UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


(Mark
One)




[x]
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the quarterly period ended June 30, 2008





OR





[_]
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from __________________ to __________________





Commission
File Number    0-17304





Cistera Networks,
Inc.


(Exact
name of registrant as specified in its charter)





Nevada
              (State
      or other jurisdiction of incorporation or organization)
            91-1944887
              (I.R.S.
      Employer Identification No.)





6509 Windcrest Drive, Suite
160, Plano,
Texas       75024


(Address
of principal executive
offices)               (Zip
Code)





972-381-4699


(Registrant's
telephone number, including area code)







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 whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer,” “accelerated filer” “non-accelerated
filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check one):




Large
      accelerated filer 
            
            Accelerated
      filer 
            
            Non-accelerated
      filer 
            
            Smaller
      reporting company ý







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




As of
August 19, 2008, 17,325,374 of the registrant’s stock, $0.001 par value per
share, were outstanding.







CISTERA
NETWORKS, INC & SUBSIDIARY




TABLE
OF CONTENTS









Explanatory
      Note
            2







PART
I: FINANCIAL INFORMATION




Item
      1.
            Financial
      Statements:Consolidated
      Balance Sheets – June 30, 2008 (unaudited) and March 31, 2008
      (audited)
            3Consolidated
      Statements of Operations – For the three months ended June 30, 2008and 2007 (unaudited)
            4Consolidated
      Statement of Stockholders’ Deficit – June 30, 2008 (unaudited) andMarch 31, 2008 (audited)
            5Consolidated
      Statements of Cash Flows – For the three months ended June 30, 2008and 2007 (unaudited)
            6Notes
      to Consolidated Financial Statements (unaudited)
            8Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            22Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            31Item
      4T.
            Controls
      and Procedures
            31


PART
II: OTHER INFORMATION




Item
      1.
            Legal
      Proceedings
            33Item
      1A.
            Risk
      Factors
            33Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            33Item
      3.
            Defaults
      Upon Senior Securities
            34Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            34Item
      5.
            Other
      Information
            34Item
      6.
            Exhibits
            34SIGNATURE
            
            35







1


EXPLANATORY NOTE





This
Quarterly Report on Form 10-Q (the “Report”) for the quarterly period ended June
30, 2008 includes a restatement of our consolidated financial statements for the
quarterly period ended June 30, 2007 (and related disclosures). The table below
summarizes the impact to the Statement of Operations:








Adjustments
      to Statements of OperationsConvertible
      Promissory Notes and Warrants
            
            
            Registration
      payment arrangements
            
            
            TotalThree
      months ended June 30, 2007
            
            $
            (370,715
            )
            
            $
            (166,465
            )
            
            $
            (537,180
            )Cumulative
      effect at April 1, 2007
            
            
            (1,288,668
            )
            
            
            -
            
            
            
            (1,288,668
            )Total
            
            $
            (1,659,383
            )
            
            $
            (166,465
            )
            
            $
            (1,825,848
            )





The
Company is restating its Consolidated Statements of Operations
and Consolidated Statements of Cash Flows for the three months ended
June 30, 2007 to reflect: (i) a correction in its accounting for its Senior
Unsecured Convertible Promissory Notes and detachable warrants issued in private
placements during the period from December 2004 to April 2007 (the “PP1 Notes,”
“PP1 Warrants,” “PP2 Notes” and “PP2 Warrants”) and (ii) a correction in its
accounting for registration payment arrangements associated with the
aforementioned securities.  The Company has concluded that its original
accounting for the PP1 Notes and PP1 Warrants issued in fiscal year 2005 and the
PP2 Notes and PP2 Warrants issued in fiscal years 2007 and 2008, including the
associated registration payments was incorrect, and that the necessary
adjustments were material to the consolidated financial statements as of and for
the three months ended June 30, 2007.





A further
discussion of the restatement of the consolidated financial statements for this
fiscal period is contained under “Part I, Item 2 – Management’s Discussion and
Analysis of Financial Condition and Results of Operations and in Note 3 to the
unaudited consolidated financial statements of this Report.








2


Part
I. FINANCIAL INFORMATION




Item
1. Financial Statements


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
BALANCE SHEET


(Unaudited)


June
      30, 2008
            
            
            March
      31, 2008Current
      assetsCash
      and cash equivalents
            
            $
            296,279
            
            
            $
            125,007Restricted
      cash
            
            
            50,000
            
            
            
            50,000Accounts
      receivable, net of allowance for doubtful accounts of $-0-
            
            
            176,726
            
            
            
            248,186Related
      party receivables
            
            
            13,337
            
            
            
            15,837Inventory
            
            
            194,013
            
            
            
            187,960Prepaid
      expenses
            
            
            32,663
            
            
            
            46,030Total
      current assets
            
            
            763,018
            
            
            
            673,020Property
      and equipment, net
            
            
            358,196
            
            
            
            355,411Intangible
      assets, net
            
            
            1,955,274
            
            
            
            2,023,218Total
      long-term assets
            
            
            2,313,470
            
            
            
            2,378,629TOTAL
      ASSETS
            
            $
            3,076,488
            
            
            $
            3,051,649Current
      liabilitiesAccounts
      payable
            
            $
            520,324
            
            
            $
            420,603Related
      party payables
            
            
            128,828
            
            
            
            129,702Accrued
      liquidated damages – outside investors
            
            
            177,024
            
            
            
            629,957Accrued
      liquidated damages – related parties
            
            
            -
            
            
            
            41,485Accrued
      liabilities
            
            
            1,184,329
            
            
            
            1,076,360Deferred
      revenue
            
            
            998,687
            
            
            
            971,474Current portion of long-term debt, net of discount
            
            
            725,714
            
            
            
            425,707Total
      current liabilities
            
            
            3,734,906
            
            
            
            3,695,288Convertible
      promissory notes – outside investors, net of discount
            
            
            -
            
            
            
            1,606,300Convertible
      promissory notes – related parties, net of discount
            
            
            -
            
            
            
            59,719Deferred
      revenue
            
            
            209,984
            
            
            
            225,917Other
      long-term liabilities
            
            
            38,651
            
            
            
            285,470Total
      long-term liabilities
            
            
            248,635
            
            
            
            2,177,406Total
      liabilities
            
            
            3,983,541
            
            
            
            5,872,694Commitments
      and Contingencies (Note 6)Stockholders’
      deficit:Preferred
      stock, $0.001 par value; 1,000,000 shares authorized;-0-
      shares issued and outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.001 par value; 50,000,000 shares authorized;15,992,625
      and 8,820,192 shares issued and outstanding, respectively
            
            
            15,992
            
            
            
            8,820Additional
      paid-in capital
            
            
            18,594,600
            
            
            
            13,764,517Accumulated deficit
            
            
            (19,517,645
            )
            
            
            (16,594,382
            )Total
      stockholders’ deficit
            
            
            (907,053
            )
            
            
            (2,821,045
            )TOTAL
      LIABILITIES AND STOCKHOLDERS’ DEFICIT
            
            $
            3,076,488
            
            
            $
            3,051,649





The
accompanying notes are an integral part of these consolidated financial
statements.


3


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF OPERATIONS


(Unaudited)


Three
      months endedJune
      30,2008
            
            
            2007As
      restatedRevenuesConvergence
      solutions
            
            $
            522,393
            
            
            $
            461,938Professional
      services
            
            
            60,708
            
            
            
            104,050Support
      and maintenance
            
            
            217,459
            
            
            
            113,799Total
      revenues
            
            
            800,560
            
            
            
            679,787Cost
      of revenuesConvergence
      solutions
            
            
            133,032
            
            
            
            139,656Professional
      services
            
            
            50,500
            
            
            
            46,875Support
      and maintenance
            
            
            23,184
            
            
            
            20,700Total
      cost of revenues
            
            
            206,716
            
            
            
            207,231Gross
      Profit
            
            
            593,844
            
            
            
            472,556Operating
      expensesSales
      and marketing
            
            
            296,006
            
            
            
            246,843Software
      development
            
            
            158,589
            
            
            
            129,035Engineering
      and support
            
            
            149,596
            
            
            
            70,782General
      and administrative
            
            
            429,149
            
            
            
            260,019Depreciation
      and amortization
            
            
            98,156
            
            
            
            80,936Total
      operating expenses
            
            
            1,131,496
            
            
            
            787,615Loss
      from operations
            
            
            (537,652
            )
            
            
            (315,059
            )Other
      income (expense)Interest
      income
            
            
            82
            
            
            
            9,589Interest
      expense
            
            
            (83,182
            )
            
            
            (73,424
            )Charge
      for inducements related to stock issued to convertible note
      holders
            
            
            (1,192,813
            )
            
            
            -Amortization
      of discount on convertible notes – outside investors
            
            
            (1,079,937
            )
            
            
            (361,034
            )Amortization
      of discount on convertible notes – related parties
            
            
            (41,060
            )
            
            
            (9,681
            )Credit
      (charge) for estimated liquidated damages
            
            
            11,299
            
            
            
            (251,176
            )Total
      other income (expense)
            
            
            (2,385,611
            )
            
            
            (685,726
            )Net
      loss
            
            $
            (
      2,923,263
            )
            
            $
            (
      1,000,785
            )Basic
      & diluted net loss per share
            
            $
            (0.31
            )
            
            $
            (0.12
            )Weighted
      average shares outstanding – basic and diluted
            
            
            9,421,126
            
            
            
            8,292,022





The
accompanying notes are an integral part of these consolidated financial
statements.


4


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENT OF STOCKHOLDERS' DEFICIT


(Unaudited)


Preferred
      Stock
            
            
            Common
      Stock
            
            
            Additional
      Paid-in Capital
            
            
            Accumulated
      Deficit
            
            
            Total
      Stockholders’ DeficitShares
            
            
            Amount
            
            
            Shares
            
            
            AmountBalances
      at March 31, 2008
            
            
            -
            
            
            $
            -
            
            
            
            8,820,192
            
            
            $
            8,820
            
            
            $
            13,764,517
            
            
            $
            (16,594,382
            )
            
            $
            (2,821,045
            )Stock
      issued from the conversionof convertible notes
            
            
            
            
            
            
            
            
            
            
            6,175,872
            
            
            
            6,176
            
            
            
            3,280,940
            
            
            
            
            
            
            
            3,287,116Stock
      issued from the exercise ofwarrants
            
            
            
            
            
            
            
            
            
            
            937,784
            
            
            
            938
            
            
            
            356,388
            
            
            
            
            
            
            
            357,326Stock
      issued for waiver ofregistration rights payments
            
            
            
            
            
            
            
            
            
            
            58,777
            
            
            
            58
            
            
            
            21,983
            
            
            
            
            
            
            
            22,041Inducement
      charges related toconversion of convertiblenotes and exercise of warrants
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,170,772
            
            
            
            
            
            
            
            1,170,772Net
      loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,923,263
            )
            
            
            (2,923,263
            )Balances
      at June 30, 2008
            
            
            -
            
            
            $
            -
            
            
            
            15,992,625
            
            
            $
            15,992
            
            
            $
            18,594,600
            
            
            $
            (19,517,645
            )
            
            $
            (907,053
            )





















































The
accompanying notes are an integral part of these consolidated financial
statements.


5


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(Unaudited)





Three
      months endedJune
      30,2008
            
            
            2007As
      restatedCASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
            
            $
            (2,923,263
            )
            
            $
            (1,000,785
            )Adjustments
      used to reconcile net loss to net cash used in operating
      activities:Charge
      for inducement to convert debt to convertible promissory
    notes
            
            
            1,170,772
            
            
            
            -Charge
      for stock issued for waiver of registration rights
payments
            
            
            22,041
            
            
            
            -Charge
      (credit) for liquidated damages
            
            
            (11,299
            )
            
            
            251,176Amortization
      of discount on convertible promissory notes
            
            
            1,120,997
            
            
            
            370,715Depreciation
      and amortization
            
            
            98,156
            
            
            
            80,935Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            73,960
            
            
            
            (307,097
            )Inventory
            
            
            (6,053
            )
            
            
            10,440Prepaid
      expenses
            
            
            13,367
            
            
            
            1,568Accounts
      payable
            
            
            98,847
            
            
            
            (100,812
            )Accrued
      liabilities
            
            
            183,010
            
            
            
            45,934Deferred
      revenue
            
            
            11,280
            
            
            
            219,761Other
      long-tem liabilities
            
            
            22,451
            
            
            
            -Net
      cash used in operating activities
            
            
            (125,734
            )
            
            
            (428,165
            )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment, net
            
            
            (32,997
            )
            
            
            (69,779
            )Net
      cash used in investing activities
            
            
            (32,997
            )
            
            
            (69,779
            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Increase
      in restricted cash
            
            
            -
            
            
            
            -Net
      borrowings (payments) on line of credit
            
            
            32,497
            
            
            
            (62,094
            )Net
      proceeds from issuance of convertible promissory notes
            
            
            -
            
            
            
            1,225,000Net
      proceeds from exercise of warrants
            
            
            304,014
            
            
            
            -Payments
      on convertible promissory notes and other loans
            
            
            (6,508
            )
            
            
            (61,000
            )Payments
      on other notes payable and capital lease
            
            
            -
            
            
            
            (1,007
            )Net
      cash provided by financing activities
            
            
            330,003
            
            
            
            1,100,899Net
      increase in cash and cash equivalents
            
            
            171,272
            
            
            
            602,955Cash
      and cash equivalents at beginning of period
            
            
            125,007
            
            
            
            534,871Cash
      and cash equivalents at end of period
            
            $
            296,279
            
            
            $
            1,137,826











The
accompanying notes are an integral part of these consolidated financial
statements.


6




CISTERA
      NETWORKS, INC. & SUBSIDIARY
              CONSOLIDATED
      STATEMENTS OF CASH FLOWS (continued)
              (Unaudited)Three
      months endedJune
      30,2008
            
            
            2007As
      restatedSUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash
      paid during the year for:Interest
            
            $
            105
            
            
            $
            9,798Income
      taxes
            
            
            -
            
            
            
            -SUPPLEMENTAL
      DISCLOSURE OF NON-CASH INVESTING ANDFINANCING
      ACTIVITIES:Conversion
      of convertible promissory notes and related accrued interest
      andaccrued
      liquidated damages to common stock
            
            $
            3,287,116
            
            
            $
            -Conversion
      of accounts payable and other accrued liabilities to
      convertibleto
      common stock
            
            
            53,312
            
            
            
            359,885Allocation
      of discount on convertible promissory notes to warrants
            
            
            -
            
            
            
            488,054Discount
      related to beneficial conversion feature on convertible
      promissorynotes
            
            
            -
            
            
            
            815,599OTHER
      NON-CASH TRANSACTIONS:Cumulative effect of
      change in accounting principle:Reclassification
      of warrants from derivative financial instruments to
equitysecurities
      (as valued at inception)
            
            
            -
            
            
            $
            2,730,824Accrued
      liquidated damages at April 1, 2007
            
            
            -
            
            
            
            289,518Reclassification
      of warrants from derivative financial instruments to
equitysecurities
      (as valued at April 1, 2007)
            
            
            -
            
            
            
            (2,265,227
            )Cumulative
      effect of change in accounting principle
            
            $
            -
            
            
            $
            755,115











































The
accompanying notes are an integral part of these consolidated financial
statements.


7
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


NOTE 1 – BASIS OF
PRESENTATION





The
accompanying unaudited consolidated financial statements of Cistera Networks,
Inc. (“Cistera” the “Company” or “we”) and its wholly-owned subsidiary have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission (“SEC”). All significant intercompany transactions and balances have
been eliminated in consolidation. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America (“US GAAP”) have
been condensed or omitted pursuant to such rules and regulations. In the opinion
of management, the unaudited consolidated financial statements have been
prepared on the same basis as the annual audited consolidated financial
statements, and reflect all adjustments, consisting only of normal, recurring
adjustments, necessary for a fair presentation in accordance with US GAAP. The
results of operations for interim periods presented are not necessarily
indicative of the operating results for the full year. These unaudited
consolidated financial statements should be read in connection with the
consolidated financial statements and notes thereto included in the Company’s
Annual Report on Form 10-KSB for the fiscal year ended March 31, 2008 (the “2008
10-KSB”).





Significant
Accounting Policies





The
Company prepares its financial statements in accordance with US GAAP. The
accounting policies most fundamental to understanding our financial statements
are those relating to recognition of revenue, our use of estimates and the
accounting for convertible debt and warrants. For a detailed discussion on the
application of these accounting policies, see Note 2 to our audited consolidated
financial statements contained in our 2008 10-KSB.





Recently
Issued Accounting Pronouncements





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 157, Fair Value Measurements(“SFAS 157”) which defines fair value, establishes a framework for
measurement and expands disclosure about fair value measurements. Where
applicable, SFAS 157 simplifies and codifies related guidance within generally
accepted accounting principles. The Company adopted SFAS 157 in the first
quarter of fiscal year 2009. As permitted by FASB Staff Position, FSP FAS 157-2,
the Company will adopt SFAS 157 for non-financial assets and liabilities
recognized on a non-recurring basis as of April 1, 2009. The adoption of SFAS
157 did not impact the Company’s results of operations, financial position or
cash flows. The Company is still evaluating the impact, if any, that adoption of
SFAS 157 in the first quarter of fiscal year 2010 for the remaining assets and
liabilities will have on the Company’s results of operations, financial position
or cash flows




In
February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities—Including an Amendment of FASB
Statement No. 115." SFAS 159 permits companies to measure many
financial instruments and certain other items at fair value at specified
election dates. Unrealized gains and losses on these items will be reported in
earnings at each subsequent reporting date. The fair value option may be applied
instrument by instrument (with a few exceptions), is irrevocable and is applied
only to entire instruments and not to portions of instruments. SFAS 159 is
effective for fiscal years beginning after November 15, 2007. We intend to
adopt the standard beginning in the first quarter of fiscal year 2010. We are
currently assessing the impact of SFAS 159 on our financial statements and
do not believe it will have a material impact.






In December 2007, the FASB issued SFAS No. 160,
“Non-Controlling Interests in Consolidated Financial Statements” (“SFAS 160”),
which requires all entities to report non-controlling (minority interests) in
subsidiaries with equity in the consolidated financial statements, but separate
from the parent stockholders' equity. We intend to adopt the standard beginning
in the first quarter of fiscal year 2010. We are currently evaluating the impact
of adopting SFAS 160 on our financial statements and do not believe it will
have a material impact.




8
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)




In
December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business
Combinations" ("SFAS 141R"), which replaces FASB Statement No. 141.
SFAS 141R establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any non-controlling interest in the acquiree
and the goodwill acquired. The Statement also establishes disclosure
requirements that will enable users to evaluate the nature and financial effects
of the business combination. We intend to adopt the standard beginning in the
first quarter of fiscal year 2010. We are currently evaluating the impact of
adopting SFAS 141R on our financial statements and do not believe it will
have a material impact.




Balance
Sheet Accounts





Accrued liabilities are
comprised of the following:




June
      30, 2008
            
            
            March
      31, 2008Accrued
      interest
            
            $
            142,975
            
            
            $
            88,375Reserve
      for litigation contingency
            
            
            650,000
            
            
            
            650,000Accrued
      compensation and payroll taxes
            
            
            338,345
            
            
            
            234,029Other
            
            
            53,009
            
            
            
            103,956$
            1,184,329
            
            
            $
            1,076,360





Other long-term liabilities
are comprised of the following:




Accrued
      interest
            
            $
            -
            
            
            $
            269,270Other
            
            
            38,651
            
            
            
            16,200$
            38,651
            
            
            $
            285,470





Loss
per Share





Basic
earnings (loss) per share is based on the weighted average number of common
shares outstanding.





Diluted
earnings (loss) per share is computed using the weighted average number of
common shares outstanding plus the number of common shares that would be issued
assuming exercise or conversion of all potentially dilutive common stock
equivalents.  The Company had approximately 6.5 million and 10.3
million potentially dilutive common stock equivalents (in the form of stock
options and stock purchase warrants) outstanding as of June 30, 2008 and 2007,
respectively. These potentially dilutive common stock equivalents have been
excluded from the diluted share calculations for the three months ended June 30,
2008 and 2007, respectively, as they were antidilutive as a result of the net
losses incurred for those periods. Accordingly, basic shares equal diluted
shares for all periods presented.




9
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Significant
Customers and Concentration of Credit Risk





The
following table shows significant customers as a percentage of accounts
receivable at June 30, 2008 and 2007 and as a percentage of revenue for the
three months ended June 30, 2008 and 2007.  A customer is included in
the table if they comprise 10% of either accounts receivable or revenue for
either 2008 or 2007.





Accounts
      receivable
            
            Revenue
      for the three monthsJune
      30,
            
            ended
      June 30,2008
            
            2007
            
            2008
            
            2007Customer
      A
            
            19.6%
            
            16.4%
            
            2.1%
            
            13.1%Customer
      B
            
            27.2%
            
            -%
            
            3.9%
            
            -%Customer
      C
            
            -%
            
            11.6%
            
            10.8%
            
            5.4%Customer
      D
            
            -%
            
            15.2%
            
            -%
            
            5.5%Customer
      E
            
            -%
            
            15.4%
            
            0.5%
            
            1.2%Customer
      F
            
            -%
            
            -%
            
            12.1%
            
            -%





Reclassifications





Certain
reclassifications have been made in the fiscal year 2008 financial statements to
conform to the fiscal year 2009 presentation.





NOTE
2 - FINANCIAL CONDITION





The
accompanying consolidated financial statements have been prepared in conformity
with US GAAP (except with regard to omission of certain disclosures within
interim financial statements, as permitted by the SEC), which contemplate our
continuation as a going concern and do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary if we were unable to
continue as a going concern. However, the report of our independent registered
public accounting firm on our consolidated financial statements, as of and for
the year ended March 31, 2008, contains an explanatory paragraph expressing
substantial doubt as to our ability to continue as a going concern. The “going
concern” explanatory paragraph resulted from, among other things, the
substantial losses from operations we have incurred since inception, our
liquidity position and the net loss of $5.2 million for the year ended March 31,
2008, which included non-cash charges of $1.9 million related to amortization of
discounts associated with our sale and issuance of Senior Unsecured Convertible
Promissory Notes in the fiscal years 2007 and 2008 (“the PP2 Notes”) and
negative working capital (current liabilities in excess of current assets) of
$3.0 million as of March 31, 2008.  In addition, we had a net loss of
$2.9 million for the three months ended June 30, 2008, which included non-cash
charges in the amount of $2.3 million related to the amortization of discounts
associated with the PP2 Notes and inducements related to the conversion of PP2
Notes and exercise of warrants issued with the PP1 Notes (“PP1 Warrants”) and
the exercise of warrants issued with the PP2 Notes (“PP2
Warrants”).  Also, as of June 30, 2008, we have negative working
capital (current liabilities in excess of current assets) of $3.0
million.





Accordingly,
as of June 30, 2008, the recoverability of a major portion of the recorded asset
amounts is dependent on our continuing operations, which in turn is dependent on
our ability to maintain our current financing arrangements and our ability to
become profitable in our future operations. These factors raise substantial
doubt about the Company’s ability to continue as a going concern. These
consolidated financial statements do not reflect adjustments that would be
necessary if the Company were unable to continue as a going
concern.





10
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


The
Company improved its liquidity through the execution of its Short Term
Investment Incentive Plan (the “STIIP”), which it completed in June and July of
2008, and which raised approximately $844,000 in cash from the exercises of
warrants and reduced debt, accrued interest and accrued liquidated damages by
approximately $3.2 million.  As of June 30, 2008, the Company had
received cash proceeds of approximately $304,000 from warrant
exercises.  In July 2008, the Company received additional cash
proceeds of approximately $540,000 from warrant exercises.  While
management believes that this action mitigates the substantial doubt about the
Company’s ability to continue as a going concern, the Company will need to
become profitable in the near future through generating higher revenues or
lowering operating costs, or a combination of the two.  The Company
will likely need to renegotiate the payment or conversion of the remaining
principal balance due on its PP2 Notes or raise additional capital, or a
combination of the two.  If we raise additional capital, it could be
in the form of equity or debt, or a combination of the two. There can be no
assurance that the Company will be successful in these endeavors or that the
cost savings or required new capital will be sufficient.





NOTE 3 – RESTATEMENT OF
PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS





The
Company has restated its Consolidated Statement of Operations and Statement of
Cash Flows for the three months ended June 30, 2007 to reflect a correction in
its accounting for its PP1 Notes, PP1 Warrants, PP2 Notes, and PP2
Warrants).  The Company intends to restate and refile its Annual
Report on Form 10-KSB for the fiscal year ended March 31, 2007 and restate and
refile its Quarterly Reports on Form 10-QSB for the periods ended June 30, 2007,
September 30, 2007 and December 31, 2007 in a reasonably practicable time
period.





In
addition, the Company has restated its Consolidated Statement of Operations and
Statement of Cash Flows for the three months ended June 30, 2007 to reflect a
correction in its accounting for registration payment arrangements as required
under FASB Staff Position No. 00-19-2, “Accounting for Registration Payment
Arrangements” (“FSP 00-19-2”).  FSP 00-19-02 was effective April 1,
2007 for the Company, and the Company incorrectly accounted for its registration
payment arrangements as of the effective date (which required the recording of a
cumulative effect of a change in accounting principle) and for the three months
ended June 30, 2007. See further discussion in Note 4.





The table
below summarizes the impact to the Consolidated Statement of
Operations:





Adjustments
      to Statements of OperationsConvertible
      Promissory Notes and Warrants
            
            
            Registration
      Payment Arrangements
            
            
            TotalThree
      months ended June 30 2007
            
            $
            (370,715
            )
            
            $
            (166,465
            )
            
            $
            (537,180
            )Cumulative
      effect at April 1, 2007
            
            
            (1,288,668
            )
            
            
            -
            
            
            
            (1,288,668
            )Total
            
            $
            (1,659,383
            )
            
            $
            (166,465
            )
            
            $
            (1,825,848
            )








11
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


The table
below summarizes the effect of the restatement adjustments on the Consolidated
Statement of Operations for the three months ended June 30,
2007:


As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedOther
      income (expense)Interest
      income
            
            $
            9,589
            
            
            $
            -
            
            
            $
            9,589Interest
      expense
            
            
            (158,135
            )
            
            
            84,711
            
            
            
            (73,424
            )Amortization
      of discount on convertible promissorynotes
            
            
            -
            
            
            
            (370,715
            )
            
            
            (370,715
            )Charge
      for estimated liquidated damages
            
            
            -
            
            
            
            (251,176
            )
            
            
            (251,176
            )Total
      other income (expense)
            
            
            (148,546
            )
            
            
            (537,180
            )
            
            
            (685,726
            )Net
      loss
            
            $
            (463,605
            )
            
            $
            (537,180
            )
            
            $
            (1,000,785
            )Basic
      & diluted net loss per share
            
            $
            (0.06
            )
            
            $
            (0.06
            )
            
            $
            (0.12
            )Weighted
      average shares outstanding–
      basic and diluted
            
            
            8,292,022
            
            
            
            
            
            
            
            8,292,022





The table
below summarizes the effect of the restatement adjustments on the Consolidated
Balance Sheet as of June 30, 2007:


As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedCurrent
      liabilities:Accounts
      and related party payables
            
            $
            381,089
            
            
            $
            -
            
            
            $
            381,089Accrued
      liquidated damages
            
            
            -
            
            
            
            540,694
            
            
            
            540,694Accrued
      liabilities
            
            
            444,716
            
            
            
            (84,711
            )
            
            
            360,005Deferred
      revenue
            
            
            654,996
            
            
            
            
            
            
            
            654,996Current
      portion of long-term debt, net of discount
            
            
            95,408
            
            
            
            
            
            
            
            95,408Total
      current liabilities
            
            
            1,576,209
            
            
            
            455,983
            
            
            
            2,032,192Convertible
      promissory notes, net of discount
            
            
            3,485,491
            
            
            
            (2,596,149
            )
            
            
            889,342Deferred
      revenue
            
            
            114,912
            
            
            
            
            
            
            
            114,912Total
      long-term liabilities
            
            
            3,600,403
            
            
            
            (2,596,149
            )
            
            
            1,004,254Total
      liabilities
            
            
            5,176,612
            
            
            
            (2,140,166
            )
            
            
            3,036,446Stockholders’
      equity (deficit):Preferred
      stock
            
            
            -
            
            
            
            
            
            
            
            -Common
      stock
            
            
            8,292
            
            
            
            
            
            
            
            8,292Additional
      paid-in capital
            
            
            8,739,970
            
            
            
            4,820,830
            
            
            
            13,560,800Cumulative
      effect of adoption of FSP 00-19-2
            
            
            -
            
            
            
            (755,115
            )
            
            
            (755,115
            )Accumulated deficit
            
            
            (9,662,085
            )
            
            
            (1,925,549
            )
            
            
            (11,587,634
            )Total
      stockholders’ equity (deficit)
            
            
            (913,823
            )
            
            
            2,140,166
            
            
            
            1,226,343TOTAL
      LIABILITIES AND STOCKHOLDERS’EQUITY
      (DEFICIT)
            
            $
            4,262,789
            
            
            $
            -
            
            
            $
            4,262,789


12
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


The table
below summarizes the effect of the restatement adjustments as well as the
correction in errors in the reporting of components of cash flows from
operations and cash flows from financing activities on the Consolidated
Statement of Cash Flows for the three months ended June 30, 2007:





Cash flows restatement
      tableAs
      previously reported
            
            
            Adjustments
            
            
            As
      restatedCASH
      FLOWS FROM OPERATING ACTIVITIESNet
      loss
            
            $
            (463,605
            )
            
            $
            (537,180
            )
            
            $
            (1,000,785
            )Adjustments
      used to reconcile net loss to net cash used inoperating
      activities:Charge
      for estimated liquidated damages
            
            
            -
            
            
            
            251,176
            
            
            
            251,176Amortization
      of discount on convertible promissory notes
            
            
            -
            
            
            
            370,715
            
            
            
            370,715Depreciation
      and amortization
            
            
            80,936
            
            
            
            (1
            )
            
            
            80,935Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            (307,094
            )
            
            
            (3
            )
            
            
            (307,097
            )Inventory
            
            
            10,440
            
            
            
            
            
            
            
            10,440Prepaid
      expenses
            
            
            1,568
            
            
            
            
            
            
            
            1,568Accounts
      payable
            
            
            (176,745
            )
            
            
            75,933
            
            
            
            (100,812
            )Accrued
      interest
            
            
            -
            
            
            
            (24,090
            )
            
            
            (24,090
            )Other
      accrued liabilities
            
            
            (153,307
            )
            
            
            223,331
            
            
            
            70,024Deferred
      revenue
            
            
            219,758
            
            
            
            3
            
            
            
            219,761Net
      cash used in operating activities
            
            
            (788,049
            )
            
            
            359,884
            
            
            
            (428,165
            )Net
      cash used in investing activities
            
            
            (69,780
            )
            
            
            1
            
            
            
            (69,779
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      proceeds from issuance of convertible promissory notes
            
            
            1,584,885
            
            
            
            (359,885
            )
            
            
            1,225,000Payments
      on convertible promissory notes and other loans
            
            
            (61,000
            )
            
            
            
            
            
            
            (61,000
            )Net
      payments on line of credit
            
            
            (62,094
            )
            
            
            
            
            
            
            (62,094
            )Payments
      on capital lease
            
            
            (1,007
            )
            
            
            
            
            
            
            (1,007
            )Net
      cash provided by financing activities
            
            
            1,460,784
            
            
            
            (359,885
            )
            
            
            1,100,899Net
      increase (decrease) in cash and cash equivalents
            
            
            602,955
            
            
            
            
            
            
            
            602,955Cash
      and cash equivalents at beginning of year
            
            
            534,871
            
            
            
            
            
            
            
            534,871Cash
      and cash equivalents at end of year
            
            $
            1,137,826
            
            
            $
            -
            
            
            $
            1,137,826


13
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)





Cash
      flowsrestatement
      table
              (continued)As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedSUPPLEMENTAL
      DISCLOSURE OF NON-CASHINVESTING
      AND FINANCING ACTIVITIES:Conversion
      of accounts payable and other accrued liabilities toconvertible
      promissory notes
            
            $
            -
            
            
            $
            359,885
            
            
            $
            359,885Allocation
      of discount on convertible promissory notes toderivative
      financial instruments - warrants
            
            
            -
            
            
            
            488,054
            
            
            
            488,054Discount
      related to beneficial conversion feature on convertiblepromissory
      notes
            
            
            -
            
            
            
            815,599
            
            
            
            815,599OTHER
      NON-CASH TRANSACTIONS:Cumulative effect of
      change in accounting principle(a):Reclassification
      of warrants from derivative financialinstruments
      to equity securities (as valued at inception)
            
            $
            -
            
            
            $
            2,730,824
            
            
            $
            2,730,824Accrued
      liquidated damages at April 1, 2007
            
            
            -
            
            
            
            289,518
            
            
            
            289,518Reclassification
      of warrants from derivative financialinstruments
      to equity securities (as valued at April 1, 2007)
            
            
            -
            
            
            
            (2,265,227
            )
            
            
            (2,265,227
            )Cumulative
      effect of change in accounting principle
            
            $
            -
            
            
            $
            755,115
            
            
            $
            755,115(a)
      Relates to the adoption of FSP 00-19-2





Convertible Promissory Notes
and Warrants





The
Company concluded that its original accounting for the PP1 Notes and PP1
Warrants issued in fiscal year 2005 and the PP2 Notes and PP2 Warrants issued in
fiscal year 2007 and fiscal year 2008 was incorrect and that the necessary
adjustments were material to the fiscal year 2007 and 2008 consolidated
financial statements.





The
Company based its conclusion upon a further review of the documents associated
with the Notes and Warrants and considered the following sources as relevant
guidance in determining the proper accounting treatment for the Notes and
Warrants.





·
            SFAS
      133, Accounting for
      Derivative Instruments and Hedging Activities(“SFAS
      133”),


·
            APB
      Opinion 14, Accounting
      for Convertible Debt and Debt Issued with Stock Purchase Warrants
      (“APB 14”),


·
            Emerging
      Issues Task Force (EITF) Issue 00-19, Accounting for Derivative
      Financial Instruments Indexed to, and Potentially Settled in, a Company’s
      Own Stock(“EITF 00-19”),


·
            EITF
      05-2,The Meaning of
      “Conventional Convertible Debt Instrument”(“EITF
      05-2”),


·
            EITF
      98-5, Accounting for
      Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Ratios (“EITF
  98-5”),


·
            EITF
      00-27, Application of
      Issue No. 98-5 to Certain Convertible Instruments (“EITF
      00-27”),


·
            SEC
      Staff Accounting
      Bulletin No. 107(“SAB 107”)





14
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Conversion Feature of the
Notes





The
Company concluded that the Notes met the definition of “conventional convertible
debt” (as defined in EITF 00-19 and affirmed in EITF 05-2), and therefore the
conversion feature did not meet the definition of a derivative under SFAS 133
and was not bifurcated from the debt host instrument.





Valuation of the Notes and
Warrants and Beneficial Conversion Feature





We
accounted for the fair value of both the Notes and the Warrants under the
requirements of EITF 98-5 and EITF 00-27 and allocated the respective relative
fair value percentages of each in determining the initial values of the Notes
and the Warrants.  Any value attributed to the Warrants was recorded
as a discount on the Notes which is amortized over the life of the
Notes.  Because the Warrants were determined to be derivative
liabilities (see conclusion in next section below), the Company recorded them at
the full fair value as calculated under the Black-Scholes option pricing model
(“BS model”).  After determining the recorded value of the Warrants
and Notes (if any), we calculated the beneficial conversion feature of the
Notes, which resulted in an additional debt discount which was amortized over
the life of the Notes.





Classification and
Accounting for the Warrants





We
evaluated the Warrants as a potential free standing derivative under the
criteria in paragraph 11(a) of SFAS 133, which require that a contract
(Warrants) issued by a reporting entity be accounted for as a derivative unless
it is both (1) indexed to its own stock and (2) classified in stockholders’
equity in its statement of financial position. We concluded that the Warrants
were indexed to the Company’s own stock and should be classified in
stockholders’ equity and would qualify for the scope exception contained in this
paragraph.  The Company was required to further review the
requirements for equity classification contained in paragraphs 12-32 of EITF
00-19.  The Company concluded that it had not met criteria (2) above
based on the requirements for equity classification in EITF
00-19.  Specifically, both the PP1 and PP2 Notes contain registration
rights agreements (the “RR agreements”) that stipulate that the Company must
register all “registrable securities” (defined as the “shares of Common Stock
issuable upon conversion of the Notes and the shares of Common Stock issuable
upon exercise of the Warrants”) within a time frame (and this was deemed to be
outside of the control of the Company).  In the event of not filing a
registration statement by a specified date or by not having a registration
effective by a specified date, the Company was obligated to pay liquidated
damages in the amount of 1% of the then current outstanding amount of the Notes
plus accrued interest.  The Company accrued all required liquidated
damages, beginning in FY 2005 with the PP1 Notes. Liquidated damages required
under the RR Agreement for the PP1 Notes ceased on September 25, 2005, which was
the date that the Company filed its initial registration statement for the PP1
Notes and PP1 Warrants.





Accordingly,
the Company concluded that the Warrants did not satisfy the requirement for
equity classification and should be classified, recorded and prospectively
accounted for as derivative liabilities until it had registered all underlying
shares to the Warrants or until such time that the RR agreements are no longer
in effect.  The prospective accounting required that the Warrants be
remeasured at each balance sheet date based on estimated fair value and any
resultant changes in fair value be recorded to the Statement of
Operations.





The
Company used the BS model for calculating the fair value of all Warrants issued
based on the following assumptions:





Warrants
      issued in PP1
            
            Warrants
      issued in PP2Expected
      volatility
            128%
            
            100%-104%Expected
      term
            5
      years
            
            5
      yearsRisk-free
      interest rate
            3.58%
      - 4.33%
            
            4.46%
      - 4.65%Expected
      dividend yield
            0%
            
            0%





15
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


We
estimated volatility primarily based on historical volatility rates through the
date of each closing of the PP1 and PP2 offerings. The Warrants have a
transferability provision and based on guidance provided in SAB 107 for options
issued with such a provision, we used the full, five-year contractual term as
the expected term in the initial valuation of the Warrants.  For the
risk-free interest rate, we used the five year U.S. Treasury zero coupon rate
for the initial valuation of the Warrants.  Expected volatilities,
expected terms and risk-free interest rates were adjusted as of each quarterly
period commensurate with the remaining contractual lives of the Warrants on such
dates and were used to determine the estimated fair value of the Warrants under
the BS model.





NOTE 4 – DEBT





As of
June 30, 2008, the Company had $989,071 of gross principal, accrued interest of
$142,975 and accrued liquidated damages of $177,024 outstanding on its PP1 Notes
and PP2 Notes.  The Notes bear interest at an annual rate of 8%,
compounded quarterly.





PP1
Notes





The
outstanding principal and accrued interest are convertible into shares of common
stock at a conversion rate equal to the lesser of (a) $1.30 per share, or (b) a
25% discount to the average closing bid price of the Company’s common stock for
the five days including and immediately preceding the interest compounding date,
provided that in no event shall the conversion price per share be less than
$1.00 per share.  The PP1 Notes may be converted, in whole or in part,
at the option of the PP1 Note holder on any interest compounding
date.





In
addition, if the Company subsequently issues or sells any new securities
convertible, exercisable or exchangeable into shares of our common stock
(“convertible securities”) in a private transaction and receives gross proceeds
of at least $500,000, the PP1 Notes may be converted, in whole or in part at the
option of the note holders, into the convertible securities, upon the same terms
and conditions governing the issuance of the convertible securities in the
private transaction.  The right of the PP1 Note holders to convert
their notes into convertible securities does not apply to any convertible
securities issued by the Company (a) in connection with a merger, acquisition or
consolidation of the Company, (b) in connection with strategic license
agreements and other partnering arrangements so long as such issuances are not
for the purpose of raising capital, (c) in connection with bona fide firm
underwritten public offerings of its securities, (d) pursuant to the Company’s
incentive and stock option plans, (e) as a result of the exercise of options or
warrants or conversion of convertible notes or preferred stock which were
granted or issued as of December 13, 2004.





The PP1
Warrants have a term of five years and are exercisable at an exercise price of
$1.30 per share.  Subject to an effective registration statement
covering the resale of the shares of common stock issuable upon exercise of the
PP1 Warrants, the Company may, upon thirty days prior written notice, redeem the
PP1 Warrants for $0.10 per share, in whole or in part, if our common stock
closes with a bid price of at least $3.50 for any ten (10) out of fifteen (15)
consecutive trading days.





As stated
in Note 3, the Company has restated its consolidated financial statements for
the three months ended June 30, 2007 for the accounting it originally applied in
the initial valuation and recording of the PP1 Notes.  The restatement
impact on the June 30, 2007 quarter is related to the amortization of the
discount associated with the PP1 Notes.  See specific accounting
treatment in Note 3.





PP2
Notes





The PP2
Notes bear interest at the rate of 8% per annum, compounded quarterly on each
March 31, June 30, September 30 and December 31 anniversary that they are
outstanding (each, an interest compounding date).  The outstanding
principal and all accrued interest become due and payable two years from the
date of the PP2 Notes.  The outstanding principal and accrued interest
are convertible into shares of common stock at a fixed rate of $0.75 per
share.  The PP2 Notes may be converted, in whole or in part, at the
option of the PP2 Note holder on any interest compounding date.


16
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


In
addition, if the Company subsequently issues or sells any new securities
convertible, exercisable or exchangeable into shares of our common stock
(“convertible securities”) in a private transaction and receives gross proceeds
of at least $500,000, the PP2 Notes may be converted, in whole or in part at the
option of the note holders, into the convertible securities, upon the same terms
and conditions governing the issuance of the convertible securities in the
private transaction.  The right of the PP2 Note holders to convert
their notes into convertible securities does not apply to any convertible
securities issued by the Company (a) in connection with a merger, acquisition or
consolidation of the Company, (b) in connection with strategic license
agreements and other partnering arrangements so long as such issuances are not
for the purpose of raising capital, (c) in connection with bona fide firm
underwritten public offerings of its securities, (d) pursuant to the Company’s
incentive and stock option plans, (e) as a result of the exercise of options or
warrants or conversion of convertible notes or preferred stock which were
granted or issued as of December 13, 2004.





The
Company may prepay the PP2 Notes in whole or in part, upon thirty days prior
written notice to note holders; provided that partial prepayments may be made
only in increments of $10,000 and, provided further, that the PP2 Note holders
may convert the amount of the proposed prepayment into shares of our common
stock at any time.





The PP2
Warrants have a term of five years and are exercisable at an exercise price of
$1.00 per share.  Subject to an effective registration statement
covering the resale of the shares of common stock issuable upon exercise of the
PP2 Warrants, the Company may, upon thirty days prior written notice, redeem the
PP2 Warrants for $0.10 per share, in whole or in part, if our common stock
closes with a bid price of at least $3.50 for any ten (10) out of fifteen (15)
consecutive trading days.





As stated
in Note 3, the Company has restated its consolidated financial statements for
the three months ended June 30, 2007 for the accounting it originally applied in
the initial valuation and recording of the PP2 Notes.  The restatement
impact on the June 30, 2007 quarter is related to the amortization of the
discount associated with the PP2 Notes.  See specific accounting
treatment in Note 3.





Short Term Investment
Incentive Plan (“STIIP”)





Under the
STIIP, which commenced on June 9, 2008, the Company temporarily modified the
terms of its outstanding PP1 Notes, PP2 Notes, PP1 Warrants and PP2 Warrants.
During the period beginning June 9, 2008 through June 24, 2008 (the “Conversion
Period”), the conversion price of the PP1 Notes and PP2 Notes, which were $1.00
and $0.75 per share, respectively, were reduced to $0.53 per share. In addition,
the exercise price for the PP1 Warrants and the PP2 Warrants, which were $1.30
and $1.00 per share, respectively, were reduced to $0.40 per
share.  As of June 30, 2008, certain PP2 Note holders converted
$3,240,290, comprised of $2,470,156 in principal and $770,134 in accrued
interest and liquidated damages into approximately 6.2 million shares of the
Company’s common stock at the reduced conversion price. Also as of June 30,
2008, certain PP1 and PP2 Warrant holders exercised 757,409 PP1 and PP2 Warrants
at an exercise price of $0.40 per share.  All PP1 and PP2 Warrant
holders who exercised their warrants also received three additional warrants
(the “Bonus Warrants”) for every ten warrants exercised.  The Bonus
Warrants were exercisable through June 24, 2008 at an exercise price of $0.30
per share, and if not exercised on or before such date, the exercise price for
such Bonus Warrants was increased to $0.60 per share.  As of June 30, 2008,
a total of 180,375 Bonus Warrants were exercised at $0.30 per share.  The
bonus warrants were valued using the BS model and a charge was recorded with a
corresponding credit to additional paid-in capital in the amount of $36,125 for
the three months ended June 30, 2008.  The bonus warrants expire on
April 6, 2012.




As of
June 30, the total cash proceeds received from the exercises of the PP1, PP2 and
Bonus Warrants was approximately $304,000.  In July 2008, a total of
approximately 1.4 million additional PP1, PP2 and Bonus Warrants were exercised
at the reduced prices, generating additional cash proceeds of approximately
$540,000.




17
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Due to
the reduction in the conversion prices of the Notes and in accordance with FASB
Statement No. 84, “Induced Conversions of Convertible Debt an amendment of APB
Opinion No. 26” (“SFAS 84”), the Company calculated and recorded an inducement
charge and a corresponding credit to additional paid-in capital for the three
months ended June 30, 2008 in the amount of $931,893 for the fair value of
common stock issued based on the reduced price in excess of the fair value of
the common stock issuable pursuant to the original conversion
price.




For the
three months ended June 30, 2008 and 2007, the Company recorded $1,120,997 and
$370,715 respectively, of amortization of debt discounts associated with the PP2
Notes.  For the three months ended June 30, 2008 the total
amortization charge included $747,357 for the write-off of unamortized debt
discounts related to the conversion of $2,470,156 in principal of PP2 Notes
under the Company’s STIIP.




The
Company accounted for the reduction in the exercise price of the Warrants in
accordance with the guidance in SFAS 123(R), “Share-based payment” (“SFAS 123R”)
and FASB Staff Position No. FSP FAS 123(R)-6, “Technical Corrections of FASB
Statement No. 123(R)” for a modification due to a short-term
inducement.  Accordingly, the Company recorded a charge and a
corresponding credit to additional paid-in capital for the three months ended
June 30, 2008 in the amount of $202,743 for the difference between the fair
value of the Warrants immediately before and after the modification multiplied
by the number of Warrants that were exercised during the Conversion Period of
the STIIP.  The fair values of the Warrants were calculated using a BS
model.




Line
of Credit




On May
18, 2007, the Company secured a line of credit with JPMorgan Chase Bank in the
amount of $50,000.  The line of credit carries an interest rate of
prime plus one half point.  The line of credit is secured with a
deposit guarantee of $50,000.  At June 30, 2008, the total amount
outstanding on this line of credit was $50,000.




The
Company’s total debt as of June 30, 2008, all of which is current, is as
follows:











Line
      of credit
            
            $
            50,000PP1
      Notes:Principal
            
            
            64,495Accrued
      interest
            
            
            30,04194,536PP2
      Notes:Principal
            
            
            924,576Accrued
      interest
            
            
            112,934Less:
      unamortized discount
            
            
            (313,357
            )724,153Accrued
      liquidated damages
            
            
            177,024Total
            
            $
            1,045,713





18
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Registration Payment
Arrangements





On
December 21, 2006, the EITF issued FASB Staff Position No. 00-19-2 (“FSP
00-19-2”).  FSP 00-19-2 was effective immediately for registration
payment arrangements and the financial instruments subject to those arrangements
that were entered into or modified subsequent to the date of issuance of this
FSP. For registration payment arrangements and financial instruments subject to
those arrangements that were entered into prior to the issuance of this FSP, the
FSP was effective for financial statements issued for fiscal years beginning
after December 15, 2006, and interim periods within those fiscal
years.  Effective April 1, 2007, the Company adopted FSP 00-19-2,
which was applicable to the accounting for the liquidated damages on the PP2
Notes.





FSP
00-19-2 required the Company to account for contingent liquidated damages
separately from the financial instruments to which they relate, which were the
Notes and Warrants issued and sold in the PP1 and PP2
offerings.  Prior to the adoption of FSP-00-19-2, the Company
accounted for the Warrants as derivative liabilities based on the requirement of
the Company to register all underlying shares to the Notes and the
Warrants.  The Company concluded that with the separate accounting
required under FSP 00-19-2 for the liquidated damages, the Warrants by
themselves were properly classified as equity securities (having met all
requirements of EITF 00-19 for equity classification) as of the adoption
date.





Under FSP
00-19-2, the Company is required to estimate and record a contingent liability
if the likelihood is probable that it will pay liquidated damages in future
periods, calculated in accordance with the SFAS 5, “Accounting for
Contingencies” (“SFAS 5”) and FASB Interpretation No. 14, “Reasonable Estimation
of the Amount of a Loss.”  Further, FSP 00-19-2 requires that “the
financial instrument(s) subject to the registration payment arrangement shall be
recognized and measured in accordance with other applicable GAAP (for example
SFAS 133 and EITF 00-19) without regard to the contingent obligation to transfer
consideration pursuant to the registration payment arrangement.” Accordingly, on
the date of adoption, the Company accounted for the Warrants separately from the
liquidated damages obligations.





Based on
the above requirements, the Company recorded a cumulative effect of an
accounting change entry (i.e., a charge to the beginning balance of the
accumulated deficit) as of April 1, 2007 for the combination of:  1)
the reclassification of the Warrants from derivative liabilities to equity
securities, and 2) a contingent liability for probable future payment of
liquidated damages (based on the Company’s best estimate as of the date of
adoption, which is through March 31, 2008).  The amount of the
contingent liability recorded was approximately $289,000.  Also, as
part of the cumulative effect of an accounting change entry, the Company
reclassified the Warrants from derivative liabilities to equity
securities.  The difference between the Warrants as measured on the
date of adoption and their original recorded value was included in the charge to
the beginning balance of the Accumulated deficit.  This amount was
approximately $466,000.  The total of the cumulative effect of this
accounting change was $755,000.





On April
5, 2007, the Company closed the balance of its PP2 offering and, in accordance
with FSP 00-19-2, recorded a contingent liability and related charge to the
consolidated Statement of Operations for estimated liquidated damages related to
this funding through March 31, 2008.  The amount recorded was
$251,176.





The
Company evaluated the contingent liability for liquidated damages at June 30,
September 30 and December 31, 2007 and concluded that the facts and
circumstances had not changed as to the appropriateness of the March 31, 2008
date.  As of March 31, 2008, the Company was in substantial
discussions with a majority of investors to convert their Notes, exercise their
Warrants and remove the registration requirements of the underlying shares to
the Notes and Warrants.  As a result, as of March 31, 2008, the
Company concluded that it was probable that it would execute an agreement under
these terms and estimated and recorded an additional contingent liability and
related charge for liquidated damages through June 30, 2008.





19
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


As of
March 31, 2008, the Company estimated and accrued $671,342 related to liquidated
damages related to the PP2 Notes and concluded that this amount was the maximum
pay-out required.  On June 24, 2008, the Company executed agreements
with certain investors comprising approximately 70% of the original principal
investment of PP2 to convert their outstanding Notes at a reduced price of
$0.53.  On June 30, 2008, the Company executed an agreement with the
institutional investor in the PP2 offering that had the contractual right to
liquidated damages.  In exchange for the waiver from the investor, the
Company issued to the investor 58,777 shares of its common stock. The agreement
terminated any assessment of liquidated damages beyond June 24, 2008. For the
three months ended June 30, 2008, the Company recorded a charge and credit to
additional paid-in capital for the fair value of these shares issued in the
amount of $22,041.





The table
below summarizes the cumulative effect entry recorded as of April 1, 2007 for
the adoption of FSP 00-19-2:





Accumulated
      deficit, April 1, 2007 (as restated)
            
            $
            (10,586,847
            )Adjustments
      for the cumulative effect of the change in accounting
      principle:Contingent
      liability recorded for estimated liquidated damages
            
            
            (289,518
            )Reclassification
      of Warrants from derivative liabilities to equity
    securities
            
            
            (465,597
            )Total
      adjustments
            
            
            (755,115
            )Accumulated
      deficit, April 1, 2007, as adjusted
            
            $
            (11,341,962
            )





NOTE 5 – STOCKHOLDERS’
DEFICIT





On April
21, 2008, a PP2 Note holder converted $46,613 of principal amount, accrued
interest and accrued liquidated damages related to a PP2 Note into 62,150 shares
of common stock





Under the
STIIP and on June 24, 2008 (the “Effective Date”), certain PP2 Note holders
converted their PP2 Notes in the principal amount of $2,479,167 plus accrued
interest and accrued liquidated damages of $770,134 at a reduced conversion
price of $0.53 per common share in exchange for 6,113,872 shares of the
Company’s common stock.  Additionally, on the Effective Date, certain
PP1 and PP2 Warrant holders exercised their PP1 and PP2 Warrants, respectively,
at a reduced exercise price of $0.40 in exchange for 430,109 shares of the
Company’s common stock.  Further, each Warrant holder received three
bonus warrants for every ten PP1 or PP2 Warrants that were exercised and 507,675
of these bonus warrants were exercised at $0.30 per share.  The
remaining unexercised bonus warrants were exercisable at a price of $0.60
through April 6, 2012.





As
discussed in Note 4 and for the three months ended June 30, 2008, the Company
recorded a charge and a corresponding credit to paid-in capital in the amount of
$1,170,772 for inducements related to the conversions of the PP2 Notes and the
exercises of the PP1 and PP2 Warrants.





20
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


NOTE 6 – COMMITMENTS AND
CONTINGENCIES





The
Company and certain of its current and former officers and directors are
defendants in litigation pending in Dallas, Texas, styled KINGDON R. HUGHES VS.
GREGORY T. ROYAL, CYNTHIA A. GARR, JAMES T. MILLER, JR., CHARLES STIDHAM, CNH
HOLDINGS COMPANY D/B/A CISTERA NETWORKS AND XBRIDGE SOFTWARE, INC.; Cause No.
DV05-0600-G; G-134th District Court, Dallas County, Texas.  The
plaintiff has alleged a number of complaints against the defendants, including
breach of fiduciary duty, misappropriation of corporate opportunities, fraud,
fraudulent inducement, breach of contract, tortuous interference with contract,
fraudulent transfer, and shareholder oppression arising in connection with the
license agreement between the Company and XBridge in May 2003 and the
acquisition of XBridge by the Company in May 2005.  The parties held a
mediation conference in April 2006 and have come to an understanding with
respect to the principle elements of a potential settlement.




We are
currently in the process of negotiating definitive settlement agreements. In
accordance with SFAS 5, “Accounting for Contingencies” (“SFAS 5”), we recorded a
contingent liability in the amount of $650,000 as of March 31, 2008 related to
the outstanding litigation.  As of June 30, 2008, the Company believes
that this amount represents the best estimate of a potential
settlement.




NOTE 7 - RELATED PARTY
TRANSACTIONS





On April
5, 2007, the Company issued PP2 Notes to the Company’s CEO and director, Derek
Downs, and the Company’s Chief Technology Officer and director, Greg Royal for
accrued, but unpaid base salary due to each as of this date.  On June
24, 2008, both individuals converted their PP2 notes plus accrued interest as
part of the STIIP.  Mr. Downs and Mr. Royal converted $38,940 and
$91,871, respectively into 73,471 and 173,341 shares of our common stock at a
conversion price of $0.53.  After this conversion, the Company no
longer had any indebtedness with either Mr. Downs or Mr. Royal.


21


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





FORWARD-LOOKING
STATEMENTS





This
report contains “forward-looking statements” within the meaning of the Private
Securities Litigation Reform Act of 1995. In many but not all cases you can
identify forward-looking statements by words such as “anticipate,”
“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,”
“should,” “will” and “would” or the negative of these terms or other similar
expressions.  These forward-looking statements include statements regarding
our expectations, beliefs, or intentions about the future, and are based on
information available to us at this time. We assume no obligation to update any
of these statements and specifically decline any obligation to update or correct
any forward-looking statements to reflect events or circumstances after the date
of such statements or to reflect the occurrence of anticipated or unanticipated
events. Actual events and results could differ materially from our expectations
as a result of many factors, including those identified in this report. We urge
you to review and consider those factors, and those identified from time to time
in our reports and filings with the SEC, for information about risks and
uncertainties that may affect our future results. All forward-looking statements
we make after the date of this filing are also qualified by this cautionary
statement and identified risks. Additional risk factors are discussed in our
Annual Report on Form 10-KSB for the fiscal year ended March 31, 2008 and our
other reports filed with the SEC, to which reference should be
made.





Executive Summary and Recent
Business Developments





We have
continued to prepare for growth by taking steps to enhance corporate governance,
especially in the finance and accounting area.  With the changes made
this quarter, we believe that we are better positioned to meet the reporting and
disclosure requirements in a timely manner for future filings.





We booked
our largest sale to date this quarter to a state in the Midwestern
U.S.  During the second fiscal quarter of fiscal year 2009, we
invoiced and recognized revenue on this order.  The customer paid
approximately $800,000 to one of our value-added resellers for the Cistera
solution, and Cistera received payment from the reseller partner for an amount
less the reseller discount.   We believe that this transaction
confirms the increasing demand for the Company’s Event Alerting &
Notification and Quality Assurance & Compliance solutions in the public
sector—defined as state and local government and
education.  We have focused marketing and sales efforts on this
industry segment, and have built up a large customer installed base over the
years with state and local governments and educational
institutions.





We have
continued to support and benefit from Cisco’s Industry Solutions Partner Network
(ISPN) program and the incentives it provides for our Resellers to promote and
incorporate third-party applications such as ours into their
deployments.  Capitalizing on this sales channel opportunity has been
a major focus for the past several quarters, and that focus is now paying
off.  We have realized a number of opportunities and new relationships
as a result of this program and our visibility within it.





We have
worked to significantly restructure our partner program and began rolling the
new program out to our channel partners this quarter.  We’ve designed
the program to ensure that we are effectively allocating resources to the “high
producing” partners in each of our key markets.  A key element of the
program is formal partner commitments to specific revenue generation levels in
return for product discounts and marketing and sales support. As this program
matures, it will help us anticipate support requirements. We are working
diligently to improve our revenue pipeline visibility with each
organization.  There has been a very positive response from partners
regarding the new program, with a number of partners electing to increase their
revenue commitments with us in order to qualify for the resource allocation
benefits.





22


We are
providing installation engineer certification classes for our partners in an
effort to leverage our channel partners’ resources in supporting increased
demand for our products, and to allow us to recognize revenue upon acceptance of
the convergence solutions by the reseller. This calendar year we have certified
24 additional installation engineers for ten partners, and more classes are
scheduled. Another benefit of this program is the installation engineers are
recognizing additional opportunities with the customer where Cistera solutions
can be positioned, and recommending follow-on sales of our
products.  Subsequent application sales enhance the customers’ “return
on investment” as they already reside on the Cistera ConvergenceServer and can be activated
with a license key.





On the
research and development front, our engineers completed work on Cistera 1.8 that
included enhancements to the platform and a number of the application
engines.  We expect to release Cistera 1.9 with additional
enhancements this fiscal year.  The hosted solution effort with
Sylantro is continuing to develop albeit slower than anticipated due to the
level of integration that was required to deliver full
functionality.  We have completed the technical integration that
required buy-in and development changes from Aastra, Acme Packets and
Polycom.  We have several pilot opportunities with Sylantro, and are
in talks with one of our resellers regarding a customer pilot.  We
will have product demonstrations and Greg Royal, the Company’s founder and CTO,
will speak at the Sylantro Global Summit in Las Vegas in October.





Restatements of Previously
Issued Consolidated Financial Statements





We have
restated our Consolidated Statement of Operations and Statement of
Cash Flows for the three months ended June 30, 2007 to reflect a correction in
our accounting for its PP1 Notes, PP1 Warrants, PP2 Notes, and PP2
Warrants.  We intend to restate and refile our Annual Report on Form
10-KSB for the fiscal year ended March 31, 2007 and restate and refile our
Quarterly Reports on Form 10-QSB for the periods ended June 30, 2007, September
30, 2007 and December 31, 2007 in a reasonably practicable time
period.





In
addition, we have restated our Consolidated Statement of Operations and
Statement of Cash Flows for the three months ended June 30, 2007 to reflect a
correction in our accounting for registration payment arrangements as required
under FASB Staff Position No. 00-19-2, “Accounting for Registration Payment
Arrangements” (“FSP 00-19-2”).  FSP 00-19-02 was effective April 1,
2007 for the Company, and we incorrectly accounted for the registration payment
arrangements as of the effective date (which required the recording of a
cumulative effect of a change in accounting principle) and for the three months
ended June 30, 2007.  See further discussion in Note 4 to the
consolidated financial statements included in this report.





The table
below summarizes the impact to the Consolidated Statement of
Operations:





Adjustments
      to Statements of OperationsConvertible
      Promissory Notes and Warrants
            
            
            Registration
      Payment Arrangements
            
            
            TotalThree
      months ended June 30 2007
            
            $
            (370,715
            )
            
            $
            (166,465
            )
            
            $
            (537,180
            )Cumulative
      effect at April 1, 2007
            
            
            (1,288,668
            )
            
            
            -
            
            
            
            (1,288,668
            )Total
            
            $
            (1,659,383
            )
            
            $
            (166,465
            )
            
            $
            (1,825,848
            )





23


The table
below summarizes the effect of the restatement adjustments on the Consolidated
Statement of Operations for the three months ended June 30, 2007:





As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedOther
      income (expense)Interest
      income
            
            $
            9,589
            
            
            $
            -
            
            
            $
            9,589Interest
      expense
            
            
            (158,135
            )
            
            
            84,711
            
            
            
            (73,424
            )Amortization
      of discount onconvertible
      promissory notes
            
            
            -
            
            
            
            (370,715
            )
            
            
            (370,715
            )Charge
      for estimated liquidated damages
            
            
            -
            
            
            
            (251,176
            )
            
            
            (251,176
            )Total
      other income (expense)
            
            
            (148,546
            )
            
            
            (537,180
            )
            
            
            (685,726
            )Net
      loss
            
            $
            (463,605
            )
            
            $
            (537,180
            )
            
            $
            (1,000,785
            )Basic
      & diluted net loss per share
            
            $
            (0.06
            )
            
            $
            (0.06
            )
            
            $
            (0.12
            )Weighted
      average shares outstanding–
      basic and diluted
            
            
            8,292,022
            
            
            
            
            
            
            
            8,292,022




The table
below summarizes the effect of the restatement adjustments on the Consolidated
Balance Sheet as of June 30, 2007:





As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedCurrent
      liabilities:Accounts
      and related party payables
            
            $
            381,089
            
            
            $
            -
            
            
            $
            381,089Accrued
      liquidated damages
            
            
            -
            
            
            
            540,694
            
            
            
            540,694Accrued
      liabilities
            
            
            444,716
            
            
            
            (84,711
            )
            
            
            360,005Deferred
      revenue
            
            
            654,996
            
            
            
            
            
            
            
            654,996Current
      portion of long-term debt, net of discount
            
            
            95,408
            
            
            
            
            
            
            
            95,408Total
      current liabilities
            
            
            1,576,209
            
            
            
            455,983
            
            
            
            2,032,192Convertible
      promissory notes, net of discount
            
            
            3,485,491
            
            
            
            (2,596,149
            )
            
            
            889,342Deferred
      revenue
            
            
            114,912
            
            
            
            
            
            
            
            114,912Total
      long-term liabilities
            
            
            3,600,403
            
            
            
            (2,596,149
            )
            
            
            1,004,254Total
      liabilities
            
            
            5,176,612
            
            
            
            (2,140,166
            )
            
            
            3,036,446Stockholders’
      equity (deficit):Preferred
      stock
            
            
            -
            
            
            
            
            
            
            
            -Common
      stock
            
            
            8,292
            
            
            
            
            
            
            
            8,292Additional
      paid-in capital
            
            
            8,739,970
            
            
            
            4,820,830
            
            
            
            13,560,800Cumulative
      effect of adoption of FSP 00-19-2
            
            
            -
            
            
            
            (755,115
            )
            
            
            (755,115
            )Accumulated deficit
            
            
            (9,662,085
            )
            
            
            (1,925,549
            )
            
            
            (11,587,634
            )Total
      stockholders’ equity (deficit)
            
            
            (913,823
            )
            
            
            2,140,166
            
            
            
            1,226,343TOTAL
      LIABILITIES AND STOCKHOLDERS’EQUITY
      (DEFICIT)
            
            $
            4,262,789
            
            
            $
            -
            
            
            $
            4,262,789


24


The table
below summarizes the effect of the restatement adjustments as well as the
correction in errors in the reporting of components of cash flows from
operations and cash flows from financing activities on the Consolidated
Statement of Cash Flows for the three months ended June 30, 2007:





Cash flows restatement
      tableAs
      previously reported
            
            
            Adjustments
            
            
            As
      restatedCASH
      FLOWS FROM OPERATING ACTIVITIESNet
      loss
            
            $
            (463,605
            )
            
            $
            (537,180
            )
            
            $
            (1,000,785
            )Adjustments
      used to reconcile net loss to net cash used inoperating
      activities:Charge
      for estimated liquidated damages
            
            
            -
            
            
            
            251,176
            
            
            
            251,176Amortization
      of discount on convertible promissory notes
            
            
            -
            
            
            
            370,715
            
            
            
            370,715Depreciation
      and amortization
            
            
            80,936
            
            
            
            (1
            )
            
            
            80,935Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            (307,094
            )
            
            
            (3
            )
            
            
            (307,097
            )Inventory
            
            
            10,440
            
            
            
            
            
            
            
            10,440Prepaid
      expenses
            
            
            1,568
            
            
            
            
            
            
            
            1,568Accounts
      payable
            
            
            (176,745
            )
            
            
            75,933
            
            
            
            (100,812
            )Accrued
      interest
            
            
            -
            
            
            
            (24,090
            )
            
            
            (24,090
            )Other
      accrued liabilities
            
            
            (153,307
            )
            
            
            223,331
            
            
            
            70,024Deferred
      revenue
            
            
            219,758
            
            
            
            3
            
            
            
            219,761Net
      cash used in operating activities
            
            
            (788,049
            )
            
            
            359,884
            
            
            
            (428,165
            )Net
      cash used in investing activities
            
            
            (69,780
            )
            
            
            1
            
            
            
            (69,779
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      proceeds from issuance of convertible promissory notes
            
            
            1,584,885
            
            
            
            (359,885
            )
            
            
            1,225,000Payments
      on convertible promissory notes and other loans
            
            
            (61,000
            )
            
            
            -
            
            
            
            (61,000
            )Net
      payments on line of credit
            
            
            (62,094
            )
            
            
            -
            
            
            
            (62,094
            )Payments
      on capital lease
            
            
            (1,007
            )
            
            
            -
            
            
            
            (1,007
            )Net
      cash provided by financing activities
            
            
            1,460,784
            
            
            
            (359,885
            )
            
            
            1,100,899Net
      increase (decrease) in cash and cash equivalents
            
            
            602,955
            
            
            
            
            
            
            
            602,955Cash
      and cash equivalents at beginning of year
            
            
            534,871
            
            
            
            
            
            
            
            534,871Cash
      and cash equivalents at end of year
            
            $
            1,137,826
            
            
            $
            -
            
            
            $
            1,137,826


25





Cash
      flowsrestatement
      table
              (continued)As
      previously reported
            
            
            Adjustments
            
            
            As
      restatedSUPPLEMENTAL
      DISCLOSURE OF NON-CASHINVESTING
      AND FINANCING ACTIVITIES:Conversion
      of accounts payable and other accrued liabilities toconvertible
      promissory notes
            
            $
            -
            
            
            $
            359,885
            
            
            $
            359,885Allocation
      of discount on convertible promissory notes toderivative
      financial instruments - warrants
            
            
            -
            
            
            
            488,054
            
            
            
            488,054Discount
      related to beneficial conversion feature on convertiblepromissory
      notes
            
            
            -
            
            
            
            815,599
            
            
            
            815,599OTHER
      NON-CASH TRANSACTIONS:Cumulative effect of
      change in accounting principle(a):Reclassification
      of warrants from derivative financialinstruments
      to equity securities (as valued at inception)
            
            $
            -
            
            
            $
            2,730,824
            
            
            $
            2,730,824Accrued
      liquidated damages at April 1, 2007
            
            
            -
            
            
            
            289,518
            
            
            
            289,518Reclassification
      of warrants from derivative financialinstruments
      to equity securities (as valued at April 1, 2007)
            
            
            -
            
            
            
            (2,265,227
            )
            
            
            (2,265,227
            )Cumulative
      effect of change in accounting principle
            
            $
            -
            
            
            $
            755,115
            
            
            $
            755,115(a)
      Relates to the adoption of FSP 00-19-2





Convertible Promissory Notes
and Warrants





We
concluded that our original accounting for the PP1 Notes and PP1 Warrants issued
in fiscal year 2005 and the PP2 Notes and PP2 Warrants issued in fiscal year
2007 and fiscal year 2008 was incorrect and that the necessary adjustments were
material to the fiscal year 2007 and 2008 consolidated financial
statements.





We based
our conclusion upon a further review of the documents associated with the Notes
and Warrants and considered the following sources as relevant guidance in
determining the proper accounting treatment for the Notes and
Warrants.





·
            SFAS
      133, Accounting for
      Derivative Instruments and Hedging Activities(“SFAS
      133”),


·
            APB
      Opinion 14, Accounting
      for Convertible Debt and Debt Issued with Stock Purchase Warrants
      (“APB 14”),


·
            Emerging
      Issues Task Force (EITF) Issue 00-19, Accounting for Derivative
      Financial Instruments Indexed to, and Potentially Settled in, a Company’s
      Own Stock(“EITF 00-19”),


·
            EITF
      05-2,The Meaning of
      “Conventional Convertible Debt Instrument”(“EITF
      05-2”),


·
            EITF
      98-5, Accounting for
      Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Ratios (“EITF
  98-5”),


·
            EITF
      00-27, Application of
      Issue No. 98-5 to Certain Convertible Instruments (“EITF
      00-27”),


·
            SEC
      Staff Accounting
      Bulletin No. 107(“SAB 107”)





For a
detailed description of the accounting applied in the restatement related to the
PP1 and PP2 Notes and the PP1 and PP2 Warrants, see Note 3 to the consolidated
financial statements contained in this report.


26


Registration Payment
Arrangements





On
December 21, 2006, the EITF issued FASB Staff Position No. 00-19-2 (“FSP
00-19-2”).  FSP 00-19-2 was effective immediately for registration
payment arrangements and the financial instruments subject to those arrangements
that were entered into or modified subsequent to the date of issuance of this
FSP. For registration payment arrangements and financial instruments subject to
those arrangements that were entered into prior to the issuance of this FSP, the
FSP was effective for financial statements issued for fiscal years beginning
after December 15, 2006, and interim periods within those fiscal
years.  Effective April 1, 2007, we adopted FSP 00-19-2, which was
applicable to the accounting for the liquidated damages on the PP2
Notes.  See detailed discussion of the accounting required under this
FSP in Note 4 to the consolidated financial statement included in this
report.





Based on
the accounting and reporting requirements of FSP 00-19, we (as part of the
restatement required for the three months ended June 30, 2007) recorded a
cumulative effect of an accounting change entry (i.e., a charge to the beginning
balance of the accumulated deficit) as of April 1, 2007 for the combination
of:  1) the reclassification of the Warrants from derivative
liabilities to equity securities, and 2) a contingent liability for probable
future payment of liquidated damages (based on the Company’s best estimate as of
the date of adoption, which is through March 31, 2008).  The amount of
the contingent liability recorded was approximately $289,000.  Also,
as part of the cumulative effect of an accounting change entry, we reclassified
the Warrants from derivative liabilities to equity securities.  The
difference between the Warrants as measured on the date of adoption and their
original recorded value was included in the charge to the beginning balance of
the Accumulated deficit.  This amount was approximately
$466,000.  The total of the cumulative effect of this accounting
change was $755,000.





On April
5, 2007, we closed the balance of our PP2 offering and, in accordance with FSP
00-19-2, recorded a contingent liability and related charge to the consolidated
Statement of Operations for estimated liquidated damages related to this funding
through March 31, 2008.  The amount recorded was
$251,176.





We
evaluated the contingent liability for liquidated damages at June 30, September
30 and December 31, 2007 and concluded that the facts and circumstances had not
changed as to the appropriateness of the March 31, 2008 date.  As of
March 31, 2008, we were in substantial discussions with a majority of investors
to convert their Notes, exercise their Warrants and remove the registration
requirements of the underlying shares to the Notes and Warrants.  As a
result, as of March 31, 2008, we concluded that it was probable that it would
execute an agreement under these terms and estimated and recorded an additional
contingent liability and related charge for liquidated damages through June 30,
2008.





As of
March 31, 2008, we estimated and accrued $671,342 related to liquidated damages
related to the PP2 Notes and concluded that this amount was the maximum pay-out
required.  On June 24, 2008, we executed agreements with certain
investors comprising approximately 70% of the original principal investment of
PP2 to convert their outstanding Notes at a reduced price of
$0.53.  On June 30, 2008, we executed an agreement with the
institutional investor in the PP2 offering that had the contractual right to
liquidated damages.  In exchange for the waiver from the investor, we
issued to the investor 58,777 shares of our common stock.  The
agreement terminated any assessment of liquidated damages beyond June 24, 2008.
For the three months ended June 30, 2008, we recorded a charge and credit to
additional paid-in capital for the fair value of these shares issued in the
amount of $22,041.





The table
below summarizes the cumulative effect entry recorded as of April 1, 2007 for
the adoption of FSP 00-19-2:





Accumulated
      deficit, April 1, 2007 (as restated)
            
            $
            (10,586,847
            )Adjustments
      for the cumulative effect of the change in accounting
      principle:Contingent
      liability recorded for estimated liquidated damages
            
            
            (289,518
            )Reclassification
      of Warrants from derivative liabilities to equity
    securities
            
            
            (465,597
            )Total
      adjustments
            
            
            (755,115
            )Accumulated
      deficit, April 1, 2007, as adjusted
            
            $
            (11,341,962
            )





27


Results of
Operations





For
      the three months ended June 30,2008
            
            
            %
      of rev
            
            
            2007
            
            
            %
      of rev(As
      restated)Revenues:Convergence
      solutions
            
            $
            522,393
            
            
            
            65%
            
            
            $
            461,938
            
            
            
            68%Professional
      services
            
            
            60,708
            
            
            
            8%
            
            
            
            104,050
            
            
            
            15%Support
      and maintenance
            
            
            217,459
            
            
            
            27%
            
            
            
            113,799
            
            
            
            17%Total
      revenues
            
            
            800,560
            
            
            
            100%
            
            
            
            679,787
            
            
            
            100%Cost
      of revenues:Convergence
      solutions
            
            
            133,032
            
            
            
            17%
            
            
            
            139,656
            
            
            
            20%Professional
      services
            
            
            50,500
            
            
            
            6%
            
            
            
            46,875
            
            
            
            7%Support
      and maintenance
            
            
            23,184
            
            
            
            3%
            
            
            
            20,700
            
            
            
            3%Total
      cost of revenues
            
            
            206,716
            
            
            
            26%
            
            
            
            207,231
            
            
            
            30%Gross
      Profit
            
            
            593,844
            
            
            
            74%
            
            
            
            472,556
            
            
            
            70%Operating
      expenses:Sales
      and marketing
            
            
            296,006
            
            
            
            37%
            
            
            
            246,843
            
            
            
            36%Software
      development
            
            
            158,589
            
            
            
            20%
            
            
            
            129,035
            
            
            
            19%Engineering
      and support
            
            
            149,596
            
            
            
            19%
            
            
            
            70,782
            
            
            
            10%General
      and administrative
            
            
            429,149
            
            
            
            53%
            
            
            
            260,019
            
            
            
            38%Depreciation
      and amortization
            
            
            98,156
            
            
            
            12%
            
            
            
            80,936
            
            
            
            12%Total operating expenses
            
            
            1,131,496
            
            
            
            141%
            
            
            
            787,615
            
            
            
            115%Loss
      from operations
            
            
            (537,652
            )
            
            
            (67)%
            
            
            
            (315,059
            )
            
            
            (45)%Other
      income (expense)Interest
      income
            
            
            82
            
            
            
            -%
            
            
            
            9,589
            
            
            
            1%Interest
      expense
            
            
            (83,182
            )
            
            
            (10)%
            
            
            
            (73,424
            )
            
            
            (11)%Charge
      for inducements related to stockissued
      to convertible note holders
            
            
            (1,192,813
            )
            
            
            (149)%
            
            
            
            -
            
            
            
            -Amortization
      of discount on convertiblenotes
            
            
            (1,120,997
            )
            
            
            (140)%
            
            
            
            (370,715
            )
            
            
            (54)%Credit
      (charge) for estimated liquidateddamages
            
            
            11,299
            
            
            
            1%
            
            
            
            (251,176
            )
            
            
            (37)%Total
      other income (expense)
            
            
            (2,385,611
            )
            
            
            (298)%
            
            
            
            (685,726
            )
            
            
            (101)%Net
      loss
            
            $
            (2,923,263
            )
            
            
            (365)%
            
            
            $
            (1,000,785
            )
            
            
            (146)%Basic
      & diluted net loss per share
            
            $
            (0.31
            )
            
            
            
            
            
            $
            (0.12
            )Weighted
      average shares outstanding – basicand
      diluted
            
            
            9,421,126
            
            
            
            
            
            
            
            8,292,022





28


Revenue





Revenue
for the quarter ended June 30, 2008 increased $120,773 or approximately 18% from
the comparable prior year quarter primarily due to increased support and
maintenance revenue.  This increase was primarily attributable to our
increased installed base from the prior year.





Gross Profit and Gross
Margin





Gross
profit for the quarter ended June 30, 2008 increased $121,288 or approximately
26% from the comparable prior year quarter primarily due to increased
revenue.  Gross margin also increased in the June 2008 quarter as
compared to the June 2007 quarter from 70% to 74%.  This increase was
primarily due to the higher percentage of support and maintenance revenue (which
carries a significantly higher gross margin as compared to the other revenue
components) to total revenue over the prior year quarter.





Operating
Expenses





Operating
expenses, excluding depreciation and amortization increased from $706,679 in the
June 2007 quarter to $1,033,340 in the June 2008 quarter, an increase of
$326,661.  The increasewas primarily attributable
to: 1) increased salaries that were applied over the course of fiscal year 2008
for a significant number of employees, who had been receiving much below the
“average market” salaries for similar positions; 2) increased headcount in most
departments; 3) higher payroll taxes as a result of the higher salaries and
increased personnel; 4) increased facilities related expenses due to our new
corporate office location, which has more square footage but a lower cost per
square foot; 5) higher professional fees in the accounting and finance area;
and, 6) a decrease in utilization of engineering and support personnel for
professional services work as compared to internal infrastructure support, which
was required in the short-term as part of the transition to the new corporate
office location.





Amortization of Debt
Discount





The
amortization of debt discount on our PP2 Notes in the June 2008 quarter
increased approximately $750,000 from the June 2007 quarter primarily as a
result of the significant amount of PP2 Notes that were converted in June 2008
as part of our “Short Term Investment Incentive Plan” (the
“STIIP”).  As required under GAAP, all unamortized debt discount
outstanding at the date of the conversion was expensed.  See further
discussion of the STIIP under “Liquidity” under this Item.





Charge for Inducements
related to Stock Issued to Convertible Note Holders





As part
of the STIIP, we lowered the conversion price of our PP2 Notes and the exercise
price of both our PP1 and PP2 Warrants.  As required under GAAP, we
recorded a non-cash charge in the amount of $1,192,813 related to these
inducements.  See further discussion of the STIIP under “Liquidity”
under this Item.





Liquidated
Damages





The
decrease in the charge for liquidated damages from the June 2007 quarter was
primarily the result of the settlement of future liquidated damages as of June
24, 2008.  As of June 30, 2008, we recorded an adjustment to the
amount of accrued liquidated damages for PP2 Note holders who did not convert
their notes in the STIIP.  As part of an agreement dated June 30, 2008
with the investor in the PP2 offering that had the contractual right to
liquidated damages, we issued to the investor 58,777 shares of our common stock
in exchange for a waiver on future liquidated damages after June 24,
2008.





29


Liquidity
and Capital Resources





The
unaudited consolidated financial statements contained in this report have been
prepared in conformity with US GAAP (except with regard to omission of certain
disclosures within interim financial statements, as permitted by the SEC), which
contemplate our continuation as a going concern and do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary if
we were unable to continue as a going concern. However, the report of our
independent registered public accounting firm on our consolidated financial
statements, as of and for the year ended March 31, 2008, contains an explanatory
paragraph expressing substantial doubt as to our ability to continue as a going
concern. The “going concern” explanatory paragraph resulted from, among other
things, the substantial losses from operations we have incurred since inception,
our liquidity position and net loss of $5.2 million for the year ended March 31,
2008, which included non-cash charges of $1.9 million related to amortization of
discounts associated with our PP2 Notes and negative working capital (current
liabilities in excess of current assets) of $3.0 million as of March 31,
2008.  In addition, we had a net loss of $2.9 million for the three
months ended June 30, 2008, which included non-cash charges of $2.3 million
related to amortization of discounts associated with the PP2 Notes and
inducements related to the conversion of PP2 Notes and the exercise of the PP1
Warrants and the PP2 Warrants.  Also, as of June 30, 2008, we have
negative working capital (current liabilities in excess of current assets) of
$3.0 million. Accordingly, as of June 30, 2008, the recoverability of a major
portion of the recorded asset amounts is dependent on our continuing operations,
which in turn is dependent on our ability to maintain our current financing
arrangements and our ability to become profitable in our future operations.
These factors raise substantial doubt about the Company’s ability to continue as
a going concern. These consolidated financial statements do not reflect
adjustments that would be necessary if we were unable to continue as a “going
concern.”





We
improved our liquidity through the execution of the STIIP, which we completed in
June and July of 2008, and which raised approximately $844,000 in cash from the
exercises of PP1, PP2 and Bonus Warrants and reduced debt, accrued interest and
accrued liquidated damages of approximately $3.2 million.  As of June
30, 2008, we had received cash proceeds of approximately $304,000 from the
exercises of the Warrants.  In July 2008, we received an additional
$540,000 from the exercise of the Warrants.  While management believes
that this action mitigates the substantial doubt about the Company’s ability to
continue as a going concern, we will need to become profitable in the near
future though generating higher revenues or lowering operating costs, or a
combination of the two.  We will likely need to renegotiate the
payment or conversion of the remaining principal due on our PP2 Notes or raise
additional capital, or a combination of the two. If we need to raise additional
capital it could be in the form of equity or debt, or a combination of the two.
There can be no assurance that we will be successful in these endeavors or that
the cost savings or required new capital will be sufficient.





Cash and Cash
Flows





Our cash
and cash equivalents at June 30, 2008 were $296,279. For the three months ended
June 30, 2008, net cash used in operations was $125,734.  The primary
use of cash was the net loss incurred for the period of $2,923,263 adjusted for
noncash charges of $1,192,813 related to inducement charges for the conversions
of certain PP2 Notes and the exercises of certain PP1 and PP2 Warrants,
$1,170,772 related to the amortization of discounts on the PP2 Notes and $98,156
for depreciation and amortization.  Net cash used in investing
activities of $32,997 related to purchases of computer equipment and office
furniture.  Net cash from financing activities of $330,003 was
primarily the result of the net proceeds raised from the exercise of certain PP1
and PP2 Warrants as part of the STIIP.





30


ContractualObligations





Our
current material contractual obligations are our corporate office lease and the
principal, accrued interest and accrued liquidated damages under our PP1 and PP2
Notes.  During the current quarter there were no changes to our
corporate office lease obligations and a significant portion of the PP2 Note
obligations, including accrued interest and accrued liquidated damages, was
converted as of June 30, 2008.  The following amounts are due within
the current fiscal year under the PP1 and the PP2 Notes, all of which is payable
within the next ten months:





PP1
      Notes:Principal
            
            $
            64,495Accrued
      interest
            
            
            30,04194,536PP2
      Notes:Principal
            
            
            924,576Accrued
      interest
            
            
            112,9341,037,510Accrued
      liquidated damages
            
            
            177,024Total
            
            $
            1,309,070





Critical Accounting
Policies





We
prepare our financial statements in accordance with US GAAP. The accounting
policies most fundamental to understanding our financial statements are those
relating to recognition of revenue, our use of estimates and the accounting for
convertible debt and warrants. For a detailed discussion on the application of
these accounting policies, see Note 2 to our audited consolidated financial
statements contained in our 2008 10-KSB.





Recently Issued Accounting
Pronouncements





We
discuss the potential impact of recent accounting pronouncements in Note 1 to
the unaudited consolidated financial statements contained in this
report.








Item
3. Quantitative and Qualitative Disclosures About Market Risk





As a
smaller reporting company, we are not required to provide this
information.








Item
4(T). Controls and Procedures





Background




As
described in this report in the Explanatory Note, Note 3 to our unaudited
consolidated financial statements, and Item 2. Management’s Discussion and
Analysis of Financial Condition, we have restated our consolidated financial
statements for the three months ended June 30, 2007.  We also intend
to restate and refile our Annual Report on Form 10-KSB for the fiscal year ended
March 31, 2007 and restate and refile our Quarterly Reports on Form 10-QSB for
the periods ended June 30, 2007, September 30, 2007 and December 31, 2007 in a
reasonably practicable time period.  Based on these restatements, we
have identified deficiencies in our internal control over financial reporting.
These control deficiencies failed to prevent or detect certain accounting
errors, which required a restatement of our previously issued financial
statements. The control deficiencies represent material weaknesses in our
internal control over financial reporting and require corrective and remedial
actions.




31


Evaluation of Disclosure
Controls and Procedures




Disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under
the Exchange Act) are designed to ensure that information required to be
disclosed in reports filed or submitted under the Exchange Act is recorded,
processed, summarized, and reported within the time periods specified in SEC
rules and forms and that such information is accumulated and communicated to
management, including our Chief Executive Officer, who is also currently our
interim Chief Financial Officer(the “Certifying Officer”), to allow timely
decisions regarding required disclosures.





As of
June 30, 2008, we carried out an analysis, under the supervision and with the
participation of our management, including our Certifying Officer of the
effectiveness of the design and operation of our disclosure controls and
procedures. Based on the restatements noted above, that management and our board
of directors deemed necessary and communicated on a Form 8-K filing dated August
6, 2008, the Certifying Officer concluded that our disclosure controls and
procedures were not effective as of the end of this reporting
period.





The
Certifying Officer also previously determined as a result of the restatements
noted above that our disclosure controls and procedures and internal controls
over financial reporting were not effective as of March 31, 2008 and identified
remediation measures to be implemented during the fiscal year
2009.  We estimate that during the second half of fiscal 2009, the
Certifying Officer, along with the Company’s other management representatives,
will complete remediation measures that may include engaging an independent
consulting firm to further evaluate, remediate, implement, document and test the
internal controls in these key areas:





1.
            Financial
      Reporting, including technical accounting surrounding complex accounting
      transactions


2.
            Order
      Entry Accounting & Reporting


3.
            Debt/Equity
      Accounting & Compliance


4.
            Cash
      & Other Working Capital
Management


5.
            Compensation
      Accounting & Administration


6.
            Other
      Assets & Liability Account
Management





We will
also monitor our disclosure controls and procedures on a continuing basis to
ensure that information required to be disclosed in the reports we file or
submit under the Exchange Act is accumulated and communicated to our management,
including its principal executive and principal financial officers, as
appropriate, to allow timely decisions regarding required disclosure. In the
future as such controls change in relation to developments in the our business
and financial reporting requirements, our evaluation and monitoring measures
will also address any additional corrective actions that may be
required.





Inherent Limitations of
Internal Controls





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








32


PART
II - OTHER INFORMATION





Item
1.  Legal Proceedings





The
Company and certain of its current and former officers and directors are
defendants in litigation pending in Dallas, Texas, styled KINGDON R. HUGHES VS.
GREGORY T. ROYAL, CYNTHIA A. GARR, JAMES T. MILLER, JR., CHARLES STIDHAM, CNH
HOLDINGS COMPANY D/B/A CISTERA NETWORKS AND XBRIDGE SOFTWARE, INC.; Cause No.
DV05-0600-G; G-134th District Court, Dallas County, Texas.  The
plaintiff has alleged a number of complaints against the defendants, including
breach of fiduciary duty, misappropriation of corporate opportunities, fraud,
fraudulent inducement, breach of contract, tortuous interference with contract,
fraudulent transfer, and shareholder oppression arising in connection with the
license agreement between the Company and XBridge in May 2003 and the
acquisition of XBridge by the Company in May 2005.  The parties held a
mediation conference in April 2006 and have come to an understanding with
respect to the principle elements of a potential settlement.  We are
currently in the process of negotiating definitive settlement
agreements.





Item
1A.  Risk Factors





As a
smaller reporting company, we are not required to provide this
information.





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





Set forth
below is information regarding the issuance and sales of the Company’s
securities without registration during the period covered by this
Report.  No such sales involved the use of an underwriter, no
advertising or public solicitation were involved, the securities bear a
restrictive legend, were applicable, and no commissions were paid in connection
with the sale of any securities.





On June
9, 2008, the Company temporarily modified the terms of its outstanding
convertible notes and warrants issued in its December 2004 and April 2007
private placements.  During the period beginning June 9, 2008 through
June 24, 2008, the conversion price of such notes, currently $1.00 per share for
notes issued in December 2004 and $0.75 per share for notes issued in April
2007, was lowered to $0.53 per share.  In addition the exercise price
for the warrants, currently $1.30 per share for warrants issued in December 2004
and $1.00 for warrants issued in April 2007, was reduced to $0.40 per share, and
each warrant holder received three additional warrants (each, a “bonus warrant”)
for every ten warrants exercised during this period.  The bonus
warrants were exercisable through June 24, 2008 at an exercise price of $0.30
per share, and if not exercised on or before such date, the exercise price for
such bonus warrants was increased to $0.60 per share.  The bonus
warrants expire on April 6, 2012.





This
program resulted in the generation of approximately $843,000 in cash proceeds
from new investment through warrant exercises, and approximately $3.2 million of
its outstanding convertible notes and associated accrued interest were converted
into common equity.  All amounts reported herein are subject to final
clearing through financial institutions.





In
connection with the program, the Company and Roaring Fork Capital SBIC, LP,
agreed to terminate the Company’s obligation to secure an effective registration
statement with respect to the shares of common stock underlying the convertible
notes and warrants held by Roaring Fork, and waived any damages related to such
failure.  In exchange for this termination and waiver, the Company
agreed to issue to Roaring Fork an additional 58,777 shares of the Company’s
common stock, and agreed to certain anti-dilution rights relative to the shares
issued to Roaring Fork upon conversion of the convertible notes and
warrants.





The
issuance of the shares of our common stock described above were made in private
transactions or private placements intending to meet the requirements of one or
more exemptions from registration.  In addition to any noted exemption
below, we relied upon Regulation D, Section 4(2) and Rule 144 of the Securities
Act of 1933, as amended (the “Act”).  Other than the securities
mentioned above, we have not issued or sold any securities during the period
covered by this Report.





33


Item
3.  Defaults Upon Senior Securities





None





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





None





Item
5.  Other Information





None





Item
6.  Exhibits





31.1        Certification
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.





32.1        Certification
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


34


SIGNATURE





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





CISTERA
      NETWORKS, INC.Date: August 29, 2008
            /s/    Derek P.
      DownsDerek
      P. DownsChief
      Executive Officer and interimChief
      Financial Officer(Principal
      Executive, Financial andAccounting
      Officer)