UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

SPESCOM SOFTWARE INC.

(Exact name of registrant as specified in its charter)

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    ý         NO    o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES    o         NO    ý

Number of shares of Common Stock outstanding at August 15, 2005: 36,776,028

Number of Sequentially Numbered Pages: 27

SPESCOM SOFTWARE INC.

INDEX

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PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

SPESCOM SOFTWARE INC.

CONSOLIDATED BALANCE SHEETS

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

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SPESCOM SOFTWARE INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

4

SPESCOM SOFTWARE Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

* See Note 2 for supplemental cash flow information.

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

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SPESCOM SOFTWARE INC.

CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1 - Basis of Presentation

The accompanying consolidated financial statements as of June 30, 2005 and for the three and nine months ended June 30, 2005 and 2004 are unaudited. The consolidated financial statements and related notes have been prepared in accordance with generally accepted accounting principles applicable to interim periods.  In the opinion of management, the consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the consolidated financial position, operating results and cash flows for the periods presented.

The information contained in the following Condensed Notes to the Consolidated Financial Statements is condensed from that which would appear in the annual consolidated financial statements; accordingly, the consolidated financial statements included herein should be reviewed in conjunction with the consolidated financial statements and related notes thereto contained in Spescom Software Inc.’s (the “Company”) Annual Report on Form 10-K/A for the year ended September 30, 2004.  It should be understood that the accounting measurements at an interim date inherently involve greater reliance on estimates than at year-end.  The results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year.

Note 2 – Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements are prepared using accounting principles generally accepted in the United States of America and include the accounts of the Company and its wholly-owned United Kingdom subsidiary, Spescom Software, Ltd. All significant intercompany balances and transactions have been eliminated.

Foreign Currency

The functional currency of the Company’s United Kingdom subsidiary is the pound sterling. Assets and liabilities are translated into U.S. dollars at end-of-period exchange rates. Revenues and expenses are translated at average exchange rates in effect for the period. Net currency exchange gains or losses resulting from such translations are excluded from net income and are accumulated in a separate component of shareholders’ deficit as accumulated other comprehensive income (loss). Gains and losses resulting from foreign currency transactions, which are not significant, are included in the consolidated statements of operations.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and also requires disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by management include revenue recognition estimates, the viability of recognizing deferred income tax assets, capitalized software costs and the valuation of equity instruments, and the allowance for doubtful accounts.  Significant changes in these estimates may have a material impact on the financial statements.

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Revenue Recognition

The Company’s revenues are derived from sales of its document and configuration management systems that are primarily composed of software and services, including maintenance, training and consulting services, and third party software and hardware. The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2 “Software Revenue Recognition” and SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions” and Staff Accounting Bulletin (“SAB”) No. 101, updated by SAB’s 103 and 104 “Update of Codification of Staff Accounting Bulletins.”

Software license and third party product revenues are recognized upon shipment of the product if no significant vendor obligations remain and collection is probable. In cases where a significant vendor obligation exists, revenue recognition is delayed until such obligation has been satisfied. For new software products where a historical record has not yet been demonstrated that acceptance is perfunctory, the Company defers recognition of revenue until acceptance has occurred.  If an undelivered element of the arrangement exists under the license arrangement, a portion of revenue is deferred based on vendor-specific objective evidence (VSOE) of the fair value of the undelivered element until delivery occurs.  If VSOE does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.  Annual maintenance revenues, which consist of ongoing support and product updates, are recognized on a straight-line basis over the term of the contract. Payments received in advance of performance of the related service for maintenance contracts are recorded as deferred revenue. Revenues from training and consulting services are recognized when the services are performed and adequate evidence of providing such services is available. Contract revenues for long-term contracts or programs requiring specialized systems are recognized using the percentage-of-completion method of accounting, primarily based on contract labor hours incurred to date compared with total estimated labor hours at completion. Provisions for anticipated contract losses are recognized at the time they become known.

Contracts are billed based on the terms of the contract. There are no retentions in billed contract receivables. Unbilled contract receivables relate to revenues earned but not billed at the end of the period.

The Company considers many factors when applying accounting principles generally accepted in the United States of America related to revenue recognition.  These factors include, but are not limited to:

•                                          The actual contractual terms, such as payment terms, delivery dates, and pricing of the various product and service elements of a contract

•                                          Availability of products to be delivered

•                                          Time period over which services are to be performed

•                                          Creditworthiness of the customer

•                                          The complexity of customizations to the Company’s software required by service contracts

•                                          The sales channel through which the sale is made (direct, VAR, distributor, etc.)

•                                          Discounts given for each element of a contract

•                                          Any commitments made as to installation or implementation of “go live” dates

Each of the relevant factors is analyzed to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer.  Management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards.  Any misjudgment or error by management in its evaluation of the factors and the application of the standards, especially with respect to complex or new types of transactions, could have a material adverse effect on the Company’s future operating results.

Fair Value of Financial Instruments

Statement of Financial Accounting Standards (“SFAS”) No. 107, “Disclosures About Fair Value of Financial Instruments”, requires management to disclose the estimated fair value of certain assets and liabilities defined by SFAS No. 107 as cash or a contractual obligation that both conveys to one entity a right to receive cash or other financial instruments from another entity, and imposes on the other entity the obligation to deliver cash or other financial instruments to the first entity. At June 30, 2005 and September 30, 2004, management believes that the carrying amounts of cash and cash equivalents, short-term investments, accounts receivable and accounts payable, and accrued expenses approximate fair value because of the short maturity of these financial instruments. The Company believes that the carrying value of its loans approximate their fair values based on current market rates of interest.

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Concentration of Credit Risk

The Company provides products and services to customers in a variety of industries worldwide, including local governments, petrochemicals, utilities, manufacturing and transportation. Concentration of credit risk with respect to trade receivables is limited due to the geographic and industry dispersion of the Company’s customer base. The Company has not experienced significant credit losses on its customer accounts. Ameren UE and CSC International Systems Ltd accounted for 20% and 17%, respectively, of trade accounts receivable at June 30, 2005 and Network Rail and Constellation Energy Group accounted for 23% and 15%, respectively, of trade accounts receivable at September 30, 2004.

A small number of customers have typically accounted for a large percentage of the Company’s annual revenues. Network Rail and CSC International Systems Ltd accounted for 18% and 10%, respectively, of revenue for the nine months ended June 30, 2005, while Network Rail and Constellation Energy Group accounted for 27% and 17%, respectively of revenue for the nine months ended June 30, 2004.  The Company’s reliance on relatively few customers could have a material adverse effect on the results of its operations on a quarterly basis.

Property and Equipment

Property and equipment is recorded at cost and depreciated using the straight-line method over useful lives of two to seven years. Leasehold improvements are amortized on a straight-line basis over the shorter of their useful life or the term of the related lease. Expenditures for ordinary repairs and maintenance are expensed as incurred while major additions and improvements are capitalized.

Software Development Costs and Purchased Software

Software development costs and purchased software are capitalized under FAS 86, “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed,” when technological feasibility and marketability of the related product have been established. Software development costs incurred solely in connection with a specific contract are charged to cost of revenues. Capitalized software costs are amortized on a product-by-product basis, beginning when the product is available for general release to customers. Annual amortization expense is calculated using the greater of the ratio of each product’s current gross revenues to the total of current and expected gross revenues or the straight-line method over the estimated useful life of three to five years. The unamortized value of capitalized software costs was $423,000 and $15,000 at June 30, 2005 and September 30, 2004, respectively.  The related amortization expense was $19,000 and $51,000 for the nine months ended June 30, 2005 and 2004, respectively.

Long-lived Assets

The Company assesses potential impairments to its long-lived assets when there is evidence that events or changes in circumstances have made recovery of the asset’s carrying value unlikely. An impairment loss would be recognized when the sum of the expected future net cash flows is less than the carrying amount of the asset.  The Company concluded for the nine months ended June 30, 2005, that there were no events or changes in circumstances that would indicate that the carrying amounts of long-lived assets were impaired.

Stock-Based Compensation

The Company measures compensation expense for its stock-based employee compensation plans using the intrinsic value method and provides pro forma disclosures of net loss and basic and diluted net loss per share as if the fair value-based method had been applied in measuring compensation expense. The Company applies SFAS No.123, Accounting for Stock-Based Compensation and Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its employee stock-based compensation plan.

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No compensation cost was recognized for employee stock option grants during 2005 and 2004 based upon the intrinsic value method, which were fixed in nature, as the options were granted at exercise prices equal to fair market value on the date of grant. Had compensation cost for the Company’s employee stock-based compensation plan been determined based on the fair value at the grant dates the disclosure requirements of SFAS No. 148, which amends the disclosure requirements of FAS 123, would have been as follows:

Under FAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants:

Income Taxes

Current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is established for the expected future consequences resulting from the differences in the financial reporting and tax bases of assets and liabilities. Deferred income tax expense (benefit) is the change during the year in the deferred income tax asset or liability. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be “more likely than not” realized in the future based on the Company’s current and expected operating results.

Net Income (Loss) per Common Share

Basic net income (loss) per common share is computed as net income (loss) divided by the weighted average number of common shares outstanding during the year. Diluted net income (loss) per common share is computed as net loss divided by the weighted average number of common shares and potential common shares, using the treasury stock method, outstanding during the year and assumes conversion into common stock at the beginning of each period of all outstanding shares of convertible preferred stock, stock options, warrants and other potential common stock. Computations of diluted net income (loss) per share do not give effect to individual potential common stock for any period in which their inclusion would be anti-dilutive.

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Statements of Cash Flows

The following table provides supplemental cash flow information:

Note 3 – Related Party Transactions

As of June 30, 2005 and September 30, 2004 there were 5,291 shares of Series F Convertible Preferred Stock with a stated value of $1,000 per share held by Spescom Ltd., the majority shareholder of the Company.  The Series F Convertible Preferred Stock is convertible into common stock, at the stated conversion price of $0.45 per share subject to certain adjustments.  The conversion is at the option of Spescom Ltd through September 30, 2008.  The outstanding Series F Convertible Preferred Stock is entitled to receive dividends of 5% of the stated value of $1,000 per share per annum, payable on a quarterly basis in cash or common stock (valued on the basis of average per share market value on the 30 trading days immediately prior to the date on which such dividend is declared by the Board of Directors).  Unpaid dividends accrue interest at the rate of 8% per annum.  As of June 30, 2005, unpaid dividends and accrued interest amounted to $463,000 and $29,000, respectively as compared to $198,000 and $4,000, respectively as of June 30, 2004.

On November 18, 2003 the Company issued a note payable to Spescom UK, a wholly-owned subsidiary of Spescom Ltd., with a principal balance of $600,000 bearing an interest rate of 5% per annum.  The note was repaid during fiscal 2004.  Interest expense on the note for fiscal 2004 was $9,000.

The Company has two existing demand notes payable to Spescom UK for $400,000 and $100,000, each bearing an interest rate of 10% per annum.  As of June 30, 2005 and September 30, 2004, the balance on the notes including interest was $610,000 and $557,000, respectively.  Spescom Ltd. has agreed that it will not cause Spescom UK to demand repayment under the two notes prior to October 1, 2005.  Interest expense on the notes was $15,000 and $42,000 for the three and nine months ended June 30, 2005, respectively compared to $13,000 and $38,000 for the same periods in 2004, respectively.  These notes are collateralized by a security interest in favor of Spescom UK in respect of all the Company’s assets.

Under a royalty arrangement beginning in fiscal 2004, Spescom Ltd. resells the Company’s software and maintenance services in South Africa.  Royalty revenue recognized under this agreement for the three and nine months ended June 30, 2005 totaled $19,000 and $40,000, respectively.

In December 2004, the Company entered into an agreement with Spescom Ltd. in which the Company relocated certain engineering personnel to South Africa to work out of Spescom Ltd. facilities.  As part of the agreement Spescom Ltd. bills the Company for wages and an administrative fee that covers office rent and information technology costs on a monthly basis.  For the nine months ended June 30, 2005, total expenses under this arrangement were $64,000.

Spescom UK provides certain administrative and accounting functions for the Company’s United Kingdom subsidiary.  The Company is billed a monthly fee by Spescom UK for reimbursement of certain costs in the United Kingdom including the office facilities, all accounting and human resources services, and certain corporate marketing activities.  For the three and nine months ended June 30, 2005 the administrative fees totaled $148,000 and $457,000, respectively, compared to $148,000 and $439,000 for the three and nine months ended June 30, 2004.  The office rent for the Company’s United Kingdom operations included in the administrative fee totaled $86,000 and $267,000, respectively for the three and nine months ended June 30, 2005 compared to $86,000 and $257,000, respectively for the three and nine months ended June 30, 2004.  At June 30, 2005 and September 30, 2004 the Company had a payable to Spescom UK of $99,000 and $90,000, respectively.  In 1999, as part of an agreement to sell the 60% interest in its United Kingdom subsidiary to Spescom Ltd., the lease for the United Kingdom office facility was to be assigned to Spescom Ltd.; however, the landlord did not grant its consent to the assignment.  Since 1999, Spescom UK has paid the lease for the entire office directly to the landlord.  The lease expires in March 2006 and has an annual rent of $618,000.  A portion of the office has been subleased to third party tenants for an annual rent of $284,000.  The sublease also expires March 2006.

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Spescom Ltd. and the Company have entered into a license agreement pursuant to which Spescom Ltd. has licensed to the Company the right to use the name “Spescom” and to use a trademark owned by Spescom Ltd. related to certain computer software. The Company will not pay any royalties to Spescom Ltd. in connection with this license. The license is for an indefinite term, but is terminable by either party upon 60 days prior written notice. Under the license agreement, Spescom Ltd. has agreed to indemnify and hold harmless the Company and its directors, officers, employees and agents against liabilities arising from any claim brought against the Company that alleges that Spescom Ltd.’s or the Company’s use of the licensed trademark infringes the rights of any third party, provided that the Company is in material compliance with the provisions of the license agreement.

Note 4 – Receivables

Note 5 – Reconciliation of Net Income (Loss) and Shares Used in Per Share Computations:

Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period.  Contingently issued shares are included in the computation of basic net income (loss) per share when the related conditions are satisfied.  Diluted net income (loss) per share is computed using the weighted average number of common shares and potentially dilutive securities outstanding during the period.  Potentially dilutive securities consist of contingently issued shares, the common shares issuable upon conversion of preferred stock or convertible debt and shares issuable upon the exercise of stock options and common stock warrants.  Potentially dilutive securities are excluded from the computation if their effect is anti-dilutive.

As of June 30, 2005, a total of 4,030,000 stock options, 3,758,335 common stock warrants, 5,291 shares of Series F Convertible Preferred Stock, and 1,900 shares of Series G Convertible Preferred Stock, were excluded from the diluted net income (loss) per share calculation, as their effect would be anti-dilutive.  As of June 30, 2004, a total of 3,795,659 stock options, 1,008,335 common stock warrants, and 5,291 shares of Series F Convertible Preferred Stock were excluded from the diluted net income (loss) per share calculation, as their effect would be anti-dilutive.

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Note 6 – Segment and Geographic Information

The Company has one business segment, which consists of the development and sale of a suite of integrated document, configuration and records management software products.

Revenues for the three and nine month periods ended June 30, 2005 and 2004 by customer location were as follows:

Note 7 – Recent Accounting Pronouncements

In May 2005, the FASB issued Statement of Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections” an amendment to Accounting Principles Bulletin (APB) Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” though SFAS No. 154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to accounting for changes in estimates, changes in reporting entity, and the correction of errors. SFAS No. 154 establishes new standards on accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so.  SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005.

Note 8 – Equity

November 2004 Private Placement

On November 5, 2004, the Company completed a financing arrangement whereby the Company issued 2,200 shares of our Series G Convertible Preferred Stock (“Series G Stock”) along with 2,750,000 common stock warrants for gross proceeds of $2,200,000.  The Series G Stock is convertible into common stock at a price equal to 85% of the volume weighted average price of the Company’s common stock during the five trading days immediately preceding the conversion date; however, the conversion price can be no higher than $0.40 per share and no lower than $0.30 per share.  The 2,750,000 warrants have an exercise price of $0.44 per share and expire November 5, 2007.  The Company incurred $450,000 in expenses related to the transaction and issued 825,000 common stock warrants to an investment consulting firm.  The 825,000 warrants were comprised of 550,000 warrants with an exercise price of $0.40 per share which expire November 5, 2009 and 275,000 warrants which have an exercise price of $0.44 which expire on November 5, 2007. In connection with the financing, the Company recorded a beneficial conversion of $2,200,000 on the Series G Stock as a deemed dividend for the nine months ended June 30, 2005.

The Series G Stock is entitled to a liquidation preference equal to $1,000 per share, plus declared but unpaid dividends per share.  Commencing on the date of issuance of the Series G Stock, and continuing until the effective date of the registration statement on Form S-2 pursuant to which the Series G Stock is registered, the Series G Stock is also entitled to receive dividends of 5% of the stated value of $1,000 per share per annum, payable monthly in arrears on the last day of each month based on the number of Series G Stock outstanding as of the first day of such month.  The dividend for the Series G Stock is only payable until the registration statement for the common stock underlying the Series G Stock is declared effective by the Securities and Exchange Commission (“SEC”).  On March 22, 2005 the SEC declared the registration statement effective.  Thus the Series G Stock is no longer entitled to dividends.  For the nine months ended June 30, 2005, the Company issued 82,050 shares of common stock with a value of $37,000 as a dividend on the Series G Stock.  In April 2005, 300 shares of the Series G Stock with a value of $300,000 was converted into 928,367 shares of the Company’s common stock.

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Warrants for Services

On November 4, 2004, the Company issued to a public relations firm warrants to purchase 1,000,000 shares of its common stock at $0.40 per share, expiring November 3, 2007. The warrants vest and become exercisable as follows: (i) 500,000 warrants vest on the date that the average of the last sale price of the Company’s stock on the OTC Bulletin Board for the ten trading days immediately preceding such date (the “Market Price”) exceeds $0.60 per share, (ii) 250,000 warrants vest on the date that the Market Price exceeds $0.70 per share, and (iii) the remaining 250,000 warrants vest on the date that the Market Price exceeds $0.80 per share.  The fair value of the warrants, which was determined to be $30,000, was recognized ratably over the six months of the service agreement.

Note 9 – Subsequent Event

On August 8, 2005, Carl H. Mostert resigned as Chief Executive Officer and Director of the Company, effective as of August 16, 2005. In accordance with the Company’s agreement with Mr. Mostert requiring 6 months’ notice of termination, the Company intends to continue to pay Mr. Mostert’s salary for a period of six months and to provide him with continued medical and life insurance benefits during that period.

On August 8, 2005, the Company appointed Keith Stentiford as interim Chief Executive Officer effective as of August 16, 2005.  Mr. Stentiford joined the Company on January 3, 2005 as Vice President Business Development.  Mr. Stentiford joined Spescom after having worked at Siemens AG (“Siemens”) for over 25 years in various senior business development and sales management positions.  In the past five years prior to joining the Company, he served as Vice President in the Siemens Transportation and Systems Company, responsible for the Americas Turnkey Business Operations.

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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 Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or anticipated results, including those set forth under “Certain Factors That May Affect Future Results” below and elsewhere in, or incorporated by reference into, this report.

In some cases, you can identify forward looking statements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,” or the negative of these terms.  These and similar expressions are intended to identify forward-looking statements.  When used in the following discussion, the words “believes,” “anticipates” and similar expressions are intended to identify forward-looking statements.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof  The forward-looking statements in this report are based upon management’s current expectations and belief, which management believes are reasonable.  These statements represent our estimates and assumptions only as of the date of this Quarterly Report on Form 10-Q, and we undertakes no obligation to publicly release the result of any revisions to these forward-looking statements, which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

The following discussion should be read in conjunction with the Selected Consolidated Financial Data and the Consolidated Financial Statements, including the Notes thereto.

OVERVIEW

The Company develops, markets and supports eB, its integrated suite of collaborative document, configuration and records management software solutions.  The eB suite enables organizations in a broad range of industries to create, capture, store, manage, share and distribute critical business information regarding their customers, products, assets and processes in an efficient manner.  The eB suite also enables them to maintain complete, up-to-date information about the configuration of their products, assets and infrastructures so that they can achieve operational excellence and compliance with regulatory requirements.  eB provides the capabilities of an Enterprise Content Management (ECM)/Electronic Document Management (EDM) System, but extends these capabilities by also managing the “things’ that the content/documents relate to such as products, assets, functions, processes, requirements, projects, organizations, locations, work orders, etc.  As a result, eB can be used to manage the lifecycle of physical items (e.g. products, equipment or assets), and the requirements (e.g. functional, safety, performance, environmental, etc.) that govern them.  It enables intelligent relationships to be defined between these items thereby creating an interdependency model.  As a result, the effects of any change on requirements, documents and items can be determined and change can be managed to effectively ensure information integrity.  In particular, eB enables organizations with extensive and complex physical infrastructures to efficiently identify, classify, structure, link, and manage documents, physical items, and requirements throughout their lifecycles and ensure that conformance between these is maintained by means of an automated change process.

We develop, market and support eB.  Our revenues in the three months ended June 30, 2005 decreased by 55% from the same period in the prior fiscal year due to lower license and services revenue.  For the nine months ended June 30, 2005 our revenues decreased by 30% from the same period in the prior fiscal year due to the fact that the Company in the prior year had several large license sales to a new and existing customers, while there was no similarly large sale in the current year.  The Company’s license revenue fluctuates from quarter to quarter as reflected by the decrease in license and service sales during the quarter.

Our revenues are derived from licenses of our software to our customers, services that we provide under maintenance support contracts and our non-maintenance services, consisting primarily of design studies, system implementation and training.  Of our total revenues for the three months ended June 30, 2005, license revenues accounted for 11%, maintenance services revenues accounted for 56% and non-maintenance services revenues represented 33%.  For the nine months ended June 30, 2005, license revenues accounted for 11%, maintenance services revenues accounted for 50% and non-maintenance services revenues represented 39%.

Many of our customers are located outside the United States, with foreign-originated revenues accounting for 45% and 73% of revenues for the three months ended June 30, 2005 and 2004, respectively and 49% and 50% of revenues for the nine months ended June 30, 2005 and 2004, respectively.  Our revenues for the nine months ended June 30, 2005 reflect a foreign currency loss of $119,000 as compared to last year, due to the declining value of the dollar during the year.

The decrease in revenues during the three and nine months ended June 30, 2005 resulted in a decrease in our gross profit from 79% to 56% of revenues and 72% to 58% of revenues, respectively.  Operating expenses increased during the three and nine months ended June 30, 2005 from 62% to 96% of revenues and 72% to 99% of revenues, respectively.

At June 30, 2005, our principal sources of liquidity consisted of $310,000 of cash and cash equivalents, compared to $109,000 at September 30, 2004.  On November 5, 2004, we completed a private placement of preferred stock which resulted in gross proceeds of $2,200,000.

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CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies which are most critical to aid in fully understanding and evaluating reported financial results include the following:

Revenue Recognition

The Company enters into contractual arrangements with end-users that may include licensing of the Company’s software products, product support and maintenance services, consulting services or various combinations thereof, including the sale of such products or services separately.  The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2 “Software Revenue Recognition” and SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions” and Staff Accounting Bulletin (“SAB”)  No. 101, updated by SAB’s 103 and 104 “Update of Codification of Staff Accounting Bulletins.”

Software license and third party product revenues are recognized upon shipment of the product if no significant vendor obligations remain and collection is probable. In cases where a significant vendor obligation exists, revenue recognition is delayed until such obligation has been satisfied. For new software products where a historical record has not yet been demonstrated that acceptance is perfunctory, the Company defers recognition of revenue until acceptance has occurred. If an undelivered element of the arrangement exists under the license arrangement, a portion of revenue is deferred based on vendor-specific objective evidence (VSOE) of the fair value of the undelivered element until delivery occurs.  If VSOE does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.  Annual maintenance revenues, which consist of ongoing support and product updates, are recognized on a straight-line basis over the term of the contract. Payments received in advance of performance of the related service for maintenance contracts are recorded as deferred revenue. Revenues from training and consulting services are recognized when the services are performed and adequate evidence of providing such services is available. Contract revenues for long-term contracts or programs requiring specialized systems are recognized using the percentage-of-completion method of accounting, primarily based on contract labor hours incurred to date compared with total estimated labor hours at completion. Provisions for anticipated contract losses are recognized at the time they become known.

Contracts are billed based on the terms of the contract. There are no retentions in billed contract receivables. Unbilled contract receivables relate to revenues earned but not billed at the end of the period.

The Company considers many factors when applying accounting principles generally accepted in the United States of America related to revenue recognition.  These factors include, but are not limited to:

•                                          The actual contractual terms, such as payment terms, delivery dates, and pricing of the various product and service elements of a contract

•                                          Availability of products to be delivered

•                                          Time period over which services are to be performed

•                                          Creditworthiness of the customer

•                                          The complexity of customizations to the Company’s software required by service contracts

•                                          The sales channel through which the sale is made (direct, VAR, distributor, etc.)

•                                          Discounts given for each element of a contract

•                                          Any commitments made as to installation or implementation of “go live” dates

Each of the relevant factors is analyzed to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer.  Management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards.  Any misjudgment or error by management in its evaluation of the factors and the application of the standards, especially with respect to complex or new types of transactions, could have a material adverse effect on the Company’s future operating results.

Allowance for Doubtful Accounts

The Company sells its products directly to end-users, generally requiring a significant up-front payment and remaining terms appropriate for the creditworthiness of the customer. The Company also sells its products to VARs and other software distributors generally under terms appropriate for the creditworthiness of the VAR or distributor. The Company retains no continuing obligations on sales to VARs.  Receivables from customers are generally unsecured. The Company continuously monitors its customer account balances and actively pursues collections on past due balances. The Company maintains an allowance for doubtful accounts which is comprised of a general reserve based on historical collections performance plus a specific reserve for certain known customer collections issues. If actual bad debts are greater than the reserves calculated based on historical trends and known customer issues, the Company may be required to book additional bad debt expense which could have a material adverse effect on our business, results of operations and financial condition for the periods in which such additional expense occurs.

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RESULTS OF OPERATIONS

The following table sets forth the condensed consolidated statement of operations expressed as a percentage of total revenue for the periods indicated:

Revenues

License Revenues

(in thousands)

License revenues decreased by $1,410,000, or 90%, to $149,000 from $1,559,000 for the three months ended June 30, 2005 compared to the same period a year ago.  The Company’s license revenues fluctuate from quarter to quarter which is reflected in the decrease in license sales in the current quarter.  License revenue decreased $2,534,000, or 83%, to $503,000 from $3,037,000 for the nine months end June 30, 2005 as compared to the same period a year ago.  In the prior year two large sales of licenses to Network Rail and Constellation Energy amounted to $1.5 million and $750,000, respectively, while there were no similar size sales in the current year.  The length of time it takes to establish new customer relationships typically ranges from 6 to 12 months, and as such the timing of sales can fluctuate significantly from quarter to quarter.

Despite the relatively weak license revenue in the three and nine months ended June 30, 2005, we believe that if the Company is successful in capitalizing on its pipeline of sales opportunities, license revenues will increase.  The Company’s license revenues can fluctuate from quarter to quarter, based on the timing of customer orders due to the long sales cycle and changes in customers’ internal plans for the rollout of software licenses.

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Although the Company has historically generated the majority of its revenues from its direct sales force, the Company has also established a network of third-party VARs, system integrators and OEMs who build and sell systems (with components or complete systems provided by the Company) that address specific customer needs within various industries, including those targeted directly by the Company.  Sales through indirect channels for the three months ended June 30, 2005 amounted to $89,000 or 7% of total revenue compared to $71,000 or 3% of total revenue for the same period in 2004.  Sales through indirect channels for the nine months ended June 30, 2005 amounted to $322,000 or 7% of total revenue compared to $371,000 or 6% of total revenue for the same period in 2004.

A small number of customers have typically accounted for a large percentage of the Company’s annual revenues. Network Rail and CSC International Systems Ltd accounted for 18% and 10%, respectively, of revenue for the nine months ended June 30, 2005, while Network Rail and Constellation Energy Group accounted for 27% and 17%, respectively of revenue for the nine months ended June 30, 2004.  The Company’s reliance on relatively few customers could have a material adverse effect on the results of its operations on a quarterly basis.

Service and Other Revenues

(in thousands)

Services and other revenues are comprised of maintenance and non-maintenance services.  Non-maintenance services typically relate to business process studies, implementation of systems and training which vary with the level of license revenues while maintenance revenue is primarily dependent on customers renewing their annual maintenance support contracts.

Services and other revenue decreased $193,000, or 14%, from $1,341,000 to $1,148,000 for the three months ended June 30, 2005 compared to the same period a year ago.  The decrease is primarily due to lower maintenance service revenue of $143,000, relating to a reduction in customer maintenance requirements of several existing customers.  Also in this quarter non-maintenance revenue decreased by $50,000, as compared to the same period a year ago, related to delayed expansion of customer systems and upgrades from older legacy systems to newer versions of eB.

Services and other revenue increased $531,000, or 15%, from $3,589,000 to $4,120,000 for the nine months ended June 30, 2005 compared to the same period a year ago.  The increase is primarily due to higher non-maintenance service revenue of $558,000, relating to an increased demand for consulting services relating to customers expanding the integration of eB into additional departments and to upgrading from older legacy systems to the current versions of eB.  The increase in non-maintenance service revenue was partially offset by a reduction in maintenance revenue of $27,000 as compared to the same period a year ago, which reflects decreased customer maintenance requirements for certain existing customers.

Fluctuations in license revenue can impact service revenues in future periods as customers implement the software licensed by the Company and require maintenance support.  As such, we anticipate service and other revenue will fluctuate primarily with sales to new customers because new customers require more services that typically include a business process study, integration with other business systems and training.  In addition, service and other revenues will continue to fluctuate from quarter to quarter based on the timing of customer orders.

Cost of Revenues

Cost of License Revenues

(in thousands)

Cost of license revenue consists of costs associated with reselling third-party products and amortization of capitalized software development costs.

Cost of license revenue increased by $25,000, or 68%, from $37,000 to $62,000 for the three months ended June 30, 2005 compared to the same period a year ago.  The increase is due primarily to $31,000 in higher third-party costs as the Company experienced an increase in sales of third-party products during the quarter which was partially offset by a decrease of $6,000 in amortization expense of software costs as a result of a majority of such costs being fully amortized in fiscal 2004.  The 90% decrease in license revenue resulted in a reduced gross profit percentage of license revenues to 58 % for the three months ended June 30, 2005 as compared to 98% for the same period a year ago.  Also contributing to the decrease was the proportional increase in third party products which typically have a lower margin than the sale of the Company’s proprietary software products.

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Cost of license revenue decreased by $8,000, or 4%, from $178,000 to $170,000 for the nine months ended June 30, 2005 compared to the same period a year ago.  The decrease was primarily due to the reduced amortization expense of $24,000 related to capitalized software as mentioned above.  The 83% decrease in license revenue combined with costs of license revenue decreasing 4% resulted in a reduction in gross profit percentage of license revenues to 66% for the nine months ended June 30, 2005 as compared to 94% for the same period a year ago.

We expect the cost of license revenues to fluctuate based on fluctuations in license revenues and in customer requirements for third-party software products since the cost of meeting these customer requirements have the largest impact on cost of license revenues.

Cost of Services and Other Revenues

(in thousands)