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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington D.C., 20549** **FORM 10-QSB** (Mark One)   þ **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934****For the quarterly period ended June 30, 2006**   o **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934****For the transition period            to****Commission file number: 001-15835****US Dataworks, Inc.**(Exact name of small business issuer as specified in its charter)   **Nevada** **84-1290152**(State or other jurisdiction of (I.R.S. employer identification number)incorporation or organization)     **5301 Hollister Road, Suite 250**  **Houston, Texas** **77040**(Address of principal executive offices) (Zip Code)Issuer’s telephone number: (713) 934-3855Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirements for the past90 days. YES þ NO oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). YES o NO þNumber of shares of Common Stock outstanding as of August 1, 2006: 30,527,621Transitional Small Business Disclosure Format (Check one): YES o NO þ  
 

 
**US DATAWORKS, INC.**TABLE OF CONTENTSFORM 10-QSBQUARTERLY PERIOD ENDED JUNE 30, 2006       Page PART I — FINANCIAL INFORMATION  1      Item 1. Financial Statements  1      **NOTES TO UNAUDITED FINANCIAL STATEMENTS**  6      Item 2. Management’s Discussion and Analysis or Plan of Operation  15      Item 3. Controls and Procedures  22      PART II — OTHER INFORMATION  22      Item 3. Legal Proceedings  23      Item 6. Exhibits  23      **SIGNATURE**  24  Section 302 Certification of CEO Section 302 Certification of CFO Section 906 Certification of CEO Section 906 Certification of CFO
 

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**PART I — FINANCIAL INFORMATION****Item 1. Financial Statements****US DATAWORKS, INC.****BALANCE SHEET****June 30, 2006****(Unaudited)**     **ASSETS**         Current assets:    Cash and cash equivalents $657,184 Accounts receivable, net of allowance for doubtful accounts of $0  2,264,469 Prepaid expenses and other current assets  230,388          Total current assets  3,152,041      Property and equipment, net  451,856 Goodwill, net  14,133,629 Other assets  43,224          Total assets $17,780,750     The accompanying notes are an integral part of these financial statements.
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**US DATAWORKS, INC.****BALANCE SHEET****June 30, 2006****(Unaudited)**     **LIABILITIES AND STOCKHOLDERS’ EQUITY**     Current liabilities:    Note payable— related party $39,000 Current portion of convertible promissory notes, net of unamortized discount of $350,509  726,290 Deferred revenue — current  739,739 Accounts payable  496,680 Accrued expenses  452,124 Interest payable Interest payable  60,877 Derivative— Compounded Embedded within Note  326,274 Derivative — Warrants  188,521     Total current liabilities  3,029,505 Convertible promissory note  256,066     Total liabilities Interest payable  3,285,571          Commitments and Contingencies         Stockholders’ Equity:    Convertible Series B preferred stock, $0.0001 par value700,000 shares authorized, 549,667 shares issued and outstanding $0.75 liquidationpreference, dividends of $221,050 in arrears  55 Common stock, $0.0001 par value90,000,000 shares authorized and 30,437,877 shares issued and outstanding  3,044 Additional paid-in capital  63,202,788 Accumulated deficit  (48,710,708)    Total shareholders’ equity  14,495,179          Total liabilities and stockholders’ equity $17,780,750     The accompanying notes are an integral part of these financial statements.
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**US DATAWORKS, INC.****STATEMENTS OF OPERATIONS****For the Three Months Ended June 30,****(Unaudited)**               As Restated   **2006**  **2005** Revenues:        Software licensing revenues $379,255  $299,120 Software transactional revenues  313,996   181,243 Software maintenance revenues  103,765   92,326 Professional services revenues  418,072   507,650                 Total revenues  1,215,088   1,080,339          Cost of Sales  522,299   377,501                 Gross Profit  692,789   702,838          Operating expenses:        General and administrative  1,762,948   1,554,275 Depreciation and amortization  33,060   88,525        Total operating expense  1,796,008   1,642,800                 Loss from operations  (1,103,219)  (939,962)                Other income (expense)        Financing costs  —   — Interest expense  (92,172)  (53,605)Other income  8,475   6,799 Gain/(Loss) on derivative liabilities  (413,454)  208,269                 Total other expense  (497,151)  161,463                 Loss before provision for income taxes  (1,600,370)  (778,499)Provision for income taxes  —   —                 Net loss $(1,600,370) $(778,499)                Basic and diluted loss per share $(0.05) $(0.03)                Basic and diluted weighted-average shares outstanding  30,269,429   28,972,005        The accompanying notes are an integral part of these financial statements.
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**US DATAWORKS, INC.****STATEMENTS OF CASH FLOW****For the Three Months Ended June 30,****(Unaudited)**               **As Restated**   **2006**  **2005** Cash flows from operating activities:-        Net loss from continuing operations  (1,600,370) $(778,499)Adjustments to reconcile net loss to net cash used in operating activities:        Depreciation and amortization of property and equipment  33,060   88,525 Amortization of note discount on convertible promissory  72,967   31,072 Amortization of deferred compensation expense  —   (8,217)Issuance of warrants for services  —   26,456 Issuance of options to third party for services  —   11,426 Stock based compensation  262,056   — (Gain)/Loss on derivatives  413,454   (208,269)Changes in operating assets and liabilities:        Accounts receivable  (772,781)  86,331 Cost and estimated earnings in excess of billings on uncompleted contracts  238,000   — Prepaid expenses and other current assets  (63,874)  (73,605)Deferred revenue  522,985   (283,313)Accounts payable  265,268   70,091 Accrued expenses  (10,414)  18,216 Interest payable  19,205   19,205                 Net cash used in operating activities  (620,444)  (1,000,581)                Cash flows from investing activities:        Purchase of property and equipment  (12,810)  (40,982)       Net cash used in investing activities  (12,810)  (40,982)       The accompanying notes are an integral part of these financial statements.
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**US DATAWORKS, INC.****STATEMENTS OF CASH FLOW****For the Three Months Ended June 30,****(Unaudited)**               **As Restated**   **2006**  **2005** Cash flows from financing activities:        Proceeds from convertible promissory note  —   700,000 Proceeds from stock sale  —   600,000 Stock issuance costs  —   (14,550)Net cash provided by financing activities  —   1,285,450        Net increase (decrease) in cash and cash equivalents  (633,254)  243,887 Cash and cash equivalents, beginning of period  1,290,438   1,525,386        Cash and cash equivalents, end of period  657,184  $1,769,273                 Supplemental disclosures of cash flow informationInterest paid  —   —        The accompanying notes are an integral part of these financial statements.
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**US DATAWORKS, INC.****NOTES TO UNAUDITED FINANCIAL STATEMENTS****1.** **Organization and Business**   **General**   US Dataworks, Inc. (the “Company”), a Nevada corporation, develops, markets, and supportspayment processing software for the financial services industry. Its customer base includes manyof the largest financial institutions as well as credit card companies, government institutions,and high-volume merchants in the United States. The Company was formerly known as Sonicport,Inc. **2.** **Summary of Significant Accounting Policies**   **Revenue Recognition**   The Company recognizes revenues in accordance with the provisions of the American Institute ofCertified Public Accountants’ Statement of Position 97-2, “Software Revenue Recognition.” TheCompany licenses its software products under nonexclusive, nontransferable license agreements.These arrangements do not require significant production, modification, or customization,therefore, revenue is recognized when a license agreement has been signed, delivery of thesoftware product has occurred, the related fee is fixed or determinable, and collectibility isprobable.   In certain instances, the Company licenses its software on a transactional fee basis in lieu ofan up-front licensing fee. In these arrangements, the customer is charged a fee based upon thenumber of items processed by the software and the Company recognizes revenue as thesetransactions occur. The transaction fee also includes the provision of standard maintenance andsupport services as well as product upgrades should such upgrades become available.   If professional services were provided in conjunction with the installation of the softwarelicensed, revenue is recognized when these services have been provided.   For license agreements that include a separately identifiable fee for contracted maintenanceservices, such maintenance revenues are recognized on a straight-line basis over the life of themaintenance agreement noted in the agreement, but following any installation period of thesoftware.   **Goodwill**   Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards(SFAS) No. 142 “Goodwill and Other Intangible Assets,” which establishes new accounting andreporting requirements for goodwill and other intangible assets. Under SFAS No. 142, allgoodwill amortization ceased effective January 1, 2002.   The goodwill recorded on the Company’s books is from the acquisition of US Dataworks, Inc. infiscal year 2001 which remains the Company’s single reporting unit. SFAS 142 requires goodwillfor each reporting unit of an entity be tested for impairment by comparing the fair value ofeach reporting unit with its carrying value. Fair value is determined using a combination of thediscounted cash flow, market multiple and market capitalization valuation approaches.Significant estimates used in the methodologies include estimates of future cash flows, futureshort-term and long-term growth rates, weighted average cost of capital and estimates of marketmultiples for each reportable unit. On an ongoing basis, absent any impairment indicators, theCompany performs impairment tests annually during the fourth quarter.   SFAS 142 requires goodwill to be tested annually and between annual tests if events occur orcircumstances change that would more likely than not reduce the fair value of the reportableunit below its carrying amount.
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  The Company did not have an impairment of goodwill to record for the years ended March 31, 2006or March 31, 2005.   **Convertible Debt Financing – Derivative Liabilities**   The Company reviews the terms of convertible debt and equity instruments issued to determinewhether there are embedded derivative instruments, including embedded conversion options, thatare required to be bifurcated and accounted for separately as a derivative financial instrument.In circumstances where the convertible instrument contains more than one embedded derivativeinstrument, including the conversion option, that is required to be bifurcated , the bifurcatedderivative instruments are accounted for as a single, compound derivative instrument. Also, inconnection with the sale of convertible debt and equity instruments, the Company may issuefreestanding options or warrants that may, depending on their terms, be accounted for asderivative instrument liabilities, rather than as equity.   In accordance with Statement of Financial Accounting Standards No. 133, “Accounting forDerivative Instruments and Hedging Activities”, as amended (“SFAS 133”), the convertible debtholder’s conversion right provision, interest rate adjustment provision, interest rateadjustment provision, liquidated damages clause, cash premium option, and the redemption option(collectively, the debt features) contained in the terms governing the convertible notes are notclearly and closely related to the characteristics of the notes. Accordingly, the featuresqualify as embedded derivative instruments at issuance and, because they do not qualify for anyscope exception within SFAS 133, they are required by SFAS 133 to be accounted for separatelyfrom the debt instrument and recorded as derivative instrument liabilities.   **Stock Options**   Effective April 1, 2006, the Company adopted the Statement of Financial Accounting Standards No.123 (revised 2004), Share-Based Payment (SFAS 123R), which require the measurement andrecognition of compensation expense for all share-based payment awards made to employees anddirectors, including employee stock options, based on estimated fair values. The Company adoptedSFAS 123R using the modified prospective transition method, which requires the application ofthe accounting standard as of April 1, 2006, the first day of the Company’s fiscal year 2007.The Company’s Financial Statements as of and for the three months ended June 30, 2006 reflectthe impact of SFAS 123R. In accordance with the modified prospective transition method, theCompany’s Financial Statements for prior periods have not been restated to reflect, and donot include, the impact of SFAS 123R. Stock-based compensation expense recognized under SFAS123R for the three months ended June 30, 2006 was $262,056, which consists of stock-basedcompensation expense related to employee and director stock options and restricted stockissuances.   SFAS 123R requires companies to estimate the fair value of share-based payment awards on thedate of grant using an option-pricing model. The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite service periods in thecompany’s Statement of Operations. Prior to the adoption of SFAS 123R, the Company accounted forstock-based awards to employees and directors using the intrinsic value method in accordancewith APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting forStock-Based Compensation, (SFAS 123). Under the intrinsic value method, no stock-basedcompensation expense had been recognized in the Company’s Statement of Operations prior toJanuary 1, 2006 because the exercise price of the Company’s stock options granted to employeesand directors was equal to or greater than the fair market value of the underlying stock at thedate of grant. The proforma disclosures for the three months ended June 30, 2005 are asfollows:
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       **For the Three Months Ended**  **June 30,**  **As Restated**  **2005**Net loss as reported $(778,499)     Add stock-based employee compensationexpense included in net loss as reported,net of related tax effects  3⁄4 Deduct stock-based employee compensationexpense determined under the fair valuebased method for all awards, net of relatedtax effects $(307,452)Net loss; pro forma $(1,085,951)Basic and diluted loss per share, as reported $(0.03)Basic and diluted loss per share, pro forma $(0.04)  The fair value of these options was estimated at the date of grant using the Black-Scholesoption pricing model with the following weighted-average assumptions for the three months endedJune 30, 2005: dividend yields of 0%; expected volatility of 65%, risk-free interest rates of3.69%, and expected lives of 3 years. There were no stock options granted during the threemonths ended June 30, 2005.   Stock-based compensation expense recognized during the period is based on the value of theportion of share-based payment awards that is ultimately expected to vest during the period.Compensation expense recognized for all employee stock options awards granted is recognized overtheir respective vesting periods unless the vesting period is graded. As stock-basedcompensation expense recognized in the Statement of Operations for the three months ended June30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimatedforfeitures.   Upon adoption of SFAS 123R the Company continued to use the Black-Scholes option valuationmodel, which requires management to make certain assumptions for estimating the fair value ofemployee stock options granted at the date of the grant. In determining the compensation cost ofthe options granted during the three months ended June 30, 2006, as specified by SFAS 123R, thefair value of each option grant has been estimated on the date of grant using the Black-Scholespricing model and the weighted average assumptions used in these calculations are summarized asfollows:       For the three months ended  June 30, 2006Risk-free Interest Rate  4.95%Expected Life of Options Granted 3 yearsExpected Volatility  87%Expected Dividend Yield  0   As of June 30, 2006, there was approximately $406,221 of total unrecognized compensation costrelated to nonvested share-based compensation arrangements, which is expected to be recognizedover a period of 3 years**.**   **Loss per Share**   The Company calculates loss per share in accordance with SFAS No. 128, “Earnings per Share.”Basic loss per share is computed by dividing the net loss by the weighted-average number ofcommon shares outstanding. Diluted loss per share is computed in a similar manner to basic lossper share except that the denominator is
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  increased to include the number of additional common shares that would have been outstanding if the potential common stock equivalents had beenissued and if the additional common shares were dilutive.   The following potential common stock equivalents have been excluded from the computation ofdiluted net loss per share for the periods presented because the effect would have beenanti-dilutive (options and warrants typically convert on a one-for-one basis, see conversiondetails of the preferred stock stated below for the common stock shares issuable uponconversion):           **For the Three Months Ended**  **June 30,**  **2006** **2005**Options outstanding under the Company’s stock option plans  6,809,449   3,926,783 Options granted outside the Company’s stock option plans  1,160,000   1,160,000 Warrants issued in conjunction with private placements  5,689,933   4,947,859 Warrants issued as a financing cost for notes payableand convertible notes payable  2,083,783   2,194,837 Warrants issued for services rendered and litigation settlement  100,769   360,769 Warrants issued as part of the US Dataworks, Inc. acquisition  3⁄4   67,200 Convertible Series B preferred stock (a)  109,933   109,933  (a) The Series B preferred stock is convertible into shares of common stock at a conversionprice of $3.75 per share.  **Estimates**   The preparation of financial statements requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Actual results could differ from those estimates.   **Concentrations of Credit Risk**   The Company sells its products throughout the United States and extends credit to its customers.It also performs ongoing credit evaluations of such customers. The Company does not obtaincollateral to secure its accounts receivable. The Company evaluates its accounts receivable on aregular basis for collectibility and provides for an allowance for potential credit losses asdeemed necessary.   Four of our customers accounted for 25%, 23%, 12% and 11% of our net revenues for the threemonths ended June 30, 2006. One of these customers, which represented 15% of our quarterlyrevenues, was the result of our relationship with one of our strategic resellers. Four of ourcustomers accounted for 34%, 19%, 16% and 12% of our net revenues for the three months endedJune 30, 2005.   At June 30, 2006, amounts due from a significant customer accounted for 73% of accountsreceivable. **3.** **Restatement of Quarterly Information**   The Company concluded that it was necessary to restate its financial results for the interimperiod ended June 30, 2005 to reflect additional non-operatinggains and losses related to certain features included is the Company’s debt that requirederivative treatment.   The Company had previously classified the value of its conversion features and warrants topurchase common stock as debt discounts. After further review, the Company has determined thatthese instruments should have been recorded as derivative liabilities and therefore, the fairvalue of each instrument must be recorded as a derivative liability on the Company’s balancesheet. Changes in the fair values of these instruments will result
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  in adjustments to the amountof the recorded derivative liabilities and the corresponding gain or loss will be recorded inthe Company’s statement of operations. At the date of the conversion of each respectiveinstrument or portion thereof (or exercise of the options or warrants or portion thereof, as thecase may be), the corresponding derivative liability will be reclassified as equity.**STATEMENTS OF OPERATIONS****For Quarter ending June 30, 2005**               **As Previously**         **Reported**  **Adjustments**  **As Restated** Revenue $1,080,339  $—  $1,080,339 Loss from operations  (939,962)  —   (939,962)Other income (expense):            Financing costs  (11,704)  11,704   — Interest expense  (23,933)  (29,672)  (53,605)Loss on extinguishment of debt  —   —   — Gain/Loss on derivatives  —   208,269   208,269 Other income (expense)  6,799   —   6,799                        Net income / loss $(968,800) $190,301  $(778,499)                       Net income / loss per common share; basic and undiluted $(0.03) $—  $(0.03)          **BALANCE SHEET**               **As Previously**      **Reported** **Adjustments** **As Restated**Total Assets $17,498,722  $—  $17,498,722 Total liabilities  1,872,562   394,883   2,267,445  Stockholders Equity  15,626,160   (394,883)  15,231,277 **4.** **Property and Equipment**   Property and equipment as of June 30, 2006 consisted of the following:     Furniture and fixtures $77,559 Automobile  15,072 Office and telephone equipment  92,795 Computer equipment  549,264 Computer software  1,271,098 Leasehold improvements  62,997        2,068,785 Less accumulated depreciation and amortization  (1,616,929)    Total $451,856       Depreciation and amortization expense for the three months ended June 30, 2006 and 2005 was$33,060 and $88,525, respectively.
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**5.** **Convertible Promissory Notes**  Convertible promissory notes at June 30, 2006 consisted of the following:     Convertible promissory note, interest at 10% perannum, unsecured, $512,133 due September 15, 2006, $256,066due September 15, 2007 $768,199      Convertible promissory note issued June 16, 2005 with $70,000 OriginalIssue Discount, due in 15 equal monthly installments beginning April 15, 2006,net of unamortized discount of $350,509  214,158             982,357      Less current portion  (726,291)         Long-term portion $256,066       Convertible promissory note with interest at 10% per annum    This note is an amendment and restatement of a note in the same principal amount originallydated September 15, 2004. The original note was issued effective September 15, 2004 inconnection with the November 2004 settlement of a lawsuit brought by an investor in December2003. The amended note is convertible at any time, at the holder’s election, into shares of theCompany’s common stock at a per share conversion price of $1.10, subject to standardantidilution provisions.   The amended note is effective September 15, 2005 and extended a principal payment of $256,067originally due September 15, 2005 for one year. In consideration of this amendment, the Companyissued the holder a common stock purchase warrant to purchase up to 650,000 shares of theCompany’s common stock at an exercise price of $0.59 per share. The warrant will expire onSeptember 15, 2008.   The changes to this debt caused the accounting treatment to be an extinguishment of the old debtand issuance of new debt instead of being treated as modification of debt. Therefore, theexcess of the fair value of the note and warrants over the carrying amount of the debt is$206,000 and has been recorded as a loss on extinguishment for the year ended March 31, 2006.   In connection with the November 2004 settlement, the Company also issued a warrant to purchase160,000 shares of the Company’s common stock at a purchase price of $0.75 per share, whichwarrant will expire on November 10, 2006.   Using the Black-Scholes pricing model the Company has determined the value of the warrantsissued in connection with the settlement to be $126,000. This amount, together with the value ofthe convertible promissory note, the value of the plaintiff’s legal expense reimbursement andthe Company’s legal costs incurred in connection with the settlement totaled $924,200 and hasbeen recorded as Investor litigation settlement expense for the year ended March 31, 2005.   Convertible promissory note issued June 16, 2005 with $70,000 Original Issue Discount   On June 16, 2005, the Company entered into a Securities Purchase Agreement with an institutionalinvestor (the “Debenture Agreement”) for the sale of a convertible debenture with a principalamount of $770,000 and an original issue discount of $70,000 for gross proceeds of $700,000.The debenture is convertible at anytime at the discretion of the holder at a price per share of$0.572 into 1,346,154 shares of the Company’s common stock. The convertible debenture is to berepaid in 15 monthly installments of $51,333.33 beginning April 15, 2006. The Company may alsoelect, upon proper notice, to pay any monthly installment in shares of the Company’s commonstock based on a conversion price equal to the lesser of (i) the then applicable conversionprice, or (ii) 90% of the volume weighted average price of the Company’s common stock for the 10trading days immediately preceding the payment; provided, that, such conversion price must be atleast equal to the
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  conversion floor of $0.23, or such monthly installment must be paid in cash.This convertible debenture was amended on March 9, 2006, pursuant to which the Company must,within 25 calendar days prior to each monthly payment, deliver 89,744 shares of its common stockto the holders, which represents the monthly installment amount divided by the then conversionprice with the first monthly payment becoming due on April 17, 2006. In connection with theDebenture Agreement, the Company issued two groups of warrants, Short Term Warrants and LongTerm Warrants to the institutional investor. The Short Term Warrants allow the institutionalinvestor to purchase an aggregate of 407,926 shares of the Company’s common stock with anexercise price of $0.572 per share exercisable for a period of 180 days at any time after thelater of (i) the effective date of the registration statement (as described below) or (ii)December 16, 2005. The Long Term Warrants allow the institutional investor to purchase anaggregate of 471,154 shares of the Company’s common stock with an exercise price of $0.572 pershare exercisable at anytime from December 16, 2005 through December 16, 2008; provided,however, the institutional investor will not be permitted to exercise a warrant to the extentthat the number of shares of the Company’s common stock beneficially owned by such institutionalinvestor taken together with the number of shares to be issued upon exercise of the warrantequals or exceeds 4.999% of the Company’s then issued and outstanding shares of common stock.The warrants also contain trading market restrictions that preclude the Company from issuing shares of common stock upon exercise thereof if such issuance, when aggregated with otherissuances of the Company’s common stock pursuant to the warrants, would exceed 19.999% of theCompany’s then issued and outstanding shares of common stock, unless the Company has previouslyobtained the required shareholder approval. Pursuant to a Registration Rights Agreement datedJune 16, 2005 between the Company and the institutional investor, the Company agreed to file aregistration statement for the resale of the shares of the Company’s common stock that may beissued to the institutional investor upon the conversion of the convertible debenture and theexercise of the Short Term Warrants and the Long Term Warrants. The registration statementcovering these securities was effective on September 1, 2005.   In accordance with Statement of Financial Accounting Standards No. 133 “Accounting forDerivative Instruments and Hedging Activities” (“SFAS 133”), the debt features contained in theterms governing the notes are not clearly and closely related to the characteristics of thenotes. Accordingly, the debt features qualify as embedded derivative instruments at issuanceand, because they did not qualify for any scope exception within SFAS 133, they were required tobe accounted for separately from the debt instrument and recorded as derivative financialinstruments.   At the date of issuance, the embedded debt feature had an estimated initial fair value of$449,089, which was recorded as a discount to the convertible notes and derivative liability onour balance sheet. In subsequent periods, if the price of the security changes, the embeddedderivative financial instrument related to the debt features will be adjusted to the fair valuewith the corresponding charge or credit to other income/(expense). The estimated fair value ofthe debt features was determined using the probability weighted averaged expected cash flows /Lattice Model with a closing price of $0.65, a conversion price as defined in the respectivenote agreement and a period of two years. Concerning the debt features, the model uses severalassumptions including: historical stock price volatility, approximate risk-free interest rate(3.5%), remaining term to maturity, and the closing price of the company’s common stock todetermine the estimated fair value of the derivative liability. For the quarter ended June 30,2006, due in part to an increase in the market value of the Company’s common stock , the Companyrecorded an other income item on the statement of operations for thechange in fair value of the embedded debt feature of approximately ($207,858). At June 30,2006, the estimated fair value of the embedded debt feature was approximately $326,274.   The recorded value of the embedded debt feature related to this debt can fluctuate significantbased on fluctuations in the fair value of the Company’s common stock.   The warrants included with this note for purchase of the Company’s common stock had an initialvalue of $271,940. This amount has been classified as a derivative financial instrument andrecorded as a liability on our consolidated balance sheet in accordance with SFAS 133. Theestimated fair value of the warrants at the date of issuance was determined using theBlack-Scholes option-pricing model with a closing price of $1.14, the respective exercise priceof the warrants, a 2 year term, and a 90% volatility factor relative to the date of issuance.The model uses several assumptions including: historical stock price volatility, approximaterisk-free interest rate (3.50%), remaining term to maturity, and the closing price of thecompany’s common stock to determine the estimated fair value of the derivative liability. Inaccordance with the provisions of SFAS 133,
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  the Company is required to adjust the carrying valueof the instrument to its fair value at each balance sheet date and recognize any change sincethe prior balance sheet date as a component of other income/ (expense) on its statement ofoperations. The warrant derivative liability at June 30, 2006, increased to a fair value of$188,521, due in part to an increase in the market value of the company’s common stock, whichresulted in an other income item of ($75,691).   The recorded value of the warrants can fluctuate significantly based on fluctuations in themarket value of the underlying securities of the issuer of the warrants, as well as in thevolatility of the stock price during the term used for observation and the term remaining forthe warrants.   Due to changes in value upon the conversion of this debt when shares were issued for requiredprincipal payments, additional losses were incurred amounting to $129,905. This loss is theresult of differences in the settlement method and the assumptions that were used in theoriginal derivative valuation. 6. **Commitments and Contingencies**   **Employment Agreements**   On April 3, 2006, the Company entered into an employment agreement with each of its President,Payment Products Division and Vice Chairman, Sr. Vice President and Chief Technology Officer,and Vice President of Business Development and General Counsel, for a term of three years withautomatic renewal for successive one-year terms unless either party gives timely notice ofnon-renewal.   Annual base salary for the President, Payment Products Division and Vice Chairman of the Companyis $190,000 and pursuant to the terms of the agreement he is entitled to receive an option topurchase 550,000 shares of the Company’s common stock. This option vests over a 3 year periodwith 150,000 shares vesting on April 3, 2006 and 200,000 shares vesting on each of April 3,2007 and 2008. In addition the President, Payment Products Division and Vice Chairman isentitled to receive a bonus of $48,125 for year end 2006.   Annual base salary for the Senior Vice President and Chief Technology Officer of the Company is$185,000 and pursuant to the terms of the agreement he is entitled to receive 200,000 shares ofrestricted common stock. The restricted shares vest over a 3 year period with 25,000 sharesvesting on April 3, 2006 and 87,500 shares vesting on each of April 3, 2007 and 2008. The SeniorVice President and Chief Technology Officer is also eligible to receive a quarterly bonus ofequal to 3.5% of the increase in the Company’s revenue from fiscal year quarter to fiscal yearquarter and to receive a bonus of $78,750 for fiscal year 2006.   Annual base salary for the Vice President of Business Development and General Counsel of theCompany is $175,000, and pursuant to the terms of the agreement he is entitled to receive anoption to purchase 700,000 shares of the Company’s common stock. This option vests over a 3year period with 300,000 shares vesting on April 3, 2006 and 200,000 shares vesting on each ofApril 3, 2007 and, 2008. The Vice President of BusinessDevelopment and General Counsel is also eligible to receive a quarterly bonus based upon theCompany’s future acquisitions or mergers.   On May 23, 2006, the Company entered into an employment agreement with its Chairman of the Boardand Chief Executive Officer. The agreement has a 2 year term with automatic renewal forsuccessive one year terms unless either party gives timely notice of non-renewal. His annualbase salary is $220,000 and he is entitled to receive 100,000 shares of restricted common stockthat vest immediately and is entitled to receive an option to purchase 600,000 shares of theCompany’s common stock. This option vests as to 300,000 shares on each of May 22, 2007 and2008.   **Litigation**   In June 2005, two of our former employees initiated arbitration against the Company alleging wrongfultermination and sought severance pay. Arbitration was held on March 28, 2006 and on June 19,2006, the arbitration ruled that each employee was entitled to $90,000 in severance pay, as wellas costs and interest. These amounts were included in accrued liabilities at March 31, 2006.
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**7.** **Stockholders’ Equity**   **Preferred Stock**   The Company has 10,000,000 authorized shares of $0.0001 par value preferred stock. The preferredstock may be issued in series, from time to time, with such designations, rights, preferences,and limitations as the Board of Directors may determine by resolution.   **Convertible Series B Preferred Stock**   The Company has 700,000 authorized shares of $0.0001 par value convertible Series B preferredstock.   In August and October 2000, the Company issued 509,333 and 133,666 units respectively, in aprivate placement for gross proceeds of $382,000 and $100,250, respectively. Each unit consistedof one share of the Company’s voting convertible Series B preferred stock (the “Series B”) and awarrant, exercisable through October 2003, to purchase one share of the Company’s common stock.The Series B has a liquidation preference of $0.75 per share and carries a 10% cumulativedividend payable each March 1 and September 1. The Company has the right to redeem the Series Bat any time after issuance at a redemption price of $0.83 per share, plus any accrued but unpaiddividends. The Series B is convertible upon issuance into common stock at $3.75 per share. Thewarrant entitles the holder to purchase one share of the Company’s common stock at $6.25 pershare, which represents 115% of the market value of the Company’s stock at the closing date.   In May 2001, an investor in the Series B rescinded its acquisition and returned to the Company13,333 shares and warrants for the purchase of 2,667 shares of common stock in exchange for thereturn of its investment of $10,000.   In August 2004, an investor in the Series B elected to convert his 79,999 shares and accordinglywas issued 15,998 shares of the Company’s common stock.   At June 30, 2006, there were accumulated, undeclared dividends in arrears of $221,050 or $0.40per share.   **Common Stock**   **Common Stock and Warrants**   During the three months ended June 30, 2005, the Company completed the following:   Sale of Common Stock and Warrants   Effective June 16, 2005, the Company entered into definitive agreements with nine accreditedinvestors for the sale of 1,258,654 shares of Common Stock for gross proceeds of $600,000. Theagreements also provide that the Company will issue warrants, exercisable over a three yearperiod, to purchase up to 314,664 shares of Common Stock at an exercise price of $0.715 pershare and an additional 314,664 shares of Common Stock at an exercise price of $0.812 per share.In July 2005, upon receipt of approval of the American Stock Exchange for issuance of the shares of Common Stock, the agreements were completed and the investors were issued the sharesof Common Stock and warrants.   In the quarter ended June 30, 2006, the Company issued 303,116 shares of Common Stock with avalue of $154,000 to pay down debt associated with the convertiblepromissory note issued June 16, 2005.   **Stock Options**   In August 1999, the Company implemented its 1999 Stock Option Plan (the “1999 Plan”). In August2000, the Company’s Board of Directors approved the 2000 Stock Option Plan (the “2000 Plan”),which amends and restates the 1999 Plan. Under the 2000 Plan, the maximum aggregate number of shares which may be granted is 6,000,000. The exercise price must not be less than the fairmarket value on the date of grant of the option. The options vest in varying increments overvarying periods and expire 10 years from the date of vesting. In the case of incentive stockoptions granted to any 10% owners of the Company, the exercise price must not be less than
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  100%of the fair market value on the date of grant. Such incentive stock options vest in varyingincrements and expire five years from the date of vesting.   During the three months ended June 30, 2006 the Company granted 2,261,500 stock options tocertain employees that may be exercised at prices ranging between $0.46 and $0.82.   The following table summarizes certain information relative to stock options:                   2000 Stock Option Plan Outside of Plan      Weighted-            Average Exercise     Weighted-Average  Shares Price Shares Exercise PriceOutstanding, March 31, 2006  3,499,115  $0.94   1,160,000  $1.02 Granted  2,261,500  $0.60  —  Exercised  —   —   —     Forfeited/canceled  111,166  $1.65   —  $0.00 Outstanding, June 30, 2006  5,649,449  $0.78   1,160,000  $1.02 Exercisable, June 30, 2006  3,837,949  $1.69   1,160,000  $1.02   The weighted-average remaining life and the weighted-average exercise price of all of theoptions outstanding at June 30, 2006 were 8.4 years and $0.82, respectively. The exercise pricesfor the options outstanding at June 30, 2006 ranged from $0.44 to $6.25, and informationrelating to these options is as follows:                                       Weighted-AverageRange of     Stock Weighted-Average Weighted- ExerciseExercise Stock Options Options Remaining Average Price of OptionsPrices Outstanding Exercisable Contractual Life Exercise Price Exercisable$0.44 – 0.80  4,209,113   2,772,613  8.78 years $0.56  $0.55 $0.81 – 1.35  1,856,336   1,481,336  8.06 years $0.93  $0.96 $1.36 – 6.25  744,000   744,000  7.60 years $1.96  $1.96    6,809,449   4,997,949             **Restricted Stock**The Company granted 200,000 shares of restricted common stock to the Senior Vice President andChief Technology Officer and 100,000 shares of restricted common stock to the Chairman of the Boardand Chief Executive Officer associated with employment agreements reached with each. The sharesare granted under the 1999 stock option plan (the “1999 plan”) as amended and restated by the 2000stock option plan (the “2000 plan”).**Item 2. Management’s Discussion and Analysis or Plan of Operation.**     The following discussion and analysis of our financial condition and results of operationsshould be read with the consolidated financial statements and related notes included elsewhere inthis Quarterly Report on Form 10-QSB.     When used in this Quarterly Report on Form 10QSB, the words “expects,” “anticipates,”“believes,” “plans,” “will” and similar expressions are intended to identify forward-lookingstatements. These are statements that relate to future periods and include, but are not limited to,statements regarding our critical accounting policies, adequacy of capital resources, our potentialprofessional services contracts and the related benefits, demand for software and professionalservices, demand for our solutions, expectations regarding net losses, expectations regarding cashflow and sources of revenue, statements regarding our growth and profitability, investments inmarketing and promotion,
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our need for future financing, our dependence on our strategic partners,our dependence on personnel, our disclosure controls and procedures, our ability to respond torapid technological change and statements regarding future acquisitions or investments.Forward-looking statements are subject to certain risks and uncertainties that could cause actualresults to differ materially from those projected. These risks and uncertainties include, but arenot limited to, those discussed below, as well as risks related to our ability to develop andtimely introduce products that address market demand, the impact of alternative technologicaladvances and competitive products, market fluctuations, our ability to obtain future financing, andthe risks set forth below under “Factors That May Affect Our Results.” These forward-lookingstatements speak only as of the date hereof. We expressly disclaim any obligation or undertaking torelease publicly any updates or revisions to any forward-looking statements contained herein toreflect any change in our expectations with regard thereto or any change in events, conditions orcircumstances on which any such statement is based.**Critical Accounting Policies**     The following discussion and analysis of our financial condition and results of operations isbased upon our financial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Onan on-going basis, we evaluate these estimates, including those related to revenue recognition andconcentration of credit risk. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.     We believe that of the significant accounting policies used in the preparation of ourfinancial statements (see Note 2 to the Financial Statements), the following are criticalaccounting policies, which may involve a higher degree of judgment, complexity and estimates.*Revenue Recognition*     We recognize revenues in accordance with the provisions of the American Institute of CertifiedPublic Accountants’ Statement of Position 97-2, “Software Revenue Recognition.” We license oursoftware products under non-exclusive, non-transferable license agreements. These arrangements donot require significant production, modification or customization, therefore revenue is recognizedwhen the license agreement has been signed, delivery of the software product has occurred, therelated fee is fixed or determinable and collectibility is probable.     In certain instances, we license our software on a transactional fee basis in lieu of anup-front licensing fee. In these arrangements, the customer is charged a fee based upon the numberof items processed by the software and we recognize revenue as these transactions occur. Thetransaction fee also includes the provision of standard maintenance and support services, as wellas product upgrades should such upgrades become available.     If professional services are provided in conjunction with the installation of the softwarelicensed, revenue is recognized when those services have been provided.     For license agreements that include a separately identifiable fee for contracted maintenanceservices, such revenues are recognized on a straight-line basis over the life of the maintenanceagreement noted in the license agreement, but following any installation period of the software.*Concentrations of Credit Risk*     We extend credit to our customers and perform ongoing credit evaluations of our customers. Wedo not obtain collateral from our customers to secure our accounts receivable. We evaluate ouraccounts receivable on a regular basis for collectibility and provide for an allowance forpotential credit losses as deemed necessary.
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     Four of our customers, the Federal Reserve Bank, American Express, Citibank and Regulusaccounted for 25%, 23%, 12% and 11%, respectively, of our net revenues ended June 30, 2006. Fourof our customers accounted for 34%, 19%, 16% and 12% of our net revenues for the three months endedJune 30, 2005.     At June 30, 2006, amounts due from a significant customer accounted for 73% of accountsreceivable.**Results of Operations**     The results of operations reflected in this discussion include our operations for the threemonth periods ended June 30, 2006 and 2005.     *Revenues*     Revenues totaled $1,215,088 for the three months ended June 30, 2006 compared to revenues of$1,080,339 for the three months ended June 30, 2005, an increase of $134,749, or 13%. The increasein revenues was primarily attributable to an increase in transactional revenues of $132,753, or73%, an increase in license revenues of $80,135, or 27%, and an increase in maintenance revenue of$11,439, or 12%, offset by a decrease in service revenues of $89,578, or 17%. Transactionalrevenues increased in the first quarter of the current fiscal year compared to thesame period in the prior year principally as a result of previously installed customerssubject to transactional fees increasing their utilization of our software solutions, along withadditional new customers utilizing our software solutions     The increase in license revenue in the first quarter is due primarily to the sale ofadditional third party software that can be integrated and utilized by our customers using oursoftware solution. Maintenance revenues increased principally due to a larger number of installedcustomers subject to annual maintenance fees. The decrease in service revenue is due primarily tothe completion of the installation and conversion services performed at two customers locations inthe prior year.     *Cost of Sales*     Costs of sales principally include the cost of Thomson Financial EPICWareTM software or otherthird party software resold in conjunction with our software as well as costs of our personnel whoperform the services associated with our software maintenance, support, training and installationactivities. Cost of sales increased by $144,798, or 38%, to $522,299 for the three months endedJune 30, 2006 from $377,501 for the three months ended June 30, 2005, principally due to a $183,285increase in the cost of EPICWareTM and other third party software resold offset by a decrease of$38,487 in personnel cost related to services, maintenance support, training and installationservices.     *Operating Expenses*     Total operating expenses increased by $153,208, or 9%, to $1,796,008 for the three monthsended June 30, 2006 from $1,642,800 for the three months ended June 30, 2005. The increase inoperating expenses was principally attributable to $262,056 in stock based compensation expense inthe current year associated with adoption of FASB123R, $84,659 in bonuses associated with the newemployment agreements entered into with key personnel in the current year, $17,328 in commissionsearned on previously signed contracts paid to sales personnel, $19,424 increase in telephoneexpense and a $29,458 increase in travel expenses associated with the completion of softwareinstallation and the generation and follow up on new sales opportunities. These operating costincreases were offset by decreases in other areas, principally a decrease of $221,938 in personnelcosts associated with a decrease in head count.     *Other Expenses*     Other expenses, including interest expense and financing costs, increased $658,614, or 408%,to $497,151 for the three months ended June 30, 2006 from $(161,463) for the three months endedJune 30, 2005. The increase was
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primarily due to ongoing quarterly analysis related to the embeddedderivatives associated with convertible promissory note of June 16, 2005.     *Net Loss*     Net loss increased by $821,871, or 106%, to a net loss of $1,600,370 for the three monthsended June 30, 2006 from $778,499 for the three months ended June 30, 2005.**Liquidity and Capital Resources**     We have incurred significant losses and negative cash flows from operations for the last twofiscal years. We have obtained our required cash resources through the sale of debt and equitysecurities. We may not operate profitably in the future and may be required to continue the sale ofdebt and equity securities to finance our operations.     We have specific plans to address our financial situation as follows: **•** We expect to enter into a month-to-month professional services contract with anexisting major financial services customer in early September 2006 that could generaterevenue sufficient to significantly reduce the negative cash flows from our operationsfor fiscal 2007.  **•** Additionally, we believe that the demand for our software and professional serviceswill continue to expand as the United States market adopts the new payment processingopportunities available under changing regulations such as the Check Clearing Act forthe 21st Century and NACHA’s back office conversion, which allows theconversion of paper checks in the back offices of retail merchants and government. Webelieve that increased demand for our solutions, including our recently introducedClearingworks product, will lead to increased cash flows from up-front license fees,transaction based contract fees and increases in professional services revenues.  **•** We have entered into a strategic alliance with one of the largest merchant serviceproviders, or MSP, which will allow this MSP to sell Clearingworks as part of its ARCand back office conversion services. We expect this alliance to positively affect ourprofitability.     There can be no assurance that our planned activities will be successful or that we willultimately attain profitability. Our long term viability depends on our ability to obtain adequatesources of debt or equity funding to fund the continuation of our business operations and toultimately achieve adequate profitability and cash flows to sustain our operations. We will need toincrease revenues from software licenses, transaction based software license contracts andprofessional services agreements to become profitable.     Cash and cash equivalents decreased by $633,254 to $657,184 at June 30, 2006 from $1,290,438at March 31, 2006. Cash used for operating activities was $620,444 in the three months ended June30, 2006 compared to $1,000,581 in the same period in the prior year.     Cash used for investing activities of $12,810 and $40,982 in the three months ended June 30,2006 and June 30, 2005, respectively, was due to equipment purchases.     Financing activities provided no cash in the three months ended June 30, 2006 compared to$1,285,450 in the three months ended June 30, 2005.     As a result of our increased level of transactional revenues achieved in fiscal 2006, and theexpected increase in revenues from recently received and contemplated contracts, we believe wecurrently have adequate capital resources to fund our anticipated cash needs through March 31,2007. However, an adverse business or legal development could require us to raise additionalfinancing sooner than anticipated. We recognize that we may be required to raise such additionalcapital, at times and in amounts, which are uncertain, especially under the current capital marketconditions. If we are unable to acquire additional capital or are required to raise it on termsthat are less satisfactory than we desire, it may have a material adverse effect on our financialcondition. In the event we raise additional equity, these financings may result in dilution toexisting shareholders.
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**Factors That May Affect Our Results****We have a general history of losses and may not operate profitably in the future.**     We have a history of losses and our net losses and negative cash flow may continue for theforeseeable future. As of June 30, 2006, our accumulated deficit was $(48,710,708). We believe thatour planned growth and profitability will depend in large part on our ability to promote our brandname, gain clients and expand our relationships with clients for whom we would provide licensingagreements and system integration. Accordingly, we intend to invest heavily in marketing, strategicpartnership, development of our client base and development of our marketing technology andoperating infrastructure. If we are not successful in promoting our brand name and expanding ourclient base, it will have a material adverse effect on our financial condition and our ability tocontinue to operate our business.**Our ability to continue as a going concern may be contingent upon our ability to secure capitalfrom prospective investors or lenders.**     Theaccompanying consolidated financial statements have been prepared assuming we will continueon a going concern basis, which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. We believe we currently have adequate cash to fundanticipated cash needs through March 31, 2007. However, we may need to raise additional capital inthe future. Any equity financing may be dilutive to shareholders, and debt financing, if available,will increase expenses and may involve restrictive covenants. We may be required to raiseadditional capital, at times and in amounts that are uncertain, especially under the currentcapital market conditions. These factors raise substantial doubt about the Company’s ability tocontinue as a going concern. Under these circumstances, if we are unable to obtain additionalcapital or are required to raise it on undesirable terms, it may have a material adverse effect onour financial condition, which could require us to: **•** curtail our operations significantly;  **•** sell significant assets;  **•** seek arrangements with strategic partners or other parties that may requireus to relinquish significant rights to products, technologies or markets; or  **•** explore other strategic alternatives including a merger or sale of USDataworks.     Our financial statements do not include any adjustments relating to the recoverability andclassification of recorded assets or liabilities that might be necessary should the Company beunable to continue as a going concern.     **Our operating results are subject to fluctuations caused by many factors that could cause us tofail to achieve our revenue or profitability expectations, which in turn could cause our stockprice to decline.**     Our operating results can vary significantly depending upon a number factors, many of whichare outside our control. Factors that may affect our quarterly operating results include: **•** market acceptance of and changes in demand for our products and services;  **•** gain or loss of clients or strategic relationships;  **•** announcement or introduction of new software, services and products by us or by our competitors;  **•** our ability to build brand recognition;  **•** timing of sales to customers;  **•** price competition;  **•** our ability to upgrade and develop systems and infrastructure to accommodate growth;
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 **•** our ability to attract and integrate new personnel in a timely and effective manner;  **•** our ability to introduce and market products and services in accordance with market demand;  **•** changes in governmental regulation;  **•** reduction in or delay of capital spending by our clients due to the effectsof terrorism, war and political instability; and  **•** general economic conditions, including economic conditions specific to thefinancial services industry.     In addition, each quarter we derive a significant portion of our revenue from agreementssigned at the end of the quarter. Our operating results could suffer if the timing of theseagreements is delayed. Depending on the type of agreements we enter into, we may not be able torecognize revenue under these agreements in the quarter in whichthey are signed. Some of all of these factors could negatively affect demand for our productsand services, and our future operating results.     Most of our operating expenses are relatively fixed in the short-term. We may be unable to adjustspending rapidly to compensate for any unexpected sales shortfall, which could harm our quarterlyoperating results. Because of the emerging nature of the markets in which we compete, we do nothave the ability to predict future operating results with any certainty. Because of the abovefactors, you should not rely on period-to-period comparisons of results of operation as anindication of future performances.**We may not be able to maintain our relationships with strategic partners, which may cause our cashflow to decline.**     We may not be able to maintain our relationships with strategic partners, such as BancTec andComputer Sciences Corporation. These strategic relationships are a core component of our sales anddistribution strategy. The loss of a strategic partner could harm our financial results.**Because a small number of customers have historically accounted for and, may in future periodsaccount for, substantial portions of our revenue, our revenue could decline because of delays ofcustomer orders or the failure to retain customers.**     We have a small number of customers that account for a significant portion of our revenue. Ourrevenue could decline because of a delay in signing agreements with a single customer or thefailure to retain an existing customer. In addition, we may not obtain additional customers. Thefailure to obtain additional customers or the failure to retain existing customers will harm ouroperating results.**If general economic and business conditions do not improve, we may experience decreased revenue orlower growth rates.**     The revenue growth and profitability of our business depends on the overall demand forcomputer software and services in the product segments in which we compete. Because our sales areprimarily to major banking and government customers, our business also depends on general economicand business conditions. A softening of demand caused by a weakening of the economy may result indecreased revenue or lower growth rates. As a result, we may not be able to effectively promotefuture license revenue growth in our application business.**We may not be able to attract, retain or integrate key personnel, which may prevent us fromsuccessfully operating our business.**     We may not be able to retain our key personnel or attract other qualified personnel in thefuture. Our success will depend upon the continued service of key management personnel. The loss ofservices of any of the key members of our management team or our failure to attract and retainother key personnel could disrupt operations and have a negative effect on employee productivityand morale and harm our financial results.
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**We operate in a market that is intensely and increasingly competitive, and if we are unable tocompete successfully, our revenue could decline and we may be unable to gain market share.**     The market for financial services software is relatively new and highly competitive. Ourfuture success will depend on our ability to adapt to rapidly changing technologies, evolvingindustry standards, product offerings and evolving demands of the marketplace.     Some of our competitors have: **•** longer operating histories;  **•** larger installed customer bases;  **•** greater name recognition and longer relationships with clients; and  **•** significantly greater financial, technical, marketing and public relationsresources than US Dataworks.     Our competitors may also be better positioned to address technological and market developmentsor may react more favorably to technological changes. We compete on the basis of a number offactors, including: **•** the breadth and quality of services;  **•** creative design and systems engineering expertise;  **•** pricing;  **•** technological innovation; and  **•** understanding clients’ strategies and needs.     Competitors may develop or offer strategic services that provide significant technological,creative, performance, price or other advantages over the services we offer. If we fail to gainmarket share or lose existing market share, our financial condition, operating results and businesscould be adversely affected and the value of the investment in us could be reduced significantly.We may not have the financial resources, technical expertise or marketing, distribution or supportcapabilities to compete successfully.**We may be responsible for maintaining the confidentiality of our client’s sensitive information,and any unauthorized use or disclosure could result in substantial damages and harm our reputation.**     The services we provide for our clients may grant us access to confidential or proprietaryclient information. Any unauthorized disclosure or use could result in a claim against us forsubstantial damages and could harm our reputation. Our contractual provisions attempting to limitthese damages may not be enforceable in all instances or may otherwise fail to adequately protectus from liability for damages.**If we do not adequately protect our intellectual property, our business may suffer, we may loserevenue or we may be required to spend significant time and resources to defend our intellectualproperty rights.**     We rely on a combination of patent, trademark, trade secrets, confidentiality procedures andcontractual procedures to protect our intellectual property rights. If we are unable to adequatelyprotect our intellectual property, our business may suffer from the piracy of our technology andthe associated loss in revenue. Any patents that we may hold may not sufficiently protect ourintellectual property and may be challenged by third parties. Our efforts to protect ourintellectual property rights, may not prevent the misappropriation of our intellectual property.These infringement claims or any future claims could cause us to spend significant time and moneyto defend our intellectual property rights, redesign our products or develop or license asubstitute technology. We may be unsuccessful in acquiring or developing substitute technology andany required license may be unavailable on commercially reasonable terms, if at all. In the eventof litigation to determine the validity of any third party claims or claims by us against suchthird party, such litigation, whether or not determined in our favor, could result in
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significantexpense and divert the efforts of our technical and management personnel, regardless of the outcomeof such litigation. Furthermore, other parties may also independently develop similar or competingproducts that do not infringe upon our intellectual property rights.**We may be unable to consummate future potential acquisitions or investments or successfullyintegrate acquired businesses or investments or foreign operations with our business, which maydisrupt our business, divert management’s attention and slow our ability to expand the range of ourtechnologies and products.**     We intend to continue to expand the range of our technologies and products, and we may acquireor make investments in additional complementary businesses, technologies or products, ifappropriate opportunities arise. We may be unable to identify suitable acquisition or investmentcandidates at reasonable prices or on reasonable terms, or consummate future acquisitions orinvestments, each of which could slow our growth strategy. We have no prior history or experiencein investing in or acquiring and integrating complementary businesses and therefore may havedifficulties completing such transactions or realizing the benefits of such transactions, orthey may have a negative effect on our business. Such investments or acquisitions could require usto devote a substantial amount of time and resources and could place a significant strain on ourmanagement and personnel. To finance any acquisitions, we may choose to issue shares of our commonstock, which would dilute your interest in us. Any future acquisitions by us also could result insignificant write-offs or the incurrence of debt and contingent liabilities, any of which couldharm our operating results.**Item 3. Controls and Procedures**     (a) ***Evaluation of disclosure controls and procedures***. We maintain “disclosure controls andprocedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934,or the Exchange Act, that are designed to ensure that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed, summarized, andreported within the time periods specified in Securities and Exchange Commission rules and forms,and that such information is accumulated and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, or persons performing similar functions, asappropriate, to allow timely decisions regarding required disclosure. In designing and evaluatingour disclosure controls and procedures, management recognized that disclosure controls andprocedures, no matter how well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the disclosure controls and procedures are met. Our disclosurecontrols and procedures have been designed to meet reasonable assurance standards. Additionally, indesigning disclosure controls and procedures, our management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible disclosure controls andprocedures. The design of any disclosure controls and procedures also is based in part upon certainassumptions about the likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential future conditions.     Based on their evaluation as of the end of the period covered by this Quarterly Report on Form10-QSB, our Chief Executive Officer and Chief Financial Officer, or persons performing similarfunctions, have concluded that, as of that date, our disclosure controls and procedures wereeffective at the reasonable assurance level.     (b) ***Changes in internal control over financial reporting***. There was no change in our internalcontrol over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identifiedin connection with management’s evaluation during our last fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal control over financialreporting.**PART II — OTHER INFORMATION**
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**Item 3. Legal Proceedings**     From time to time, we are involved in various legal and other proceedings that are incidentalto the conduct of our business. We believe that none of these proceedings, if adversely determined,would have a material effect on our financial condition, results of operations or cash flows.     In June 2005, two of our former employees initiated arbitration against us alleging wrongfultermination and sought severance pay. Arbitration was held on March 28, 2006 and on June 19, 2006,the arbitrator ruled that each employee was entitled to $90,000 in severance pay, as well as costsand interest.**Item 6. Exhibits**     The exhibits listed below are required by Item 601 of Regulation S-B.   **Exhibit**  **Number** **Description of Document**10.1† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and John J. Figone (incorporated by reference to Exhibit 10.1 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.2† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and Terry E. Stepanik (incorporated by reference to Exhibit 10.2 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.3† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and Mario Villarreal (incorporated by reference to Exhibit 10.3 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.4† Employment Agreement dated and effective as of May 23, 2006 by and between US Dataworks,Inc. and Charles E. Ramey (incorporated by reference to Exhibit 10.1 to the Registrant’sCurrent Report on Form 8-K filed May 26, 2006).   31.1 Section 302 Certification of Chief Executive Officer.   31.2 Section 302 Certification of Chief Financial Officer or person performing similar functions.   32.1 Section 906 Certification of Chief Executive Officer.   32.2 Section 906 Certification of Chief Financial Officer or person performing similar functions. † Indicates management contract or compensatory plan or arrangement.
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**SIGNATURE**     In accordance with the requirements of the Exchange Act, the registrant caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.     Dated: August 14, 2006         US DATAWORKS, INC.           By /s/ John T. McLaughlin       John T. McLaughlin      Chief Accounting Officer      (Accounting Officer      and Duly Authorized Officer)  
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EXHIBIT INDEX   **Exhibit**  **Number** **Description of Document**10.1† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and John J. Figone (incorporated by reference to Exhibit 10.1 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.2† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and Terry E. Stepanik (incorporated by reference to Exhibit 10.2 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.3† Employment Agreement dated and effective as of April 3, 2006 by and between US Dataworks,Inc. and Mario Villarreal (incorporated by reference to Exhibit 10.3 to the Registrant’sCurrent Report on Form 8-K filed April 5, 2006).   10.4† Employment Agreement dated and effective as of May 23, 2006 by and between US Dataworks,Inc. and Charles E. Ramey (incorporated by reference to Exhibit 10.1 to the Registrant’sCurrent Report on Form 8-K filed May 26, 2006).   31.1 Section 302 Certification of Chief Executive Officer.   31.2 Section 302 Certification of Chief Financial Officer or person performing similar functions.   32.1 Section 906 Certification of Chief Executive Officer.   32.2 Section 906 Certification of Chief Financial Officer or person performing similar functions. † Indicates management contract or compensatory plan or arrangement.
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