10QSB/A 1 form10qsb-a22806.htm FORM 10-QSB/A (2-28-06) Form 10-QSB/A (2-28-06)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-QSB/A
QUARTERLY REPORT

x Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended February 28, 2006

 o Transition Report pursuant to 13 or 15(d) of the Securities Exchange Act of 1934


Commission File Number 000-31090
 
SYSTEMS EVOLUTION INC.
 

 

(Exact name of Small Business Issuer as specified in its charter)


 Idaho
82-0291029
(State or other jurisdiction of
incorporation or organization)
(IRS Employer Identification No.)



10777 Westheimer Road, Suite 810
Houston, Texas 77042
(Address of principal executive offices)


713-979-1600




Issuer's telephone number

None

 

(Former name, former address and former fiscal year,
if changed since last report)


Check whether the issuer (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities and 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.

(1) x Yes o No

(2) x Yes o No

The number of shares of issuer's Common Stock outstanding as of April 19, 2006:
187,922,760 shares





 

SYSTEMS EVOLUTION INC.
INDEX
QUARTERLY REPORT ON FORM 10-QSB
FOR QUARTERLY PERIOD ENDED February 28, 2006
 

PART I. FINANCIAL INFORMATION
ITEM 1 - Unaudited Consolidated Financial Statements
 
a.
Consolidated Balance Sheets as of February 28, 2006 (Unaudited) and May 31, 2005
b. Consolidated Statements of Operations for the Three And Nine Months Ended February 28, 2006 and 2005 (Unaudited)
c. Consolidated Statements of Cash Flows for the Nine Months Ended February 28, 2006 and 2005 (Unaudited)
d. Notes to Consolidated Financial Statements (Unaudited)
ITEM 2 - Management's Discussion and Analysis
ITEM 3 - Controls and Procedures

PART II. OTHER INFORMATION
  ITEM 6 - Exhibits      

SIGNATURES

EXHIBIT 31 - Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
EXHIBIT 32 - Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002





This amendment to the Form 10-QSB for the period ended February 28, 2006, as previously filed on April 19, 2006 includes restated financial statements to properly reflect derivative accounting for warrants issued to consultants, the conversion features of the convertible notes payable and associated warrants.

Warrants issued to consultants and the warrants associated with the Convertible Notes payable have been accounted for as freestanding derivative liabilities instead of equity as was originally filed. Additionally, the embedded conversion options of the convertible notes payable have been bifurcated from the debt and accounted for separately as derivative liabilities instead of equity as was originally filed. We have added notes 6 and 7 further explaining the derivative liabilities and provided information on subsequent changes.

We are required to record the fair value of the embedded conversion options and the warrants on our balance sheet with changes in the values of these derivatives reflected in the consolidated statement of operations as “Gain (loss) on derivative liabilities.” The effect on our consolidated statement of operations for the quarters ended February 28, 2006 and 2005 of the non-cash changes related to accounting separately for these derivative liabilities and modifying the estimated volatility was an increase in our net loss of $8,273,975 and a decrease in our net loss of $3,083,064, respectively. The cumulative effect on our consolidated balance sheets as of February 28, 2006 and 2005 was an additional liability of $15,383,398 and $5,616,981, respectively and a decrease in stockholders' equity of $13,481,316 and $4,998,498, respectively.

In all other material respects, this Amended Quarterly Report on Form 10-QSB/A is unchanged from the Quarterly Report on Form 10-QSB previously filed by the Company. This amendment should also be read in conjunction with our amended Annual Report on Form 10-KSB/A for the fiscal year ended May 31, 2005.


PART I. FINANCIAL INFORMATION

ITEM 1 - Unaudited Consolidated Financial Statements

SYSTEMS EVOLUTION, INC.
CONSOLIDATED BALANCE SHEETS
February 28, 2006 and May 31, 2005
(Unaudited)
                                                                                                                                                                     
 
 
 
 
 
 
February 28, 2006
(Unaudited)
(Restated)
 
 
 
 
May 31, 2005
(Restated)
  
ASSETS
 
 
 
        
Current Assets
 
 
        
Cash
$
6,404
  
$
66,060
  
Accounts receivable, net of allowance for doubtful accounts of $17,211 and $23,341
 
560,825
    
319,612
  
Unbilled revenue
  
223,479
    
476,541
  
Prepaid expenses and other current assets
 
18,537
    
71,580
  
Total Current Assets
 
809,245
    
933,793
  
 
 
 
        
Unamortized debt issue costs, net of accumulated amortization of $720,010 and $43,586, respectively
 
4,654,958
    
5,331,382
  
Other assets
  
10,639
    
8,971
  
Furniture and equipment, net of accumulated depreciation of $178,224 and $132,361, respectively
 
99,308
    
127,330
  
Goodwill
  
1,231,648
    
1,231,648
  
Intangibles, net of $1,189,971 and $650,847 amortization and impairment, respectively
 
1,122,537
    
1,661,664
  
TOTAL ASSETS
$
7,928,335
  
$
9,294,788
  
 
 
 
        
LIABILITIES AND STOCKHOLDERS' DEFICIT
 
 
        
 
 
 
        
Current Liabilities
 
 
        
Accounts payable
$
605,523
  
$
281,702
  
Accrued expenses
 
597,969
    
242,345
  
Deferred revenue
  
-
    
15,509
  
Notes payable
 
57,419
    
50,096
  
Current portion of convertible notes, net of unamortized discount of $75,754
  
77,482
    
-
  
Derivative liability
  
16,748,720
    
5,731,053
  
Total Current Liabilities
  
18,087,113
    
6,320,705
  
 
 
 
        
Deferred rents
  
19,546
    
-
  
Convertible notes, net of unamortized discount of $264,084
 
74,739
    
23,544
  
Long-term debt - related parties
 
131,509
    
133,599
  
Total Liabilities
  
18,312,907
    
6,477,848
  
 
 
 
        
STOCKHOLDERS' DEFICIT
 
 
        
Common stock, no par value,
750,000,000 shares authorized,
187,922,760 shares issued and outstanding
 
 
 
7,857,464
    
7,297,683
  
Accumulated deficit
  
(18,242,036
)
  
(4,480,743
)
Total Stockholders' Deficit
  
(10,384,572
)
  
2,816,940
  
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT
$
7,928,335
  
$
9,294,788
  








SYSTEMS EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Three and Nine Months Ended February 28, 2006 and 2005
(unaudited)

     
Three Months
  
Nine Months
     
2006
(Restated)
  
2005
(Restated)
  
2006
(Restated)
  
2005
(Restated)
 
 
 
      
 
      
Revenues
 
$
1,116,756
$
1,798,459
$
3,521,743
$
3,277,505
                   
Cost of Goods Sold
    
298,591
  
349,792
  
1,216,459
  
863,267
 
 
 
 
 
  
 
 
 
  
Gross Profit
    
818,165
  
1,448,667
  
2,305,284
  
2,414,308
                   
Operating Expenses:
                  
Payroll and related costs
 
 
847,706
 
1,500,352
 
2,747,981
 
2,965,529
General, administrative, and selling
 
 
158,241
 
544,178
 
639,377
 
2,547,348
Depreciation & amortization
    
194,996
  
245,450
  
583,032
  
496,609
                   
Operating loss
 
 
(382,778)
 
(841,313)
 
(1,665,106)
 
(3,595,178)
 
 
 
 
 
  
 
 
 
  
Interest expense
 
 
(416,046)
 
(70,544)
 
(1,303,356)
 
(146,225)
Gain (loss) on derivative liabilities
    
(8,777,651)
  
2,414,999
  
(10,798,652)
  
1,859,849
Other Income
    
6
 
4,703
  
15,937
 
4,703
Other costs
    
(1,343)
  
-
  
(10,116)
  
-
 
 
 
 
 
  
 
 
 
  
Net income / (loss)
 
$
(9,577,812)
$
1,507,845
$
(13,761,293)
$
(1,876,851)
 
 
 
 
 
  
 
 
 
  
Basic loss per share
 
$
(0.09)
$
0.02
$
(0.09)
$
(0.03)
Diluted loss per share
  
$
(0.09)
$
0.01
$
(0.09)
$
(0.03)
 
 
 
 
 
  
 
 
 
  
                   
Weighted average shares outstanding
 
 
107,974,507
 
79,481,122
 
146,695,700
 
68,385,086
Fully diluted weighted average shares outstanding
    
107,974,507
  
244,390,213
  
146,695,700
 
68,385,086





SYSTEMS EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended February 28, 2006 and 2005
(unaudited)
 
 
 
 
 
      
     
                                  2006
                                  (Restated)
  
2005
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
  
 
 
Net loss
 
       $
(13,761,293)
 
    $                         (1,876,851)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
      
Derivative gain / (loss)
    
10,798,652
  
                             (1,859,849)
Depreciation and amortization
 
 
583,032
  
                                   553,138
Amortization of discount on notes payable
    
320,015
  
                                     12,414
Amortization of deferred financing costs
    
676,424
  
                                     24,981
Shares issued for services
 
 
312,058
  
                                1,866,801
Shares issued for bonus
    
-
  
                                     32,694
Tax benefit
    
-
  
                                    (4,703)
Changes in:
 
 
      
Accounts receivable
 
 
(241,214)
  
                                  (78,548)
Prepaid expenses and other current assets
    
306,105
  
                                (372,515)
Other assets
 
 
(1,668)
  
                                  (58,947)
Accounts payable
 
 
329,822
  
                                     18,523
Unearned service revenue
    
                                       (15,509)
               
                      -
Accrued expenses
 
 
375,024
        
             89,571
NET CASH USED IN OPERATING ACTIVITIES
 
 
                                     (318,552)
     
      (1,633,291)
 
 
 
      
CASH FLOWS FROM INVESTING ACTIVITIES
 
 
      
Purchase of CMS
    
             -
  
                                       3,723
Purchase of Next Hire
    
             -
  
                                  (12,811)
Purchase of Duration Software
    
             -
  
                                (425,836)
Purchase of equipment
 
 
                                         (2,500)
  
           (34,988)
NET CASH USED IN INVESTING ACTIVITIES
 
 
                                         (2,500)
  
         (469,912)
 
 
 
      
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
      
Proceeds from notes payable and long-term debt
   
     3,940
  
                                 238,399
Payments on notes payable and long-term debt
    
  (10,000)
  
                               (687,292)
Proceeds from convertible notes
    
  250,000
  
        2,825,000
Deferred rent
    
   17,456
  
                     -
Cash paid for financing costs
    
                                                   -
  
         (358,468)
Common stock issued for cash
    
                                                    -
  
           124,840
Proceeds from exercise of warrants
 
 
--
 
               2,250
NET CASH PROVIDED BY FINANCING ACTIVITIES
 
 
                                       261,396
  
        2,144,729
 
 
 
      
NET CHANGE IN CASH
 
 
                                       (59,656)
  
                                     41,526
- Cash, beginning of period
 
  
                                         66,060
  
                                     19,522
- Cash, end of period
 
         $
                                           6,404
 
 $                                   61,048
           
SUPPLEMENTAL CASH FLOW INFORMATION:
          
Interest paid
  
$
                                           3,792
 
 $                                   26,677
Income Taxes paid
    
                                                   -
  
                                               -
 
 
 
      
NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
      
Common stock issued for acquisition of CMS
 
  
                                                   -
  
                                   104,000
Common stock issued for acquisition of Duration
    
                                                   -
  
                                2,250,000
Common stock issued for acquisition of Next Hire
    
                                                   -
  
                                     40,000
Common stock issued for computer equipment
 
 
                                                   -
  
                                     52,070
Common stock issued for debt
    
                                       216,738
  
                                     31,029
Discount of notes payable
    
                                       250,000
  
                                               -




SYSTEMS EVOLUTION INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
February 28, 2006
(UNAUDITED)

NOTE 1 - BASIS OF PRESENTATION
 
The accompanying unaudited interim financial statements of Systems Evolution Inc. ("SEVI") have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules of the Securities and Exchange Commission ("SEC"), and should be read in conjunction with the audited financial statements and notes thereto contained in the SEVI's Annual Report filed with the SEC on Form 10-KSB. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the financial statements which would substantially duplicate the disclosure contained in the audited financial statements for fiscal 2005 as reported in the 10-KSB have been omitted.

Impairment of Long-Lived Assets - SEVI reviews the carrying value of its long-lived assets annually or whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be appropriate. SEVI assesses recoverability of the carrying value of the asset by estimating the future net cash flows expected to result from the asset, including eventual disposition. If the future net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and fair value.


NOTE 2 - STOCK BASED COMPENSATION

SEVI accounts for stock-based compensation under the intrinsic value method. Under this method, SEVI recognizes no compensation expense for stock options granted when the number of underlying shares is known and exercise price of the option is greater than or equal to the fair market value of the stock on the date of grant. The following table illustrates the effect on net loss and net loss per share if SEVI had applied the fair value provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation for the nine months ended February 28, 2006 and 2005:


 
 
 
Three Months
Ending February 28,
 
  
 
 
 
2006
(Restated)
      
2005
(Restated)
 
 
 
 
 
 
  
 
 
 
Net income / (loss) as reported
 
 
 $          (9,577,812)
    
$
                  1,507,845
  
Add: intrinsic value expense recorded
 
 
-
      
108,265
  
Deduct: total stock-based employee compensation expense determined under fair value based method
 
 
-
      
(374,039)
          
Pro forma net loss
 
$
(9,577,812)
    
 
                       $                 1,242,071
  
                 
Basic and diluted net loss per common share:
 
 
            
As reported
 
$
(0.09)
    
 
                      $                           0.02
  
Pro forma
 
 
(0.09)
      
0.02
  

 
 
 
Nine Months
Ending February 28,
 
  
 
 
 
2006
(Restated)
      
2005
(Restated)
 
 
 
 
 
 
  
 
 
 
Net income / (loss) as reported
 
 
  $          (13,761,293)
    
$
               (1,876,851)
     
Add: intrinsic value expense recorded
 
 
-
      
534,751
  
Deduct: total stock-based employee compensation expense determined under fair value based method
 
 
-
      
(1,112,617)
 
Pro forma net loss
 
$
(13,761,293)
      
                    $                 (2,454,717)
 
                 
Basic and diluted net loss per common share:
 
 
            
As reported
 
$
(0.09)
      
                  $                          (0.03)
 
Pro forma
 
 
(0.09)
      
                                                 (0.04)
 

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: (1) 1.5% risk-free interest rate, (2) expected option life is the actual remaining life of the options as of each year end, (3) expected volatility is from 181% to 781% and (4) zero expected dividends.


NOTE 3 - CONVERTIBLE NOTES

During 2005, SEVI issued a total of $3,075,000 in convertible promissory notes pursuant to a private placement. Promissory notes for $1,825,000 are convertible at the holder’s option into SEVI common stock at $0.05 per share, accrue interest at 8% per annum, and have 36,500,000 warrants attached to them. During the second quarter of 2006 SEVI issued an additional $250,000 in convertible promissory notes pursuant to a private placement. Additionally, $150,000 of the promissory notes were converted into 3,000,000 shares of SEVI common stock during the second quarter of 2005 and $41,338 of the promissory notes were converted into 11,482,740 shares of common stock during the quarter ended February 28, 2006. Interest on these notes is payable semi-annually, and the notes mature on August 31, 2007. The warrants were denominated as Series A, B, C, and D warrants. The following table summarizes each series.

Series
Number of shares
Exercise Price
Expiration
A
9,125,000
$0.06
90 days from registration of underlying common shares
B
9,125,000
$0.07
180 days from registration of underlying common shares
C
9,125,000
$0.08
270 days from registration of underlying common shares
D
9,125,000
$0.15
August 31, 2009
 
36,500,000
    

Promissory notes for $1,500,000 are convertible at the holders’ option into SEVI common stock at the lesser of 50% of the average of the three lowest trading prices 20 days prior to one day before the holder sends the conversion notice to SEVI or $0.13 per share, accrue interest at 8% per annum, and have 4,500,000 warrants attached to them. The exercise price of the warrants is $0.08 per share. The warrants are exercisable for 5 years. Accrued interest and principal are due at maturity. $500,000 matures on December 30, 2006, $500,000 matures on January 14, 2007, $250,000 matures on April 28, 2007, and $250,000 matures on November 14, 2007.

The notes have been discounted for the fair value of the embedded conversion options and freestanding warrants accounted for as derivatives. All discounts will be amortized over the life of the notes using the effective interest method. The fair values of the derivatives were calculated using the Cox-Ross-Rubestein model. See note 6 for more information on the derivatives. Variables used in the Cox-Ross-Rubestein model include (1) 2.75% to 3.84% risk-free interest rate, (2) expected volatility of 125% and (3) zero expected dividends.

A summary of the convertible notes at February 28, 2006 and May 31, 2005 is as follows:
 
  
February 28, 2006
    
May 31, 2005
  
Gross proceeds from notes
$
3,325,000
 
$
3,075,000
 
Less: Value of derivatives
 
(3,325,000
)
 
(3,075,000
)
Less: Retirement of debt for stock
 
(191,337
)
 
-
 
Add: Amortization of discounts
 
343,558
 
  
23,544
 
Carrying value of notes on February 28, 2006
  
152,221
 
  
23,544
  
Less current portion
  
(77,482
)
  
-
  
Long-term convertible notes, net
$
74,739
  
$
23,544
  


NOTE 4 - COMMON STOCK

During the three months ending August 31, 2005, SEVI issued the following shares:

 
·
In July 2005, SEVI issued 6,361,691 shares per a board resolution to offer restricted SEVI shares in exchange for all vested options in a one for one exchange (one vested option for one restricted SEVI share) as of May 31, 2005 for those still employed by SEVI as of June 30th, 2005. SEVI received a signed agreement from all option holders in order to receive the Share Grant that stipulates the Holder agrees to give up all un-vested options; these agreements amended all employment contracts then in force as of May 31, 2005.
 
·
In July 2005, SEVI issued 300,000 shares valued at $6,000 to directors of SEVI as of December 2004.

During the three months ending November 30, 2005, SEVI issued the following shares:

 
·
In September 2005, SEVI issued 3,120,000 shares in exchange for the conversion of a $150,000 convertible promissory note held by Platinum Partners Value Arbitrage Fund LP and the associated accrued interest of $6,000.
 
·
In November 2005, SEVI issued 1,340,000 shares valued at $0.01 per share in exchange for interest accrued on the convertible notes issued September 2004.
·  
In November 2005, SEVI issued 4,000,000 shares valued at $0.01 per share in exchange for an executed release from an employment contract with an officer of SEVI.
·  
In November 2005, SEVI issued 4,500,000 shares valued at $0.01 per share, per board resolution, to individuals taking on new management positions with SEVI.
·  
In November 2005, SEVI issued 4,165,512 shares valued at $0.01 per share, per board resolution to individuals for services.

During the three months ending February 28, 2006, SEVI issued the following shares:

·  
In January 2006, SEVI issued 4,191,074 shares in exchange for the conversion of $15,088 convertible promissory notes held by various convertible note holders.
·  
In January 2006, SEVI issued 1,538,461 shares valued at $.0065 per share in exchange for legal services from Mark L. Baum and Philip E. Koehnke for the month of January 2006.
·  
In February 2006, SEVI issued 7,291,666 shares in exchange for the conversion of $26,250 convertible promissory notes held by various convertible note holders.
·  
In February 2006, SEVI issued 2,222,222 shares valued at $.0045 per share in exchange for legal services from Mark L. Baum and Philip E. Koehnke for the month of February 2006.

Subsequent to February 28, 2006:

·  
In March 2006, SEVI issued 5,000,000 shares to Allen Goldsmith, principal with Technology Navigators, Inc. for payment of outstanding accounts payable. As of the end of February 2006 shares of the stock had not been sold, therefore the value of the stock had not been determined. The shares were sold between March 1, 2006 and March 8, 2006 for an average price of $.01862 per share.
·  
In March 2006, SEVI issued 1,000,000 unrestricted shares and 500,000 restricted shares valued at $.04 per share to Pinchus Gold as compensation under a 12 month consulting services agreement.
·  
In March 2006, SEVI issued 5,000,000 shares to Mr. Pinchus Gold upon his exercise of warrants issued to Mr. Gold as a part of the service agreement contract discussed above. The warrants were exercisable at $.01 per share.
·  
In March 2006, SEVI issued 9,781,111 shares in exchange for the conversion of $35,212 convertible promissory notes held by various convertible note holders.
·  
In March 2006, SEVI issued 917,000 shares valued at $.01125 per share, per board resolution, to an individual as compensation under their bonus plan.
·  
In March 2006, SEVI issued 6,000,000 shares to Allen Goldsmith principal with Technology Navigators, Inc. in payment of outstanding accounts payable. The shares were sold between March 13, 2006 and March 29, 2006 for an average price of $.03612 per share.
·  
In March 2006, SEVI issued an additional 5,000,000 shares to Mr. Pinchus Gold upon his exercise of warrants issued to Mr. Gold as part of the service agreement contract discussed above. The warrants were exercisable at $.0125 per share.
·  
In March 2006, SEVI issued 12,000,000 shares to Mr. James Panther upon his exercise of warrants issued to Mr. Panther as part of an advisory services agreement. Mr. Panther’s services center on the restructuring of the convertible notes outstanding for SEVI. The warrants were exercised at $.0138 per share.
·  
In March 2006, SEVI issued 872,600 shares valued at $.01146 per share, in exchange for legal services from Mark L. Baum for the month of March 2006.
·  
In March 2006, SEVI issued 2,452,000 shares valued at $.02 per share to Bob C. Johnson, per board resolution, as compensation for 90 days.
·  
In April 2006, SEVI issued 5,000,000 shares valued at $.03 per share to Triangle Technology, Inc. in payment of outstanding accounts payable.
·  
In April 2006, SEVI issued 3,372,000 shares valued at $.02 per share, per board resolution for installment payments to 4 individuals.
·  
In April 2006, SEVI issued 9,526,000 shares valued at $.02 per share per board resolution, as compensation for 90 days to 6 employees.

NOTE 5 - SEGMENT INFORMATION

Reportable segments are based on internal organizational structure and are comprised of the Consulting division (“Consulting”) (this represents a name change from Business & Technology or “B&T”, instigated on January 1, 2006) or the Next Hire Consultants (“NHC”) division. The Consulting division provides high-end, value-added software development services and the NHC division provides contract staff and permanent placement services.

Segment financial information is summarized as follows:

(Restated)
Consulting
NHC
Corporate and other
Total
Three Months ended February 28, 2006
       
Revenue
$ 742,495
$ 316,932
$ 57,329
$ 1,116,756
Depreciation and amortization
4,950
-
190,046
194,996
Interest expense
441
-
415,605
416,046
Net income (loss)
(133,888)
116,727
(9,560,651)
(9,577,812)
Total assets
668,909
167,476
7,091,950
7,928,335
Expenditures for long-lived assets
-
-
-
-
         
Three Months ending February 28, 2005
        
Revenue
$ 1,625,309
$ 173,150
$ -
$ 1,798,459
Depreciation and amortization
7,390
-
238,060
245,450
Interest expense
602
940
69,002
70,544
Net income (loss)
(1,652)
22,931
1,486,566
1,507,845
Expenditures for long-lived assets
17,985
-
456
29,546
         
Nine Months ended February 28, 2006
        
Revenue
$ 2,767,243
$ 722,301
$ 32,199
$ 3,521,743
Depreciation and amortization
14,474
-
570,515
584,989
Interest expense
2,630
-
1,300,726
1,303,356
Net income (loss)
(396,866)
129,582
(13,494,009)
(13,761,293)
Total assets
668,909
167,476
7,091,950
7,928,335
Expenditures for long-lived assets
13,383
-
4,457
17,840
         
Nine Months ending February 28, 2005
        
Revenue
$ 2,999,263
$ 272,982
$ 5,260
$ 3,277,505
Depreciation and amortization
11,709
-
484,900
496,609
Interest expense
2,744
940
142,541
146,225
Net income (loss)
(273,894)
(33,073)
(1,569,884)
(1,876,851)
Expenditures for long-lived assets
24,338
3,687
5,436
34,988


NOTE 6 - DERIVATIVES

SEVI evaluated the application of SFAS 133 and EITF 00-19 for all of its financial instruments and identified the following financial instruments as derivatives:

1)  
Embedded conversion option of Convertible Notes

2)  
Warrants to purchase common stock associated with the Convertible Notes

3)  
Warrants to purchase common stock issued with consulting agreements for two individuals (“Consulting Warrants”)

Based on the guidance in SFAS 133 and EITF 00-19, SEVI bifurcated and separately accounted for the embedded conversion options of the Convertible Notes Payable because the conversion price was not fixed and was not convertible into a fixed number of shares.

Furthermore, SEVI concluded that the exercise price and the number of shares to be issued under the “Consulting Warrants” and the Convertible Notes Warrants are fixed. However, because the Convertible Notes might result in issuing an indeterminate number of shares, it cannot be concluded that SEVI has a sufficient number of authorized shares to settle either group of warrants. As such, the warrants were accounted for as derivative liabilities.

SEVI is required to record the fair value of the conversion options and the warrants on its balance sheet with changes in the values of these derivatives reflected in the consolidated statement of operations as “Gain (loss) on embedded derivative liability.” The derivative liabilities were not previously classified as such in SEVI's historical financial statements causing those financial statements to be restated. See note 7 for details.
 
The impact of the application of SFAS 133 and EITF 00-19 on the balance sheet as of February 28, 2006 is as follows:

Embedded conversion option in Convertible Debenture
$16,300,360
Convertible Debenture warrants
249,631
Consulting warrants
198,729
Total
$16,748,720

The fair values were calculated using the Cox-Ross-Rubenstein model. Variables used in the Cox-Ross-Rubenstein model include (1) 4.6% risk-free interest rate, (2) expected volatility of 125% and (3) zero expected dividends. The impact on statements of operations for the three and six months ended February 28, 2006 and 2005 is as follows:

 
Three months ended February 28,
Nine months ended February 28,
 
    2006
    2005
    2006
     2005
Embedded Conversion Option in Convertible Debenture
$(8,655,395)
$ (145,429)
$(11,512,447)
$(8,486,066)
Convertible Debenture warrants
(67,947)
1,451,589
428,819
6,285,465
Consulting warrants
(54,309)
1,108,839
284,976
4,060,450
Total gain (loss) on derivative liabilities:
$(8,777,651)
$2,414,999
$(10,798,652)
$ 1,859,849


NOTE 7 - RESTATEMENT

SEVI restated its 2005 quarterly financial statements from amounts previously reported. SEVI has determined that certain financial instruments issued by SEVI contain features that require accounting for these features as derivative instruments. Accordingly, warrants issued to consultants, the conversion options of the Note Payable and Convertible Debentures and their associated warrants were orignally accounted for as equity and should have been accounted for as derivative liabilities. Note 6 was added to disclose the derivative instrument liabilities and provide information on subsequent changes. In addition, SEVI has modified the estimated volatility used in the Cox-Ross-Rubenstein option pricing model used to value the warrants issued to consultants, the warrants issued to the debentures holders and the conversion options embedded in the Note Payable and the Convertible Debentures. Additionally, SEVI has changes the amortization of the discount to be on the effective interest method instead of the straight-line method.

SEVI is required to record the fair value of the conversion features and the warrants on the balance sheet at fair value with changes in the values of these derivatives reflected in the consolidated statement of operations as “Gain (loss) on derivative instrument liabilities.”

Following is a summary of the restatement adjustments:


 
Balance Sheet February 28, 2006
Balance Sheet May 31, 2005
 
As Reported
Adjustments
As Restated
As Reported
Adjustments
As Restated
             
Cash
$ 6,404
  
$ 6,404
$ 66,060
  
$ 66,060
Accounts receivable
560,825
  
560,825
319,612
  
319,612
Unbilled revenue
223,479
  
223,479
476,541
  
476,541
Prepaid expenses and other current assets
18,537
  
18,537
71,580
  
71,580
Deferred financing costs
2,752,876
$ 1,902,082
4,654,958
4,236,848
$ 1,094,534
5,331,382
Other assets
10,639
  
10,639
8,971
  
8,971
Furniture and equipment
99,308
  
99,308
127,330
  
127,330
Goodwill
1,231,648
  
1,231,648
1,231,648
  
1,231,648
Intangibles
1,122,537
  
1,122,537
1,661,664
  
1,661,664
             
Total assets
$ 6,026,253
$ 1,902,082
$ 7,928,335
$ 8,200,254
$ 1,094,534
$ 9,294,788
             
             
Accounts payable
$ 605,523
  
$ 605,523
$ 281,702
  
$ 281,702
Accrued expenses
597,969
  
597,969
242,345
  
242,345
Deferred revenue
-
  
-
15,509
  
15,509
Notes payable
57,419
  
57,419
50,096
  
50,096
Current portion of convertible notes, net
-
$ 77,482
77,482
-
  
-
Current portion derivative liability
-
13,402,498
13,402,498
-
$ 1,107,343
1,107,343
Deferred Rents
19,546
  
19,546
-
  
-
Convertible note
1,517,543
(1,442,804)
74,739
800,107
(776,563)
23,544
Derivative liability
-
3,346,222
3,346,222
-
4,623,710
4,623,710
Long-term debt - related parties
131,509
  
131,509
133,599
  
133,599
             
Total liabilities
2,929,509
15,383,398
18,312,907
1,523,358
4,954,490
6,477,848
             
Common stock
16,263,858
(8,406,394)
7,857,464
15,485,062
(8,187,379)
7,297,683
Accumulated deficit
(13,167,114)
(5,074,922)
(18,242,036)
(8,808,166)
4,327,423
(4,480,743)
             
Total equity/(deficit)
3,096,744
(13,481,316)
(10,384,572)
6,676,896
(3,859,956)
2,816,940
             
Total Liabilities and Equity/(Deficit)
$ 6,026,253
$ 1,902,082
$ 7,928,335
$ 8,200,254
$ 1,094,534
$ 9,294,788
             

 
Three Months Ended February 28, 2006
Three Months Ended February 28, 2005
 
As Reported
Adjustments
As Restated
As Reported
Adjustments
As Restated
             
Gross Profit
$ 818,163
$ 2
$ 818,165
$ 1,448,667
  
$ 1,448,667
             
Operating Expenses:
            
Payroll and related
847,706
  
847,706
1,500,352
  
1,500,352
General and administrative
157,447
794
158,241
524,178
$ 20,000
544,178
Depreciation and amortization
194,997
(1)
194,996
245,450
  
245,450
             
Operating loss
(381,987)
(791)
(382,778)
(821,313)
(20,000)
(841,313)
             
Interest expense
(920,513)
504,467
(416,046)
(758,609)
688,065
(70,544)
Other income
6
  
6
-
  
-
Tax benefit
-
  
-
4,703
  
4,703
Other costs
(1,343)
  
(1,343)
-
  
-
Gain (loss) on derivative instrument liabilities
-
(8,777,651)
(8,777,651)
-
2,414,999
2,414,999
             
Net income / (loss)
$ (1,303,837)
$ (8,273,975)
$ (9,577,812)
$(1,575,219)
$ 3,083,064
$ 1,507,845
             
Basic and diluted loss per share
$ (0.01)
  
$ (0.09)
$ (0.02)
  
$ (0.01)

 
Nine Months Ended February 28, 2006
Nine Months Ended February 28, 2005
 
As Reported
Adjustments
As Restated
As Reported
Adjustments
As Restated
             
             
Gross Profit
$ 2,305,284
  
$ 2,305,284
$ 2,414,308
  
$ 2,414,308
             
Operating Expenses:
            
Payroll and related costs
2,747,981
  
2,747,981
2,965,529
  
2,965,529
General , administrative and selling
637,109
$ 311
637,420
2,527,348
$ 20,000
2,547,348
Depreciation and amortization
584,989
  
584,989
496,609
  
496,609
             
Operating loss
(1,664,795)
(311)
(1,665,106)
(3,575,178)
(20,000)
(3,595,178)
             
Interest expense
(2,699,663)
1,396,307
(1,303,356)
(1,386,673))
1,240,448
(146,225)
Other income
15,937
  
15,937
-
  
-
Tax benefit
-
  
-
4,703
  
4,703
Other costs
(10,116)
  
(10,116)
-
  
-
Gain (loss) on derivative instrument liabilities
-
(10,798,652)
(10,798,652)
-
1,859,849
1,859,849
             
Net loss
$ (4,358,637)
$ (9,402,656)
$ (13,761,293)
$ (4,957,148)
$ 3,080,297
$(1,876,851)
             
Basic and diluted loss per share
$ (0.03)
  
$ (0.09)
$ (0.07)
  
$ (0.02)



ITEM 2 - Management's Discussion and Analysis

FORWARD LOOKING STATEMENTS

This quarterly report contains forward-looking statements that involve risks and uncertainties. We use words such as anticipate, believe, plan, expect, future, intend and similar expressions to identify such forward-looking statements. You should not place too much reliance on these forward-looking statements. Our actual results are likely to differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described in this section.

The Company, previously known as Wallace Resources Inc., was organized in the State of Idaho on August 26, 1968. Systems Evolution Inc., our Texas operating company was acquired by the Company on September 9, 2003, and after the acquisition, the Company's current directors and management took control of the Company. We generate revenue from professional services performed for our end-user customers and the end-user customers of our software partners.
        
Revenue is derived primarily from professional services provided on a time and materials basis, with the remaining revenue provided from fixed fee engagements. For time and material contracts, revenue is recognized and billed by multiplying the number of hours expended by our professionals in the performance of the contract by the established billing rates. For fixed fee projects, revenue is generally recognized using the proportionate performance method. Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses are determined. Billings in excess of costs plus earnings are classified as deferred revenues. On many projects we are also reimbursed for out-of-pocket expenses such as airfare, lodging and meals. These reimbursements are included as a component of revenue.

Our revenue and operating results are subject to substantial variations based on our customers' expenditures and the frequency with which we are chosen to perform services for our customers. Revenue from any given customer will vary from period to period.
 
Our gross margins are affected by trends in the utilization rate of our professionals (defined as the percentage of our professionals' time billed to customers, divided by the total available hours in the respective period), the salaries we pay our consulting professionals, and the average rate we receive from our customers. If a project ends earlier than scheduled or we retain professionals in advance of receiving project assignments, our utilization rate will decline and adversely affect our gross margins.

Recent Developments

In October 2005, SEVI entered into a teaming agreement with The Project Group Inc. (“TPG”), a company currently in Chapter 11 Bankruptcy and publicly traded on the Pink Sheets with the symbol PJTGQ. TPG is an integrator of Microsoft Project software and a Microsoft Gold Partner. This teaming agreement provides SEVI and TPG the ability to increase market penetration by cross marketing our services (software development) to TPG clients and TPG’s services (Microsoft Project implementation) to our clients, increase operating efficiencies by integrating our physical Houston offices, and gain Microsoft Gold Partner status (achieved October 2005).

Furthermore, on October 4, 2005, SEVI and TPG entered into a non-binding term sheet that provides a plan of reorganization of TPG in bankruptcy court and the corporate integration of the two companies after TPG emerges from bankruptcy. “The entire transaction and relevant terms are subject to approval by the respective Board of Directors of SEVI and TPG, our respective shareholders as required, by the SEVI convertible note holders as required, by the creditors of TPG, and the Bankruptcy Court.”

SEVI discontinued the $1,500,000 factoring facility with Allied Capital Partners, LP on the anniversary of the facility as provided in the original agreement with no costs associated with its discontinuance.  

In March 2006, SEVI amended its Amended 2006 Stock Incentive Plan to include up to 100,000,000 shares, from 50,000,000 shares, that may be issued pursuant to the Amended Plan, all upon the terms and subject to the provisions of the Amended Plan. This plan provides for the grant, at the discretion of the Compensation Committee of the Board of Directors, of stock awards of common stock, restricted stock awards of common stock, or stock options to purchase common stock of the Corporation.

Results of Operations for the three month periods ended February 28, 2006 and 2005

Total gross profit decreased from $1,448,667 for the three month period ended February 28, 2005 to $818,165 for the three month period ended February 28, 2006, a decrease of 44%. The decrease in gross profit resulted from decreased sales in the Consulting division and other revenues from Corporate and other. The decrease in Consulting and Other was partially offset by an increase in placement fees generated in the NHC division.

Net income from operations decreased from net income of $1,507,845 for the three month period ended February 28, 2005 to a net loss of $(9,577,812) for the three month period ended February 25, 2006. The decrease in the loss is attributable to reductions in payroll costs and general and administrative costs within the period along with a $8,777,651 adjustment for loss on derivative instrument liabilities.

Operating Expenses

Payroll and related costs make up the majority of our cost of revenue. Total payroll and related costs decreased from $1,500,352 for the three month period ended February 28, 2005 to $847,706 for the three month period ended February 28, 2006, a decrease of 44%. This decrease is attributed to reduction in operations related staff.

General and administrative expenses consist of salaries and benefits for sales, executive and administrative employees, training, marketing activities, investor relations, recruiting, non-reimbursable travel costs and expenses and miscellaneous expenses. General and administrative expenses decreased from $544,178 for three month period ended February 28, 2005 to $158,241 for the three month period ended February 28, 2006. This decrease is related to retaining a small administrative management team and little ongoing professional services.

Derivatives

The gain (loss) on derivative liabilities changed from a gain of $2,414,999 for the three month period ended Febraury 28, 2005 to a loss of $8,777,651 for the three month period ended February 28, 2006. This change is the result of additional derivative liabilities and the negative change in the valuation of the derivative liabilities.

Liquidity and Capital Resources

Net cash used by operating activities was $318,552 for the nine month period ended February 28, 2006 compared to $1,883,291 used by operating activities for the nine month period ended February 28, 2005.

Net cash provided by financing activities was $261,396 for the nine month period ended February 28, 2006 compared to $2,394,729 for nine month period ended February 28, 2005.

On August 31, 2004, the Company executed a Purchase Agreement with certain institutional and accredited investors under which the Company agreed to sell and the purchasers agreed to purchase convertible promissory notes due August 31, 2007 (the "Notes") in the aggregate principal amount of up to $2,500,000 bearing interest at the rate of 8% per annum and convertible into shares of our Common Stock at a conversion price of $0.05 per share. On September 9, 2004, the Company completed the sale of an aggregate of $1,825,000 in Notes and accompanying Warrants under the Purchase Agreement which resulted in net proceeds to the Company of $1,542,417. The Notes are initially convertible into 36,500,000 shares of Common Stock, and an additional 36,500,000 shares of Common Stock are reserved for issuance upon exercise of the Warrants issued to the note holders.

On December 30, 2004, we executed a securities purchase agreement with certain institutional and accredited investors for the sale of 8% Callable Secured Promissory Notes and accompanying Warrants. Under this agreement, on December 30, 2004, we completed the sale of an aggregate of $500,000 of these Notes, which resulted in net proceeds to SEVI of $408,148; on January 14, 2005, completed the sale of an additional $500,000 of these Notes, with net proceeds to SEVI of $497,500; on April 29, 2005 completed the sale of an additional $250,000 principal amount of these notes with net proceeds to SEVI of $230,000; and on November 14, 2005 completed the sale of an additional $250,000 principal amount of these notes with net proceeds to SEVI of $250,000.

The Company estimates that our requirements for additional capital over the next 12 months will be in the range of $1,324,000 or four times our net cash used in operating activities. There can be no assurance we will be able to raise this additional required capital on satisfactory terms, or at all. In the event we are unable to obtain such additional capital or to obtain it on acceptable terms or in sufficient amounts, the impact thereof would have a material adverse effect on our business, operating results, financial condition and may affect our ability to carry on as a Company.

Critical Accounting Policies

Consulting revenues are comprised of revenue from professional services fees recognized primarily on a time and materials basis as performed. For fixed fee engagements, revenue is recognized using the proportionate performance method (based on the ratio of hours expended to total estimated hours). Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses are determined. Billings in excess of costs plus earnings are classified as deferred revenues. Our normal payment terms are net 30 days. We record an expense for the expected losses on uncollectible accounts receivable each period based on known facts and circumstances for the respective period.

Deferred Financing Costs

Deferred financing costs relate to the cost incurred in the arrangement of Systems Evolution Inc.'s debt agreement and are being amortized using the straight-line method over the terms of the related debt.


ITEM 3 - Controls and Procedures

Disclosure Controls and Procedures. The Company's management, with the participation of the Company's Chief Executive Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer has concluded that, as of the end of such period, the Company's disclosure controls and procedures were not effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act. The disclosure controls and procedures were not effective due to late filing and derivative accounting and disclosures. The Company has implemented procedures to properly account for and disclose the derivatives.

Internal Control Over Financial Reporting. There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II - OTHER INFORMATION
 
ITEM 6 - Exhibits and Report on Form 8-K

(a) Exhibits.

Ex
31  Certification of Chief Executive Officer and Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.


Ex
32 Certification of Chief Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.



SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, as amended, the Company caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
                 
Dated: June 15, 2006
 
 Systems Evolution Inc.
 
/s/ Robert C. Rhodes
______________________________
Robert C. Rhodes
Chief Executive Officer
Chief Financial Officer