**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q/A**


(Amendment
      No. 1)





**ý**
            **QUARTERLY
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934****For
                the quarterly period ended December 31, 2005****o**
            **TRANSITION
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934**





**Commission
      file number 001-15789**





**STRATUS
      SERVICES GROUP, INC.**


(Exact
      name of Registrant as specified in its charter)





Delaware
            
            22-3499261(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification No.)**500
                Craig Road, Suite 201, Manalapan, New Jersey
                07726**(Address
                of principal executive offices)**(732)
                866-0300**(Registrant’s
                telephone number, including area code)Securities
                registered under Section 12(b) of the Exchange Act:**Not
                Applicable**Securities
                registered under Section 12(g) of the Exchange Act:Common
                Stock, $.04 par value(Title
                of class)





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





*Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer or a non-accelerated filer. See definition of “accelerated
      filer” and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check
      One)*





Large
                Accelerated Filero
            Accelerated
                Filero
            Non-Accelerated
                Filero





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





*The
      number of shares of Common Stock, $.04 par value, outstanding as of February
      17,
      2006 was 34,946,425.*





**1**




Explanatory
      Note




The
      form 10-Q is being amended to restate the accompanying consolidated financial
      statements.  In August 2006, management determined that certain warrants
      issued in connection with an exchange offer and a public offering in August
      2004
      should have been recorded as derivative liabilities at the time they were
      issued.  We have added Note 12 to disclose derivative instrument
      liabilities and made revisions to "Management's Discussion and Analysis of
      Financial Condition and Results of Operations" to reflect the
      restatement.




**We
      are required to record the fair value of the warrants on our balance sheet
      at
      fair value with changes in the value of the warrants as non-operating gains
      or
      losses on our consolidated statement of operations.  The effect of the
      non-cash charges related to accounting for the warrant liability on our
      consolidated statement of operations for the three months ended December 31,
      2005 was an increase in our net earnings attributable to common stockholders
      of
      $2,135.  The effect on our consolidated statement of operations for the
      three months ended December 31, 2004 was an increase in our net loss
      attributable to common stockholders of $284,648.  There was no change in
      basic or diluted net earnings (loss) attributable to common stockholders per
      share for the three months ended December 31, 2005.  Basic and diluted net
      loss attributable to common stockholders per share for the three months ended
      December 31, 2004 increased by $.02.  The effect on our consolidated
      balance sheet as of September 30, 2005 was an increase in current liabilities
      of
      $2,135 and a corresponding decrease in stockholders'
      equity.**




In
      all other material respects, this Amended
      Quarterly Report on Form 10-Q/A is unchanged from the Quarterly Report on Form
      10-Q prevously filed by the Company on February 17, 2006.  This amendment
      should also be read in conjunction with our amended Annual Report on Form 10-K/A
      for the year ended September 30, 2005.





**2**


**STRATUS
      SERVICES GROUP, INC.**


Condensed
      Consolidated Balance Sheets


(Unaudited)





**December
                31,**
            
            
            **September
                30,**Assets
            
            
            **2005**
            
            
            **2005**(Unaudited)
            
            
            **(Restated)**
            
            
            **(Restated)**Current
                assetsCash
            
            $
            10,871
            
            $
            40,784Accounts
                receivable-less allowance for doubtful accounts of
                $3,039,000and
                $3,039,000
            
            
            3,725,626
            
            
            11,591,026Unbilled
                receivables
            
            
            95,327
            
            
            2,484,799Notes
                receivable (current portion)
            
            
            44,419
            
            
            39,016Due
                from related party
            
            
            1,064,264
            
            
            -Prepaid
                insurance
            
            
            344,055
            
            
            455,881Prepaid
                expenses and other current assets
            
            
            27,719
            
            
            264,485Assets
                held for sale
            
            
            -
            
            
            3,656,5395,312,281
            
            
            18,532,530Notes
                receivable (net of current portion)
            
            
            42,190
            
            
            47,593Property
                and equipment, net of accumulated depreciation
            
            
            183,832
            
            
            182,606Other
                assets
            
            
            34,906
            
            
            34,906$
            5,573,209
            
            $
            18,797,635Liabilities
                and Stockholders’ Equity (Deficiency)Current
                liabilitiesLoans
                payable (current portion)
            
            $
            73,450
            
            $
            73,450Loans
                payable - related parties
            
            
            107,721
            
            
            111,723Notes
                payable - acquisitions (current portion)
            
            
            200,857
            
            
            182,439Note
                payable - related party (current portion)
            
            
            1,800,000
            
            
            -Line
                of credit
            
            
            970,093
            
            
            8,931,689Cash
                overdraft
            
            
            -
            
            
            14,731Insurance
                obligation payable
            
            
            29,887
            
            
            113,373Accounts
                payable and accrued expenses
            
            
            4,393,708
            
            
            4,574,587Accounts
                payable - related parties
            
            
            73,086
            
            
            1,232,342Accrued
                payroll and taxes
            
            
            229,580
            
            
            284,834Payroll
                taxes payable
            
            
            3,989,626
            
            
            4,160,539Series
                A redemption payable
            
            
            300,000
            
            
            300,000Warrant
              liability
            
            
            -
            
            
            2,135Series
                I convertible preferred stock (including unpaid dividends
                of$40,091)
            
            
            -
            
            
            2,217,591Liabilities
                held for sale
            
            
            -
            
            
            5,494,27912,168,008
            
            
            27,693,712Notes
                payable - acquisitions (net of current portion)
            
            
            461,294
            
            
            490,848Note
                payable - related party (net of current portion)
            
            
            556,850
            
            
            -Payroll
                taxes payable
            
            
            336,546
            
            
            449,046Convertible
                debt
            
            
            40,000
            
            
            40,00013,562,698
            
            
            28,673,606Commitments
                and contingenciesStockholders’
                equity (deficiency)Preferred
                stock, $.01 par value, 5,000,000 shares authorizedSeries
                E non-voting convertible preferred stock, $.01 par value,247
                shares issued and outstanding, liquidation preference of
                $24,700
            
            
            24,700
            
            
            24,700





See
      notes
      to condensed consolidated financial statements





**3**





Series
                F voting convertible preferred stock, $.01 par value, 6,000shares
                issued and outstanding, liquidation preference of $600,000(including
                unpaid dividends of $104,500 and $94,000)
            
            
            704,500
            
            
            694,000Common
                stock, $.04 par value, 100,000,000 shares authorized;
                23,446,423and
                19,606,423 shares issued and outstanding
            
            
            937,857
            
            
            784,257Additional
                paid-in capital
            
            
            10,696,971
            
            
            10,835,031Accumulated
                deficit
            
            
            (20,353,517
            )
            
            (22,213,959
            )Total
                stockholders’ equity (deficiency)
            
            
            (7,989,489
            )
            
            (9,875,971
            )$
            5,573,209
            
            $
            18,797,635








See
      notes
      to condensed consolidated financial statements


**4**


**STRATUS
      SERVICES GROUP, INC.**


Condensed
      Consolidated Statements of Operations


(Unaudited)








**Three
                Months Ended****December
                31,****2005**
            
            
            **2004****(Restated)**
            
            
            **(Restated)**Revenues
            
            $
            1,233,858
            
            $
            1,112,846Cost
                of revenues ($389,735 and $7,925 to related parties)
            
            
            822,256
            
            
            785,884Gross
                profit
            
            
            411,602
            
            
            326,962Selling,
                general and administrative expenses
            
            
            1,246,033
            
            
            1,084,810Operating (loss)
                from continuing operations
            
            
            (834,431
            )
            
            (757,848
            )Interest
                expense
            
            
            (299,351
            )
            
            (207,795
            )Other
                income (expense)
            
            
            (57,309
            )
            
            (45,605
            )Gain
              (loss) on change in fair value of warrants
            
            
            2,135
            
            
            (284,648
            )(Loss)
                from continuing operations
            
            
            (1,188,956
            )
            
            (1,295,896
            )Discontinued
                operations - income (loss) from discontinued operations
            
            
            (107,044
            )
            
            1,024,992Gain
                on sale of discontinued operations (net)
            
            
            3,156,442
            
            
            -Net
                earnings (loss)
            
            
            1,860,442
            
            
            (270,904
            )Dividends
                on preferred stock
            
            
            (10,500
            )
            
            (10,500
            )Net
                earnings (loss) attributable to common stockholders
            
            $
            1,849,942
            
            $
            (281,404
            )Net
                earnings (loss) per share attributable to common
                stockholdersBasic:(Loss)
                from continuing operations
            
            $
            (.06
            )
            $
            (.08
            )Earnings
                from discontinued operations
            
            
            .15
            
            
            .06Net
                earnings (loss)
            
            $
            .09
            
            $
            (.02
            )Diluted:(Loss)
                from continuing operations
            
            $
            (.06
            )
            $
            (.08
            )Earnings
                from discontinued operations
            
            
            .14
            
            
            .06Net
                earnings (loss)
            
            $
            .08
            
            $
            (.02
            )Weighted
                average shares outstanding per common shareBasic
            
            
            20,432,727
            
            
            16,820,354Diluted
            
            
            23,115,798
            
            
            16,820,354

















See
      notes
      to condensed consolidated financial statements


**5**


**STRATUS
      SERVICES GROUP, INC.**


Condensed
      Consolidated Statements of Cash Flows


(Unaudited)







**Three
                Months Ended****December
                31,****2005**
            
            
            **2004**Cash
                flows from operating activities
            
            
            **(Restated)**
            ****
            ****
            **(Restated)**Net
                (loss) from continuing operations
            
            $
            (1,188,956
            )
            $
            (1,295,896
            )Net
                earnings - discontinued operations
            
            
            3,049,398
            
            
            1,024,992Adjustments
                to reconcile net earnings to net cash used by operating
                activitiesDepreciation
            
            
            50,904
            
            
            72,620Amortization
            
            
            41,902
            
            
            102,622Provision
                for doubtful accounts
            
            
            -
            
            
            25,000Deferred
                financing costs amortization
            
            
            -
            
            
            402Gain
                on sale of discontinued operations
            
            
            (3,156,442
            )
            
            -Imputed
                interest
            
            
            133
            
            
            19,209Dividends
                on preferred stock
            
            
            163,625
            
            
            65,084Intrinsic
                value of the beneficial conversion feature of convertible preferred
                stock
            
            
            1,674
            
            
            -(Gain)
              loss on change in fair value of warrants
            
            
            (2,135
            )
            
            284,648Changes
                in operating assets and liabilitiesAccounts
                receivable
            
            
            8,224,976
            
            
            1,534,273Due
                from related party
            
            
            185,736
            
            
            -Prepaid
                insurance
            
            
            111,826
            
            
            (115,440
            )Prepaid
                expenses and other current assets
            
            
            231,118
            
            
            10,626Other
                assets
            
            
            (1,000
            )
            
            32,976Insurance
                obligation payable
            
            
            (83,486
            )
            
            (100,895
            )Accrued
                payroll and taxes
            
            
            (55,254
            )
            
            (510,943
            )Payroll
                taxes payable
            
            
            (283,413
            )
            
            (144,314
            )Accounts
                payable and accrued expenses
            
            
            (1,390,135
            )
            
            (1,005,269
            )Accrued
                interest
            
            
            3,809
            
            
            (73,792
            )Total
                adjustments
            
            
            4,043,838
            
            
            196,8075,904,280
            
            
            (74,097
            )Cash
                flows (used in) investing activitiesPurchase
                of property and equipment
            
            
            (13,977
            )
            
            (74,131
            )Cash
                received in connection with sale of discontinued
                operations(net
                of $10,000 in costs in 2005)
            
            
            98,861
            
            
            -Collection
                of notes receivable
            
            
            -
            
            
            6,66984,884
            
            
            (67,462
            )Cash
                flows from financing activitiesNet
                repayments of line of credit
            
            
            (5,989,075
            )
            
            (1,082,210
            )Proceeds
                from loans payable - related parties
            
            
            -
            
            
            400,000Payments
                of loans payable
            
            
            -
            
            
            (16,078
            )Payments
                of loans payable - related parties
            
            
            (4,002
            )
            
            (42,710
            )Payments
                of notes payable - acquisitions
            
            
            (11,269
            )
            
            (275,418
            )Cash
                overdraft
            
            
            (14,731
            )
            
            468,454Redemption
                of preferred stock
            
            
            -
            
            
            (34,000
            )Dividends
                paid
            
            
            -
            
            
            (10,000
            )(6,019,077
            )
            
            (591,962
            )Net
                change in cash
            
            
            (29,913
            )
            
            (733,521
            )Cash
                - beginning
            
            
            40,784
            
            
            735,726Cash
                - ending
            
            $
            10,871
            
            $
            2,205Supplemental
                disclosure of cash paidInterest
            
            $
            305,299
            
            $
            418,523





See
      notes
      to condensed consolidated financial statements


**6**





Schedule
                of non-cash investing and financing activitiesSale
                of discontinued operations:Gain
                on sale
            
            $
            3,156,442
            
            $
            -Net
                assets sold
            
            
            1,683,783
            
            
            -Cancellation
                of accounts payable - related parties (net)
            
            
            (3,541,364
            )
            
            -Due
                from related party
            
            
            (1,250,000
            )
            
            -Accrued
                expenses
            
            
            50,000
            
            
            -Net
                cash received
            
            $
            98,861
            
            $
            -Issuance
                of common stock upon conversion of convertible preferred
                stock
            
            $
            24,366
            
            $
            -Cumulative
                dividends on preferred stock
            
            $
            10,500
            
            $
            10,500Accrued
                interest converted to loan payable
            
            $
            -
            
            $
            21,600Put
                option liability converted to loan payable
            
            $
            -
            
            $
            18,000








See
      notes
      to condensed consolidated financial statements


**7**


**STRATUS
      SERVICES GROUP, INC.**


Notes
      to
      Condensed Consolidated Financial Statements


(Unaudited)





**NOTE
      1 - BASIS OF PRESENTATION**





The
      accompanying condensed consolidated financial statements have been prepared
      by
      the Company, without audit, pursuant to the rules and regulations of the
      Securities and Exchange Commission. Certain information and disclosures normally
      included in financial statements prepared in accordance with accounting
      principles generally accepted in the United States have been condensed or
      omitted pursuant to such rules and regulations. These condensed financial
      statements reflect all adjustments (consisting only of normal recurring
      adjustments) that, in the opinion of management, are necessary to present fairly
      the financial position, the results of operations and cash flows of the Company
      for the periods presented. It is suggested that these condensed financial
      statements be read in conjunction with the consolidated financial statements
      and
      the notes thereto included in the Company’s Annual Report on Form
      10-K.





The
      results of operations for the interim periods presented are not necessarily
      indicative of the results to be expected for the full year.





Until
      December 2005, Stratus Services Group, Inc. together with its 50%-owned
      consolidated joint venture, (the “Company”) was a national provider of staffing
      and productivity consulting services. Prior to December 2005, the Company
      operated a network of 29 offices in 7 states. In December 2005, the Company
      completed a series of asset sales transactions pursuant to which it sold
      substantially all of the assets that it used to conduct its staffing services
      business (see Note 6). As a result, the Company is no longer conducting active
      staffing services for any clients and is not operating any branch offices.
      The
      Company plans to focus on expanding its information technology staffing
      solutions business, which is conducted through its 50% owned consolidated joint
      venture, Stratus Technology Services, LLC (“STS”) (see Notes 1 and
      10).





**NOTE
      2 - LIQUIDITY**





At
      December 31, 2005, the Company had limited liquid resources. Current liabilities
      were $12,168,008 and current assets were $5,312,281. The difference of
      $6,855,727 is a working capital deficit, which is primarily the result of losses
      incurred during the last four years. These factors, among others, indicate
      that
      the Company may be unable to continue as a going concern. The financial
      statements do not include any adjustments relating to the recoverability and
      classification of liabilities that might be necessary should the Company be
      unable to continue as a going concern.





Management
      recognizes that the Company’s continuation as a going concern is dependent upon
      its ability to generate sufficient cash flow to allow it to satisfy its
      obligations on a timely basis, to fund the operation and capital needs, and
      to
      obtain additional financing as may be necessary.





Management
      of the Company has taken steps to revise and reduce its operating requirements,
      which it believes will be sufficient to assure continued operations and
      implementation of the Company’s plans. The steps include closing branches that
      are not profitable, consolidating branches and reductions in staffing and other
      selling, general and administrative expense, and most significantly, the asset
      sales transactions that were completed in December 2005 (see Note
      5).





The
      Company continues to pursue other sources of equity or long-term debt
      financings. The Company also continues to negotiate payment plans and other
      accommodations with its creditors.





**NOTE
      3 - ACCOUNTING FOR STOCK-BASED COMPENSATION**





Effective
      October 1, 2005, the Company adopted Statement of Financial Accounting Standard
      (“SFAS”) No. 123(R) (revised 2004), *Share-Based
      Payment* ,
      using
      the modified prospective application transition method. All outstanding stock
      options at September 30, 2005, were fully-vested. Accordingly, the adoption
      of
      SFAS No. 123(R) did not have a significant impact on our financial position,
      results of operations or cash flows because the intrinsic value method under
      the
      Accounting Principles Board (“APB”) Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      were
      materially consistent with the Company's recognition of compensation expense
      under the equity plans.





The
      following table illustrates, for the three months ended December 31, 2004,
      the
      effect on net earnings (loss) and net earnings (loss) per share had compensation
      expense for the employee stock-based plans been recorded based on the fair
      value
      method using the Black-Scholes option pricing model under SFAS No. 123, as
      amended:


**8**





**Three
                Months****Ended****December
                31, 2004****(Restated)**Net
                (loss), as reported
            
            $
            (281,404
            )Deduct:
                total stock-based compensation expense determined under fair value
                method
            
            
            (187,442
            )Net
                loss, as adjusted
            
            $
            (468,846
            )Basic
                and diluted net loss per share:As
                reported
            
            $
            (.02
            )As
                adjusted
            
            $
            (.03
            )





During
      the three months ended December 31, 2005, the Company did not have any
      share-based payment transactions.





**NOTE
      4 - EARNINGS/LOSS PER SHARE**





Basic
      “Earnings Per Share” (“EPS”) excludes dilution and is computed by dividing
      earnings available to common stockholders by the weighted-average number of
      common shares outstanding during the period. Diluted EPS assumes conversion
      of
      dilutive options and warrants, and the issuance of common stock for all other
      potentially dilutive equivalent shares outstanding. There were 2,683,071 and
      -0-
      dilutive shares for the three months ended December 31, 2005 and December 31,
      2004, respectively. Outstanding common stock options and warrants not included
      in the computation of earnings per share for the three months ended December
      31,
      2005 and 2004, totaled 18,611,403 and 17,111,403, respectively. These options
      and warrants were excluded because their inclusion would have an anti-dilutive
      effect on earnings per share.





**NOTE
      5 - DISCONTINUED OPERATIONS**





(a)
            In
                December 2005, the Company completed the following series of transactions
                pursuant to which it sold substantially all of the assets used to
                conduct
                its staffing services business, other then the IT staffing solutions
                business that is conducted through the Company’s 50% owned joint venture,
                STS.





(i)
            On
                December 2, 2005, the Company completed the sale, effective as of
                November
                21, 2005, of substantially all of the tangible and intangible assets,
                excluding accounts receivable, of several of its offices located
                in the
                Western half of the United States (the “ALS Purchased Assets”) to ALS, LLC
                (“ALS”), a related party (see Note 10). The offices sold were the
                following: Chino, California; Colton, California; Los Nietos, California;
                Ontario, California; Santa Fe Springs, California and the Phoenix,
                Arizona
                branches and the Dallas Morning News Account (the “Western Offices”).
                Pursuant to the terms of an Asset Purchase Agreement between the
                Company
                and ALS dated December 2, 2005 (the “ALS Asset Purchase Agreement”), the
                purchase price for the ALS Purchased Assets is payable as
                follows:





•
            $250,000
                is payable over the 60 days following December 2, 2005, at a rate
                no
                faster than $125,000 per 30 days;




•
            $1,000,000
                payable by ALS will be paid directly to certain taxing authorities
                to
                reduce the Company’s tax obligations;
                and




•
            $3,537,000
                which was paid by means of the cancellation of all net indebtedness
                owed
                by the Company to ALS outstanding as of the close of business on
                December
                2, 2005.




In
      addition to the foregoing amounts, ALS also assumed the Company’s obligation to
      pay $798,626 due under a certain promissory note issued by the Company in
      connection with an acquisition to Provisional Employment Solutions, Inc. As
      a
      result of the sale of the ALS Purchased Assets to ALS, all sums due and owing
      to
      ALS by the Company were deemed paid in full and no further obligations
      remain.





(ii)  On
      December 5, 2005, the Company completed the sale, effective as of November
      28,
      2005 (the “AI Effective Date”), of substantially all of the tangible and
      intangible assets, excluding accounts receivable and other certain items, as
      described below, of three of its California offices (the “AI Purchased Assets”)
      to Accountabilities, Inc. (AI”). The offices sold were the following: Culver
      City, California; Lawndale, California and Orange, California (the “Other
      California Offices”). Pursuant to the terms of an Asset Purchase Agreement
      between the Company and AI dated December 5, 2005 (the “AI Asset Purchase
      Agreement”), AI has agreed to pay to the Company an earnout amount equal to two
      percent of the sales of the Other California Offices for the first twelve month
      period after the AI Effective Date; one percent of the sales of the Other
      California Offices for the second twelve month period after the AI Effective


**9**


Date;
      and
      one percent of the sales of the Other California Offices for the third twelve
      month period from the AI Effective Date. In addition, a Demand Subordinated
      Promissory Note between the Company and AI dated September 15, 2005, which
      had
      an outstanding principal balance of $125,000 at the time of closing was deemed
      paid and marked canceled.





Certain
      assets held by the other California Offices were excluded from the sale,
      including cash and cash equivalents, accounts receivable and the Company’s
      rights to receive payments from any source.





(iii) On
      December 7, 2005, the Company completed the sale, effective as of November
      28,
      2005 (the “SOP Effective Date”), of substantially all of the tangible and
      intangible assets, excluding accounts receivable and other assets as described
      below, of several of its Northeastern offices (the “SOP Purchased Assets”) to
      Source One Personnel, Inc. (“SOP”). The offices sold were the following: Cherry
      Hill, New Jersey; New Brunswick, New Jersey; Mount Royal/Paulsboro, New Jersey
      (soon to be Woodbury Heights, New Jersey); Pennsauken, New Jersey; Norristown,
      Pennsylvania; Fairless Hills, Pennsylvania; New Castle, Delaware and the former
      Freehold, New Jersey profit center (the “NJ/PA/DE Offices”). The assets of Deer
      Park, New York, Leominster, Massachusetts, Lowell, Massachusetts and Athol,
      Massachusetts (the “Earn Out Offices”) were also purchased (collectively the
“NJ/PA/DE Offices” and the “Earn Out Offices” shall be referred to as the
“Purchased Offices”). In addition to the foregoing, the SOP Purchased Assets
      also included substantially all of the tangible and intangible assets, excluding
      accounts receivable and other assets as described below, used by the Company
      in
      the operation of its business at certain facilities of certain customers
      including the following: the Setco facility in Cranbury, New Jersey, the Record
      facility in Hackensack, New Jersey, the UPS-MI (formerly RMX) facility in Long
      Island, New York, the UPS-MI (formerly RMX) facility in the State of
      Connecticut, the UPS-MI (formerly RMX) facility in the State of Ohio, the APX
      facility in Clifton, New Jersey (the “Earn Out On-Site Business”) and the
      Burlington Coat Factory in Burlington, New Jersey, the Burlington Coat Factory
      facility in Edgewater Park, New Jersey and the UPS-MI (formerly RMX) facility
      in
      Paulsboro, New Jersey (the foregoing business and the “Earn Out On-Site
      Businesses” shall be referred to herein collectively as the “On-Site
      Businesses”). Pursuant to the SOP Asset Purchase Agreement between the Company
      and SOP dated December 7, 2005 (the “SOP Asset Purchase Agreement:), the
      purchase price for the SOP Purchased Assets was payable as follows (the “SOP
      Purchase Price”):





•
            An
                aggregate of $974,031 of indebtedness owed by the Company to SOP
                (i) under
                certain promissory notes previously issued by the Company to SOP
                and (ii)
                in connection with a put right previously exercised by SOP with respect
                to
                400,000 shares of our common stock was
                cancelled.




•
            SOP
                is required to make the following earn out payments to the Company
                during
                the three year period commencing on the SOP Effective Date (the “Earn Out
                Period”):




•
            Two
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the initial twelve months of
                the Earn
                Out Period.




•
            One
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the second twelve months of the
                Earn
                Out Period.




•
            One
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the third twelve months of the
                Earn
                Out Period.




Certain
      assets held by the Purchased Businesses were excluded from the sale, including
      cash and cash equivalents, accounts receivable, and the Company’s rights to
      receive payments from any source.





(iv)
            On
                December 7, 2005 (the “Closing Date”), the Company completed the sale of
                substantially all of the tangible and intangible assets, excluding
                cash
                and cash equivalents, of two of its California branch offices (the
“TES
                Purchased Assets”) to Tri-State Employment Service, Inc. (“TES”). The
                offices sold were the following: Bellflower, California and West
                Covina,
                California (the “California Branch Offices”). Pursuant to the terms of an
                Asset Purchase Agreement between the Company and TES dated December
                7,
                2005 (the “TES Asset Purchase Agreement”), TES has agreed to pay to the
                Company an earnout amount as
                follows:





•
            two
                percent of sales of the California Branch Offices to existing clients
                for
                the first twelve month period after the Closing
                Date;




•
            one
                percent of sales of the California Branch Offices to existing clients
                for
                the second twelve month period after the Closing Date;
                and




**10**


•
            one
                percent of sales of the California Branch Offices to existing clients
                for
                the third twelve month period after the Closing
                Date.




For
      purposes of calculating the amount owed by TES to the Company, in no event
      shall
      the aggregate annual sales to such clients exceed $25,000,000. In addition,
      on
      or before April 15, 2006, the Company will be required to prepare a
      reconciliation reflecting collections from accounts receivable including in
      the
      TES Purchased Assets. To the extent collections from such accounts receivable
      are less than invoice sales, TES is entitled to offset against future payments
      to the Company an amount equal to two percent of the amount of such shortfall.
      If after April 15, 2006, TES collects any amounts reflected on its
      reconciliation as being uncollected, TES will remit to the Company two percent
      of such additional collections.





On
      the
      Closing Date, TES made a payment of $1,972,521 to the Company’s lender (see Note
      6) and acquired the lender’s rights to certain of the Company’s accounts
      receivable that collateralize its obligation to the lender. As a result of
      this
      transaction, the Company’s obligations to the lender were reduced by $1,972,521.
      The Company is required to reimburse TES by April 15, 2006 for certain costs
      and
      fees, including interest, incurred by TES in connection with its transaction
      with the Lender. The Company does not anticipate that such costs will be
      significant.





(b)
            Effective
                as of June 5, 2005 (the “Effective Date”), the Company sold substantially
                all of the assets, excluding accounts receivable of its six Northern
                California offices to ALS (see Note
                10).





The
      consolidated financial statements for all periods presented have been restated
      to reflect discontinued operations of the aforementioned asset sales. The
      operating results of discontinued operations are summarized as
      follows:





**Three
                Months Ended****December
                31,****2005**
            
            
            **2004**Revenues
            
            $
            18,265,587
            
            $
            32,015,205Cost
                of revenues
            
            
            16,218,630
            
            
            27,608,074Gross
                profit
            
            
            2,046,957
            
            
            4,407,131Selling,
                general and administrative expenses
            
            
            1,950,622
            
            
            3,146,409Operating
                income
            
            
            96,335
            
            
            1,260,722Interest
                expense
            
            
            (205,056
            )
            
            (232,020
            )Other
                income (expense)
            
            
            1,677
            
            
            (3,710
            )Net
                income (loss)
            
            $
            (107,044
            )
            $
            1,024,992





Assets
      of
      the discontinued operations have been reflected in the condensed consolidated
      balance sheet as current assets held for sale. The liabilities that were assumed
      or cancelled by the purchasers are reflected as current liabilities held for
      sale. The following is a summary of assets and liabilities of discontinued
      operations at September 30, 2005:





**September
                30,****2005**Pre-paid
                expenses and other current assets
            
            $
            61,781Property
                and equipment, net
            
            
            291,552Goodwill
            
            
            2,553,081Intangible
                assets, net
            
            
            689,182Other
                assets
            
            
            60,943Total
                assets of discontinued operations
            
            $
            3,656,539Loans
                payable
            
            
            125,000Notes
                payable - acquisitions
            
            
            936,820Accounts
                payable and accrued expenses
            
            
            185,037Accounts
                payable - related parties
            
            
            3,597,422Put
                options liability
            
            
            650,000Total
                liabilities of discontinued operations
            
            $
            5,494,279





**11**


The
      gain
      (loss) on sale of discontinued operations for the three months ended December
      31, 2005 is summarized as follows:





Sold
                to:ALS
            
            $
            4,340,459AI
            
            
            (297,437
            )SOP
            
            
            (331,265
            )TES
            
            
            (495,315
            )3,216,442Other
                costs of sales
            
            
            (60,000
            )Gain
                on sale of discontinued operations
            
            $
            3,156,442





The
      above
      gain includes earnout payments of $73,861.





**NOTE
      6 - LINE OF CREDIT**





The
      Company had a loan and security agreement (the “Loan Agreement”) with Capital
      Temp Funds, Inc. (the “Lender”) which provided for a line of credit up to 85% of
      eligible accounts receivable, as defined, not to exceed $12,000,000. Until
      April
      10, 2003, advances under the Loan Agreement bore interest at a rate of prime
      plus 1-3/4%. The Loan Agreement restricted the Company’s ability to incur other
      indebtedness, pay dividends and repurchase stock. Effective April 10, 2003,
      the
      Company entered into a modification of the Loan Agreement which provided that
      borrowings under the Loan Agreement would bear interest at 3% above the prime
      rate. Borrowings under the Loan Agreement were collateralized by substantially
      all of the Company’s assets.





On
      January 15, 2005, the Company entered into a Forbearance Agreement (the
“Forbearance Agreement”) pursuant to which Lender agreed to forebear from
      accelerating obligations and/or enforcing existing defaults.




The
      Forbearance Agreement amended the Loan Agreement to reduce the maximum credit
      line to $12,000,000, which, after March 1, 2005 was further reduced by $250,000
      per month.




On
      August
      11, 2005, the Company and the Lender entered into an Amended and Restated
      Forbearance Agreement (the “Amended Forbearance Agreement”) whereby the Lender
      had again agreed to forbear from accelerating obligations and/or enforcing
      existing defaults until the earlier to occur of (a) August 26, 2005 or (b)
      the
      date of any Forbearance Default, as defined (the “Forbearance
      Period”).




The
      Amended Forbearance Agreement provided that during the Forbearance Period,
      the
      maximum credit line would be $10,500,000.




Between
      August 25, 2005 and December 21, 2005, the Lender granted the Company a series
      of extensions of the Amended Forbearance Agreement. An extension granted in
      November 2005 was conditioned upon, among other things, the Company and ALS
      entering into a binding agreement providing for a sale to ALS of certain assets
      of the Company. The Company and ALS entered into such an agreement on November
      3, 2005. As a condition to obtaining an extension granted in December 2005,
      the
      Company was required to represent that it had closed the sale of assets to
      ALS
      and to acknowledge and agree that any loans and advances made by the Lender
      during the extension period would be the last requested advances under the
      Loan
      Agreement. The final extension of the Amended Forbearance Agreement expired
      on
      December 21, 2005. As of January 31, 2006, the Company repaid all of the
      indebtedness under the Loan Agreement.




The
      Lender charged the Company $350,000 of fees in connection with the Forbearance
      Agreement, the Amended Forbearance Agreement and the various extensions thereof
      during the three months ended December 31, 2005.




In
      connection with the Company and the Lender entering into the Amended Forbearance
      Agreement, the Company, the Lender and ALS also entered into the ALS
      Forbearance, whereby ALS agreed to forbear, through August 25, 2005, from
      enforcing payment defaults under the Company’s Outsourcing Agreement (see Note
      11). All of the Company’s obligations under the Company’s Outsourcing Agreement
      with ALS were satisfied in connection with the sale of assets to ALS which
      occurred in December 2005 (see Note 5).




On
      January 3, 2006, the Company’s consolidated 50% owned joint venture, STS (see
      Notes 1 and 10), entered into a factoring and security agreement (the “Factoring
      Agreement”) with Action Capital Corporation (“Action”). The Factoring Agreement
      provides for the sale of up to $1,500,000 of acceptable accounts receivable
      of
      STS to Action. Action will reserve and withhold an amount in a reserve account
      equal to 10% of the face amount of accounts receivable purchased under the
      Factoring Agreement. Action has full recourse against STS including, without
      limitation, the right to charge-back




**12**


or
      sell
      back any accounts receivable, if not paid within 90 days of the date of
      purchase. The Factoring Agreement provides for STS to pay interest of prime
      plus
      1% plus a monthly fee of .6% on the daily average of unpaid
      advances.




**NOTE
      7 - PAYROLL TAX LIABILITIES**





During
      fiscal 2003, the Company was notified by both the New Jersey Department of
      Labor
      and the California Employment Development Department (the “EDD”) that, if
      certain payroll delinquencies were not cured, judgment would be entered against
      the Company. As of December 31, 2005, there was still an aggregate of $4.3
      million in delinquent payroll taxes outstanding which are included in “Payroll
      taxes payable” on the balance sheet. Judgment has not been entered against the
      Company in California. While judgment has been entered against the Company
      in
      New Jersey, no actions have been taken to enforce same.





On
      January 7, 2005, the Company entered into a payment plan agreement with the
      EDD
      with regard to the Company’s past due and unpaid unemployment
      taxes.





The
      Company is to continue to pay $12,500 per week to be first applied to its unpaid
      employment tax liability of $966,546 (as of December 31, 2005) for periods
      prior
      to the second quarter 2004; then to second quarter 2004 and third quarter 2004
      employment taxes to the extent not already paid, then to interest and then
      to
      penalties.





The
      weekly payment of $12,500 is to increase for a three month period following
      any
      quarter in which the Company’s reported income is above $200,000 based on a
      percentage increase tied to the amount in excess of $200,000. The Company
      believes that consistent with the parties’ intentions when entering into the
      Plan, the gain on sale of discontinued operations, which resulted in no cash
      to
      the Company, would be excluded from reported income.





**NOTE
      8 - INCOME TAXES**





No
      income
      tax expense was recorded in the three months ended December 31, 2005, because
      the Company recognized a deferred tax benefit resulting from the utilization
      of
      the Company’s net operating loss carryforwards.





**NOTE
      9 - PREFERRED STOCK**





**a.**  **Series
      E**





The
      shares of Series E Preferred Stock have a stated value of $100 per share. The
      holders of the Series E Preferred Stock are entitled to cumulative dividends
      at
      a rate of 6% of the stated value per year, payable every 120 days, in preference
      and priority to any payment of any dividend on the Company’s Common Stock.
      Dividends may be paid, at the Company’s option, either in cash or in shares of
      Common Stock, valued at the Series E Conversion Price (as defined below).
      Holders of Series E Preferred Stock are entitled to a liquidation preference
      of
      $100 per share, plus accrued and unpaid dividends.





The
      Series E Preferred Stock is convertible into Common Stock at a conversion price
      equal to 75% of the average of the closing bid prices, for the five trading
      days
      preceding the conversion date, for the Common Stock. The number of shares
      issuable upon conversion is determined by multiplying the number of shares
      of
      Series E Preferred Stock to be converted by $100, and dividing the result by
      the
      Series E Conversion Price then in effect.





Holders
      of Series E Preferred Stock do not have any voting rights, except as required
      by
      law.





The
      Company may redeem the shares of the Series E Preferred Stock at any time prior
      to conversion, at a redemption price of 115% of the purchase price paid for
      the
      Series E Preferred Shares, plus any accrued but unpaid dividends.





**b.**  **Series
      F**





In
      July
      2002, the Company’s Chief Executive Officer invested $1,000,000 in the Company
      in exchange for 10,000 shares of newly created Series F Convertible Preferred
      Stock (the “Series F Preferred Stock”), which has a stated value of $100 per
      share.





The
      holder of the Series F Preferred Stock is entitled to receive, from assets
      legally available therefore, cumulative dividends at a rate of 7% per year,
      accrued daily, payable monthly, in preference and priority to any payment of
      any
      dividend on the Common Stock and on the Series F Preferred Stock. Dividends
      may
      be paid, at the Company’s option, either in cash or in shares of Common Stock,
      valued at the Series F Conversion Price (as defined below). Holders of Series
      F
      Preferred Stock are entitled to a liquidation preference of $100 per share,
      plus
      accrued and unpaid dividends.


**13**


The
      Series F Preferred Stock is convertible into Common Stock at a conversion price
      equal to $.40 per share. The number of shares issuable upon conversion is
      determined by multiplying the number of shares of Series F Preferred Stock
      to be
      converted by $100, and dividing the result by the Series F Conversion
      Price.





Except
      as
      otherwise required by law, holders of Series F Preferred Stock and holders
      of
      Common Stock shall vote together as a single class on each matter submitted
      to a
      vote of stockholders. Each outstanding share of Series F Preferred Stock shall
      be entitled to the number of votes equal to the number of full shares of Common
      Stock into which each such share of Series F Preferred Stock is then convertible
      on the date for determination of stockholders entitled to vote at the meeting.
      Holders of the Series F Preferred Stock are entitled to vote as a separate
      class
      on any proposed amendment to the terms of the Series F Preferred Stock which
      would increase or decrease the number of authorized shares of Series F Preferred
      Stock or have an adverse impact on the Series F Preferred Stock and on any
      proposal to create a new class of shares having rights or preferences equal
      to
      or having priority to the Series F Preferred Stock.





The
      Company may redeem the shares of the Series F Preferred Stock at any time prior
      to conversion at a redemption price of 115% of the purchase price paid for
      the
      Series F Preferred Shares plus any accrued but unpaid dividends.





**c.**  **Series
      I**





The
      Company was required to redeem each share of the Series I Preferred Stock for
      an
      amount equal to the stated value of $100 per share plus all accrued and unpaid
      dividends on August 5, 2005, the one year anniversary date of the issuance
      of
      the Series I Preferred Stock to the extent permitted by applicable law;
      provided, however, that the Company had the right to extend the required
      redemption date for an additional one year, in which case the Company was
      required to pay all dividends accrued through the first year of issuance in
      cash
      and issue to each holder of Series I Preferred Stock a number of shares of
      its
      common stock which then have a value equal to 10% of the stated value of the
      Series I Preferred Stock held. In addition, because the Company extended the
      redemption date, it was required to pay dividends quarterly and pay an advisory
      fee to an advisor designated by the holders of the Series I Preferred Stock
      in
      an amount equal to 10% of the aggregate stated value of the outstanding shares
      of Series I Preferred Stock, 80% of which was payable in cash and 20% of which
      will be paid in shares of the Company’s common stock, valued at the then current
      market value. If the Company did not redeem the Series I Preferred Stock by
      the
      extended redemption date, the dividend rate of the Series I Preferred Stock
      would have increased to 24% per year and the Series I Preferred Stock would
      have
      been convertible, at the option of the holder, into either common stock at
      a
      conversion price equal to 80% of the average closing bid price of the common
      stock during the five trading days preceding the conversion or common stock
      and
      warrants at a rate of 125 shares of common stock and 250 warrants for each
      $100
      of stated value and accrued and unpaid dividends represented by the Series
      I
      Preferred Stock. Holders of Series I Preferred Stock had no voting rights,
      except as provided by law and with respect to certain limited
      matters.





Pinnacle
      Investment Partners, LP (“Pinnacle”), the holder of the shares of the Company’s
      Series I Preferred Stock (see Note 10) notified the Company that the Company
      was
      in default of its obligations to pay $30,000 of the $174,200 cash portion of
      the
      advisory fee which was required to be paid in connection with the Company’s
      election to extend the date by which it was required to redeem the Series I
      Preferred Stock to August 5, 2006. The Company was also in default for
      non-payment of $40,091 of dividends on the Series I Preferred Stock that were
      due on September 30, 2005.





The
      Company permitted Pinnacle to convert 41 shares of Series I Preferred Stock
      into
      840,000 shares of common stock in October 2005 as a result of the payment
      defaults.





In
      December 2005, the Company permitted Pinnacle to convert an aggregate of 203
      shares of Series I Preferred Stock into 3,000,000 shares of Common Stock and
      agreed to pay to Pinnacle a default fee $100,000.





On
      January 13, 2006, the Company entered into an agreement with Pinnacle, pursuant
      to which the Company issued to Pinnacle, effective December 28, 2005, a secured
      convertible promissory note (the “Convertible Note”) in the aggregate principal
      amount of $2,356,850 in exchange for 21,531 shares of the Company’s Series I
      Preferred Stock held by Pinnacle. As a result of the exchange, there are no
      longer any shares of Series I Preferred Stock outstanding, and the Company
      no
      longer has any obligation to pay to Pinnacle any amounts owed to it under the
      terms of the Series I Preferred Stock, including $103,716 of unpaid dividends
      which had accrued through December 28, 2005. The Convertible Note, which is
      secured by substantially all of the Company’s assets, becomes due as
      follows:




•  $1,800,000
      becomes due and payable in cash upon the earlier of the Company’s receipt of
      $1,800,000 of accounts receivable or March 15, 2006.




•  $331,850
      and accrued interest at a rate of 12% per annum is payable in 24 equal
      installments of principal and interest during the period commencing June 28,
      2007 and ending on May 28, 2009.




**14**




•  $225,000
      and accrued interest thereon at the rate of 6% per annum becomes due and payable
      on December 28, 2007; provided, however, that the Company has the right to
      pay
      such amount in cash or shares of its common stock (valued at $0.0072 per
      share).




Pinnacle
      has the right to convert the principal amount of and interest accrued under
      the
      Convertible Note at any time as follows:




•  $331,850
      of the principal amount and unpaid interest accrued thereon is convertible
      into
      the Company’s common stock at a conversion price of $.06 per share.




•  $225,000
      of the principal amount and unpaid accrued interest thereon is convertible
      into
      the Company’s common stock at a conversion price of $0.0072.





Pinnacle
      may not convert the Convertible Note to the extent that the conversion would
      result in Pinnacle owning in excess of 9.999% of the then issued and outstanding
      shares of common stock of the Company. Pinnacle may waive this conversion
      restriction upon not less than 60 days prior notice to the Company.







**NOTE
      10 - RELATED PARTY TRANSACTIONS**





***Consulting
      Fees***


An
      entity
      which employs the son of the Chief Executive Officer of the Company (the (“CEO”)
      provides consulting services to the Company. Consulting expense was $28,000
      and
      $47,651 for the three months ended December 31, 2005 and 2004, respectively.
      The
      Company has paid consulting fees to an entity whose stockholder is another
      son
      of the CEO of the Company. Consulting fees amounted to $-0- and $32,500 for
      the
      three months ended December 31, 2005 and 2004, respectively.





***Joint
      Venture***


The
      Company provides information technology staffing services through a joint
      venture, STS (see Note 1), in which the Company has a 50% interest. A son of
      the
      CEO of the Company has a majority interest in the other 50%
      venturer.





***Payroll
      Outsourcing***


The
      Company was a party to an Outsourcing Agreement with ALS pursuant to which
      ALS
      and its affiliate, Advantage Services Group, LLC (“Advantage”), were to provide
      payroll outsourcing services for all of the Company’s in-house staff, except for
      its corporate employees, and customer staffing requirements. As a result of
      this
      arrangement, all of the Company’s field personnel were employees of ALS. The
      Company paid agreed upon pay rates, plus burden (payroll taxes and workers’
compensation insurance) plus a fee ranging between 2% and 3% (0% - 1 1⁄2%
      effective June 10, 2005) of pay rates. On June 10, 2005, the Company entered
      into a Second Addendum to Outsourcing Agreement with ALS, which, among other
      things, reduced certain rates charged by ALS to the Company. The total amount
      charged by ALS under this agreement and similar agreements previously in effect
      between the parties was $17,226,000 and $24,120,000 in the three months ended
      December 31, 2005 and 2004, respectively. Accounts payable - related parties
      in
      the attached condensed consolidated balance sheets at December 31, 2005 and
      September 30, 2005, represents amounts due to ALS and Advantage.





The
      Company terminated the Outsourcing Agreement effective February 3,
      2006.





***Other***


An
      entity
      through which the son of the CEO is employed is a consultant to AI (see Note
      5).





The
      nephew of the CEO of the Company is affiliated with Pinnacle Investment
      Partners, LP, the holder of the shares of the Company’s Series I Preferred Stock
      (see Note 9). The Company believes that PIP Management Inc., which has been
      designated as the advisor to the Series I holders (see Note 9), is also
      affiliated with Pinnacle Investment Partners, LP.





**NOTE
      11 - SUBSEQUENT EVENTS**





On
      January 12, 2006, the Company issued an aggregate of 11,500,000 shares of its
      common stock as follows:




•  2,000,000
      shares to the Company’s CEO;


•  2,000,000
      shares to the Company’s Chief Financial Officer;


•
2,000,000
        shares to an employee, who is the son of the Company’s CEO and has a majority
        interest in the other 50% venturer of STS (see Note 1 and
        10);
 •
2,000,000
          shares to a member of the Company’s Board of Directors;
 •
2,000,000
            shares to an entity which employs another son of the Company’s CEO (see Note
            10), and;
 •
500,000
              shares each to three former members of the Company’s Board of
              Directors.




The
        Shares, with a value aggregating $92,000 were issued in recognition of
        contributions made to the Company in recent periods.
  NOTE
        12 - DERIVATIVE INSTRUMENTS AND
        RESTATEMENT
  In
        accordance with SFAS No. 133 and EITF 00-19,
        in August 2006, the Company determined that certain warrants to purchase
        the Company's common stock should be separately accounted for as
        liabilities.  The Company had not classified those derivative liabilities
        as such in its previously issued financial statements.  In order to reflect
        these changes, the Company restated its financial statements for the years
        ended
        September 30, 2005 and 2004, and the quarterly periods therein, to record
        the
        fair value of these warrants on the Company's balance sheet as a liability
        and
        record changes in the values of these derivatives in the Company's consolidated
        statements of operations as "Gain (loss) on change in fair value of
        warrants".
  The
        aggregate balance sheet amount shown for the warrant
        liability increased from $5,265,989 at September 30, 2004 to $5,550,637 at
        December 31, 2004 and decreased from $2,135 at September 30, 2005 to $-0-
        at
        December 31, 2005, resulting in a loss on change in fair value of
        warrants of $284,648 in the consolidated statement of operations for the
        three months ended December 31, 2004 and a gain of $2,135 for the three months
        ended December 31, 2005.  This resulted in total liabilities being
        understated by $2,135 at September 30, 2005.


**15**


**Item
      2 -**  **MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**


**AND
      RESULTS OF OPERATIONS**





This
      Form
      10-Q contains “forward-looking statements” within the meaning of Section 27A of
      the Securities Act of 1933, as amended and Section 21E of the Securities
      Exchange Act of 1934, as amended. These statements relate to future economic
      performance, plans and objectives of management for future operations and
      projections of revenue and other financial items that are based on the beliefs
      of our management, as well as assumptions made by, and information currently
      available to, our management. The words “expect”, “estimate”, “anticipate”,
“believe”, “intend”, and similar expressions are intended to identify
      forward-looking statements. Such statements involve assumptions, uncertainties
      and risks. If one or more of these risks or uncertainties materialize or
      underlying assumptions prove incorrect, actual outcomes may vary materially
      from
      those anticipated, estimated or expected. Among the key factors that may have
      a
      direct bearing on our expected operating results, performance or financial
      condition are economic conditions facing the staffing industry generally;
      uncertainties related to the job market and our ability to attract qualified
      candidates; uncertainties associated with our brief operating history; our
      ability to raise additional capital; our ability to achieve and manage growth;
      our ability to attract and retain qualified personnel; our ability to develop
      new services; our ability to enhance and expand existing offices; our ability
      to
      open new offices; general economic conditions; and other factors discussed
      from
      time to time in our filings with the Securities and Exchange Commission. These
      factors are not intended to represent a complete list of all risks and
      uncertainties inherent in our business. The following discussion and analysis
      should be read in conjunction with the Condensed Consolidated Financial
      Statements and notes appearing elsewhere in this report.





Our
      critical accounting policies and estimates are described in our Annual Report
      on
      Form 10-K for the fiscal year ended September 30, 2005.





**Introduction**





Through
      December 2005, we provided a wide range of staffing services and productivity
      consulting services associated with such staffing services nationally through
      a
      network of offices located throughout the United States. Regardless of the
      type
      of temporary service offering we provided, we recognized revenues based on
      hours
      worked by assigned personnel. Generally, we billed our customers a
      pre-negotiated, fixed rate per hour for the hours worked by our temporary
      employees. Therefore, we did not separate our various service offerings into
      separate offering segments. We did not routinely provide discrete financial
      information about any particular service offering. We also did not conduct
      any
      regular reviews of, nor make decisions about, allocating any particular
      resources to a particular service offering to assess its performance. As set
      forth below, certain of our service offerings targeted specific markets, but
      we
      did not necessarily conduct separate marketing campaigns for such services.
      Pursuant to the Outsourcing Agreement that was in place with ALS, ALS was
      responsible for paying wages, workers’ compensation, unemployment compensation
      insurance, Medicare and Social Security taxes and other general payroll related
      expenses for all of the temporary employees we placed, and we were billed for
      such expenses plus a fee by ALS. These expenses are included in the cost of
      revenue. Because we paid our temporary employees only for the hours they
      actually worked, wages for our temporary personnel were a variable cost that
      increased or decreased in proportion to revenues. Gross profit margin varied
      depending on the type of services offered. In some instances, temporary
      employees placed by us may have decided to accept an offer of permanent
      employment from the customer and thereby “convert” the temporary position to a
      permanent position. Fees received from such conversions were included in our
      revenues. Selling, general and administrative expenses include payroll for
      management and administrative employees, office occupancy costs, sales and
      marketing expenses and other general and administrative costs.





In
      December 2005, we completed a series of asset sale transactions pursuant to
      which we sold our staffing operations. As a result of such sales, we no longer
      actively conduct any staffing services business, other than IT staffing
      solutions services conducted through our 50% owned joint venture, STS. As a
      result of these asset sale transactions, we expect that our revenues in fiscal
      2006 will be substantially less than revenues achieved in fiscal 2005. During
      fiscal 2006, we plan to expand the IT staffing solutions business we conduct
      through STS; however, we can give no assurance that such efforts will be
      successful.


**16**


**Results
      of Operations**


**Discontinued
      Operations/Acquisition on Disposition of Assets**





In
      December 2005, we completed the following series of transactions pursuant to
      which we sold substantially all of our assets used to conduct our staffing
      services business, other than the IT staffing solutions business that is
      conducted through our 50% owned joint venture, Stratus Technology Services,
      LLC:





(a)
            On
                December 2, 2005, we completed the sale, effective as of November
                21,
                2005, of substantially all of the tangible and intangible assets,
                excluding accounts receivable, of several of our offices located
                in the
                Western half of the United States (the “ALS Purchased Assets”) to ALS, LLC
                (“ALS”). The offices sold were the following: Chino, California; Colton,
                California; Los Angeles, California; Los Nietos, California; Ontario,
                California; Santa Fe Springs, California and the Phoenix, Arizona
                branches
                and the Dallas Morning News Account (the “Western Offices”). Pursuant to
                the terms of an Asset Purchase Agreement between us and ALS dated
                December
                2, 2005 (the “ALS Asset Purchase Agreement”), the purchase price for the
                ALS Purchased Assets is payable as
                follows:





•
            $250,000
                is payable over the 60 days following December 2, 2005, for our documented
                cash flow requirements, all of which is payable at a rte no faster
                than
                $125,000 per 30 days;





•
            $1,000,000
                payable by ALS will be paid directly to certain taxing authorities
                to
                reduce our tax obligations; and





•
            $3,537,000
                which was paid by means of the cancellation of all net indebtedness
                owed
                by us to ALS outstanding as of the close of business on December
                2,
                2005.





In
                addition to the foregoing amounts, ALS also assumed our obligation
                to pay
                $798,626 due under a certain promissory note issued by us to Provisional
                Employment Solutions, Inc. As a result of the sale of the ALS Purchased
                Assets to ALS, all sums due and owing to ALS by Stratus were deemed
                paid
                in full and no further obligations
                remain.





In
      connection with the transaction, we entered into Non-Compete and
      Non-Solicitation Agreements with ALS pursuant to which we agreed not to compete
      with ALS with the customers of and in the geographic area of the Western
      Offices, and ALS agreed not to compete with us with respect to certain customers
      and accounts, including, accounts serviced by our remaining offices, for a
      period of two years.




(b)
            On
                December 5, 2005, we completed the sale, effective as of November
                28, 2005
                (the “AI Effective Date”), of substantially all of the tangible and
                intangible assets, excluding accounts receivable and other certain
                items,
                as described below, of three of our California offices (the “AI Purchased
                Assets”) to Accountabilities, Inc. (“AI”) The offices sold were the
                following: Culver City, California; Lawndale, California and Orange,
                California (the “Other California Offices”). Pursuant to the terms of an
                Asset Purchase Agreement between the Company and AI dated December
                5, 2005
                (the “AI Asset Purchase Agreement”), AI has agreed to pay to us an earnout
                amount equal to two percent of the sales of the Other California
                Offices
                for the first twelve month period after the AI Effective Date; one
                percent
                of the sales of the Other California Offices for the second twelve
                month
                period after the AI Effective Date; and one percent of the sales
                of the
                Other California Offices for the third twelve month period from the
                AI
                Effective Date. In addition, a Demand Subordinated Promissory Note
                between
                us and AI dated September 15, 2005 which had an outstanding principal
                balance of $125,000 at the time of closing was deemed paid and marked
                canceled.




Certain
      assets held by the Other California Offices were excluded from the sale,
      including cash and cash equivalents, accounts receivable, and our rights to
      receive payments from any source.




In
      connection with the AI transaction, we entered into Non-Compete and
      Non-Solicitation Agreements with AI pursuant to which we agreed not to compete
      with AI with the customers of and in the geographic area of the Other California
      Offices, and AI agreed not to compete with us with respect to certain customers
      and accounts, including, accounts serviced by our remaining offices, for a
      period of three years.




(c)
            On
                December 7, 2005, we completed the sale, effective as of November
                28, 2005
                (the “SOP Effective Date”), of substantially all of the tangible and
                intangible assets, excluding accounts receivable and other assets
                as
                described below, of several of our Northeastern offices (the “SOP
                Purchased Assets”) to Source One Personnel, Inc. (“SOP”). The offices sold
                were the following: Cherry Hill, New Jersey; New Brunswick, New Jersey;
                Mount Royal/Paulsboro, New Jersey (soon to be Woodbury Heights, New
                Jersey); Pennsauken, New Jersey; Norristown, Pennsylvania; Fairless
                Hills,
                Pennsylvania; New Castle Delaware and the former Freehold, New Jersey
                profit




**17**


center
                (the “NJ/PA/DE Offices”). The assets of Deer Park, New York, Leominster,
                Massachusetts, Lowell, Massachusetts and Athol, Massachusetts (the
“Earn
                Out Offices”) were also purchased (collectively the “NJ/PA/DE Offices” and
                the “Earn Out Offices” shall be referred to as the “Purchased Offices”).
                In addition to the foregoing, the SOP Purchased Assets also included
                substantially all of the tangible and intangible assets, excluding
                accounts receivable and other assets as described below, used by
                us in the
                operation of our business at certain facilities of certain customers
                including the following: the Setco facility in Cranbury New Jersey,
                the
                Record facility in Hackensack, New Jersey, the UPS-MI (formerly RMX)
                facility in Long Island, New York, the UPS-MI (formerly RMX) facility
                in
                the State of Connecticut, the UPS-MI (formerly RMX) facility in the
                State
                of Ohio, the APX facility in Clifton, New Jersey (the “Earn Out On-Site
                Business”) and the Burlington Coat Factory in Burlington, New Jersey, the
                Burlington Coat Factory facility in Edgewater Park, New Jersey and
                the
                UPS-MI (formerly RMX) facility in Paulsboro, New Jersey (the foregoing
                business and the “Earn-Out On-Site Businesses” shall be referred to herein
                collectively as the “On-Site Businesses”). Pursuant to the SOP Asset
                Purchase Agreement between us and SOP dated December 7, 2005 (the
“SOP
                Asset Purchase Agreement”), the purchase price for the SOP Purchased
                Assets was payable as follows (the “SOP Purchase
                Price”):




·
            An
                aggregate of $974,031 of indebtedness owed by us to SOP (i) under
                certain
                promissory notes previously issued by us to SOP and (ii) in connection
                with a put right previously exercised by SOP with respect to 400,000
                shares of our common stock was
                cancelled.




·
            SOP
                is required to make the following earn out payments to us during
                the three
                year period commencing on the SOP Effective Date (the “Earn Out
                Period”):




·
            Two
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the initial twelve months of
                the Earn
                Out Period.




·
            One
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the second twelve months of the
                Earn
                Out Period.




·
            One
                percent of sales (excluding taxes on sales) from the Earn Out Offices
                and
                the Earn Out On-Site Businesses for the third twelve months of the
                Earn
                Out Period.




Certain
      assets held by the Purchased Offices were excluded from the sale, including
      cash
      and cash equivalents, accounts receivable, our rights to receive payments from
      any source.




In
      connection with the SOP transaction, we entered into Non-Compete and
      Non-Solicitation Agreements with SOP pursuant to which we agreed not to compete
      with SOP with respect to the business acquired from us by SOP for a period
      of
      two years.




(d)
            On
                December 7, 2005 (the “Closing Date”), we completed the sale of
                substantially all of the tangible and intangible assets, excluding
                cash
                and cash equivalents, of two of our California branch offices (the
“TES
                Purchased Assets”) to Tri-State Employment Service, Inc. (“TES”). The
                offices sold were the following: Bellflower, California and West
                Covina,
                California (the “California Branch Offices”). Pursuant to the terms of an
                Asset Purchase Agreement between the Registrant and TES dated December
                7,
                2005 (the “TES Asset Purchase Agreement”), TES has agreed to pay to us as
                follows:




·
            two
                percent of sales of the California Branch Offices to existing clients
                for
                the first twelve month period after the Closing
                Date;




·
            one
                percent of sales of the California Branch Offices to existing clients
                for
                the second twelve month period after the Closing Date; and




·
            one
                percent of sales of the California Branch Offices to existing clients
                for
                the third twelve month period after the Closing Date.




For
      purposes of calculating the amount owed by TES to us, in no event shall the
      aggregate annual sales to such clients exceed $25,000,000. In addition, on
      or
      before April 15, 2006, TES will be required to prepare a reconciliation
      reflecting collections from accounts receivable including in the TES Purchased
      Assets. To the extent collections from such accounts receivable are less than
      invoice sales, TES is entitled to offset against future payments to us an amount
      equal to two percent of the amount of such shortfall. If after April 15, 2006
      TES




**18**


collects
      any amounts reflected on its reconciliation as being uncollected, TES will
      remit
      to us two percent of such additional collections.




On
      the
      Closing Date, TES made a payment of $1,972,521 to our lender and acquired the
      lender’s rights to certain of our accounts receivable that collateralize our
      obligation to the lender. As a result of this transaction, our obligations
      to
      the lender were reduced by $1,972,521. We are required to reimburse TES by
      April
      15, 2006 for certain costs and fees, including interest, incurred by TES in
      connection with its transaction with the Lender. The Company does not anticipate
      that such costs will be significant.




In
      connection with the TES transaction, we entered into Non-Compete and
      Non-Solicitation Agreements pursuant to which we agreed not to compete with
      TES
      with the customers of and in the geographic area of the California Branch
      Offices, and TES agreed not to compete with Stratus with respect to certain
      customers and accounts, including, accounts serviced by Stratus’ remaining
      offices, for a period of three years.




The
      foregoing transactions resulted in a $3,156,443 net gain on sale of discontinued
      operations which is summarized as follows:




Sold
                to:ALS
            
            $
            4,340,459AI
            
            
            (297,347
            )SOP
            
            
            (331,265
            )TES
            
            
            (495,315
            )3,216,442Other
                costs of sales
            
            
            (60,000
            )Gain
                on sale of discontinued operations
            
            $
            3,156,442





The
      above
      gain includes earnout payments of $73,861.




**Continuing
      Operations**


**Three
      Months Ended December 31, 2005 Compared to Three Months Ended December 31,
      2004**





***Revenues.*** Revenues
      increased 10.9% to $1,233,858 for the three months ended December 31, 2005
      from
      $1,112,846 for the three months ended December 31, 2004. This increase was
      primarily a result of an increase in permanent placements.





***Gross
      Profit.*** Gross
      profit increased 26.2% to $412,602 for the three months ended December 31,
      2005
      from $326,962 for the three months ended December 31, 2004, primarily as a
      result of increased revenues. Gross profit as a percentage of revenues increased
      to 33.4% for the three months ended December 31, 2005 from 29.4% for the three
      months ended December 31, 2004. This increase was a result of increased
      permanent placements.





***Selling,
      General and Administrative Expenses.*** ** Selling,
      general and administrative expenses (“SG&A”) increased 14.9% to $1,246,033
      for the three months ended December 31, 2005 from $1,084,810 for the three
      months ended December 31, 2004. Selling, general and administrative expenses
      as
      a percentage of revenues increased to 101.0% for the three months ended December
      31, 2005 from 97.5% for the three months ended December 31, 2004. SG&A in
      the three months ended December 31, 2005, includes $350,000 of fees charged
      to
      us by our Lender in connection with the Forbearance Agreement, the Amended
      Forbearance Agreement and the various extensions thereof (see Note 6 to the
      Condensed Consolidated Financial Statements).





As
      a
      result of the asset sales transactions completed in December 2005, the Company
      began reducing its corporate overhead structure to be more in line with the
      remaining revenues. These reductions expect to be substantially completed in
      February 2006 and we anticipate reducing quarterly SG&A by approximately
      $600,000.





***Interest
      Expense.*** Interest
      expense increased 40.2% to $299,351 for the three months ended December 31,
      2005
      from ** $207,795
      for the three months ended December 31, 2004. Interest expense in the three
      months ended December 31, 2005, includes $100,000 of the principal amount of
      the
      Convertible Note issued in exchange for our Series I Preferred Stock that was
      attributable to the settlement of our obligation to pay certain advisory fees
      and dividend payments under the terms of the Series I Preferred Stock. (see
      Note
      9 to the Condensed Consolidated Financial Statements).





***Loss
      on Change in Fair Value of Warrants**.*  We recognized a
      non-cash gain (loss) as a result of the increase in the fair value of certain
      warrants accounted for as a derivative liability of $2,135 and ($284,648) in
      the
      three months ended December 31, 2005 and 2004, respectively.




***Net
      Loss Attributable to Common Stockholders.*** ** As
      a
      result of the foregoing, we had a net loss attributable to common stockholders
      of $1,199,456, for the three months ended December 31, 2005 compared to a net
      loss attributable to common stockholders of $1,306,396 for the three months
      ended December 31, 2004.


**19**


**Liquidity
      and Capital Resources**





At
      December 31, 2005, we had limited liquid resources. Current liabilities were
      $12,168,008 and current assets were $5,312,281. The difference of $6,855,727
      is
      a working capital deficit, which is primarily the result of losses incurred
      during the last four years. This condition raises substantial doubts about
      our
      ability to continue as a going concern. The financial statements do not include
      any adjustments to reflect the possible future effect on the recoverability
      and
      classification of assets or the amounts and classification of liabilities that
      may result from the outcome of this uncertainty.





Our
      continuation of existence is dependent upon our ability to generate sufficient
      cash flow to meet our continuing obligations on a timely basis, to fund the
      operating and capital needs, and to obtain additional financing as may be
      necessary.





We
      have
      taken steps to revise and reduce our operating requirements, which we believe
      will be sufficient to assure continued operations and implementation of our
      plans. The steps include closing branches that are not profitable, reductions
      in
      staffing, and other selling, general and administrative expenses, and most
      significantly, the asset sales transactions that were completed in December
      2005. We continue to pursue other sources of equity or long-term debt
      financings. We also continue to negotiate payments plans and other
      accommodations with our creditors. We believe that the collection of receivables
      that we retained after completion of the asset sale transactions and earnout
      payments to which we are entitled in connection with the Asset Sales will
      provide us with sufficient cash flow to support our operations in the next
      twelve months.





Net
      cash
      provided by (used in) operating activities was $5,904,780 and $(74,097) in
      the
      three months ended December 30, 2005 and 2004, respectively.





Net
      cash
      provided by (used in) investing activities was $84,884 and $(67,462) in the
      three months ended December 31, 2005 and 2004, respectively. Net cash received
      in connection with the sale of discontinued operations was $98,861, including
      earnout payments of $73,861, in the three months ended December 31, 2005. Cash
      used for capital expenditures was $13,977 and $74,131 in the three months ended
      December 31, 2005 and 2004, respectively.





Net
      cash
      used in financing activities was $6,019,077 and $591,962 in the three months
      ended December 31, 2005 and 2004, respectively. We had net repayments of
      $5,989,095 and $1,082,210 under our line of credit in the three months ended
      December 31, 2005 and 2004, respectively. Net short-term borrowings (repayments)
      were $(4,002) and $341,212 in the three months ended December 31, 2005 and
      2004,
      respectively. Net short-term borrowings in the three months ended December
      31,
      2004, includes $400,000 loaned to us by our Chief Executive Officer. Payments
      of
      notes payable - acquisitions was $11,269 and $275,418 in the three months ended
      December 31, 2005 and 2004, respectively.





Our
      principal uses of cash through December 2005 were to fund temporary employee
      payroll expense and employer related payroll taxes, investment in capital
      equipment, start-up expenses of new offices, expansion of services offered,
      workers’ compensation, general liability and other insurance coverages, debt
      service and costs relating to other transactions such as acquisitions. Temporary
      employees were paid weekly, as were payments under our payroll outsourcing
      agreements with related parties (see Note 10 to the Condensed Consolidated
      Financial Statements).





Through
      December 2005, we had a loan and security agreement (the “Loan Agreement”) with
      Capital Temp Funds, Inc. (the “Lender”) which provided for a line of credit up
      to 85% of eligible accounts receivable, as defined, not to exceed $12,000,000.
      Until April 10, 2003, advances under the Loan Agreement bore interest at a
      rate
      of prime plus -3/4%. The Loan Agreement restricted our ability to incur other
      indebtedness, pay dividends and repurchase stock. Effective April 10, 2003,
      we
      entered into a modification of the Loan Agreement which provided that borrowings
      under the Loan Agreement would bear interest at 3% above the prime rate.
      Borrowings under the Loan Agreement are collateralized by substantially all
      of
      our assets. As of September 30, 2005, $8,931,689 was outstanding under the
      credit agreement.





During
      the year ended September 30, 2005, we were in violation of the following
      covenants under the Loan Agreement:





(i)
            Failing
                to meet the tangible net worth requirement;(ii)
            Our
                common stock being delisted from the Nasdaq SmallCap Market;
                and(iii)
            Our
                having delinquent state, local and federal
                taxes





**20**


We
      had
      received a waiver from the lender on all of the above violations.





On
      January 15, 2005, we entered into a Forbearance Agreement (the “Forbearance
      Agreement”) pursuant to which the Lender agreed to forebear from accelerating
      obligations and/or enforcing existing defaults. The Forbearance Agreement
      amended the Loan Agreement to reduce the maximum credit line to $12,000,000,
      which, after March 1, 2005 was further reduced by $250,000 per
      month.




On
      August
      11, 2005, we entered into an Amended and Restated Forbearance Agreement (the
      “Amended Forbearance Agreement”) whereby the Lender had again agreed to forbear
      from accelerating obligations and/or enforcing existing defaults until the
      earlier to occur of (a) August 26, 2005 or (b) the date of any Forbearance
      Default, as defined (the “Forbearance Period”).




The
      Amended Forbearance Agreement provided that during the Forbearance Period,
      the
      maximum credit line would be $10,500,000.




Between
      August 25, 2005 and December 21, 2005, the Lender granted us a series of
      extensions of the Amended Forbearance Agreement. An extension granted in
      November 2005 was conditioned upon, among other things, our entry into a binding
      agreement providing for a sale to ALS of the assets of our offices in Southern
      California, the Phoenix region and its Dallas Morning News account. We entered
      into such an agreement with ALS on November 3, 2005. As a condition to obtaining
      an extension granted in December 2005, we were required to represent that we
      had
      closed the sale of assets to ALS and to acknowledge and agree that any loans
      and
      advances made by the Lender during the extension period would be the last
      requested advances under the Loan Agreement. The final extension of the Amended
      Forbearance Agreement expired on December 21, 2005. At such time, $2,431,808
      of
      indebtedness remained outstanding under the Loan Agreement. As of January 31,
      2006, we had repaid all of the indebtedness.




The
      Lender charged us $412,500 of fees in connection with the Forbearance Agreement,
      the Amended Forbearance Agreement and the various extensions thereof during
      the
      fiscal year ended September 30, 2005 and $350,000 during the three months ended
      December 31, 2005.




In
      connection with us and the Lender entering into the Amended Forbearance
      Agreement, we, the Lender and ALS also entered into the ALS Forbearance, whereby
      ALS agreed to forbear, through August 25, 2005, from enforcing payment defaults
      under our Outsourcing Agreement with ALS subject to certain conditions. All
      of
      our obligations under our Outsourcing Agreement with ALS were satisfied in
      connection with the sale of assets to ALS which occurred in December
      2005.




In
      January 2006, STS entered into a Factoring and Security Agreement (the
“Factoring Agreement”) with Action Capital Corporation (“Action”) which provides
      for the sale of up to $1,500,000 of accounts receivable of STS to Action. Action
      will reserve and withhold in a reserve account, an amount equal to 10% of the
      face amount of accounts receivable purchased under the Factoring Agreement.
      Action has full recourse against STS, including the right to charge-back or
      sell
      back any accounts receivable if not paid within 90 days of the date of purchase.
      The Factoring Agreement provides for interest at an annual rate of prime plus
      1%
      plus a monthly fee of .6% on the daily average of unpaid balances.




SOP
      had
      the right to require us to repurchase 100,000 shares of our common stock at
      a
      price of $8.00 per share at any time after July 27, 2003 and before the later
      of
      July 27, 2005 and the full payment of the outstanding note that we issued to
      it
      in connection with the acquisition transaction completed with SOP in July 2001.
      SOP exercised this right on July 29, 2003. During the year ended September
      30,
      2004, we paid $150,000 against this liability, which is reflected as “put
      options liability” on the condensed consolidated balance sheet. Our remaining
      repurchase obligation was cancelled in connection with the closing of the asset
      sale transaction that we completed with SOP in December 2005.




During
      fiscal 2003, we were notified by both the New Jersey Department of Labor and
      the
      California Employment Development Department (the “EDD”) that, if certain
      payroll delinquencies were not cured, judgment would be entered against us.
      As
      of December 30, 2005, there was still an aggregate of $4.3 million in delinquent
      payroll taxes outstanding, including interest and penalties, which are included
      in “Payroll taxes payable” on the balance sheet as of December 31, 2005.
      Judgment has not been entered against us in California. While judgment has
      been
      entered against us in New Jersey, no actions have been taken to enforce same.
      On
      January 7, 2005, we entered into a payment plan agreement with the EDD, which
      requires us to pay $12,500 per week to the EDD. The $12,500 weekly payment
      is
      subject to increase for a three month period following any quarter in which
      our
      reported income exceeds $200,000, based upon a percentage related to the amount
      of increase above $200,000.




In
      January 2006 we entered into an agreement with the holder of all of the
      outstanding shares of our Series I Preferred Stock pursuant to which we issued
      to the holder, effective as of December 28, 2005, a secured convertible
      promissory note


**21**


in
      the
      aggregate principal amount of $2,356,750 in exchange for all of such shares
      of
      Series I Preferred Stock. See Note 9 to the Condensed Consolidated Financial
      Statements.





As
      of
      December 31, 2005, there were no off-balance sheet arrangements, unconsolidated
      subsidiaries, commitments or guarantees of other parties, except as disclosed
      in
      the notes to financial statements. Stockholders’ (deficiency) at that date was
      $(7,989,489).





We
      engaged in various transactions with related parties during the three months
      ended December 31, 2004 including the following:





•
            We
                paid $28,000 to an entity which employs Jeffrey J. Raymond, the son
                of
                Joseph J. Raymond, our Chairman, President and Chief Executive Officer,
                for consulting services. This amount was included in selling, general
                and
                administrative expense. The services provided included the identification
                of acquisition candidates, acquisition advisory services, due diligence,
                post-acquisition transition services, customer relations, accounts
                receivable collection and strategic planning advice.•
            Joseph
                J. Raymond, Jr., the son of Joseph J. Raymond, our Chairman, President
                and
                Chief Executive Officer, is a 50% member in ALS, LLC, which is the
                holding
                company for Advantage. We were a party to an Outsourcing Agreement
                with
                ALS and pursuant to which ALS provided payroll outsourcing services
                for
                all our in-house staff, except for our corporate employees, and customer
                staffing requirements. As a result of this arrangement, all of our
                field
                personnel were employed by ALS until December 2005. We paid agreed
                upon
                pay rates, plus burden (payroll taxes and workers’ compensation insurance)
                plus a fee ranging between 2% and 3% (0% - 1 1⁄2% effective June 10, 2005)
                of pay rates to ALS. The total amount charged by ALS under this agreement
                was $17,226,000 in the three months ended December 31, 2005.•
            At
                December 31, 2005, we owed: $15,000 under a short term loan made
                to us by
                Joseph J. Raymond, our President and Chief Executive Officer; $41,000
                under a demand note bearing interest at 10% per annum to a corporation
                owned by the son of Joseph J. Raymond; $10,123 to a trust formed
                for the
                benefit of a family member of a former member of our Board of Directors
                under a promissory note bearing interest at 12% per annum which became
                due
                in full in August 2005 and $41,598 to a former member of our Board
                of
                Directors under a promissory note bearing interest at 12% per annum
                which
                becomes due in full in May 2006.•
            Accounts
                payable and accrued expenses - related parties in the attached condensed
                consolidated balance sheets at December 31 and September 30, 2005,
                represents amounts due to ALS and Advantage.•
            The
                nephew of our Chairman, President and CEO is affiliated with Pinnacle
                Investment Partners, LP, which held 21,163 shares of our Series I
                Preferred Stock as of September 30, 2005. The Company also believes
                that
                PIP Management, Inc., which was designated as the advisor to the
                Series I
                holders, is also affiliated with Pinnacle Investment Partners,
                LP.•
            In
                December 2005, we sold substantially all of the assets, excluding
                accounts
                receivable, of certain other offices located in California and Arizona
                to
                ALS. See “Management’s Discussion and Analysis of Financial Condition and
                Results of Operations-Discontinued Operations/Acquisition or Disposition
                of Assets” and Note 5 to the Condensed Consolidated Financial
                Statements.•
            In
                December 2005, we sold substantially all of the assets, excluding
                accounts
                receivable and certain other items of three of our California offices
                to
                AI. The son of Joseph J. Raymond, our Chairman, President and Chief
                Executive Officer, is employed by an entity which serves as a consultant
                to Accountabilities, Inc. See “Management’s Discussion and Analysis of
                Financial Condition and Results of Operations/Acquisition or Disposition
                of Assets” and Note 5 to the Condensed Consolidated Financial
                Statements.








**22**


**Contractual
      Obligations**





Our
      aggregate contractual obligations are as follows:





**Payments
                Due by Fiscal Period (in Thousands)****2007
                -**
            
            
            **2009
                -****Total**
            
            
            **2006**
            
            
            **2008**
            
            
            **2010**
            
            
            **Thereafter**Contractual
                Obligations:Long-term
                debt obligations
            
            $
            3,200
            
            $
            2,182
            
            $
            751
            
            $
            267
            
            $
            -Operating
                lease obligations
            
            
            383
            
            
            244
            
            
            139
            
            
            -
            
            
            -Series
                A redemption payable
            
            
            300
            
            
            300
            
            
            -
            
            
            -
            
            
            -Earnout
                liability
            
            
            86
            
            
            86
            
            
            -
            
            
            -
            
            
            -Payroll
                tax liability (c)
            
            
            989
            
            
            650
            
            
            337
            
            
            -
            
            
            -TOTAL
            
            $
            4,956
            
            $
            3,462
            
            $
            1,227
            
            $
            267
            
            $
            -





(a)
            Exclusive
                of interest and penalties. Payments may be accelerated based upon
                future
                operating result benchmarks.





**Seasonality**





Our
      business follows the seasonal trends of our customer’s business. Historically,
      we have experienced lower revenues in the first calendar quarter with revenues
      accelerating during the second and third calendar quarters and then starting
      to
      slow again during the fourth calendar quarter.





**Impact
      of Inflation**





We
      believe that since our inception, inflation has not had a significant impact
      on
      our results of operations.





**Sensitive
      Accounting Estimates**





The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the amounts reported in the financial statements and notes. Significant
      estimates include management’s estimate of the carrying value of accounts
      receivable, the impairment of goodwill and the establishment of valuation
      reserves offsetting deferred tax assets. Actual results could differ from those
      estimates. The Company’s critical accounting policies relating to these items
      are described in the Company’s Annual Report on Form 10-K for the year ended
      September 30, 2005. As of December 31, 2005, there have been no material changes
      to any of the critical accounting policies contained therein.





**Item
                3.**
            **QUANTITATIVE
                AND QUALITATIVE DISCLOSURE ABOUT MARKET
                RISKS**





During
      fiscal 2005, we were subject to the risk of fluctuating interest rates in the
      ordinary course of business for borrowings under our Loan and Security
      Agreement, as modified by the Forbearance Agreement with Capital Tempfunds,
      Inc.
      This credit agreement provided for a line of credit up to 85% of eligible
      accounts receivable, not to exceed $12,000,000. Advances under this credit
      agreement bore interest at a rate of prime plus 3%. The line or credit was
      terminated in December 2005 and no additional borrowings are permitted under
      the
      line of credit. In January 2006, STS entered into a Factoring Agreement, which
      provides for the sale of up to $1,500,000 of accounts receivable to Action.
      STS
      is charged interest at an annual rate of prime plus 1%, plus a monthly
      management fee of .6% on the daily average of unpaid balances. As a result,
      we
      continue to be subject to the risk of fluctuating interest rates.





We
      believe that our business operations are not exposed to market risk relating
      to
      foreign currency exchange risk or commodity price risk.





**Item
                4.**
            **CONTROLS
                AND PROCEDURES**





**23**


In
      March
      2006, the Securities and Exchange Commission requested that we amend our Annual
      Report on Form 10-K for the fiscal year ended September 30, 2005 to remove
      the
      audit report issued by Amper Politziner & Mattia, P.C., our predecessor
      auditor, on our financial statements as of and for the years ended September
      30,
      2004 and 2003, inasmuch as we had not obtained permission from the predecessor
      auditor to include such report in the filing as contemplated by Public Company
      Accounting Oversight Board Statements of Auditing Standards Section 508. 
Our Chief Executive Officer and Chief Financial Officer have concluded that
      the
      inclusion of the predecessor auditor report in our Form 10-K for the fiscal
      year
      ended September 30, 2005 represents a material weakness in our review of
      applicable financial reporting regulatory requirements when preparing our
      financial statements.  A "material weakness" is a reportable condition in
      which the design or operation of one or more of the specific control components
      has a defect or defects that could have a material adverse effect on our ability
      to record, process, summarize and report financial data in the financial
      statements in a timely manner.  We are addressing the weakness in our
      review of the application of applicable financial reporting regulatory
      requirements by improving the training of our personnel and researching,
      identifying, analyzing, documenting and reviewing applicable regulatory
      requirements.




In
      connection with its audit of, and in the issuance of its report on our financial
      statements for the year ended September 30, 2004, Amper Politziner & Mattia,
      P.C. delivered a letter to the Audit Committee of our Board of Directors and
      our
      management that identified three items that it considered to be material
      weaknesses in the effectiveness of our internal controls pursuant to standards
      established by the American Institute of Certified Public Accountants. 
Those material weaknesses arose due to (1) limited resources and manpower in
      the
      finance department; (2) inadequacy of the financial review process; and (3)
      inadequate documentation of certain financial procedures.  While we believe
      that we have adequate policies, we agreed with our independent auditors that
      our
      implementation of those policies should be improved.  As a result, although
      we were unable to expand the number of personnel in the accounting function
      due
      to financial contstraints, we did provide additional training to existing staff
      which allowed us to increase redundancies in our system and improve our
      segregation of duties.




In
      addition in August 2006, we identified deficiencies in our internal controls
      and
      disclosure controls related to the accounting for certain warrants, primarily
      with respect to accounting for derivative liabilities in accordance with EITF
      00-19 and SFAS 133.  We restated our consolidated financial statements for
      the years ended September 30, 2004 and 2005, in order to correct the accounting
      in such financial statements with respect to derivative liabilities in
      accordance with EITF 00-19 and SFAS 133.  Since July 2006, we have
      undertaken improvements to our internal controls in an effort to remediate
      those
      deficiencies by training our accounting staff to understand and implement the
      requirements of EITF 00-19 and SFAS 133.




Notwithstanding
      the material weaknesses and deficiencies described above, our management,
      including our Chief Executive Officer and Chief Financial Officer believes
      that
      the consolidated financial statements, as restated, included in the 2005 Form
      10-K/A and this report on Form 10-Q fairly present in all material respects
      our
      financial condition, results of operations and cash flows for the periods
      presented.




Our
      management, including the Chief Executive Officer and Chief Financial Officer
      does not expect that our disclosure controls and procedures or our internal
      control over financial reporting will prevent all error and all fraud.  A
      control system, no matter how well designed and operated, can provide only
      reasonable, not absolute, assurance that the objectives of the control system
      are met.  Because of the inherent limitations in all control systems, no
      evaluation of controls can provide absolute assurance that all control issues
      and instances of fraud, if any, within the company have been
      detected.




There
      were no significant changes in our internal controls during the quarter
      ended December 31, 2005 that have materially affected, or are reasonably
      likely to have materially affected, our internal controls subsequent to the
      date
      we carried out our evaluation.


**24**





**Part
                II**
            **Other
                Information****Item
                1.**
            **Legal
                Proceedings**





We
      are
      involved, from time to time, in routine litigation arising in the ordinary
      course of business. We do not believe that any currently pending litigation
      will
      have a material adverse effect on our financial position or results of
      operations.





**Item
                1A.**
            **Risk
                Factors**





There
      have been no material changes with respect to the risk factors disclosed in
      our
      Report on Form 10-K for the fiscal year ended September 30, 2005.





**Item
                2.**
            **Unregistered
                Sales of Equity Securities and Use of
                Proceeds**





Information
      with respect to the issuance of the Convertible Note in exchange for all of
      our
      outstanding shares of Series I Preferred Stock which was deemed effective as
      of
      December 28, 2005 was presented in our Report on Form 8-K filed with the
      Securities and Exchange Commission on January 18, 2006.





**Item
                3.**
            **Defaults
                Upon Senior Securities**





Dividends
      on our Series F Preferred Stock accrue at a rate of 7% per annum, payable
      monthly. As of the date of the filing of this report, $110,000 is in arrears
      on
      the Series F Preferred Stock.





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





There
      were no matters submitted to a vote of our security holders during the three
      months ended December 31, 2005.





**Item
                5.**
            **Other
                Information**





Not
      applicable.


**25**





**Item
                6**
            **Exhibits**





**Number**
            **Description**31.1
            Certification
                of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley
                Act
                of 200231.2
            Certification
                of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley
                Act
                of 200232.1
            Certification
                of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley
                Act
                of 200232.2
            Certification
                of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley
                Act
                of 2002





**26**


**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





**STRATUS
              SERVICES GROUP, INC.**Date: August
              15, 2006
            By:
            /s/ Joseph
              J.
              RaymondChairman
                of the
                Board of Directors,
              President
                and
                Chief Executive Officer


Date: August
              15, 2006
            By:
            /s/ Michael
              A. MaltzmanVice
                President and Chief Financial Officer
              Principal Financial and Accounting
                Officer




27