation for ACT Electronics for three years and has held numerous management positions with ACT and other
electronics manufacturers in the areas of finance, production, sales, and plant management. Mr. Laffoon was one of the four officers involved in the
1993 IPO of CMC Industries an electronics contract manufacturer company on the NASDAQ. He holds a Bachelor of Science degree in Business Administration and did his
Masters work at St. Louis University.




On September 15, 2005, CSPR accepted the resignation of
Robert Schnabl as interim President and Chief Executive Officer (CEO) of the Company and formally appointed Walt Duffey as CEO and Juan Carlos Ramos as
President of the Company.




Mr. Duffey has been Director of the Company since January
26, 2005. He has been Vice President of Operations of Cortelco, Inc. since March 1998. Prior to his appointment to Vice President of Operations, he
held the positions of Director of Operations and Product Manager after joining Cortelco in 1996. From 19871996, Mr. Duffey held the positions of
Material Manager and Operations Manager with CECO Door Products. Prior to 1987, he held numerous supervisory and management positions with ITT
Telecommunications. Mr. Duffey has over thirty years of experience in various business activities related to product and inventory management,
accounting, manufacturing, distribution management and operations management. He is a certified practitioner of the American Production and Inventory
Control Society and holds a Bachelor of Science degree in Business Administration with minors in Accounting and Economics from Union University in
Jackson, Tennessee.




Mr. Ramos became President of the Company in September
2005 and served as a General Manager from October 2004 to September 2005. Mr. Ramos was an independent associate consultant of Business Advisers Inc.
from February 2004 to October 2004. Mr. Ramos served as a General Manager of Alliance Networks from November 2002 to February 2004. From April 2000 to
July 2002, Mr. Ramos was Strategy Business consultant for Europraxis Consulting Group (Indra). Mr. Ramos has taken courses toward a Ph.D. in
Electronics and Telecom Engineering from the University of Surrey and University of Catalonia. Mr. Ramos received a masters degree in business
administration from ESADE Business School and a bachelors degree in Physics from the University of Barcelona.




22


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PART III


|ITEM
9 |  | DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
|------ |  | ---------------------------------------------------------------------------------------------------------------



Executive Officers




The following table sets forth information as to the
persons who serve as our executive officers. The Companys board of directors may appoint additional executive officers from time to
time.







|Name              |  | Age |    | Title
|----------------- |  | --- | -- | -----
|Walt
Duffey       |  |     | 60 |      
|Juan Carlos
Ramos |  |     | 36 |      
|Francisco
Sanchez |  |     | 57 |      



WALT DUFFEY became Chief Executive Officer of the Company in September 2005 and served as a Director of the Company from January 2005
to September 2005. He has been Vice President of Operations of Cortelco, Inc. since March 1998. Prior to his appointment to Vice President of
Operations, he held the positions of Director of Operations and Product Manager after joining Cortelco in 1996. From 19871996, Mr. Duffey held
the positions of Material Manager and Operations Manager with CECO Door Products. Prior to 1987, he held numerous supervisory and management positions
with ITT Telecommunications. Mr. Duffey has over thirty years of experience in various business activities related to product and inventory management,
accounting, manufacturing, distribution management and operations management. He is a certified practitioner of the American Production and Inventory
Control Society and holds a Bachelor of Science degree in Business Administration with minors in Accounting and Economics from Union University in
Jackson, Tennessee.




JUAN CARLOS RAMOS became President of the Company in
September 2005 and served as a General Manager from October 2004 to September 2005. Mr. Ramos was an independent associate consultant of Business
Advisers Inc. from February 2004 to October 2004. Mr. Ramos served as a General Manager of Alliance Networks from November 2002 to February 2004. From
April 2000 to July 2002, Mr. Ramos was Strategy Business consultant for Europraxis Consulting Group (Indra). Mr. Ramos has taken courses toward a Ph.D.
in Electronics and Telecom Engineering from the University of Surrey and University of Catalonia. Mr. Ramos received a masters degree in business
administration from ESADE Business School and a bachelors degree in Physics from the University of Barcelona.




FRANCISCO SANCHEZ became Chief Financial Officer of the
Company in July 2000 and became Vice PresidentFinance and Administration in April 1999. Mr. Sanchez served as a director of the Company from
January 2002 to September 2002. He was Vice President  Finance and Administration of CPR from July 1998 until April 1999. From June 1987 to June
1998, Mr. Sanchez was Caribbean Region Comptroller for H.B. Fuller Company. From June 1978 to May 1987, Mr. Sanchez held executive positions, Assistant
Comptroller in manufacturing, sales and marketing at ITT Industries, Inc. Mr. Sanchez received a masters degree from Metropolitan University and
a BBA from Puerto Rico University.




Information set forth under the captions Election of
Directors and Section 16(a) Beneficial Ownership Reporting Compliance in the Companys definitive Proxy Statement for the 2005
Annual Meeting of Shareholders to be held on January 10, 2006 (the Proxy Statement), which will be filed with the Securities and Exchange
Commission not later than 120 days after July 31, 2005, are incorporated herein by reference in response to this item.




We have adopted a Code of Ethics that applies to all
employees, which is attached as Exhibit 14.1 to this report.


|ITEM
10 |  | EXECUTIVE COMPENSATION
|------- |  | ----------------------



Information set forth under the caption Executive
Compensation in the Proxy Statement is incorporated herein by reference in response to this item.




23


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|ITEM
11 |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDERS MATTERS
|------- |  | -----------------------------------------------------------------------------------------------



Information set forth under the caption Stock
Ownership in the Proxy Statement is incorporated herein by reference in response to this item.




ITEM 12 CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS




Information set forth under the caption Certain
Transactions in the Proxy Statement is incorporated herein by reference.




ITEM 13 EXHIBITS




The exhibits listed in the Exhibit Index following the
signature page of this report are filed as part of this report or are incorporated by reference herein.




Financial Statements




The following information appears in Item 7 of Part II of
this Report:




 Independent Auditors
Report  Balance Sheet as of July 31, 2005  Statements of Operations for the Years Ended July 31, 2005 and 2004 
Statements of Changes in Stockholders Equity for the Years Ended July 31, 2005 and 2004  Statements of Cash Flows for the Years Ended
July 31, 2005 and 2004  Notes to Financial Statements




All other schedules are omitted because they are not
required, not applicable, or the required information is otherwise shown in the consolidated financial statements or the notes
thereto.


|ITEM
14 |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|------- |  | --------------------------------------



Information set forth under the caption Fees Paid to
the Independent Auditors in the Proxy Statement is incorporated herein by reference.




24


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SIGNATURES




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




CORTELCO SYSTEMS PUERTO RICO,
INC.


|By |  | /s/ Francisco SanchezFrancisco Sanchez, Vice President, Chief Financial Officer, Treasury (Principal Financial Officer)
|-- |  | -----------------------------------------------------------------------------------------------------------------------



Dated: October 28,
2005




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







|Name                                   |  |  |  | Title                                                                                                            |  | Date            
|-------------------------------------- |  |  |  | ---------------------------------------------------------------------------------------------------------------- |  | ----------------
|                                      
|/s/ Walt
DuffeyWalt Duffey             |  |  |  | Chief
Executive Officer (Principal Executive Officer)                                                            |  | October 28,
2005
|                                      
|/s/ Juan Carlos
RamosJuan Carlos Ramos |  |  |  | President                                                                                                        |  | October 28,
2005
|                                      
|/s/ Francisco
SanchezFrancisco Sanchez |  |  |  | Vice
President, Chief Financial Officer, Treasury (Principal Financial Officer and Principal Accounting Officer) |  | October 28,
2005
|                                      
|/s/ Sergio
MorenSergio Moren           |  |  |  | Director                                                                                                         |  | October 28,
2005
|                                      
|/s/ Alan L
LaffoonAlan L Laffoon       |  |  |  | Director                                                                                                         |  | October 28,
2005
|                                      
|/s/ Gloria LeeGloria Lee               |  |  |  | Director                                                                                                         |  | October 28,
2005



25


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EXHIBIT INDEX




Documents listed below are being filed as exhibits
herewith. Exhibits identified by asterisks (*) are being incorporated herein by reference and, pursuant to Rule 12b-32 of the General Rules and
Regulations promulgated by the Commission under the Securities Exchange Act of 1934, reference is made to such documents as previously filed exhibits
with the Commission.







|Exhibit Number |  |  |  | Description of Document                                                                                                 
|-------------- |  |  |  | ------------------------------------------------------------------------------------------------------------------------
|3.1*           |  |  |  | Amended and Restated Certificate of Incorporation of Cortelco Systems Puerto Rico, Inc. (CSPR).                       
|3.2*           |  |  |  | Amended and Restated Bylaws of CSPR.                                                                                    
|4.1*           |  |  |  | Amended and Restated Certificate of Incorporation of CSPR (filed as Exhibit 3.1).                                       
|4.2*           |  |  |  | Amended and Restated Bylaws of CSPR (filed as Exhibit 3.2).                                                             
|4.3*           |  |  |  | Form
of certificate representing common stock, par value $.01 per share, of CSPR.                                       
|10.1*          |  |  |  | Distribution Agreement dated as of January 30, 2002, between eOn and CSPR (filed as Exhibit 2.1).                       
|10.2*          |  |  |  | Employee Matters Agreement dated as of January 30, 2002 between eOn and CSPR (filed as Exhibit 2.2).                    
|10.3*          |  |  |  | Confidential Disclosure Agreement dated as of January 30, 2002 between eOn and CSPR (filed as Exhibit 2.3).             
|10.4*          |  |  |  | CSPR
2002 Equity Incentive Plan.                                                                                        
|10.5*          |  |  |  | Lease
Agreement dated as of March 1, 1999, between CSPR and Cortelco Puerto Rico, Inc.                                  
|10.6(a)*       |  |  |  | Sales
Agency Agreement dated as of December 19, 1995, between Celulares Telefonica, Inc. and CSPR (Spanish).            
|10.6(b)*       |  |  |  | Sales
Agency Agreement dated as of December 19, 1995, between Celulares Telefonica, Inc. and CSPR (English translation).
|10.7*          |  |  |  | Mitel
Caribbean VAR Agreement dated as of December 7, 2001, between Mitel Networks, Inc. and CSPR.                      
|10.8*          |  |  |  | Asset
Purchase Agreement dated as of May 14, 2001, between CSPR and Ochoa Telecom, Inc.                                 
|10.9*          |  |  |  | Form
of Dealer Agreement between eOn and CSPR.                                                                          
|14.1           |  |  |  | Code
of Ethics                                                                                                          
|31.1           |  |  |  | Officers Certification pursuant to Rules 13a-14(a) of the Securities Exchange Act of 1934.                             
|32.1           |  |  |  | Officers Certification pursuant to 18 U.S.C ss1350.                                                                    
|              

|  |                                                                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Incorporated
by reference to CSPRs Registration Statement on Form 10 or amendments thereto, filed with the Securities Exchange Commission on February 12,
2002.








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