**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 thequarterly period ended: September 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**

 

----

 

**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)            |
| ** **                                                       | ** ** | ** **                         |
| **(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 90days.     Yes   ý     No   o

 

As of November 11,2005, there were 31,696,565 shares of common stock, $0.001 par value, of theregistrant issued and outstanding.

 

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

 

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

 

 

----

 

**VISTULA COMMUNICATIONS SERVICES, INC.**

 

**FORM 10-QSB**

 

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

 

Facing Page

 

Table of Contents

 
| PART I.  | FINANCIAL INFORMATION(*):                                                                                                                  |                                                                                        |   |
|---------------|--------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                                       |
|          | Item 1.                                                                                                                                    | Financial Statements                                                                        |   |
|          |                                                                                                                                       |
|          | Consolidated Balance Sheets as of September 30, 2005 (unaudited)  and December 31, 2004                                          |                                                                                        |
|          |                                                                                                                                       |
|          | Consolidated Statements of Operations for the Three and Nine Months  ended September 30, 2005 and September 30, 2004 (unaudited) |                                                                                        |
|          |                                                                                                                                       |
|          | Consolidated Statements of Stockholders’ Deficit for the Nine Months  ended September 30, 2005 (unaudited)                       |                                                                                        |
|          |                                                                                                                                       |
|          | Consolidated Statements of Cash Flows for the Nine Months ended September 30,  2005 and September 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    |                                                                                                                                       |                                                                                        |   |
|               |                                                                                                                                            |                                                                                             |        |  |  |  |

 

----

(*)                                 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 should beread 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

----

 

**PART I.  FINANCIAL INFORMATION**

 

**Item1.  Financial Statements.**

** **

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

ConsolidatedBalance Sheets as of September 30, 2005 and December 31, 2004

 
| ** **                                                                                                                                                                                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                       | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                       | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current  assets:                                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and  cash equivalents                                                                                                                                                                       |       | $                            | 241,413    |                        | $          | 3,221 |   |
| Accounts  receivable                                                                                                                                                                             |       | 102,974                      |       | 55,991                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                       |       | 1,088,955                    |       | 228,870                     |       |
| Total  current assets                                                                                                                                                                            |       | 1,433,342                    |       | 288,082                     |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Property and  equipment, net                                                                                                                                                                     |       | 2,097,118                    |       | 1,997,621                   |       |
| Deferred  financing costs                                                                                                                                                                        |       | 703,574                      |       | —                      |       |
| Other assets                                                                                                                                                                                     |       | 58,670                       |       | —                      |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                             |       | $                            | 4,292,704  |                        | $          | 2,285,703 |   |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                                  |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                            |       |                         |       |                        |       |
| Accounts  payable                                                                                                                                                                                |       | $                            | 1,019,566  |                        | $          | 537,660 |   |
| Accrued  expenses                                                                                                                                                                                |       | 506,908                      |       | 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                                                                                                                                                                       |       | 2,671,474                    |       | 2,558,633                   |       |
| Capital  lease obligation                                                                                                                                                                        |       | —                       |       | 1,971,167                   |       |
| Convertible  debentures                                                                                                                                                                          |       | 5,455,167                    |       | —                      |       |
| Total  liabilities                                                                                                                                                                               |       | 8,126,641                    |       | 4,529,800                   |       |
| Stockholders’  deficit:                                                                                                                                                                     |       |                         |       |                        |       |
| Common  stock, $0.001 par value, 100,000,000 shares authorized, 28,306,067 and  24,454,406 shares issued and outstanding as of September 30, 2005 and December 31,  2004, respectively |       | 28,306                       |       | 24,454                      |       |
| Additional  paid-in capital                                                                                                                                                                      |       | 9,280,693                    |       | 2,608,581                   |       |
| Deferred  compensation                                                                                                                                                                           |       | (14,381                      | )          | (399,000                    | )          |
| Accumulated  deficit                                                                                                                                                                             |       | (13,018,991                  | )          | (4,394,997                  | )          |
| Accumulated  other comprehensive loss                                                                                                                                                            |       | (109,564                     | )          | (83,135                     | )          |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Total  stockholders’ deficit                                                                                                                                                                |       | (3,833,937                   | )          | (2,244,097                  | )          |
|                                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                             |       | $                            | 4,292,704  |                        | $          | 2,285,703 |   |

 

See accompanying notes to unauditedconsolidated financial statements.

 

3

----

 

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

ConsolidatedStatements of Operations for theThree and Nine Months ended September 30, 2005 and 2004

 
| ** **                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(unaudited)**                            | ** ** | **(unaudited)**                           | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| Net revenues                                           |       | $                                          | 262,050    |                                      | $          | 513,563 |   | $ | 614,378 |   | $ | 2,329,571 |   |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Cost of revenues                                       |       | 301,120                                    |       | 426,782                                   |       | 719,955 |   | 2,107,794 |   |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Gross margin                                           |       | (39,070                                    | )          | 86,781                                    |       | (105,577 | ) | 221,777 |   |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Selling, general and administrative  expenses          |       | 4,536,424                                  |       | 640,790                                   |       | 7,654,878 |   | 2,146,458 |   |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Loss from  operations                                  |       | (4,575,494                                 | )          | (554,009                                  | )          | (7,760,455 | ) | (1,924,681 | ) |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense, net                                  |       | (445,778                                   | )          | (31,220                                   | )          | (863,539 | ) | (88,877 | ) |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                               |       | $                                          | (5,021,272 | )                                         | $          | (585,229 | ) | $ | (8,623,994 | ) | $ | (2,013,558 | ) |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average  basic and diluted shares outstanding |       | 26,192,848                                 |       | 24,416,363                                |       | 25,327,068 |   | 24,159,220 |   |
|                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted net loss per common share            |       | $                                          | (0.19      | )                                         | $          | (0.02 | ) | $ | (0.34 | ) | $ | (0.08 | ) |

 

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

 

4

----

 

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

ConsolidatedStatements of Stockholders’ Deficit for theNine Months ended September 30, 2005

**(unaudited)**

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Deferred** | ** ** | **Accumulated**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
|----------------------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|--------------|------------|------------------|------------|---------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**  | ** ** | **Compensation** | ** ** | **Deficit**                           | ** ** | **Loss**                      | ** ** | **Deficit**       | ** ** | **Loss** | ** ** |
| 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           |       |   |   |
| Issuance of stock options                                                  |       |             |       |                    |       | 1,814,840    |       | (1,814,840       | )          |                                  |       |                          |       | —            |       |   |   |
| Amortization of deferred stock compensation                                |       |             |       |                    |       |         |       | 2,199,459        |       |                                  |       |                          |       | 2,199,459         |       |   |   |
| Issuance of warrants with convertible debentures                           |       |             |       |                    |       | 1,780,844    |       |             |       |                                  |       |                          |       | 1,780,844         |       |   |   |
| Issuance of warrant pursuant to consulting agreement                       |       |             |       |                    |       | 29,913       |       |             |       |                                  |       |                          |       | 29,913            |       |   |   |
| Issuance of common stock pursuant to debenture  conversions                |       | 2,566,661        |       | 2,567                   |       | 1,352,489    |       |             |       |                                  |       |                          |       | 1,355,056         |       |   |   |
| Issuance of common stock pursuant to marketing and  distribution agreement |       | 500,000          |       | 500                     |       | 999,500      |       |             |       |                                  |       |                          |       | 1,000,000         |       |   |   |
| Exercise of stock options                                                  |       | 60,000           |       | 60                      |       | 2,940        |       |             |       |                                  |       |                          |       | 3,000             |       |   |   |
| Compensation expense associated with options issued  to non-employees      |       |             |       |                    |       | 367,437      |       |             |       |                                  |       |                          |       | 367,437           |       |   |   |
| Net loss                                                                   |       |             |       |                    |       |         |       |             |       | (8,623,994                            | )          |                          |       | (8,623,994        | )          | $ | (8,623,994 | ) |
| Change in cumulative translation adjustment                                |       |             |       |                    |       |         |       |             |       |                                  |       | (26,429                       | )          | (26,429           | )          | (26,429 | ) |
| Balance, September 30, 2005                                           |       | 28,306,067       |       | $                       | 28,306     |         | $          | 9,280,693        |       | $                                     | (14,381    | )                             | $          | (13,018,991       | )          | $ | (109,564 | ) | $ | (3,833,937 | ) | $ | (8,650,423 | ) |

 

See accompanying notes to unauditedconsolidated financial statements.

 

5

----

 

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

ConsolidatedStatements of Cash Flows for theNine Months ended September 30, 2005 and 2004

 
| ** **                                                                                                | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                                                                | ** ** | **(unaudited)**                          | ** ** | **(unaudited)** | ** ** |
| Cash flows  from operating activities:                                                                    |       |                                     |       |   |   |
| Net loss                                                                                                  |       | $                                        | (8,623,994 | ) | (2,013,558 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                              |       |                                     |       |   |   |
| Depreciation                                                                                              |       | 97,150                                   |       | 31,877 |   |
| Payment of  Company expenses by stockholders recorded as a capital contribution                           |       | —                                   |       | 82,500 |   |
| Non cash  compensation expense                                                                            |       | 2,566,896                                |       | 435,000 |   |
| Non cash  financing charge                                                                                |       | —                                   |       | 22,500 |   |
| Non cash  issuance of common stock pursuant to distribution and marketing agreement                       |       | 1,000,000                                |       | — |   |
| Non cash  interest expense                                                                                |       | 467,474                                  |       | 86,499 |   |
| 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                                                                  |       | —                                   |       | 179,642 |   |
| Changes in  assets and liabilities:                                                                       |       |                                     |       |   |   |
| (Increase)  decrease in:                                                                                  |       |                                     |       |   |   |
| Accounts  receivable                                                                                      |       | (46,983                                  | )          | (37,903 | ) |
| Prepaid  expenses and other current assets                                                                |       | (918,755                                 | )          | (61,843 | ) |
| Increase  (decrease) in:                                                                                  |       |                                     |       |   |   |
| Accounts  payable                                                                                         |       | 481,906                                  |       | 127,324 |   |
| Accrued  expenses                                                                                         |       | (546,579                                 | )          | 749,232 |   |
| Net cash  used in operating activities                                                                    |       | (5,492,972                               | )          | (166,697 | ) |
|                                                                                                      |       |                                     |       |   |   |
| Cash flows  from investing activities:                                                                    |       |                                     |       |   |   |
| Purchases of  property and equipment                                                                      |       | (408,701                                 | )          | (68,459 | ) |
| Net cash  used in investing activities                                                                    |       | (408,701                                 | )          | (68,459 | ) |
|                                                                                                      |       |                                     |       |   |   |
| Cash flows  from financing activities:                                                                    |       |                                     |       |   |   |
| Payments on  due to stockholder                                                                           |       | (801,630                                 | )          | (35,229 | ) |
| Payment of  capital lease obligation                                                                      |       | (500,000                                 | )          | — |   |
| Proceeds  from issuance of convertible promissory note to related party                                   |       | —                                   |       | 175,000 |   |
| Proceeds  from issuance of common stock                                                                   |       | 3,000                                    |       | 5,000 |   |
| Proceeds  from issuance of convertible debentures and warrants, net of deferred  financing costs          |       | 7,452,874                                |       | — |   |
| Net cash  provided by financing activities                                                                |       | 6,154,244                                |       | 144,771 |   |
|                                                                                                      |       |                                     |       |   |   |
| Effect of  exchange rates on cash                                                                         |       | (14,379                                  | )          | 8,942 |   |
|                                                                                                      |       |                                     |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                     |       | 238,192                                  |       | (81,443 | ) |
| Cash and  cash equivalents, beginning of period                                                           |       | 3,221                                    |       | 88,644 |   |
|                                                                                                      |       |                                     |       |   |   |
| Cash and  cash equivalents, end of period                                                                 |       | $                                        | 241,413    |   | 7,201 |   |
|                                                                                                      |       |                                     |       |   |   |
| **Supplemental  disclosure of cash flow information:**                                                    |       |                                     |       |   |   |
|                                                                                                      |       |                                     |       |   |   |
| Cash paid  for interest                                                                                   |       | $                                        | 433,042    |   | — |   |
| 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 purchase of assets under capital lease obligation                   |       | $                                        | 324,874    |   | — |   |
| Issuance of  note payable pursuant to purchase of assets under capital lease obligation                   |       | $                                        | 970,000    |   | — |   |
| Issuance of  common stock pursuant to debenture conversions                                               |       | $                                        | 1,355,056  |   | — |   |
| 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

----

 

**VISTULA COMMUNICATIONSSERVICES, INC.**

** **

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**September 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 Company’s audited annual financial statementsfor the fiscal year ended December 31, 2004 and the footnotes thereto.Those audited financial statements are included in the Company’s Annual Reporton Form 10-KSB, which was filed with the Securities and ExchangeCommission (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, VistulaLimited.  The South African rand is thefunctional currency of its 60% owned subsidiary, Vistula CommunicationsServices SA (Pty) Ltd.  Assets andliabilities of the Company’s international operations are translated into U.S.dollars at exchange rates that are in effect on the balance sheet date andequity accounts are translated at historical exchange rates.  Income and expense items are translated ataverage exchange rates which are in effect during the year.  Translation adjustments are accumulated in othercomprehensive loss as a separate component of stockholders’ deficit in theconsolidated balance sheet. Transaction gains (losses) were immaterial for thethree and nine month periods ended September 30, 2005 and 2004.

 

Inthe event that the Company is not successful in implementing its business plan,or does not raise third-party capital, the Company will have to curtail certainexpenditures, seek additional financing from one of its principal stockholders,or both in order to sustain operations.  One of the Company’s principalstockholders has historically provided working capital advances and has causeda 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 a lender to issue standby letters of credit in favor of itsvendors, the Company expects that the stockholder will continue to providefunds for operations in 2005, as and if needed, until such time that theCompany’s operations are self-sustaining or the Company raises additionalexternal capital, as the case may be.  As described in Note 17, in October 2005the Company received $3.0 million in net proceeds from the exercise of warrantsassociated with the convertible debentures described in Note 14.  Also, although the acquired equipmentdescribed in Note 10 has been placed in service as of September 30, 2005,only nominal revenues have been generated to date.  Cash flow has therefore been negativelyaffected, and if the Company is unable to raise additional financing during thefourth quarter of 2005 or the first quarter of 2006, it will look to thisprincipal stockholder to provide working capital funding until additionalcapital can be obtained.

 

Certain amounts from 2004 and from the first two quarters of 2005 havebeen reclassified to conform with the current presentation.

 

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

 

Statement of Financial Accounting Standards (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 directors and employees under AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees,*and follows the disclosure-onlyalternative under SFAS No. 123, as amended by Statement of FinancialAccounting 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. The weighted average assumptions usedfor stock options granted to directors and employees during 2005 are asfollows:

 
| Risk-free  interest rate |   | 4.05    | %      |
|--------------------------|--------|---------|--------|
| Expected dividend yield  |   | 0       |   |
| Expected lives           |   | 5 years |   |
| Expected volatility      |   | 80      | %      |

 

7

----

 

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

 
| ** **                                                                    | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                          |       |                                      |       |                                     |       |   |   |   |   |
| Net loss as  reported                                                         |       | $                                         | (5,021,272 | )                                        | $          | (585,229 | ) | $ | (8,623,994 | ) | $ | (2,013,558 | ) |
| Stock  compensation expense included in net loss                              |       | 1,802,459                                 |       | 41,000                                   |       | 2,199,459 |   | 395,000 |   |
| Stock  compensation expense determined using fair value method for all awards |       | (2,116,747                                | )          | (5,887                                   | )          | (2,599,663 | ) | (443,513 | ) |
| Pro forma  net loss                                                           |       | $                                         | (5,335,560 | )                                        | $          | (550,116 | ) | $ | (9,024,198 | ) | $ | (2,062,071 | ) |
|                                                                          |       |                                      |       |                                     |       |   |   |   |   |
| Loss per  share (basic and diluted) as reported                               |       | $                                         | (0.19      | )                                        | $          | (0.02 | ) | $ | (0.34 | ) | $ | (0.08 | ) |
| Pro forma  loss per share (basic and diluted)                                 |       | $                                         | (0.20      | )                                        | $          | (0.02 | ) | $ | (0.36 | ) | $ | (0.09 | ) |

 

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, when required by EITF No. 96-18.  For the three and nine month periods ended September 30,2005, the Company recorded $367,437 in compensation expense pertaining tooptions granted to non-employees. No compensation expense pertaining to optionsgranted to non-employees was recorded during the three and nine month periodsended September 30, 2004. In March 2005 the Company issued a fullyvested warrant to purchase 100,000 shares of common stock pursuant to aconsulting agreement.  The warrant wasvalued at $29,913 using the Black-Scholes option pricing model and charged toselling, general and administrative expense for the three month period ended March 31,2005.

 

Between July 7, 2005 and July 14, 2005 the Companyissued 1,538,000 stock options to directors and employees at an exercise priceof $0.45 per share, 1,525,000 of which were fully vested at the date of grant.During the three months ended September 30, 2005, the non-cash compensation expenserelated to these stock options was $1,800,459 and $14,381 is reflected asdeferred compensation at September 30, 2005 that will be amortized overthe respective vesting period of the applicable stock options.

 

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 andamends SFAS 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 either the “modified prospective” method or the“modified retrospective” method.  Underthe “modified prospective” method, compensation cost is recognized beginningwith the effective date of SFAS No. 123R (a) based on therequirements of SFAS No. 123R for all share-based payments granted afterthe effective date and (b) based on the requirements of SFAS No. 123for all awards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date. The “modified retrospective”method, which includes the requirements of the modified prospective methoddescribed above, also permits entities to restate based on the amountspreviously recognized under SFAS No. 123 for purposes of pro formadisclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. The Company has yet to determine whichmethod 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 above. The Company is currently evaluating the impact of the adoptionof SFAS No. 123R on its financial position and results of operations,including the valuation methods and support for the assumptions that underliethe valuation of the awards.

 

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

 

The Company accounts for income taxes in accordancewith SFAS No. 109, *Accounting forIncome Taxes*. Under SFAS No. 109, deferred tax assets orliabilities are computed based on the difference between the financialstatements and income tax basis of assets and liabilities, and net operatingloss carryforwards, using the enacted tax rates. Deferred income tax expense orbenefit is based on changes in the asset or liability from period toperiod.  The Company did not record aprovision for federal, state or foreign income taxes for the three or ninemonth periods ended September 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

----

 

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

 

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

 
| ** **               | ** ** | **September 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|--------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | ** **                    | ** ** |
| Royalties                |       | $                            | 400,000    |                          | $          | 150,000 |   |
| Call termination charges |       | 315,607                      |       | 28,756                        |       |
| Maintenance agreement    |       | 74,972                       |       | —                        |       |
| Value-added tax          |       | 73,296                       |       | —                        |       |
| Insurance                |       | 67,429                       |       | —                        |       |
| Non-trade receivables    |       | 64,647                       |       | —                        |       |
| Co-location              |       | 28,685                       |       | —                        |       |
| Equipment and rent       |       | 27,298                       |       | 41,707                        |       |
| Salaries                 |       | 20,000                       |       | —                        |       |
| Other                    |       | 17,021                       |       | 8,407                         |       |
| Total                    |       | $                            | 1,088,955  |                          | $          | 228,870 |   |

 

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

 
| ** **               | ** ** | **September 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|--------------------------|------------|------------------------------|------------|-------------------------------|------------|
| Equipment rent           |       | $                            | 30,243     |                          | $          | — |   |
| Call termination charges |       | 21,661                       |       | —                        |       |
| Other                    |       | 6,766                        |       | —                        |       |
| Total                    |       | $                            | 58,670     |                          | $          | — |   |

 

Deferred financing costs at September 30, 2005were incurred in connection with the Company’s issuance of convertibledebentures and warrants as described in Note 14, which costs are being amortizedover the life of the convertible debentures.

 

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

 
| ** **                          | ** ** | **September 30,  2005** | ** ** | **December 31,****2004** | ** ** |
|-------------------------------------|------------|------------------------------|------------|-------------------------------|------------|
|                                |       |                         |       |                          |       |
| Professional fees                   |       | $                            | 149,632    |                          | $          | 573,323 |   |
| Payroll and payroll-related         |       | 140,635                      |       | 167,500                       |       |
| Travel                              |       | 48,489                       |       | 107,767                       |       |
| Advance deposit on warrant exercise |       | 30,000                       |       | —                        |       |
| Accrued termination costs           |       | 25,762                       |       | —                        |       |
| Property and equipment              |       | 24,364                       |       | —                        |       |
| Consulting                          |       | 20,273                       |       | —                        |       |
| Telephone                           |       | 19,703                       |       | —                        |       |
| Interest                            |       | 14,630                       |       | —                        |       |
| Directors’ fees                |       | 7,950                        |       | 59,346                        |       |
| Rent                                |       | 5,562                        |       | 25,848                        |       |
| Printing                            |       | —                       |       | 50,764                        |       |
| Value-added tax payable             |       | —                       |       | 47,024                        |       |
| Other                               |       | 19,908                       |       | 12,771                        |       |
|                                |       | $                            | 506,908    |                          | $          | 1,044,343 |   |

 

9

----

 

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

 

For the three and nine month periods ended September 30,2005 and 2004, the components of other comprehensive loss consisted of theCompany’s net loss and foreign currency translation adjustments.  Comprehensive loss was $5,026,320 and$579,600 for the three months ended September 30, 2005 and 2004,respectively, and $8,650,423 and $2,004,234 for the nine months ended September 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 nine month periods ended September 30, 2005, 4,868,000outstanding stock options, 9,302,500 outstanding warrants, and 8,633,333common shares issuable upon conversion of the convertible debentures were excluded from the calculation ofdiluted earnings per share for the three and nine month periods ended September 30,2005, because they were anti-dilutive. In 2004, 2,825,000 outstandingstock options were excluded from the calculation of diluted earnings per sharefor the nine month period ended September 30, 2004, because they wereanti-dilutive.

 

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

 

In February 2004, the board of directorsadopted the 2004 Stock Incentive Plan (the “Plan”). The Plan initially covered 6,000,000shares of the Company’s common stock issuable upon exercise of incentive stockoptions and non-statutory stock options and in connection with grants ofrestricted stock. The Plan was amended by the Board, on June 3, 2005 to,among other things, increase the number of shares available for options orrestricted stock grants from 6,000,000 to 8,000,000.  The shareholders of the Company approved theamendment to the Plan on July 14, 2005. The Board has the authority to select the employees, officers,directors, consultants and advisors to whom options are granted and determinethe terms of each option, including (i) the number of shares of commonstock subject to the option, (ii) when the option becomes exercisable, (iii) theoption exercise price, which must be at least 100% (110% in the case ofincentive stock options granted to a stockholder owning in excess of 10% of theCompany’s common stock) of the fair market value of the common stock as of thedate of grant and (iv) the duration of the option, which may be up to 10years or, in the case of incentive stock options issued to a stockholder owningin excess of 10% of the Company’s common stock, five years.

 

Options for a total of 6,668,000 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 had a contractual right to the grantof these options. The Company has treated these 1,500,000 options asoutstanding at September 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 had 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 September 30,2005, there were outstanding under the plan options to purchase an aggregate4,868,000 shares of common stock.

 

The Company has reflected pre-tax charges toearnings in the three and nine month periods ended September 30, 2005 of$1,802,459 and $2,199,459, respectively, for the compensation value of alldirector and employee stock options granted.

 

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

 

In January 2004, the Company entered intoemployment and non-competition agreements with three individuals.  The agreements were amended and restated in May 2004.  These agreements had initial terms that beganon January 1, 2004 and ended between March 2005 and June 2005.  The agreements provided for annual salariestotaling $300,000, as well as bonuses totaling $285,000 if certain Companyperformance goals were achieved as defined in the agreements.  As of September 30, 2005 no bonuses havebeen accrued or paid as such goals have not been met.  Two of the employees resigned as of June 30,2004.  The remaining individual continuedhis employment with the Company as an employee-at-will through November 2,2005, when he submitted his resignation. See Note 17.

 

10

----

 

**(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 $82,500 for the three and ninemonth periods ended September 30, 2004, respectively, with correspondingcredits recorded in additional paid-in capital. There were no contributed services during the three and nine monthperiods ended September 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 $25,000 and$180,000 were recorded as expense and charged to additional paid-in capital forthe three and nine month periods ended September 30, 2004,respectively.  The Chairman did not payany Company expense during the three and nine month periods ended September 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 recertify or relicense 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 underlyingequipment.  The promissory note bearsinterest at 8.25% per annum and is payable monthly in arrears.  A principal payment of $100,000 was due on September 30,2005 and was paid on October 3, 2005. An additional principal payment of $100,000 is due 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 endedSeptember 30, 2004, and $23,707 and $86,499 related to interest expensefor the nine month periods ended September 30, 2005 and 2004,respectively.  The equipment was placedin service in August 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 a conversionfeature.

 

11

----

 

**(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 October 31, 2005, the Chairman has drawn approximately $262,000 underthis facility to pay expenses incurred and accrued by the Company and itsaffiliates. Seven letters of credit in the aggregate amount of approximately$1,182,000 have been issued by the lender under the credit facility of whichapproximately $472,000 have been issued in favor of vendors to the Company andits affiliates at the request of the Chairman. As of October 31, 2005, approximately$426,000 was undrawn and available under the credit facility and approximately$2,574,000 was outstanding. The Company may obtain future advances from theChairman from both the credit facility and the Chairman’s other personal assetsin order to meet certain working capital needs. The Chairman may also cause thelender under the credit facility to issue standby letters of credit in favor ofone or more of the Company’s vendors to secure the Company’s obligations tosuch vendor or vendors. While the Chairman is not obligated to provide theseadvances to the Company or to cause the lender to issue standby letters ofcredit in favor of the Company’s vendors, the Company expects the Chairman tocontinue providing funds for operations in 2005 as and if needed. If theCompany is unable to raise additional external capital, the Company may becomedependent on the Chairman to fund its operations and provide growthcapital.  There can be no assurances thatthe Company can 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. Vistula Limited has no recourse provisions thatwould enable it to recover monies from third parties with respect to amounts itis required to pay under the guarantee. Vistula Limited does not have anycollateral it could obtain to recover amounts paid under the guarantee. TheCompany has evaluated the fair value of the guarantee in accordance withFinancial Accounting Standards Board Interpretation No. 45 (FIN 45) anddetermined the value to be immaterial to the financial statements and, as aresult, no liability has been recorded.

 

Shortly after the first closing of the private placementdescribed in Note 14, the Company received a letter sent on behalf of KevinDann & 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 they are, or were serving, at the Company’srequest as a directors (or in any other capacity). The term of the indemnificationperiod is 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

 

12

----

 

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 to defendlawsuits or settle claims related to these indemnification agreements. As aresult, the Company believes the estimated fair value of these agreements isminimal.

 

**(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 convertiblepromissory notes in the principal amounts of $125,000 and $50,000 on July 12,2004 and on August 11, 2004, respectively. Both convertible promissorynotes have a one-year term, accrue interest at the rate of 7% per annum and areconvertible into shares of the Company’s common stock at the price of $1.50 pershare. On August 11, 2005, the pension plan confirmed its earlieragreement to extend the maturity date of both promissory notes until December 31,2005.

 

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

 

On February 18, 2005 and March 4,2005, the Company completed a private placement of convertible debentures andwarrants to a group of sophisticated institutional and individual investors. Inthe private placement, the Company sold convertible debentures in the aggregateprincipal amount of $8,400,000 and warrants to purchase an aggregate of8,400,000 shares of its common stock. The Company paid placement fees to theplacement agent in the aggregate amount of $802,500. 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.  As of September 30,2005, $1,925,000 in outstanding principal amount of convertible debentures hasbeen converted into 2,566,661 shares of common stock.  The carrying amount of these notes of$1,355,056 has been reflected as equity as of September 30, 2005.

 

13

----

 

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 share. The Company determined the value of the warrant to be $184,844 using theBlack-Scholes pricing model and the following assumptions: risk freeinterest rate, 3.9%; expected divided yield, 0; expected life, 5 years; andexpected volatility, 80%.  The Company recorded the value of thiswarrant as deferred financing fees. In addition, the Company paid legal expenses and broker fees of$947,127, which have been recorded as deferred financing fees.  The deferred financing fees are beingamortized to interest expense using the straight-line method through thematurity date of the debentures. When holders convert their debentures intocommon stock of the Company, the pro-rata capitalized deferred financing feesare charged to interest expense.

 

The Company alsoissued 8,400,000 warrants to the investors to purchase shares of theCompany’s common stock at an exercise price of $1.00 per share.  TheCompany determined the value of the warrants to be $1,933,108 using theBlack-Scholes pricing model and the following assumptions: risk freeinterest rate, 3.9%; expected divided yield, 0; expected life, 5 years;and expected volatility, 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. When holders convert their debentures into common stock of the Company,the pro-rata capitalized deferred financing fees are charged to interestexpense.  As of September 30,2005, the unamortized portion of the discount was $1,019,831.

 

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 nobeneficial conversion feature.

 

For both of the Black-Scholes computationsdescribed above, the Company used $0.45 as the fair value of its common stock,representing management’s determination of fair value based on an independentappraisal.  There was no current tradingmarket for the Company’s common stock at the time of the debenture and warrantallocation.  See Note 17 regardingconversions of debentures and exercise of warrants subsequent to September 30,2005.

 

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

 

On August 11, 2004, theCompany entered into a distribution and marketing agreement with NetYantra Inc.and NetYantra India Pvt. Ltd. (collectively, “NetYantra”) pursuant to whichNetYantra has granted to the Company the exclusive worldwide rights (other thanin India where NetYantra is headquartered and subject to certain existingdistribution agreements) to market and distribute the V-CubeTM IP-PBX softwareplatform to Tier 1 carriers, telecommunications equipment manufacturers,internet service providers, large corporations, small and medium enterprises,and other business entities and individual retail customers. Under thedistribution and marketing agreement, in consideration for the marketing anddistribution rights granted to the Company by NetYantra, the Company has paidNetYantra $400,000 and is required to pay NetYantra fifty percent of certainnet revenues that the Company derives from the distribution of the V-CubeTMplatform. This amount paid by the Company is creditable against future royaltycommitments.  Accordingly, the Companyrecorded this amount as prepaid royalties and will expense such prepaid amountas royalties accrue.

 

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 issue toNetYantra 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).  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 issued 500,000 shares of its common stock to NetYantra incompliance with the agreement.  Thispayment is not creditable toward royalty commitments and was charged to expense.

 

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.

 

14

----

 

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

 

In May 2005, the FASB issued SFAS No. 154,*Accounting Changes and Error Corrections*,a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS No. 154).Previously, APB No. 20, *AccountingChanges* and SFAS No. 3, *ReportingAccounting Changes in Interim Financial Statements* required theinclusion of the cumulative effect of changes in accounting principle in netincome of the period of the change. SFAS No. 154 requires companies torecognize a change in accounting principle, including a change required by anew accounting pronouncement, when the pronouncement does not include specific transitionprovisions, retrospectively to prior periods’ financial statements. The Companywill assess the impact of a retrospective application of a change in accountingprinciple in accordance with SFAS No. 154 if such a change arises afterthe effective date of January 1, 2006.

 

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

 

Subsequentto September 30, 2005 and through November 4, 2005, an additional$150,000 in outstanding principal of convertible debentures issued by theCompany has been converted into 199,999 shares of common stock.

 

On October 7, 2005,the Company entered into Warrant Exercise Agreements with certain holders ofwarrants issued in the private placement that closed on February 18 and March 4,2005 (the “Private Placement”). See Note 14. Under these agreements, the Companyagreed to issue new common stock purchase warrants (“New Warrants”) in theevent of the warrant holders’ exercise on or before October 31, 2005 oftheir outstanding warrants.  The NewWarrants were to be exercisable for a number of shares equal to the number ofshares they purchased upon such exercise of the outstanding warrants. Inaccordance with the terms of the Securities Purchase Agreement entered into inconnection with the Private Placement, the Company offered to enter into aWarrant Exercise Agreement with each of the holders of warrants issued inconnection with the Private Placement.

 

At the close of businesson October 31, 2005, holders of warrants issued in the Private Placementexercised those warrants with respect to a total of 3,190,499 shares of commonstock, and the Company received gross cash proceeds of $3,190,499.  In accordance with the warrant exerciseagreements, the Company is issuing to these holders New Warrants to purchase upto an aggregate 3,190,499 shares of common stock at an exercise price of $1.50per share.  The Company is required topay a placement fee to the placement agent in connection with this privateplacement consisting of $159,525 in cash and a warrant to purchase up to 159,525shares of common stock, which warrant will be on substantially the same termsas the New Warrants.  The Company hasagreed to register for resale under the Securities Act of 1933, as amended, theshares underlying the New Warrants pursuant to a Registration Rights Agreementdated as of October 3, 2005.  The issuance of the New Warrants andthe warrant to the placement agent is exempt from registration under Section 4(2) ofthe Securities Act of 1933, as amended.

 

Effective as of October 10,2005, Vistula Limited, a wholly owned subsidiary of the Company, entered into alicense agreement with Intuate Limited pursuant to which Intuate grants VistulaLimited and its affiliates (including the Company) a non-exclusive, perpetuallicense to use Intuate’s VoIP system comprising a customer portal, billingengine, VoIP gateway, and pre-paid call control platform.  In consideration for such license, VistulaLimited is required to pay Intuate £154,000, plus applicable VAT, within fourweeks of the effective date of the license agreement (which amount has not beenpaid as of November 18, 2005), an additional £50,000 for each additionalphysical deployment of the Intuate system by Vistula Limited or its affiliates,and 20% of the net margin derived by Vistula Limited or its affiliates from theIntuate system.

 

Effective November 1, 2005 the Company enteredinto a sublease for approximately 1,300 square feet of office space in NewYork. The Company previously was a tenant-at-will in this office space.  The term of the sublease is 24 months with anannual rent of $78,174.

 

On November 8, 2005, Adam Bishop was appointedas the president and chief executive officer of our wholly-owned subsidiary,Vistula USA, Inc., replacing Mark Scully. Mr. Scully submitted hisresignation on November 2, 2005.

 

15

----

 

**Item2.  Management’s Discussion and Analysisof Financial 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.

 

16

----

 

•                                          We currentlyderive a significant portion of revenue from a limited number of contracts andcustomers and, if we are unable to replace these contracts upon completion andmaintain customer relationships, we could have a significant decrease in ourrevenues 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.

 

17

----

 

•                                          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.

 

18

----

 

**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 first quarterof 2005, through Vistula, Vistula USA and Vistula SA, we began to market theV-CubeTM Voice over Internet Protocol, or “VoIP”, IP-PBX software platform totelecommunications carriers, Internet service providers, or “ISPs”, largecorporations and small and medium enterprises, or “SMEs”, throughout the world.

 

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 are collectivelyreferred to as the “Vistula Companies.” The Vistula Companies have switching facilities in London and LosAngeles and interconnect agreements with suppliers and customers in theselocations.  We believe that the VistulaCompanies are positioned to take advantage of the disruption and uncertainty inthe telecommunications sector over the past few years. We believe theopportunity for well-managed wholesale carriers such as the Vistula Companiesis 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, weentered into a distribution and marketing agreement with Telstra EuropeLimited, a U.K.-based telecommunications carrier. Under this agreement, welicense Telstra Europe to provide hosted IP-PBX services to its customers usingthe hosted V-CubeTM IP-PBX platform. The agreement grants Telstra Europe anexclusive license to provide the hosted solution to its customers in the UnitedKingdom and Ireland for a period of five years. The monthly license fee payableby Telstra Europe to us is based on the number of individual users at thevarious Telstra Europe customers who are using the VoIP services provided byTelstra Europe through use of the V-CubeTM platform. We hope to leverage themarketing advantages and customer relationships of Telstra Europe to provide uswith regular monthly revenue.  No revenuehas been realized from this agreement through September 30, 2005.

 

***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.

 

19

----

 

**Critical Accounting Policies**

 

Our consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States. These accounting principles require us to make certainestimates, judgments and assumptions. We believe that the estimates, judgmentsand assumptions upon which we rely are reasonable based upon informationavailable to us at the time that these estimates, judgments and assumptions aremade. These estimates, judgments and assumptions can affect the reportedamounts of assets and liabilities as of the date of the financial statements,as well as the reported amounts of revenues and expenses during the periodspresented. Those estimates and judgments are based on management’s historicalexperience, the terms of existing agreements, our observance of trends in theindustry, information that we obtain from our customers and outside sources,and on various other assumptions that management believes to be reasonable andappropriate under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. To the extent there are material differences between these estimates,judgments or assumptions and actual results, our financial statements will beaffected.

 

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 forthe three month period ended September 30, 2005. We did not make anychanges to this policy during this period.

 

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

 

**Results of Operations**

 

Revenues for the three-month period ended September 30, 2005 decreased by 49% over the comparable fiscal period in 2004 to $262,050.  Revenue for the nine-month period ended September 30, 2005 decreased by 74% over the comparable fiscal period in 2004 to $614,378. 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 in the U.K. due to our efforts being focused in establishing a presence in the VoIP marketplace.  In addition, Vistula USA has been unable to generate material revenues in the wholesale market during 2005.  We believe that during the remainder of 2005, we will derive revenues from the equipment described in Note 10 enabling us to attract and serve new customers.

 

Cost of revenues for thethree-month period ended September 30, 2005, was $301,120, a 29% decreaseas compared to the same period in fiscal 2004. Cost of revenues for thenine-month period ended September 30, 2005 was $719,955, a 66% decrease ascompared to the same period in fiscal 2004. These overall decreases relate to the reduction in call volume revenuesduring the 2005 periods. Engineering costs classified as cost of revenues forthe three-month period ended September 30, 2005 of $53,085 increased 34%as compared to the same period in fiscal 2004, and engineering costs classifiedas cost of revenues for the nine-month period ended September 30, 2005 of$185,086 increased 56% as compared to the same period in fiscal 2004.  Both the three and nine month increases aredue to expenditures pertaining to support of the wholesale business andinitiating routing services in the U.S.

 

Selling, general and administrative costs increased by608% to $4,536,424 for the three-month period ended September 30, 2005 ascompared to the same period in fiscal 2004, and increased by 257% to $7,654,878for the nine-month period ended September 30, 2005 as compared to the sameperiod in fiscal 2004. During the three-month period ended September 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; an increase in sales and marketing expenses incurred in promoting theCompany’s VoIP product offering; an increase in rent due to new offices in theUK and South Africa; an increase in depreciation expense due to thecommencement of depreciation of the equipment discussed in Note 10; an increasein non-cash compensation expense due to stock options granted; and a $1,000,000non-cash expense for the issuance of 500,000 shares per the NetYantra agreementdescribed in Note 15.  During thenine-month period ended September 30, 2005, we incurred increasedcompensation for employees and consultants and increased travel as the VoIPplatform was being marketed; increased professional fees, due in part to thepublic reporting requirements of the Company; an increase in sales and marketingexpenses in creating awareness of the Company’s VoIP product offering;increased investment banking fees as the Company engaged in fundraisingactivities; an increase in each of regulatory fees, printing, and insurancecosts, all related to the transition of the Company to a public-reportingentity; an increase in rent due to new offices in the UK and South Africa; anincrease in depreciation expense due to the commencement of depreciation of theequipment discussed in Note 10; an increase in non-cash compensation expensedue to stock options granted; and a $1,000,000 non-cash expense for theissuance of 500,000 shares per the NetYantra agreement described in Note 15.

 

20

----

 

Interest expense, net increased 1,328% to $445,778 forthe three-month period ended September 30, 2005 as compared to the sameperiod in fiscal 2004 and increased by 872% to $863,539 for the nine-monthperiod ended September 30, 2005 as compared to the same period in fiscal2004. During the three and nine month periods ended September 30, 2005 weincurred interest expense on the convertible debentures, interest expense onthe convertible promissory note to a related party, and interest expense on thenote payable issued in the acquisition of equipment described in Note 10. Theamortization of the capitalized finance fees and the debt discount described inNote 14 are included in interest expense. During the three and nine monthperiods ended September 30, 2004 we only incurred interest expense on thecapital lease obligation described in Note 10.

 

For the three-month period ended September 30, 2005, we incurred a loss of $(5,021,272) or $(0.19) loss per common share, basic and diluted.  For the nine-month period ended September 30, 2005, we incurred a loss of $(8,623,994) or $(0.34) loss per common share, basic and diluted.

 

**Liquidity And Capital Resources**

 

As of September 30, 2005, we had cash and cash equivalents of approximately $241,000 and a working capital deficit of approximately $1,238,000.  This represents an increase in cash and cash equivalents of approximately $238,000 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 September 30, 2005, we have generated losses of approximately $(13,019,000).  Net accounts receivable were approximately $103,000 at September 30, 2005, an increase of approximately 84% from December 31, 2004.  Accounts payable, accrued expenses and due to stockholder decreased approximately $857,000 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, 2005 and March 4, 2005, wecompleted a private placement of convertible debentures and warrants to a groupof sophisticated institutional and individual investors. In the privateplacement, we sold convertible debentures in the aggregate principal amount of$8,400,000 and warrants to purchase an aggregate of 8,400,000 shares of ourcommon stock. We paid placement fees to the placement agent in the aggregateamount of $802,500 and we also issued to the placement agent a warrant topurchase up to 802,500 shares of our common stock at an initial exercise priceof $1.00 per share. The debentures accrue interest daily at a rate of 8% perannum, 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.  Through November 4, 2005, $2,075,000 inoutstanding principal amount of convertible debentures has been converted into2,766,660 shares of common stock reducing the amount of interest required to bepaid in future periods.    Subsequent to September 30,2005, 3,190,499 warrants issued in the private placement have been exercised,resulting in net cash proceeds to the Company of $3,030,974, after placement agenetfees of $159,525.

 

We have made expendituresfor capital equipment from our inception until September 30, 2005 ofapproximately $392,000 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 unanticipatedrecertification costs.  Under the termsof the promissory note, interest accrues daily at a rate of 8.25% and ispayable monthly in arrears.  An initialprincipal payment of $100,000 has been made. An additional principal payment of $100,000 is due on December 31,2005. The remaining principal and any unpaid interest is payable on the firstanniversary of the closing of the purchase.

 

21

----

 

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 have paid NetYantra $400,000 and we are required to pay NetYantra fiftypercent of certain net revenues that the Company derives from the distributionof the V-CubeTM platform.

 

In addition, the agreement stated that in theevent that our common stock was quoted or traded on a stock market on or beforethe first anniversary of the agreement, we would issue to NetYantra shares ofthe Company’s common stock having a market value of $1,000,000 based on theopening price of the Company’s common stock on the first day of trading (or, atthe Company’s option, pay to NetYantra a cash payment of $1,000,000 instead ofissuing such shares).  On July 21,2005, public trading in the Company’s common stock began jointly on the OTCBulletin Board and the Pink Sheets Electronic Quotation Service under thetrading symbol “VSTL.”  The opening salewas at a price of $2.00 per share. The Company issued 500,000 shares of itscommon stock to NetYantra in compliance with the agreement.

 

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 as and if needed, until such time that ouroperations are self-sustaining or we raise additional external capital, as thecase may be.  As described in Note 17, inOctober 2005 the Company realized $3.0 million in net proceeds from theexercise of warrants associated with the convertible debentures described inNote 14.  Also, although the acquiredequipment described in Note 10 has been placed in service as of September 30,2005, only nominal revenues have been generated to date.  Cash flow has therefore been negativelyaffected and, if we are unable to raise additional financing during the fourthquarter of 2005 or first quarter of 2006, we will look to this principalstockholder 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.

 

22

----

 

**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 VistulaLimited and its affiliates to secure obligations of those entities to theirvendors. In light of the circumstances surrounding the guaranty, including thefact that the obligations of the stockholder under the credit facility aresecured by significant assets in which the stockholder has a beneficialinterest, we believe that the potential liability and obligations of VistulaLimited under this guaranty are not reasonably likely to have a materialcurrent or future effect on our financial condition, results of operations,liquidity or capital resources.  Althoughthe acquired equipment described in Note 10 has been placed in service as of September 30,2005, only nominal revenues have been generated to date.  Cash flow has therefore been negativelyaffected and, if we are unable to raise additional financing during the fourthquarter of 2005 or first quarter of 2006, we will look to this principalstockholder to provide working capital funding until additional capital can beobtained.

 

23

----

 

**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 September 30, 2005.

 

On March 28,2005, our independent registered public accounting firm at the time, Vitale,Caturano & Company, Ltd., advised us in connection with the completionof their audit for the 2004 fiscal year that they had identified certainmatters involving the operation of our internal controls that they consideredto 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 and documentationnecessary to yield proper accounting consideration and recording. Among theissues identified or addressed late in the audit process were accounting forstock option arrangements, prepaid royalties, severance accruals, certainrevenue contracts, reconciling and verifying shareholder loans, cutoff ofaccounts 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 September 30, 2005.  Moreover, we believe that

 

24

----

 

throughoutthe 2005 fiscal year, we have allocated significant resources to remediation ofthe material weakness identified by Vitale, Caturano & Company,Ltd.  In arriving at this conclusion, ourmanagement considered the following factors:

 

•      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 quarterlyreports for the first and second quarters, and this quarterly report within thetime periods specified 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.

 

•      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.

 

We believethat the increased staffing and improvement in our accounting software haveaddressed the concerns that Vitale, Caturano & Company, Ltd. raised inrelation to the timeliness of our closing process.

 

*Changes in InternalControls Over Financial Reporting*

 

As notedabove, at the beginning of the quarter ended September 30, 2005, we addeda full-time manager of accounting and administration to our staff.  We believe this increase in staffing hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

25

----

 

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

 

**Item 6.  Exhibits**

 

**(a) Exhibits.**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                           |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                   |
| 10.1(1)             |       | Consulting Agreement by and between Vistula  Communications Services, Inc. and Executive Management Services Limited  dated August 17, 2005.                                                                                                      |
| 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.      |

 

----

*                    Filed herewith.

 

(1)             Incorporated by reference to Exhibit 10.1 tothe Company’s current report on Form 8-K filed with the Securities and ExchangeCommission on August 18, 2005.

 

26

----

 

**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on 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 |

 

27

----