UNITED
        STATES
 SECURITIES
        AND EXCHANGE COMMISSION
 WASHINGTON,
        D.C. 20549
  **FORM
        10-K**
 
 (Mark
        One)
 
 [X]
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 [FEE REQUIRED]
 
 **For
        the Fiscal Year Ended January 1, 2006**
 
 OR
 
 []
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 [NO FEE REQUIRED]
 
 For
        the
        transition period from ___________ to ______________
 
 **Commission
        file number: 0-28234**
    
  
 **MEXICAN
        RESTAURANTS, INC.**
 (Exact
        name of registrant as specified in its charter)
 
 **Texas**
              **76-0493269**(State
                  or other jurisdiction of
                incorporation
                  or organization)
              (IRS
                  Employer Identification Number)
 
 **1135
                  Edgebrook, Houston, Texas**
              **77034-1899**(Address
                  of Principal Executive Offices)
              (Zip
                  Code)
 
 Registrant’s
        telephone number, including area code: **713-943-7574**
 
 Securities
        registered pursuant to Section 12(b) of the Act:
 **None**
 
 Securities
        registered pursuant to Section 12(g) of the Act:
 **Common
        Stock, $.01 par value**
 (Title
        of
        class)
 
 Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.
 Yes   ̈  No þ
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act. Yes   ̈  No þ
 
 Indicate
        by check mark whether the Registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the Registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.  Yes X  No
        ____
 
 Indicate
        by check mark if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K is not contained herein, and will not be contained, to the
        best
        of Registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-K or any amendment
        to this
        Form 10-K. [X ]
 
 Indicate
        by check mark whether the Registrant is an accelerated filer (as defined
        in Rule
        12b-2 of the Securities Exchange Act of 1934). Yes   No X
  1
  
 The
        aggregate market value of the Registrant’s Common Stock held by non-affiliates
        of the Registrant, based on the sale trade price of the Common Stock as reported
        by the Nasdaq Small Cap Market on July 3, 2005, the last business day of
        the Registrant’s
        most recently completed second quarter, was $14,026,756. For purposes of
        this
        computation, all officers, directors and 10% beneficial owners of the registrant
        are deemed to be affiliates. Such determination should not be deemed an
        admission that such officers, directors or 10% beneficial owners are, in
        fact,
        affiliates of the Registrant.
  Number
        of
        shares outstanding of the Registrant’s Common Stock, as of March 28, 2006:
        3,356,977 shares of Common Stock, par value $.01.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 Specified
        portions of the Company’s definitive proxy statement in connection with the 2006
        Annual Meeting of Shareholders to be held May 23, 2006, to be filed with
        the
        Securities and Exchange Commission pursuant to Regulation 14A, are incorporated
        by reference into Part III of this report.
 
 **Table
        of Contents**
 
 **Part
                  I**
              
              **Page**Special
                  Note Regarding Forward-Looking Statements
              2Item
                  1.
              Business
              4Item
                  1A.
              Risk
                  Factors
              10Item
                  1B.
              Unresolved
                  Staff Comments
              12Item
                  2.
              Properties
              12Item
                  3.
              Legal
                  Proceedings
              13Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              14**Part
                  II**Item
                  5.
              Market
                  for the Registrant’s Common Equity, Related Shareholder Matters and Issuer
                  Purchases of Equity Securities
              14Item
                  6.
              Selected
                  Financial Data
              15Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              16Item
                  7A.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              22Item
                  8.
              Financial
                  Statements and Supplementary Data
              22Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              23Item
                  9A.
              Controls
                  and Procedures
              23Item
                  9B.
              Other
                  Information
              23**Part
                  III**Item
                  10.
              Directors
                  and Executive Officers of the Registrant
              23Item
                  11.
              Executive
                  Compensation
              23Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Shareholder Matters
              24Item
                  13.
              Certain
                  Relationships and Related Transactions
              24Item
                  14.
              Principal
                  Accountant Fees and Services
              24**Part
                  IV**Item
                  15.
              Exhibits
                  and Financial Statement Schedules
              24
 
 
 **SPECIAL
        NOTE REGARDING FORWARD-LOOKING STATEMENTS**
 
 Certain
        statements in this Form 10-K constitute “forward-looking statements” within the
        meaning of the Private Securities Litigation Reform Act of 1995 (the “Reform
        Act”). Such forward-looking statements involve known and unknown risks,
        uncertainties and other facts which may cause the actual results, performance
        or
        achievements of Mexican Restaurants, Inc. and its subsidiaries (the “Company”),
        its restaurants, area developers and franchisees to be materially different
        from
        any future results, performance or achievements expressed or implied by such
        forward-looking statements. Such factors include, among others, the following:
        general economic and business conditions; competition; success of operating
        initiatives; development and operating costs; advertising and promotional
        efforts; brand awareness; adverse publicity; acceptance of new product
        offerings; availability, locations and terms of sites for store development;
        changes in
  2
  business
        strategy or development plans; quality of management; availability, terms
        and
        development of capital; business abilities and judgment of personnel;
        availability of qualified personnel; food, labor and employee benefit costs;
        area developers’ adherence to development schedules; changes in, or the failure
        to comply with government regulations; regional weather conditions or
        weather-related events; construction schedules; and other factors referenced
        in
        the Form 10-K. The use in this Form 10-K of such words as “believes”,
“anticipates”, “expects”, “intends”, “plans” and similar expressions with
        respect to future activities or other future events or conditions are intended
        to identify forward-looking statements, but are not the exclusive means of
        identifying such statements. The success of the Company is dependent on the
        efforts of the Company, its employees, its area developers, and franchisees
        and
        the manner in which they operate and develop stores in light of various factors,
        including those set forth above.
 
 Although
        the Company believes that the assumptions underlying the forward-looking
        statements contained herein are reasonable, any of the assumptions could
        be
        inaccurate, and therefore, there can be no assurance that the forward-looking
        statements included in this Form 10-K will prove to be accurate. In light
        of the significant uncertainties inherent in the forward-looking statements
        included herein, the inclusion of such information should not be regarded
        as a
        representation by the Company that its objectives or plans will be
        achieved.
 
  3
  
 **PART
        I**
 
 **ITEM
        1.**   **BUSINESS**
 
 **General**
 
 Mexican
        Restaurants, Inc. (the “Company”) operates and franchises Mexican-theme
        restaurants featuring various elements associated with the casual dining
        experience under the names Casa Olé®, Monterey’s Tex-Mex Café®, Monterey’s
        Little Mexico®, Tortuga Coastal Cantina®, La Señorita® and Crazy Jose’s®. The
        Casa Olé, Monterey, Tortuga, La Señorita and Crazy Jose’s concepts have
        been in business for 34, 51, 12, 27 and 19 years, respectively. Today the
        Company operates 60 restaurants, franchises 18 restaurants and licenses one
        restaurant in various communities across Texas, Louisiana, Oklahoma and
        Michigan. The Casa Olé, Monterey, La Señorita and Crazy Jose’s restaurants are
        designed to appeal to a broad range of customers, and are located primarily
        in
        small and in medium-sized communities and middle-income areas of larger markets.
        The Tortuga Coastal Cantina restaurants also are designed to appeal to a
        broad
        range of customers and are located primarily in Houston suburban markets.
        The
        restaurants offer fresh, quality food, affordable prices, friendly service
        and
        comfortable surroundings. Menus feature a variety of traditional Mexican
        and
        Tex-Mex selections, complemented by the Company's own original Mexican-based
        recipes, designed to have broad appeal. The Company believes that the
        established success of the Company in existing markets, its focus on
        middle-income customers, and the skills of its management team provide
        significant opportunities to realize the value inherent in the Mexican
        restaurant market and increase revenues in existing markets.
 
 The
        Company was incorporated under the name “Casa Olé Restaurants, Inc.” under the
        laws of the State of Texas in February 1996, and had its initial public offering
        of Common Stock in April 1996. In May 1999, the Company changed its corporate
        name to Mexican Restaurants, Inc. The Company operates as a holding company
        and
        conducts substantially all of its operations through its subsidiaries. All
        references to the Company include the Company and its subsidiaries, unless
        otherwise stated.
 
 Since
        its
        inception as a public company, the Company has primarily grown through the
        acquisition of other Mexican food restaurant companies. In
        July
        1997, the Company purchased all of the outstanding stock of Monterey’s
        Acquisition Corp. (“MAC”). At the time of the acquisition, MAC owned and
        operated 26 restaurants in Texas and Oklahoma under the names “Monterey’s
        Tex-Mex Café,” “Monterey’s Little Mexico” and “Tortuga Coastal Cantina.”
 
 In
        April
        1999, the Company purchased 100% of the outstanding stock of La Señorita
        Restaurants, a Mexican restaurant chain operated in the State of Michigan.
        The
        Company purchased the shares of common stock of La Señorita for $4.0 million.
        The transaction was funded with the Company’s revolving line of credit with Bank
        of America. At the time of the acquisition, La Señorita operated five
        company-owned restaurants, and three franchise restaurants.
 
 On
        January 7,
        2004, the Company completed its purchase of 13 restaurants and related assets
        from its Beaumont-based franchisee and affiliates for a total consideration
        of
        approximately $13.75 million. The financing for the acquisition was provided
        by
        Fleet National Bank, CNL and the sellers. The restaurants acquired include
        eight
        Casa Olé restaurants located in Southeast Texas, two Casa Olé restaurants
        located in Southwest Louisiana, and three Crazy Jose’s restaurants located in
        Southeast Texas.
 
 On
        October 14, 2004, the Company completed its purchase of one franchise restaurant
        in Brenham, Texas for approximately $215,000. The restaurant was closed,
        remodeled and re-opened on November 22, 2004.
 
  **Strategy
        and Concept**
 
 The
        Company’s objective is to be perceived as a value leader in the Mexican theme
        segment of the full-service casual dining marketplace. To accomplish this
        objective, the Company has developed strategies designed to achieve and maintain
        high levels of customer loyalty, frequent patronage and profitability. The
        key
        strategic elements are:
 
 Ÿ
              Offering
                  consistent, high-quality, original recipe Mexican menu items that
                  reflect
                  both national and local taste
                  preferences;
  4
  
 
 Ÿ
              Pricing
                  its menu offerings at levels below many family and casual-dining
                  restaurant concepts;
 
 Ÿ
              Selecting,
                  training and motivating its employees to enhance customer dining
                  experiences and the friendly casual atmosphere of its
                  restaurants;
 
 Ÿ
              Providing
                  customers with the friendly, attentive service typically associated
                  with
                  more expensive casual-dining experiences;
                  and
 
 Ÿ
              Reinforcing
                  the perceived value of the dining experience with a comfortable
                  and
                  inviting Mexican decor.
 
 
 ***Menu.*** The
        Company’s restaurants offer high-quality products with a distinctive, yet mild
        taste profile with mainstream appeal. Fresh ingredients are a critical recipe
        component, and the majority of menu items are prepared daily in the kitchen
        of
        each restaurant from original recipes.
 
 The
        menus
        feature a wide variety of entrees including enchiladas, combination platters,
        burritos, fajitas, coastal seafood and other house specialties. The menu
        also
        includes soup, salads, appetizers and desserts. From time to time the Company
        also introduces new dishes designed to keep the menus fresh. Alcoholic beverages
        are served as a complement to meals and represent a range of less than 5%
        of
        sales at its more family-oriented locations, and up to 20% in its more
        casual-oriented dining locations. At Company-owned restaurants the dinner
        menu
        entrees presently range in price from $4.99 to $15.95, with most items priced
        between $5.95 and $9.95. Lunch prices at most Company-owned restaurants
        presently range from $4.99 to $8.95.
 
 ***Atmosphere
        and Layout.*** The
        Company emphasizes an attractive interior and exterior design for each of
        its
        restaurants. The typical restaurant has an inviting and interesting Mexican
        exterior. The interior decor is comfortable Mexican in appearance to reinforce
        the perceived value of the dining experience. Stucco, tile floors, carpets,
        plants and a variety of paint colors are integral features of each restaurant's
        decor. These decor features are incorporated in a floor plan designed to
        provide
        a comfortable atmosphere. The Company’s restaurant designs are sufficiently
        flexible to accommodate a variety of available sites and development
        opportunities, such as malls, end-caps of strip shopping centers and free
        standing buildings, including conversions to the Company’s restaurant design.
        The restaurant facility is also designed to serve a high volume of customers
        in
        a relatively limited period of time. The Company's restaurants typically
        range
        in size from approximately 4,000 to 5,600 square feet, with an average of
        approximately 4,500 square feet and a seating capacity of approximately
        180.
 
 **Growth
        Strategy**
 
 The
        Company believes that the unit economics of the various restaurant concepts
        of
        the Company, as well as their value orientation and focus on middle income
        customers, provide significant potential opportunities for growth. The Company’s
        long-standing strategy to capitalize on these growth opportunities has been
        comprised of two key elements:
 
 ***Improve
        Same Restaurant Sales and Profits*** .
        The
        Company’s first growth opportunity is to improve the sales and controllable
        income of existing restaurants (controllable income consists of restaurant
        sales
        less food and beverage expenses, labor and controllable expenses, such as
        utilities and repair and maintenance expenses, but excludes advertising and
        occupancy expenses). This is accomplished through an emphasis on restaurant
        operations, coupled with improving marketing, purchasing and other
        organizational efficiencies (see “Restaurant Operations” below). During fiscal
        year 2006, the Company expects to focus on improving sales and profitability
        so
        that it can maximize free cash flow, which it will use to pay off debt, remodel
        existing restaurants, build new restaurants, acquire existing franchise
        restaurants and to make repurchases of its common stock when it determines
        such
        repurchases are a prudent use of its capital.
  ***Increased
        Penetration of Existing Markets.*** The
        Company’s second growth opportunity is, when it believes market conditions
        warrant, to increase the number of restaurants in existing Designated Market
        Areas (“DMAs”) and to expand into contiguous new markets. The DMA concept is a
        mapping tool developed by the A.C. Nielsen Co. that measures the size of
        a
        particular market by reference to communities included within a common
        television market. The Company's objective in increasing the density of
        Company-owned restaurants within existing markets is to improve operating
        efficiencies in such markets and to realize improved overhead absorption.
        In
        addition, the Company believes that increasing the density of restaurants
        in
        both Company-owned and franchised markets will assist it in achieving effective
        media penetration while
  5
  
 
 
 maintaining
        or reducing advertising costs as a percentage of revenues in the relevant
        markets. The Company believes that careful and prudent site selection within
        existing markets will avoid cannibalization of the sales bases of existing
        restaurants.
 
 In
        implementing its unit expansion strategy, the Company may use a combination
        of
        franchised and Company-owned restaurants. The number of such restaurants
        developed in any period will vary. The Company believes that a mix of franchised
        and Company-owned restaurants would enable it to realize accelerated expansion
        opportunities, while maintaining majority or sole ownership of a significant
        number of restaurants. Generally the Company does not anticipate opening
        franchised and Company-owned restaurants within the same market. In seeking
        franchisees, the Company will continue to primarily target experienced
        multi-unit restaurant operators with knowledge of a particular geographic
        market
        and financial resources sufficient to execute the Company's development
        strategy.
 
 The
        restaurant industry is a competitive and fragmented business. Moreover, the
        restaurant industry is characterized by a high initial capital investment.
        Our
        focus is not on new restaurant expansion just to generate additional sales,
        but
        a balanced approach that emphasizes same-restaurant sales growth and selective
        new restaurant development and acquisitions of existing franchise restaurants.
        During fiscal 2005, the Company opened one new restaurant and closed, remodeled
        and re-opened an existing restaurant. The Company plans to build two new
        restaurants in fiscal year 2006, as well as significantly remodel one existing
        restaurant and moderately remodel eight existing restaurants.
 
 The
        Company
        anticipates it will continue to selectively acquire existing franchised
        restaurants from time to time when such opportunities arise, as well as actively
        promote the development of new franchise restaurants (see “Franchising” below).
        Further, the Company will continue to review potential strategic acquisitions
        within the Mexican food restaurant industry that would complement our existing
        corporate culture.
 
 **Site
        Selection**
 
 When
        developing new restaurant sites, senior management of the Company devotes
        significant time and resources to analyzing prospective sites for the Company’s
        restaurants. Senior management has also created and utilizes a site selection
        committee, which reviews and approves each site to be developed. In addition,
        the Company conducts customer surveys to define precisely the demographic
        profile of the customer base of each of the Company’s restaurant concepts. The
        Company’s site selection criteria focus on:
  1)
              matching
                  the customer profile of the respective restaurant concept to the
                  profile
                  of the population of the target local
                  market;
 
 2)
              easy
                  site accessibility, adequate parking, and prominent visibility
                  of each
                  site under consideration;
 
 3)
              the
                  site’s strategic location within the
                  marketplace;
 
 4)
              the
                  site’s proximity to the major concentration of shopping centers within
                  the
                  market;
 
 5)
              the
                  site’s proximity to a large employment base to support the lunch segment;
                  and
 
 6)
              the
                  impact of competition from other restaurants in the
                  market.
 
 The
        Company believes that a sufficient number of suitable sites are available
        for
        contemplated Company and franchise development in existing markets. Based
        on its
        current planning and market information, the Company plans to open two new
        restaurants in fiscal year 2006. The anticipated total investment for a 4,200
        to
        5,600 square foot restaurant, including land, building, equipment, signage,
        site
        work, furniture, fixtures and decor ranges between $1.4 and $2.1 million
        (including capitalized lease value). Additionally, training and other
        pre-opening costs are anticipated to approximate $50,000 to $100,000 per
        location. The cost of developing and operating a Company restaurant can vary
        based upon fluctuations in land acquisition and site improvement costs,
        construction costs in various markets, the size of the particular restaurant
        and
        other factors. Although the Company anticipates that development costs
        associated with near-term restaurants will range between $1.4 and $2.1 million,
        there can be no assurance of this. Where possible, the Company uses build
        to
        suit, lease conversion or sale and leaseback transactions in an effort to
        limit
        its cash investment to approximately $550,000 per location.
  6
  
 
  **Restaurant
        Operations**
 
 ***Management
        and Employees.*** **** The
        management staff of each restaurant is responsible for managing the restaurant's
        operations. Each Company-owned restaurant operates with a general manager,
        one
        or more assistant managers and a kitchen manager or a chef. Including managers,
        restaurants have an average of 50 full-time and part-time employees. The
        Company
        historically has spent considerable effort developing its employees, allowing
        it
        to promote from within. As an additional incentive to its restaurant management
        personnel, the Company has a bonus plan in which restaurant managers can
        receive
        monthly bonuses based on a percentage of their restaurants’ controllable
        profits.
 
 The
        Company’s regional supervisors, who report directly to the Company’s Directors
        of Operation, offer support to the store managers. Each supervisor is eligible
        for a monthly bonus based on a percentage of controllable profits of the
        stores
        under their control.
 
 As
        of
        January 1, 2006, the Company employed approximately 3,171 people, of whom
        approximately 3,120 were restaurant personnel at the Company-owned restaurants
        and 51 were corporate personnel. The Company considers its employee relations
        to
        be good. Most employees, other than restaurant management and corporate
        personnel, are paid on an hourly basis. The Company’s employees are not covered
        by a collective bargaining agreement.
 
 ***Training
        and Quality Control.*** The
        Company requires its hourly employees to participate in a formal training
        program carried out at the individual restaurants, with the on-the-job training
        program varying from three days to two weeks based upon the applicable position.
        Managers of both Company-owned and franchised restaurants are trained at
        one of
        the Company's specified training stores by that store's general manager and
        are
        then certified upon completion of a four to six week program that encompasses
        all aspects of restaurant operations as well as personnel management and
        policy
        and procedures, with special emphasis on quality control and customer relations.
        To evaluate ongoing employee service and provide rewards to employees, the
        Company employs a "mystery shopper" program that consists of two anonymous
        visits per month per restaurant. The Company's franchise agreement requires
        each
        franchised restaurant to employ a general manager who has completed the
        Company's training program at one of the Company's specified training stores.
        Compliance with the Company's operational standards is monitored for both
        Company-owned and franchised restaurants by random, on-site visits by corporate
        management, regular inspections by regional supervisors, the ongoing direction
        of a corporate quality control manager and the mystery shopper program.
 
 ***Marketing
        and Advertising.*** The
        Company believes that when media penetration is achieved in a particular
        market,
        investments in radio and television advertising can generate significant
        increases in revenues in a cost-effective manner. During fiscal 2005, the
        Company spent approximately 3.0% of restaurant revenues on various forms
        of
        advertising and plans to spend a comparable amount in fiscal 2006. Besides
        radio
        and television, the Company makes use of in-store promotions, involvement
        in
        community activities, and customer word-of-mouth to maintain their performance.
 
 ***Purchasing.*** **** The
        Company strives to obtain consistent quality products at competitive prices
        from
        reliable sources. The Company works with its distributors and other purveyors
        to
        ensure the integrity, quality, price and availability of the various raw
        ingredients. The Company researches and tests various products in an effort
        to
        maintain quality and to be responsive to changing customer tastes. The Company
        operates a centralized purchasing system that is utilized by all of the
        Company-owned restaurants and is available to the Company's franchisees.
        Under
        the Company's franchise agreement, if a franchisee wishes to purchase from
        a
        supplier other than a currently approved supplier, it must first submit the
        products and supplier to the Company for approval. Regardless of the purchase
        source, all purchases must comply with the Company's product specifications.
        The
        Company’s ability to maintain consistent product quality throughout its
        operations depends upon acquiring specified food products and supplies from
        reliable sources. Management believes that all essential food and beverage
        products are available from other qualified sources at competitive
        prices.
 
 **Franchising**
 
 The
        Company currently has 10 franchisees operating a total of 18 restaurants
        and one
        licensee operating one restaurant. Most franchisees operate one or two
        restaurants. No new franchise restaurants were opened during fiscal 2005.
        In
        fiscal year 2004, one new franchise restaurant was opened, one was closed,
        and
        11 franchise restaurants were sold to the Company. The Company’s largest
        franchisee, based in Beaumont, sold its 10 Casa Olé restaurants, three Crazy
        Jose’s
  7
  
 restaurants,
        and related assets to the Company on January 7, 2004, and a Casa Olé franchisee
        sold its Brenham, Texas restaurant to the Company on October 14, 2004.
 
 Franchising
        allows the Company to expand the number of stores and penetrate markets more
        quickly and with less capital than developing Company-owned stores. The Company
        has the first right of refusal when a franchisee decides to sell its
        restaurant(s). Historically, the Company has selectively acquired franchisee
        restaurants when reasonably available. At the same time, the Company plans
        to
        expand its base of franchise restaurants. Consequently, in 2004 the Company
        updated its Casa Olé and La Señorita Uniform Franchise Offering Circular
        (“UFOC”) in order to pursue new franchisees.
 
 Franchisees
        are selected on the basis of various factors, including business background,
        experience and financial resources. In seeking new franchisees, the Company
        targets experienced multi-unit restaurant operators with knowledge of a
        particular geographic market and financial resources sufficient to execute
        the
        Company's development schedule. Under the current franchise agreement,
        franchisees are required to operate their stores in compliance with the
        Company's policies, standards and specifications, including matters such
        as menu
        items, ingredients, materials, supplies, services, fixtures, furnishings,
        decor
        and signs. In addition, franchisees are required to purchase, directly from
        the
        Company or its authorized agent, spice packages for use in the preparation
        of
        certain menu items, and must purchase certain other items from approved
        suppliers unless written consent is received from the Company.
 
 ***Franchise
        Agreements.*** ** The
        Company enters into a franchise agreement with each franchisee that grants
        the
        franchisee the right to develop a single store within a specific territory
        at a
        site approved by the Company. The franchisee then has limited exclusive rights
        within the territory. Under the Company's current standard franchise agreement,
        the franchisee is required to pay a franchise fee of $25,000 per restaurant.
        The
        current standard franchise agreement provides for an initial term of
        15 years (with a limited renewal option) and payment of a royalty of 3% to
        5% of gross sales. The termination dates of the Company's franchise
        agreements with its existing franchisees currently range from 2006 to 2015.
 
 Franchise
        agreements are not assignable without the prior written consent of the Company.
        Also, the Company retains rights of first refusal with respect to any proposed
        sales by the franchisee. Franchisees are not permitted to compete with the
        Company during the term of the franchise agreement and for a limited time,
        and
        in a limited area, after the term of the franchise agreement. The enforceability
        and permitted scope of such noncompetition provisions varies from state to
        state. The Company has the right to terminate any franchise agreement for
        certain specific reasons, including a franchisee's failure to make payments
        when
        due or failure to adhere to the Company's policies and standards. Many state
        franchise laws, however, limit the ability of a franchisor to terminate or
        refuse to renew a franchise. See "Item 1. Business—Government
        Regulation".
 
 Prior
        forms of the Company's franchise agreements may contain terms that vary from
        those described above, including with respect to the payment or nonpayment
        of
        advertising fees and royalties, the term of the agreement, and assignability,
        noncompetition and termination provisions.
 
 ***Franchisee
        Training and Support.*** ** Under
        the
        current franchise agreement, each franchisee (or if the franchisee is a business
        organization, a manager designated by the franchisee) is required to personally
        participate in the operation of the franchise. Before opening the franchisee's
        business to the public, the Company provides training at its approved training
        facility for each franchisee's general manager, assistant manager and kitchen
        manager or chef. The Company recommends that the franchisee, if the franchisee
        is other than the general manager, or if a business organization, its chief
        operating officer, attend such training. The Company also provides a training
        team to assist the franchisee in opening its restaurant. The team, supervised
        by
        the Director of Training, will assist and advise the franchisee and/or its
        manager in all phases of the opening operation for a seven to fourteen day
        period. The formal training program required of hourly employees and management,
        along with continued oversight by the Company's quality control manager,
        is
        designed to promote consistency of operations.
 
 ***Area
        Developers.*** ** The
        area
        development agreement is an extension of the standard franchise agreement.
        The
        area development agreement provides area developers with the right to execute
        more than one franchise agreement in accordance with a fixed development
        schedule. Restaurants established under these agreements must be located
        in a
        specific territory in which the area developer will have limited exclusive
        rights. Area developers pay an initial development fee generally equal to
        the
        total initial franchise fee for the first franchise agreement to be executed
        pursuant to the development schedule plus 10% of the initial franchise fee
        for
        each additional franchise agreement to be executed pursuant to the development
        schedule. Generally the initial development fee is not refundable, but will
        be
        applied in the proportions described above to the initial franchise fee payable
        for each franchise agreement executed pursuant to the development schedule.
        New
        area developers
  8
  
 
 will
        pay
        monthly royalties for all restaurants established under such franchise
        agreements on a declining scale generally ranging from 5% of gross sales
        for the
        initial restaurant to 3% of gross sales for the fourth restaurant and thereafter
        as additional restaurants are developed. Area development agreements are
        not
        assignable without the prior written consent of the Company. The Company
        will
        retain rights of first refusal with respect to proposed sales of restaurants
        by
        the area developers. Area developers are not permitted to compete with the
        Company. As described above, the enforceability and permitted scope of such
        noncompetition provisions may vary from state to state. If an area developer
        fails to meet its development schedule obligations, the Company can, among
        other
        things, terminate the area development agreement or modify the territory
        in the
        agreement. These termination rights may be limited by applicable state franchise
        laws. The Company is currently seeking new area developers. One area developer,
        a Beaumont-based franchisee, sold its 10 Casa Ole franchise restaurants and
        related assets to the Company on January 7, 2004 (the Company also purchased
        three Crazy Jose’s restaurants in the same transaction). The Company currently
        has two area developers operating a total of four and three restaurants,
        respectively.
 
 **Competition**
 
 The
        restaurant industry is intensely competitive. Competition is based upon a
        number
        of factors, including concept, price, location, quality and service. The
        Company
        competes against a broad range of other family dining concepts, including
        those
        focusing on various other types of ethnic food, as well as local restaurants
        in
        its various markets. The Company also competes against other quick service
        and
        casual dining concepts within the Mexican and Tex-Mex food segment. Many
        of the
        Company's competitors are well established and have substantially greater
        financial and other resources than the Company. Some of the Company's
        competitors may be better established in markets where the Company’s restaurants
        are or may be located. Also, the Company competes for qualified franchisees
        with
        franchisors of other restaurants and various other concepts.
 
 The
        success of a particular restaurant concept is also affected by many other
        factors, including national, regional or local economic and real estate
        conditions, changes in consumer tastes and eating habits, demographic trends,
        weather, traffic patterns, and the type, number and location of competing
        restaurants. In addition, factors such as inflation, increased food, labor
        and
        benefit costs, and the availability of experienced management and hourly
        employees may adversely affect the restaurant industry in general and the
        Company's restaurants in particular.
 
 **Government
        Regulation**
 
 Each
        restaurant is subject to regulation by federal agencies and to licensing
        and
        regulation by state and local health, sanitation, safety, fire and other
        departments relating to the development and operation of restaurants. These
        include regulations pertaining to the environmental, building and zoning
        requirements in the preparation and sale of food. The Company is also subject
        to
        laws governing the service of alcohol and its relationship with employees,
        including minimum wage requirements, overtime, working conditions and
        immigration requirements. Difficulties or failures in obtaining the required
        construction and operating licenses, permits or approvals could delay or
        prevent
        the opening of a specific new restaurant. The Company believes that it is
        operating in substantial compliance with applicable laws and regulations
        that
        govern its operations.
 
 Alcoholic
        beverage control regulations require each of the Company’s restaurants to apply
        to a state authority and, in certain locations, county or municipal authorities,
        for a license or permit to sell alcoholic beverages on the premises and to
        provide service for extended hours. Typically, licenses must be renewed annually
        and may be revoked or suspended for cause at any time. Alcoholic beverage
        control regulations relate to numerous aspects of the Company's restaurants,
        including minimum age of patrons drinking alcoholic beverages and of employees
        serving alcoholic beverages, training, hours of operation, advertising,
        wholesale purchasing, inventory control and handling, storage and dispensing
        of
        alcoholic beverages. The Company is also subject to "dramshop" statutes that
        generally provide that a person injured by an intoxicated person may seek
        to
        recover damages from an establishment determined to have wrongfully served
        alcoholic beverages to the intoxicated person. The Company carries liquor
        liability coverage as part of its existing comprehensive general liability
        insurance. Additionally, within thirty days of employment by the Company,
        each
        Texas employee of the Company who serves alcoholic beverages is required
        to
        attend an alcoholic seller training program that has been approved by the
        Texas
        Alcoholic Beverage Commission and endorsed by the Texas Restaurant Association
        and that endeavors to educate the server to detect and prevent overservice,
        as
        well as underage service, of the customers at the Company’s restaurants.
  9
   In
        connection with the sale of franchises, the Company is subject to the United
        States Federal Trade Commission rules and regulations and state laws that
        regulate the offer and sale of franchises and business opportunities. The
        Company is also subject to laws that regulate certain aspects of such
        relationships. To date, the Company has had no claims with respect
 to
        its
        programs and, based on the nature of any potential compliance issues identified,
        does not believe that compliance issues associated with its historic franchising
        programs will have a material adverse effect on its results of operations
        or
        financial condition. The Company believes that it is operating in substantial
        compliance with applicable laws and regulations that govern franchising
        programs.
 
 The
        federal Americans with Disabilities Act prohibits discrimination on the basis
        of
        disability in public accommodations and employment. The Company is required
        to
        comply with the Americans with Disabilities Act and regulations relating
        to
        accommodating the needs of the disabled in connection with the construction
        of
        new facilities and with significant renovations of existing facilities.
 
 The
        Company is subject to various local, state and federal laws regulating the
        discharge of pollutants into the environment. The Company believes that it
        conducts its operations in substantial compliance with applicable environmental
        laws and regulations. The Company conducts environmental audits of each proposed
        restaurant site in order to determine whether there is any evidence of
        contamination prior to purchasing or entering into a lease with respect to
        such
        site. To date, the Company's operations have not been materially adversely
        affected by the cost of compliance with applicable environmental
        laws.
 
 **Trademarks,
        Service Marks and Trade Dress**
 
 The
        Company believes its trademarks, service marks and trade dress have significant
        value and are important to its marketing efforts. It has registered the
        trademarks for “Casa Olé”, “Casa Olé Mexican Restaurant”, “Monterey’s Tex-Mex
        Café”, “Monterey’s Little Mexico”, “Tortuga Cantina”, “La Señorita” and “Crazy
        Jose’s” with the U.S. Patent and Trademark Office.
 
 **ITEM
        1A.**  **RISK
        FACTORS**
 
 You
        should carefully consider the following risk factors as well as the other
        information contained or incorporated by reference in this report, as these
        are
        important factors, among others, that could cause our actual results to differ
        from our expected or historical results. It is not possible to predict or
        identify all such factors. Consequently, you should not consider any such
        list
        to be a complete statement of all of our potential risks or
        uncertainties.
 
 ***Seasonal
        Fluctuations in Sales and Earnings Affect Our Quarterly
        Results.*** **** Our
        sales
        and earnings fluctuate seasonally. Historically our highest sales and earnings
        have occurred in the second and third calendar quarters, which we believe
        is
        typical of the restaurant industry and consumer spending patterns in general.
        In
        addition, quarterly results have been and, in the future are likely to be,
        substantially affected by the timing of new restaurant openings. Because
        of the
        seasonality of our business and the impact of new restaurant openings, results
        for any calendar quarter are not necessarily indicative of the results that
        may
        be achieved for a full fiscal year and cannot be used to indicate financial
        performance for the entire year.
 
 ***Inflation
        May Adversely Impact Our Net Income.*** **** We **** believe
        that inflation impacted net income during fiscal year 2005. Substantial
        increases in utility expenses, energy-related materials such as paper supplies,
        and health insurance costs had a marked impact on our operating results to
        the
        extent such increases could not be passed along to customers. There can be
        no
        assurance that we will not experience the same inflationary impact in the
        future. If operating expenses increase, our management intends to attempt
        to
        recover increased costs by increasing prices to the extent deemed advisable
        in
        light of competitive conditions.
 
 ***An
        Increase
        In Our Interest Rates May Adversely Impact Net Income.*** Our
        exposure to interest rate fluctuations is limited to our outstanding bank
        debt
        with Bank of America. The interest rate is either the prime rate or LIBOR
        plus a
        stipulated percentage. Accordingly, we are impacted by changes in the prime
        rate
        and LIBOR. As of January 1, 2006, we had $2.5 million outstanding on our
        credit
        facility with Bank of America. We are presently in full compliance with all
        debt
        covenants as amended. We expect to be in compliance with all debt covenants
        in
        fiscal year 2006. As of January 1, 2006, we also had $3.0 million in notes
        which
        have a fixed interest rate of 7.0% (See Note 3 in the accompanying Consolidated
        Financial Statements). We plan to prepay $2.5 million in notes on March 31,
        2006
        by borrowing from our Bank of America credit facility.
  10
  
 ***Our
        Financial Covenants Could Adversely Affect Our Ability to
        Borrow.*** Under
        our current credit agreement with Bank of America, we are subject to certain
        reporting requirements and financial covenants, including requirements that
        we
        maintain minimum levels of net worth and various financial ratios. Although
        we
        are currently in compliance with such financial covenants, an erosion of
        our
        business could place us out of compliance in future periods. Potential remedies
        for the lender if we are not in compliance include declaring all outstanding
        amounts immediately payable, terminating commitments and enforcing any liens;
        however, in the event of any future noncompliance we may seek a waiver from
        such
        lender. See Note 3, Long-term Debt, of Notes to Consolidated Financial
        Statements.
 
 ***Rising
        Insurance Costs Could Negatively Impact Our
        Profitability.*** We are
        insured against a variety of uncertainties. While the cost of certain insurance
        coverages increased in 2005, we were able to negotiate lower premium costs
        for
        other insurance coverages, and in general, were able to minimize the overall
        increase and impact of all total insurance costs to us. Each year, we renew
        our
        insurance coverages. While we try to be proactive in our efforts to control
        insurance costs, market forces beyond our control may thwart our ability
        to
        manage these costs. For example, we expect insurance premiums for property
        and
        casualty insurance to increase in light of the impact of Hurricane Rita on
        the
        Texas and Louisiana Gulf Coast. An increase in premiums could have a negative
        impact on our profitability if we are not able to negate the effect of such
        increases by continuing to improve our operating efficiencies.
 
 ***Our
        Small Restaurant Base and Geographic Concentration Make Our Operations More
        Susceptible to Local Economic Conditions.*** The
        results achieved to date by our relatively small restaurant base may not
        be
        indicative of the results of a larger number of restaurants in a more
        geographically dispersed area. Because of our relatively small restaurant
        base,
        an unsuccessful new restaurant could have a more significant effect on our
        results of operations than would be the case in a company owning more
        restaurants. Additionally, given our present geographic concentration (all
        of
        our company-owned units are currently in Texas, especially along the Gulf
        Coast
        region, Oklahoma, Louisiana and Michigan), results of operations may be
        adversely affected by economic or other conditions in the region, such as
        hurricanes, and any adverse publicity in the region relating to our restaurants
        could have a more pronounced adverse effect on our overall sales than might
        be
        the case if our restaurants were more broadly dispersed.
 
 ***Our
        Management and Directors Hold a Majority of the Common Stock.*** Approximately
        69.3% of our Common Stock and rights to acquire Common Stock are beneficially
        owned or held by Larry N. Forehand, David Nierenberg, Michael D. Domec and
        Louis
        P. Neeb, directors and/or executive officers. As a result, these individuals
        have substantial control over matters requiring shareholder approval, including
        the election of directors.
 
 ***Competition
        May Adversely Affect Our Operations and Financial
        Results.*** The
        restaurant industry is highly competitive with respect to price, service,
        restaurant location and food quality, and is often affected by changes in
        consumer tastes, economic conditions, population and traffic patterns. We
        compete within each market against other family dining concepts, as well
        as
        quick service and casual dining concepts, for customers, employees and
        franchisees. Several of our competitors operate more restaurants and have
        significantly greater financial resources and longer operating histories
        than we
        do. Our inability to successfully compete with the other restaurants in our
        markets could prevent us from increasing or sustaining our revenues and
        profitability and result in a material adverse effect on our business, financial
        condition, results of operations or cash flows.
 
 ***Changes
        in General Economic and Political Conditions Affect Consumer Spending and
        May
        Harm Our Revenues and Operating Results.*** The
        United States experienced an economic expansion throughout most of 2005,
        including Texas where the majority of our restaurants operate. Although the
        forecast for 2006 is generally favorable, there are a few significant economic
        developments that could weaken economic conditions. Rising fuel and energy
        costs
        could reduce consumers’ level of discretionary spending. A decrease in
        discretionary spending could impact the frequency with which our customers
        choose to dine out or the amount they spend on meals while dining out, thereby
        decreasing our revenues. Additionally, the continued responses to the terrorist
        attacks on the United States, possible future terrorist attacks and the conflict
        in Iraq and its aftermath may exacerbate current economic conditions and
        lead to
        a weakening in the economy. Adverse economic conditions and any related decrease
        in discretionary spending by our customers could have an adverse effect on
        our
        revenues and operating results.
 
 ***Implementing
        Our Growth Strategy May Strain its Resources.*** Our
        ability to expand by adding Company-owned and franchised restaurants will
        depend
        on a number of factors, including the availability of suitable locations,
        the
        ability to hire, train and retain an adequate number of experienced management
        and hourly employees, the availability of acceptable lease terms and adequate
        financing, timely construction of restaurants, the ability to obtain various
        government permits and licenses and other factors, some of which are beyond
        our
        control. The opening of additional franchised restaurants will
  11
  
 depend,
        in part, upon the ability of existing and future franchisees to obtain financing
        or investment capital adequate to meet their market development obligations.
        Based on our experience in attempting to grow outside our existing markets,
        we
        have found there can be limited consumer acceptance and that the cost of
        such
        efforts can have a material adverse impact on our financial
        results.
 
 ***Shares
        Eligible for Future Sale Could Adversely Impact the Stock Price.*** Sales
        of
        substantial amounts of shares in the public market could adversely affect
        the
        market price of our Common Stock. In connection with our 1996 initial public
        offering, we granted limited registration rights to holders of warrants granted
        by us and Larry N. Forehand to Louis P. Neeb, Tex-Mex Partners, L.C. and
        a
        former officer to register the 757,465 underlying shares of Common Stock
        subject
        to such warrants in connection with registrations otherwise undertaken by
        us.
        Such warrants have an exercise price of $10.90 per share. If we register
        these
        shares and these shareholders are able to sell a large portion of their holdings
        on the open market at one time, the market price of the Common Stock will
        likely
        decline. In any event, the market price of the Common Stock could be subject
        to
        significant fluctuations in response to our operating results and other factors.
        These warrants will expire on April 24, 2006.
 
 ***Litigation
        Could Have a Material Adverse Effect on Our Business.*** From
        time to time we are subject of complaints or litigation from guests alleging
        food-borne illness, injury or other food quality, health or operational
        concerns. We may be adversely affected by publicity resulting from such
        allegations, regardless of whether such allegations are valid or whether
        it is
        liable. We are also subject to complaints or allegations from former or
        prospective employees from time to time. A lawsuit or claim could result
        in an
        adverse decision against us that could have a materially adverse effect on
        our
        business.
 
 We
        are
        subject to state “dramshop” laws and regulations, which generally provide that a
        person injured by an intoxicated person may seek to recover damages from
        an
        establishment that wrongfully served alcoholic beverages to such person.
        Although we carry liquor liability coverage as part of our existing
        comprehensive general liability insurance, we may still be subject to a judgment
        in excess of our insurance coverage and we may not be able to obtain or continue
        to maintain such insurance coverage at reasonable costs, or at all.
 
 ***Compliance
        with Changing Regulation of Corporate Governance and Public Disclosure May
        Result in Additional Expenses.*** Keeping
        up-to-date and in compliance with changing laws, regulations and standards
        relating to corporate governance and public disclosure, including the
        Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules,
        has required an increased amount of management attention and external resources.
        We remain committed to maintaining high standards of corporate governance
        and
        public disclosure. As a result, we intend to invest all reasonably necessary
        resources to comply with evolving standards, and this investment may result
        in
        increased general and administrative expenses and a diversion of management
        time
        and attention from revenue-generating activities to compliance
        activities.
 
 **ITEM
        1B.**  **UNRESOLVED
        STAFF COMMENTS**
 
 None.
 
 **ITEM
        2.**  **PROPERTIES**
 
 In
        fiscal
        year 2005, the Company's executive offices were located in approximately
        10,015
        square feet of office space in Houston, Texas. The offices are currently
        leased
        by the Company from Gillett Properties, Ltd., under a gross lease (where
        the
        landlord pays utilities and property taxes) expiring in December 2009, with
        rental payments of $10,500 per month. See "Notes to Consolidated Financial
        Statements—Related Party Transactions." The Company believes that its properties
        are generally well maintained, in good condition and adequate for its
        operations. Further, the Company believes that suitable additional or
        replacement space under comparable terms will be available if required.
 
 Real
        estate leased for Company-owned restaurants is typically leased under triple
        net
        leases that require the Company to pay real estate taxes and utilities, to
        maintain insurance with respect to the premises and in certain cases to pay
        contingent rent based on sales in excess of specified amounts. Generally
        the
        non-mall locations for the Company-owned restaurants have initial terms of
        10 to 20 years with renewal options.
 
 The
        Company owns the land and buildings of one restaurant location; all remaining
        locations are leased. In fiscal year 2005, the Company sold an office building
        for $360,000, net of closing costs, that was acquired last year with the
  12
  
 
 Beaumont-based
        franchisee stores and related assets. In fiscal year 2004, the Company sold
        a
        previously closed restaurant in Plainview, Texas for $422,000 in cash.
 
 During
        fiscal year 2005, the Company opened one new restaurant and closed one
        under-performing restaurant that the Company plans to sublease. During fiscal
        year 2004, the Company acquired eleven franchise restaurants and closed four
        under-performing restaurants, for which two of the leases have expired, one
        in
        which the property was subleased, and one in which the leasehold interest
        was
        sold. During fiscal year 2003, the Company opened one new restaurant and
        closed
        one under-performing restaurant (lease expired in June of 2004).
 
 **Restaurant
        Locations**
 
 At
        January 1, 2006, the Company had 60 Company-operated restaurants, 18 franchise
        restaurants and one licensed restaurant. As of such date, the Company operated
        and franchised 42 Casa Olé restaurants in the State of Texas and four in the
        State of Louisiana; operated four Monterey’s Tex-Mex Café restaurants in the
        State of Oklahoma; operated and licensed 15 Monterey’s Little Mexico restaurants
        in the State of Texas; operated five Tortuga Coastal Cantina restaurants
        in the
        State of Texas; operated three Crazy Jose’s in the State of Texas, and also
        operated and franchised six La Señorita restaurants in the State of Michigan.
        The Company’s portfolio of restaurants is summarized below:
 
 **Casa
                  Olé**Company-operated
              29
              LeasedFranchisee-operated
              17**Concept
                  total**
              46**Monterey’s
                  Tex-Mex Café**Company-operated
              4
              Leased**Concept
                  total**
              4**Monterey’s
                  Little Mexico**Company-operated
              14
              LeasedLicensee-operated
              1**Concept
                  total**
              15**Tortuga
                  Coastal Cantina**Company-operated
              5
              Leased**Concept
                  total**
              5**La
                  Señorita**Company-operated
              5
              LeasedFranchisee-operated
              1**Concept
                  total**
              6**Crazy
                  Jose’s**Company-operated
              3
              Leased**Concept
                  total**
              3**System
                  total**
              79
 
 
 **ITEM
        3.**  **LEGAL
        PROCEEDINGS**
 
 The
        Company is involved from time to time in litigation relating to claims arising
        from its operations in the normal course of business. Management believes
        that
        the ultimate disposition of all uninsured matters resulting from existing
        litigation will not have a material adverse effect on the Company’s business or
        financial position.
  13
  
 
 **ITEM
        4.**  **SUBMISSION
        OF MATTERS TO A VOTE OF SECURITY HOLDERS**
 
 On
        November 8, 2005, the Company held a Special Meeting of Shareholders, in
        which
        the Company’s shareholders approved a proposal to adopt and approve the Mexican
        Restaurants, Inc. 2005 Long Term Incentive Plan. There were 2,603,209 votes
        for,
        44,027 against and 200 votes withheld. There were no abstentions or broker
        non-votes on this proposal.
 
 
 **PART
        II**
 
 **ITEM
        5.**  **MARKET
        FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
        OF EQUITY SECURITIES**
 
 ***Market
        Information.*** The
        Company’s Common Stock trades on the Nasdaq Small Cap Market tier of The Nasdaq
        Stock Market under the symbol “CASA.” The following table sets forth the range
        of quarterly high and low reported sale prices of the Company’s Common Stock on
        the Nasdaq Small Cap Market during each of the Company’s fiscal quarters since
        the end of the Company’s 2003 fiscal year.
 
 **HIGH**
              
              **LOW****Fiscal
                  Year 2004:**First
                  Quarter (ended March 28, 2004)
              
              
              4.88
              
              
              3.65Second
                  Quarter (ended June 27, 2004)
              
              
              7.00
              
              
              5.05Third
                  Quarter (ended September 26, 2004)
              
              
              9.25
              
              
              6.49Fourth
                  Quarter (ended January 2, 2005)
              
              
              9.42
              
              
              7.87**Fiscal
                  Year 2005:**First
                  Quarter (ended April 3, 2005)
              
              
              10.50
              
              
              8.50Second
                  Quarter (ended July 3, 2005)
              
              
              10.42
              
              
              7.79Third
                  Quarter (ended October 2, 2005)
              
              
              10.50
              
              
              8.69Fourth
                  Quarter (ended January 1, 2006)
              
              
              12.06
              
              
              9.17**Fiscal
                  Year 2006:**First
                  Quarter (as of March 28, 2006)
              
              
              13.33
              
              
              10.00
 
 ***Holders.*** As
        of
        March 28, 2006, the Company estimates that there were approximately 850
        beneficial owners of the Company’s Common Stock, represented by approximately 50
        holders of record, and 3,356,977 shares of Common Stock
        outstanding.
 
 ***Issuer
        Purchases.*** During
        its fiscal 2005 fourth quarter, the Company purchased 100,000 shares of its
        Common Stock.
 
 During
        2005, the Company purchased 181,300 shares of its common stock at a cost
        of
        approximately $1.7 million. The following table contains information for
        shares
        repurchased during the fourth quarter of 2005.
 
 Period
              
              (a)
                  Total Number of
                Shares
                  Purchased
              
              (b)
                  Average Price
                Paid
                  per Share
              
              (c)
                  Total Number of
                Shares
                  Purchased as Part of Publicly AnnouncedPlans
                  or Programs
              
              (d)
                  Maximum Number
                Of
                  Shares (or Approximate Dollar Value) of Shares That May Yet Be
                  Purchased
                  Underthe
                  Plans Or ProgramsOct.
                  3, 2005 -
                Oct.
                  30, 2005
              
              
              0
              
              
              
              
              
              0
              
              $
              1,249,733Oct.
                  31, 2005 -
                Nov.
                  27, 2005
              
              
              100,000
              
              
              9.88
              
              
              181,300
              
              $
              261,733Nov.
                  28, 2005 -
                Jan.
                  1, 2006
              
              
              0
              
              
              
              
              
              0
              
              $
              261,733
 
  14
  
 
 ***Dividends.*** Since
        its 1996 initial public offering, the Company has not paid cash dividends
        on its
        Common Stock. The Company intends to retain earnings of the Company to support
        operations, to finance expansion and pay down its debt, and does not intend
        to
        pay cash dividends on the Common Stock for the foreseeable future. In addition,
        the Company’s current credit agreement prohibits the payment of any cash
        dividends. Any payment of cash dividends in the future will be at the discretion
        of the Board of Directors and will depend upon such factors as earnings levels,
        capital requirements, the Company’s financial condition, the ability to do so
        under then-existing credit agreements and other factors deemed relevant by
        the
        Board of Directors.
 
 **ITEM
        6.**  **SELECTED
        FINANCIAL DATA**
 
 The
        selected financial data set forth below should be read in conjunction with
        and
        are qualified by reference to the Consolidated Financial Statements and the
        related Notes thereto included in Item 8. hereof and "Management's Discussion
        and Analysis of Financial Condition and Results of Operations" included in
        Item
        7. hereof.
 
 **Fiscal
                  Years**(In
                  thousands, except share and per share amounts)**2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005****Income
                  Statement Data:**Revenues:Restaurant
                  sales
              
              $
              55,237
              
              $
              52,927
              
              $
              52,882
              
              $
              77,027
              
              $
              79,975Franchise
                  fees, royalties and other
              
              
              1,393
              
              
              1,181
              
              
              1,139
              
              
              753
              
              
              694Business
                  interruption
              
              
              --
              
              
              105
              
              
              --
              
              
              --
              
              
              53456,630
              
              
              54,213
              
              
              54,021
              
              
              77,780
              
              
              81,203Costs
                  and expenses:Cost
                  of sales
              
              
              15,204
              
              
              14,306
              
              
              14,591
              
              
              21,384
              
              
              21,849Restaurant
                  operating expenses
              
              
              31,432
              
              
              29,809
              
              
              30,242
              
              
              42,904
              
              
              44,946General
                  and administrative
              
              
              5,457
              
              
              5,198
              
              
              5,306
              
              
              6,587
              
              
              6,942Depreciation
                  and amortization
              
              
              2,086
              
              
              1,882
              
              
              2,030
              
              
              2,237
              
              
              2,778Asset
                  impairments and restaurant closure
                Costs
              
              
              972
              
              
              --
              
              
              655
              
              
              701
              
              
              -(Gain)
                  loss on prop.-Hurricane Rita
              
              
              --
              
              
              --
              
              
              --
              
              
              --
              
              
              (471
              )(Gain)
                  loss on sale of assets
              
              
              --
              
              
              (28
              )
              
              (292
              )
              
              182
              
              
              36955,151
              
              
              51,167
              
              
              52,532
              
              
              73,995
              
              
              76,412Operating
                  income
              
              
              1,479
              
              
              3,046
              
              
              1,489
              
              
              3,785
              
              
              4,791Other
                  income (expense), net
              
              
              (302
              )
              
              (85
              )
              
              (97
              )
              
              (459
              )
              
              (404
              )Income
                  before income tax expense
              
              
              1,177
              
              
              2,961
              
              
              1,392
              
              
              3,326
              
              
              4,387Income
                  tax expense (benefit)
              
              
              221
              
              
              981
              
              
              490
              
              
              1,070
              
              
              1,433Income
                  from continuing operations
              
              
              956
              
              
              1,980
              
              
              902
              
              
              2,256
              
              
              2,954Discontinued
                  OperationsLoss
                  from discontinued operations, net of taxes
              
              
              (107
              )
              
              (276
              )
              
              (1,937
              )
              
              (495
              )
              
              (637
              )Net
                  income (loss)
              
              $
              849
              
              $
              1,704
              
              
              ($
                  1,035
              )
              $
              1,761
              
              $
              2,317
  15
  
 Basic
                  income (loss) per share:Income
                  from continuing operations
              
              $
              0.27
              
              $
              0
                  .57
              
              $
              0.26
              
              $
              0.67
              
              $
              0.87Loss
                  from discontinued operations
              
              
              (0.03
              )
              
              (0.08
              )
              
              (0.57
              )
              
              (0.15
              )
              
              (0.19
              )Net
                  income (loss)
              
              $
              0.24
              
              $
              0.49
              
              $
              (
                  0.31
              )
              $
              0.52
              
              $
              0.68Diluted
                  income (loss) per share:Income
                  from continuing operations
              
              $
              0.27
              
              $
              0.56
              
              $
              0.26
              
              $
              0.62
              
              $
              0.80Loss
                  from discontinued operations
              
              
              (0.03
              )
              
              (0.08
              )
              
              (0.57
              )
              
              (0.14
              )
              
              (0.17
              )Net
                  income (loss)
              
              $
              0.24
              
              $
              0.48
              
              $
              (0.31
              )
              $
              0.48
              
              $
              0.63Weighted
                  average shares - Basic
              
              
              3,520,687
              
              
              3,447,957
              
              
              3,384,605
              
              
              3,388,489
              
              
              3,415,806Weighted
                  average shares - Diluted
              
              
              3,527,291
              
              
              3,520,769
              
              
              3,430,380
              
              
              3,634,849
              
              
              3,700,876
 
 
 In
        fiscal
        2001, the Company’s consolidated statements of income and cash flows included
        goodwill amortization. With the adoption of SFAS No. 142, no goodwill
        amortization was recorded for fiscal 2002, 2003, 2004 and 2005. The following
        table provides a reconciliation of reported net income to adjusted net income
        excluding goodwill amortization:
 
 
 **2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005**(In
                  thousands except per share amounts)Reported
                  net income (loss)
              
              $
              849
              
              $
              1,704
              
              $
              (1,035
              )
              $
              1,761
              
              $
              2,317Add
                  back:Goodwill amortization, (net of tax)
              
              
              284
              
              
              --
              
              
              --
              
              
              --
              
              
              --Adjusted
                  net income (loss)
              
              $
              1,133
              
              $
              1,704
              
              $
              (1,035
              )
              $
              1,761
              
              $
              2,317Basic
                  earnings per share:Reported
                  net income (loss)
              
              $
              0.24
              
              $
              0.49
              
              $
              (0.31
              )
              $
              0.52
              
              $
              0.68Goodwill
                  amortization
              
              
              0.08
              
              
              --
              
              
              --
              
              
              --
              
              
              --Adjusted
                  net income (loss)
              
              $
              0.32
              
              $
              0.49
              
              $
              (0.31
              )
              $
              0.52
              
              $
              0.68Diluted
                  earnings per share:Reported
                  net income (loss)
              
              $
              0.24
              
              $
              0.48
              
              $
              (0.31
              )
              $
              0.48
              
              $
              0.63Goodwill
                  amortization
              
              
              0.08
              
              
              --
              
              
              --
              
              
              --
              
              
              --Adjusted
                  net income (loss)
              
              $
              0.32
              
              $
              0.48
              
              $
              (0.31
              )
              $
              0.48
              
              $
              0.63
 
 
  As
                  of the End of Fiscal Years**2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005**(In
                  thousands)**Balance
                  Sheet Data:**Working
                  capital (deficit)
              
              $
              (3,154
              )
              $
              (2,736
              )
              $
              (2,669
              )
              $
              (1,359
              )
              $
              (1,632
              )Total
                  assets
              
              $
              30,067
              
              $
              28,983
              
              $
              25,861
              
              $
              32,326
              
              $
              33,137Long-term
                  debt, less
                current
                  portion
              
              $
              5,573
              
              $
              3,400
              
              $
              1,775
              
              $
              6,000
              
              $
              4,500Total
                  stockholders’ equity
              
              $
              15,717
              
              $
              16,948
              
              $
              15,954
              
              $
              17,868
              
              $
              18,884
 
 
 **ITEM
                  7.**
              **MANAGEMENT’S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS**
 
 Certain
        statements set forth below under this caption constitute “forward-looking
        statements” within the meaning of the Reform Act. See “Special Note Regarding
        Forward-Looking Statements” above for additional factors relating to such
  16
  statements.  The
        following discussion and analysis should be read in conjunction with the
        Company’s Consolidated Financial Statements and Notes thereto appearing
        elsewhere in this Report. Additional information concerning factors that
        could
        cause results to differ materially from those in any forward-looking statements
        is contained under “Item 1A. Risk Factors”.
 
 **General
        Overview**
 
 The
        Company was organized under the laws of the State of Texas in February 1996. ** Pursuant
        to the reorganization of the Company in preparation for its 1996 initial
        public
        offering of Common Stock, the shareholders of related prior corporations
        contributed to the Company all outstanding shares of capital stock of each
        corporation, and the Company issued to such shareholders in exchange therefore
        an aggregate of 2,732,705 shares of its Common Stock. The exchange
        transaction was completed April 1996, and, as a result, the corporations
        became
        wholly-owned subsidiaries of the Company, and each shareholder of the Company
        received a number of shares of Common Stock in the Company.
 
 The
        Company operates and franchises Mexican-theme restaurants featuring various
        elements associated with the casual dining experience under the names Casa
        Olé,
        Monterey’s Tex-Mex Café, Monterey’s Little Mexico, Tortuga Coastal Cantina,
        Crazy Jose’s and La Señorita. At January 1, 2006 the Company operated 60
        restaurants, franchised 18 restaurants and licensed one restaurant in various
        communities in Texas, Louisiana, Oklahoma and Michigan.
 
 The
        Company's primary source of revenues is the sale of food and beverages at
        Company-owned restaurants. The Company also derives revenues from franchise
        fees, royalties and other franchise-related activities. Franchise fee revenue
        from an individual franchise sale is recognized when all services relating
        to
        the sale have been performed and the restaurant has commenced operation.
        Initial
        franchise fees relating to area franchise sales are recognized ratably in
        proportion to services that are required to be performed pursuant to the
        area
        franchise or development agreements and proportionately as the restaurants
        within the area are opened.
 
 The
        consolidated statements of income and cash flows for fiscal years 2005, 2004
        and
        2003 have been adjusted to remove the operations of closed restaurants, which
        have been reclassified as discontinued operations. Consequently, the
        consolidated statements of income and cash flows for fiscal years 2004 and
        2003
        shown in the accompanying consolidated financial statements have been
        reclassified to conform to the 2005 presentation. These reclassifications
        had no
        effect on total assets, total liabilities, stockholders’ equity or net
        income.
  **Fiscal
        Year**
 
 The
        Company has a 52/53 week fiscal year ending on the Sunday nearest December
        31.
        References in this Report to fiscal 2003, 2004 and 2005 relate to the periods
        ended December 28, 2003, January 2, 2005 and January 1, 2006, respectively.
        Fiscal years 2003 and 2005 presented herein consisted of 52 weeks. Fiscal
        year
        2004 presented herein consisted of 53 weeks.
 
 **Results
        of Operations**
 
 **Fiscal
        Year 2005 Compared to Fiscal Year 2004 as Adjusted for Discontinued
        Operations**
 
 ***Revenues*** **.** The
        Company’s revenues for the fiscal year ended January 1, 2006 were up $3.4
        million or 4.4% to $81.2 million compared with fiscal year 2004. Restaurant
        sales for fiscal year 2005 increased $2.9 million or 3.8% to $80.0 million
        compared with fiscal year 2004, despite being closed a total of 309 store-days
        during the third and fourth quarters due to the impact of Hurricane Rita.
        Fiscal
        year 2005 had 52 weeks of revenue compared to 53 weeks of revenue for fiscal
        year 2004, resulting in $1.6 million in additional revenue for fiscal 2004.
        The
        increase in restaurant sales reflects the opening of one new restaurant and
        positive same-restaurant sales. The Company has had eight consecutive quarters
        of positive same-restaurant sales. For fiscal 2005, total system same-restaurant
        sales increased 3.8%, Company-owned same restaurant sales increased 4.6%
        and
        franchise-owned same-restaurant sales increased 1.2% from fiscal year 2004.
 
 Franchise
        fees, royalties and other decreased $58,991 or 7.8% primarily due to lower
        royalty income resulting from the closure of a Houston-based franchise
        restaurant. In the fourth quarter of fiscal 2005, the Company recorded $534,163
        of business interruption proceeds related to the Hurricane Rita insurance
        claim.
 
 ***Costs
        and Expenses*** *.* Costs of
        sales, consisting of food, beverage, liquor, supplies and paper costs, decreased
        as a percent of restaurant sales 50 basis points to 27.3% compared with 27.8%
        in
        fiscal 2004. The improvement reflects lower dairy, cheese, meat and poultry
        costs which was partially offset by higher produce, paper and supplies, beverage
        and liquor
  17
  costs
        and
        fuel surcharges. Beverage costs were higher reflecting the increased sale
        of
        bottled products, and liquor costs were higher due to various reduced price
        promotions.
 
 **** Despite
        positive same-store sales, labor and other related expenses, as a percentage
        of
        restaurant sales, remained at 32.8% in fiscal 2005 compared with fiscal 2004,
        reflecting higher health insurance premiums, training expense and overtime
        expense associated with post hurricane labor shortages.
 
 Restaurant
        operating expenses, which primarily includes rent, property taxes, utilities,
        repair and maintenance, liquor taxes, property insurance, general liability
        insurance and advertising, increased in fiscal 2005 as a percentage of
        restaurant sales 40 basis points to 23.3% as compared with 22.9% in fiscal
        2004.
        The increase reflects higher electricity, natural gas, water and sewer cost,
        coupons and credit collection expenses.
  General
        and administrative expenses consist of expenses associated with corporate
        and
        administrative functions that support restaurant operations. General and
        administrative expenses as a percentage of total sales remained at 8.5% in
        fiscal 2005 as compared with fiscal 2004. Actual general and administrative
        expenses increased $354,876. The increase reflects higher legal, audit, health
        insurance and SEC reporting expenses. Legal expenses reflect an unusually
        high
        level of litigation expense as the Company successfully defended one employee
        lawsuit and successfully negotiated the settlement of another employee lawsuit.
        Additional legal expenses included updating the Uniform Franchise Offering
        Circular for Casa Olé and legal expenses associated with the development and
        adoption of the Mexican Restaurants, Inc. 2005 Long Term Incentive Plan
        (“LTIP”). The higher audit cost reflects last year’s KPMG audit and subsequent
        change to new auditors (UHY MANN FRANKFORT STEIN AND LIPP CPA’S, L.L.P.). The
        increase in SEC reporting costs was primarily due to the LTIP.
 
 Depreciation
        and amortization expenses include the depreciation of fixed assets and the
        amortization of intangible assets. Depreciation and amortization expense
        increased as a percentage of restaurant sales 50 basis points to 3.4% in
        fiscal
        year 2005 as compared with 2.9% in fiscal year 2004. Actual depreciation
        and
        amortization expense increased $540,690 in fiscal year 2005 compared with
        fiscal
        year 2004. The increase reflects additional depreciation expense for remodeled
        restaurants, new restaurants, and the replacement of equipment and leasehold
        improvements in various existing restaurants.
 
 During
        fiscal year 2005, the Company incurred $77,942 in pre-opening expenses related
        to the opening of one new restaurant and the re-opening of a remodeled
        restaurant. In fiscal year 2004, the Company spent $56,478 in pre-opening
        expenses related to the remodel of one existing restaurant and the remodel
        of
        one acquired Casa Olé franchise restaurant.
 
 ***Hurricane
        Rita Loss (Gain).*** On
        September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number
        of the Company’s restaurants in that region. The Company subsequently hired an
        insurance consulting firm to assist management with the filing of its insurance
        claim. Based on the low range of the consulting firm’s estimate and negotiations
        with the insurance carrier, the Company recorded an insurance claim of $1.6
        million in the fourth quarter of fiscal 2005.
 
 The
        consolidated statement of operations ended January 1, 2006, includes a separate
        line item for a gain of $470,702 resulting from assets damaged by Hurricane
        Rita
        and other expenses offset by insurance proceeds for the replacement of assets.
        The Company’s insurers paid $300,000 during the fourth quarter of 2005 and
        $785,028 in the first quarter of 2006 related to the property damage claim.
        Additionally, the Company has recognized $534,163 for estimated business
        interruption proceeds.
 
 ***(Gain)
        Loss on Sale of Assets*** .
        During
        fiscal 2005, the Company recorded a loss on the sale of assets of $369,001.
        The
        loss was primarily due to the disposition of assets related to the remodel
        of
        existing restaurants, the sale of an office building that was acquired in
        fiscal
        2004 in the purchase of the Beaumont-based franchisee stores and related
        assets
        and the sale of a joint ventured restaurant. During fiscal 2004, the Company
        recorded a loss of $182,359 on the disposition of assets, primarily related
        to
        the remodel of existing restaurants and sale of a leasehold interest of another
        existing restaurant.
 
 ***Other
        Income (Expense)*** .
        Net
        expense decreased $54,915 to $403,864 in fiscal 2005 compared with a net
        expense
        of $458,779 in fiscal 2004. Interest expense decreased $32,210 to $521,161
        in
        fiscal 2005 compared with interest expense of $553,371 in fiscal 2004,
        reflecting a decrease in outstanding debt which was partially offset by higher
        interest rates.
 
 ***Income
        Tax Expense.*** The
        Company’s effective tax rate from continuing operations for fiscal 2005 was
        32.6% as compared to fiscal year 2004 of 32.2%. In fiscal year 2005, the
        Company
        had a higher pretax income from continuing operations compared to fiscal
        2004.
        In both years, the permanent differences were approximately the same, resulting
        in a slightly higher effective tax rate in fiscal 2005.
  18
  
 
 ***Restaurant
        Closure Costs and***  ***Discontinued
        Operations*** .
        In
        fiscal year 2005, the Company recorded asset impairment and restaurant closure
        costs of $790,708, all of which is included in discontinued operations related
        to the 2005 closure of one restaurant pursuant to Statement on Financial
        Accounting Standards No. 146. In fiscal 2004, the Company recorded asset
        impairment and restaurant closure costs of $868,580, of which $167,898 related
        to the fiscal 2004 closure of three restaurants. In fiscal 2003, the Company
        recorded asset impairment and restaurant closure costs of $2,908,406, of
        which
        $2,252,998 related to the fiscal 2003 closure of one restaurant and inclusion
        of
        discontinued operations related to the fiscal 2004 closure of three restaurants
        and the fiscal 2005 closure of one restaurant.
 
 In
        fiscal
        2004, the Company incurred $700,682 of impairment expenses in continuing
        operations related primarily to four Tortuga restaurants that the Company
        wanted
        to position for re-concept to one of the Company’s other Mexican food concepts.
        Because of improved operating performance, the Company did not re-concept
        the
        four Tortuga restaurants in fiscal 2005. In addition, two Monterey’s
        restaurants, which were impaired in 2003, incurred a small impairment in
        2004.
        These two restaurants will be closed at the expiration of their operating
        leases.
 
 The
        circumstances and testing leading to an impairment charge were determined
        in
        accordance with SFAS No. 144 which requires that property, plant and equipment
        be reviewed for impairment whenever events or changes in circumstances indicate
        that the carrying amount of an asset may not be recoverable.
 
 **Fiscal
        2004 Compared to Fiscal 2003 as Adjusted for Discontinued
        Operations**
 
 ***Revenues*** **.** The
        Company’s revenues for the fiscal year ended January 2, 2005 were up $23.7
        million or 44.0% to $77.8 million compared with fiscal year 2003. Restaurant
        sales for fiscal year 2004 increased $24.1 million or 45.7% to $77.0 million
        compared with fiscal year 2003. The increase reflects the January 2004
        acquisition of 13 restaurants and related assets from the Company’s
        Beaumont-based franchisee. The increase also reflects positive same-restaurant
        sales. Each quarter in fiscal 2004 had positive same-restaurant sales. For
        fiscal 2004, total system same-restaurant sales increased 3.1%, Company-owned
        same restaurant sales increased 3.3% and franchise-owned same-restaurant
        sales
        increased 2.6% from fiscal year 2003.
 
 Franchise
        fees, royalties and other decreased $385,975 or 33.9% to $753,293, reflecting
        lost royalty income from the acquisition of the Beaumont-based franchise
        restaurants, the acquisition of the Brenham, Texas franchise restaurant,
        and the
        closure of a Houston based franchise restaurant.
 
 ***Costs
        and Expenses*** *.* Costs of
        sales, consisting of food, beverage, liquor, supplies and paper costs, increased
        as a percent of restaurant sales 20 basis points to 27.8% compared with 27.6%
        in
        fiscal 2003. The increase reflects higher cheese and protein commodity
        prices.
 
 **** Labor
        and
        other related expenses decreased as a percentage of restaurant sales 10 basis
        points to 32.8% compared with 32.9% in fiscal 2003. The decrease in labor
        as a
        percentage of restaurant sales reflects labor efficiencies gained from positive
        same-restaurant sales.
 
 Restaurant
        operating expenses, which primarily includes rent, property taxes, utilities,
        repair and maintenance, liquor taxes, property insurance, general liability
        insurance and advertising, decreased as a percentage of restaurant sales
        120
        basis points to 22.9% in fiscal year 2004 as compared with 24.1% in fiscal
        year
        2003. Much of the improvement reflects the advertising efficiency gained
        with
        the acquisition of the Beaumont-based restaurants. Further, the Beaumont-based
        restaurants have lower occupancy costs and liquor taxes relative to their
        sales
        volumes, which when consolidated brought the overall percentage of these
        costs
        down. And finally, general liability and property insurance premiums decreased
        as a percentage of restaurant sales in fiscal 2004 compared with fiscal 2003.
 
 General
        and administrative expenses consist of expenses associated with corporate
        and
        administrative functions that support restaurant operations. General and
        administrative expenses decreased as a percentage of total sales 130 basis
        points to 8.5% in fiscal year 2004 as compared with 9.8% in fiscal year 2003.
        The improvement reflects efficiencies gained with the acquisition of the
        Beaumont-based restaurants, offset in part by executive and non-executive
        bonus
        accruals and higher professional and legal expenses.
 
 Depreciation
        and amortization expenses include the depreciation of fixed assets and the
        amortization of intangible assets. Depreciation and amortization expense
        decreased as a percentage of restaurant sales 90 basis points to 2.9% in
        fiscal
  19
  year
        2004
        as compared with 3.8% in fiscal year 2003. Actual depreciation and amortization
        expense increased $207,011 in fiscal
        year 2004 compared with fiscal year 2003. The decrease as a percentage of
        total
        sales reflects the acquisition of the Beaumont-based restaurants, which had
        a
        smaller asset base relative to the restaurant sales added.
 
 During
        fiscal year 2004, the Company incurred $56,478 in pre-opening expenses related
        to the remodel of two existing restaurants and the remodel of one acquired
        Casa
        Olé franchise restaurant. In fiscal year 2003, the Company spent $95,891 in
        pre-opening expenses related to the purchase of one franchise restaurant
        that
        the Company remodeled for a new grand opening.
 
 ***(Gain)
        Loss on Sale of Assets*** .
        During
        fiscal year 2004, the Company recorded a loss of $182,359 on the disposition
        of
        assets, primarily related to the remodel of one existing restaurant and the
        sale
        of a leasehold interest of another existing restaurant. During fiscal year
        2003,
        the Company recorded a gain of $292,052 for insurance proceeds received from
        fire damage at the Humble, Texas restaurant location.
 
 ***Other
        Income (Expense)*** .
        Net
        expense increased $362,148 to $458,779 in fiscal year 2004 compared with
        a net
        expense of $96,631 in fiscal year 2003. Interest expense increased $311,082
        to
        $553,371 in fiscal year 2004 compared with interest expense of $242,289 in
        fiscal year 2003, reflecting the increase in outstanding debt incurred for
        the
        acquisition of the Beaumont-based restaurants.
 
 ***Income
        Tax Expense.*** The
        Company’s effective tax rate from continuing operations for fiscal year 2004 was
        32.2% as compared to fiscal year 2003 of 35.2%. In fiscal year 2004, the
        Company
        had a significantly higher pretax income compared to fiscal 2003. In both
        years,
        the permanent differences were approximately the same, resulting in a lower
        effective tax rate in fiscal 2004.
 
 ***Restaurant
        Closure Costs and***  ***Discontinued
        Operations.*** In
        fiscal
        2004, the Company recorded asset impairment and restaurant closure costs
        of
        $868,580, of which $167,898 related to the fiscal 2004 closure of three
        restaurants. In fiscal 2003, the Company recorded asset impairment and
        restaurant closure costs of $2,908,406, of which $2,252,998 related to the
        fiscal 2003 closure of one restaurant and inclusion of discontinued operations
        related to the fiscal 2004 closure of three restaurants.
 
 In
        fiscal
        2004, the Company incurred $700,682 of impairment expenses in continuing
        operations related primarily to four Tortuga restaurants that the Company
        wanted
        to position for re-concept to one of the Company’s other Mexican food concepts.
        Because of improved operating performance, the Company did not re-concept
        the
        four Tortuga restaurants in fiscal 2005. In addition, two Monterey’s
        restaurants, which were impaired in 2003, incurred a small impairment in
        2004.
        These two restaurants will be closed at the expiration of their operating
        leases.
 
 The
        circumstances and testing leading to the impairment in fiscal 2004 are
        determined in accordance with SFAS No. 144 which requires that property,
        plant
        and equipment be reviewed for impairment whenever events or changes in
        circumstances indicate that the carrying amount of an asset may not be
        recoverable.
 
 **Liquidity
        and Capital Resources**
 
 The
        Company met fiscal 2005 capital requirements with cash generated by operations
        and with its cash reserves. In fiscal 2005, the Company's operations generated
        approximately $6.2 million in cash, as compared with $5.7 million in fiscal
        2004 and $2.4 million in fiscal 2003. As of January 1, 2006, the Company
        had a working capital deficit of approximately $1.6 million, compared with
        a
        working capital deficit of approximately $1.4 million at January 2, 2005.
        A
        working capital deficit is common in the restaurant industry, since restaurant
        companies do not typically require a significant investment in either accounts
        receivable or inventory.
 
 The
        Company's principal capital requirements are the funding of routine capital
        expenditures, new restaurant development or acquisitions and remodeling of
        older
        units. During fiscal 2005, total cash used for capital requirements was
        approximately $4.6 million ($1.9 million on routine capital expenditures,
        $600,000 on one new restaurant, $1.4 million on remodels and $680,000 for
        hurricane expenditures). The Company also received approximately $360,000
        from
        the sale of an office building that was acquired in January 2004 acquisition
        of
        the Beaumont-based franchisee stores and related assets. The Company opened
        one
        new restaurant in Humble, Texas near the end of the second quarter of fiscal
        2005. That restaurant
  20
  is
        presently exceeding our sales expectations. During the third quarter of fiscal
        2005, the Company closed and later re-opened one restaurant after extensive
        remodeling. That restaurant is also exceeding our sales expectations.
        Additionally, six restaurants were moderately remodeled (not requiring closures)
        and one restaurant parking lot was expanded. The balance of capital expenditures
        was for necessary replacement of equipment and leasehold improvements in
        various
        older restaurants and for hurricane repairs. During the fourth quarter of
        fiscal
        2005, the Company signed a new lease for a restaurant it plans to open in
        the
        first quarter of fiscal 2006.
 
 For
        fiscal
        year 2006, the Company plans to develop two new restaurants, extensively
        remodel
        one restaurant and moderately remodel eight other restaurants. The estimated
        capital needed for fiscal year 2006 for general corporate purposes, including
        remodeling and new restaurant expansion, is approximately $4.2 million.
 
 Over
        the last
        several years, the Company’s debt was incurred to carry out acquisitions, to
        develop new restaurants, and to remodel existing restaurants, as well as
        to
        accommodate other working capital needs. The Company anticipates that it
        will
        use excess cash flow during fiscal year 2006 to pay down acquisition debt
        approximately $2.5 million.
 
 On
        January 7,
        2004, the Company completed its purchase of 13 restaurants and related assets
        from its Beaumont-based franchisee for a total consideration of approximately
        $13.75 million. The financing for the acquisition was provided by Bank of
        America (formerly Fleet National Bank), CNL Franchise Network, LP (“CNL’) and
        the sellers of the Beaumont-based franchise restaurants. Bank of America
        provided $3.1 million of the acquisition price by amending its credit facility
        with Mexican Restaurants, Inc. Six of the acquired restaurants were concurrently
        sold to CNL for $8.325 million in a sale-leaseback transaction. The sellers
        accepted $3.0 million in notes from Mexican Restaurants, Inc. for the balance
        of
        the purchase price. The seller notes pay interest only for five years, with
        $1.5
        million in principal due on January 7, 2009 and $1.5 million in principal
        amortizing over an additional five years. The Company plans to prepay $2.5
        million of the seller notes on March 31, 2006 by borrowing on its Bank of
        America credit facility.
 
 On
        October
        14, 2004, the Company completed its purchase of one franchise restaurant
        in
        Brenham, Texas for approximately $215,000. The restaurant was closed, remodeled
        and re-opened on November 22, 2004. The Company spent $329,489 remodeling
        the
        restaurant.
  On
        January 7,
        2004, Bank of America amended its $10.0 million credit facility to accommodate
        the acquisition of the Beaumont-based franchise restaurants. The amended
        credit
        facility consists of a $5.0 million term note that requires quarterly principal
        payments of $250,000 and matures on June 30, 2008. The credit facility also
        includes a $5.0 million revolving line of credit that matures on January
        7,
        2007. The interest rate is either the prime rate or LIBOR plus a stipulated
        percentage. Accordingly, the Company is impacted by changes in the prime
        rate
        and LIBOR. The Company is subject to a non-use fee of 0.75% on the unused
        portion of the revolver from the date of the credit agreement. During fiscal
        2005, the Company paid debt down $1.5 million. As of January 1, 2006, the
        Company’s outstanding debt to Bank of America was $2.5 million and its
        outstanding debt on seller notes was $3.0 million, for a total indebtedness
        of
        $5.5 million.
  On
        April
        1, 2005, the Company and Bank of America amended the $10.0 million credit
        facility to accommodate the Company’s growth plans. The amendment allows for
        additional capital expenditures, revised certain covenant ratios, increased
        the
        amount of allowable stock repurchases, and extended the maturity date of
        the
        revolving line of credit to January 7, 2009. Effective June 30, 2005, the
        Company and Bank of America further amended the $10.0 million credit facility
        to
        revise certain ratios affected by Hurricane Rita and the Company’s stock
        repurchase program, and to lower the applicable interest rate margins. The
        Company is in full compliance with all debt covenants as amended. The Company
        expects to be in compliance with all debt covenants throughout fiscal
        2006.
 
 On
        May 9,
        2005, the Company announced its plan to implement a limited stock repurchase
        program in a manner permitted under its bank financing agreement. Under this
        program, the Company could spend up to $1.0 million over the next 12 months
        (not
        to exceed $500,000 in any one quarter) to repurchase outstanding shares of
        its
        common stock. On September 7, 2005, the Company’s Board of Directors approved an
        increase of $1,000,000 to its stock repurchase program announced on May 9,
        2005.
        The Company has entered into a repurchase plan designed to comply with Rules
        10b5-1 and 10b-18 under the Securities and Exchange Act of 1934, under which
        an
        agent appointed by the Company will determine the time, amount, and price
        at
        which purchases of common stock will be made, subject to certain parameters
        established in advance by the Company. As of January 1, 2006, the Company
        repurchased 181,300 shares of its common stock for a total price of $1.7
        million. During this same period, Company employees exercised 121,472 options
        and the Company received $430,544 in net proceeds. The shares acquired are
        being
        held for general corporate purposes, including the offset of the dilutive
        effect
        on shareholders from the exercise of stock options.
  21
  
 The
        Company’s management believes that with its operating cash flow and the
        Company’s revolving line of credit with Bank of America, funds will be
        sufficient to meet operating requirements and to finance routine capital
        expenditures and new restaurant growth through the end of the 2006 fiscal
        year.
        Unless the Company violates an important debt covenant, the Company’s credit
        facility with Bank of America is not subject to triggering events that would
        cause the credit facility to become due sooner than the maturity dates described
        in the previous paragraphs.
 
 ***Contractual
        Obligations and Commitments.***
 
 The
        following table summarizes the Company’s total contractual cash obligations as
        of January 1, 2006 (in thousands):
  **Contractual
                  Obligation**
              
              **Total**
              
              **Less
                  than**
                **1
                  Year**
              
              **1
                  to 3**
                **Years**
              
              **3
                  to 5**
                **Years**
              
              **More
                  Than**
                **5
                  Years**Long-Term
                  Debt
              
              $
              5,500,000
              
              $
              1,000,000
              
              $
              1,500,000
              
              $
              2,075,000
              
              $
              925,000Long-Term
                  Debt Fixed Interest
              
              
              896,875
              
              
              210,000
              
              
              420,000
              
              
              169,750
              
              
              97,125Operating
                  Leases
              
              
              53,762,438
              
              
              5,534,205
              
              
              10,693,148
              
              
              9,719,610
              
              
              27,815,475Total
                  Contractual Cash Obligations
              
              $
              60,159,313
              
              $
              6,744,205
              
              $
              12,613,148
              
              $
              11,964,360
              
              $
              28,837,600
 
 The
        contractual obligation table does not include interest payments on our long-term
        debt with Bank of America (formerly Fleet National Bank) due to the variable
        interest rates under our credit facility and the varying debt balance during
        the
        year. The contractual interest rate for our credit facility is either the
        prime
        rate or LIBOR base rate plus a stipulated margin. See Note 3 to our consolidated
        financial statements for balances and terms of our credit facility at January
        1,
        2006.
  ***Related
        Parties.*** In
        May
        1998 the Board of Directors of the Company adopted a program to assist
        executives and five key employees of the Company in their purchasing of shares
        of the Company. As adopted, the program provided for the Company to assist
        the
        executives and key employees in obtaining third party loans to finance such
        purchases. As of February 1, 2003, the maturity date of the employee third
        party
        loans, the Company no longer guarantees employee third party loans.
 
 The
        Company provides accounting and administrative services for the Casa Olé Media
        and Production Funds. The Casa Olé Media and Production Funds are
        not-for-profit, unconsolidated entities used to collect money from company-owned
        and franchise-owned restaurants to pay for the marketing of Casa Olé
restaurants. Each restaurant contributes an agreed upon percentage of its
        sales
        to the funds.
 
 
 **ITEM
        7A.**  **QUANTITATIVE
        AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**
 
 The
        Company does not have or participate in transactions involving derivative,
        financial and commodity instruments. The Company’s long-term debt bears interest
        at floating market rates, based upon either the prime rate or LIBOR plus
        a
        stipulated percentage. Based on amounts outstanding at year-end, a 1% change
        in
        interest rates would change interest expense by approximately
        $25,000.
 
 **ITEM
        8.**  **FINANCIAL
        STATEMENTS AND SUPPLEMENTARY DATA**
  The
        Financial Statements and Supplementary Data are set forth herein commencing
        on
        page F-1 of this report.
 
 The
        Company has prepared these financial statements in conformity with accounting
        principles generally accepted in the United States of America. The Company
        is
        responsible for the fairness and reliability of the financial statements
        and
        other financial data included in this report. In the preparation of the
        financial statements, it is necessary for the Company to make informed estimates
        and judgments based on the currently available information on the effects
        of
        certain events and transactions.
 
 The
        audit
        committee of the Company’s board of directors is composed of three directors who
        are not our employees. This committee meets periodically with the Company’s
        independent public accountants and management. Our independent public
        accountants have full and free access to the audit committee to meet, with
        and
        without management being present, to discuss the results of their audits
        and the
        quality of the Company’s financial reporting.
  22
  
 
 **ITEM
        9.**  **CHANGES
        IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
        DISCLOSURE**
 
 Not
        applicable.
 
 **ITEM
        9A.**  **CONTROLS
        AND PROCEDURES**
 
 *(a)*  *Evaluation
        of disclosure controls and procedures.*
 
 The
        Company maintains disclosure controls and procedures, which it has designed
        to
        ensure that material information related to the Company, including its
        consolidated subsidiaries, is made known to a group comprised of designated
        members of the Company’s senior management and/or the certifying officer
        ( *i.e.* ,
        Chief
        Executive Officer and Chief Financial Officer) on a timely basis. In response
        to
        recent legislation and proposed regulations, the Company reviewed its internal
        control structure and its disclosure controls and procedures. Although the
        Company believes its pre-existing disclosure controls and procedures were
        adequate to enable the Company to comply with its disclosure obligations,
        as a
        result of such review, the Company implemented minor changes, primarily to
        formalize and document the procedures already in place. As of the end of
        the
        period covered by this report, the Company carried out an evaluation, under
        the
        supervision and with the participation of the Company’s management, including
        the Company’s Chief Executive Officer and Chief Financial Officer, of the
        effectiveness of the design and operation of the Company’s disclosure controls
        and procedures pursuant to Securities Exchange Act of 1934, as amended, Rule
        13a-15 and 15d-15. Based upon that evaluation, the Chief Executive Officer
        and
        Chief Financial Officer concluded that the Company’s disclosure controls and
        procedures are effective in timely alerting them to material information
        relating to the Company (including its consolidated subsidiaries) required
        to be
        disclosed by the Company in the reports that the Company files or submits
        under
        the Securities Exchange Act of 1934 is recorded, processed, summarized and
        reported within the time periods specified in the Securities and Exchange
        Commission’s rules and forms.
 
 *(b)*  *Changes
        in internal controls*
 
 There
        were no significant changes in the Company’s internal controls or in other
        factors, including any corrective actions with regard to significant
        deficiencies and material weaknesses that could significantly affect, or
        is
        reasonably likely to affect, these controls subsequent to the date of their
        evaluation.
 
 **ITEM
        9B.**  **OTHER
        INFORMATION**
 
 None.
 
 
 **PART
        III**
 
 **ITEM
        10.**  **DIRECTORS
        AND EXECUTIVE OFFICERS OF THE REGISTRANT**
 
 The
        information called for by this Item 10 is incorporated herein by reference
        to
        the Company’s definitive proxy statement to be filed with the Securities and
        Exchange Commission pursuant to Regulation 14A not later than 120 days after
        the
        end of the fiscal year covered by this report.
 
 
 **ITEM
        11.**  **EXECUTIVE
        COMPENSATION**
 
 The
        information called for by this Item 11 is incorporated herein by reference
        to
        the Company’s definitive proxy statement to be filed with the Securities and
        Exchange Commission pursuant to Regulation 14A not later than 120 days after
        the
        end of the fiscal year covered by this report.
 
 
 
 
  23
  
 **ITEM
        12.**  **SECURITY
        OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER
        MATTERS**
 
 The
        information called for by this Item 12 is incorporated herein by reference
        to
        the Company’s definitive proxy statement to be filed with the Securities and
        Exchange Commission pursuant to Regulation 14A not later than 120 days after
        the
        end of the fiscal year covered by this report.
 
 **ITEM
        13.**  **CERTAIN
        RELATIONSHIPS AND RELATED TRANSACTIONS**
 
 The
        information called for by this Item 13 is incorporated herein by reference
        to
        the Company’s definitive proxy statement to be filed with the Securities and
        Exchange Commission pursuant to Regulation 14A not later than 120 days after
        the
        end of the fiscal year covered by this report.
 
 **ITEM
        14.**  **PRINCIPAL
        ACCOUNTANT FEES AND SERVICES**
 
 The
        information called for by this Item 14 is incorporated herein by reference
        to
        the Company’s definitive proxy statement to be filed with the Securities and
        Exchange Commission pursuant to Regulation 14A not later than 120 days after
        the
        end of the fiscal year covered by this report.
  
 **PART
        IV**
 
 **ITEM
        15.**  **EXHIBITS
        AND FINANCIAL STATEMENT SCHEDULES**
 
 (a)
              The
                  following documents are filed as part of this
                  Report:
 
 1.
              Financial
                  Statements:
 
 The
        Financial Statements are listed in the index to Consolidated Financial
        Statements on page F-1 of this Report.
 
 2.
              The
                  following exhibits are filed as part of this report. The exhibits
                  designated with a cross are management contracts and compensatory
                  plans
                  and arrangements required to be filed as exhibits to this report.
 
 3.  Exhibits:
 
 3.1
              Articles
                  of Incorporation of the Company, as amended (incorporated by reference
                  to
                  the corresponding Exhibit number of the Company’s Form 8-K filed on May
                  25, 1999 with the Securities and Exchange Commission).‡3.2
              Bylaws
                  of the Company.‡4.1
              Specimen
                  of Certificate of Common Stock of the Company.4.2
              Articles
                  of Incorporation of the Company (see 3.1 above).‡4.3
              Bylaws
                  of the Company (see 3.2 above).‡10.1
              Employment
                  Agreement by and between the Company and Louis P. Neeb dated
                  February 28, 1996.10.2
              Indemnity
                  Agreement by and between the Company and Louis P. Neeb dated as of
                  April 10, 1996 (incorporated by reference to Exhibit 10.4 of the
                  Company’s Form S-1 Registration Statement filed under the Securities Act
                  of 1933, dated April 24, 1996, with the Securities and Exchange
                  Commission
                  (Registration Number 333-1678) (the “1996 Form
                  S-1”)).
  24
  
 10.3
              Indemnity
                  Agreement by and between the Company and Larry N. Forehand dated as
                  of April 10, 1996 (incorporated by reference to Exhibit 10.5 of the
                  1996 Form S-1).10.4
              Indemnity
                  Agreement by and between the Company and John C. Textor dated as
                  of
                  April 10, 1996 (incorporated by reference to Exhibit 10.6 of the 1996
                  From S-1).10.5
              Indemnity
                  Agreement by and between the Company and Michael D. Domec dated as of
                  April 10, 1996 (incorporated by reference to Exhibit 10.8 of the 1996
                  Form S-1).10.6
              Indemnity
                  Agreement by and between the Company and J. J. Fitzsimmons dated
                  as of
                  April 10, 1996 (incorporated by reference to Exhibit 10.10 of the
                  1996 Form S-1).10.7
              Indemnity
                  Agreement by and between the Company and Richard E. Rivera dated as
                  of April 10, 1996 (incorporated by reference to Exhibit 10.11 of the
                  1996 Form S-1).10.8
              Corrected
                  Warrant Agreement by and between the Company and Louis P. Neeb dated
                  as of February 26, 1996 (incorporated by reference to Exhibit 10.12
                  of the 1996 Form S-1).10.9
              Corrected
                  Warrant Agreement by and between the Company and Tex-Mex Partners,
                  L.C.
                  dated as of February 26, 1996 (incorporated by reference to Exhibit
                  10.13 of the 1996 Form S-1).10.10
              Form
                  of the Company's Multi-Unit Development Agreement (incorporated
                  by
                  reference to Exhibit 10.14 of the 1996 Form S-1).10.11
              Form
                  of the Company's Franchise Agreement (incorporated by reference
                  to Exhibit
                  10.15 of the 1996 Form S-1).†10.12
              1996
                  Long Term Incentive Plan (incorporated by reference to Exhibit
                  10.16 of
                  the 1996 Form S-1).†10.13
              Mexican
                  Restaurants, Inc. 2005 Long Term Incentive Plan (incorporated by
                  reference
                  to Exhibit 99.1 of the 2005 Form S8 filed December 1,
                  2005).†10.14
              Stock
                  Option Plan for Non-Employee Directors (incorporated by reference
                  to
                  Exhibit 10.17 of the 1996 Form S-1).10.15
              Corrected
                  Warrant Agreement by and between Larry N. Forehand and Louis
                  P. Neeb dated as of February 26, 1996 (incorporated by reference
                  to Exhibit 10.31 of the 1996 Form S-1).10.16
              Corrected
                  Warrant Agreement by and between Larry N. Forehand and Tex-Mex
                  Partners, L.C. dated as of February 26, 1996 (incorporated by
                  reference to Exhibit 10.32 of the 1996 Form S-1).10.17
              Corrected
                  Warrant Agreement by and between Larry N. Forehand and Patrick
                  A. Morris dated as of February 26, 1996 (incorporated by
                  reference to Exhibit 10.33 of the 1996 Form S-1).10.18
              Corrected
                  Warrant Agreement by and between Larry N. Forehand and Stacy
                  M. Riffe dated as of February 26, 1996 (incorporated by
                  reference to Exhibit 10.34 of the 1996 Form S-1).10.19
              Indemnification
                  letter agreement by Larry N. Forehand dated April 10, 1996
                  (incorporated by reference to Exhibit 10.35 of the 1996 Form S-1).†10.20
              1996
                  Manager’s Stock Option Plan (incorporated by reference to Exhibit 99.2
                  of
                  the Company’s Form S-8 Registration Statement filed under the Securities
                  Act of 1933, dated February 24, 1997 filed with the Securities
                  and
                  Exchange Commission).
  25
  
 †10.22
              Employment
                  Agreement by and between the Company and Andrew J. Dennard dated
                  May 20,
                  1997 (incorporated by reference to Exhibit 10.45 of the Company’s Form
                  10-K Annual Report filed on March 30, 1998 with the Securities
                  and
                  Exchange Commission).10.23
              Fleet
                  Revolving Credit and Term Loan Agreement between Mexican Restaurants,
                  Inc., as the Borrower, and Fleet National Bank, as the Bank, for
                  $10,000,000 dated June 29, 2001 and as amended on January 7, 2004
                  and
                  April 1, 2005 (incorporated by reference to Exhibit 10.22 of the
                  Company’s
                  Form 10-K Annual Report filed on April, 2005 with the Securities
                  and
                  Exchange Commission).*10.24
              Amendment
                  No. 2 to Amended and Restated Revolving Credit and Term Loan Agreement
                  dated November 15, 2005 (effective June 30, 2005) between Mexican
                  Restaurants, Inc., as the Borrower, and Bank of America, as the
                  Bank, for
                  $10,000,000 dated June 29, 2001 and as amended on January 7, 2004
                  and
                  April 1, 2005.*†10.25
              Performance
                  Unit Agreement by and between Mexican Restaurants, Inc. and Andrew
                  Dennard
                  dated August 16, 2005.*†10.26
              Performance
                  Unit Agreement by and between Mexican Restaurants, Inc. and Curt
                  Glowacki
                  dated August 16, 2005.*†10.27
              Performance
                  Unit Agreement by and between Mexican Restaurants, Inc. and Louis
                  P. Neeb
                  dated August 16, 2005.*†10.28
              Performance
                  Unit Agreement by and between Mexican Restaurants, Inc. and Dennis
                  Vegas
                  dated August 16, 2005.21.1
              List
                  of subsidiaries of the Company (incorporated by reference to Exhibit
                  22.1
                  of the Company’s Form S-1 Registration Statement Under the Securities Act
                  of 1933, dated April 24, 1996, filed by the Company with the Securities
                  and Exchange Commission).*23.1
              Consent
                  of UHY MANN FRANKFORT STEIN & LIPP CPAs, LLP, Independent Registered
                  Public Accounting Firm.*23.2
              Consent
                  of KPMG, LLP, Independent Registered Public Accounting
                  Firm.*24.1
              Power
                  of Attorney (included on the signature page to this Form
                  10-K).*31.1
              Certification
                  filed pursuant to Rule 13a-14(a) or Rule 15d-14(a).*31.2
              Certification
                  filed pursuant to Rule 13a-14(a) or Rule 15d-14(a).#32.1
              Certification
                  of Chief Executive Officer furnished pursuant to 18 U.S.C. Section
                  1350,
                  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.#32.2
              Certification
                  of Chief Financial Officer furnished pursuant to 18 U.S.C. Section
                  1350,
                  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002._____*
              Filed
                  herewith.‡
              Incorporated
                  by reference to corresponding Exhibit number of the Company’s Form S-1
                  Registration Statement under the Securities Act of 1933, dated
                  April 24,
                  1996, with the Securities and Exchange Commission (Registration
                  number
                  333-1678) (the “1996 Form S-1”).†
              Management
                  contract or compensatory plan or arrangement.#
              Furnished
                  herewith.
 
  26
  
 **SIGNATURES**
 
 Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of
        1934, the Registrant has duly caused this report to be signed on its behalf
        by
        the undersigned, thereunto duly authorized on March 30, 2006.
 
 MEXICAN
                  RESTAURANTS, INC.*By:
                  /s/ Louis P. Neeb*Louis
                  P. Neeb,Chairman
                  of the Board of Directors
 
 **POWER
        OF ATTORNEY**
 
 KNOW
        ALL
        MEN AND WOMEN BY THESE PRESENTS, that each person whose signature appears
        below
        constitutes and appoints Louis P. Neeb, Curt Glowacki and Andrew Dennard,
        and
        each of them, such individual’s true and lawful attorneys-in-fact and agents,
        with full power of substitution and resubstitution, for such individual and
        in
        his or her name, place and stead, in any and all capacities, to sign any
        and all
        amendments to this Form 10-K under the Securities Exchange Act of 1934, and
        to
        file the same, with all exhibits thereto, and all documents in connection
        therewith, with the Securities and Exchange Commission, granting unto said
        attorneys-in-fact and agents, and each of them, full power and authority
        to do
        and perform each and every act and thing requisite and necessary to be done
        in
        and about the premises as fully to all intents and purposes as he or she
        might
        or could do in person, hereby ratifying and confirming all that said
        attorneys-in-fact and agents, or any of them, or their substitute or
        substitutes, may lawfully do or cause to be done by virtue hereof.
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, this Report has
        been
        signed by the following persons in the capacities and on the dates
        indicated.
 
 **Signatures**
              **Title**
              **Date***/s/
                  Louis P. Neeb*
              Chairman
                  of the Board of Directors
              March
                  30, 2006Louis
                  P. Neeb*/s/
                  Larry N. Forehand*
              Founder
                  and Vice Chairman of the Board of Directors
              March
                  30, 2006Larry
                  N. Forehand*/s/
                  Curt Glowacki*
              President
                  and Chief Executive Officer and Director
              March
                  30, 2006Curt
                  Glowacki
              (Principal
                  Executive Officer)*/s/
                  Andrew J. Dennard*
              Exec.
                  Vice President and Chief Financial Officer
              March
                  30, 2006Andrew
                  J. Dennard
              (Principal
                  Financial and Accounting Officer)*/s/
                  David Nierenberg*
              Director
              March
                  30, 2006David
                  Nierenberg*/s/
                  Michael D. Domec*
              Director
              March
                  30, 2006Michael
                  D. Domec*/s/
                  J. J. Fitzsimmons*
              Director
              March
                  30, 2006J.
                  J. Fitzsimmons*/s/
                  Thomas E. Martin*
              Director
              March
                  30, 2006Thomas
                  E. Martin*/s/
                  J. Stuart Sargent*
              Director
              March
                  30, 2006J.
                  Stuart Sargent
 
  27
  
 
 **Exhibit
        31.1**
 
 
 **CERTIFICATION
        PURSUANT TO**
 **SECTION
        302 OF THE SARBANES-OXLEY ACT OF 2002**
 
 
 I,
        Curt
        Glowacki, certify that:
 
 1.
        I have
        reviewed this report on Form 10-K of Mexican Restaurants, Inc.;
 
 2.
        Based
        on my knowledge, this report does not contain any untrue statement of a material
        fact or omit to state a material fact necessary to make the statements made,
        in
        light of the circumstances under which such statements were made, not misleading
        with respect to the period covered by this report;
 
 3.
        Based
        on my knowledge, the financial statements, and other financial information
        included in this annual report, fairly present in all material respects the
        financial condition, results of operations and cash flows of the Registrant
        as
        of, and for, the periods presented in this report;
 
 4.
        The
        Registrant’s other certifying officer and I are responsible for establishing and
        maintaining disclosure controls and procedures (as defined in Exchange Act
        Rules
        13a-15(e) and 15d-15(e) for the Registrant and have:
 
 ( a)
        designed such disclosure controls and procedures, or caused such disclosure
        controls and procedures to be designed under our supervision, to ensure that
        material information relating to the Registrant, including its consolidated
        subsidiaries, is made known to us by others within those entities, particularly
        during the period in which this report is being prepared;
 
 (b)  evaluated
        the effectiveness of the Registrant’s disclosure controls and procedures and
        presented in this report our conclusions about the effectiveness of the
        disclosure controls and procedures, as of the end of the period covered by
        this
        report based on such evaluation; and
  (c)  disclosed
        in this report any change in the Registrant’s internal control over financial
        reporting that occurred during the Registrant’s most recent fiscal quarter (the
        Registrant’s fourth fiscal quarter in the case of an annual report) that has
        materially affected, or is reasonably likely to materially affect, the
        Registrant’s internal control over financial reporting; and
  5.  The
        Registrant’s other certifying officer(s) and I have disclosed, based on our most
        recent evaluation of internal control over financial reporting, to the
        Registrant’s auditors and the audit committee of the Registrant’s board of
        directors (or persons performing the equivalent functions):
 
 (a)
        all
        significant deficiencies and material weaknesses in the design or operation
        of
        internal control over financial
 reporting
        which are reasonably likely to adversely affect the Registrant’s ability to
        record, process, summarize
 and
        report financial information; and
 
 (a)
              any
                  fraud, whether or not material, that involves management or other
                  employees who have a significant role in
 the
        Registrant’s internal control over financial reporting.
 
 March
        30,
        2006
  */s/
                  Curt Glowacki*By:
                  Curt Glowacki,Chief
                  Executive Officer
 
  28
  
 
 
 **Exhibit
        31.2**
 
 
 **CERTIFICATION
        PURSUANT TO**
 **SECTION
        302 OF THE SARBANES-OXLEY ACT OF 2002**
 
 
 I,
        Andrew
        J. Dennard, certify that:
 
 1.
        I have
        reviewed this report on Form 10-K of Mexican Restaurants, Inc.;
 
 2.
        Based
        on my knowledge, this report does not contain any untrue statement of a material
        fact or omit to state a material fact necessary to make the statements made,
        in
        light of the circumstances under which such statements were made, not misleading
        with respect to the period covered by this report;
 
 3.
        Based
        on my knowledge, the financial statements, and other financial information
        included in this annual report, fairly present in all material respects the
        financial condition, results of operations and cash flows of the Registrant
        as
        of, and for, the periods presented in this report;
 
 4.
        The
        Registrant’s other certifying officers and I are responsible for establishing
        and maintaining disclosure controls and procedures (as defined in Exchange
        Act
        Rules 13a-15(e) and 15d-15(e) for the Registrant and have:
 
 ( a)
        designed such disclosure controls and procedures, or caused such disclosure
        controls and procedures to be designed under our supervision, to ensure that
        material information relating to the Registrant, including its consolidated
        subsidiaries, is made known to us by others within those entities, particularly
        during the period in which this report is being prepared;
 
 (b)  evaluated
        the effectiveness of the Registrant’s disclosure controls and procedures and
        presented in this report our conclusions about the effectiveness of the
        disclosure controls and procedures, as of the end of the period covered by
        this
        report based on such evaluation; and
  (c)  disclosed
        in this report any change in the Registrant’s internal control over financial
        reporting that occurred during the Registrant’s most recent fiscal quarter (the
        Registrant’s fourth fiscal quarter in the case of an annual report) that has
        materially affected, or is reasonably likely to materially affect, the
        Registrant’s internal control over financial reporting; and
  5.  The
        Registrant’s other certifying officer(s) and I have disclosed, based on our most
        recent evaluation of internal control over financial reporting, to the
        Registrant’s auditors and the audit committee of the Registrant’s board of
        directors (or persons performing the equivalent functions):
 
 (a)
        all
        significant deficiencies and material weaknesses in the design or operation
        of
        internal control over financial
 reporting
        which are reasonably likely to adversely affect the Registrant’s ability to
        record, process, summarize
 and
        report financial information; and
 
 (b)
              any
                  fraud, whether or not material, that involves management or other
                  employees who have a significant role in
 the
        Registrant’s internal control over financial reporting.
 
 March
        30,
        2006
  */s/
                  Andrew J. Dennard*By:
                  Andrew J. Dennard,Chief
                  Financial Officer
 
 29
  
 
 
 
 **MEXICAN
        RESTAURANTS, INC.**
 
 **INDEX
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **Page**Report
                  of Independent Registered Public Accounting Firm
              F-2Report
                  of Independent Registered Public Accounting Firm
              F-3Consolidated
                  Balance Sheets as of January 2, 2005 and January 1, 2006
              F-4Consolidated
                  Statements of Operations for each of the years in the three fiscal-year
                period
                  ended January 1, 2006
              F-5Consolidated
                  Statements of Stockholders' Equity for each of the years in
                the
                  three fiscal-year period ended January 1, 2006
              F-6Consolidated
                  Statements of Cash Flows for each of the years in the three
                fiscal-year
                  period ended January 1, 2006
              F-7Notes
                  to Consolidated Financial Statements
              F-8
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-1
  
  
 **Exhibit
        23.1**
 
 **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 
 
 The
        Board
        of Directors and Stockholders
 Mexican
        Restaurants, Inc. and Subsidiaries:
 
 
 We
        have
        audited the accompanying consolidated balance sheet of Mexican Restaurants,
        Inc.
        and subsidiaries (the “Company”) as of January 1, 2006, and the related
        consolidated statements of operations, stockholders' equity and cash flows
        for
        the year ended January 1, 2006. These consolidated financial statements are
        the
        responsibility of the Company's management. Our responsibility is to express
        an
        opinion on these consolidated financial statements based on our
        audit.
 
 We
        conducted our audit in accordance with the standards of the Public Company
        Accounting Oversight Board (United States of America). Those standards require
        that we plan and perform the audit to obtain reasonable assurance about whether
        the consolidated financial statements are free of material misstatement.
        An
        audit includes examining, on a test basis, evidence supporting the amounts
        and
        disclosures in the consolidated financial statements. An audit also includes
        assessing the accounting principles used and significant estimates made by
        management, as well as evaluating the overall consolidated financial statement
        presentation. We believe that our audit provides a reasonable basis for our
        opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the consolidated financial position of Mexican
        Restaurants, Inc. and subsidiaries as of January 1, 2006, and the consolidated
        results of their operations and their cash flows for the year ended January
        1,
        2006, in conformity with accounting principles generally accepted in the
        United
        States of America.
 
   
 UHY
        MANN
        FRANKFORT STEIN & LIPP CPAs, LLP
 
 
 Houston,
        Texas
 March
        27,
        2006
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-2
  
  
 E **xhibit
        23.2**
 
 
 **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 
 
 The
        Board
        of Directors and Stockholders
 Mexican
        Restaurants, Inc.:
  We
        have
        audited the accompanying consolidated balance sheet of Mexican Restaurants,
        Inc.
        and subsidiaries as of January 2, 2005, and the related consolidated statements
        of operations, stockholders’ equity, and cash flows for each of the years in the
        two-year period ended January 2, 2005. These consolidated financial statements
        are the responsibility of the Company’s management. Our responsibility is to
        express an opinion on these consolidated financial statements based on our
        audits.
  We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
  In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the financial position of Mexican Restaurants,
        Inc.
        and subsidiaries as of January 2, 2005, and the results of their operations
        and
        their cash flows for each of the years in the two-year period ended January
        2,
        2005, in conformity with U.S. generally accepted accounting
        principles.
  
  
  (signed)
        KPMG LLP
  
 
 
 Houston,
        Texas
 March
        28,
        2005, except for Note 1, as to which the date is March 30, 2006
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-3
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        BALANCE SHEETS**
 **January
        2, 2005 and January 1, 2006**
 
 
 **Fiscal
                  Years****ASSETS**
              
              **2004**
              
              **2005**Current
                  assets:Cash
                  and cash equivalents
              
              $
              1,293,836
              
              $
              788,109Royalties
                  receivable
              
              
              85,377
              
              
              176,649Other
                  receivables
              
              
              701,413
              
              
              2,088,035Inventory
              
              
              658,687
              
              
              744,397Taxes
                  receivable
              
              
              573,840
              
              
              --Prepaid
                  expenses and other current assets
              
              
              832,928
              
              
              833,678Total
                  current assets
              
              
              4,146,081
              
              
              4,630,868Property,
                  plant and equipment
              
              
              28,929,887
              
              
              31,511,205Less
                  accumulated depreciation
              
              
              (13,464,153
              )
              
              (15,315,864
              )Net
                  property, plant and equipment
              
              
              15,465,734
              
              
              16,195,341Goodwill
              
              
              10,902,664
              
              
              10,902,664Deferred
                  tax assets
              
              
              619,087
              
              
              256,274Property
                  held for sale, net
              
              
              505,118
              
              
              625,318Other
                  assets
              
              
              687,502
              
              
              526,804$
              32,326,186
              
              $
              33,137,269**LIABILITIES
                  AND STOCKHOLDERS' EQUITY**Current
                  liabilities:Current
                  installments of long-term debt
              
              $
              1,000,000
              
              $
              1,000,000Accounts
                  payable
              
              
              1,623,859
              
              
              1,710,068Income
                  taxes payable
              
              
              --
              
              
              203,116Accrued
                  sales and liquor taxes
              
              
              740,898
              
              
              127,283Accrued
                  payroll and taxes
              
              
              1,043,182
              
              
              1,685,235Accrued
                  expenses
              
              
              1,097,640
              
              
              1,536,895Total
                  current liabilities
              
              
              5,505,579
              
              
              6,262,597Long-term
                  debt
              
              
              6,000,000
              
              
              4,500,000Other
                  liabilities
              
              
              1,183,426
              
              
              1,930,056Deferred
                  gain
              
              
              1,769,212
              
              
              1,561,070Stockholders'
                  equity:Preferred
                  stock, $.01 par value, 1,000,000 shares authorized, none
                  issued
              
              
              --
              
              
              --Common
                  stock, $0.01 par value, 20,000,000 shares authorized, 4,732,705
                  shares
                issued
              
              
              47,327
              
              
              47,327Additional
                  paid-in capital
              
              
              20,121,076
              
              
              19,406,139Retained
                  earnings
              
              
              9,303,791
              
              
              11,620,788Deferred
                  Compensation
              
              
              (6,303
              )
              
              --Treasury
                  stock, cost of 1,308,500 common shares in 2004 and 1,368,328 common
                shares
                  in 2005
              
              
              (11,597,922
              )
              
              (12,190,708
              )Total
                  stockholders' equity
              
              
              17,867,969
              
              
              18,883,546$
              32,326,186
              
              $
              33,137,269
 
 See
        accompanying notes to consolidated financial statements.
 F-4
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
 **For
        the fiscal years ended December 28, 2003,**
 **January
        2, 2005 and January 1, 2006**
 
  **Fiscal
                  Years********2003**
              
              ******2004**
              
              ******2005**Revenues:
                Restaurant
                  sales
              
              $
              52,882,270
              
              $
              77,026,420
              
              $
              79,974,937Franchise
                  fees, royalties and other
              
              
              1,139,268
              
              
              753,293
              
              
              694,302Business
                  interruption
              
              
              --
              
              
              --
              
              
              534,16354,021,538
              
              
              77,779,713
              
              
              81,203,402Costs
                  and expenses:Cost
                  of sales
              
              
              14,591,387
              
              
              21,384,135
              
              
              21,849,096Labor
              
              
              17,420,803
              
              
              25,241,550
              
              
              26,207,831Restaurant
                  operating expenses
              
              
              12,724,407
              
              
              17,605,751
              
              
              18,659,054General
                  and administrative
              
              
              5,306,211
              
              
              6,586,807
              
              
              6,941,683Depreciation
                  and amortization
              
              
              2,030,377
              
              
              2,237,388
              
              
              2,778,078Pre-opening
                  costs
              
              
              95,891
              
              
              56,478
              
              
              77,942Impairments
                  and restaurant closure costs
              
              
              655,408
              
              
              700,682
              
              
              --Gain
                  on disposal of assets - Hurricane Rita
              
              
              --
              
              
              --
              
              
              (470,702
              )(Gain)
                  loss on sale of assets
              
              
              (292,052
              )
              
              182,359
              
              
              369,00152,532,432
              
              
              73,995,150
              
              
              76,411,983Operating
                  income
              
              
              1,489,106
              
              
              3,784,563
              
              
              4,791,419Other
                  income (expense):Interest
                  income
              
              
              28,736
              
              
              9,711
              
              
              3,451Interest
                  expense
              
              
              (242,289
              )
              
              (553,371
              )
              
              (521,161
              )Other,
                  net
              
              
              116,922
              
              
              84,881
              
              
              113,846(96,631
              )
              
              (458,779
              )
              
              (403,864
              )Income
                  from continuing operations before income taxes
              
              
              1,392,475
              
              
              3,325,784
              
              
              4,387,555Income
                  tax expense
              
              
              490,644
              
              
              1,069,690
              
              
              1,433,191Income
                  from continuing operations
              
              
              901,831
              
              
              2,256,094
              
              
              2,954,364Discontinued
                  Operations:Loss
                  from discontinued operations
              
              
              (813,591
              )
              
              (415,859
              )
              
              (222,193
              )Impairments
                  and restaurant closure costs
              
              
              (2,252,998
              )
              
              (167,898
              )
              
              (790,708
              )Loss
                  on sale of assets
              
              
              (28,156
              )
              
              (210,150
              )
              
              (210
              )Loss
                  from discontinued operations before income taxes
              
              
              (3,094,745
              )
              
              (793,907
              )
              
              (1,013,111
              )Income
                  tax benefit
              
              
              1,158,006
              
              
              298,787
              
              
              375,744Loss
                  from discontinued operations
              
              
              (1,936,739
              )
              
              (495,120
              )
              
              (637,367
              )Net
                  Income (loss)
              
              $
              (1,034,908
              )
              $
              1,760,974
              
              $
              2,316,997Basic
                  income (loss) per share:Income
                  from continuing operations
              
              $
              0.26
              
              $
              0.67
              
              $
              0.87Loss
                  from discontinued operations
              
              
              (0.57
              )
              
              (0.15
              )
              
              (0.19
              )Net
                  income (loss)
              
              $
              (0.31
              )
              $
              0.52
              
              $
              0.68Diluted
                  income (loss) per share:Income
                  from continuing operations
              
              $
              0.26
              
              $
              0.62
              
              $
              0.80Loss
                  from discontinued operations
              
              
              (0.57
              )
              
              (0.14
              )
              
              (0.17
              )Net
                  income (loss)
              
              $
              (0.31
              )
              $
              0.48
              
              $
              0.63Weighted
                  average number of shares (basic)
              
              
              3,384,605
              
              
              3,388,489
              
              
              3,415,806Weighted
                  average number of shares (diluted)
              
              
              3,430,380
              
              
              3,634,849
              
              
              3,700,876
 
 See
        accompanying notes to consolidated financial statements .
 
 F-5
  
  
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS' EQUITY**
 
 **For
        the fiscal years ended**
 **December
        28, 2003, January 2, 2005**
 **and
        January, 1 2006**
 
 **Common****Stock**
              
              **Additional**
                **Paid-in**
                **Capital**
              
              **Retained**
                **Earnings**
              
              **Deferred**
                **Compensation**
              
              **Treasury**
                **Stock**
              
              **Total**
                **Stockholders’**
                **Equity**Balances
                  at December 29, 2002
              
              $
              47,327
              
              $
              20,121,076
              
              $
              8,577,725
              
              $
              (88,911
              )
              $
              (11,709,513
              )
              $
              16,947,704Amortization
                  of Deferred Compensation
              
              
              --
              
              
              --
              
              
              --
              
              
              41,304
              
              
              --
              
              
              41,304Net
                  loss
              
              
              --
              
              
              --
              
              
              (1,034,908
              )
              
              --
              
              
              --
              
              
              (1,034,908
              )Balances
                  at December 28, 2003
              
              $
              47,327
              
              $
              20,121,076
              
              $
              7,542,817
              
              $
              (47,607
              )
              $
              (11,709,513
              )
              $
              15,954,100Exercise
                  of Stock Options
              
              
              --
              
              
              --
              
              
              --
              
              
              --
              
              
              111,591
              
              
              111,591Amortization
                  of Deferred Compensation
              
              
              --
              
              
              --
              
              
              --
              
              
              41,304
              
              
              --
              
              
              41,304Net
                  income
              
              
              --
              
              
              --
              
              
              1,760,974
              
              
              --
              
              
              --
              
              
              1,760,974Balances
                  at January 2, 2005
              
              $
              47,327
              
              $
              20,121,076
              
              $
              9,303,791
              
              $
              (6,303
              )
              $
              (11,597,922
              )
              $
              17,867,969Exercise
                  of Stock Options Through
                Issuance
                  of Treasury Shares
              
              
              --
              
              
              (714,937
              )
              
              --
              
              
              --
              
              
              1,145,481
              
              
              430,544Repurchase
                  of shares
              
              
              --
              
              
              --
              
              
              --
              
              
              --
              
              
              (1,738,267
              )
              
              (1,738,267
              )Amortization
                  of Deferred Compensation
              
              
              --
              
              
              --
              
              
              --
              
              
              6,303
              
              
              --
              
              
              6,303Net
                  income
              
              
              --
              
              
              --
              
              
              2,316,997
              
              
              --
              
              
              --
              
              
              2,316,997Balances
                  at January 1, 2006
              
              $
              47,327
              
              $
              19,406,139
              
              $
              11,620,788
              
              $
              --
              
              $
              (12,190,708
              )
              $
              18,883,546
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 See
        accompanying notes to consolidated financial statements.
 
 
 F-6
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **For
        the fiscal years ended December 28, 2003, January 2, 2005 and January 1,
        2006**
 **Fiscal
                  Years****2003**
              
              **2004**
              
              **2005**(Revised.
                  See Note 1)
              
              (Revised.
                  See
                Note
                  1)**Cash
                  flows from operating activities:**Net
                  income (loss)
              
              $
              (1,034,908
              )
              $
              1,760,974
              
              $
              2,316,997Adjustment
                  to reconcile net income (loss) to net cash provided by operating
                activitiesDepreciation
                  and amortization
              
              
              2,030,377
              
              
              2,237,388
              
              
              2,778,078Deferred
                  gain amortization
              
              
              (208,143
              )
              
              (208,185
              )
              
              (208,142
              )Loss
                  from discontinued operations
              
              
              1,936,739
              
              
              495,120
              
              
              637,367Asset
                  impairments and restaurant closure costs
              
              
              655,408
              
              
              700,682
              
              
              --Impairment
                  of Notes Receivable
              
              
              196,109
              
              
              --
              
              
              --(Gain)
                  loss on sale of property, plant and equipment
              
              
              (10,129
              )
              
              182,359
              
              
              369,001Gain
                  on disposal of assets - Hurricane Rita
              
              
              --
              
              
              --
              
              
              (470,702
              )Deferred
                  compensation expense
              
              
              41,304
              
              
              41,304
              
              
              6,303Gain
                  from insurance proceeds
              
              
              (478,032
              )
              
              --
              
              
              (534,163
              )Deferred
                  income taxes (benefit)
              
              
              (70,235
              )
              
              509,739
              
              
              676,841Changes
                  in assets and liabilities, net of effects of acquisitionsRoyalties
                  receivable
              
              
              (37,486
              )
              
              94,140
              
              
              (91,272
              )Other
                  receivables
              
              
              220,855
              
              
              (308,281
              )
              
              (36,751
              )Taxes
                  receivable/payable
              
              
              37,876
              
              
              (228,834
              )
              
              776,956Inventory
              
              
              (9,385
              )
              
              9,458
              
              
              (276,026
              )Prepaids
                  and other current assets
              
              
              (118,361
              )
              
              (147,403
              )
              
              313Other
                  assets
              
              
              (374,268
              )
              
              34,548
              
              
              4,074Accounts
                  payable
              
              
              (415,872
              )
              
              25,576
              
              
              17,353Accrued
                  expenses and other liabilities
              
              
              20,914
              
              
              129,741
              
              
              309,249Deferred
                  rent and other long-term liabilities
              
              
              29,760
              
              
              312,609
              
              
              139,988Net
                  cash provided by continuing operations
              
              
              2,412,523
              
              
              5,640,935
              
              
              6,415,464Net
                  cash provided (used) in discontinued operations
              
              
              (7,610
              )
              
              62,055
              
              
              (173,225
              )Net
                  cash provided by operating activities
              
              
              2,404,913
              
              
              5,702,990
              
              
              6,242,239**Cash
                  flows from investing activities:**Insurance
                  proceeds received from fire loss (2003) & Hurricane Rita loss
                  (2005)
              
              
              488,629
              
              
              --
              
              
              300,000Purchase
                  of property, plant and equipment
              
              
              (1,750,402
              )
              
              (2,886,281
              )
              
              (4,581,258
              )Proceeds
                  from sale of property, plant and equipment
              
              
              476,500
              
              
              655,752
              
              
              372,691Business
                  Acquisitions, net of cash acquired
              
              
              --
              
              
              (6,767,916
              )
              
              --Net
                  cash used in continuing operations
              
              
              (785,273
              )
              
              (
                  8,998,445
              )
              
              (
                  3,908,567
              )Net
                  cash used in discontinued operations
              
              
              (155,134
              )
              
              (113,342
              )
              
              (31,676
              )Net
                  cash used in investing activities
              
              
              (940,407
              )
              
              (9,111,787
              )
              
              (3,940,243
              )**Cash
                  flows from financing activities:**Net
                  borrowings (payment) under line of credit agreement
              
              
              (1,625,000
              )
              
              1,225,000
              
              
              (1,500,000
              )Purchase
                  of treasury stock
              
              
              --
              
              
              --
              
              
              (1,738,267
              )Exercise
                  of Stock Options
              
              
              --
              
              
              111,591
              
              
              430,544Additions
                  to Long term Notes Payable
              
              
              --
              
              
              3,000,000
              
              
              --Net
                  cash provided by (used in) financing activities
              
              
              (1,625,000
              )
              
              4,336,591
              
              
              (2,807,723
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              (160,494
              )
              
              927,794
              
              
              (505,727
              )Cash
                  and cash equivalents at beginning of year
              
              
              526,536
              
              
              366,042
              
              
              1,293,836Cash
                  and cash equivalents at end of year
              
              $
              366,042
              
              $
              1,293,836
              
              $
              788,109**Supplemental
                  disclosure of cash flow information:**Cash
                  paid during the year:Interest
              
              $
              265,262
              
              $
              494,844
              
              $
              561,972Income
                  taxes
              
              $
              304,453
              
              $
              464,532
              
              $
              297,693Non-cash
                  financing activities:CNL
                  real estate transaction
              
              
              --
              
              
              8,325,000
              
              
              --
 See
        accompanying notes to consolidated financial statements.
 F-7
  
  
 
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **December
        28, 2003, January 2, 2005 and January 1, 2006**
 
 **(1)
        Description of Business and Summary of Significant Accounting
        Policies**
 
 *(a)
        Description of Business*
 
 On
        February 16, 1996, Mexican Restaurants, Inc. (formerly Casa Olé
Restaurants, Inc.) was incorporated in the State of Texas, and on April 24,
        1996, its initial public offering of 2,000,000 shares of Common Stock became
        effective. Mexican Restaurants, Inc. is the holding company for Casa Olé
Franchise Services, Inc. and several subsidiary restaurant operating
        corporations (collectively the “Company”). Casa Olé Franchise Services, Inc. was
        incorporated in 1977, and derives its revenues from the collection of franchise
        fees under a series of protected location franchise agreements and from the
        sale
        of restaurant accessories to the franchisees of those protected location
        franchise agreements. The restaurants feature moderately priced Mexican and
        Tex-Mex food served in a casual atmosphere. The first Casa Olé restaurant was
        opened in 1973.
 
 On
        July
        2, 1997, the Company purchased 100% of the outstanding stock of Monterey’s
        Acquisition Corp. (“MAC”). The Company purchased the shares of common stock for
        $4.0 million, paid off outstanding debt and accrued interest totaling $7.1
        million and funded various other agreed upon items approximating $500,000.
        At
        the time of the acquisition, MAC owned and operated 26 restaurants in Texas
        and
        Oklahoma under the names “Monterey’s Tex-Mex Café,” “Monterey’s Little Mexico”
and “Tortuga Coastal Cantina.”
 
 On
        April
        30, 1999, the Company purchased 100% of the outstanding stock of La Señorita
        Restaurants, a Mexican restaurant chain operated in the State of Michigan.
        The
        Company purchased the shares of common stock of La Señorita for $4.0 million.
        The transaction was funded with the Company’s revolving line of credit with Bank
        of America. At the time of the acquisition, La Señorita operated five
        company-owned restaurants, and three franchise restaurants.
 
 On
        January 7,
        2004, the Company completed its purchase of 13 restaurants and related assets
        from its Beaumont-based franchisee, Thomas Harken, and Mr. Harken's operating
        partner, Victor Gonzalez, for a total consideration of approximately $13.75
        million. The financing for the acquisition was provided by Fleet National
        Bank,
        CNL and the sellers. The restaurants acquired include 8 Casa Olé restaurants
        located in Southeast Texas, 2 Casa Olé restaurants located in Southwest
        Louisiana, and 3 Crazy Jose’s restaurants located in Southeast Texas. In the
        past year these restaurants had combined sales of over $20 million.
 
 On
        October 14, 2004, the Company completed its purchase of one franchise restaurant
        in Brenham, Texas for approximately $215,000. The restaurant was closed,
        remodeled and re-opened on November 22, 2004. The Company spent $329,489
        remodeling the restaurant.
 
 The
        consolidated statements of operations and cash flows for fiscal years 2005,
        2004, and 2003 have been adjusted to remove the operations of closed
        restaurants, which have been reclassified as discontinued operations.
        Consequently, the consolidated statements of operations and cash flows for
        the
        fiscal years 2004 and 2003 shown in the accompanying consolidated financial
        statements have been reclassified to conform to the 2005 presentation. These
        reclassifications have no effect on total assets, total liabilities,
        stockholders equity or net income.
 
 *(b)
        Principles of Consolidation*
 
 The
        consolidated financial statements include the accounts of Mexican Restaurants,
        Inc. and its wholly-owned subsidiaries, after elimination of all significant
        inter-company transactions. The Company owns and operates various Mexican
        restaurant concepts principally in Texas, Oklahoma, Louisiana and Michigan.
        The
        Company’s three Idaho restaurants were closed on December 30, 2001 and the
        restaurants are either subleased or leased to third parties. The Company
        also
        franchises the Casa Olé concept principally in Texas and Louisiana and the La
        Señorita concept principally in the State of Michigan.
 
 
 F-8
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 *(c)
        Fiscal Year*
 
 The
        Company maintains its accounting records on a 52/53 week fiscal year ending
        on the Sunday nearest December 31. Fiscal years 2003 and 2005 consisted of
        52
        weeks and fiscal year 2004 consisted of 53 weeks.
  *(d)
        Cash Equivalents*
 
 For
        purposes of the statements of cash flows, the Company considers all highly
        liquid investments with original maturities of three months or less to be
        cash
        equivalents.
 
 *(e)
        Inventory*
 
 Inventory,
        which is comprised of food and beverages, is stated at the lower of cost
        or
        market. Cost is determined using the first-in, first-out method. Miscellaneous
        restaurant supplies are included in inventory and valued on a specific
        identification basis.
 
 *(f)
        Pre-opening Costs*
 
 Pre-opening
        costs primarily consists of hiring and training employees associated with
        the
        opening of a new restaurant and are expensed upon the opening of the restaurant.
 
 *(g)
        Property, Plant and Equipment*
 
 Property,
        plant and equipment are stated at cost. Depreciation on equipment and on
        buildings and improvements is calculated on the straight-line method over
        the
        estimated useful lives of the assets. Leasehold improvements are amortized
        straight-line over the shorter of the lease term plus options reasonably
        assured
        or estimated useful life of the assets.
 
 Buildings
                  and improvements
              20-40 yearsVehicles
              5 yearsEquipment
              3-15
                  yearsLeasehold
                  improvements
              2-25 years
  At
        the
        opening of a new restaurant, the initial purchase of smallwares is capitalized
        as restaurant equipment, but not depreciated. Subsequent purchases of smallwares
        are expensed as incurred.
  Significant
        expenditures that add materially to the utility or useful lives of property,
        plant and equipment are capitalized. All other maintenance and repair costs
        are
        charged to current operations. The cost and related accumulated depreciation
        of
        assets replaced, retired or otherwise disposed of are eliminated from the
        property accounts and any gain or loss is reflected as other income and expense.
 
 Property,
        plant and equipment are reviewed for impairment whenever events or changes
        in
        circumstances indicate that the carrying amount of an asset may not be
        recoverable pursuant to Statement on Financial Accounting Standards No. 144.
        The
        various indicators leading to the testing of these long-lived assets include
        declines in revenues, a current cash flow loss combined with a forecast
        demonstrating continuing cash flow losses, current market conditions and
        competitive intrusion. The service potential of the assets includes assessment
        of future cash-flow-generating capacity, the remaining lives of the assets,
        the
        remaining term of the operating lease and evaluation of future cash flows
        associated with potential capital expenditures. The method for determining
        the
        fair value of impaired assets to be sold is based on its appraised fair market
        value or the value that a third party buyer would be willing to
        pay.
 
 In
        fiscal
        year 2005, the Company recorded asset impairment and restaurant closure costs
        of
        $790,708, all of which is included in discontinued operations related to
        the
        2005 closure of one restaurant pursuant to Statement on Financial Accounting
        Standards No. 146. In fiscal 2004, the Company recorded asset impairment
        and
        restaurant closure costs of
 F-9
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 $868,580,
        of which $167,898 related to the fiscal 2004 closure of three restaurants.
        In
        fiscal 2003, the Company recorded asset impairment and restaurant closure
        costs
        of $2,908,406, of which $2,252,998 related to the fiscal 2003 closure of
        one
        restaurant and inclusion of discontinued operations related to the fiscal
        2004
        closure of three restaurants and the fiscal 2005 closure of one
        restaurant.
 
 In
        fiscal
        2004, the Company incurred $700,682 of impairment expenses in continuing
        operations related primarily to four Tortuga restaurants that the Company
        wanted
        to position for re-concept to one of the Company’s other Mexican food concepts.
        Because of improved operating performance, the Company did not re-concept
        the
        four Tortuga restaurants in fiscal 2005. In addition, two Monterey’s
        restaurants, which were impaired in 2003, incurred a small impairment in
        2004.
        These two restaurants will be closed at the expiration of their operating
        leases.
 
 Property
        held for sale is separately aggregated in the consolidated balance sheets
        and is
        recorded at the lower of cost or net realizable value.
 
 *(h)*
              *Impairment
                  of Property Held for Sale*
  In
        fiscal
        2005, the Company recorded an impairment charge of $29,800 related to the
        pending sale of the Pt. Arthur, Texas pad site that was acquired in the 2004
        acquisition of 13 restaurants from its Beaumont-based franchisee.
 
 
 *(i)*
              *Goodwill
                  and Other Intangible Assets*
 
 Goodwill
        represents the excess of costs over fair value of assets of businesses acquired.
        The Company adopted the provisions of SFAS No. 142, *Goodwill
        and Other Intangible Assets* ,
        as of
        January 1, 2002. Goodwill and intangible assets acquired in a purchase business
        combination and determined to have an indefinite useful life are not amortized,
        but instead tested for impairment at least annually in accordance with the
        provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets
        with estimable useful lives be amortized over their respective estimated
        useful
        lives to their estimated residual values, and reviewed for impairment in
        accordance with SFAS No. 144, *Accounting
        for Impairment or Disposal of Long-Lived Assets* .
 
 At
        January 1, 2006 and January 2, 2005, the consolidated balance sheets included
        $10.9 million of goodwill primarily resulting from the MAC, La Señorita and
        Beaumont-based franchisee acquisitions. In connection with SFAS No. 142’s
        transitional goodwill impairment evaluation, the Statement required the Company
        to perform an assessment of whether there was an indication that goodwill
        is
        impaired as of the date of adoption. To accomplish this, the Company was
        required to identify its reporting units and determine the carrying value
        of
        each reporting unit by assigning the assets and liabilities, including the
        existing goodwill and intangible assets, to those reporting units as of January
        1, 2002. The Company was required to determine the fair value of each reporting
        unit and compare it to the carrying amount of the reporting unit within six
        months of January 1, 2002. To the extent the carrying amount of a reporting
        unit
        exceeded the fair value of the reporting unit, the Company would be required
        to
        perform the second step of the transitional impairment test, as this is an
        indication that the reporting unit goodwill may be impaired. For purposes
        of
        applying SFAS No. 142 impairment testing, the Company believes it is operating
        in one segment. Although each restaurant is measured and analyzed by Company
        management for performance, since the economic characteristics and operations
        are similar across restaurant concept lines, the reporting unit is considered
        to
        be equivalent to the Company’s operating segment. Management evaluated goodwill
        as required by SFAS 142 upon its adoption and annually as of December 28,
        2003,
        January 2, 2005 and January 1, 2006. Management performed its goodwill
        impairment testing for each year and determined that the fair value exceeded
        the
        carrying amount of the reporting units and that no impairment of goodwill
        exists.
  *(j)* *Impairment of Long-Lived Assets*
 
 In
        accordance with SFAS No. 144, long-lived assets, such as property, plant,
        and
        equipment, and purchased intangibles subject to amortization, are reviewed
        for
        impairment whenever events or changes in circumstances indicate that the
        carrying amount of an asset may not be recoverable. Recoverability of assets
        to
        be held and used is measured by a comparison of the carrying amount of an
        asset
        to estimated undiscounted future cash flows expected to be generated by the
 F-10
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 asset.
        If
        the carrying amount of an asset exceeds its estimated future cash flows,
        an
        impairment charge is recognized by the amount by which the carrying amount
        of
        the asset exceeds the fair value of the asset. Assets to be disposed of would
        be
        separately presented in the balance sheet and reported at the lower of the
        carrying amount or fair value less costs to sell, and are no longer depreciated.
        The assets and liabilities of a disposed group classified as held for sale
        would
        be presented separately in the appropriate asset and liability sections of
        the
        balance sheet. The revenues and expenses, as well as gains, losses, and
        impairments, from those assets are reported in the discontinued operations
        section of the consolidated statement of operations for all periods
        presented.
 
 Goodwill
        and intangible assets not subject to amortization are tested annually for
        impairment, and are tested for impairment more frequently if events and
        circumstances indicate that the asset might be impaired. An impairment loss
        is
        recognized to the extent that the carrying amount exceeds the asset’s fair
        value.
  *(k)
        Deferred Rent Recognition*
 
 The
        Company expenses lease rentals that have escalating rents on a straight line
        basis over the life of each lease pursuant to Statement of Financial Accounting
        Standards No. 13. Incentive allowances provided by landlords under leasing
        arrangements are deferred as a liability and amortized to income as an
        adjustment to rent expense over the life of the lease.
 
 *(l)
        Income Taxes*
 
 Income
        taxes are provided based on the asset and liability method of accounting
        pursuant to Statement of Financial Accounting Standards (SFAS) No. 109, *Accounting
        for Income Taxes.*
 
 *(m)
        Revenue Recognition*
 
 The
        Company records revenue from the sale of food, soft beverages and alcoholic
        beverages as products are sold. Franchise fee revenue from an individual
        franchise sale is recognized when all services relating to the sale have
        been
        performed and the restaurant has commenced operation. Initial franchise fees
        relating to area franchise sales are recognized ratably in proportion to
        services that are required to be performed pursuant to the area franchise
        or
        development agreements and proportionately as the restaurants within the
        area
        are opened.
 
 *(n)
        Stock Options*
 
 In
        December 2004, the FASB issued SFAS 123 (Revised), “Share-Based Payment”, a
        revision of SFAS 123, “Accounting for Stock-Based Compensation.” SFAS 123R
        required the fair value measurement of all stock-based payments to employees,
        including grants of employee stock options, and recognition of those expenses
        in
        the statement of operations. SFAS 123R is effective for reporting periods
        beginning after December 15, 2005. We will continue to account for stock-based
        compensation using the intrinsic value method until adoption of SFAS 123R
        in the
        first quarter of fiscal 2006. Historically, the compensation expense recognized
        related to stock options under this method has been minimal. The Company
        expects
        that the adoption of SFAS 123R, using the fair value of the options at the
        grant
        date to determine compensation cost, will result in amounts that are similar
        to
        the current pro forma disclosures under SFAS 123. The Company anticipates
        utilizing the modified prospective method upon adoption.
 
 The
        Company has adopted the disclosure-only provisions of the FASB issued SFAS
        No.
        148, *Accounting
        for Stock-Based Compensation - Transition and Disclosure, an amendment of
        FASB
        Statement No. 123,* which
        amends SFAS No. 123, “Accounting for Stock-Based Compensation,” and has
        accounted for stock-based compensation using the intrinsic value method
        prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock
        Issued to Employees” and related interpretations. Accordingly, no compensation
        cost has been recognized for stock options or warrants. Had compensation
        cost
        for the Company’s outstanding stock options and warrants been determined based
        on the fair value at the grant date for awards consistent with the provisions
        of
        SFAS No. 123, the Company’s net income and net income per share would have been
        reduced to the pro forma amounts indicated below for fiscal years 2003, 2004
        and
        2005:
 
 F-11
  
  
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 
 **2003**
              
              **2004**
              
              **2005**Net
                  income (loss) - as reported
              
              $
              (1,034,908
              )
              $
              1,760,974
              
              $
              2,316,997Less:
                  Stock based compensation expense, determined under fair value
                based
                  method for all awards, net of tax
              
              
              (44,568
              )
              
              (29,380
              )
              
              (34,073
              )Proforma
                  net income (loss) - pro forma for SFAS No. 123
              
              
              (1,079,476
              )
              
              1,731,594
              
              
              2,282,924Net
                  income (loss) per share - as reported
              
              
              (0.31
              )
              
              0.52
              
              
              0.68Pro
                  forma net income (loss) per share - pro forma for SFAS No.
                  123
              
              
              (0.32
              )
              
              0.51
              
              
              0.67
  *(o)
        Use of Estimates*
 
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities at the date of the financial statements and the reported amounts
        of
        revenues and expenses during the reporting period. Actual results could differ
        from those estimates.
 
 *(p)*
              *Insurance
                  proceeds*
 
 On
        September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number
        of the Company’s restaurants in that region. The Company subsequently hired an
        insurance consulting firm to assist management with the filing of its insurance
        claim. Based on the low range of the consulting firm’s estimate and negotiations
        with the insurance carrier, the Company recorded an insurance claim of $1.6
        million in the fourth quarter of fiscal 2005.
 
 The
        consolidated statement of operations for the year ended January 1, 2006,
        includes a separate line item for a gain of $470,702 resulting from assets
        damaged by Hurricane Rita and other expenses offset by insurance proceeds
        for
        the replacement of assets. The Company’s insurers paid $300,000 during the
        fourth quarter of 2005 and $785,028 in first quarter of 2006 related to the
        property damage claim. Additionally, the Company has recognized $534,163
        for
        estimated business interruption proceeds.
  During
        fiscal year 2003, the Company recorded a gain of $478,032 for insurance proceeds
        received from fire damage at the Humble, Texas restaurant location. There
        were
        no insurance claims recorded in 2004.
  *(q)*
              *Recently
                  Issued Accounting Standards*
 
 In
        December 2004, the Financial Accounting Standards Board (“FASB”) issued
        Statement of Financial Accounting Standards (“SFAS”) No.123 (Revised),
        Share-Based Payments, a revision of SFAS No.123, Accounting for Stock-Based
        Compensation. SFAS No.123R requires the fair value measurement of all
        stock-based payments to employees, including grants of employee stock options,
        and recognition of those expenses in the statement of operations. SFAS No.123R
        is effective for the first annual reporting period beginning after December
        15,
        2005. We will continue to account for stock-based compensation using the
        intrinsic value method until adoption of SFAS No.123R on January 2, 2006.
        Historically, the compensation expense recognized related to stock options
        under
        the intrinsic value method has been minimal. As a result, adoption of the
        provisions of SFAS No.123R is expected to have an impact to reported net
        income
        and earnings per share. The Company expects that the adoption of SFAS 123R,
        using the fair value of the options at the grant date to determine compensation
        cost, will result in amounts that are similar to the current pro forma
        disclosures under SFAS 123. The Company anticipates utilizing the modified
        prospective method upon adoption.
 
 In
        December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets—an
        amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.
        This
        Statement amends APB Opinion No. 29 Accounting for Nonmonetary Transactions,
        based on the principle that exchanges of nonmonetary assets should be measured
        based on the fair value of the assets exchanged. Certain of the disclosure
        modifications are required for fiscal periods beginning after June 15, 2005.
        The
        adoption of SFAS No. 153 will not have a material effect on the Company’s
        financial statements.
 
 
 F-12
  
  
 
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 In
        May
        2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections
        - a
        replacement of APB Opinion No. 20 and FASB Statement No. 3. This statement
        replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3,
        Reporting Accounting Changes in Interim Financial Statements, and changes
        the
        requirements for the accounting for and reporting of a change in accounting
        principle. This Statement applies to all voluntary changes in accounting
        principle and is required for accounting changes and corrections of errors
        made
        in fiscal years beginning after December 15, 2005.
 
 On
        October 6, 2005, the FASB released FASB Staff Position (“FSP”) FAS No. 13-1,
        Accounting for Rental Costs Incurred during a Construction Period. This FSP
        affects companies that are engaged in construction activities on buildings
        or
        grounds accounted for as operating leases. The FSP requires the Company to
        expense rental costs associated with these leases, starting on the date that
        the
        tenant is given control of the premises. As a result, companies must cease
        capitalizing rental costs during construction periods. The FSP is effective
        for
        the first reporting period beginning after December 15, 2005. Retrospective
        application is permitted, but not required. The Company has determined that
        the
        adoption of FSP FAS No. 13-1 will not have a material effect on the Company’s
        financial statements.
 
 *(r)
        Reclassifications*
 
 Certain
        reclassifications have been made at January 2, 2005 to conform with
        classifications at January 1, 2006. These reclassifications have no effect
        on
        the Company’s net income or financial position as previously reported.
 
 *(s)
        Consolidated Statements of Cash Flows*
 
 We
        have
        revised the Consolidated Statements of Cash Flows for 2003 and 2004 consistent
        with 2005 to reconcile net cash provided by operating activities from net
        income
        (loss) instead of net income (loss) from continuing operations.
 
 *(t)
        Advertising Expense*
 
 Each
        year
        the Company prepares a budget for advertising expenses to promote each of
        the
        Company’s restaurant brands. Prepaid advertising is deferred and amortized to
        expense based on estimates of usage. For fiscal years 2005, 2004 and 2003
        the
        Company recorded advertising expense in continuing operations of $2,415,829,
        $2,248,854 and $1,813,929 which represents 3.0%, 2.9% and 3.4% of restaurant
        sales from continuing operations, respectively.
 
 **(2)
        Property, Plant and Equipment**
 
 Property,
        plant and equipment at January 2, 2005 and January 1, 2006 are as
        follows:
  
 **2004**
              
              **2005**Land
              
              $
              360,750
              
              $
              60,750Buildings
                  and improvements
              
              
              250,000
              
              
              --Vehicles
              
              
              20,874
              
              
              16,874Equipment
                  and Smallwares
              
              
              17,809,973
              
              
              19,415,556Leasehold
                  Improvements
              
              
              10,341,598
              
              
              11,988,06328,783,195
              
              
              31,481,243Less:
                  Accumulated Depreciation
              
              
              (13,464,153
              )
              
              (15,315,864
              )15,319,042
              
              
              16,165,379Construction
                  in Progress
              
              
              146,692
              
              
              29,962Net
              
              $
              15,465,734
              
              $
              16,195,341
 
 
 F-13
  
  
 
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 
 **(3)
        Long-term Debt**
 
 Long-term
        debt consists of the following at January 2, 2005 and January 1,
        2006:
 
 **2004**
              
              **2005**Term
                  Note
              
              $
              4,000,000
              
              $
              2,500,000Revolving
                  Line of Credit
              
              
              --
              
              
              --Other
                  long-term debt
              
              
              3,000,000
              
              
              3,000,000Total
                  long-term debt
              
              
              7,000,000
              
              
              5,500,000Less
                  current installments
              
              
              (1,000,000
              )
              
              (1,000,000
              )Long-term
                  debt, excluding current installments
              
              $
              6,000,000
              
              $
              4,500,000
 
 On
        January 7,
        2004, Bank of America (formerly Fleet National Bank) amended its $10.0 million
        credit facility to accommodate the acquisition of the Beaumont-based franchise
        restaurants. The amended credit facility consists of a $5.0 million term
        note
        that requires quarterly principal payments of $250,000 and matures on June
        30,
        2008. The credit facility also includes a $5.0 million revolving line of
        credit.
        The interest rate is either the prime rate or LIBOR plus a stipulated
        percentage. Accordingly, the Company is impacted by changes in the prime
        rate
        and LIBOR. The Company is subject to a non-use fee of 0.75% on the unused
        portion of the revolver from the date of the credit agreement.
 
 On
        April 1,
        2005, the Company and Bank of America amended the $10.0 million credit facility
        to accommodate the Company’s growth plans. The amendment allows for additional
        capital expenditures, revised certain covenant ratios, increased the amount
        of
        allowable stock repurchases, and extended the maturity date of the revolving
        line of credit to January 7, 2009. Effective June 30, 2005, the Company and
        Bank
        of America further amended the $10.0 million credit facility to revise certain
        ratios affected by Hurricane Rita and the Company’s stock repurchase program,
        and to lower the applicable interest rate margins. As of January 1, 2006,
        the
        Company had $2.5 million outstanding on the credit facility and $3.0 million
        in
        notes for a total indebtedness of $5.5 million. The Company acquired 13
        restaurants from its Beaumont-based franchisee in January 2004. Part of the
        financing for the acquisition included $3.0 million in notes issued by Mexican
        Restaurants to the sellers. The seller notes pay interest for five years,
        with
        $1.5 million in principal due on January 7, 2009 and $1.5 million in principal
        amortizing over an additional five years. The Company is in full compliance
        with
        all debt covenants as amended. The Company expects to be in compliance with
        all
        debt covenants in fiscal year 2006.
 
 Maturities
                  on long-term debt are as follows:Year
                  Ending2006
              
              $
              1,000,0002007
              
              
              1,000,0002008
              
              
              500,0002009
              
              
              1,775,0002010
              
              
              300,000Thereafter
              
              
              925,000$
              5,500,000
 
 
 
 
 
 F-14
  
  
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 
 **(4)
        Income Taxes**
 
 The
        provision for income tax expense from continuing operations is summarized
        as
        follows for fiscal years 2003, 2004 and 2005:
 **2003**
              
              **2004**
              
              **2005**Current:Federal
              
              $
              388,764
              
              $
              462,609
              
              $
              625,433****State and local
              
              
              172,115
              
              
              97,342
              
              
              130,917Deferred
                  (benefit)
              
              
              (70,235
              )
              
              509,739
              
              
              676,841$
              490,644
              
              $
              1,069,690
              
              $
              1,433,191
 
 
 The
        income tax benefit from discontinued operations is summarized as follows
        for
        fiscal years 2003, 2004 and 2005:
 
 **2003**
              
              **2004**
              
              **2005**Current:Federal
              
              $
              332,174
              
              $
              361,148
              
              $
              49,764****State and local
              
              
              78,347
              
              
              80,986
              
              
              11,952,Deferred
                  (provision)
              
              
              747,485
              
              
              (143,347
              )
              
              314,028$
              1,158,006
              
              $
              298,787
              
              $
              375,744
 
 The
        actual income tax expense differs from expected income tax expense calculated
        by
        applying the U.S. federal corporate tax rate to income before income tax
        expense
        from continuing operations as follows:
 
 **2003**
              
              **2004**
              
              **2005**Expected
                  tax expenseFederal
              
              $
              505,743
              
              $
              1,130,766
              
              $
              1,491,769****State
                  tax expense, netState and local
              
              
              126,622
              
              
              99,518
              
              
              128,176Non-deductible
                  amortization
              
              
              3,391
              
              
              3,391
              
              
              3,391Tax
                  credits
              
              
              (123,905
              )
              
              (169,079
              )
              
              (162,325
              )Other
              
              
              (21,207
              )
              
              5,094
              
              
              (27,820
              )$
              490,644
              
              $
              1,069,690
              
              $
              1,433,191
 
 The
        tax
        effects of temporary differences that give rise to significant portions of
        deferred tax assets and liabilities at January 2, 2005 and January 1, 2006
        are
        as follows:
 **January
                  2, 2005**
              
              **January
                  1, 2006**Deferred
                  tax assets:Sale-leaseback
              
              $
              654,212
              
              $
              577,128Tax
                  credit carryforwards
              
              
              591,592
              
              
              472,385Asset
                  impairments
              
              
              747,699
              
              
              561,794Accrued
                  expenses
              
              
              40,397
              
              
              110,351$
              2,033,900
              
              $
              1,721,658Deferred
                  tax liabilities:Other
              
              
              ($
                  8,219
              )
              
              ($
                  8,160
              )Depreciation
                  differences
              
              
              (
                  1,406,594
              )
              
              (
                  1,457,224
              )($1,414,813
              )
              
              ($1,465,384
              )Net
                  deferred taxes
              
              $
              619,087
              
              $
              256,274
   F-15
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 At
        January 1, 2006, the Company determined that it was more likely than not
        that
        the deferred tax assets would be realized based on the level of historical
        taxable income and projections of future taxable income over the periods
        in
        which the deferred tax assets are deductible. At January 1, 2006, the Company
        has tax credit carryforwards of $472,385 which are available to reduce future
        Federal regular income taxes, if any, over an indefinite period.
 
 **(5)
        Common Stock, Options and Warrants**
  *(a)*
              *2005
                  Long Term Incentive Plan*
 
 The
        Board
        of Directors and shareholders of the Company have approved the Mexican
        Restaurants, Inc. 2005 Long Term Incentive Plan (the "Incentive Plan"). The
        Incentive Plan authorizes the granting of up to 350,000 shares of Common
        Stock
        in the form of incentive stock options and non-qualified stock options to
        key
        executives and other key employees of the Company, including officers of
        the
        Company and its subsidiaries. The purpose of the 2005 Plan is to benefit
        and
        advance the interests of the Company by attracting and retaining qualified
        directors and key executive and managerial employees; motivating employees,
        by
        making appropriate awards, to achieve long-range goals; providing incentive
        compensation that is competitive with other corporations; and further aligning
        the interests of directors, employees and other participants with those of
        other
        shareholders. It is anticipated that the 350,000 shares proposed to be
        authorized under the 2005 Plan, together with the shares remaining under
        the
        1996 Plan, will enable the Company to provide sufficient grants of awards
        for
        the foreseeable future. Also, the inclusion of authority to grant various
        forms
        of equity compensation in addition to stock options, including restricted
        stock,
        will allow the Company to tailor future awards to the Company’s specific needs
        and circumstances at that time.
 
 *(b)
        1996 Long Term Incentive Plan*
  The
        Board
        of Directors and shareholders of the Company have approved the Mexican
        Restaurants, Inc. 1996 Long Term Incentive Plan (the "Incentive Plan"). The
        Incentive Plan, as amended, authorizes the granting of up to 500,000 shares
        of
        Common Stock in the form of incentive stock options and non-qualified stock
        options to key executives and other key employees of the Company, including
        officers of the Company and its subsidiaries. The purpose of the Incentive
        Plan
        is to attract and retain key employees, to motivate key employees to achieve
        long-range goals and to further align the interests of key employees with
        those
        of the other shareholders of the Company. Options granted under the Incentive
        Plan will generally vest and become exercisable at the rate of 10% on the
        first
        anniversary of the date of grant, 15% on the second anniversary of the
        date
        of grant, and 25% on each of the third through fifth anniversaries of the
        date
        of grant. All stock options granted pursuant to the 1996 Long Term Incentive
        Plan will be nonqualified stock options and will remain exercisable until
        the
        earlier of ten years from the date of grant or no more than 90 days after
        the
        optionee ceases to be an employee of the Company.
 
 *(c)*  *Stock
        Option Plan for Non-Employee Directors*
  The
        Company has adopted the Mexican Restaurants, Inc. Stock Option Plan for
        Non-Employee Directors (the “Directors Plan”) for its outside directors and has
        reserved 200,000 shares of Common Stock for issuance thereunder. The Directors
        Plan provides that each outside director will automatically be granted an
        option
        to purchase 10,000 shares of Common Stock at the time of becoming a director.
        These options will be exercisable in 20% increments and will vest equally
        over
        the five-year period from the date of grant. Such options are priced at the
        fair
        market value at the time an individual is elected as a director. Until the
        third
        quarter of fiscal year 2002, each outside director received options to purchase
        1,500 shares of Common Stock quarterly, plus additional options for attendance
        at committee meetings, exercisable at the fair market value of the Common
        Stock
        at the close of business on the date immediately preceding the date of grant.
        Such annual options will vest at the conclusion of one year, so long as the
        individual remains a director of the Company. All stock options granted pursuant
        to the Directors Plan will be nonqualified stock options and will remain
        exercisable until the earlier of ten years from the date of grant or six
        months
        after the optionee ceases to be a director of the Company.
 
 As
        of the
        third quarter of fiscal year 2002, compensation for each outside director
        was
        changed from quarterly options to cash payments of $2,000 per quarter and
        $1,000
        per board meeting attended. The chairman of the audit committee receives
        compensation of $6,250 per quarter.
 F-16
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 During
        fiscal year 2005, the Company’s employees exercised 121,472 stock options in the
        open market. The Company received $430,544 in exchange for 121,472 shares
        of
        common stock that was previously held as Treasury stock.
 
 On
        November 15 and 18 of fiscal 2004, one director exercised 30,200 of his options
        in the open market. The Company received $111,591 in exchange for 30,200
        shares
        of common stock that was previously held as Treasury stock.
 
 *(d)* **** *1996
        Manager’s Stock Option Plan*
 
 The
        Company
        has adopted the 1996 Manager’s Stock Option Plan (the “Manager’s Plan”)
        specifically for its store-level managers. The Manager’s Plan authorizes the
        granting of up to 200,000 shares of Common Stock in the form of non-qualified
        stock options to store-level managers of the Company. The purpose of the
        Manager’s Plan is to attract, retain and motivate restaurant managers to achieve
        long-range goals and to further align the interests of those employees with
        those of the other shareholders of the Company. Options granted under the
        Manager’s Plan will generally vest and become exercisable at the rate of 10% on
        the first anniversary of the date of grant, 15% on the second anniversary
        of the
        date of grant, and
        25%
        on each of the third through fifth anniversaries of the date of grant. All
        stock
        options granted pursuant to the 1996 Manager’s Stock Option Plan will be
        nonqualified stock options and will remain exercisable until the earlier
        of ten
        years from the date of grant or no more than 90 days after the optionee ceases
        to be an employee of the Company.
 
 *(e)*
              *Warrants*
 
 In
        conjunction with the initial public offering, the Company entered into warrant
        agreements with Louis P. Neeb and Tex-Mex, a limited liability company in
        which a member of the Board of Directors prior to February 14, 2000 is a
        principal, pursuant to which Mr. Neeb and Tex-Mex acquired warrants to
        purchase shares of Common Stock at the initial public offering ($11.00 per
        share) price less the amount paid for the warrant ($.10 per share) for an
        aggregate amount of Common Stock equal to ten percent (10%) of the shares
        of
        Common Stock of the Company outstanding upon consummation of the initial
        public
        offering, such shares to be allocated 5%, or 179,885 shares, to
        Mr. Neeb and 5%, or 179,885 shares, to Tex-Mex. The Company's warrants
        to Mr. Neeb became exercisable on the second anniversary of the initial
        public offering, and the Company's warrants to Tex-Mex became exercisable
        on the
        first anniversary of the initial public offering. The warrants expire on
        April
        24, 2006.
 
 In
        late
        fiscal 1998 the Company exchanged a note valued in the amount of $148,534
        (principal and accrued interest) for 98,301 warrants to purchase Common Stock
        previously held by a former officer of the Company. The warrants, which were
        granted by Larry N. Forehand with an exercise price of $10.90 per share,
        became
        exercisable in April 1998. Upon an exercise by Mr. Neeb or Tex-Mex of the
        warrants granted to them by the Company, the Company plans to exercise these
        newly acquired warrants simultaneously and use the warrant shares acquired
        from
        Mr. Forehand to satisfy a portion of its obligations under its warrant
        agreements with Mr. Neeb and Tex-Mex.
 
 *(f)
        Stock Transactions*
 
 During
        1999 and 2000 the Company authorized the granting of 64,000 shares of restricted
        stock to key executives. The awards were valued at an average of $3.50 per
        share
        and will vest in 20% increments over a five year period from the date of
        the
        grant. Compensation expense of $41,304, $41,304 and $6,303 was recognized
        in
        fiscal years 2003, 2004 and 2005 respectively.
 
 On
        May 9,
        2005, the Company announced its plan to implement a limited stock repurchase
        program in a manner permitted under its bank financing agreement. Under this
        program, the Company could spend up to $1.0 million over the next 12 months
        (not
        to exceed $500,000 in any one quarter) to repurchase outstanding shares of
        its
        common stock. On September 7, 2005, the Company’s Board of Directors approved an
        increase of $1.0 million to its stock repurchase program announced on May
        9,
        2005.  During
        fiscal year 2005, the Company repurchased 181,300 shares of common stock
        for
        $1,738,267. During fiscal year 2004 and 2003, the Company did not repurchase
        any
        of its common shares.
 
 
 F-17
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 
 *(g)
                  Option and Warrant Summary*
              
              
              
              Weighted
                  AverageShares
              
              Exercise
                  PriceBalance
                  at December 28, 2003:Granted
              
              
              24,500
              
              $
              3.31Exercised
              
              
              --
              
              
              --Canceled
              
              
              (36,000
              )
              
              4.671,028,970
              
              $
              6.87Balance
                  at January 2, 2005:Granted
              
              
              --
              
              $
              --Exercised
              
              
              30,200
              
              
              3.70Canceled
              
              
              22,500
              
              
              7.36976,270
              
              $
              6.96Balance
                  at January 1, 2006:Granted
              
              
              260,000
              
              $
              12.00Exercised
              
              
              121,472
              
              
              3.54Canceled
              
              
              10,750
              
              
              5.681,104,048
              
              $
              8.54
 The
        options (744,278) and warrants (359,770) outstanding at January 1, 2006 had
        exercise prices ranging between $2.50 to $12.00, of which 395,000 of the
        options
        had exercise prices ranging from $8.63 to $12.00, and 359,770 of the warrants
        had a exercise price of $10.90. As of January 1, 2006, 1,052,635 options
        and
        warrants were exercisable at an average price of $8.78.
 
 The
        weighted average fair value of the options and warrants granted during 2003,
        2004 and 2005 is estimated at $1.40, $0.00 and $0.00 per share (no options
        or
        warrants were granted in 2004 and the options granted in 2005 are fully vested),
        respectively, on the date of grant using the Black-Scholes option-pricing
        model
        with the following assumptions: volatility of 44% for 2003, 35% for 2004
        and 28%
        for 2005, risk-free interest rate of 3.0% for 2003, 3.4% for 2004 and 4.1%
        for
        2005, an expected life of 5 years for options and 4 years for warrants and
        0%
        dividend yield.
  *(h)
        Income Per Share*
 
 Basic
        income per share is based on the weighted average shares outstanding without
        any
        dilutive effects considered. Diluted income per share reflects dilution from
        all
        contingently issuable shares, including options and warrants. For fiscal
        years
        2004 and 2005, the effect of dilutive stock options increase the weighted
        average shares outstanding by approximately 246,360 and 285,070 shares
        respectively. For fiscal year 2003, the effect of dilutive stock options
        did not
        affect the determination of diluted income per share. For fiscal years 2004
        and
        2005, such stock options and warrants did affect the determination of diluted
        income approximately $0.04 and $0.05 per share, respectively. Approximately
        454,570 and 405,870 options and warrants were considered antidilutive for
        fiscal
        years 2004 and 2005 respectively. For fiscal year 2003 all shares were
        considered antidilutive. The options and warrants that are considered
        antidilutive have a grant price that exceeds the market price as of the end
        of
        each fiscal year.
 
 **(6)
        Leases**
 
 The
        Company leases restaurant operating space and equipment under non-cancelable
        operating leases which expire at various dates through January 31,
        2024.
 
 The
        restaurant operating space base agreements typically provide for a minimum
        lease
        rent plus common area maintenance, insurance, and real estate taxes, plus
        additional percentage rent based upon revenues of the restaurant (generally
        2%
        to 7%) and may be renewed for periods ranging from five to twenty-five
        years.
 F-18
  
  **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 On
        June
        25, 1998, the Company completed a sale-leaseback transaction involving the
        sale
        and leaseback of land, building and improvements of 13 company-owned
        restaurants. The properties were sold for $11.5 million and resulted in a
        gain
        of approximately $3.5 million that was deferred and is amortized over the
        terms
        of the leases, which are 15 years each. The deferred gain at January 2, 2005
        and
        January 1, 2006 was $1,769,212 and $1,561,070, respectively. The leases are
        classified as operating leases in accordance with SFAS No. 13 “Accounting for
        Leases”. Subsequent to the original transaction one lease was sold. The
        remaining 12 leases have a total future minimum lease obligation of
        approximately $9,415,509 and are included in the future minimum lease payment
        schedule below.
 
 Future
        minimum lease payments (which includes the three closed restaurants scheduled
        below) under non-cancelable operating leases with initial or remaining lease
        terms in excess of one year as of January 1, 2006 are
        approximately:
  Year
                  Ending2006
              
              $
              5,534,2052007
              
              
              5,454,3382008
              
              
              5,238,8102009
              
              
              5,090,7442010
              
              
              4,628,866Thereafter
              
              
              27,815,475$
              53,762,438
 
 On
        December 30, 2001 the Company closed three under-performing Idaho restaurants
        (which are included in the table above) and in fiscal year 2002 the Company
        subleased those restaurants to other local operators. Two of the subtenants
        have
        two five year options to extend their leases, and one of the subtenants has
        one
        five year option to extend its lease. Future minimum lease receipts under
        non-cancelable operating leases with initial or remaining lease terms in
        excess
        of one year as of January 1, 2006 are approximately:
 
 
 Year
                  Ending2006
              
              $
              303,5002007
              
              
              233,5002008
              
              
              145,221Thereafter
              
              
              --$
              682,221
 
 
 Rent
        expense for restaurant operating space and equipment amounted to approximately
        $4,478,663, $5,964,086 and $6,103,154 for the fiscal years 2003, 2004 and
        2005,
        respectively.
 
 **(7)**
              **Acquisition**
 
 On
        January 7, 2004, the Company completed its purchase of 13 restaurants and
        related assets from its Beaumont-based franchisee for a total consideration
        of
        approximately $13.75 million. The financing for the acquisition was provided
        by
        Bank of America (formerly Fleet National Bank), CNL Franchise Network, LP
        (“CNL”) and the sellers of the Beaumont-based franchise restaurants. Bank of
        America (formerly Fleet National Bank) provided $3.1 million of the acquisition
        financing by amending its existing credit facility with Mexican Restaurants,
        Inc. Six of the acquired restaurants were concurrently sold to CNL for $8.325
        million in a sale-leaseback transaction. The sellers accepted $3.0 million
        in
        notes from Mexican Restaurants, Inc. for the balance of the purchase price.
        The
        seller notes require the payment of interest only for five years, with $1.5
        million in principal due on January 7, 2009 and $1.5 million in principal
        amortizing over an additional five years.
 F-19
  
  
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 The
        acquisition was accounted for under SFAS 141 and results of operations are
        included in the accompanying financial statements from the date of acquisition.
        The assets acquired and liabilities assumed of the acquisition were recorded
        at
        estimated fair values using comparables, appraisals, and records.
  A
        summary
        of the assets acquired and liabilities assumed in the acquisition
        follow:
 
 Estimated
                  fair value of assets acquired:Current
                  assets
              
              $
              184,601Property
                  and equipment
              
              
              2,946,365Other
                  assets
              
              
              175,000Goodwill
              
              
              3,283,916Total
                  assets
              
              $
              6,589,882Less:
                  Cash acquired
              
              
              (35,150
              )Net
                  assets acquired
              
              $
              6,554,732
 
 On
        October 14, 2004, the Company completed its purchase of one franchise restaurant
        in Brenham, Texas for approximately $215,000, which included $164,509 classified
        as goodwill. The restaurant was closed, remodeled and re-opened on November
        22,
        2004.
 
 **(8)**
              **401(k)
                  Plan**
 
 Beginning
        in fiscal year 1998, the Company established a **** defined
        contribution 401(k) plan that covers substantially all full-time employees
        meeting certain age and service requirements. Participating employees may
        elect
        to defer a percentage of their qualifying compensation as voluntary employee
        contributions. The Company may contribute additional amounts at the discretion
        of management. The Company did not make any contributions to the plan in
        fiscal
        years 2003, 2004 and 2005.
 
 **(9)**
              **Related
                  Party Transactions**
 
 The Company leased its executive offices from a company owned by two
        shareholders of Mexican Restaurants, Inc. Net lease expense related to these
        facilities in fiscal 2003 and 2004 was $125,188 and $10,416 respectively.
        The
        building was sold to a non-related party on February 20, 2004.
  The
        Company provides accounting and administrative services for the Casa Olé Media
        and Production Funds. The Casa Olé Media and Production Funds are
        not-for-profit, unconsolidated entities used to collect money from company
        -owned and franchise-owned restaurants to pay for the marketing of Casa Olé
restaurants. Each restaurant contributes an agreed upon percentage of its
        sales
        to the funds.
 
 **(10)**
              **Contingencies**
 
 The
        Company has litigation, claims and assessments that arise in the normal course
        of business. Management believes that the Company’s financial position or
        results of operations will not be materially affected by such
        matters.
 
 **(11)**
              **Subsequent
                  Events**
 
 The
        Company acquired 13 restaurants from its Beaumont-based franchisee in January
        2004. Part of the financing for the acquisition included $3.0 million in
        notes
        issued by Mexican Restaurants, Inc. to the sellers. The seller notes pay
        interest for five years, with $1.5 million in principal due on January 7,
        2009
        and $1.5 million in principal amortizing over an additional five years. The
        Company has decided to prepay $2.5 million of the seller notes on March 31,
        2006. Although the Company is not obligated to make any principal payments
        on
        the seller notes until 2009, a decision was made to prepay a large portion
        of
        the 7% seller notes by borrowing on its Bank of America credit facility.
        The
        interest rate on the line of credit is either the prime rate or LIBOR plus
        a
        stipulated percentage, which is currently lower than 7%.
 F-20
  
  
 **MEXICAN
        RESTAURANTS, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**
 
 **(12)**
              **Selected
                  Quarterly Financial Data
                  (Unaudited)**
 
 The
        unaudited quarterly results for the fiscal year ended January 2, 2005 and
        January 1, 2006 were as follows (in thousands, except per share
        data):
 
 
 Fiscal
                  Year 2004 Quarter Ended**January
                  02**
              
              **September
                  26**
              
              **June
                  27**
              
              **March
                  28**Revenues
              
              $
              20,057
              
              $
              19,600
              
              $
              19,485
              
              $
              18,638Income
                  from continuing operations
              
              
              223
              
              
              639
              
              
              701
              
              
              693Loss
                  from discontinued operations
              
              
              (199
              )
              
              (56
              )
              
              (78
              )
              
              (162
              )Net
                  income (loss)
              
              
              24
              
              
              583
              
              
              623
              
              
              531Basic
                  income per shareIncome
                  from continuing operations
              
              $
              0.07
              
              $
              0.19
              
              $
              0.20
              
              $
              0.21Loss
                  from discontinued operations
              
              
              ($
                  0.06
              )
              
              ($
                  0.02
              )
              
              ($
                  0.02
              )
              
              ($
                  0.05
              )Net
                  income (loss)
              
              $
              0.01
              
              $
              0.17
              
              $
              0.18
              
              $
              0.16Diluted
                  income per shareIncome
                  from continuing operations
              
              $
              0.06
              
              $
              0.18
              
              $
              0.19
              
              $
              0.20Loss
                  from discontinued operations
              
              
              ($
                  0.05
              )
              
              ($
                  0.02
              )
              
              ($
                  0.02
              )
              
              ($
                  0.05
              )Net
                  income (loss)
              
              $
              0.01
              
              $
              0.16
              
              $
              0.17
              
              $
              0.15
 
 
 Fiscal
                  Year 2005 Quarter Ended**January
                  01**
              
              **October
                  2**
              
              **July
                  3**
              
              **April
                  3**Revenues
              
              $
              20,887
              
              $
              19,773
              
              $
              20,466
              
              $
              20,078Income
                  from continuing operations
              
              
              1,653
              
              
              68
              
              
              534
              
              
              698Loss
                  from discontinued operations
              
              
              (545
              )
              
              (37
              )
              
              (32
              )
              
              (23
              )Net
                  income (loss)
              
              
              1,108
              
              
              31
              
              
              502
              
              
              675Basic
                  income per shareIncome
                  from continuing operations
              
              $
              0.49
              
              $
              0.02
              
              $
              0.16
              
              $
              0.21Loss
                  from discontinued operations
              
              
              ($
                  0.16
              )
              
              ($
                  0.01
              )
              
              ($
                  0.01
              )
              
              ($
                  0.01
              )Net
                  income (loss)
              
              $
              0.33
              
              $
              0.01
              
              $
              0.15
              
              $
              0.20Diluted
                  income per shareIncome
                  from continuing operations
              
              $
              0.45
              
              $
              0.02
              
              $
              0.15
              
              $
              0.19Loss
                  from discontinued operations
              
              
              ($
                  0.15
              )
              
              ($
                  0.01
              )
              
              ($
                  0.01
              )
              
              ($
                  0.01
              )Net
                  income (loss)
              
              $
              0.30
              
              $
              0.01
              
              $
              0.14
              
              $
              0.18
 
  In
        the
        4 th quarter
        of fiscal 2004, the Company recognized asset impairment and restaurant closure
        costs of $700,682. In the 3 rd and
        4 th quarters
        of 2005, the Company recognized a loss from Hurricane Rita of $274,328 and
        a
        gain of $1,279,193. Excluding these infrequently occurring costs, income
        from
        continuing operations would be $764,000 for the 4 th quarter
        of 2004 and $269,000 and $772,000 for the 3 rd and
        4 th quarters
        of 2005, respectively.
 
 
 
 
 
 
 F-21
  
  
 
 
 **Exhibit
        32.1**
 
 **CERTIFICATION
        PURSUANT TO**
 **18
        U.S.C. SECTION 1350,**
 **AS
        ADOPTED PURSUANT TO**
 **SECTION
        906 OF THE SARBANES-OXLEY ACT OF 2002**
 
 In
        connection with the Annual Report of Mexican Restaurants, Inc. (the Company)
        on
        Form 10-K for the period ending January 1, 2006 as filed with the Securities
        and
        Exchange Commission on the date hereof (the Report), I, Curt Glowacki, Chief
        Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as
        adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:
 
 (1)
              The
                  Report fully complies with the requirements of section 13(a) or
                  15(d) of
                  the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d));
                  and
 
 (2)
              The
                  information contained in the Report fairly presents, in all material
                  respects, the financial condition and results of operations of
                  the
                  Company.
 
 */s/
        Curt Glowacki*
 
 Curt
        Glowacki
 Chief
        Executive Officer
 March
        30,
        2006
 
 The
        foregoing certification is being forwarded solely pursuant to Section 906
        of the
        Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter
        63
        of Title 18, United States Code).
  
  
 **Exhibit
        32.2**
 
 **CERTIFICATION
        PURSUANT TO**
 **18
        U.S.C. SECTION 1350,**
 **AS
        ADOPTED PURSUANT TO**
 **SECTION
        906 OF THE SARBANES-OXLEY ACT OF 2002**
 
 In
        connection with the Annual Report of Mexican Restaurants, Inc. (the Company)
        on
        Form 10-K for the period ending January 1, 2006 as filed with the Securities
        and
        Exchange Commission on the date hereof (the Report), I, Andrew J. Dennard,
        Chief
        Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as
        adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:
 
 (3)
              The
                  Report fully complies with the requirements of section 13(a) or
                  15(d) of
                  the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d));
                  and
 
 (4)
              The
                  information contained in the Report fairly presents, in all material
                  respects, the financial condition and results of operations of
                  the
                  Company.
 
 */s/
        Andrew J. Dennard*
 
 Andrew
        J.
        Dennard
 Chief
        Financial Officer
 March
        30,
        2006
 
 The
        foregoing certification is being forwarded solely pursuant to Section 906
        of the
        Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter
        63
        of Title 18, United States Code).