**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB/A**

(Amendment No.1)

 

**(Mark One)**

 
| **ý** | ** ** | **QUARTERLY REPORT UNDER SECTION 13  OR 15(D) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|------------|------------|---------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended: June 30, 2005**

 

**OR**

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

 

**For the transition periodfrom                            to                            **

 

**Commission File Number 000-50758**

 

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**VISTULA COMMUNICATIONS SERVICES, INC.**

(Exactname of Small Business Issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **20-0734966**                     |
|------------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |
|                                                             |       |                               |
| **Suite 801,  405 Park Avenue**                             |
| **New York,  New York 10022**                                    |
| (Address of principal executive offices and zip code)            |
| ** **                                                       | ** ** | ** **                         |
| **40  Portman Square, 4th Floor**                                |
| **London  W1H 6LT**                                              |
| **United  Kingdom**                                              |
| (Former  address of principal executive offices and zip code)    |
| ** **                                                       | ** ** | ** **                         |
| **(212)  317-8900**                                              |
| (Issuer’s telephone number, including area code)            |

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.     Yes   ý     No   o

 

As of August 5, 2005,there were 25,797,738 shares of common stock, $0.001 par value, of theregistrant issued and outstanding.

 

Transitional Small BusinessDisclosure Format (Check one):     Yes   o     No   ý

 

 

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**VISTULA COMMUNICATIONS SERVICES, INC.**

 

**FORM 10-QSB**

 

**FOR THE THREE MONTHS ENDED JUNE 30, 2005**

 

Facing Page

 

Table of Contents

 
| PART I.  | FINANCIAL  INFORMATION(*):                                                                                                      |                                                                                        |   |
|---------------|---------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                            |
|          | Item 1.                                                                                                                         | Financial  Statements                                                                       |   |
|          |                                                                                                                            |
|          | Consolidated Balance Sheets as of June 30, 2005 (unaudited) and December 31,  2004                                    |                                                                                        |
|          |                                                                                                                            |
|          | Consolidated Statements of Operations for the Three and Six Months  ended June 30, 2005 and June 30, 2004 (unaudited) |                                                                                        |
|          |                                                                                                                            |
|          | Consolidated Statements of Stockholders’ Deficit for the Six Months  ended June 30, 2005 (unaudited)                  |                                                                                        |
|          |                                                                                                                            |
|          | Consolidated Statements of Cash Flows for the Six Months ended June 30,  2005 and June 30, 2004 (unaudited)           |                                                                                        |
|          |                                                                                                                            |
|          | Notes to Consolidated Financial Statements                                                                                      |                                                                                        |
|          |                                                                                                                            |
|          | Item 2.                                                                                                                         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|          |                                                                                                                            |
|          | Item 3.                                                                                                                         | Controls and  Procedures                                                                    |   |
|          |                                                                                                                            |
| PART II. | OTHER  INFORMATION                                                                                                              |                                                                                        |   |
|          |                                                                                                                            |
|          | Item 6.                                                                                                                         | Exhibits                                                                                    |   |
|          |                                                                                                                            |
| SIGNATURES    |                                                                                                                            |                                                                                        |   |
|               |                                                                                                                                 |                                                                                             |        |  |  |  |

 

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(*)                                 All of thefinancial statements contained in this Quarterly Report are unaudited with theexception of the financial information as of December 31, 2004, which hasbeen derived from our audited financial statements as of that date and shouldbe read in conjunction therewith. Our audited financial statements as of December 31,2004 and for the year then ended, and the notes thereto, can be found in ourAnnual Report on Form 10-KSB (File No. 000-50758), which was filedwith the Securities and Exchange Commission on March 31, 2005.

 

2

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**PART I.  FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

***VISTULA COMMUNICATIONS SERVICES, INC.***

ConsolidatedBalance Sheets as of June 30, 2005 and

December 31,2004

 
| ** **                                                                                                                                                                                  | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current  assets:                                                                                                                                                                            | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and  cash equivalents                                                                                                                                                                  |       | $                       | 1,442,902  |                        | $          | 3,221 |   |
| Accounts  receivable (net of reserves of $2,611 and $0 at June 30, 2005 and December 31,  2004, respectively)                                                                     |       | 82,635                  |       | 55,991                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                  |       | 769,592                 |       | 228,870                     |       |
| Total  current assets                                                                                                                                                                       |       | 2,295,129               |       | 288,082                     |       |
|                                                                                                                                                                                        |       |                    |       |                        |       |
| Property and  equipment, net                                                                                                                                                                |       | 2,100,454               |       | 1,997,621                   |       |
| Deferred  financing costs                                                                                                                                                                   |       | 1,007,167               |       | —                      |       |
| Other assets                                                                                                                                                                                |       | 60,068                  |       | —                      |       |
|                                                                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                                                                        |       | $                       | 5,462,818  |                        | $          | 2,285,703 |   |
|                                                                                                                                                                                        |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                             |       |                    |       |                        |       |
| Current  liabilities:                                                                                                                                                                       |       |                    |       |                        |       |
| Accounts  payable                                                                                                                                                                           |       | $                       | 370,479    |                        | $          | 537,660 |   |
| Accrued  expenses                                                                                                                                                                           |       | 313,491                 |       | 1,044,343                   |       |
| Due to  stockholder                                                                                                                                                                         |       | —                  |       | 801,630                     |       |
| Convertible  promissory note to related party                                                                                                                                               |       | 175,000                 |       | 175,000                     |       |
| Note payable                                                                                                                                                                                |       | 970,000                 |       | —                      |       |
| Total  current liabilities                                                                                                                                                                  |       | 1,828,970               |       | 2,558,633                   |       |
| Capital  lease obligation                                                                                                                                                                   |       | —                  |       | 1,971,167                   |       |
| Convertible  debentures                                                                                                                                                                     |       | 6,969,418               |       | —                      |       |
| Total  liabilities                                                                                                                                                                          |       | 8,798,388               |       | 4,529,800                   |       |
| Stockholders’  deficit:                                                                                                                                                                |       |                    |       |                        |       |
| Common  stock, $0.001 par value, 100,000,000 shares authorized, 25,179,406 and  24,454,406 shares issued and outstanding as of June 30, 2005 and December 31,  2004, respectively |       | 25,179                  |       | 24,454                      |       |
| Additional  paid-in capital                                                                                                                                                                 |       | 4,743,487               |       | 2,608,581                   |       |
| Deferred  compensation                                                                                                                                                                      |       | (2,000                  | )          | (399,000                    | )          |
| Accumulated  deficit                                                                                                                                                                        |       | (7,997,719              | )          | (4,394,997                  | )          |
| Accumulated  other comprehensive loss                                                                                                                                                       |       | (104,517                | )          | (83,135                     | )          |
|                                                                                                                                                                                        |       |                    |       |                        |       |
| Total  stockholders’ deficit                                                                                                                                                           |       | (3,335,570              | )          | (2,244,097                  | )          |
|                                                                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                                                                        |       | $                       | 5,462,818  |                        | $          | 2,285,703 |   |

 

See accompanying notes tounaudited consolidated financial statements.

 

3

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***VISTULA COMMUNICATIONS SERVICES, INC.***

ConsolidatedStatements of Operations for the

Threeand Six Months ended June 30, 2005 and 2004

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(unaudited)**                       | ** ** | **(unaudited)**                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| Net revenues                                           |       | $                                     | 230,130    |                                | $          | 829,382 |   | $ | 352,327 |   | $ | 1,816,008 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Cost of  revenues                                      |       | 244,946                               |       | 692,179                             |       | 499,433 |   | 1,612,962 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Gross margin                                           |       | (14,816                               | )          | 137,203                             |       | (147,106 | ) | 203,046 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Selling,  general and administrative expenses          |       | 1,889,957                             |       | 1,129,203                           |       | 3,037,855 |   | 1,573,717 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Loss from  operations                                  |       | (1,904,773                            | )          | (992,000                            | )          | (3,184,961 | ) | (1,370,671 | ) |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Interest  expense, net                                 |       | (287,030                              | )          | (28,833                             | )          | (417,761 | ) | (57,656 | ) |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                               |       | $                                     | (2,191,803 | )                                   | $          | (1,020,833 | ) | $ | (3,602,722 | ) | $ | (1,428,327 | ) |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average  basic and diluted shares outstanding |       | 25,179,406                            |       | 24,173,471                          |       | 24,887,003 |   | 24,029,236 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Basic and  diluted net loss per common share           |       | $                                     | (0.09      | )                                   | $          | (0.04 | ) | $ | (0.14 | ) | $ | (0.06 | ) |

 

**See accompanying notes to unaudited consolidatedfinancial statements.**

 

4

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***VISTULA COMMUNICATIONS SERVICES, INC.***

ConsolidatedStatements of Stockholders’ Deficit for the

SixMonths ended June 30, 2005

**(unaudited)**

 
| ** **                                           | ** ** | ** ** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total  Stockholders’  Deficit** | ** ** | **Comprehensive  Loss** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------------------------------|------------|----------------------------|------------|--------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | ** ** |
| **Common Stock**                                     |
| **Shares**                                           | ** ** | **Amount** |
| Balance, December 31, 2004                      |       | 24,454,406 |       | $                                | 24,454     |                       | $          | 2,608,581                |       | $                                           | (399,000   | )                                      | $          | (4,394,997              | )          | $ | (83,135 | ) | $ | (2,244,097 | ) |   |   |
| Issuance of common stock                             |       | 725,000    |       | 725                              |       | 324,149                    |       |                     |       |                                        |       |                                   |       | 324,874                 |       |   |   |
| Amortization of deferred stock compensation          |       |       |       |                             |       |                       |       | 397,000                  |       |                                        |       |                                   |       | 397,000                 |       |   |   |
| Issuance of warrants and convertible debentures      |       |       |       |                             |       | 1,780,844                  |       |                     |       |                                        |       |                                   |       | 1,780,844               |       |   |   |
| Issuance of warrant pursuant to consulting agreement |       |       |       |                             |       | 29,913                     |       |                     |       |                                        |       |                                   |       | 29,913                  |       |   |   |
| Net loss                                             |       |       |       |                             |       |                       |       |                     |       | (3,602,722                                  | )          |                                   |       | (3,602,722              | )          | $ | (3,602,722 | ) |
| Change in cumulative translation adjustment          |       |       |       |                             |       |                       |       |                     |       |                                        |       | (21,382                                | )          | (21,382                 | )          | (21,382 | ) |
| Balance, June 30, 2005                          |       | 25,179,406 |       | $                                | 25,179     |                       | $          | 4,743,487                |       | $                                           | (2,000     | )                                      | $          | (7,997,719              | )          | $ | (104,517 | ) | $ | (3,335,570 | ) | $ | (3,624,104 | ) |

 

See accompanying notes to unauditedconsolidated financial statements.

 

5

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***VISTULA COMMUNICATIONS SERVICES, INC.***

ConsolidatedStatements of Cash Flows for the

SixMonths ended June 30, 2005 and 2004

 
| ** **                                                                                                | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                                                                                                | ** ** | **(unaudited)**                    | ** ** | **(unaudited)** | ** ** |
| Cash flows  from operating activities:                                                                    |       |                               |       |   |   |
| Net loss                                                                                                  |       | $                                  | (3,602,722 | ) | $ | (1,428,327 | ) |
| Adjustments  to reconcile net loss to net cash provided by (used in) operating activities:                |       |                               |       |   |   |
| Depreciation                                                                                              |       | 27,970                             |       | 20,570 |   |
| Payment of  Company expenses by stockholders recorded as a capital contribution                           |       | —                             |       | 155,405 |   |
| Non cash  compensation expense                                                                            |       | 397,000                            |       | 394,000 |   |
| Non cash  interest expense                                                                                |       | 320,012                            |       | 57,666 |   |
| Services  paid for by issuance of common stock                                                            |       | $                                  | —     |   | $ | 188,733 |   |
| Issuance of  warrant pursuant to consulting agreement                                                     |       | 29,913                             |       | — |   |
| Loss on  property and equipment                                                                           |       | —                             |       | 43,300 |   |
| Contribution  of services by stockholder                                                                  |       | —                             |       | 55,000 |   |
| Changes in  assets and liabilities:                                                                       |       |                               |       |   |   |
| (Increase)  decrease in:                                                                                  |       |                               |       |   |   |
| Accounts  receivable                                                                                      |       | (26,644                            | )          | (351,698 | ) |
| Prepaid  expenses and other current assets                                                                |       | (600,790                           | )          | 4,617 |   |
| Increase  (decrease) in:                                                                                  |       |                               |       |   |   |
| Accounts  payable                                                                                         |       | (167,182                           | )          | 145,776 |   |
| Accrued  expenses                                                                                         |       | (736,935                           | )          | 769,603 |   |
| Net cash  provided by (used in) operating activities                                                      |       | (4,359,378                         | )          | 54,645 |   |
|                                                                                                      |       |                               |       |   |   |
| Cash flows  from investing activities:                                                                    |       |                               |       |   |   |
| Purchases of  property and equipment                                                                      |       | (339,765                           | )          | (68,458 | ) |
| Net cash  used in investing activities                                                                    |       | (339,765                           | )          | (68,458 | ) |
|                                                                                                      |       |                               |       |   |   |
| Cash flows  from financing activities:                                                                    |       |                               |       |   |   |
| Payments on  due to stockholder                                                                           |       | (801,630                           | )          | (26,061 | ) |
| Payment of  capital lease obligation                                                                      |       | (500,000                           | )          | — |   |
|                                                                                                      |       |                               |       |   |   |
| Proceeds  from issuance of common stock                                                                   |       | —                             |       | 5,000 |   |
| Proceeds  from issuance of convertible debentures and warrants, net of deferred  financing costs          |       | 7,452,874                          |       | — |   |
| Net cash  provided by (used in) financing activities                                                      |       | 6,151,244                          |       | (21,061 | ) |
|                                                                                                      |       |                               |       |   |   |
| Effect of  exchange rates on cash                                                                         |       | (12,420                            | )          | 928 |   |
|                                                                                                      |       |                               |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                     |       | 1,439,681                          |       | (33,946 | ) |
| Cash and  cash equivalents, beginning of period                                                           |       | 3,221                              |       | 88,644 |   |
|                                                                                                      |       |                               |       |   |   |
| Cash and  cash equivalents, end of period                                                                 |       | $                                  | 1,442,902  |   | $ | 54,698 |   |
|                                                                                                      |       |                               |       |   |   |
| **Supplemental  disclosure of cash flow information:**                                                    |       |                               |       |   |   |
|                                                                                                      |       |                               |       |   |   |
| Cash paid  for interest                                                                                   |       | $                                  | 251,418    |   | $ | — |   |
|                                                                                                      |       |                               |       |   |   |
| Cash paid  for taxes                                                                                      |       | $                                  | —     |   | $ | — |   |
|                                                                                                      |       |                               |       |   |   |
| **Supplemental  disclosure of non cash financing activities:**                                            |       |                               |       |   |   |
|                                                                                                      |       |                               |       |   |   |
| Equipment  acquired pursuant to capital lease obligation                                                  |       | $                                  | —     |   | $ | 1,855,835 |   |
| Issuance of  common stock pursuant to capital lease obligation                                            |       | $                                  | 324,874    |   | $ | — |   |
|                                                                                                      |       |                               |       |   |   |
| Issuance of  note payable pursuant to capital lease obligation                                            |       | $                                  | 970,000    |   | $ | — |   |
|                                                                                                      |       |                               |       |   |   |
| Issuance of  common stock warrants in connection with convertible debenture financing                     |       | $                                  | 184,844    |   | $ | — |   |
| Reduction in  fixed assets and related indebtedness pursuant to modification of asset  purchase agreement |       | $                                  | 200,000    |   | $ | — |   |

 

See accompanying notes tounaudited consolidated financial statements.

 

6

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**VISTULA COMMUNICATIONSSERVICES, INC.**

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**June 30,2005**

 

**(1)****                                ****Basis of Presentation**

 

The accompanying unaudited consolidated financialstatements of Vistula Communications Services, Inc. (“Vistula” or the “Company”)have been prepared in accordance with accounting principles generally acceptedin the United States (GAAP) for interim financial information and with theinstructions to Form 10-QSB and Item 310 of Regulation S-B.Accordingly, they do not include all of the information and footnotes requiredby GAAP for complete financial statements. In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary forthe fair presentation of the results for the interim periods have beenincluded. The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying notes. Interim resultsare not necessarily indicative of results to be expected for the entire fiscalyear ending December 31, 2005. These unaudited financial statements shouldbe read in conjunction with the audited financial statements and related notesthereto included in the Company’s audited annual financial statements for thefiscal year ended December 31, 2004. Those audited financial statementsare included in the Company’s Annual Report on Form 10-KSB, which wasfiled with the Securities and Exchange Commission (SEC) on March 31, 2005.

 

TheCompany uses the United States dollar as its reporting currency. The Britishpound is the functional currency of its wholly-owned subsidiary, Vistula Limited.  The South African rand is the functionalcurrency of its 60% owned subsidiary, Vistula Communications Services SA (Pty)Ltd.  Assets and liabilities of theCompany’s international operations are translated into U.S. dollars at exchangerates that are in effect on the balance sheet date and equity accounts aretranslated at historical exchange rates. Income and expense items are translated at average exchange rates whichare in effect during the year.  Translationadjustments are accumulated in other comprehensive loss as a separate componentof stockholders’ deficit in the consolidated balance sheet. Transaction gains(losses) were immaterial for the three and six month periods ended June 30,2005 and 2004.

 

Inthe event that the Company is not successful in implementing its business plan,and does not otherwise raise third-party capital, the Company will have tocurtail certain expenditures, seek additional financing from its principalstockholder, or both in order to sustain operations.  The principalstockholder has historically provided working capital advances, and has causedthe lender to issue letters of credit in favor of certain vendors. While thestockholder is not obligated to provide these working capital advances to theCompany or to cause the lender to issue standby letters of credit in favor ofits vendors, the Company expects that the stockholder will continue to providefunds for operations in 2005 as and if needed, until such time that the Company’soperations are self-sustaining or the Company raises additional externalcapital, as the case may be.  The Company has not generated revenues fromthe acquired equipment described in Note 10 to the financial statements,although the Company expects to commence revenue activity from this equipmentduring the third quarter of 2005.  Cash flow has therefore been negativelyimpacted and, if the Company is unable to raise additional financing during thethird quarter of 2005, it will look to this stockholder to provide workingcapital funding until additional capital can be obtained.

 

**(2)****                                ****Stock-Based Compensation**

 

Statement of Financial Accounting Standard (SFAS) No. 123,*Accounting for Stock-Based Compensation*requiresthe measurement of the fair value of stock options and warrants to be includedin the statement of operations or disclosed in the notes to financialstatements.  The Company accounts forstock-based compensation for employees under Accounting Principles Board (APB)Opinion No. 25, *Accounting for StockIssued to Employees,*and follows the disclosure-only alternative underSFAS No. 123, as amended by Statement of Financial Accounting Standard(SFAS) No. 148,*Accounting forStock-Based Compensation—Transition and Disclosure*.

 

Commonstock options granted have been valued using the Black-Scholes option pricingmodel prescribed by SFAS No. 123. There were no stock options granted toemployees during the six months ended June 30, 2005. The weighted averageassumptions used for stock options granted during 2004 are as follows:

 
| Risk-free  interest rate |   | 3.55    | %      |
|--------------------------|--------|---------|--------|
| Expected  dividend yield |   | 0       |   |
| Expected  lives          |   | 5 years |   |
| Expected  volatility     |   | 80      | %      |

 

7

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The following tableillustrates the effect on net loss and loss per share if the fair value-basedmethod had been applied to all outstanding and unvested awards for each of thethree and six month periods ended June 30, 2005 and 2004, respectively:

 
| ** **                                                                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                          |       |                                 |       |                               |       |   |   |   |   |
| Net loss as  reported                                                         |       | $                                    | (2,191,803 | )                                  | $          | (1,020,833 | ) | $ | (3,602,722 | ) | $ | (1,428,327 | ) |
| Stock  compensation expense included in net loss                              |       | 198,500                              |       | 354,000                            |       | 397,000 |   | 354,000 |   |
| Stock  compensation expense determined using fair value method for all awards |       | (241,458                             | )          | (437,626                           | )          | (482,916 | ) | (437,626 | ) |
| Pro forma  net loss                                                           |       | $                                    | (2,234,761 | )                                  | $          | (1,104,459 | ) | $ | (3,688,638 | ) | $ | (1,511,953 | ) |
|                                                                          |       |                                 |       |                               |       |   |   |   |   |
| Loss per  share (basic and diluted) as reported                               |       | $                                    | (0.09      | )                                  | $          | (0.04 | ) | $ | (0.14 | ) | $ | (0.06 | ) |
| Pro forma  loss per share (basic and diluted)                                 |       | $                                    | (0.09      | )                                  | $          | (0.05 | ) | $ | (0.15 | ) | $ | (0.06 | ) |

 

In accordance with Emerging Issues Task Force (EITF)No. 96-18,*Accounting for EquityInstruments that are Issued to Other than Employees for Acquiring, or inConnection with Selling, Goods or Services*, the Company recordscompensation expense equal to the fair value of the options granted tonon-employees over the vesting period, which is generally the period ofservice.  The Company remeasures the fairvalue of non-employee awards at each reporting date, as set forth in EITF No. 96-18.  In March 2005 the Company issued awarrant to purchase 100,000 shares of common stock pursuant to a consultingagreement.  The warrant was valued at$29,913 using the Black-Scholes option pricing model and charged to selling,general and administrative expense for the three month period ended March 31,2005.

 

On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) (“SFASNo. 123R”), *Share-Based Payment*, which is arevision of SFAS No. 123, *Accounting for Stock-BasedCompensation*. SFAS No 123R supersedes APB No. 25 and amendsSFAS No. 95, *Statement of Cash Flows*.Generally, the approach in SFAS No. 123R is similar to the approachdescribed in SFAS No. 123. However, SFAS No. 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the statement of operations based on their fair values atthe date of grant. Pro forma disclosure is no longer an alternative. SFAS No. 123Rmust be adopted in fiscal periods beginning after December 15, 2005. Earlyadoption will be permitted in periods in which financial statements have notyet been issued. The Company expects to adopt SFAS No. 123R on January 1,2006.

 

SFAS No. 123R permits public companiesto adopt its requirements using one of two methods. A “modified prospective”method in which compensation cost is recognized beginning with the effectivedate (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123 for all awards granted to employees prior tothe effective date of SFAS No. 123R that remain unvested on the effectivedate. A “modified retrospective” method which includes the requirements of themodified prospective method described above, but also permits entities torestate based on the amounts previously recognized under SFAS No. 123 forpurposes of pro forma disclosures either (a) all prior periods presentedor (b) prior interim periods of the year of adoption. The Company has yetto determine which method to use in adopting SFAS No. 123R.

 

As permitted by SFAS No. 123, theCompany currently accounts for share-based payments to employees using APB No. 25’sintrinsic value method. Accordingly, the adoption of SFAS No. 123R’s fairvalue method may have a significant impact on the Company’s results ofoperations, although it will have no impact on the Company’s overall financialposition. The impact of adoption of SFAS No. 123R cannot be predicted atthis time because it will depend on the levels of share-based payments grantedin the future. However, had the Company adopted SFAS No. 123R in priorperiods, the impact of that standard would have approximated the impact of SFASNo. 123 as described in the disclosure of pro forma net loss and net lossper share in Note 2 to the Company’s financial statements. The Company iscurrently evaluating the impact of the adoption of SFAS No. 123R on itsfinancial position and results of operations, including the valuation methodsand support for the assumptions that underlie the valuation of the awards.

 

**(3)****                                ****Income Taxes**

 

The Company accounts for income taxes in accordancewith Statement of Financial Accounting Standard (SFAS) No. 109, *Accounting for Income Taxes*. Under SFAS No. 109,deferred tax assets or liabilities are computed based on the difference betweenthe financial statements and income tax basis of assets and liabilities, andnet operating loss carryforwards, using the enacted tax rates. Deferred incometax expense or benefit is based on changes in the asset or liability fromperiod to period.  The Company did notrecord a provision for federal, state or foreign income taxes for the three orsix month periods ended June 30, 2005 and 2004 because the Company hasexperienced losses since inception. The Company has not recorded a benefit fordeferred tax assets as their realizability is uncertain.

 

8

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**(4)****                                ****Balance Sheet Detail**

 

Prepaid expenses and other current assets at June 30,2005 and December 31, 2004 consisted of the following:

 
| ** **                | ** ** | **June 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|---------------------------|------------|-------------------------|------------|-------------------------------|------------|
|                      |       |                    |       |                          |       |
| Call  termination charges |       | $                       | 303,590    |                          | $          | 28,756 |   |
| Royalties                 |       | 150,000                 |       | 150,000                       |       |
| Maintenance  agreement    |       | 109,575                 |       | —                        |       |
| Insurance                 |       | 94,236                  |       | —                        |       |
| Co-location               |       | 34,815                  |       | —                        |       |
| Salaries                  |       | 20,000                  |       | —                        |       |
| Equipment  and rent       |       | 18,198                  |       | 41,707                        |       |
| Non-trade  receivables    |       | 15,710                  |       | —                        |       |
| Other                     |       | 23,468                  |       | 8,407                         |       |
| Total                     |       | $                       | 769,592    |                          | $          | 228,870 |   |

 

Other assets at June 30, 2005 and December 31,2004 consisted of the following:

 
| ** **                | ** ** | **June 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|---------------------------|------------|-------------------------|------------|-------------------------------|------------|
| Equipment  rent           |       | $                       | 30,963     |                          | $          | — |   |
| Call  termination charges |       | 22,177                  |       | —                        |       |
| Other                     |       | 6,928                   |       | —                        |       |
| Total                     |       | $                       | 60,068     |                          | $          | — |   |

 

Deferred financing costs at June 30, 2005 wereincurred in connection with the Company’s issuance of convertible debentures andwarrants as described in Note 14, which costs are being amortized over the lifeof the convertible debentures.

 

Accrued expenses at June 30, 2005 and December 31,2004 consisted of the following:

 
| ** **                   | ** ** | **June 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|------------------------------|------------|-------------------------|------------|-------------------------------|------------|
|                         |       |                    |       |                          |       |
| Payroll and  payroll-related |       | $                       | 125,305    |                          | $          | 167,500 |   |
| Professional  fees           |       | 118,054                 |       | 573,323                       |       |
| Travel                       |       | 29,102                  |       | 107,767                       |       |
| Accrued  termination costs   |       | 17,952                  |       | —                        |       |
| Directors’  fees        |       | 7,950                   |       | 59,346                        |       |
| Printing                     |       | —                  |       | 50,764                        |       |
| VAT payable                  |       | —                  |       | 47,024                        |       |
| Rent                         |       | —                  |       | 25,848                        |       |
| Other                        |       | 15,128                  |       | 12,771                        |       |
|                         |       | $                       | 313,491    |                          | $          | 1,044,343 |   |

 

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**(5)****                                ****Comprehensive Loss**

 

For the three and six month periods ended June 30,2005 and 2004, the components of other comprehensive loss consisted of theCompany’s net loss and foreign currency translation adjustments.  Comprehensive loss was $2,225,807 and$1,046,021 for the three months ended June 30, 2005 and 2004,respectively, and $3,624,104 and $1,500,601, for the six months ended June 30,2005 and 2004, respectively.

 

**(6)****                                ****Net Loss Per Share**

 

Basic net loss per share is computed by dividing netloss for the period by the weighted average number of common shares outstandingduring the period.  Diluted net loss pershare is computed by dividing net loss by the weighted average number of commonshares outstanding during the period plus the dilutive effect of outstandingstock options.  As there was a net lossfor the three and six month periods ended June 30, 2005, 3,025,000outstanding stock options, 9,302,500 outstanding warrants, and11,200,000 common shares issuable upon exercise of the conversion feature ofthe convertible debentures wereexcluded from the calculation of diluted earnings per share for the three and sixmonth periods ended June 30, 2005, respectively, because they wereanti-dilutive. In 2004, 2,825,000 outstanding stock options were excludedfrom the calculation of diluted earnings per share for the six month periodended June 30, 2004, respectively, because they were anti-dilutive.

 

**(7)****                                ****Stock Incentive Plan**

 

In February 2004, the board of directorsadopted the 2004 Stock Incentive Plan (the “Plan”). The Plan initially covered6,000,000 shares of the Company’s common stock issuable upon exercise of incentivestock options and non-statutory stock options and in connection with grants ofrestricted stock. The Plan was amended by the Board, subject to shareholderapproval, on June 3, 2005 to, among other things, increase the number ofshares available for options or restricted stock grants from 6,000,000 to8,000,000.  The shareholders of theCompany approved the amendment to the Plan, and therefore it became effectiveon July 14, 2005.  The Board has theauthority to select the employees, officers, directors, consultants andadvisors to whom options are granted and determine the terms of each option,including (i) the number of shares of common stock subject to the option, (ii) whenthe option becomes exercisable, (iii) the option exercise price, whichmust be at least 100% (110% in the case of incentive stock options granted to astockholder owning in excess of 10% of the Company’s common stock) of the fairmarket value of the common stock as of the date of grant and (iv) theduration of the option, which may be up to 10 years or provided that incentivestock options issued to a stockholder owning in excess of 10% of the Company’scommon stock, may not have a term of more than five years.

 

Options for a total of 4,825,000 shares have beengranted under the Plan. OnJune 30, 2004 two employees terminated their employment with theCompany.  As a result, 1,500,000 options were forfeited.  Pursuant toan employment agreement, another employee has a contractual right to the grantof these options. The Company has treated these 1,500,000 options asoutstanding at June 30, 2005 for the purposes of calculating stockcompensation expense.  On October 19, 2004,the Company granted 2,000,000 options to purchase common stock to its thennewly-appointed chief executive officer. The options have an exercise price of$.10 per share and were fully vested upon grant.  In February 2005 this officer resignedand agreed to relinquish 1,800,000 options in exchange for a right to exerciseall or any part of the remaining 200,000 options for a period of 12 months fromtermination.  As a result, as of June 30,2005, there were outstanding under the plan options to purchase an aggregate3,025,000 shares of common stock.

 

The Company has reflected pre-tax charges toearnings in the three and six month periods ended June 30, 2005 of$198,500 and $397,000, respectively, for the compensation value of the optionsgranted.  At June 30, 2005, anadditional $2,000 of deferred compensation remains on the accompanying balancesheet that will be amortized during the third quarter of 2005 as the underlyingstock option vests.

 

**(8)****                                ****Employment Agreements**

 

In January 2004, the Company entered intoemployment and non-competition agreements with three key individuals.  The agreements were amended and restated in May 2004.  These agreements have initial terms thatbegin on January 1, 2004 and end between March 2005 and June 2005and may be renewed for successive annual terms if both the Company and theemployee agree in writing.  Theagreements provide for annual salaries totaling $300,000, as well as bonusestotaling $285,000 if certain Company performance goals are achieved as definedin the agreement.  As of June 30,2005 no bonuses have been accrued as such goals have not been met.  If the Company elects to terminate theemployees without cause, the employees are entitled to receive severancepayments equal to six months of their salaries. Two of the employees resigned as of June 30, 2004.  The remaining individual is continuing hisemployment with the Company as an employee-at-will.

 

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**(9)****                                ****Related Party Transactions**

 

Contributed Services

 

Duringthe year ended December 31, 2004 certain stockholders contributed servicesto the Company. Pursuant to Staff Accounting Bulletin Topic 5T (SAB.T.5T), theCompany recorded compensation of $27,500 and $55,000 for the three and six monthperiods ended June 30, 2004, respectively, with corresponding creditsrecorded in additional paid-in capital. There were no contributed services during the three or six month periodsended June 30, 2005.

 

Expenses Paid By Stockholder

 

During2004, the Chairman paid certain legal, accounting and operating expenses onbehalf of the Company.  Pursuant toSAB.T.5T, expenses not expected to be repaid of approximately $52,000 and$155,000 were recorded as expense and charged to additional paid-in capital forthe three and six month periods ended June 30, 2004, respectively.  The Chairman did not pay any Company expenseduring the three and six month periods ended June 30, 2005.

 

**(10)****                         ****Asset Purchase**

 

In January 2004, theCompany signed an agreement to purchase certain equipment from another entityin exchange for $2,000,000, less any fees, costs and expenses incurred by theCompany to re-certify or re-license such assets by June 30, 2004. Theagreement was amended on May 5, 2004. As a result of the amendment, thepurchase price for the equipment was $1,670,000 and 725,000 shares of commonstock having a value of approximately $325,000. On March 15, 2005, theagreement was further amended, at which time the Company completed the purchaseof this equipment.  In consideration forthe equipment purchased, the Company paid $500,000 in March 2005, issued725,000 shares of common stock, and issued a promissory note for the balancedue of $1,170,000.  The note wassubsequently adjusted to reduce the principal amount to $970,000, reflective ofunanticipated recertification costs, which reduced the basis of the underlying equipment.  The promissory note bears interest at 8.25%per annum and is payable monthly in arrears. Principal payments of $100,000 are due on September 30, 2005 and December 31,2005, with the balance of the principal ($770,000) due on March 15, 2006.

 

ThroughMarch 15, 2005, the Company accounted for the agreement as a capital leasein accordance with Statement of Financial Accounting Standard (SFAS) No. 13*Accounting for Leases*and reflected the liability as a capitallease obligation. As of March 15, 2005, the obligation has been includedin the consolidated balance sheet under the caption “Note Payable.”

 

The Company originally recorded the present value ofthe minimum lease payments as an asset of $1,855,835.  The future minimum lease payments related tothe capital lease were $2,000,000, which included $144,165 related tointerest.  The Company recorded $28,333related to the interest expense on the capital lease for the three months endedJune 30, 2004, and $23,707 and $56,666 related to interest expense for thesix month periods ended June 30, 2005 and 2004, respectively.  The equipment was not placed in service as ofJune 30, 2005.

 

The Company has deemed the May 5, 2004amendment described above to be a modification of the lease pursuant to SFAS No. 13.  As of May 5, 2004, the balance of theasset and associated capital lease obligation was adjusted by an amount equalto the difference between the present value of the future minimum leasepayments under the modified agreement and the present balance of theobligation, with no resulting gain or loss recognized.  Under certain circumstances, the cash portionof the obligation was convertible into the Company’s common stock, at thelessor’s option.  The Company accountedfor the conversion feature associated with the capital lease obligationincluded in the May 2004 amendment pursuant to EITF Issue No. 98-5, *Accounting for Convertible Securities with BeneficialConversion Features or Contingently Adjustable Conversion Ratios*,whereby the Company measured the beneficial conversion feature on the amendmentdate, but did not record any charge until the contingencies were resolved.  Upon completion of the purchase in March 2005,the conversion feature expired, therefore no charge was recorded.  The promissory note does not include aconversion feature.

 

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**(11)****                         ****Commitments andContingencies**

 

From its inception through the closings ofthe convertible debenture financing described in Note 14, the Company sustainedits operations through funding provided by the Chairman, as well as contributedservices by the Chairman and other stockholders. The Chairman has made advancesto the Company from a $3,000,000 credit facility established in the name of theChairman, as well as from other of the Chairman’s personal assets. The creditfacility was established by the Chairman in February of 2003 and was firstdrawn upon by the Chairman in May of 2003. Borrowings are payable by theChairman upon demand.  Interest accruesat the bank’s base rate plus 2% for the first $300,000 of borrowings and at thebank’s base rate plus 5% on all additional borrowings.  Under the credit facility, the lender mayissue standby letters of credit for the benefit of third parties at the requestof the Chairman. The obligations of the Chairman under the credit facility aresecured by certain property in which the Chairman has a beneficial interest. Asof June 30, 2005, the Chairman has drawn approximately $262,000 under thisfacility to pay expenses incurred and accrued by the Company and itsaffiliates. Seven letters of credit in the aggregate amount of $1,195,000 havebeen issued by the lender under the credit facility of which $477,000 have beenissued in favor of vendors to the Company and its affiliates at the request ofthe Chairman. As of June 30, 2005, approximately $436,000 was undrawn andavailable under the credit facility and $2,564,000 was outstanding. The Companymay obtain future advances from the Chairman from both the credit facility andthe Chairman’s other personal assets in order to meet certain working capitalneeds. The Chairman may also cause the lender under the credit facility toissue standby letters of credit in favor of one or more of the Company’svendors to secure the Company’s obligations to such vendor or vendors. Whilethe Chairman is not obligated to provide these advances to the Company or tocause the lender to issue standby letters of credit in favor of the Company’svendors, the Company expects the Chairman to continue providing funds foroperations in 2005 as and if needed. If the Company is unable to raiseadditional external capital, the Company may become dependent on the Chairmanto fund its operations and provide growth capital.  There can be no assurances that the Companycan raise such capital on acceptable terms, if at all.

 

The credit facility is guaranteed by theCompany’s wholly owned subsidiary, Vistula Limited. The lender under the creditfacility requested that Vistula Limited provide the guarantee as a condition toproviding the facility since it was anticipated that a portion of the drawingsunder the facility would be advanced to, or used to pay expenses of, VistulaLimited. Vistula Limited shall be required to perform its obligations under theguarantee in the event that the Chairman fails to pay to the lender any amountspayable under the credit facility when due. The maximum amount of futurepayments the guarantor could be required to make under the guarantee is$3,000,000, plus interest, fees, costs and expenses payable to the lender underthe credit facility. The guarantee shall continue in effect until all of theobligations and liabilities of the Chairman under the credit facility have beenpaid or satisfied in full. The Company has no recourse provisions that wouldenable it to recover monies from third parties with respect to amounts it isrequired to pay under the guarantee. The Company does not have any collateralit could obtain to recover amounts paid under the guarantee. The Company hasevaluated the fair value of the guarantee in accordance with FinancialAccounting Standards Board Interpretation No. 45 (FIN 45) and determinedthe value to be immaterial to the financial statements and, as a result, noliability has been recorded.

 

Shortly after the first closing of the privateplacement described in Note 14, the Company received a letter on behalf ofKevin Dann & Partners, LLC (“KDP”), a placement agent the Company hadretained prior to the engagement of IndiGo Securities, LLC as placement agent,demanding a placement fee of $227,000. The letter also included a claim that KDP would be entitled toadditional fees in the event of future closings.  In the Company’s response to this letter, theCompany denied any such liability to KDP.On June 5, 2005 the Company entered into a Settlement Agreementwith KDP under which the Company paid $25,000 to KDP upon signing of theSettlement Agreement and agreed to pay $25,000 on December 9, 2005 inexchange for a full release of all claims against the Company.

 

**(12)****                          Indemnification**

 

As permitted under Delaware law, theCompany has agreements with its directors whereby it indemnifies them forcertain events or occurrences while the director is, or was serving, at theCompany’s request as a director (or in any other capacity). The term of the indemnificationperiod is for the director’s lifetime. The maximum potential amount of futurepayments the Company could be required to make under these indemnificationagreements is unlimited; however, the Company has a director and

 

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officer insurance policy pursuant to which the Companymay recover all or a portion of amounts it pays to directors under theirindemnification agreements. As a result of its insurance policy coverage, theCompany believes the estimated fair value of these indemnification agreementsis minimal.

 

The Company enters into standardindemnification agreements in the ordinary course of its business. Pursuant tothese agreements, the Company indemnifies, holds harmless, and agrees to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally distributors, agents, or customers, in connection with any patent,copyright, trademark, trade secret or other intellectual property infringementclaim by any third party with respect to the Company’s products. The term ofthese indemnification agreements is generally perpetual. The maximum potentialamount of future payments the Company could be required to make under theseindemnification agreements is often capped at a dollar figure. In addition, theCompany has agreed to indemnify the investors in the convertible debenturefinancing described in Note 14 against certain losses.  The Company has never incurred costs todefend lawsuits or settle claims related to these indemnification agreements.As a result, the Company believes the estimated fair value of these agreementsis minimal.

 

**(13)****                         ****Convertible Promissory Note to Related Party**

 

On July 2, 2004, the Company enteredinto a note subscription agreement with the J. Rothschild Assurance SelfInvested Personal Pension Plan No. 2, the sole beneficiary of which is theCompany’s Chairman, chief executive officer and president, Mr. RupertGalliers-Pratt. The note subscription agreement was amended and restated on August 11,2004. Under the amended and restated note subscription agreement, the Companyissued and sold to Mr. Galliers-Pratt’s pension plan a convertiblepromissory note in the principal amount of $125,000 on July 12, 2004 andthe Company issued and sold to the pension plan a convertible promissory notein the principal amount of $50,000 on August 11, 2004. Both convertiblepromissory notes have a one-year term, accrue interest at the rate of 7% perannum and are convertible into shares of the Company’s common stock at theprice of $1.50 per share. On August 11, 2005, the pension plan confirmedits earlier agreement to extend the maturity date of both promissory notesuntil December 31, 2005.

 

**(14)****                          ConvertibleDebentures**

 

On February 18, 2005 and March 4, 2005, the Company completeda private placement of convertible debentures and warrants to a group ofsophisticated institutional and individual investors. In the private placement,the Company sold convertible debentures in the aggregate principal amount of$8,400,000 and warrants to purchase an aggregate of 8,400,000 shares of itscommon stock. The Company paid placement fees to the placement agent in theaggregate amount of $802,500. The debentures accrue interest daily at a rate of8% per annum, which interest is payable quarterly on each March 31, June 30,September 30 and December 31 following the issue date.  The final interest payment is due on the dateof maturity of the debentures, the third anniversary of the issue date.

 

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In connection withthe debenture financing transaction, the Company issued warrants to theplacement agent to purchase 802,500 shares of the Company’s common stockat an exercise price of $1.00 per each common stock share.  The Company determined the value of thewarrant to be $184,844 using the Black-Scholes pricing model and thefollowing assumptions: risk free interest rate, 3.9%; expected divided yield,0; expected life, 5 years; and expected volatility, 80%.  TheCompany recorded the value of this warrant as deferred financingfees.  In addition, the Company paidlegal expenses and broker fees of $947,127, which have been recorded asdeferred financing fees.  The deferredfinancing fees are being amortized to investment fees expense using thestraight-line method through the maturity date of the debentures.

 

In connection withthe debenture financing transaction, the Company issued 8,400,000warrants to the investors to purchase shares of the Company’s common stock atan exercise price of $1.00 per each share of common stock.  The Companydetermined the value of the warrants to be $1,933,108 using the Black-Scholespricing model and the following assumptions: risk free interest rate,3.9%; expected divided yield, 0; expected life, 5 years; and expectedvolatility, 80%.  The Company allocated value to the debt andthe warrant based on their relative fair values in accordance with AccountingPrinciples Board Opinion No. 14, *Accounting for ConvertibleDebt and Debt Issued with Stock Purchase Warrants,* resulting in anallocation of $1,596,000 to the warrants. The warrants were recorded as a discount to thedebenture and a credit to additional paid-in capital.  This discountis amortized to interest expense using the effective interest rate methodthrough the maturity date of the debentures. As of June 30, 2005, the unamortized portion of thediscount was $1,430,582.

 

After allocation ofthe proceeds between the debentures and the warrants, the Company consideredwhether the conversion terms of the debenture result in a beneficial conversionfeature, pursuant to Emerging Issue Task Force Nos. 98-5 and 00-27.  The Company determined that there was not abeneficial conversion feature.

 

For both of theBlack-Scholes computations described above, the Company used $0.45 as the fairvalue of its common stock.  Because therewas no current trading market for the Company’s common stock at the time of thedebenture and warrant allocation, management’s determination of fair value wasbased on an independent appraisal.

 

See subsequentevents Note 17 regarding conversions of debentures.

 

**(15)****                          Distributionand Marketing Agreement**

 

On August 11, 2004, the Company enteredinto a distribution and marketing agreement with NetYantra Inc. and NetYantraIndia Pvt. Ltd. (collectively, “NetYantra”) pursuant to which NetYantra grantsto the Company the exclusive worldwide rights (other than in India whereNetYantra is headquartered and subject to certain existing distributionagreements) to market and distribute the V-CubeTM IP-PBX software platform toTier 1 carriers, telecommunications equipment manufacturers, internet serviceproviders, large corporations, small and medium enterprises, and other businessentities and individual retail customers. Under the distribution and marketingagreement, in consideration for the marketing and distribution rights grantedto the Company by NetYantra, the Company paid NetYantra $150,000 (the “InitialPayment”) and is required to:

 

•                  PayNetYantra the amount of $250,000 (the “Second Payment”) on the day immediatelyfollowing the first anniversary of the signing of the agreement; and

 

•                  PayNetYantra fifty percent of certain net revenues that the Company derives fromthe distribution of the V-CubeTM platform.

 

TheCompany did not pay the Second Payment on the due date for payment and hasreceived a notice of this default from NetYantra. The Company has untilSeptember 13, 2005 to cure this default under the terms of distributionagreement. The Company has notified NetYantra of its default in its obligationto sign and deliver an escrow agreement required by the distribution agreement.The Company expects to pay the Second Payment to NetYantra prior to the end ofthe cure period.

 

Amountspaid by the Company pursuant to the Initial Payment and the Second Payment arecreditable against future royalty commitments. Accordingly, the Company recorded the amount paid pursuant to theInitial Payment, and will record the amount of the Second Payment when paid, asprepaid royalties and will expense such prepaid amounts as royaltiesaccrue.  Should the Company fail to makeany of these payments, NetYantra may terminate the agreement.

 

In addition, the agreement stated that in theevent that the Company’s common stock was quoted or traded on a stock market onor before the first anniversary of the agreement, the Company would also issueto NetYantra shares of the Company’s common stock having a market value of$1,000,000 based on the opening price of the Company’s common stock on thefirst day of trading (or, at the Company’s option, pay to NetYantra a cashpayment of $1,000,000 instead of issuing such shares). Should the Company failto issue these shares, or make the cash payment, NetYantra may terminate theagreement.  This payment, whether in theform of common stock or cash, is not creditable towards royalty commitments andwill be expensed when and if it becomes payable.  On July 21, 2005, public trading in theCompany’s common stock began jointly on the OTC Bulletin Board and the PinkSheets Electronic Quotation Service under the trading symbol “VSTL.”  The opening sale was at a price of $2.00 pershare. The Company is in the process of issuing 500,000 shares of its commonstock to NetYantra in compliance with the agreement.

 

Theagreement is for an initial term of five years. NetYantra may elect toterminate the exclusivity granted to the Company under the agreement after aperiod of two years for any reason.

 

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**(16)****                          NewAccounting Pronouncement**

 

In May 2005, the FASB issued FASBStatement No. 154, “Accounting Changes and Error Corrections, a replacementof APB Opinion No. 20 and FASB Statement No. 3” (SFAS No. 154).Previously, APB No. 20, “Accounting Changes” and SFAS

No. 3, “Reporting Accounting Changes in Interim FinancialStatements” required the inclusion of the cumulative effect of changes in accountingprinciple in net income of the period of the change. SFAS No. 154 requirescompanies to recognize a change in accounting principle, including a changerequired by a new accounting pronouncement when the pronouncement does notinclude specific

transition provisions, retrospectively to prior periods’ financialstatements. The Company will assess the impact of a retrospective

application of a change in accounting principle in accordance with SFASNo. 154 when such a change arises after the effective date of January 1,2006.

 

**(17)****                          SubsequentEvents**

 

In July 2005 the Company issuednonqualified stock options to purchase 1,748,000 shares of common stock to employees,board members and consultants at $0.45 per share.

 

The Company’s2004 Stock Incentive Plan was amended by the Board, subject to shareholderapproval, on June 3, 2005 to, among other things, increase the number ofshares available for options or restricted stock grants from 6,000,000 to8,000,000.  The shareholders of theCompany approved the amendment to the Plan, and therefore it became effectiveon July 14, 2005.

 

OnJuly 21, 2005, public trading in the Company’s common stock began jointlyon the OTC Bulletin Board and the Pink Sheets Electronic Quotation Serviceunder the trading symbol “VSTL”.

 

ThroughAugust 5, 2005, $418,750 in outstanding principal amount of convertibledebentures issued by the Company has been converted into 558,332 shares ofcommon stock.

 

OnAugust 11, 2005 the J. Rothschild Assurance Self Invested Personal PensionPlan No. 2 confirmed its earlier agreement to extend the maturity date ofboth promissory notes (see Note 13) until December 31, 2005.

 

On August 14, 2005, theCompany received a notice of default from NetYantra under the distributionagreement with NetYantra as described in Note 15.

 

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

**Introduction**

 

The following informationshould be read in conjunction with the financial statements and notes theretoin Part I, Item 1 of this Quarterly Report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in our Annual Report on Form 10-KSB for the year ended December 31,2004 (File No. 000-50758).

 

**CautionaryStatements**

 

We do not provide forecastsof our future financial performance. However, from time to time, informationprovided by us or statements made by our employees may contain “forward-looking”information that involves risks and uncertainties.  In particular, statements contained in thisQuarterly Report that are not historical facts constitute forward-lookingstatements and are made under the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Forward-looking statements involve substantial risks anduncertainties.  You can identify thesestatements by forward-looking words such as “may”, “will”, “expect”, “anticipate”,“believe”, “estimate”, “continue”, and similar words.  You should read forward-looking statementscarefully because they: (1) discuss our future expectations; (2) containprojections of our future operating results or financial condition; or (3) stateother “forward-looking” information. Various factors described below, as well as any other instances ofcautionary language in this Quarterly Report, refer to or provide examples ofrisks, uncertainties and events that may cause our actual results to bematerially different than the expectations described in our forward-lookingstatements.  You should be aware that theoccurrence of any of the events or factors described below and elsewhere inthis Quarterly Report could materially and adversely affect our business.  All forward-looking statements included inthis Quarterly Report are based on information available to us on the datehereof, and we assume no obligation to update any such forward-lookingstatements.

 

Eachforward-looking statement should be read in conjunction with the financialstatements and notes thereto in Part I, Item 1 of this Quarterly Report,this section, and Management’s Discussion and Analysis of Financial Conditionand Results of Operations contained in our Annual Report on Form 10-KSBfor the year ended December 31, 2004 (File No.000-50758), including butnot limited to the section therein entitled “Factors Affecting FuturePerformance.”

 

In additionto the risks and uncertainties faced generally by participants in thetelecommunication industry, we face the following risks and uncertainties:

 

•                                          We have a limited operating history and therefore, we may not be able toaccurately forecast future results and operating losses in future periods couldbe greater than expected.

 

•                                          If we do not obtain a substantial amount of additional financing, we mayhave to curtail or suspend operations.

 

•                                          We may continue to lose money on our operations.

 

•                                          If we fail toestablish the Vistula, V-CubeTM and Cardlink brands or to attract new customers,we may not be able to increase our revenues sufficiently to fund ouroperations.

 

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•                                          We currentlyderive a significant portion of revenue from a limited number of largecontracts and customers and, if we are unable to replace large contracts uponcompletion and maintain customer relationships, we could have a significantdecrease in our revenues that would negatively impact our results.

 

•                                          We mayexperience significant fluctuations in our results as a result of uncertaintiesrelating to our ability to generate additional revenues, manage ourexpenditures and other factors, certain of which are outside of our control.

 

•                                          Our contractstypically contain provisions giving customers the ability to terminate theircontracts under various circumstances and we may not be able to replace therevenues from such contracts that may have an adverse effect on our revenuesand operating results.

 

•                                          We may not be able to promptly reduce expenses in response to anydecrease in our revenues, which would result in lower net margins.

 

•                                          If we are unable to collect receivables from development stage customersand other telecommunications companies, our operating results may be materiallyharmed.

 

•                                          The extent of our dependence on international operations may give rise toincreased management challenges and could harm our results of operations.

 

•                                          Providing services outside the United States carries the additional riskof currency fluctuations and foreign exchange controls imposed by certaincountries since many of our non-U.S. projects are undertaken in local currency.

 

•                                          Our inability to anticipate or adapt to changes in technology may harmour competitive position, reputation and opportunities for revenue growth.

 

•                                          We may not be able to hire or retain a sufficient number of qualifiedengineers and other employees to meet our customers’ needs or maintain thequality of our services.

 

•                                          Future acquisitions of new companies or technologies may result indisruption to our business and expose us to risks associated with acquisitions.

 

•                                          The consolidation of telecommunication service providers could adverselyimpact our business.

 

•                                          Government regulations may adversely affect our business.

 

•                                          If we fail to retain our key personnel and attract and retain additionalqualified personnel, we might not be able to meet our customers’ needs.

 

•                                          Our internal controls and procedures need improvement.

 

•                                          The management of our finances and the quality and timeliness of ourfinancial reporting may be adversely affected if we are unable to increase thesize and capabilities of our internal administrative and finance function asour business grows.

 

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•                                          We will not be successful if we do not grow our customer base beyond ourinitial customers.

 

•                                          If we do not respond rapidly to technological changes or to changes inindustry standards, our products and services could become obsolete.

 

•                                          We will notretain customers or attract new customers if we do not anticipate and meetspecific customer requirements and if our products and services do notadequately interoperate with our customers’ existing networks.

 

•                                          If we fail tocompete successfully, our ability to increase our revenues or achieveprofitability will be impaired.

 

•                                          Our business isexposed to the general conditions of the telecommunications market.

 

•                                          The markets for wholesale voice services (particularly VoIP services) andpre-pay products are new and evolving and, if these markets do not develop asexpected, it could have a material adverse effect on our business.

 

•                                          Intellectual property infringement claims against us or any of oursubsidiaries, even without merit, could require us to enter into costlylicenses or deprive us of the technology we need. Failure to adequately protectour intellectual property rights could have a material adverse effect on ourbusiness.

 

•                                          If our products contain defects, then our sales are likely to suffer, andwe may be exposed to legal claims.

 

•                                          We may be subject to litigation.

 

Because of the foregoing and other factors, we mayexperience material fluctuations in our future operating results on a quarterlyor annual basis which could materially adversely affect our business andfinancial condition.

 

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**Overview**

 

VistulaCommunications Services, Inc. (“VCS”, the “Company” or “we”) currently hasthree wholly-owned subsidiaries: Vistula Limited (“Vistula”), Vistula USA, Inc.(“Vistula USA”) and Cardlink Services Limited (“Cardlink”) and one subsidiarythat is 60% owned, Vistula Communications Services SA (Pty) Ltd. (“Vistula SA”).  Through Vistula, Vistula USA, and Vistula SA,we currently provide wholesale value-added telecommunications services(including direct and partner voice routing services) to Tier 1 and Tier 2telecommunication carriers and transit operators. Beginning in the firstquarter of 2005, through Vistula, Vistula USA and Vistula SA, we began tomarket the V-CubeTM Voice over Internet Protocol, or “VoIP”, IP-PBX softwareplatform to telecommunications carriers, Internet service providers, or “ISPs”,large corporations and small and medium enterprises, or “SMEs”, throughout theworld.

 

Throughour Cardlink subsidiary, which is currently inactive, we plan to market anddistribute electronic top-up software, which enables prepayment for servicesprovided by mobile telephone operators, and associated services to Tier 1 andTier 2 telecommunications carriers and transit network operators throughout theworld.  Cardlink developed a softwareproduct suite that enabled mobile operators to electronically processprepayments from “pay-as-you-go” mobile phone customers.

 

***Vistula, Vistula USA, and Vistula SA***

 

Vistula, Vistula USA, andVistula SA are aggregators of wholesale telecommunications services to Tier 1and Tier 2 telecommunications carriers and transit network operators.  Vistula, Vistula USA, and Vistula SA arecollectively referred to as the “Vistula Companies.”  The Vistula Companies have switchingfacilities in London and Los Angeles and interconnect agreements with suppliersand customers in these locations.  Webelieve that the Vistula Companies are positioned to take advantage of thedisruption and uncertainty in the telecommunications sector over the past fewyears. The collapse of a significant number of competitive wholesale serviceproviders has meant that profit margins have improved significantly and webelieve the opportunity for well managed wholesale carriers such as the VistulaCompanies is significant.

 

The Vistula Companies beganto actively market the V-CubeTM IP-PBX software platform to carriers, transitnetwork operators, large corporations, and SMEs in the first quarter of 2005.We expect this multiple feature VoIP platform, which will enable customers toconvert their existing traditional PBX phone systems to provide VoIP capabilitywithout the need for significant investment in new hardware, will provide theVistula Companies with a highly competitive VoIP solution.

 

On April 1, 2005, we enteredinto a distribution and marketing agreement with Telstra Europe Limited, aU.K.-based telecommunications carrier. Under this agreement, we license TelstraEurope to provide hosted IP-PBX services to its customers using the hostedV-CubeTM IP-PBX platform. The agreement grants Telstra Europe an exclusivelicense to provide the hosted solution to its customers in the United Kingdomand Ireland for a period of five years. The monthly license fee payable byTelstra Europe to us is based on the number of individual users at the variousTelstra Europe customers who are using the VoIP services provided by TelstraEurope through use of the V-CubeTM platform. We hope to leverage the marketingadvantages and customer relationships of Telstra Europe to provide us with regularmonthly revenue.

 

***Cardlink***

 

Cardlink has been inactive since it was first acquired by Mr. Rupert Galliers-Pratt and certain members of his family in April 2003.  Cardlink was acquired by VCS through the share exchange completed in March, 2004. VCS intends to reactivate and refocus the operations of Cardlink. Cardlink will offer an electronic top-up, or “ETU”, software product suite which will enable mobile operators to electronically process prepayments from “pay-as-you-go” customers.  Cardlink’s products will allow these customers to “electronically top-up” their accounts with the mobile operator.  We believe that the market for these prepayment services is expanding both in the developed and in the underdeveloped regions in the world and we believe that Cardlink’s ETU product will be of significant value as new mobile operators throughout the world seek to adopt this technology.

 

We believe that the potential for providing ETU services in markets where the adoption and use of mobile telephony is growing rapidly will create significant opportunities and long-term growth potential for Cardlink.  We intend that Cardlink will typically receive a percentage of the total mobile revenues transacted through the Cardlink system.  As a result, Cardlink will be a beneficiary of any increase in mobile telephony revenues without any investment of capital in building infrastructure.  We currently expect to use third parties to provide necessary software updates, maintenance and support for these activities.

 

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**Critical Accounting Policies**

 

Our consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States. These accounting principles require us to makecertain estimates, judgments and assumptions. We believe that the estimates,judgments and assumptions upon which we rely are reasonable based uponinformation available to us at the time that these estimates, judgments andassumptions are made. These estimates, judgments and assumptions can affect thereported amounts of assets and liabilities as of the date of the financialstatements, as well as the reported amounts of revenues and expenses during theperiods presented. Those estimates and judgments are based on management’shistorical experience, the terms of existing agreements, our observance oftrends in the industry, information that we obtain from our customers andoutside sources, and on various other assumptions that management believes tobe reasonable and appropriate under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  To the extent there are material differencesbetween these estimates, judgments or assumptions and actual results, ourfinancial statements will be affected.

 

The significant accountingpolicy that we believe is most critical in fully understanding and evaluatingour reported financial results is our policy regarding revenue recognitionwhich is discussed in detail in our Annual Report on Form 10-KSB filedwith the Securities and Exchange Commission. We have reviewed and determinedthat our revenue recognition policy remains our critical accounting policy for thethree month period ended June 30, 2005. We did not make any changes tothis policy during this period.

 

For the computations described in Note 14 tothe financial statements pertaining to the convertible debentures and warrants,the Company used $0.45 as the fair value of its common stock.  Because there was no trading market for theCompany’s common stock at the time of the debenture and warrant allocation,management’s determination of fair value was based on an independent appraisal.

 

**Results of Operations**

 

Revenues for the three-month period ended June 30, 2005 decreased by 72% over the comparable fiscal period in 2004 to  $230,130.  Revenue for the six-month period ended June 30, 2005 decreased by 81% over the comparable fiscal period in 2004 to $352,327. We believe this decrease is attributable both to the decline of the UK mobile market as a re-sellable wholesale route and to our inability to attract new wholesale business due to our lack of liquidity prior to the closings of our private placement of convertible debentures and warrants in the first quarter of 2005 as described in Note 14 to the financial statements.  We believe that during the remainder of 2005 we will derive revenues from the equipment described in Note 10 to the financial statements if and when it is placed into service enabling us to attract and serve new customers.

 

Cost of revenues for thethree-month period ended June 30, 2005 was $244,946, a 65% decrease ascompared to the same period in fiscal 2004. Cost of revenues for the six-monthperiod ended June 30, 2005 was $499,433, a 69% decrease as compared to thesame period in fiscal 2004.  Engineeringcosts classified as cost of revenues for the three-month period ended June 30,2005 of $109,872 increased 691% as compared to the same period in fiscal 2004,and engineering costs classified as cost of revenues for the six-month periodended June 30, 2005 of $231,395 increased 276% as compared to the sameperiod in fiscal 2004.  Both three andsix month increases are due to expenditures pertaining to support of thewholesale business and initiating routing services in the U.S.

 

Selling, general and administrative costs increased by67% to $1,889,957 for the three-month period ended June 30, 2005 ascompared to the same period in fiscal 2004, and increased by 93% to $3,037,855for the six-month period ended June 30, 2005 as compared to the sameperiod in fiscal 2004. During the three-month period ended June 30, 2005,we incurred increased compensation for employees and consultants and increasedtravel in connection with the marketing of the VoIP platform; increasedprofessional fees, due in part to the public reporting requirements of theCompany; and an increase in sales and marketing expenses incurred in promotingthe Company’s VoIP product offering. During the six-month period ended June 30, 2005, we incurredincreased compensation for employees and consultants and increased travel asthe VoIP platform was being marketed; increased professional fees, due in part tothe public reporting requirements of the Company; an increase in sales andmarketing expenses in creating awareness of the Company’s VoIP productoffering; increased investment banking fees as the Company engaged infundraising activities; and increased regulatory fees, printing, and insurancecosts, all related to the transition of the Company to a public-reportingentity.

 

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Interest expense, net increased 895% to $287,030 forthe three-month period ended June 30, 2005 as compared to the same periodin fiscal 2004 and increased by 625% to $417,761 for the six-month period endedJune 30, 2005 as compared to the same period in fiscal 2004. During thethree and six month periods ended June 30, 2005 we incurred interestexpense on the convertible debentures, interest expense on the convertiblepromissory note to a related party, and interest expense on the note payableissued in the acquisition of equipment described in Note 10 to the financialstatements. The amortization of the debt discount described in Note 14 to thefinancial statements is also classified as interest expense. During the threeand six month periods ended June 30, 2004 we incurred interest expense onthe capital lease obligation described in Note 10 to the financial statements.

 

For the three-month period ended June 30, 2005, we incurred a loss of $(2,191,803) or approximately $(0.09) loss per common share, basic and diluted.  For the six-month period ended June 30, 2005, we incurred a loss of $(3,602,722) or approximately $(0.14) loss per common share, basic and diluted.

 

**Liquidity And Capital Resources**

 

As of June 30, 2005, we had cash and cash equivalents of approximately $1,443,000 and a working capital surplus of approximately $466,000.  This represents an increase in cash and cash equivalents of approximately $1,440,000 from December 31, 2004 and an increase in working capital from a deficit of approximately $(2,271,000) at December 31, 2004. These increases in cash and cash equivalents and working capital are principally reflective of the proceeds we received in connection with the private placement described below.  Since our inception through June 30, 2005, we have generated losses of approximately $(7,742,000).  Net accounts receivable were approximately $83,000 at June 30, 2005, an increase of approximately 48% from December 31, 2004.  Accounts payable, accrued expenses and due to stockholder decreased approximately $1,729,000 from December 31, 2004 as a result of applying a portion of the proceeds received from the issuance of convertible debentures and warrants to the payment of these outstanding obligations.

 

On February 18, 2005and March 4, 2005, we completed a private placement of convertibledebentures and warrants to a group of sophisticated institutional andindividual investors. In the private placement, we sold convertible debenturesin the aggregate principal amount of $8,400,000 and warrants to purchase anaggregate of 8,400,000 shares of our common stock. We paid placement fees tothe placement agent in the aggregate amount of $802,500 and we also issued tothe placement agent a warrant to purchase up to 802,500 shares of our commonstock at an initial exercise price of $1.00 per share. The debentures accrueinterest daily at a rate of 8% per annum, which interest is payable quarterlyon each March 31, June 30, September 30 and December 31following the issue date.  The finalinterest payment is due on the date of maturity of the debentures, the thirdanniversary of the issue date.

 

We have made expendituresfor capital equipment from our inception until June 30, 2005 ofapproximately $385,000 purchasing the telecommunications equipment necessary tobegin our business. This amount excludes the $1.9 million in telecommunicationsequipment acquired from MRS Partners LLC (“MRS Partners”) described furtherbelow.

 

On March 15, 2005, wecompleted the purchase of certain telecommunications equipment (including twoSonus Networks switches) from MRS Partners for $500,000 in cash, 725,000 sharesof our common stock and a promissory note for an aggregate principal amount of$1,170,000. Prior to the closing, we were leasing this equipment from MRSPartners.  The principal amount of thenote was subsequently adjusted to $970,000, reflective of unanticipated recertificationcosts.  Under the terms of the promissorynote, interest accrues daily at a rate of 8.25% and is payable monthly inarrears.  Principal repayments of $100,000are payable on September 30, 2005 and December 31, 2005. Theremaining principal and any unpaid interest is payable on the first anniversaryof the closing of the purchase.

 

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On August 11, 2004, weentered into a distribution and marketing agreement with NetYantra Inc.and NetYantra India Pvt. Ltd. (collectively, “NetYantra”) pursuant towhich NetYantra grants to the Company the exclusive worldwide rights (otherthan in India where NetYantra is headquartered and subject to certain existingdistribution agreements) to market and distribute the V-CubeTM IP-PBX softwareplatform developed by NetYantra to Tier 1 carriers, telecommunicationsequipment manufacturers, internet service providers, large corporations, SMEsand other business entities and individual retail customers. Under this agreement,we will be required in the future to, among other things:

 

•                  pay NetYantrathe amount of $250,000 on the day immediately following the first anniversaryof the signing of the distribution and marketing agreement; and

 

•                  pay NetYantrafifty percent of certain net revenues that the Company derives from thedistribution of the V-CubeTM platform.

 

The Company did not pay the $250,000 paymenton the due date for payment and has received a notice of this default fromNetYantra. The Company has until September 13, 2005 to cure this default underthe terms of distribution agreement. The Company has notified NetYantra of itsdefault in its obligation to sign and deliver an escrow agreement required bythe distribution agreement. The Company expects to make the outstanding paymentto NetYantra prior to the end of the cure period.

 

In addition, the agreement stated that in theevent that the Company’s common stock was quoted or traded on a stock market onor before the first anniversary of the agreement, the Company would also issueto NetYantra shares of the Company’s common stock having a market value of$1,000,000 based on the opening price of the Company’s common stock on thefirst day of trading (or, at the Company’s option, pay to NetYantra a cashpayment of $1,000,000 instead of issuing such shares). Should the Company failto issue these shares, or make the cash payment, NetYantra may terminate theagreement.  This payment, whether in theform of common stock or cash, is not creditable towards royalty commitments andwill be expensed when and if it becomes payable.  On July 21, 2005, public trading in theCompany’s common stock began jointly on the OTC Bulletin Board and the PinkSheets Electronic Quotation Service under the trading symbol “VSTL” with anopening sale at a price of $2.00 per share. The Company is in the process ofissuing 500,000 shares of its common stock to NetYantra in compliance with theagreement.

 

We expect to be able to paythe required interest and principal payments under the convertible debenturesissued in our recent private placement and the promissory note issued to MRSPartners as part of the consideration for the purchase of equipment from MRSPartners and the payments required under the NetYantra agreement from wholesalevoice services, from the remaining proceeds from our recently completedconvertible debenture and warrant financing, and/or from additional financing.

 

We believe that ouravailable cash and cash equivalents will be sufficient to meet our workingcapital requirements, including the funding of operating losses, and capitalexpenditure requirements for at least the current fiscal year, assuming thatour business plan is implemented successfully. Previously, our primary sourcesof capital had been the revenues generated from interconnect agreements withour customers and advances made by one of our principal stockholders from acredit facility established in the name of the stockholder and other of thestockholder’s personal assets.  In theevent that we do not succeed in implementing our business plan, and do nototherwise raise third-party capital, we will have to curtail certainexpenditures, seek additional financing from our principal stockholder, or bothin order to sustain operations.  As notedabove, the principal stockholder has historically provided working capitaladvances, and has caused the lender to issue letters of credit in favor ofcertain vendors. While the stockholder is not obligated to provide theseworking capital advances to us or to cause the lender to issue standby lettersof credit in favor of our vendors, we expect the stockholder to continueproviding funds for operations in 2005 as and if needed, until such time thatour operations are self-sustaining or we raise additional external capital, asthe case may be.  We have not generatedrevenues from the acquired equipment described in Note 10 to the financialstatements, although we expect to commence revenue activity from this equipmentduring the third quarter of 2005.  Ourcash flow has therefore been negatively impacted and, if we are unable to raiseadditional financing during the third quarter of 2005, we will look to thisstockholder to provide working capital funding until additional capital can beobtained.

 

Our plans for growth andexpansion will require the need for additional capital in the future. As aresult, we may have to rely upon the issuance of additional debt or equitysecurities in order to continue to grow our business as well as to fund thenegative cash flow we have experienced to date, and may experience in thefuture, as a result of these activities. If additional funds are raised throughthe issuance of equity securities, our existing stockholders may experiencesignificant dilution. In the absence of achieving profitable operations infuture periods, obtaining additional capital through asset sales, securing arevolving credit facility, debt or equity offerings, or a combination of theforegoing, we may encounter liquidity difficulties. No assurance can be giventhat we will be able to raise additional capital when needed, or at all, orthat such capital, if available, will be on acceptable terms.

 

To date, inflation has nothad a material impact on our financial results. There can be no assurance,however, that inflation will not adversely affect our financial results in thefuture.

 

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**Off-BalanceSheet Arrangements**

 

 One ofour subsidiaries, Vistula Limited, has agreed to guarantee unconditionally theobligations of one of our principal stockholders under a $3,000,000 creditfacility established in the name of the stockholder. Vistula Limited has agreedto provide this guaranty since the stockholder has to date advanced drawingsunder the credit facility to Vistula Limited and its affiliates and letters ofcredit have been issued under the facility in favor of vendors to Vistula Limitedand its affiliates to secure obligations of those entities to their vendors. Inlight of the circumstances surrounding the guaranty, including the fact thatthe obligations of the stockholder under the credit facility are secured bysignificant assets in which the stockholder has a beneficial interest, webelieve that the potential liability and obligations of Vistula under thisguaranty are not reasonably likely to have a material current or future effecton our financial condition, results of operations, liquidity or capitalresources.  To date, we have not derivedrevenues from the acquired equipment described in Note 10 to the financialstatements, although we expect to commence revenue activity from this equipmentduring the third quarter of 2005. Our cash flow has therefore been negativelyimpacted and, if we are unable to raise additional financing during the thirdquarter of 2005, we will look to this stockholder to provide working capitalfunding until additional capital can be obtained.

 

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**Item 3. Controls and Procedures.**

 

*Management Evaluation ofDisclosure Controls and Procedures*

 

Wemaintain disclosure controls and procedures, which are designed to providereasonable assurance that information required to be disclosed in the reportswe file or submit under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourchief executive officer and chief financial officer, as appropriate, to allowtimely decisions regarding required disclosure.

 

Under thesupervision and with the participation of our chief executive officer and chieffinancial officer, our management has evaluated the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisquarterly report. Based on that evaluation, our chief executive officer andchief financial officer have concluded that our disclosure controls andprocedures were effective as of June 30, 2005.

 

On March 28,2005, Vitale, Caturano & Company, Ltd., advised us in connection with thecompletion of their audit for the 2004 fiscal year that they had identifiedcertain matters involving the operation of our internal controls that theyconsidered to be a material weakness.  A “materialweakness” is a reportable condition in which the design or operation of one ormore of the internal control components does not reduce to a relatively lowlevel the risk that misstatements caused by errors or fraud in amounts thatwould be material in relation to the consolidated financial statements beingaudited may occur and not be detected within a timely period by employees inthe normal course of performing their assigned functions.

 

Thematerial weakness identified by Vitale, Caturano & Company, Ltd.related to our lack of full-time accounting and finance personnel and to a lackof sophistication in our accounting systems, which required significant manualeffort and lacked formal, documented procedures and controls over transactionreporting.  Both of these factors werethe result of the severe capital constraints we faced prior to the completionof our private financing in the first quarter of 2005.  Although we retained during the 2004 fiscalyear the services of a part-time Chief Financial Officer to assist inaccounting consideration and recording and the financial reporting process,Vitale, Caturano & Company, Ltd. noted delays in the communication ofinformation and documentation to the Chief Financial Officer.  While these matters were not formallyidentified as a material weakness until very late in the audit process, theywere presumably present from our inception in early 2003.

 

Vitale,Caturano & Company, Ltd.’s conclusion that we needed to reassess ourexisting finance organization resource requirements and re-evaluate the designand operating effectiveness of certain controls surrounding the financialstatement close process was based on several adjustments that were made in thecourse of the audit process, some of which occurred late in the audit process,and issues relating to the timely communication of information anddocumentation necessary to yield proper accounting consideration and recording.Among the issues identified or addressed late in the audit process wereaccounting for stock option arrangements, prepaid royalties, severance accruals,certain revenue contracts, reconciling and verifying shareholder loans, cutoffof accounts payable, and preparing complete financial statements with footnotedisclosures.

 

NotwithstandingVitale, Caturano & Company, Ltd.’s identification of a materialweakness in our internal controls, our management, including our chiefexecutive officer and chief financial officer, concluded that the presence ofthis material weakness did not necessitate a conclusion that our disclosurecontrols and procedures were not effective as of June 30, 2005.  In arriving at this conclusion, ourmanagement considered the following factors:

 

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•      Vitale, Caturano & Company, Ltd.’sconclusions regarding the presence of a material weakness were based largely ondelays they experienced in the communication of information and documentationduring the course of their audit, not due to any observed deficiency in ourability to make timely disclosures as required by the Securities and ExchangeCommission.

 

•      Despite the presence of the materialweakness, we filed our annual report for the 2004 fiscal year, our quarterlyreport for the first quarter, and this quarterly report within the time periodsspecified by the Securities and Exchange Commission.

 

•      Vitale, Caturano & Company, Ltd.issued its Report of IndependentRegistered Public Accounting Firm, which is included in our annual report on Form 10-KSBfor the 2004 fiscal year, without qualification.

 

•      During the quarter ended March 31,2005, we implemented automated accounting software for our U.S. operations,following the recommendation of our Chief Financial Officer made in the fourthquarter of 2004.

 

•      During the quarter ended June 30,2005, we initiated a search for a full-time manager of accounting andadministration.  We successfullyidentified a suitable candidate, and he commenced full-time employment with usin July 2005.

 

*Changes in InternalControls Over Financial Reporting*

 

Therewere no changes in our internal control over financial reporting during thequarter ended June 30, 2005 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II.****                                               ****OTHERINFORMATION**

 

**Item 6.  Exhibits**

 

**(a) Exhibits.**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                           |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                   |
| 10.1(1)             |       | Amended and Restated 2004 Stock Incentive  Plan                                                                                                                                                                                                        |
| 31.1*               |       | Certification by Rupert Galliers-Pratt  pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002, relating to Vistula Communications Services, Inc.                         |
| 31.2*               |       | Certification by George R. Vaughn pursuant  to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002, relating to Vistula Communications  Services, Inc.                             |
| 32.1*               |       | Certification by Rupert Galliers-Pratt  pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,  relating to Vistula Communications Services, Inc. |
| 32.2*               |       | Certification by George R. Vaughn pursuant  to Section 1350, Chapter 63 of Title 18, United States Code, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, relating to  Vistula Communications Services, Inc.      |

 

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*    Filed herewith.

 

(1)    Incorporated by reference to Appendix A to the Company's ProxyStatement filed with the Securities and Exchange Commission on June 30, 2005.

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|                    | Vistula Communications Services, Inc. |
|-------------------------|--------------------------------------------|
|                    |                                       |
| Date: January  30, 2006 | By:                                        | /s/ RUPERT GALLIERS-PRATT |   |
|                    |                                       | Rupert Galliers-Pratt |
|                    |                                       | Chief Executive Officer |

 

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