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



FORM 10-KSB



[ X ]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended March 31, 2006



[   ]   TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________



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|Commission File Number  000-26698



DATAWAVE SYSTEMS INC.

(Exact name of small business issuer as specified in its charter)



Delaware98-0186455(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)




Wayne Interchange Plaza One

145 Route 46 West, 3rd Floor

Wayne, NJ  07470

(Address of principal executive offices)



(973) 774-5000

(Issuers telephone number)



Securities registered under Section 12(b) of the Exchange Act:

(none)



Securities registered under Section 12(g) of the Exchange Act:

Common Stock,$0.001 par value per share



Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. [   ]



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



Check if no disclosure of delinquent filers in response to Item 405 of Regulation S-B is 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 12b-2 of the Exchange Act). Yes [  ] No [X]



Issuers revenues for its most recent fiscal year:  $32,094,017



As of June 23, 2006, there were 54,326,834 shares of the Companys common stock issued and outstanding, and the aggregate market value of such common stock held by non-affiliates was approximately $8,055,000, based on the average of the bid ($0.365) and ask ($0.37) prices of such stock on that date of $0.3675.



Documents Incorporated by Reference:  The information required by Part III of this Report, to the extent not set forth herein, is incorporated in this Report by reference to the Companys definitive proxy statement relating to its 2006 annual meeting of stockholders.  The definitive proxy statement will be filed with the Securities and Exchange Commission within 120 days after the end of the 2006 fiscal year.



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





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DATAWAVE SYSTEMS INC.

FORM 10-KSB

TABLE OF CONTENTS



PART IItem 1.Business1Item 2.Properties17Item 3.Legal Proceedings17Item 4.Submission of Matters to a Vote of Security Holders17PART IIItem 5.Market for Common Equity and Related Stockholder Matters19Item 6.Managements Discussion and Analysis of Financial Condition and Results of Operations20Item 7.Financial Statements and Supplementary Data29Item 8.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure29Item 8A.Controls and Procedures29Item 8B.Other Information30PART IIIItem 9.Directors and Executive Officers of the Registrant31**Item 10.Executive Compensation31**Item 11.Security Ownership of Certain Beneficial Owners and Management31**Item 12.Certain Relationships and Related Transactions32**Item 13.Exhibits32Item 14.Principal Accountant Fees and Services32**Signatures33Index to Financial StatementsF-1




**

Items 9 through 12 and Item 14 of Part III are incorporated by reference from the definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission within 120 days after the close of the 2006 fiscal year.



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NOTE REGARDING FORWARD LOOKING STATEMENTS

This Annual Report on Form 10-KSB contains a number of forward-looking statements that reflect managements current views and expectations with respect to our business, strategies, products, future results and events and financial performance, which include statements relating to, among other things, the ability of our company to continue to successfully compete in the telecommunications and financial products market.  In general, all statements other than statements of historical fact, including future results of operations or financial position, made in this Annual Report on Form 10-KSB are forward looking.  In particular, when used in this Annual Report, the words anticipate, believe, estimate, expect, intend, forecast, plan, future, strategy and similar expressions, as they relate to us, are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements and their absence does not mean that the statement is not forward-looking.

While these forward-looking statements, and any assumptions upon which they are based, are made in good faith and reflect our current information and judgment regarding the direction of our business, actual results will almost always vary, sometimes materially, from any estimates, predictions, projections, assumptions or other future performance suggested herein.  Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements.  These forward-looking statements are subject to various risks and uncertainties, including those discussed below in Part I, Item 1. Risk Factors.  We do not undertake any obligation to revise these forward-looking statements to reflect any future events or circumstances.  We caution the reader that important factors in some cases have affected and, in the future, could materially affect actual results and cause actual results to differ materially from the results expressed in any such estimates, projections or other forward-looking statements.

As used in this Annual Report, unless the context otherwise requires, the terms the Company, we, us, and our refer to DataWave Systems Inc., a Delaware corporation, together with our subsidiary companies.

Our consolidated financial statements are stated in United States Dollars and are prepared in accordance with accounting principles generally accepted in the United States of America.  All dollar amounts in this Annual Report are in U.S. dollars unless otherwise stated.

PART I



ITEM 1. BUSINESS

Business Overview

We are a developer and provider of prepaid and stored-value programs.  We sell and distribute prepaid and stored value products using a proprietary system for activating products at the point-of-sale.  We design, develop, own, manage and continually enhance an intelligent, automated, direct merchandising network. This network, which operates through various point-of-sale-activation devices or web-based applications, allows for point-of-sale-activation of high value, high shrinkage products, such as cash cards, prepaid phone cards and prepaid cellular time.  Our systems are scalable and flexible and can be readily modified to offer new premium stored-value products, such as prepaid gift cards and prepaid Internet cards.  In addition, we sell prepaid calling cards and point-of-sale activated prepaid cellular personal identification numbers (PINs) on a wholesale basis to certain retail operators and other customers.

We sell and distribute prepaid and stored value products through a network that includes, but is not limited to:

·

point-of-sale-activation (POSA) terminals,

·

free-standing smart machines (DTMs), and

·

cash registers or the web-based applications of some major retail chains.

All of these devices are connected to our proprietary server and database software through wireless, land line wide area networks or host-to-host connectivity, and are capable of dispensing one or multiple prepaid products and services.



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We operate our business primarily through our subsidiaries and are primarily involved in the sale and distribution of prepaid and stored value products using our proprietary technologies.  We develop, own and operate point-of-sale technology, including terminals that we market and place through the United States and Canada.

Our system distributes inactive prepaid products, which are activated only once they are purchased by the consumer, thus eliminating the risk of theft and the cost of inventory management for the retailer.

Our network systems feature:

·

the ability to activate prepaid products by assigning a value to them at the time of purchase;

·

the ability to print a prepaid PIN number on a receipt voucher at the point of purchase;

·

real-time monitoring of distribution networks;

·

detailed reporting and sales analysis  either paper or web-based;

·

the ability to remote download price adjustments or new products and services to the distribution points;

·

the capability to execute multiple simultaneous transactions in a non-stop processing environment; and

·

consumer convenience - payment options, multiple products and denominations; detailed receipts, including tax information, terms & conditions and other relevant instructions/information.

Historically, our core revenues have come from the sale of prepaid long distance phone cards.  In recent years, we have pioneered the move into prepaid cellular, prepaid cash and prepaid debit card and gift card products.

In Canada, until recent years, we had followed the traditional business model of selling bulk pre-activated live prepaid phone cards to retail establishments. In recent years, we have introduced point-of-sale-activation technology into the retail environment.  This enables us to activate or recharge prepaid products through POSA terminals and the cash register systems or web-based applications of major chains.  During fiscal 2006, we installed 995 POSA terminals in Canada and as of March 31, 2006, we had an installed base of 4,853 company-owned POSA terminals in Canada. We also provide prepaid products to 863 distributor-owned terminals and host-to-host (cash register) locations.

In the United States, we have established a network of free-standing vending machines or DTMs that sell prepaid long distance phone cards.  We also sell phone cards through POSA terminals and during fiscal 2004 we introduced a POSA host-to-host solution to a grocery chain in the North-Eastern states.  During fiscal 2006, our installed base of DTMs and over the counter terminals in the U.S. decreased by 111 due to a decline in high traffic locations, and as of March 31, 2006, we had an installed base of 809 DTMs and 224 POSA terminals and host-to-host retail locations in the United States.

Business Strategy

Our business strategy is to sell prepaid telephony and financial products and services such as phone cards, cellular airtime, Internet services, gift cards and stored-value cards using our proprietary network systems.  Elements of the strategy include increasing our penetration of premier site locations in the U.S. and retail locations in Canada, expanding our strategic relationships with suppliers, delivering new prepaid product and service offerings, developing relationships with other providers of prepaid products and services, and maintaining our electronic distribution network technological leadership.



Our goals include:

·

identifying and capitalizing on business opportunities that will make us a market leader in point-of-sale activated stored-value telephony and financial products;



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·

developing profitable, high volume, stored-value opportunities that leverage our existing technologies and relationships; and

·

pursuing only those opportunities that have high volume and a quick time to market, with realistic capital expenditures.

In fiscal 2006, we met these goals by:

·

rolling out point-of-sale activation technology to over 1,070 locations in Canada;

·

introducing POSA for cellular and long distance telephone time to our existing national customers in Canada and gaining several new national accounts;

·

completing the roll-out of prepaid cash credit to 300 National Money Mart stores in Canada for Nextwave (an equity investee of National Money Mart and DataWave).

Products and Development

DataWave initially concentrated on selling prepaid long distance phone cards through free-standing smart machines or DTMs.  We developed an over-the-counter (OTC) program as an alternative to the DTM product line, giving us access to locations where placement of a free-standing machine could not be justified, either due to low revenue expectations or to physical considerations, such as available space.

In June 2002, the OTC program was enhanced for roll-out in Canada.  This program (the POSA program) includes the ability to dispense prepaid cellular personal identification numbers (PINs) on a printed voucher, in addition to activating or recharging other prepaid products, through standalone POSA terminals and cash registers (host-to-host connectivity).  We expanded the POSA program into the U.S. during fiscal 2005.

Our current business focus is on the placement and marketing of POSA terminals, free-standing machines and host-to-host connectivity for the sale and distribution of multiple prepaid products, and the development and application of the network technologies required to support processing.

In addition, in recent years we have initiated the move into prepaid cellular and prepaid cash card and gift card products.  We intend to continue to focus on developing these products.

We own and operate all our terminals and network systems.  This requires significant capital investment.

Our Products

Prepaid Long Distance Phone Cards.  Prepaid Long Distance Phone Cards allow consumers to make domestic long distance and international calls using time that has already been purchased.  Typically, phone cards offer savings on calls made away from home or the office and provide the same rate any time of the day or week.  Rates differ depending on the country of origination and destination of the call.  We purchase time from a number of the major long-distance carriers and this enables us to tailor phone card programs to the needs of our customers.  We currently sell these through our network in both Canada and the U.S.

Prepaid Cellular Vouchers.  Prepaid Cellular Vouchers enable consumers who have prepaid programs on their cellular phones to purchase additional time to top-up their phones.  The PIN and relevant instructions are printed on a receipt at the point of purchase, thereby eliminating the need for a physical card product.  Rates differ by carrier and denomination purchased.  We are a leading reseller of prepaid cellular time in Canada, purchasing from all the national cellular carriers.  We currently sell these through our network in Canada.

Prepaid Cash Cards.  Prepaid Cash Cards give consumers, who may not have a bank account, the ability to withdraw cash from ATMs and purchase goods or services from all merchants on the applicable debit and/or credit card network.  Consumers purchase cards for a given amount and can go back to the seller to recharge/add additional funds as and when the card balance is depleted.  Consumers can check their card balance and transaction history online at a secure website.  We currently sell these through our network in Canada.



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Prepaid Internet Products.  Prepaid Internet Products let consumers prepay for various products and services that are available over the Internet.  These products provide an alternative to using a credit card and are extremely popular with younger consumers.  We currently sell these through our network in Canada.

Prepaid Third Party Gift Cards.  Prepaid Third Party Gift Cards issued by a participating retailer may be purchased by consumers at the retails outlets of another retailer, typically a convenience store or supermarket.  The gift cards are activated at the time of purchase typically for their face value.  The activated gift cards may then be redeemed by the consumer, or a person who has received the card as a gift from the consumer, to receive goods or services up to the face value of the card from the issuing retailer. We currently sell these through our network in Canada.

The Market

In Canada, the rollout of our POSA technology has been very successful, allowing us to cement relationships with existing customers and sign contracts with new customers.  We currently activate prepaid phone cards, prepaid cellular time, prepaid Internet and prepaid gift card products through POSA terminals.  In host-to-host applications, we are able to add prepaid cash cards to the product mix.

We also sell bulk quantities of specific denominated pre-activated live prepaid phone cards to retail establishments.

In the United States, we distribute prepaid phone cards primarily through our DTMs and, to a lesser extent, through host-to-host applications.  We also supply batch prepaid phone cards and promotional phone cards to certain customers.  These cards are activated with a specific amount of long distance time when the customer calls us.

In fiscal 1999, we introduced a recharge capability for all prepaid phone cards sold in the U.S. By calling a 1-800 number, a customer can add time to an existing prepaid phone card and charge the cost to a credit card. In fiscal 2006, less than 5% of revenues were derived from this program. Prepaid phone cards sold in Canada are not usually rechargeable.

We also distribute pre-activated prepaid phone cards through machines not connected to our network systems.  Approximately 1% of our machines are not networked and thus sell preactivated calling cards.  In fiscal 2006, less than 1% of our net revenues came from the sale of preactivated phone cards sold through non-networked machines.

Our Suppliers

We purchase long distance time and services from several carriers for both Canadian and U.S. businesses.  In Canada we primarily use IDT and Goldline.  In the U.S. our primary supplier is AT&T, but we also purchase from IDT and Verizon.  Our prepaid cellular time comes from Bell, Microcell Communications, Rogers/AT&T and Telus Mobility in Canada and from AT&T Wireless, Cingular, T-Mobile, TracFone and Verizon Wireless in the U.S.  Please refer to the section entitled Risk Factors; Risk of Termination of Carrier Arrangements; Dependence on Telecommunications Providers below.

We currently sell prepaid Internet products from Napster, Puretracks (music downloads), and Photochannel (prepaid digital photo printing service).

Please refer to Part II, Item 6  Managements Discussion and Analysis of Financial Condition and Results of Operations for a full discussion of the financial results of our operations.

Future Products and Services

Our network systems are scalable and flexible and permit us to offer new prepaid products and services as they become available.  Our ability to remote download new products, services or pricing to our distribution points enables us to respond quickly to the changing demands of growing markets.



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In addition to ensuring that we remain competitive with our telecommunications and financial products, we intend to expand the range of prepaid Internet products.  New products will likely include ring tones, and additional music downloads.

Revenues

We derive substantially all of our revenues from the sale of prepaid cellular products and prepaid long distance telephone products.  Airtime is purchased from cellular and long distance carriers.  Sales of prepaid calling cards and personal identification numbers under third party brands, where we are not the primary obligor of the related phone service, do not incur significant inventory risk, have no significant continuing obligation with respect to operation of the card or personal identification number subsequent to sale, and where the price to the consumer is fixed and determinable and collection is reasonably assured, are recognized at the date of sale on a net agency basis.  The resulting net agency revenue earned is calculated as the difference between the gross proceeds received and the cost of the related phone time.

Sales of prepaid cellular PINs, where we are not the primary obligor and do not incur unmitigated significant inventory or return risk, are recognized at the date of sale on a net agency basis.  PIN inventory levels reflect the purchased value of the cost of the PIN and are managed to supply a level of ten days sales; the resulting accounts payable liability is paid within the normal trade terms offered by the supplier (including cash discounts for early payment).  The underlying sales arrangements entered into by us will and do impact the presentation of revenues, inventory, accounts receivable and resulting gross profit and working capital respectively.  Accounts receivable reflect the wholesale value of the PINs and are almost always collected within fifteen days.

Sales of certain prepaid long distance cards, in particular our company or custom branded cards, where we incur inventory risk but do not provide the related telephone time are recognized on a gross basis at the date of sale to the retailer when title to the card transfers, collection of proceeds is reasonably assured, the full obligation to the phone service provider is fixed and determinable, and we have no significant continuing obligations.

Revenues from certain prepaid phone cards where our obligation to the phone service provider is not fixed or determinable at the date of delivery is deferred and recognized on a gross basis when services are rendered as the card is used or expires.

Fees and Service revenues include transaction, service and processing fees.  The nature of these fees is charges for processing transactions at the point of sale, including prepaid cellular and prepaid long distance.  Fees are included in contractual arrangements with our customers and are billed weekly to customers.  Revenues from communications processing services and Internet services are recognized at the date of sale when no significant continuing obligation exists and the fee is collected or reasonably assured.

In the U.S. marketplace we believe that our relationship with AT&T provides us with competitive advantages in the prepaid phone card market.  One element of our business strategy is to increase our penetration of premier site locations and to expand our strategic relationship with AT&T for the distribution of prepaid phone cards.

There are still opportunities for growth in this market but development of other technologies and increasing pressure on margins will limit our ability to remain profitable by depending solely on sale of prepaid long distance telephone cards.

In addition to phone cards, our business strategy is to deliver new prepaid products and services through our network systems.  We are developing relationships with other providers of prepaid products and services and evaluating other technologies to take advantage of these opportunities.

A key part of this strategy is maintaining our leadership in electronic distribution network technology.  During our fiscal year ended March 31, 2006, we continued our development efforts to enhance our network systems for introduction of new products and to provide transaction processing capability.



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Operations

Our operations include transaction processing, which in turn includes development, operation and maintenance of computer and network systems, processing, customer service and terminal configuration, roll-out and maintenance and are primarily based in Richmond, British Columbia.

Our financial systems, financial reporting and operations functions are managed from our principal operations office in British Columbia, Canada.

Our Network Systems

Our network systems offer features that benefit us, telecommunications providers, retailers, consumers and other product and service providers.  The following features distinguish our network systems from many traditional channels of distribution for prepaid products and services:

·

Scalable and flexible network and point-of-sale architectures:

we can offer a variety of branded products and services and increase the number of distribution points; we can integrate with third party switches;

·

Point-of-sale activation of prepaid products and services:

reduces losses and shrinkage from theft of live inventory; reduces inventory financing and management control costs;

·

Wireless and landline networks:

permits flexibility and mobility in site placement; facilitates connectivity to a variety of applications;

·

24/7 system availability;

·

Remote self-diagnostics:

free-standing smart machines alert us when accumulated cash should be picked up, when inventory levels are low, when malfunctions occur or when other technical service is required; ensures efficient maintenance scheduling and reduces down time; reduces operating expenses and improves cash management by maintaining inventory levels;

·

Remote downloads:

efficient updating of information including price and tax changes; accelerates introduction of new products and services;

·

Real-time credit card verifications, approval and limits:

reduces credit risks;

·

Consumer convenience:

customer determined purchase denomination; cash or credit card acceptance; itemized customer sales receipt, including taxes; 24/7 customer service; and

·

Detailed audit trail of transactions:

permits timely and accurate monthly commission payments; complete monthly reporting  either traditional paper or web-based.

Our Operations Center is the key to the overall function of the DataWave System, serving as an inventory and information repository for the distribution of prepaid products.  The Operations Center distributes prepaid products to the distribution points and records all transactions originating at that level.  Proprietary communication networks manage the information flow allowing for multiple message formats that include real-time, just-in-time and batch inventory processing for PIN-based products.  Sophisticated inventory management systems are maintained that provide reorder points, product and pricing changes as well as extensive management and reporting capabilities.



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Customer payment processing supports EDI message formats, ACH services or formats that are customer specific.  Web-based reporting systems are available to provide customers with a seamless view of activity levels.  Communication protocols are mainly TCP/IP based which allows for connectivity to a wide range of communications devices and ensures network scalability as well as the capability to develop custom interfaces for customers and suppliers.  With POSA terminals, retailers can process reports at the terminal level; the terminal processes requests and communicates with the Operations Center to validate data before printing the report at the terminal.

Our transaction processing facilities run on industry standard Intel based hardware. We use both Microsoft and Linux operating systems. We use multiprocessor servers with RAID Level 5. We use Sybase and SQL data base management systems; all data is stored fully encrypted and secure with full redundancy and complete backup procedures.  Backups are stored off site in a secure facility.  Network administrators and systems engineers are on call 24 hours a day, seven days a week.

Customer Service operates 24 hours a day, seven days a week, and provides terminal and DTM support, including transaction monitoring.  Remote diagnostics can handle many problems and an escalation process enables prompt resolution.  Customer Service provides first level response for all products.

The Market for Our Products and Services

The market for prepaid products is fast growing.  Increased use of wireless communications, use of the Internet for business and a wider acceptance of smart or stored-value cards is driving rapid growth in the use of other prepaid products.

The market for prepaid long distance phone cards consists of two primary groups: the cost-conscious and those who make long distance calls, both domestic and international, when they are away from their home or office.

Prepaid cellular products have gained rapid acceptance, particularly in Canada.  This product appeals to the credit-challenged, the budget-conscious, those who wish to provide family members with a method of contacting them in an emergency, and those who do not wish to sign a long-term contract with a cellular provider.

Internet sales have grown in the past year and this is due to the variety of products and services being offered.  This trend is expected to continue making prepaid Internet products an essential part of any prepaid product line.

As cash continues to decline as the standard payment method for day to day purchases  for example, it cannot be used for on-line shopping, which is rapidly accounting for a larger percentage of commercial transactions  the market is beginning to offer consumers other options.  Prepaid cash cards allow consumers, some of whom may not have a traditional bank account, to pay for goods and services through existing debit or credit card networks.  They also provide a secure alternative for Internet purchases as they limit financial risk to the balance on the card.

Consumers increasingly look for self-service and vendors increasingly look for smarter distribution systems.  This creates an opportunity to offer multiple prepaid products and services via a smart distribution network.  We believe that the features and benefits of our network systems, among other things, well position us to capitalize on this trend because of the features and benefits of our network systems, as well as other components of our strategy.

The prepaid phone card market in the United States has not expanded significantly in recent years, we believe in part because of changes in travel patterns and in part because more consumers are using their cell phones for long distance calls.  Our growth is expected to be mainly in other geographic areas or with other products and services.  See Risk Factors later in this section.





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Marketing Strategy

Our marketing strategy is to become a leader in delivering prepaid products and services such as phone cards, prepaid cellular time, prepaid financial products, prepaid gift and stored value cards through our network systems.  Key elements of our marketing strategy are summarized below:

Deliver new prepaid product and service offerings:  We believe that the trend towards convenient, self-service, cost-efficient merchandising provides us with the opportunity to utilize the flexibility of our network systems to offer new prepaid products and services.  We currently provide prepaid phone cards, prepaid cellular time, prepaid cash cards and have recently begun offering prepaid Internet products.  We intend to enhance these product lines and to evaluate the market for potential new product and service offerings.

Develop relationships with other providers of prepaid products and services:  We are continually evaluating new strategic relationships that will enable us to offer additional prepaid products and services of brand-name vendors.

Maintain electronic distribution network technological leadership: The capabilities of our network systems provide superior consumer convenience and risk management compared to traditional channels of distribution.  We intend to continue to develop our proprietary system to ensure that we remain at the forefront of point-of-sale-activation technology and continue to keep abreast of market trends.

Increase penetration of premier site locations:  Our objective is to increase the number of distribution points by increasing our penetration of existing and new sites.  To accomplish this objective, we intend to develop new strategic relationships and expand our current relationship with AT&T to gain access to sites such as airports, hotel chains, travel plazas, supermarkets and other prime locations.  We also intend to target new regional and national retail chains in Canada as customers for the already successful POSA terminals.

Our Marketing Plan

As of March 31, 2006, we have placed 4,853 point of sale terminals in retail locations in Canada for activation of prepaid products and services and had a further 863 host-to-host locations.  We are also seeking to expand our Canadian market share by targeting additional regional and national retailers for sales of prepaid products and services.

As of March 31, 2006 we have placed 809 free-standing smart machines and 224 POSA terminals and host-to-host locationsin the United States. We intend to increase our  presence in the United States.

We employ in-house sales and marketing personnel and also have contracts with independent agents in the United States.  The independent agents generally concentrate on identifying new site locations and arranging site contracts on our behalf.

In Canada, we employ in-house sales and marketing personnel, along with third parties, to service existing customers and market to new potential customers.

Employees

As of March 31, 2006, we and our subsidiaries employed a total of
89 individuals.  Of these, 21 employees serve in a management and administrative capacity, 17 employees serve in a sales and marketing capacity, 25 employees serve in a product development capacity, 3 employees serve in a production capacity and  23 employees serve in a service and support capacity.   These employees operate out of the following offices of our company:







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|                         |                               |                     |                     |            |                     |      
|------------------------ | ----------------------------- | ------------------- | ------------------- | ---------- | ------------------- | -----
|Office Location          | Management and Administration | Sales and Marketing | Product Development | Production | Service and Support | Total
|British Columbia, Canada | 19                            | 3                   | 23                  | 3          | 14                  | 62   
|Ontario,
Canada          | Nil                           | 9                   | 2                   | Nil        | 5                   | 16   
|Wayne,
New Jersey        | 2                             | 5                   | Nil                 | Nil        | 4                   | 11   
|Totals:                  | 21                            | 17                  | 25                  | 3          | 23                  | 89   



History of the Company

We are currently a Delaware corporation, having completed the continuance of our corporate jurisdiction from the Yukon Territory into the State of Delaware, effective on February 23, 2005.  The address of our registered office in Delaware is 1209 Orange Street, Wilmington, Delaware 19801 and the name of our registered agent at that address is The Corporation Trust Company.

Our company was originally incorporated under the laws of the Province of British Columbia on August 12, 1986, under the name Monte Carlo Resources Ltd.  On May 16, 1989, we changed our name to C.R. Provini Financial Services Corp., on January 24, 1994, to DataWave Vending Inc., and on January 15, 1997, to DataWave Systems Inc.  On September 1, 2000, we completed a continuance of our corporate jurisdiction from British Columbia to the Yukon Territory.  On February 23, 2005, we completed the continuance of our corporate jurisdiction into Delaware.

We operate our business primarily through our subsidiaries and are primarily involved in the sale and distribution of prepaid and stored value products using our proprietary technologies.  We develop, own and operate point-of-sale technology, including terminals that we market and place through the United States and Canada.

We have five subsidiaries or associates.  Neither we nor any of our subsidiaries or associates have been subject to any bankruptcy, receivership or similar proceedings.  The names of our subsidiaries and associates, their dates of incorporation, our percentage voting ownership of each and the jurisdictions in which they are incorporated are as follows:



|                                 |                              |                       |                              
|-------------------------------- | ---------------------------- | --------------------- | -----------------------------
|Name of Subsidiary or Associate  | Percentage (%) Interest Held | Date of Incorporation | Jurisdiction of Incorporation
|DataWave Services (Canada) Inc.  | 100 %                        | April 28, 1992        | British Columbia             
|DataWave Systems (U.S.) Inc.     | 100 %                        | February 8, 1995      | Nevada                       
|DataWave Services (U.S.) Inc.(1) | 100 %                        | February 8, 1995      | Nevada                       
|CXP Canada Inc.                  | 100 %                        | March 10, 1995        | Canada                       
|Nextwave Card Corp.              | 50 %                         | June 1, 2003          | Alberta                      



(1)Wholly-owned subsidiary of DataWave Systems (U.S.) Inc., a first-tier wholly-owned subsidiary of the Company.



Offices

Our principal operating office is located at Suite 110, 13575 Commerce Parkway, Richmond, British Columbia, Canada V6V 2L1 and our phone number is 604.295.1800.  Our executive office is located at Wayne Interchange Plaza One, 145 Route 46 West, 3rd Floor, Wayne, NJ  07470 and our phone number there is (973) 774-5000.  We also maintain an office in Mississauga, Ontario, Canada.



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Our Internet homepage is located at www.datawave.com and www.datawave.ca.  However, the information in, or that can be accessed through our home page is not part of this report.  Our annual reports on Form 10-KSB, quarterly reports on Form 10-QSB, current reports on Form 8-K, and amendments to such reports are available, free of charge, on our Internet homepage as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Risk Factors

The following discussion in this Annual Report on Form 10-KSB contains forward-looking statements regarding our business, prospects and results of operations that involve risks and uncertainties.  Our actual results could differ materially from the results that may be anticipated by such forward-looking statements and discussed elsewhere in this Report. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below, as well as those discussed under the captions Business and Managements Discussion and Analysis of Financial Condition and Results of Operations as well as those discussed elsewhere in this Report.  In evaluating our business, prospects and results of operations, readers should carefully consider the following factors in addition to other information presented in this Report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations.  See Note Regarding Forward Looking Statements above.

Factors Relating to Our Company and Our Business

We have low working capital which may adversely affect our ability to grow or provide continuing operations.

At March 31, 2006, we had working capital of $2,483,000.  Historically, we have had to make significant investments in inventory and expect this trend to continue as the business grows.  If we are unable to sell our inventory or to collect the receivables in a timely manner, working capital will be reduced and this may adversely affect our ability to operate; in particular, to acquire additional inventory and pay our debts as they come due.  In addition, our growth requires significant capital investment in new terminals.  We have financed this capital expenditure from working capital.  We believe that our current cash position and net cash provided by operations during the fiscal year will be sufficient to meet anticipated cash needs from working capital and capital expenditures through fiscal 2007.

The loss of any of our key customers could have a material adverse effect on our business, financial condition and results of our operations.

In fiscal 2006, 63% of our net revenues came from ten customers (18% from one customer), compared with 51% (19% from one customer) in fiscal 2005.  Loss of one or several of these customers would have a material adverse effect on our business, financial condition and results of operations.

The loss of our suppliers in Canada and the United States could have an adverse effect on our ability to provide continuing operations.

In fiscal 2006, four main suppliers accounted for 31%, 17%, 16% and 15% respectively of our gross purchases (32%, 19%, 18% and 13% in fiscal 2005).

In Canada, we rely primarily on our relationship with the major telecommunications companies for prepaid cellular airtime, and Goldline and IDT Corporation for prepaid long distance telephone services.  

We are reliant on these suppliers for services provided to major accounts.  

Loss of these services would have a material adverse effect on our ability to provide continuing operations, or, if we can access alternate services, they may be available only at higher costs which cannot be passed on to our customers.

In the United States, we rely primarily on our relationship with AT&T for prepaid long distance telephone service, as well as for joint marketing of the AT&T Prepaid Card and our network systems.  A significant portion of the



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prepaid phone cards sold in the United States by us are AT&T Prepaid Cards, and we utilize the AT&T brand name as the primary identity on most of our free-standing machines.  

Loss of use of the AT&T brand name or connection could result in substantial loss of revenues for our United States operations.

Production and maintenance of free-standing machines consists of the assembly and testing by us of a high volume of quality components manufactured by third parties.  We are dependent on a limited number of suppliers for certain of our key components, such as radio modems.  We purchase component parts on a purchase order basis and have no supply commitments from any of our suppliers.  Our reliance on certain vendors, as well as industry supply conditions generally, subject us to various risks, including the possibility of a shortage or a lack of availability of key components, quality control problems, increases in component costs and reduced control over delivery schedules, any of which could adversely affect our manufacturing and assembly process and thus our business and results of operations.

If we are not able to obtain further financing our business operations may fail.

As a growing business, we typically need more capital than we have available to us or can expect to generate through the sale of our products.  There is no guarantee that we will be able to continue to raise funds needed for our business and our continuing operations, when needed or on commercially acceptable terms.  Failure to raise the necessary funds in a timely fashion may limit our growth and continuing operations, and may even cause us to fail.

We face currency risks associated with fluctuating foreign currency valuations.

For the year ended March 31, 2006, approximately 65.8% of our sales were denominated in Canadian dollars.  A decrease in the value of the Canadian dollar in relation to the U.S. dollar after establishing prices and before our receipt of payment and conversion of such payment to U.S. dollars would have an adverse effect on our operating results.  Although the recent strengthening of the Canadian dollars has had a positive impact on our revenue attributable to sales in Canada, it has also negatively impacted our cost of revenues which may be denominated in Canadian dollars.  As of March 31, 2006, we have not entered into foreign currency contracts or other derivatives to mitigate the potential impact of foreign currency fluctuation.

We have limited operating facilities and if we are unable to deliver our service in a timely manner, then we may lose some customers and their orders.

Our primary operations, including information systems (including the server and databases for our network systems), customer service, assembly and production and general administration, are housed in a single facility in Richmond, British Columbia, Canada, with a co-location (back-up) facility at an MTS Allstream Inc. hosted facility in Vancouver, British Columbia, Canada.  Any disruption to our operations at the facility in Richmond and Vancouver due to fire, natural disaster or otherwise, could have a material adverse effect on our business, financial condition and results of operations.  Our operations are also dependent on the integrity of our network systems.  In the event that our network systems (including the wireless and landline networks of other parties used by our network systems) experience substantial down time due to power loss, technical failure, unauthorised intrusion or other interruptions, our business and operations could be materially adversely affected.

If and to the extent we are unable  to protect our proprietary technology, our business may be adversely affect.

We have sought to protect our proprietary technology through a combination of copyright, patent, trademark and trade secret laws, non-disclosure agreements and other forms of intellectual property protection.  We have obtained patent protection for two of our planned products, multiple service provider prepaid wireless service card and multiple denomination currency receiving and prepaid card dispensing apparatus, from the United States Patent and Trademark Office.  In addition, we have filed patent applications with the United States Patent and Trademark Office and have patents pending for the credit extension process using a prepaid card and prepaid broadband Internet and software service method and apparatus.  We have also filed patent applications with the Canadian Intellectual Property Office and have patents pending for the credit extension process using a prepaid card, multiple



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denomination currency receiving and prepaid card dispensing apparatus, and multiple service provider prepaid wireless service card.  Our pending patents may not be granted. Furthermore, if challenged, our patents, and generally intellectual property rights, may not be upheld.

Although we rely, in part, on contractual provisions to protect our trade secrets and proprietary know-how, these agreements may be breached and our remedies for any such breach may be inadequate., In addition, despite our efforts, our trade secrets may become known or be independently developed by competitors.

Although no lawsuits against us regarding infringement of any existing patents or other intellectual property rights are pending, nor have any claims been asserted, there can be no assurance that our operations do not or will not violate the intellectual property rights of others, or that no infringement claims will be asserted by third parties against us in the future. An assertion or finding of infringement against us could have a material adverse effect on our business, financial condition and results of operations.  In addition, our failure to obtain licenses required from third parties whose technology and intellectual property we may need could delay or prevent the development, manufacture or sale of products.

We could face declining transaction fees which may  adversely affect our revenues.

An increasing portion of our revenues is generated from transaction and service fees that we charge to our customers.  The flexibility of our technology allows it to be used for a wide variety of prepaid and stored value products, including products with relatively strong margins for which a relatively sizeable transaction fee may be charged. This diversification of products deliverable through our technology also decreases our reliance on any one supplier.  As various segments of the prepaid and stored value market mature, however, the margins on such products may decrease.  This decrease may exert a negative pressure on the transaction and service fees that we may charge. Such a decline would negatively impact our revenues.

We could experience theft of our products and credit card fraud which could materially affect the operations of our business.

We have not experienced any material losses from theft to date but prepaid product users may attempt to obtain products without rendering payment to us by unlawfully using our access numbers and PINs.  We utilize national credit card clearance systems for electronic credit card settlement.  We generally bear the same credit risks normally assumed by other users of these systems arising from returned transactions caused by unauthorised use, disputes, theft or fraud.  Although we believe that our risk management practices and bad debt reserves are adequate, there can be no assurance that such practices and reserves will protect us from theft of products, fraud and credit card losses, any of which could have a material adverse effect on our business, financial condition and results of operations.

We can also incur fraud loss from fraudulent, improper or unauthorised use of prepaid debit / stored value card being issued by alliances and joint ventures we may be or could become involved in.  We have not experienced any material losses to date resulting from involvement in alliances or joint ventures that issue prepaid debit / stored value cards, although we are still in the early stages of product roll-out.

We depend on experienced management and key technical employees and if we are unable to retain or hire such management and key technical employees in the future, then our ability to improve and implement new systems could be adversely affected.

Our growth has placed, and is expected to continue to place, significant demands on all aspects of our business including our management, financial, technical and administrative personnel and systems.  Our future operating results may largely depend upon our ability to manage growth, including improving and implementing new systems and attracting, retaining, training, managing and motivating skilled employees, particularly managers and other senior technical personnel.  There can be no assurance that a sufficient number of skilled employees will continue to be available to us or that we will be successful in training, retaining and motivating current or future employees or that such employees will achieve expected levels of performance.  In addition, as we increase our service offerings



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and expand our target markets, there will likely be additional demands on our sales and marketing resources.  We also rely on outside contractors to install and maintain our free-standing machines.  Our inability to find and contract with sufficiently experienced contractors could have a material adverse effect on our operations, including decreased free-standing machine placements and increased machine servicing costs.

The loss of Josh Emanuel or other key employees would have a materially adverse effect on our business.

We believe that continued success will depend in large part upon the efforts and abilities of a number of key employees.  The loss of the services of Joshua Emanuel as President and Chief Executive Officer or any one or more of our other key personnel could have a material adverse effect on our business because of their knowledge of the prepaid industry and their business acumen.  We have a written employment agreement with Mr. Emanuel but we do not have a key person insurance policy in place for Mr. Emmanuel.

Some of our assets and some of our officers are outside the United States, with the result that it may be difficult for investors to enforce within the United States any judgments obtained against us or any of our officers.

We are organized under the laws of Delaware, United States.  Several of our officers reside outside the United States, and nearly all of the assets of these persons and our assets are located outside of the United States.  As a result, it may not be possible for investors to effect service of process within the United States upon such persons and it may difficult for investors to enforce against us or such persons judgments predicated upon the liability provisions of the United States securities laws.  There is substantial doubt as to the enforceability against any of our officers located outside the United States in original actions or in actions of enforcement of judgments of United States courts or liabilities predicated on the civil liability provisions of United States federal securities laws.

Factors Relating to Our Industry

We operate in a highly competitive industry and our failure to compete effectively may adversely affect our ability to generate revenue.

The prepaid product market is highly competitive and is served by numerous international, national and local firms.  In the United States, we compete with major long-distance providers, including but not limited to Qwest, Verizon, MCI and Sprint, as well as with other prepaid phone card distributors, including but not limited to IDT Corporation.  We also compete with AT&T in certain locations where AT&T offers prepaid phone cards directly or through other distributors.  In Canada, we compete with long-distance providers, as well as with other prepaid phone card distributors, including but not limited to Goldline, TCI and Phone Time.  In addition, in both Canada and the United States, as the use of cellular phones and phone charge cards increases, we face increased competition from providers of these products.  Many of these competitors have significantly greater financial, technical and marketing resources, much larger distribution networks, and generate greater revenues and have greater name recognition than us.  These competitors may be able to institute and sustain price wars, or imitate the features of our network systems products, resulting in a reduction of our share of the market and reduced price levels and profit margins.

In addition, there are relatively low barriers to entry into the prepaid phone card market, and we have faced, and expect to continue to face, additional competition from new entrants.  In both the United States and Canada, we also compete with prepaid phone card distributors which own and operate switch and transmission platforms.  Such distributors may provide long distance services at a lower cost than us, and offer additional bundled features not available from our long-distance provider such as voicemail and facsimile services.  We believe that our ability to compete also depends in part on a number of competitive factors outside our control, including the reliability of competitors products and services, the ability of competitors to hire, retain and motivate qualified personnel, the price at which competitors offer comparable services and the extent of competitors responsiveness to customer needs.  We may not be able to compete effectively on pricing or other requirements with current and future competitors or competitive pressures may not materially adversely affect our business, financial condition and results of operations.



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Rapid technological changes in our industry could render our products non-competitive or obsolete and consequently affect our ability to generate revenues.

Currently we derive substantially all of our revenues from the sale of prepaid cellular time and prepaid long distance phone cards. The prepaid products and services industry is characterised by rapid technological change, new products and services, new sales channels, evolving industry standards and changing client preferences.  We believe that our success will depend, in significant part, upon our ability to make timely and cost-effective enhancements and additions to our technology and to introduce new products and services that meet customer demands.  We expect new products and services to be developed and introduced by other companies that compete with our products and services.  The proliferation of new telecommunications technology, including personal and voice communication services over the Internet, may reduce demand for long distance services, including prepaid phone cards.  We may not be successful in responding to these or other technological changes, to evolving industry standards or to new products and services offered by our current and future competitors.  In addition, we may not have access to sufficient capital for our research and development needs in order to develop new products and services.

Our revenues are seasonal which may result in our operating results being, from time to time, below the expectations of analysts and investors.

We believe that sales of prepaid products are seasonal.  Many consumers purchase prepaid long distance and cellular products while traveling during the peak travel months of July, August and September.  Sales of these products decrease during most of the shoulder and low travel seasons.  Sales of prepaid products, including gift cards and cash cards, enjoy a peak during the December holiday season.  A significant proportion of our operating expenses are fixed in advance for a quarter and if our sales are below expectations in a particular quarter, this could have a material adverse effect on our financial condition and results of operations.  We believe that period-to-period statements of our operating results are not necessarily meaningful, should not be relied upon as indications of future performance and may result in volatility in the price of our common shares.  Due to the foregoing factors, among others, our operating results may from time to time be below the expectations of analysts and investors.

We are affected by government regulations in the United States and Canada which may delay or hinder our ability to provide services and products.

The following summary of regulatory developments and legislation does not purport to describe all present and proposed federal, state and local regulations and legislation affecting the telecommunications industry.  Other existing federal and state regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change, in varying degrees, the manner in which this industry operates.  Neither the outcome of these proceedings, nor their impact upon the telecommunications industry or us can be predicted at this time.

The telecommunications industry is highly regulated in the United States at the federal, state and local levels.  Various international authorities may also seek to regulate the services provided or to be provided by us.  In the United States, federal laws and the regulations of the Federal Communications Commission (FCC) generally apply to interstate telecommunications, while state public utility commissions, public service commissions or other state regulatory authorities generally exercise jurisdiction over telecommunications that originate and terminate within the same state.  In Canada, the telecommunications industry is regulated by the Canadian Radio, Television and Telecommunications Commission (CRTC).

The FCC and state regulatory authorities in the United States and the CRTC in Canada may address regulatory non-compliance with a variety of enforcement mechanisms, including monetary forfeitures, refund orders, injunctive relief, license conditions, and/or license revocation.  The regulation of the telecommunications industry is changing rapidly and the regulatory environment varies substantially from state to state.  Moreover, as deregulation at the federal level occurs, some states are reassessing the level and scope of regulation that may be applicable to telecommunications companies.  There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our business, financial condition and results of operations.



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United States.  We are a switchless distributor of long distance telephone time purchased from carriers such as, but not limited to, AT&T.  We believe that we are not regulated as a carrier because our name is not on our prepaid phone cards and the telephone number on the prepaid phone cards is that of the underlying, regulated carrier and not ours.  Accordingly, we have not obtained any federal or state authorizations.  To the extent that federal or state regulators enforce applicable laws and regulations differently, we may be found in violation of such laws or regulations and may be required to alter our business strategy.

The sale of long distance telephone service through prepaid phone cards may be subject to escheat laws in various states.  These laws generally provide that payments or deposits received in advance or in anticipation of the provision of utility services, including telephone service, that remain unclaimed for a specific period of time after the termination of such services are deemed abandoned property and must be submitted to the state.  In the event such laws are deemed applicable, we may be required to deliver such amounts to certain states in accordance with these laws, which could have a material adverse effect on our business, financial condition or results of operations.

Pursuant to the Telecommunications Act of 1996, the FCC was granted the authority to implement certain policy objectives, including the establishment of the Universal Service Fund.  The purpose of the Universal Service Fund is to subsidize the provision of local telecommunications services to low-income consumers, schools, libraries, health care providers and rural and insular areas that are costly to serve.  Pursuant to a FCC order, Universal Service Fund contributions are generally equal to approximately four percent of a carriers interstate and international gross revenues, and approximately one percent of its intra-state end user gross revenues, effective January 1, 1998.  The FCC is expected to adjust the amount of these contributions each calendar quarter, and they may increase significantly in future periods.  Our underlying carriers may pass their respective costs through to us.

The taxation of prepaid telephone card sales and use is evolving and is not specifically addressed by the laws of many of the states in which we do business.  Some states and localities charge a tax on the point-of-sale purchase of prepaid telephone cards while others charge a tax on usage of prepaid telephone cards.  While we believe that we have adequate funds reserved for any taxes we may ultimately be required to pay, there can be no assurance that this will be the case.  In addition, certain authorities may enact legislation which specifically provides for taxation of prepaid telephone cards or other services provided by us or may interpret current laws in a manner resulting in additional tax liabilities to us.

Canada.  We have a license to resell long distance telephone time from the CRTC, a federal body which regulates media and telecommunications in Canada.  The CRTC has similar powers to the FCC in the United States.  Any telecommunications service provider in Canada is required to be licensed by the CRTC.  We believe that we have all necessary CRTC licenses to carry on our business.  Revenues generated from long distance and international communications operations are taxed according to set tariffs.  The license that we have from CRTC is applicable for those who do not operate their own telecommunications facilities, and requires us to make contributions based on our revenues according to set tariffs.

In addition, most provinces charge provincial sales taxes on products and services.  In some cases we are liable to collect the sales taxes and remit to the provinces.  We believe we have taken adequate steps to collect and remit the sales taxes where necessary, but our failure to do so would result in us being liable for taxes owed, which could adversely affect our financial condition.

Prepaid debit / stored value cards that are issued by alliances and joint ventures that we are party to are subject to banking rules and regulations and regulatory approval.  The financial institution issuing such cards also must ensure that the programs in the United States comply with Bank Safety and Soundness regulations of the United States Office of the Comptroller of the Currency and all other U.S. Office of the Comptroller of the Currency regulations such as Privacy, Know Your Customer, Anti-Money Laundering and the Patriot Act and in Canada comply with the Loan and Trust Companies Acts, Personal Information Protection and Electronic Documents Act and Proceeds of Crime (Money Laundering) and Terrorism Financing Act to name a few.  

Our

failure to comply could adversely affect our business plan and revenues if any required approvals are withdrawn.



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Factors Related to Our Common Stock

Trading of our stock may be restricted by the SECs penny stock regulations which may limit a stockholders ability to buy and sell our stock.

Our common stock is considered a penny stock, which is generally defined as any equity security that has a market price less than $5.00 per share and which is not traded on a national market system.  As a result, our securities are covered by the penny stock rules, which impose additional sales practice requirements on broker-dealers who sell to persons other than established customers and accredited investors.  The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document in a form prepared by the SEC which provides information about penny stocks and the nature and level of risks in the penny stock market.  The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market value of each penny stock held in the customers account.  The bid and offer quotations, and the broker-dealer and salesperson compensation information, must be given to the customer orally or in writing prior to effecting the transaction and must be given to the customer in writing before or with the customers confirmation.  In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from these rules, the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchasers written agreement to the transaction.  These disclosure and suitability requirements may have the effect of reducing the level of trading activity in the secondary market for the stock that is subject to these penny stock rules.  Consequently, these penny stock rules may affect the ability of broker-dealers to trade our securities.  We believe that the penny stock rules discourage investor interest in, and limit the marketability of our common stock.

The National Association of Securities Dealers, or NASD, has adopted sales practice requirements which may also limit a stockholders ability to buy and sell our stock.

In addition to the penny stock rules described above, the NASD has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer.  Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customers financial status, tax status, investment objectives and other information.  Under interpretations of these rules, the NASD believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers.  The NASD requirements make it more difficult for broker-dealers to recommend that their customers buy our common stock, which may limit investors ability to buy and sell our stock and have an adverse effect on the market for our shares.

Our common stock is illiquid and subject to price volatility unrelated to our operations.

Our common shares are currently traded on the OTC Bulletin Board, under the symbol DWVS. The average daily trading volume for our common stock during the three months prior to March 31, 2006 has been approximately 50,000 shares.  Therefore, holders of our common stock may have difficulty selling their shares in the public markets.  As a result of the registration statement we filed on February 22, 2006, a significant number of restricted and control shares have been registered and are available for resale.

Sales of a substantial number of shares of our common stock in the public market (including the shares offered under the registration statement filed on February 22, 2006, and shares available for resale under Rule 144 under the Securities Act) or the perception that such sales could occur, could significantly depress the prevailing market price of our common stock.  Further announcements concerning our or our competitors technological innovations, new product and service offerings, changes in government regulations, conditions in our market segment or changes in earnings estimates by analysts may cause the price of our common shares to fluctuate substantially.  In addition, stock prices for many technology and telecommunications companies fluctuate widely for reasons that may be unrelated to their operating results.  These fluctuations, as well as general economic, political and market conditions, may adversely affect the trading price of our common shares.



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The price of our common stock may be volatile, and a stockholders investment in our common stock could suffer a decline in value.

There has been significant volatility in the volume and market price of our common stock, and this volatility may continue in the future.  In addition, there is a greater chance for market volatility for securities that trade on the OTC Bulletin Board as opposed to a national exchange or quotation system.  This volatility may be caused by a variety of factors, including the lack of readily available quotations, the absence of consistent administrative supervision of bid and ask quotations and generally lower trading volume.  In addition, factors such as quarterly variations in our operating results, changes in financial estimates by securities analysts or our failure to meet our or their projected financial and operating results, litigation involving us, general trends relating to our industry, actions by governmental agencies, national economic and stock market considerations as well as other events and circumstances beyond our control could have a significant impact on the future market price of our common stock and the relative volatility of such market price.

We do not intend to pay cash dividends, so any return on a stockholders investment must come from appreciation.

We have not declared dividends on our common stock in the past, and do not intend to declare dividends on our common stock in the foreseeable future.  As a result, any return on investment in our common stock must come from increases in the fair market value and trading price of our common stock.

Integrated Data Corp. owns a majority of the outstanding shares of our common stock and effectively controls our company, which could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders.

As of March 31, 2006, our largest stockholder, Integrated Data Corp., beneficially owns approximately 45.8% of our outstanding common shares.  Accordingly, this single stockholder may be able to influence the outcome of stockholder votes, involving the election of directors, the adoption or amendment of provisions in our certificate of incorporation and bylaws and the approval of certain mergers or other similar transactions, such as a sale of substantially all of our assets.  Such control by our existing stockholder could have the effect of delaying, deferring or preventing a change in control of our company.

ITEM 2. PROPERTIES

We do not own any real property.

DataWave Services (Canada) Inc. occupies approximately 15,000 square feet in Richmond, British Columbia for our operating offices, finance, customer support, product development and operations under a lease expiring on December 31, 2013.  We also occupy approximately 6,200 square feet in Mississauga, Ontario under a lease which expires on January 31, 2011.  DataWave Services (U.S.) Inc. occupies approximately 5,500 square feet in Wayne, New Jersey under a lease which expires May 31, 2010.  We believe that our current lease arrangements provide adequate space for our foreseeable future needs as well as those of our subsidiaries.

ITEM 3. LEGAL PROCEEDINGS

We are not a party to any pending legal proceedings.

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

The 2005 annual general meeting of stockholders of the Company was held on August 8, 2005.  All nominees to the Board of Directors identified and described in the Companys proxy statement mailed to the stockholders, namely Joshua Emanuel, John X. Adiletta, and Vijay Fozdar, were elected at the annual meeting.  In addition, the following resolutions were approved by the stockholders at the annual meeting:



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·

Deloitte & Touche LLP, independent registered chartered accountants, was appointed as independent auditors of the Company;

·

The resolution to amend the Companys 2000 Stock Option Plan was approved.  The purpose of the amendment was to clarify the Plan to ensure consistency with the requirements of the United States Internal Revenue Code for the granting of incentive stock options, as well as to delete obsolete references to the Canadian Venture Exchange as the Company shares were no longer traded on the TSX Venture Exchange.

·

The Board of Directors was authorized to implement a reverse split of the issued and outstanding common shares of the Company on or before March 31, 2006.  The approval of the resolution also authorized the Board of Directors to revoke the resolution and abandon the reverse split.  No reverse split was implemented as of the filing date of this Form 10KSB.

The voting results for each of the above resolutions were as follows:



MotionsForAgainstWithheldElection of DirectorsJoshua Emanuel32,607,064-144,828John X. Adiletta32,648,169-103,723Vijay Fozdar32,672,659-79,233Appoint auditors32,664,711-79,681Amend Stock Option Plan26,799,361294,795-Implement reverse split31,904,622844,800-






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PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market

Our common shares are traded on the National Association of Securities Dealers Inc.s Over-the-Counter Bulletin Board (OTC Bulletin Board) in the United States under the symbol DWVS.

The following tables set forth, for the periods indicated, the high and low bid information for our common shares, as quoted on the OTC Bulletin Board.  All quotations for the OTC Bulletin Board reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.  Trading on the OTC Bulletin Board commenced in the second quarter of fiscal 1998.



HighLowFiscal 2006:Fourth quarter (ended March 31, 2006)$0.35$0.29Third quarter (ended December 31, 2005)0.230.17Second quarter (ended September 30, 2005)0.240.15First quarter (ended June 30, 2005)0.190.14Fiscal 2005:Fourth quarter (ended March 31, 2005)$ 0.21$ 0.06Third quarter (ended December 31, 2004)0.140.04Second quarter (ended September 30, 2004)0.090.05First quarter (ended June 30, 2004)0.120.08




Holders

As of June 23, 2006, there were 54,326,834 shares of common stock issued and outstanding, held by 176 stockholders of record.



Dividends

We have not paid dividends on the common stock in the past and do not anticipate paying dividends in the near future.  We intend to retain earnings, if any, for use in our business and do not anticipate paying any cash dividends.  Our directors will determine if and when dividends should be declared and paid in the future based on our financial position at the relevant time.  All of our shares of common stock are entitled to an equal share in any dividends declared and paid.

We anticipate that we will retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying cash dividends on our equity in the foreseeable future.  Any future determination with regard to the payment of dividends will be at the discretion of our Board of Directors and will be dependent upon our future earnings, financial condition, applicable dividend restrictions and capital requirements and other factors deemed relevant by the Board of Directors.









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ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included elsewhere in this Report.  Except for historical information, the following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  See Note Regarding Forward Looking Statements above.

Overview

We are an innovator and developer of prepaid and stored-value programs.  We pioneered our DataWave System that allows for point-of-sale-activation of high value, high shrinkage products, such as cash cards, prepaid phone cards and prepaid cellular time. This proprietary system works both over the Internet, and with various card activation devices.  Our network systems have been designed to work both with the prepaid platforms of other parties, as well as telecommunication and financial switches.  Our systems are scalable and flexible and can be readily modified to offer new premium stored-value products, such as prepaid gift cards and prepaid Internet cards.

Managements Summary(all dollar amounts rounded to the nearest thousand except per share amount)

Revenues for the year ended March 31, 2006 were $32,094,000 compared with $24,327,000 for fiscal 2005.  The increase of 31.9% is due to an increase in both the traditional business of prepaid long distance revenues and a significant increase in the POSA business, where activation and dispensing of prepaid cellular PINs is the primary product.

The margin (total revenues less cost of revenues, exclusive of depreciation and amortization) for fiscal 2006 was $11,441,000 an increase of $2,657,000 over fiscal 2005. The movement is attributable to an increase in the margin earned in prepaid long distance of $99,000, an increase in the fees and services margin of $667,000, an increase in the prepaid cellular margin of $1,806,000, an increase in margins from other business of $83,000 and an increase in the prepaid Internet products margin of $2,000.

Operating costs and expenses, excluding cost of revenues, increased by $1,677,000 to $9,975,000 for fiscal 2006 compared with $8,298,000 for fiscal 2005.  The increase is primarily due to increased general and administrative costs, increased product development costs and depreciation expense associated with the capital investment in POSA terminal in fiscal 2006.

Critical Accounting Policies and Estimates

The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates including, among others, those affecting revenues, the allowance for doubtful accounts, and the useful lives of tangible and intangible assets.  The discussion below is intended as a brief discussion of some of the judgments and uncertainties that can impact the application of these policies and the specific dollar amounts reported on our financial statements.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, or if management made different judgments or utilized different estimates.  Many of our estimates or judgments are based on anticipated future events or performance, and as such are forward-looking in nature, and are subject to many risks and uncertainties, including those discussed below and elsewhere in this annual report.  We do not undertake any obligation to update or revise this discussion to reflect any future events or circumstances.

We have identified below some of our accounting policies that we consider critical to our business operations and the understanding of our results of operations.  This is neither a complete list of all of our accounting policies, nor does it include all the details surrounding the accounting policies we have identified.  There are other accounting



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policies that are significant to our company.  For a more detailed discussion on the application of these and our other accounting policies, see Note 2 to the Consolidated Financial Statements for the year ended March 31, 2006.

Use of estimates

The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period.  We believe that the estimates we use are reasonable; however, actual results could differ from those estimates.

Revenue and cost recognition

Our revenues are primarily generated from the resale of prepaid long distance and cellular telephone time.  Most of our long distance and all our cellular calling cards and virtual vouchers or PINs are activated at the point-of-sale using our proprietary technologies.  We recognize revenues when all of the following criteria are met:

·

pervasive evidence of an arrangement exists,

·

delivery has occurred or services have been rendered,

·

the price is fixed or determinable, and

·

collectibility is reasonably assured.

Our revenue in Canada is primarily from the sale of prepaid long distance and from the activation and dispensing of prepaid cellular PINs.  Sales of prepaid long distance, in particular company or custom branded cards, where we incur significant inventory risk but do not provide the related telephone time are recognized on a gross basis at the date of sale to the consumer when title to the card transfers, the full obligation to the phone service provider is fixed and determinable, and we have no significant continuing obligations.

Sales of prepaid cellular PINs, where we are not the primary obligor of the related phone service or where we do not incur significant inventory or return risk, are recognized at the date of sale on a net agency basis.  The resulting net revenue is calculated as the difference between the gross proceeds received and the cost of the related phone time.  Accounts receivable reflect the wholesale value of the PINs and are collected within fifteen days.

Sale of Internet products, where we are not the primary obligor of the Internet services or where we do not incur significant inventory or return risk, are recognized at the date of sale on a net agency basis.  The resulting net revenue is calculated as the difference between the gross proceeds received and the cost of the related Internet services.

Fees and Service revenues, also a significant component of our revenues in Canada, include transaction, service and processing fees.  The nature of these fees is charges for processing transactions at the point of sale, including prepaid cellular, prepaid long distance and prepaid cash cards.  Fees are included in contractual arrangements with our customers and are billed weekly to customers.

Most of our revenue in the United States is from the sale of prepaid long distance through our network of vending machines.  As in Canada, sales where we incur significant inventory risk but do not provide the related telephone time are recorded on a gross basis at the date of sale to the consumer when title to the card transfers, the full obligation to the phone service provider is fixed and determinable, and we have no significant continuing obligations.  Sales where we are not the primary obligor of the related phone service and where we do not incur significant inventory risk (as the liability to the carrier is incurred at the point-of-sale), are recorded at the date of sale on a net agency basis.  The related U.S. accounts receivable is the retail value of the product and is typically collected within two weeks of the sale; this is primarily cash in our vending machines which is collected on a regular basis.

The underlying sales arrangements entered into by us will impact the presentation of revenues, inventory, accounts receivable and resulting margin and working capital.



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Cost of revenues for prepaid long distance phone cards consists primarily of long distance telephone time, standard phone cards, net of amounts earned on early payments to suppliers plus commissions to agents and site landlords.  Direct costs are also associated with the DTM machines including direct production salaries, parts and accessories and costs to service the machines.  Cost of revenues for transaction fees and services consists of network and communication service costs, costs of maintaining and supporting point-of-sale activation terminals and third party processing costs for transactions.  Cost of revenues excludes depreciation and amortization.

The presentation of the revenues of the majority of our business activities on a net agency basis impacts our financial statements.  Where we obtain legal title to PIN and cellular time inventory but are not the primary obligor or do not incur significant unmitigated inventory or return risk, our recording of inventory, the related trade payables and net agency revenue from its sale significantly impacts our financial statements.

Impairment of long-lived assets

We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  To determine recoverability, we compare the carrying value of the assets to the estimated future undiscounted cash flows.  Changes in estimates of cash flow may impact our determination of recoverability.  Measurement of an impairment loss for long-lived assets held for use is based on the fair value of the asset.  Long-lived assets classified as held for sale are reported at the lower of carrying value and fair value less estimated selling costs.  For assets to be disposed of other than by sale, an impairment loss is recognized when the carrying value is not recoverable and exceeds the fair value of the asset.

Goodwill and other intangible assets

We do not amortize goodwill and intangible assets with indefinite lives.  Instead, these assets are reviewed annually (or more frequently under certain conditions) for impairment.  Other intangible assets comprising customer lists and an international license are amortized over 6 and 5 years respectively, managements best estimate of their useful lives.

Deferred income taxes

We have certain tax assets relating to historical operating losses and temporary differences.  Based on our assessment of the probability of realization we have recorded a full valuation allowance against such assets and have recorded no related tax asset in the U.S.  We have recorded a deferred tax asset in Canada relating to a temporary difference that will reverse in the foreseeable future. Future conditions that impact our assessment of such realization may impact the recognition of such assets.

Stock based compensation

We account for stock-based compensation in accordance with the intrinsic value method where compensation expense is measured as the amount by which the market price of the underlying stock exceeds the exercise price of the options on the date of grant.  This compensation is amortized over the vesting period.  We provide pro-forma information regarding net income per share as if the stock-based awards to employees were estimated using a Black-Scholes option pricing model.  The model reflects managements best estimate of the fair value of its stock-based awards to employees.



Foreign currency translation

Our functional currency is the U.S.dollar since it is the currency of the primary economic environment in which the company operates.  Assets and liabilities of subsidiaries having non-U.S. dollar functional currencies are translated at year-end rate of exchange, and income statement accounts are translated at average rates of exchange for the year.  Gains or losses resulting from translating foreign currency financial statements are reflected in accumulated other comprehensive income, a separate component of stockholders equity.  Gains or losses resulting from foreign currency transactions are included in net income.



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Selected Financial Operating Data for the Fiscal Years Ended March 31, 2006 and 2005



Years Ended March 31Percentage of Revenue2006200520062005$000$000%%RevenueSales$23,893$16,78374.4%69.0%Net agency sales8,2017,54425.6%31.0%Total revenue32,09424,327100.0%100.0%Operating costs and expensesCost of revenues (exclusive of depreciation and amortization)20,65315,54364.3%63.9%General and administrative4,7073,27914.7%13.5%Selling and marketing2,0681,9066.5%7.8%Product development1,7131,3125.3%5.4%Merger costs-6590.0%2.7%Depreciation and amortization1,4881,1424.6%4.7%Total operating costs and expenses30,62923,84195.4%98.0%Operating income1,4654864.6%2.0%Other income192390.6%0.2%Foreign exchange gain12340.0%0.1%Income before income taxes1,6695595.2%2.3%Income taxes(682)-(2.1%)0.0%Equity gain from investee1551040.5%0.4%Net income$1,142$6633.6%2.7%


Revenues

For the year ended March 31, 2006, revenues were approximately $32,094,000, an increase of $7,767,000, or 31.9% over the $24,327,000 in revenues for the year ended March 31, 2005.  The increase in revenues is reflected by both an increase in the traditional prepaid long distance revenues of $580,000 and by a significant increase in the POSA business of $6,385,000, where activation and dispensing of prepaid cellular PINs is the primary product.  Annual transaction volume increased from 10,190,000 in fiscal 2005 to more than 13,500,000 in fiscal 2006.

Our ten largest customers accounted for 63% of revenues in fiscal 2006 compared with 51% in fiscal 2005 (one customer accounted for 18% of revenues in fiscal 2006 and one customer accounted for 19% of revenues in fiscal 2005).  We are actively seeking to expand our customer base for point-of-sale activation of prepaid products to mitigate the risk inherent in such a concentration.

Revenues in Canada and the United States are dependent upon the number of unit placements and locations offering prepaid products.  The following table lists the number of POSA terminals and host-to-host locations, free-standing



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machines (DTMs), over-the-counter units and traditional (or non-networked) machines in which our prepaid products are sold.  The Company owns and operates POSA terminals, all free-standing machines, over-the-counter units and traditional vending machines.  The following table reflects the growth and change of our business:







Years Ended March 31,20062005CanadaPOSA terminals (owned)4,8533,858POSA terminals (serviced or host to host)863501United StatesDTMs809920POSA terminals (owned)10527POSA terminals (serviced or host to host)119159MexicoPOSA terminals (serviced or host to host)170200Total6,9195,665


During fiscal 2006 in Canada we installed 995 POSA terminals and additional 362 host-to-host locations, generating an installed base at March 31, 2006 of
4,853 terminals with a further 863 host-to-host locations and distributor operated terminals.  In March 2006, daily point-of-sale activations averaged 36,411 compared to the March 2005 daily average of 30,492 activations.Wegenerated transaction fees of $2,924,000 for fiscal 2006 compared with $2,206,000 in fiscal 2005.  In the United States our installed base of DTMs and over the counter terminals decreased by 111 due to a decline in high traffic locations.  POSA terminals and host-to-host locations increased to 224 in fiscal 2006 (186 in fiscal 2005).

Revenues in Canada were $21,129,000 for the year ended March 31, 2006 compared with $14,334,000 for fiscal 2005, an increase of $6,795,000 or 47.4%, which is primarily attributable to an increase in both the traditional prepaid long distance revenues and the POSA business, where activation and dispensing of prepaid cellular PIN is the primary product.  Revenues from our Canadian operations in fiscal 2006 represented approximately 65.8% of our total revenues, compared to 58.9% of our total revenues in fiscal 2005.

Gross proceeds for prepaid cellular and prepaid Internet products were approximately $155,710,000 in fiscal 2006 compared with $93,185,000 in fiscal 2005, a 62.6% increase.  We record this revenue on a net agency basis (gross proceeds less payments to suppliers).  In fiscal 2006, net agency sales from this business were $3,739,000 compared with $1,934,000 in the previous year, a 93.3% increase.

Revenues in the United States were $10,936,000 for fiscal 2006 compared with $9,939,000 for fiscal 2005, an increase of $997,000 or 10.0%, which is primarily attributable to an increase in the traditional prepaid long distance revenues.  Revenues from our U.S. operations in fiscal 2006 represented approximately 34.1% of our total revenues, compared to 40.9% of our total revenues in fiscal 2005.

Revenues in Mexico were approximately $29,000 for the year ended March 31, 2006, a 46.8% decrease from fiscal 2005.  Alestra, the company that provides AT&Ts broadband and added value services in Mexico, has agreed to use our point-of-sale authorization technology to sell prepaid phone cards.

Cost of Revenue (exclusive of depreciation and amortization)

Cost of revenue (exclusive of depreciation and amortization) was approximately $20,653,000 or 64.3% of revenues, for the fiscal year ended March 31, 2006, compared to approximately $15,543,000, or 63.9% of revenues, for the fiscal year ended March 31, 2005.



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Our cost of revenue (exclusive of depreciation and amortization) consists primarily of payments to carriers who provide long distance telephone time and various services related to the production and shipping of product, supplying and maintaining our network systems, transaction processing costs, site commissions, co-op marketing and volume rebates.  In the United States, additional costs are incurred servicing and maintaining our network of free standing machines.  The increase in costs of revenue of 32.9% for fiscal 2006 compared to fiscal 2005 is due to the increase in sales of our products and additional increases in the cost of time we purchase from our suppliers.

Margin (total revenues less cost of revenues, exclusive of depreciation and amortization) increased to $11,441,000 in fiscal 2006 compared with $8,784,000 in fiscal 2005.  Margin as a percentage of revenue for fiscal 2006, however, decreased to 35.7% compared with 36.1% for fiscal 2005.  This decrease is primarily attributable to margin as a percentage of revenue on prepaid long distance decreasing from 24.0% in fiscal 2005 to 19.5% in fiscal 2006 due to continued pricing pressure.  Prepaid cellular and prepaid Internet products, which account for 11.8% of total revenues, generate margins as a percentage of revenue of approximately 2% - 7% and are accounted for on a net agency basis.  The margin for this business was $3,742,000 or 32.7% of the total margin in fiscal 2006, compared with $1,935,000 or 22.0% of the total margin in fiscal 2005.

Margin (total revenues less cost of revenues, exclusive of depreciation and amortization) on prepaid long distance was $4,905,000 for fiscal 2006 compared with $4,805,000 for fiscal 2005.  Prepaid long distance accounted for 42.9% of margin as a percentage of revenue in fiscal 2006 compared with 54.7% in fiscal 2005, this reflects the continued shift in our business from prepaid long distance to other revenue streams.



General and Administrative Expenses

General and administrative expenses were $4,707,000 or 14.7% of revenues during fiscal 2006, compared to $3,279,000 or 13.5% of revenues during fiscal 2005. The increase in costs in fiscal 2006 of approximately $1,428,000 includes the following:

·

accounting, audit and consulting fees increased by $177,000

·

rent and occupancy costs increased by $175,000 due to a full year in new offices in Richmond B.C., Canada;

·

investor relations fees increased by $175,000, as a result of obtaining the services of an investor relations firm;

·

salaries increased by $1,001,000 as a result of hiring additional staff in operations and finance, including legal counsel;

·

partially offset by decreases in various other expenses including $20,000 decrease in repair and maintenance, $20,000 decrease in insurance and $57,000 decrease in bad debt.



Selling and Marketing Expense

Selling and marketing expense increased by approximately $162,000 or 8.51% from fiscal 2005.  Expenses for the year ended March, 31 2006 were approximately $2,068,000 or 6.4% of revenues, compared with approximately $1,906,000 or 7.9% of revenues during fiscal 2005.  The increase is attributable to higher than expected sales incentive payments ($232,000 for fiscal 2006 compared with $58,000 in fiscal 2005).  Selling expenses consist primarily of salaries and the associated employee expenses. Advertising expense for fiscal 2006 was $78,000 compared with $104,000 in fiscal 2005.



Product Development

Product development expenses were approximately $1,713,000 or 5.3% of revenue for fiscal 2006, compared with approximately $1,312,000 or 5.4% of revenues during fiscal 2005.

During fiscal 2006, we continued our rapid expansion of point-of-sale technology to the Canadian marketplace with standalone terminals and development of host-to-host connections for certain customers.



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Development costs incurred after technological feasibility was established for programs associated with specific customers were deferred and will be amortized over the life of the agreements.  For fiscal 2006, we had no such development costs, compared to $102,000 for fiscal 2005.  Resources have also been focused on programs to develop new networks, platforms and relationships for supporting stored value card-based transaction programs and point-of-sale card programs.

Merger Costs

During fiscal 2005, we incurred $659,000 in costs related to the proposed merger with Integrated Data Corp.  The proposed merger was terminated by mutual agreement on November 9, 2004.  No further costs associated with the terminated merger with Integrated Data Corp. were incurred in fiscal 2006.

Depreciation and Amortization

Depreciation and amortization expense increased to $1,488,000 or 4.6% of revenues for the year ended March 31, 2006 from $1,142,000 or 4.7% of revenues for the previous year.  The increase is the result of our continuing investment in POSA terminals and the supporting network infrastructure.  Investment in POSA terminals is being depreciated on a straight line basis over three years.  At March 31, 2006 we had an installed base of 4,853 point-of-sale terminals in Canada and support another 863 locations with host-to-host network connections.  Depreciation expense of approximately $75,000 was incurred for the equipment acquired under capital lease arrangements.

Amortization of intangible assets was $330,000 for the year ended March 31, 2006, compared with $159,000 for the previous year.  Intangible assets are comprised of customer lists acquired in the purchase of AT&Ts Canadian prepaid card operations and an international license, which was purchased from Integrated Data Corp. effective February 2, 2005.  The intangible assets are amortized on a straight-line basis over six and five years respectively.  The net book value of intangible assets at March 31, 2006 and 2005 was $829,000 and $1,080,000 respectively.  Goodwill is not amortized.  We evaluate the carrying value of goodwill for impairment at least annually.

Provision for Income Taxes

Consolidated net income before taxes was $1,669,000 for the year ended March 31, 2006, compared with $560,000 for the previous year.  Tax provision was $682,000 for the year ended March 31, 2006, compared with $nil for the previous year.  Increase in tax provision for fiscal 2006 was due to increase in Canadian taxable income.  Net operating losses and capital losses in the U.S. can be applied to reduce future taxable income in the U.S..  The realization of these losses is dependent upon future earnings, if any, the timing and amount of which are uncertain.  Accordingly no accounting recognition has been given to these losses.

Liquidity and Capital Resources

Cash and cash equivalents at March 31, 2006 were approximately $6,967,000 compared with $4,527,000 at March 31, 2005.  We had working capital of $2,483,000 at March 31, 2006 compared with $924,000 at March 31, 2005.

Our operating activities provided cash of $3,417,000 during the year ended March 31, 2006 compared with cash provided of $5,013,000 during the year ended March 31, 2005.  The decrease in the cash provided by operating activities is primarily due to the timing of collections of receivables and investment in inventory versus payments to suppliers.  Our operations, development and expansion, are financed from the cash flow generated from our operating activities.

The decrease in our net cash provided by operating activities is explained below:

·

accounts payable and accrued liabilities increased by $2,852,000, including an increase of $1,695,000 for cellular products (PINs and cellular airtime), an increase in other accounts payable and accrued liabilities of $1,380,000, an increase in state and local taxes payable of $708,000, offset by a decrease of 931,000 for prepaid long distance products.



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·

accounts receivable decreased by $112,000, including a decrease of $1,319,000 for sales of point-of-sale dispensed products, mainly due to foreign exchange rate fluctuation offsetting the growth in sales of prepaid cellular, an increase of $1,736,000 for prepaid long distance products primarily due to an increase in promotional business in the U.S., a decrease in allowance for doubtful accounts of $66,000 and a decrease in other receivables of $463,000;

·

inventories increased by $1,997,000, primarily for prepaid cellular PINs products.  Inventories of prepaid cellular PINs at March 31, 2006 were $5,341,000; cellular PIN inventory is maintained at approximately thirteen days sales (thirteen days sales (gross proceeds of sales) for fiscal 2005) and the increase is the result of increased sales activity; inventories for fiscal 2006 turned around in 13 days (14 days for fiscal 2005) to provide for increased sales activity during the year;

·

depreciation, amortization and other operating expense net of equity income for the year was $1,343,000;

·

deferred income tax recovery was $230,000;

·

prepaid expenses and deposits increased by $34,000;

·

deferred revenue increased by $228,000, mainly due to an increase in non-activated PINs; and

·

net income for the year was $1,142,000.

Increases and decreases in accounts receivable, inventories, accounts payable and accrued liabilities are partly due to foreign exchange rate fluctuation.  However, the effect of foreign exchange rate fluctuation on each respective item has offset each other.

Our underlying sales arrangements for Canadian prepaid cellular PINs have a significant impact on cash flows.  Generally, accounts receivable for cellular product sales are collected within 12 days (15 days for fiscal 2005); as at April 30, 2006, all accounts receivable for cellular products outstanding at the end of the year had been collected.  Inventories for cellular products are maintained at levels to support thirteen days sales and are turned over two times a month (two times a month for fiscal 2005).  We actively manage working capital  inventory, accounts receivable and accounts payable  by quick turnover of inventory, collection terms of accounts receivable and trade terms granted by suppliers; however, our cash flows are dependent on our ability to continue managing the business cycle. We believe that cash flows in fiscal 2007 will be sufficient to finance our capital investments.

As at May 31, 2006 cash and cash equivalents were $5,492,000 reflecting increases in Accounts Receivable and Inventories as well as increases in Accounts Payable and Accrued Liabilities and working capital surplus was $2,729,000.

We used $1,010,000 in investing activities for the year ended March 31, 2006, primarily for the purchase of terminals used to dispense point-of-sale prepaid cellular PINs in Canada.  We used $79,000 in financing activities for the year ended March 31, 2006, primarily for the repayment of capital lease obligations.

During fiscal 2006, the holder of our outstanding interest-free promissory note in the amount of $600,000 converted the note into 7,500,000 newly issued common shares.

The following table sets forth our best estimates for material long-term obligations as at March 31, 2006.  Capital lease commitments for computing equipment and software systems are $65,000.  Operating leases include commitments for office space, computers and office equipment. In January, 2004, we relocated our corporate offices in Richmond, British Columbia leasing 15,000 square feet for a ten year term.

The table excludes commitments such as open purchase orders under long term agreements with customers and suppliers.  We have no minimum purchase or supply arrangements in place.  We expect that these commitments will become due in fiscal 2007.  Our contractual obligations as of March 31, 2006 (including the new Richmond office space lease of approximately $163,000 a year) were:





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Contractual ObligationsPayments Due by PeriodTotalLess Than One Year1-3 Years4-5 YearsAfter 
5 YearsCapital Lease Obligations$64,849$64,849$-$-$-Operating Leases2,255,558335,294634,029640,749645,486Total Contractual Obligations$2,320,407$400,143$634,029$640,749$645,486


Future Capital Needs and Resources

We believe that we currently have sufficient cash resources and working capital to meet our ongoing obligations during fiscal 2007 as they become due.  During fiscal 2007, we plan capital expenditure in line with 2006.

We expect to continue using cash flow generated from our operations to further finance the expansion of our wholesale point-of-sale prepaid cellular business in the Canadian market and possibly the U.S. market.  Typical cash flow terms are net 25 days for the purchase of inventory from suppliers and net 7 to 14 days for collections from customers.  Limited credit facilities from vendors may limit our working capital and cash flows to expand the business.  As this business expands, we anticipate the need to purchase additional inventory and point-of-sale terminals.  A risk to our liquidity is that customers do not pay on-time creating a temporary negative cash flow situation.  Furthermore, significant expansion of the wholesale point-of-sale prepaid cellular business in Canada is in part dependent upon expansion of credit limits from vendors to finance the purchase of PINs for inventory.

Our cash flow from operations is impacted by our margin on sales.  Pricing competition from our suppliers of long-distance telephone service may reduce margins.  Our ability to negotiate supply contracts will impact our margin, net income and operating cash flow.

Additionally, our working capital and capital requirements will depend upon numerous factors, including the level of resources that we devote to the continued development of our network systems and the development of new products and new technology, and the overall structure of potential future strategic alliances and acquisitions of products or other businesses.

Depending on the overall structure of potential future product initiatives, strategic alliances and acquisitions, we may have additional capital requirements related to funding these potential future product initiatives, strategic alliances and acquisitions of products or other businesses.  Accordingly, we may seek funding from a combination of sources, including equity and debt financing.  No assurances can be given that additional funding will be available or, if available, at terms acceptable to us.  If adequate capital is not available, our business may be materially and adversely affected.

Please refer to the Risk Factors section of Part 1, Item 1  BUSINESS of this Annual Report for additional information on Risk.



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Effect of Inflation

In our view, at no time during any of the last three fiscal years has inflation had a material impact on our sales, earnings or losses from operations, or net earnings.

Trend Information

The implementation and roll-out of point-of-sale technology in Canada is well established and we continue to increase market share for sale of prepaid products using our technologies.  During fiscal 2006, we have experienced increases in sales of prepaid cellular PINs and revenues from POSA transaction fees, primarily in Canada, and we currently expect further increases during fiscal 2007.  Revenues from our sales arrangements require active management of working capital and terms and conditions of future arrangements may impact the presentation of revenue and related working capital accounts.  We expect to deploy terminals in Canada during the current fiscal year at a pace similar to last year.

Revenues generated from the bulk sale of prepaid phone cards to retail establishments in Canada are expected to grow slowly and continued pricing pressure in the Canadian marketplace is expected to have an adverse effect on margins.

Revenues generated from the sale of prepaid long distance phone cards through the free-standing machines in the U.S. are static and may decline as usage of mobile phones increases.  Revenues generated from the promotional sale of prepaid long distance phone cards increased in fiscal 2006 but may decline in future years.  Cost of time, which is the major component of cost of revenue, is expected to decline somewhat as a result of renegotiating lower rates but continued pricing pressure in the marketplace will likely result in a decline in margins.

Product development costs are expected to continue at similar levels due to the continued development of our network systems, web sites, the development of new products and new customer relationships.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

ITEM 7. FINANCIAL STATEMENTS

Our consolidated financial statements for the fiscal year ended March 31, 2006 and notes thereto are listed in the Index to Financial Statements and filed and included elsewhere herein as a part of this Annual Report on Form 10-KSB.  Our consolidated financial statements are stated in U.S. Dollars and are prepared in accordance with U.S. GAAP.

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

None.

ITEM 8A. CONTROLS AND PROCEDURES

As required by Rule 13a-15 under the Exchange Act, as of the end of the period covered by this report, we have carried out an evaluation of the effectiveness of the design and operation of our companys disclosure controls and procedures.  This evaluation was carried out under the supervision and with the participation of our companys management, including our companys president and chief executive officer.  Based upon that evaluation, our companys president and chief executive officer concluded that our companys disclosure controls and procedures are effective at March 31, 2006.  There have been no changes in our companys internal controls over financial reporting  in connection with this evaluation that occurred during the fourth quarter of fiscal 2006 that has materially affected, or is reasonably likely to materially affect, out internal control over financial reporting.



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We are continuing to evaluate our internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002 and we expect to make necessary improvements and enhance the reliability of our internal controls over financial reporting.

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our companys reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commissions rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our companys reports filed under the Exchange Act is accumulated and communicated to management, including our companys president and chief executive officer as appropriate, to allow timely decisions regarding required disclosure.

ITEM 8B. OTHER INFORMATION

None.



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PART III

ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

We have a Code of Ethics that applies to our principal executive officer, principal financial officer, controller and others performing similar functions.  We previously filed a copy of the Code of Ethics with the SEC as an exhibit to our annual report on Form 10-KSB for our fiscal year ended March 31, 2005.

The other information called for by Part III, Item 9, is included in our proxy statement relating to our 2006 annual meeting of stockholders, and is incorporated herein by reference.  The proxy statement will be filed within 120 days of March 31, 2006, our fiscal year end.

ITEM 10. EXECUTIVE COMPENSATION

Information called for by Part III, Item 10, is included in our proxy statement relating to our 2006 annual meeting of stockholders, and is incorporated herein by reference.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Certain information called for by Part III, Item 11, is included in our proxy statement relating to our 2006 annual meeting of stockholders, and is incorporated herein by reference.

Securities authorized for issuance under equity compensations plans

The following table gives information as of March 31, 2006, the end of our most recently completed fiscal year, about shares of common stock that may be issued upon the exercise of options under our 1998 Stock Option Plan and our 2000 Stock Option Plan, which are our only existing equity compensation plans.  See also Note 4(c) to Consolidated Financial Statements of DataWave Systems Inc. included in this Report.

We will not issue any further options under the 1998 Stock Option Plan.  As of March 31, 2006, stock options for 290,000 shares were outstanding under the 1998 Stock Option Plan, of which 250,000 were issued to directors and officers of our company.

We are authorized to issue options to acquire up to 5,266,720 common shares of our company under the 2000 Stock Option Plan.



|                                                           |                                                                                             |                                                                             |                                                             
|---------------------------------------------------------- | ------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------- | ------------------------------------------------------------
|Plan category                                              | Number of securities to be issued upon exercise of outstanding options, warrants and rights | Weighted average exercise price of outstanding options, warrants and rights | Number of securities remaining available for future issuance
|                                                           | (a)                                                                                         | (b)                                                                         | (c )                                                        
|Equity compensation plans approved by security holders     | 3,745,000                                                                                   | $0.14                                                                       | 1,811,720                                                   
|Equity compensation plans not approved by security holders | Nil                                                                                         | Nil                                                                         | Nil                                                         
|Total                                                      | 3,745,000                                                                                   | $0.14                                                                       | 1,811,720                                                   



-- 31 --





---







| |  |  | 
| |  |  | 

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information called for by Part III, Item 12, is included in our proxy statement relating to our 2006 annual meeting of stockholders, and is incorporated herein by reference.

ITEM 13. EXHIBITS



|                |     |                                                                                                                                       
|--------------- | --- | --------------------------------------------------------------------------------------------------------------------------------------
|Exhibit 
Number |     | Description                                                                                                                           
|3.1             | (1) | State of Delaware Certificate of Domestication of DataWave Systems Inc.                                                               
|3.2             | (1) | State of Delaware Certificate of Incorporation of DataWave Systems Inc.                                                               
|3.3             | (1) | Bylaws of DataWave Systems Inc.                                                                                                       
|10.1            | (2) | 1998 Stock Option Plan                                                                                                                
|10.2            | (3) | 2000 Stock Option Plan (as amended)                                                                                                   
|10.3            | (4) | Form of Option Agreement                                                                                                              
|10.4            | (4) | Form of Indemnity Agreement                                                                                                           
|10.5            | (4) | Employment Agreement with Joshua Emanuel                                                                                              
|10.6            | (5) | Registration Rights Agreement with Sigma Opportunity Fund, LLC and Integrated Technology & Systems Ltd.                               
|14.1            | (4) | Code of Business Ethics                                                                                                               
|21.1            | (5) | Subsidiaries of DataWave Systems Inc.                                                                                                 
|31.1            | **  | Certification pursuant to Section 302 of the Sarbanes  Oxley Act of 2002 of Josh Emanuel                                             
|31.2            | **  | Certification pursuant to Section 302 of the Sarbanes  Oxley Act of 2002 of John Gunn                                                
|32.1            | **  | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 Of The Sarbanes-Oxley Act Of 2002 of Josh Emanuel
|32.2            | **  | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 Of The Sarbanes-Oxley Act Of 2002 of John Gunn   

**Filed herewith

(1)

Previously filed as an exhibit to, and incorporated herein by reference from, the Companys 8K report filed on March 1, 2004.

(2)

Previously filed as an exhibit to, and incorporated herein by reference from, the Companys Form 20F for the fiscal year ended March 31, 1998, filed on October 1, 1998.

(3)   Previously filed as an exhibit to, and incorporated herein by reference from, the Companys Definitive Proxy Statement or Schedule 14A filed on July 11, 2005.

(4)

Previously filed as an exhibit to, and incorporated herein by reference from, the Companys Annual Report on Form 10KSB for the fiscal year ended March 31, 2005 filed on June 26, 2005.

(5)

Previously filed as an exhibit to, and incorporated herein by reference from, the Companys Registration Statement on Form SB-2 filed on February 22, 2006.





ITEM 14. PRINCIPAL ACCOUNTANTS FEES AND SERVICES

Information called for by Part III, Item 14, is included in our proxy statement relating to our 2006 annual meeting of stockholders, and is incorporated herein by reference.  The proxy statement will be filed with Securities and Exchange Commission within 120 days after the end of our 2006 fiscal year.



-- 32 --





---





SIGNATURES

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



DataWave Systems Inc.

(Registrant)



By: /s/ John Gunn

John Gunn

General Manager, Chief Financial Officer

Date: June 27th, 2006



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.



|                     |                                                                |                
|-------------------- | -------------------------------------------------------------- | ---------------
|Signature            | Capacities                                                     | Date           
|                     |                                                                |                
|                     |                                                                |                
|/s/ Joshua Emanuel   | Chief Executive Officer and Chairman                           | June 27th, 2006
|Joshua Emanuel       | (Principal Executive Officer)                                  |                
|                     |                                                                |                
|                     |                                                                |                
|/s/ John Gunn        | General Manager and Chief Financial Officer                    | June 27th, 2006
|John Gunn            | (Principal Financial Officer and
Principal Accounting Officer) |                
|                     |                                                                |                
|/s/ John X. Adiletta | Director                                                       | June 27th, 2006
|John X. Adiletta     |                                                                |                
|                     |                                                                |                
|/s/ Vijay Fozdar     | Director                                                       | June 27th, 2006
|Vijay Fozdar         |                                                                |                
|                     |                                                                |                
|/s/ Thom Waye        | Director                                                       | June 27th, 2006
|Thom Waye            |                                                                |                
|                     |                                                                |                



-- 33 --





---





DATAWAVE SYSTEMS INC.



Form 10-KSB Annual Report





Index to Financial Statements





PageReport of Independent Registered Chartered AccountantsF-2Consolidated Financial Statements:Consolidated balance sheets as of March 31, 2006 and 2005F-3Consolidated statements of operations for the years ended March 31, 2006 and 2005F-4Consolidated statements of stockholders equity for the years ended March 31, 2006 and 2005F-5Consolidated statements of cash flows for the years ended March 31, 2006 and 2005F-6Notes to consolidated financial statementsF-7






F-1



---





Report of Independent Registered Chartered Accountants

To the Stockholders

DataWave Systems Inc.

We have audited the consolidated balance sheets of DataWave Systems Inc. and subsidiaries (the Company) as at March 31, 2006 and 2005 and the consolidated statements of operations, stockholders equity and cash flows for the years then ended.  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 Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States).  These standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of DataWave Systems Inc. and subsidiaries as at March 31, 2006 and 2005 and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Companys internal controls over financial reporting.  Accordingly, we express no such opinion.

/s/ Deloitte & Touche LLP

Independent Registered Chartered Accountants

Vancouver, Canada

June 21, 2006





F-2



---







|                                                                |                                                                  |              |  |   |              |  | 
|--------------------------------------------------------------- | ---------------------------------------------------------------- | ------------ |  | - | ------------ |  | 
|                                                                | DATAWAVE SYSTEMS INC.                                           
|                                                                | CONSOLIDATED BALANCE SHEETS                                     
|                                                                | As at March 31, 2006 and 2005                                   
|                                                                | (Expressed in United States dollars, except share amounts)      
|                                                                |                                                                 
|                                                                |                                                                  | 2006         |  |   | 2005        
|Assets                                                          |                                                                  |              |  |   |             
|Current                                                         |                                                                  |              |  |   |             
|Cash and cash equivalents                                       | $                                                                | 6,967,032    |  | $ | 4,526,512   
|Restricted cash (Note 3 (c))                                    |                                                                  | 203,807      |  |   | 34,000      
|Accounts receivable and other (Note 3 (a) and 11)               |                                                                  | 7,472,542    |  |   | 7,366,712   
|Inventories (Note 3 (b))                                        |                                                                  | 6,308,442    |  |   | 4,155,614   
|Prepaid expenses and deposits                                   |                                                                  | 383,332      |  |   | 336,800     
|Deferred income taxes (Note 6)                                  |                                                                  | 229,938      |  |   | -           
|Total current assets                                            |                                                                  | 21,565,093   |  |   | 16,419,638  
|Machinery and equipment, net (Note 3 (d))                       |                                                                  | 2,278,016    |  |   | 2,453,571   
|Equity investment  (Note 10)                                    |                                                                  | 194,850      |  |   | 39,387      
|Deferred development costs (Note 3 (e))                         |                                                                  | 51,695       |  |   | 101,567     
|Other long term receivables (Note 7)                            |                                                                  | 127,738      |  |   | 124,008     
|Goodwill (Note 3 (f))                                           |                                                                  | 1,881,910    |  |   | 1,857,985   
|Intangible assets, net (Note 3 (f))                             |                                                                  | 828,764      |  |   | 1,079,843   
|Total assets                                                    | $                                                                | 26,928,066   |  | $ | 22,075,999  
|Liabilities                                                     |                                                                  |              |  |   |             
|Current                                                         |                                                                  |              |  |   |             
|Accounts payable and accrued liabilities (Notes 3 (g))          | $                                                                | 17,890,603   |  | $ | 14,547,422  
|Deferred revenue                                                |                                                                  | 1,095,544    |  |   | 839,303     
|Current portion of capital lease obligations (Note 8)           |                                                                  | 63,884       |  |   | 78,344      
|Current portion of deferred inducement (Note 7)                 |                                                                  | 31,902       |  |   | 31,002      
|Total current liabilities                                       |                                                                  | 19,081,933   |  |   | 15,496,071  
|Capital lease obligations (Note 8)                              |                                                                  | -            |  |   | 61,668      
|Deferred income taxes (Note 6)                                  |                                                                  | 320,780      |  |   | 309,509     
|Deferred inducement (Note 7)                                    |                                                                  | 365,911      |  |   | 342,184     
|Convertible promissory note (Note 3 (h))                        |                                                                  | -            |  |   | 600,000     
|Total liabilities                                               |                                                                  | 19,768,624   |  |   | 16,809,432  
|Commitments (Note 9)                                            |                                                                  |              |  |   |             
|Stockholders equity                                            |                                                                  |              |  |   |             
|Common shares                                                   |                                                                  |              |  |   |             
|Authorized, 100,000,000 common shares, $0.001 par value         |                                                                  |              |  |   |             
|Issued, 54,326,834 and 46,826,834 shares issued and outstanding |                                                                  |              |  |   |             
|at March 31, 2006 and March 31, 2005, respectively              |                                                                  | 54,327       |  |   | 46,827      
|Additional paid-in capital                                      |                                                                  | 18,512,908   |  |   | 17,920,408  
|Accumulated other comprehensive income                          |                                                                  | 616,375      |  |   | 465,048     
|Accumulated deficit                                             |                                                                  | (12,024,168) |  |   | (13,165,716)
|Total stockholders equity                                      |                                                                  | 7,159,442    |  |   | 5,266,567   
|Total liabilities and stockholders equity                      | $                                                                | 26,928,066   |  | $ | 22,075,999  
|                                                                |                                                                  |              |  |   |             
|                                                                |                                                                 
|                                                                |                                                                 
|                                                                |                                                                  |             
|                                                                |                                                                  |             
|                                                                |                                                                 
|                                                                | See accompanying Notes to the Consolidated Financial Statements.



F-3



---



|                                                                 |  |   |            |  |   |           
|---------------------------------------------------------------- |  | - | ---------- |  | - | ----------
|DATAWAVE SYSTEMS INC.                                           
|CONSOLIDATED STATEMENTS OF OPERATIONS                           
|Years ended March 31, 2006 and 2005                             
|(Expressed in United States dollars, except share amounts)      
|                                                                
|                                                                 |  |   | 2006       |  |   | 2005      
|                                                                 |  |   |            |  |   |           
|Revenues                                                         |  |   |            |  |   |           
|Sales                                                            |  | $ | 23,893,289 |  | $ | 16,783,031
|Net agency sales (Note 5)                                        |  |   | 8,200,728  |  |   | 7,543,982 
|Total revenues                                                   |  |   | 32,094,017 |  |   | 24,327,013
|                                                                 |  |   |            |  |   |           
|Operating costs and expenses                                     |  |   |            |  |   |           
|Cost of revenues (exclusive of depreciation and amortization)    |  |   | 20,653,512 |  |   | 15,543,066
|General and administrative                                       |  |   | 4,706,619  |  |   | 3,278,871 
|Selling and marketing                                            |  |   | 2,068,272  |  |   | 1,905,988 
|Product development                                              |  |   | 1,712,788  |  |   | 1,312,263 
|Merger costs (Notes 4(b) and 11)                                 |  |   | -          |  |   | 658,652   
|Depreciation and amortization                                    |  |   | 1,487,965  |  |   | 1,142,474 
|Total operating costs and expenses                               |  |   | 30,629,156 |  |   | 23,841,314
|Operating income                                                 |  |   | 1,464,861  |  |   | 485,699   
|Other income                                                     |  |   | 192,044    |  |   | 39,265    
|Foreign exchange gain                                            |  |   | 11,646     |  |   | 34,605    
|Income before income taxes                                       |  |   | 1,668,551  |  |   | 559,569   
|Income taxes (Note 6)                                            |  |   | (682,466)  |  |   | -         
|Equity income from investee (Note 10)                            |  |   | 155,463    |  |   | 103,878   
|Net income                                                       |  | $ | 1,141,548  |  |   | 663,447   
|                                                                 |  |   |            |  |   |           
|Net income per share (Note 4(d))                                 |  |   |            |  |   |           
|- basic                                                          |  | $ | 0.02       |  | $ | 0.02      
|- diluted                                                        |  | $ | 0.02       |  | $ | 0.01      
|                                                                 |  |   |            |  |   |           
|Weighted-average number of common shares (Note 4(d))             |  |   |            |  |   |           
|- basic                                                          |  |   | 47,607,656 |  |   | 44,134,126
|- diluted                                                        |  |   | 56,164,713 |  |   | 47,494,126
|                                                                 |  |   |            |  |   |           
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|See accompanying Notes to the Consolidated Financial Statements.



F-4



---









|                                                                 |                         |                  |                            |                                        |                     |                           
|---------------------------------------------------------------- | ----------------------- | ---------------- | -------------------------- | -------------------------------------- | ------------------- | --------------------------
|DATAWAVE SYSTEMS INC.                                           
|CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY                 
|As at March 31, 2006 and 2005                                   
|(Expressed in United States dollars, except share amounts)      
|                                                                
|                                                                 |                         |                  |                            |                                        |                     |                           
|                                                                 | Number of Common Shares | Common Shares    | Additional Paid-in Capital | Accumulated Other Comprehensive Income | Accumulated Deficit | Total Stockholders Equity
|                                                                 |                         |                  |                            |                                        |                     |                           
|Balance, April 1, 2004                                           | 43,889,334              | $  15,006,743    | $    2,725,492             | $          277,966                     | $  (13,829,163)     | $    4,181,038            
|Issuance of shares 
(Note 4(b))                                  | 2,937,500               | 235,000          | -                          | -                                      | -                   | 235,000                   
|Reclassification to additional paid-in capital on emigration     |                         | (15,194,916)     | 15,194,916                 | -                                      | -                   | -                         
|Net income                                                       |                         | -                | -                          | -                                      | 663,447             | 663,447                   
|Foreign currency translation adjustment                          |                         | -                | -                          | 187,082                                | -                   | 187,082                   
|Comprehensive income                                             |                         |                  |                            |                                        |                     | 850,529                   
|                                                                 |                         |                  |                            |                                        |                     |                           
|Balance, March 31, 2005                                          | 46,826,834              | $         46,827 | $  17,920,408              | $          465,048                     | $  (13,165,716)     | $    5,266,567            
|Issuance of shares (Note 4(b))                                   | 7,500,000               | 7,500            | 592,500                    | -                                      | -                   | 600,000                   
|Net income                                                       |                         | -                | -                          | -                                      | 1,141,548           | 1,141,548                 
|Foreign currency  translation adjustment                         |                         | -                | -                          | 151,327                                | -                   | 151,327                   
|Comprehensive income                                             |                         |                  |                            |                                        |                     | 1,292,875                 
|                                                                 |                         |                  |                            |                                        |                     |                           
|Balance, March 31, 2006                                          | 54,326,834              | $         54,327 | $  18,512,908              | $           616,375                    | $  (12,024,168)     | $    7,159,442            
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|                                                                
|See accompanying Notes to the Consolidated Financial Statements.



F-5



---







|                                                                                            |  |   |         |             |   |         |             | 
|------------------------------------------------------------------------------------------- |  | - | ------- | ----------- | - | ------- | ----------- | 
|DATAWAVE SYSTEMS INC.                                                                      
|CONSOLIDATED STATEMENTS OF CASH FLOWS                                                      
|Years ended March 31, 2006 and 2005                                                        
|(Expressed in United States dollars, except share amounts)                                 
|                                                                                           
|                                                                                            |  |   |         | 2006        |   |         | 2005       
|Operating activities                                                                        |  |   |         |             |   |         |            
|Net income                                                                                  |  |   | $       | 1,141,548   |   | $       | 663,447    
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |   |         |             |   |         |            
|Depreciation and amortization                                                               |  |   |         | 1,487,965   |   |         | 1,142,474  
|Equity (income) from investments                                                            |  |   |         | (155,463)   |   |         | (103,878)  
|Deferred income taxes                                                                       |  |   |         | (229,938)   |   |         | -          
|Merger costs                                                                                |  |   |         | -           |   |         | 235,000    
|Amortization of lease inducement                                                            |  |   |         | 10,799      |   |         | 25,547     
|Net change in non-cash operating assets and liabilities                                     |  |   |         |             |   |         |            
|Accounts receivable and other                                                               |  |   |         | 112,461     |   |         | (3,787,862)
|Inventories                                                                                 |  |   |         | (1,997,801) |   |         | (2,074,656)
|Prepaid expenses and deposits                                                               |  |   |         | (34,037)    |   |         | 113,603    
|Other long term receivables                                                                 |  |   |         | 897         |   |         | -          
|Accounts payable and accrued liabilities                                                    |  |   |         | 2,851,971   |   |         | 7,981,805  
|Deferred revenue                                                                            |  |   |         | 228,222     |   |         | 817,858    
|Net cash provided by operating activities                                                   |  |   |         | 3,416,624   |   |         | 5,013,338  
|                                                                                            |  |   |         |             |   |         |            
|Investing activities                                                                        |  |   |         |             |   |         |            
|Restricted cash                                                                             |  |   |         | (169,807)   |   |         | 20,000     
|Deferred development costs                                                                  |  |   |         | -           |   |         | (94,786)   
|Purchase of machinery and equipment                                                         |  |   |         | (839,803)   |   |         | (912,044)  
|Purchase of intangible                                                                      |  |   |         | -           |   |         | (265,000)  
|Net cash used in investing activities                                                       |  |   |         | (1,009,610) |   |         | (1,251,830)
|                                                                                            |  |   |         |             |   |         |            
|Financing activity                                                                          |  |   |         |             |   |         |            
|Repayment of capital lease obligations                                                      |  |   |         | (79,470)    |   |         | (87,402)   
|Net cash used in financing activity                                                         |  |   |         | (79,470)    |   |         | (87,402)   
|                                                                                            |  |   |         |             |   |         |            
|Effect of exchange rate changes on cash and cash equivalents                                |  |   |         | 112,976     |   |         | -          
|                                                                                            |  |   |         |             |   |         |            
|Increase in cash and cash equivalents                                                       |  |   |         | 2,440,520   |   |         | 3,674,106  
|Cash and cash equivalents, beginning of year                                                |  |   |         | 4,526,512   |   |         | 852,406    
|Cash and cash equivalents, end of year                                                      |  |   | $       | 6,967,032   |   | $       | 4,526,512  
|                                                                                           
|Supplemental disclosure of cash flow information:                                          
|Interest paid                                                                               |  | $ | 9,572   |             | $ | 17,469 
|Income taxes paid                                                                           |  | $ | 90,424  |             | $ | -      
|                                                                                            |  |   |         |             |   |        
|Supplemental disclosure of non-cash financing and investing items                           |  |   |         |             |  
|                                                                                            |  |   |         |             |   |        
|Issue of promissory note on acquisition of intangible                                       |  | $ | -       |             | $ | 600,000
|Issue of 7,500,000 common shares upon conversion of promissory note                         |  | $ | 600,000 |             | $ | -      
|                                                                                           
|See accompanying Notes to the Consolidated Financial Statements.                           



F-6



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





1.

DESCRIPTION OF BUSINESS

DataWave Systems Inc. (the Company or DataWave) is a developer and provider of prepaid and stored-value programs.  DataWave sells and distributes prepaid and stored value products using a proprietary system for activating products at the point-of-sale.  DataWave designs, develops, owns, manages and continually enhances an intelligent, automated, direct merchandising network. This network, which operates through various point-of-sale-activation devices or web-based applications, allows for point-of-sale-activation of high value, high shrinkage products, such as cash cards, prepaid phone cards and prepaid cellular time.  DataWaves systems are scalable and flexible and can be readily modified to offer new premium stored-value products, such as prepaid gift cards and prepaid Internet cards.  In addition, DataWave sells prepaid calling cards and point-of-sale activated prepaid cellular personal identification numbers (PINs) on a wholesale basis to certain retail operators and other customers.

DataWave sells and distributes prepaid and stored value products through a network that includes, but is not limited to, point-of-sale-activation (POSA) terminals, free-standing smart machines (DTMs), and cash registers or the web-based applications of some major retail chains.  All of these devices are connected to our proprietary server and database software through wireless, land line wide area networks or host-to-host connectivity, and are capable of dispensing one or multiple prepaid products and services.

2.

SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States.

(a)

Principles of consolidation

The consolidated financial statements include the accounts of DataWave and its wholly-owned subsidiaries.  Intercompany transactions and balances have been eliminated.

(b)

Equity investment

In December 2002, DataWave entered into an agreement to invest in a new corporation called Nextwave Card Corp (NCC) that develops and provides prepaid stored value cash card programs.

DataWave accounts for this investment under the equity method and records its 50% share of income or loss as equity income (loss) from investee.

(c)

Use of estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period.  Estimates are used for, but not limited to, accounting for doubtful accounts, assessing the recoverability of machinery and equipment, intangibles and goodwill, amortization, valuation allowance for deferred income tax assets, accruals for cost of time in excess of amounts billed by service providers, income and capital taxes and contingencies.  Actual results could differ from those estimates.







F-7



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(d)

Foreign currency translation

DataWaves functional currency is the U.S. dollar since it is the currency of the primary economic environment in which the company operates.  Assets and liabilities of subsidiaries having non-U.S. dollar functional currencies are translated at year-end rates of exchange, and income statement accounts are translated at average rates of exchange for the year.  In accordance with SFAS No. 52, Foreign Currency Translation, gains or losses resulting from translating foreign currency financial statements are reflected in accumulated other comprehensive income, a separate component of stockholders equity.  Gains or losses resulting from foreign currency transactions are included in net income.

Due to foreign exchange rate fluctuations between the U.S. and Canadian dollars in the period, translation of the Canadian operations resulted in an increase in other comprehensive income of $151,327 for the year ended March 31, 2006 (March 31, 2005 - $187,082).

(e)

Cash and cash equivalents

Cash and cash equivalents include cash deposited in DataWaves vending equipment, cash on hand and highly liquid money market instruments with original terms to maturity of less than 90 days at the time of purchase.

(f)

Restricted cash

Restricted cash consists of cash pledges with banks as collateral for letters of credit issued.

(g)

Inventories

Inventories for prepaid long distance time and for prepaid cellular airtime are valued at the lower of weighted average cost or market value.

Inventories for cards, promotional and other supplies are valued at the lower of weighted average cost or market value.  Component parts and supplies used in the assembly of machines and related work-in-progress are included in machinery and equipment.  Slow moving and obsolete inventory is reviewed regularly and written down based on managements forecast of use over the next twelve months.

(h)

Revenue recognition

Revenues are recognized when the following criteria are met:

·

pervasive evidence of an arrangement exists

·

delivery has occurred or services have been rendered

·

the price is fixed or determinable, and

·

collectibility is reasonably assured.

In addition, the Company applies the following specific revenue recognition policies:

The Companys revenues are primarily generated from the resale of prepaid long distance and cellular telephone time, principally from the sale of prepaid calling cards and point of sale activated PINs.  Sales of prepaid calling cards and point of sale activated PINs under third party brands, where DataWave is not the primary obligor of the related phone service, has no significant continuing obligation with respect to services being rendered subsequent to sale, the price to the consumer is fixed or determinable and collection is reasonably assured, are recognized at the



F-8



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(h)

Revenue recognition (continued)

date of sale to the consumer on a net basis.  The resulting net revenue earned is calculated as the difference between the gross proceeds received and the cost of the related phone time.

Sales of Company or custom branded cards where DataWave incurs inventory risk but does not provide the related telephone time are recognized on a gross basis on the date of sale to the consumer when title to the card transfers, collectibility of proceeds is reasonably assured, the full obligation to the phone service provider is fixed or determinable, and DataWave has no significant continuing obligations.

Sales from certain prepaid phone cards where our obligation to the phone service provider is not fixed or determinable at the date of delivery are deferred and recognized on a gross basis when phone service has been delivered to the consumer, and its cost determined, or as the card is used or expires.

Sales from Internet products, where DataWave is not the primary obligor of the Internet services or where DataWave does not incur significant inventory or return risk, are recognized at the date of sale on a net agency basis.  The resulting net revenue is calculated as the difference between the gross proceeds received and the cost of the related Internet services.

Fees and Service revenues include transaction, service and processing fees.  The nature of these fees is charges for processing transactions at the point of sale, including prepaid cellular, prepaid long distance and prepaid cash card.  Fees are included in contractual arrangements with our customers and are billed weekly to customers.

(i)

Product development costs

Costs for the internal development of new software systems and substantial enhancements to existing software systems to be sold or used in the sale of products are expensed as incurred until technological feasibility has been established and revenue can be generated, at which time any additional costs are capitalized.  These costs consist of payments made to third parties and the salaries of employees working on such product development.  Amortization of product development costs commences with commercial production and is charged as an expense using the straight line method over the life of the contracts.

Research costs are charged as an expense in the period in which they are incurred.

(j)

Capitalized internal use software costs

DataWave capitalizes the cost of internal-use software which has a useful life in excess of one year in accordance with Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.  These costs consist of payments made to third parties and the salaries of employees working on such software development.  Subsequent additions, modifications or upgrades to internal-use software are capitalized only to the extent that they allow the software to perform a task it previously did not perform.  Capitalized computer software costs are amortized using the declining balance method by a percentage of 30%.

Software maintenance and training costs are expensed in the period in which they are incurred.







F-9



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(k)

Advertising costs and sales incentives

The Companys sales and other incentives are recognized as a reduction of revenue, unless an identifiable benefit is received in exchange.  For the year ended March 31, 2006, sales and other incentives included as a reduction of revenue totalled $177,551 (2005 - $138,632).

Certain advertising and promotional incentives in which the Company exercises joint-control over the expenditure, receives an incremental benefit and can ascertain the fair value of advertising and promotion incurred are included in cost of revenues.

The majority of the Companys advertising expense relates to its consumer long distance business.  Most of the advertisements are in print media, with expenses recorded as they are incurred.  For the years ended March 31, 2006 and 2005, advertising expense totalled $77,981 and $103,622 respectively, included within selling and marketing costs.

(l)

Machinery and equipment

Machinery and equipment are recorded at cost less accumulated depreciation. Depreciation is calculated over the estimated useful lives of machinery and equipment as follows:



|                                |                                             
|------------------------------- | --------------------------------------------
|Computer equipment and software | 30% declining balance                       
|Office equipment                | 20% declining balance                       
|Other machinery and equipment   | 30% declining balance                       
|Vending, DTM and POSA equipment | 3 years straight-line                       
|Leasehold improvements          | 10 years straight-line or
shorter lease term

Parts, supplies and components are depreciated when they are used.

(m)

Impairment of long-lived assets

The Company reviews its long-lived assets, other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  To determine recoverability, the Company compares the carrying value of the assets to the estimated future undiscounted cash flows.  Measurement of an impairment loss for long-lived assets held for use is based on the fair value of the asset.  Long-lived assets classified as held for sale are reported at the lower of carrying value and fair value less estimated selling costs.  For assets to be disposed of other than by sale, an impairment loss is recognized when the carrying value is not recoverable and exceeds the fair value of the asset.

(n)

Goodwill and other intangible assets

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, the Company does not amortize goodwill and intangible assets with indefinite lives.  Instead, these assets are reviewed annually (or more frequently under certain conditions) for impairment.  Other intangible assets comprising customer lists and an international license are amortized over 6 and 5 years respectively, managements best estimate of their useful lives.









F-10



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(o)

Financial instruments

(i)

Fair value

DataWave estimates that the carrying values of its cash and cash equivalents, accounts receivable, restricted cash, other long term receivables, accounts payable and accrued liabilities and capital lease obligations approximate fair value at March 31, 2006 and 2005.

(ii)

Credit risk

Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable, cash and cash equivalents.  Concentration of credit risk with respect to trade accounts receivable is significant due to the high volume of revenues from a small customer base, primarily in Canada.  This concentration of business increases the Companys risk associated with non-payment by these customers.  The Company manages the risk by regular, ongoing credit evaluations, setting payment terms at seven days, and may require customers to provide collateral to reduce risk.  DataWave places its cash and cash equivalents with several major financial institutions of high credit standing.  The Company does not believe there is significant financial risk from non-performance by the holders of the Companys cash and cash equivalents.

At March 31, 2006, the top ten customers accounted for 77% of accounts receivable (2005 - 66%).  The Company is also exposed to certain concentration of revenues and economic dependence (Note 5 (c)).

Accounts receivable also includes amounts due from contractors who collect cash from and service the Companys DTM and other vending machines.  Certain of these contractors are not bonded resulting in credit risk to the Company.

Write-offs of accounts receivable balances were not significant in each of the years ended March 31, 2006 and March 31, 2005.

(iii)

Foreign exchange risk

DataWave is exposed to foreign exchange risks due to revenues and costs denominated in Canadian dollars (Note 5 (b)).

(p)

Income taxes

DataWave follows the asset and liability method of accounting for income taxes, in accordance with SFAS No. 109 Accounting for Income Taxes.  Under this method, deferred tax assets and liabilities are determined based upon the temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases, as well as the benefits of losses available to be carried forward to future years for tax purposes.  A valuation allowance is recorded for deferred tax assets when it is not more likely than not that such deferred tax assets will be realized.  Measurement of current and deferred tax liabilities and assets is based on the provisions of the enacted tax law, the effects of future changes in tax laws or rates are not anticipated.

(q)

Earnings per share

Basic net income per common share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed in



F-11



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(q)

Earnings per share (continued)

accordance with the treasury stock method and "if converted" method, as applicable, which uses the weighted average number of common shares outstanding during the period and also includes the dilutive effect of potentially issuable common stock from outstanding stock options, warrants and convertible debt.

(r)

Stock-based compensation

The Company accounts for stock-based compensation in accordance with the intrinsic value method prescribed by APB Opinion No. 25 (APB 25), Accounting for Stock Issued to Employeesand related interpretations.  Under APB 25, compensation expense is measured as the amount by which the market price of the underlying stock exceeds the exercise price of the options on the date of grant; this compensation is amortized over the vesting period.

In accordance with SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure the Company provides pro-forma information regarding net income and net income per share for awards granted or modified after December 31, 1994 as if the stock-based awards to employees had been accounted for under the fair value method prescribed by SFAS No. 123, Accounting for Stock Based Compensation.  The fair value of the Companys stock-based awards to employees was estimated using a Black-Scholes option pricing model.  The Black-Scholes model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable.

In addition, the Black-Scholes model requires the input of highly subjective assumptions including the expected stock price volatility.  Because the Companys stock-based awards to employees have characteristics significantly different from those of traded options, changes in the subjective input assumptions can materially affect the fair value estimate.  In managements opinion, the models used reflect managements best estimate of the fair value of its stock-based awards to employees.

The fair value of the Companys stock-based awards to employees issued during 2006 and 2005 was estimated assuming no expected dividends and using the following weighted-average assumptions:

|                        |       |  |     
|----------------------- | ----- |  | ----
|                        | 2006  |  | 2005
|                        |       |  |     
|Expected life (years)   | 3.35  |  | 5.0 
|Expected volatility     | 136%  |  | 179%
|Risk-free interest rate | 4.25% |  | 3.9%



The weighted-average estimated fair values of employee stock options granted during fiscal years 2006 and 2005 were $nil and $0.09 per share, respectively.

If the computed fair values of 2006 and 2005 awards had been amortized to expense over the vesting period of the awards as prescribed by SFAS 123, net income and net income per share would have been:









F-12



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(r)

Stock-based compensation (continued)



|                                                                                                                       |      |           |      |   |          
|---------------------------------------------------------------------------------------------------------------------- | ---- | --------- | ---- | - | ---------
|                                                                                                                       | 2006 |           | 2005
|                                                                                                                       |      |           |      |   |          
|Net income  as reported                                                                                               | $    | 1,141,548 |      | $ | 663,447  
|Add:  Stock-based employee compensation 
   expense (recovery) included in reported net
   income                      |      | -         |      |   | -        
|Deduct:  Total stock-based employee compensation
   expense determined under fair value based method
   for all awards |      | (57,425)  |      |   | (238,801)
|Pro-forma net income                                                                                                   | $    | 1,084,123 |      | $ | 424,646  
|                                                                                                                       |      |           |      |   |          
|Net income per share  as reported                                                                                     |      |           |      |   |          
|Basic                                                                                                                  | $    | 0.02      |      | $ | 0.02     
|Diluted                                                                                                                | $    | 0.02      |      | $ | 0.01     
|                                                                                                                       |      |           |      |   |          
|Net income per share  pro-forma                                                                                       |      |           |      |   |          
|Basic and diluted                                                                                                      | $    | 0.02      |      | $ | 0.01     

(s)

Recently issued accounting pronouncements



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123 (revised 2004) (SFAS 123R)  Share Based Payment.  The statement eliminates the alternative to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation expense in the statement of earnings based on their fair values on the date of the grant, with the compensation expense recognized over the period in which a grantee is required to provide service in exchange for the stock award.  The fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments.  Pursuant to the SECs Final Rule Release dated April 21, 2005, the statement is effective for small business issuers, as of the beginning with the first interim or annual reporting period of the registrants first fiscal year that begins on or after December 15, 2005.  The Company will adopt the provisions of SFAS 123R on a modified prospective basis in the first quarter of fiscal 2007.  Upon adoption, all future employee stock option grants plus the balance of the non-vested grants awarded prior to April 1, 2006, will be expensed over the stock option vesting period based on the fair value at the date the options are granted.  Had the Company adopted SFAS 123R in prior periods, the magnitude of the impact on the results of operations would have approximated the impact shown in the disclosure of pro forma net income and pro forma net income per share in Note 2(r).

In June 2005, the EITF reached a consensus on Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements(EITF 05-6).  EITF 05-6 provides guidance on determining the amortization period for leasehold improvements acquired in a business combination or acquired subsequent to lease inception.  The consensus is effective and to be applied to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005.







F-13



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





2.

SIGNIFICANT ACCOUNTING POLICIES (Continued)

(s)

Recently issued accounting pronouncements (continued)

The adoption of EIFT 05-6 did not have a material impact on the Companys operating results or financial positions.

In September 2005, the EITF reached a consensus on Issue No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty(EITF 04-13).  The EITF concluded that entities that enter into inventory purchase and sales transactions with the same counterparty, in contemplation of one another, should combine the transactions and treat them as non-monetary exchanges involving inventory.  The consensus is effective for new inventory arrangements entered into, or modifications or renewals of existing inventory arrangements occurring, in interim or annual reporting periods beginning after March 15, 2006. The adoption of EITF 04-13 did not have any impact on the Companys operating results or financial positions.

In February 2006, the FASB issued Statement of Financial Accounting Standard No. 155, Accounting for Certain Hybrid Financial Instrument (SFAS 155), an amendment of SFAS 140 and SFAS 133.  SFAS 155 permits the Company to elect to measure any hybrid financial instrument at fair value (with changes in fair value recognized in earnings) if the hybrid instrument contains an embedded derivative that would otherwise be required to be bifurcated and accounted for separately under SFAS 133.  The election to measure the hybrid instrument at fair value is made on an instrument-by-instrument basis and is irreversible.  This Statement will be effective for all instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of the Companys first fiscal year that begins after September 15, 2006.  The Company expects that the adoption of SFAS 155 will have no impact on its operating results or financial position.

In March 2006, the FASB issued Statement of Financial Accounting Standard No. 156, Accounting for Servicing of Financial Assets, an amendment of SFAS 140 (SFAS 156).  This Statement provides guidance addressing the recognition and measurement of separately recognized servicing assets and liabilities, common with mortgage securitization activities, and provides an approach to simplify efforts to obtain hedge accounting treatment.  SFAS 156 is effective after the beginning of the Companys fiscal year that begins after September 15, 2006.  The Company expects that the adoption of SFAS 156 will have no impact on its operating results or financial position.



3.

BALANCE SHEET DETAILS

(a)

Accounts receivable and other

|                                                  |      |           |      |   |          
|------------------------------------------------- | ---- | --------- | ---- | - | ---------
|                                                  | 2006 |           | 2005
|                                                  |      |           |      |   |          
|Trade accounts receivable  POSA                  | $    | 6,032,997 |      | $ | 4,499,592
|Trade accounts receivable  prepaid long distance |      | 1,299,464 |      |   | 2,638,597
|Less allowance for doubtful accounts              |      | (32,486)  |      |   | (96,360) 
|Other receivables                                 |      | 172,567   |      |   | 324,883  
|                                                  | $    | 7,472,542 |      | $ | 7,366,712







F-14



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





3.

BALANCE SHEET DETAILS (Continued)

(b)

Inventories

|                                           |      |           |      |   |          
|------------------------------------------ | ---- | --------- | ---- | - | ---------
|                                           | 2006 |           | 2005
|                                           |      |           |      |   |          
|PINs and cellular time                     | $    | 5,340,942 |      | $ | 3,274,233
|Cards and prepaid long distance phone time |      | 677,294   |      |   | 646,139  
|Part and supplies                          |      | 290,206   |      |   | 235,242  
|                                           | $    | 6,308,442 |      | $ | 4,155,614

(c)

Restricted cash

As at March 31, 2006 restricted cash consists of three cash deposits pledged with banks for letters of credit issued in the amount of $168,000, $16,000 and $18,594, excluding interest.  The deposits mature June 30, 2006, December 13, 2006 and March 17, 2007, respectively, and bear interest at 3.68%, 3.5% and 4.8% per annum respectively.

As at March 31, 2005 restricted cash consisted of two cash deposits pledged with banks for letters of credit issued in the amount of $16,000 and $18,000.  The deposits matured October 18, 2005 and February 28, 2006, respectively.

(d)

Machinery and equipment

Machinery and equipment consists of the following:

|                                  |      |           |                          |   |                |  |   |          
|--------------------------------- | ---- | --------- | ------------------------ | - | -------------- |  | - | ---------
|                                  | 2006
|                                  | Cost |           | Accumulated Depreciation |   | Net Book Value
|Computer equipment and
  software | $    | 2,372,897 |                          | $ | 1,465,180      |  | $ | 907,717  
|Office equipment                  |      | 179,632   |                          |   | 90,049         |  |   | 89,583   
|Other machinery and equipment     |      | 4,440     |                          |   | 2,714          |  |   | 1,726    
|Parts, supplies, and components   |      | 374,956   |                          |   | -              |  |   | 374,956  
|Vending machines in assembly      |      | 4,960     |                          |   | -              |  |   | 4,960    
|Vending equipment                 |      | 3,476,125 |                          |   | 3,408,994      |  |   | 67,131   
|POSA equipment                    |      | 2,439,083 |                          |   | 1,897,002      |  |   | 542,081  
|Leasehold improvements            |      | 380,866   |                          |   | 91,004         |  |   | 289,862  
|                                  | $    | 9,232,959 |                          | $ | 6,954,943      |  | $ | 2,278,016



|                                  |      |           |                          |   |                |  |   |          
|--------------------------------- | ---- | --------- | ------------------------ | - | -------------- |  | - | ---------
|                                  | 2005
|                                  | Cost |           | Accumulated Depreciation |   | Net Book Value
|Computer equipment and
  software | $    | 1,921,569 |                          | $ | 1,102,811      |  | $ | 818,758  
|Office equipment                  |      | 162,449   |                          |   | 68,611         |  |   | 93,838   
|Other machinery and equipment     |      | 29,120    |                          |   | 23,827         |  |   | 5,293    
|Parts, supplies, and components   |      | 331,690   |                          |   | -              |  |   | 331,690  
|Vending machines in assembly      |      | 10,873    |                          |   | -              |  |   | 10,873   
|Vending equipment                 |      | 3,454,320 |                          |   | 3,336,090      |  |   | 118,230  
|POSA equipment                    |      | 1,969,809 |                          |   | 1,207,702      |  |   | 762,107  
|Leasehold improvements            |      | 362,318   |                          |   | 49,536         |  |   | 312,782  
|                                  | $    | 8,242,148 |                          | $ | 5,788,577      |  | $ | 2,453,571





F-15



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





3.

BALANCE SHEET DETAILS (Continued)

(d)

Machinery and equipment (continued)

Vending machines in assembly includes vending machines being built as new vending machines, machines being refurbished. Part, supplies, and components include parts and supplies used in new and refurbished machines and as replacement parts for installed vending machines.

For the year ended March 31, 2006, the Company capitalized $nil of internal use software costs as computer software (2005 - $20,773).

Machinery and equipment at March 31, 2006, includes computing equipment and software with a net book value of $179,910 (2005 - $247,974) that was acquired under capital lease (Note 8).

(e)

Deferred development costs

During the year ended March 31, 2005 the Company finalized development projects to sell suppliers products through point-of-sale activation terminals in the Canadian marketplace and to allow distributors to sell the Companys products through its own terminals.  Development costs incurred after agreements were signed to complete the projects have been deferred and will be amortized over the life of the agreements.  Net deferred development costs at March 31, 2006 were $51,695 (2005 - $101,567).

(f)

Goodwill and intangible assets

Intangible assets are comprised of goodwill, customer lists and an international license.  The goodwill and customer lists were acquired in the purchase of AT&Ts Canadian prepaid card operations.  Although DataWave may intend to add customer names and other information to the list in the future, the expected benefits of the acquired customer list apply only to the customers on that list at the date of acquisition.  The international license was repurchased from Integrated Data Corp. on February 22, 2005 for the amount of $865,000.  Details of the cost and net book value of goodwill and other intangible assets are as follows:



|                                    |      |           |      |   |          
|----------------------------------- | ---- | --------- | ---- | - | ---------
|                                    | 2006 |           | 2005
|                                    |      |           |      |   |          
|Goodwill                            | $    | 1,881,910 |      | $ | 1,857,985
|                                    |      |           |      |   |          
|Intangible assets                   |      |           |      |   |          
|Customer lists                      | $    | 738,109   |      | $ | 712,175  
|International license               | $    | 865,000   |      | $ | 865,000  
|Less accumulated amortization       |      |           |      |   |          
|Customer lists                      |      | 572,512   |      |   | 497,332  
|International license               |      | 201,833   |      |   | -        
|Net intangible assets               | $    | 828,764   |      | $ | 1,079,843
|                                    |      |           |      |   |          
|Goodwill and intangible assets, net | $    | 2,710,674 |      | $ | 2,937,828

Amortization for the next five years in total is $828,764.











F-16



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





3.

BALANCE SHEET DETAILS (Continued)

(g)

Accounts payable and accrued liabilities

|                                                |      |            |      |   |           
|----------------------------------------------- | ---- | ---------- | ---- | - | ----------
|                                                | 2006 |            | 2005
|Trade accounts payable  PINs and cellular time | $    | 10,649,953 |      | $ | 8,663,602 
|Trade accounts payable  prepaid long distance  |      | 2,118,216  |      |   | 3,209,064 
|Trade accounts payable  other                  |      | 606,587    |      |   | 500,659   
|Accrued compensation and benefits               |      | 388,044    |      |   | 56,620    
|Co-op and rebate accruals                       |      | 802,702    |      |   | 312,993   
|Long-distance time accruals                     |      | 512,521    |      |   | 599,098   
|Other accrued liabilities                       |      | 1,866,412  |      |   | 1,089,165 
|State, local, GST (net) and other taxes payable |      | 946,168    |      |   | 116,221   
|                                                | $    | 17,890,603 |      | $ | 14,547,422

On value-added tax filings in Canada, input tax credits earned are claimed against GST collected.

(h)

Convertible promissory note

In January 2005, DataWave entered into an agreement with Integrated Data Corp. (IDC) to buy back an exclusive international license for $865,000.

The purchase price of $865,000 consisted of $265,000 cash and $600,000 in the form of a two-year convertible, interest free promissory note payable to IDC.  On February 22, 2006, IDC exercised its right under the note payable and converted the $600,000 note to a total of 7,500,000 newly issued DataWave common shares at $0.08 per share.

4.

COMMON SHARES

(a)

Authorized

100,000,000 common shares with par value $0.001.

(b)

Issuance

During the year ended March 31, 2006, the Company issued 7,500,000 common shares with par value of $0.001 to Integrated Data Corp. (IDC) upon conversion of an interest free promissory note in the amount of $600,000.  (Note 3(h))

During the year ended March 31, 2005 the Company issued 2,937,500 common shares with par value $0.001.  Under the Merger Break-Up and Mutual Release Agreement with Integrated Data Corp. (IDC), the Company agreed to pay IDC $470,000 as compensation for IDCs costs relating to the merger negotiations; this was recorded under Merger costs included in the Companys operating costs for the year ended March 31, 2005.  The Company paid $235,000 in cash and issued 2,937,500 common shares to IDC, recorded at a fair value of $0.08 per share.

(c)

Share purchase options

The Company has two stock option plans in place: the 1998 Stock Option Plan and the 2000 Stock Option Plan. Under the terms of both Stock Option Plans, the Board of Directors may grant stock options to employees, officers, directors and independent consultants of the Company and its subsidiaries for their contributions to the Company.  Options granted under both Stock Option Plans are not transferable by an optionee, and each option is exercisable only by such optionee.





F-17



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





4.

COMMON SHARES (Continued)

(c)

Share purchase options (continued)

The expiry date will be fixed by the Board of Directors but will be not later than the tenth anniversary of the award date and the exercise price of each option will be not less than 100% of the fair market value on the date of grant, and will be determined by reference to the market price for our shares for the ten trading days immediately preceding the day on which the board granted the option. In no cases will an optionee be granted an option where the number of shares that may be purchased by an optionee pursuant to the option exceed, when added to the number of shares available for purchase pursuant to options previously granted to the optionee which remain exercisable, 5% of our issued and outstanding share capital as of the award date of the option being granted.

The Company will not issue any further options under the 1998 stock Option Plan.  As of March 31, 2006, stock options in respect of 290,000 shares were outstanding, of which 250,000 were issued to directors and officers of the Company.

The Company is authorized to issue options to acquire up to 5,266,720 common shares of our company under the 2000 Stock Option Plan.  The Compensation Committee of the Board of Directors resolved on August 9, 2005 to grant options in respect of 705,000 common share to the directors and certain officers and employees of the Company. As of March 31, 2006, there are 1,811,720 common shares available for future grant under the 2000 Plan.



|                                    |  |                  |  |                                 |     
|----------------------------------- |  | ---------------- |  | ------------------------------- | ----
|                                    |  | Number of shares |  | Weighted Average Exercise Price
|                                    |  |                  |  |                                 |     
|Balance outstanding, April 1, 2004  |  | 4,448,902        |  | $                               | 0.22
|Options granted                     |  | 2,750,000        |  |                                 | 0.10
|Options cancelled /Expired          |  | (3,876,402)      |  |                                 | 0.25
|Balance outstanding, March 31, 2005 |  | 3,322,500        |  | $                               | 0.12
|Options granted                     |  | 705,000          |  |                                 | 0.23
|Options cancelled /Expired          |  | (282,500)        |  |                                 | 0.19
|Balance outstanding, March 31, 2006 |  | 3,745,000        |  | $                               | 0.14

As at March 31, 2006, the following options to acquire common stock were outstanding:

|  |                      |                   |                                             |                               |                                   
|- | -------------------- | ----------------- | ------------------------------------------- | ----------------------------- | ----------------------------------
|  | Exercise Price Range | Number of Options | Weighted Average Remaining Contractual Life | Number of Exercisable Options | Expiry
 Dates                     
|  |                      |                   |                                             |                               |                                   
|$ | 0.10  0.15          | 2,850,000         | 3.8                                         | 2,716,667                     | July 31, 2007  
 January 31, 2010
|$ | 0.21  0.23          | 895,000           | 3.7                                         | 290,000                       | July 31, 2007
  -
  August 9, 2010
|  |                      | 3,745,000         |                                             | 3,006,667                     |                                   

The Compensation Committee of the Board of Directors resolved on April 12, 2006 to grant options in respect of 1,500,000 common share to officers of the Company.





F-18



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





4.

COMMON SHARES (Continued)

(d)

Earnings per share

The following table sets out the computation of basic and diluted net income per common share Basic income per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted income per share is calculated by dividing net income by the sum of the weighted average number of common shares outstanding and all additional common shares that would have been outstanding if potentially dilutive common shares had been issued during the period.  The treasury stock method is used to calculate the dilutive effect of options and warrants.



|                                                   |                             |            |           |   |            |          
|-------------------------------------------------- | --------------------------- | ---------- | --------- | - | ---------- | ---------
|                                                   |                             | 2006       |           |   | 2005      
|Numerator:                                         |                             |            |           |   |           
|Net Income                                         | $                           | 1,141,548  |           | $ | 663,447   
|                                                   |                             |            |           |   |           
|Denominator:                                       |                             |            |           |   |           
|Weighted average common shares outstanding         |                             | 47,607,656 |           |   | 44,134,126
|Effect of dilutive securities                      |                             |            |           |   |           
|                                                   | Stock Options               |            | 1,837,879 |   |            | 1,485,000
|                                                   | Convertible promissory note |            | 6,719,178 |   |            | 1,875,000
|Diluted weighted average common shares outstanding |                             | 56,164,713 |           |   | 47,494,126
|                                                   |                             |            |           |   |           
|Basic net income per share                         | $                           | 0.02       |           | $ | 0.02      
|Diluted net income per share                       | $                           | 0.02       |           | $ | 0.01      

705,000 (2005  nil) options were excluded from the earning per share computation as they were antidilutive.

5.

BUSINESS SEGMENT INFORMATION

(a)

Segmented information

DataWave manufactures and operates prepaid calling card merchandising machines and re-sells long distance telephone time through prepaid and other calling cards distributed through its machines, at retail locations and on a wholesale basis to third parties.  DataWave considers its business to consist of one reportable operating segment, therefore these consolidated financial statements have not been segmented.



F-19



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





5.

BUSINESS SEGMENT INFORMATION (Continued)

(a)

Segmented information (continued)

DataWave has total revenues of sales, net agency sales, and costs of revenues (exclusive of depreciation and amortization) analyzed by product, as follows:



|                                        |                        |                     |                           |                  |                     |              
|--------------------------------------- | ---------------------- | ------------------- | ------------------------- | ---------------- | ------------------- | -------------
|                                        | Prepaid
 Long Distance | Prepaid Cellular    | Prepaid Internet Products | Fees and Service | Other               | Total        
|Year ended March 31, 2006               |                        |                     |                           |                  |                     |              
|Canada                                  | $ 14,839,917           | $                 - | $         33,952          | $    2,597,399   | $         51,981    | $ 17,523,249 
|U.S.                                    | 5,822,804              | -                   | -                         | 326,823          | 191,393             | 6,341,020    
|Mexico                                  | -                      | -                   | -                         | -                | 29,020              | 29,020       
|Sales                                   | 20,662,721             | -                   | 33,952                    | 2,924,222        | 272,394             | 23,893,289   
|Canada                                  | -                      | 151,337,725         | 216,063                   | -                | -                   | 151,553,788  
|U.S.                                    | 7,928,125              | 4,156,408           | -                         | -                | -                   | 12,084,533   
|Mexico                                  | -                      | -                   | -                         | -                | -                   | -            
|Gross proceeds received on agency sales | 7,928,125              | 155,494,133         | 216,063                   | -                | -                   | 163,638,321  
|Less payments to suppliers              | (3,465,935)            | (151,769,720)       | (201,938)                 | -                | -                   | (155,437,593)
|Net agency sales                        | 4,462,190              | 3,724,413           | 14,125                    | -                | -                   | 8,200,728    
|Canada                                  | 14,839,917             | 3,591,637           | 48,077                    | 2,597,399        | 51,981              | 21,129,011   
|U.S.                                    | 10,284,994             | 132,776             | -                         | 326,823          | 191,393             | 10,935,986   
|Mexico                                  | -                      | -                   | -                         | -                | 29,020              | 29,020       
|Total revenue                           | 25,124,911             | 3,724,413           | 48,077                    | 2,924,222        | 272,394             | 32,094,017   
|Cost of revenues                        | 20,220,336             | -                   | 30,147                    | 401,458          | 1,571               | 20,653,512   
|Margin                                  | $   4,904,575          | $   3,724,413       | $         17,930          | $    2,522,764   | $      270,823      | $ 11,440,505 
|                                        |                        |                     |                           |                  |                     |              
|Year ended March 31, 2005               |                        |                     |                           |                  |                     |              
|Canada                                  | $ 10,289,118           | $                 - | $          4,229          | $   2,106,435    | $                 - | $ 12,399,782 
|U.S.                                    | 4,095,141              | -                   | -                         | 99,826           | 133,719             | 4,328,686    
|Mexico                                  | -                      | -                   | -                         | -                | 54,563              | 54,563       
|Sales                                   | 14,384,259             | -                   | 4,229                     | 2,206,261        | 188,282             | 16,783,031   
|Canada                                  | -                      | 92,862,525          | 322,333                   | -                | -                   | 93,184,858   
|U.S.                                    | 7,797,714              | -                   | -                         | -                | -                   | 7,797,714    
|Mexico                                  | -                      | -                   | -                         | -                | -                   | -            
|Gross proceeds received on agency sales | 7,797,714              | 92,862,525          | 322,333                   | -                | -                   | 100,982,572  
|Less payments to suppliers              | (2,187,597)            | (90,943,578)        | (307,415)                 | -                | -                   | (93,438,590) 
|Net agency sales                        | 5,610,117              | 1,918,947           | 14,918                    | -                | -                   | 7,543,982    
|Canada                                  | 10,289,118             | 1,918,947           | 19,147                    | 2,106,435        | -                   | 14,333,647   
|U.S.                                    | 9,705,258              | -                   | -                         | 99,826           | 133,719             | 9,938,803    
|Mexico                                  | -                      | -                   | -                         | -                | 54,563              | 54,563       
|Total revenue                           | 19,994,376             | 1,918,947           | 19,147                    | 2,206,261        | 188,282             | 24,327,013   
|Cost of revenues                        | 15,188,903             | -                   | 3,486                     | 350,677          | -                   | 15,543,066   
|Margin                                  | $   4,805,473          | $   1,918,947       | $        15,661           | $   1,855,584    | $     188,282       | $   8,783,947



F-20



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





5.

BUSINESS SEGMENT INFORMATION (Continued)

(b)

Geographic information

DataWave has long-lived assets and has earned revenue from sales to customers in the following geographic locations:



|              |                                       |            |      |   |                    |  |      |           |  |   |           | 
|------------- | ------------------------------------- | ---------- | ---- | - | ------------------ |  | ---- | --------- |  | - | --------- | 
|              | For the year ended and as at March 31
|              |                                       | Revenue    |      |   | Long Lived Assets
|              | 2006                                  |            | 2005 |   | 2006               |  | 2005
|              |                                       |            |      |   |                    |  |      |           |  |   |          
|Canada        | $                                     | 21,129,011 |      | $ | 14,333,647         |  | $    | 3,993,055 |  | $ | 4,090,704
|United States |                                       | 10,935,986 |      |   | 9,938,803          |  |      | 166,871   |  |   | 220,852  
|Mexico        |                                       | 29,020     |      |   | 54,563             |  |      | -         |  |   | -        
|              | $                                     | 32,094,017 |      | $ | 24,327,013         |  | $    | 4,159,926 |  | $ | 4,311,556



Long lived assets consist of machinery and equipment, and goodwill.

(c)

Concentration of revenues and economic dependence

The Company is dependent on a number of customers for revenues from point-of-sale activation products and future results depend significantly on these strategic relationships.

For the year ended March 31, 2006, the top ten customers accounted for 63% of revenues (sales and net agency sales) (2005 - 51%).  One customer accounted for 18% of revenues in fiscal 2006 (2005 - 19%).  The Company actively seeks to expand its customer base for point-of-sale activation products to mitigate this risk.

(d)

Concentration of suppliers and economic dependence

The Company is dependent on a number of suppliers for prepaid long distance and cellular time and future results depend significantly on these strategic relationships.

For the year ended March 31, 2006, the Companys four main suppliers, in descending order, accounted for 31%, 17%, 16% and 15% of cost of revenues respectively (2005  32%, 19%, 18% and 13%).  The Company actively seeks to expand its supplier base to mitigate this risk.



6.

INCOME TAXES

US and Canadian components of net income before income taxes were:



|         |                |           |                |   |          
|-------- | -------------- | --------- | -------------- | - | ---------
|         | March 31,
2006 |           | March 31,
2005
|         |                |           |                |   |          
|U.S.     | $              | (7,320)   |                | $ | 755,240  
|Canadian |                | 1,675,871 |                |   | (195,671)
|         | $              | 1,668,551 |                | $ | 559,569  

The following table reconciles the reported amount of income tax expense for the year to the amount of income tax expense that would result from applying the U.S. federal income tax rate of 34% (2005 - 39.94%).



F-21



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





6.

INCOME TAXES (Continued)



|                                                             |                |           |                |   |          
|------------------------------------------------------------ | -------------- | --------- | -------------- | - | ---------
|                                                             | March 31,
2006 |           | March 31,
2005
|                                                             |                |           |                |   |          
|Income taxes based on above                                  | $              | 567,307   |                | $ | 223,492  
|Increase (reduction) in current income taxes resulting from: |                |           |                |   |          
|Effect of foreign tax rates different from statutory rate    |                | 47,220    |                |   | 10,364   
|Tax benefit not recognized on current year losses            |                | -         |                |   | 333,773  
|Benefit on application of loss carry forwards                |                | -         |                |   | (611,228)
|Deferred revenue                                             |                | 230,812   |                |   | 47,416   
|State tax                                                    |                | 77,254    |                |   | -        
|Other                                                        |                | (10,189)  |                |   | (3,817)  
|Current income taxes                                         |                | 912,404   |                |   | -        
|Increase in deferred income tax recovery resulting from:     |                |           |                |   |          
|Reserve on deferred revenue                                  |                | (229,938) |                |   | -        
|Income tax expense                                           | $              | 682,466   |                | $ | -        



Significant components of the Companys deferred tax assets and liabilities at March 31, 2006 and 2005, in the Companys two tax jurisdictions are presented below:



|                                 |                |           |                |   |          
|-------------------------------- | -------------- | --------- | -------------- | - | ---------
|                                 | March 31,
2006 |           | March 31,
2005
|U.S.                             |                |           |                |   |          
|                                 |                |           |                |   |          
|Deferred tax assets:             |                |           |                |   |          
|Operating losses carried forward |                | 219,000   |                |   | 280,387  
|AMT credit carried forward       |                | 64,989    |                |   | -        
|Machinery and equipment          |                | 3,886     |                |   | 74,057   
|Intangible assets                |                | 55,688    |                |   | -        
|Other                            |                | 97,704    |                |   | -        
|                                 |                | 441,267   |                |   | 354,444  
|Valuation allowance              |                | (441,267) |                |   | (354,444)
|Net deferred tax assets          | $              | -         |                | $ | -        
|                                 |                |           |                |   |          
|Deferred tax liabilities:        | $              | -         |                | $ | -        





|                          |                |           |                |   |          
|------------------------- | -------------- | --------- | -------------- | - | ---------
|                          | March 31,
2006 |           | March 31,
2005
|Canada                    |                |           |                |   |          
|                          |                |           |                |   |          
|Deferred tax assets:      |                |           |                |   |          
|Deferred revenue          |                | 229,938   |                |   | 56,258   
|Machinery and equipment   |                | 150,848   |                |   | 188,416  
|Intangible assets         |                | 482,620   |                |   | 34,413   
|                          |                | 863,406   |                |   | 279,087  
|Valuation allowance       |                | (633,468) |                |   | (279,087)
|Net deferred tax assets   | $              | 229,938   |                | $ | -        
|                          |                |           |                |   |          
|Deferred tax liabilities: | $              | 320,780   |                | $ | 309,509  





F-22



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





6.

INCOME TAXES (Continued)



During fiscal 2005, the Company continued under the laws of Delaware.  Under Canadian tax laws the Company was deemed to have disposed of all of its property at fair value.  Management estimates relating to the determination of fair value and taxes resulting from the continuance are subject to the review and assessment of Canada Revenue Agency.  As a result of this continuance certain Canadian loss carryforwards expired unutilized.

In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.  The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.  The Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.  As at March 31, 2006, the Company does not believe it meets the criteria to recognize the deferred tax asset in the U.S., and has accordingly provided a full valuation allowance.  The Company recognized a deferred tax asset in Canada for the excess of the financial reporting amount over the tax basis of deferred revenue as it is apparent that the temporary difference will reverse in the foreseeable future.

As at March 31, 2006, the Company has net operating loss carryforwards for federal income tax purposes of $566,956 in the U.S., which are available, subject to restriction, to offset future federal taxable income, if any.

The U.S. net operating loss carryforwards expire as follows:



|     |   |        
|---- | - | -------
|2019 | $ | 231,611
|2022 |   | 158,496
|2024 |   | 176,849
|     | $ | 566,956

7.

DEFERRED INDUCEMENT

In January 2004, DataWave entered into a ten year lease for office space in Richmond, British Columbia, which is being amortized over the ten year term of the lease.  The agreement included cash inducements for leasehold improvements of $319,017, of which $127,738 (2005 - $124,008) is recorded as a long term receivable.  Also included were inducements for free rent.  At March 31, 2006, the deferred rent inducement was $397,813 (2005 - $373,186) less the current portion of $31,902 (2005 - $31,002).

8.

CAPITAL LEASE OBLIGATION

The future minimum lease payments for each fiscal year under the capital lease for equipment expiring in fiscal year 2007, together with the balance of the obligation under capital lease are as follows:

|                                           |   |       
|------------------------------------------ | - | ------
|2007                                       | $ | 64,849
|Total minimum lease payments               |   | 64,849
|Less: amount representing interest at 8.5% |   | 965   
|                                           |   | 63,884
|Less: current portion                      |   | 63,884
|Balance of obligation                      | $ | -     





F-23



---

DATAWAVE SYSTEMS INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Years ended March 31, 2006 and 2005

(Expressed in United States Dollars)





9.

COMMITMENTS

DataWave has the following future minimum payments with respect to operating leases for office space, computer and office equipment:



|           |   |          
|---------- | - | ---------
|2007       | $ | 335,294  
|2008       |   | 316,000  
|2009       |   | 318,029  
|2010       |   | 339,319  
|2011       |   | 301,430  
|Thereafter |   | 645,486  
|           | $ | 2,255,558

Rent expense, net of inducement, for the period ended March 31, 2006, was $525,923 (2005 - $355,174).

10.

EQUITY INVESTMENT

During 2002, the Company formed NextWave Card Corp (NCC) with a Canadian privately owned company to market and distribute stored value cards.  The Company does not control NCC and records its proportionate share (50%) of NCCs operating results using the equity method.  For the year ended March 31, 2006, DataWave recorded equity investment income of $155,463 (2005 - $103,878).

At March 31, 2006, DataWaves cumulative share of equity investment income was $194,850 (March 31, 2005 - $39,387).  NCC was financed with CAD$100 in initial equity contributions from the two stockholders and a continuing subordinated debt from the privately owned company.  NCC purchases various support services it requires from the two stockholders.

The Companys maximum exposure to loss at March 31, 2006, as a result of its involvement in NCC, was less than $194,850, being the carrying value of the investment.

The Companys equity ownership is considered a variable interest in NCC under FIN46R, Consolidation of Variable Interest Entities.  However, the Company is not the primary beneficiary and therefore has not consolidated NCC.

11.

RELATED PARTY TRANSACTIONS

During the year ended March 31, 2006 the Company charged NCC expenses of $183,375 (2004 - $81,000), which comprised sales and marketing costs incurred on behalf of NCC.  The Company also charged NCC processing revenues of $51,983 (2005 - $22,681).  As at March 31, 2006 $54,873 was due from NCC (2005 - $48,859).



F-24



---





EXHIBIT 31.1



CERTIFICATION PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Josh Emanuel, certify that:

1. I have reviewed this Annual Report on Form 10-KSB of DataWave Systems, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the small business issuer as of, and for, the periods presented in this report;

4. The small business issuers other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the small business issuer and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the small business issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the small business issuers disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the fiscal year ended March 31, 2006 covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the small business issuers internal control over financial reporting that occurred during the small business issuers most recent fiscal quarter (the small business issuers fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuers internal control over financial reporting; and

5. The small business issuers other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuers auditors and the audit committee of the small business issuers board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the small business issuers ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the small business issuers internal control over financial reporting.

Date: June 27th, 2006



By:/s/ Josh Emanuel

Josh Emanuel

Chairman and Chief Executive Officer







---





EXHIBIT 31.2



CERTIFICATION PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, John Gunn, certify that:

1. I have reviewed this Annual Report on Form 10-KSB of DataWave Systems, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the small business issuer as of, and for, the periods presented in this report;

4. The small business issuers other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the small business issuer and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the small business issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the small business issuers disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the fiscal year ended March 31, 2006 covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the small business issuers internal control over financial reporting that occurred during the small business issuers most recent fiscal quarter (the small business issuers fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuers internal control over financial reporting; and

5. The small business issuers other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuers auditors and the audit committee of the small business issuers board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the small business issuers ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the small business issuers internal control over financial reporting.

Date: June 27th, 2006

By: /s/ John Gunn

John Gunn

General Manager and Chief Financial Officer







---





EXHIBIT 32.1



CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002



I, Josh Emanuel, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge and belief:



(1)

The Annual Report on Form 10-KSB of DataWave Systems Inc. for the year ended March 31, 2006 (the Report) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and



(2)

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of DataWave Systems Inc.



By: /s/ Josh Emanuel

Josh Emanuel

Chairman, Chief Executive Officer

Dated: June 27th, 2006



A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to DataWave Systems Inc. and will be retained by DataWave Systems Inc. and furnished to the Securities and Exchange Commission or its staff upon request.









---





EXHIBIT 32.2



CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002



I, John Gunn, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge and belief:



(1)

The Annual Report on Form 10-KSB of DataWave Systems Inc. for the year ended March 31, 2006 (the Report) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and



(2)

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of DataWave Systems Inc.



By: /s/ John Gunn

John Gunn

General Manager, Chief Financial Officer

Dated: June 27th, 2006



A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to DataWave Systems Inc. and will be retained by DataWave Systems Inc. and furnished to the Securities and Exchange Commission or its staff upon request.