Terra Systems Corp - Annual Report (Small Business Issuers) (10KSB)

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United States
Securities and Exchange Commission
Washington, DC 20549

FORM 10-KSB

[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934

For the fiscal year ended December 31, 2007

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

Commission File Number: 0-31483

TERRA SYSTEMS, INC.
(Exact name of small business issuer in its charter)

UTAH 87-0476073 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 7001 South 900 East, Ste 260, Midvale, Utah 84047 ------------------------------------------- ---------- (Address of principal executive offices) (Zip Code)

Issuer's telephone number: [phone]

Securities registered under Section 12(b) of the Exchange Act: None.

Securities registered under Section 12(g) of the Exchange Act:

Common, $0.001 par value
(Title of Class)

Check whether the issuer is not required to file reports pursuant to Section 13
or 15(d) of the Exchange Act [ ]

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ]

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

State issuer's revenue for the fiscal year ended December 31, 2007: $149,994

As of April 14, 2008, when this report was prepared, the registrant had 53,246,806 shares of common stock outstanding. The aggregate market value of the 38,441,167 shares of voting stock held by non-affiliates as of that date was approximately $4,612,940.

Documents incorporated by reference: None.

Transitional Small Business Disclosure Format (check one): Yes [ ] No [X]

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Large accelerated filer |_| Accelerated filer |_|

Non-accelerated filer |_| Smaller reporting company |X|

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TABLE OF CONTENTS

PART I Item 1. Description of Business 4 Item 2. Description of Property 12 Item 3. Legal Proceedings 12 Item 4. Submission of Matters to a Vote of Security Holders 12 PART II Item 5. Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities 12 Item 6. Management's Discussion and Analysis or Plan of Operation 14 Item 7. Financial Statements 15 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 16 Item 8A. Controls and Procedures 16 Item 8B. Other Information 17 PART III Item 9. Directors, Executive Officers, Promoters Control Persons and Corporate Governance; Compliance with Section 16(a) of the Exchange Act 17 Item 10. Executive Compensation 19 Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 22 Item 12. Certain Relationships and Related Transactions, and Director Independence 23 Item 13. Exhibits 24 Item 14. Principal Accountant Fees and Services 24 Signatures 26

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PART I

Item 1. Description of Business

Historical Overview

Terra Systems, Inc. (the "Company" or "we") was formed as a Utah corporation on February 17, 1996, under the name Terra Systems, Inc., and is a development-stage company whose primary business purpose is the development and commercialization of a pneumatic conveyance system to handle materials in a bulk state.

On May 1, 1996, we merged with Xullux, Inc., a Utah corporation. In the merger, our shareholders received 48,000,000 shares of Xullux common stock in exchange for their shares of Terra Systems common stock. Following the reorganization, Xullux changed its name to Terra Systems, Inc. In this report, reference to the terms "Terra Systems," "we," "us," "our," and "the Company" refer collectively to Terra Systems, Inc., and its predecessors, unless the context clearly indicates otherwise.

Our common stock began trading in July 1996 and was quoted under the ticker symbol "TSYI" on the OTC Bulletin Board in 2001. On November 15, 2001, the stock ceased to trade on the OTC Bulletin Board, and began trading on the Pink Sheets under the ticker symbol TSYI.PK. In September 2006, our stock began trading again on the OTC Bulletin Board under the ticker symbol "TSYI".

Products

Our principal product is a low-pressure pneumatic conveyance system. Low-pressure systems such as our system are used in connection with the pulverization, moisture control, classification, transport, and processing of bulk materials in a number of basic industries.

Our system relies on a slow moving, laminar flow gas bearing to allow for the transportation of material through a carrying duct. A laminar flow gas bearing is formed when the air in the center of a pipeline is surrounded by a slow moving turbulent flow boundary air layer next to the inside wall of the pipe. It is referred to as a boundary because it acts to insulate the pipe from severe abrasive contact with the transported material. The amount of wear and tear or erosion on the inside of a pipe caused by the flow of a given material is referred to in the industry as the abrasion signature. Our process reduces this abrasion signature because the material being transported is caught up and carried by the faster moving gas in the center of the pipe. Unlike high-pressure conveyance systems, low-pressure systems do not allow for the build-up or caking of material inside the containment pipe. In pneumatic conveyance, caking typically occurs when dust combines with moisture and starts to gradually build up on the inside wall of the pipe.

Competing high-pressure pneumatic conveyance systems rely on the compression of air for operation. When the air is compressed, the moisture contained in the air collects inside the pipe. These pressurized systems have to be enclosed and can only purge moisture at the end of their conveyance cycle. The material they carry becomes exposed to this moisture, which may lead to caking. On the other hand, a low-pressure system like ours operates in an open environment. This allows the material being transported to breathe any moisture out during the transportation process.

Many of our components are pre-fabricated with final assembly occurring at the client's site. In most cases, we bill the client an hourly or daily rate for constructing a system that will vary in cost based on the customization involved for each client and their unique requirements. For example, some applications may require only product drying before going to an existing milling operation. Thus, our equipment could provide simply the product drying service onsite.

The prospective markets for our industrial particle accelerator include power generation, mining, agriculture, environmental, ceramics, construction, and materials transportation. We believe that because of the nature and flexibility of our process, many bulk materials used in basic industries can be economically separated, classified, and otherwise processed.

In addition to our patented pneumatic conveyance system, we hold a license for the patent pending "Clean Coke Technology" of Combustion Resources LLC ("Combustion Resources"). The license agreement requires that we begin

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paying a $300,000 per year minimum royalty beginning in the year 2010. The royalty is set as a fixed percentage of the net operating profit realized from the licensed Clean Coke Technology, subject to a maximum amount of $3 million in any one year. We believe that the Clean Coke Technology can be utilized to produce coke that qualifies under IRC Section 45K for the tax credit from alternative fuels provided a plant utilizing the Clean Coke Technology is built and placed in service by December 31, 2009. The Section 45K credit is subject to reduction as the Federal reference price of oil increases. We believe that there will be opportunities to realize positive economic returns from the Clean Coke Technology regardless of the incentive available from the Section 45K tax credit.

Combustion Resources, the College of Eastern Utah's Western Energy Training Center, and the Company were successful in obtaining a Federal Center of Excellence grant to develop the process controls for the system at its pilot plant (see below) in Price, Utah.

During 2007, we were contracted by Combustion Resources, and have worked with them to build and operate a pilot briquetting plant in Price, Utah. The pilot plant has a theoretical capacity of 1 ton per hour. The plant has been used to agglomerate carbon black. Carbon black is a very fine-sized material that is difficult to handle in its unagglomerated state. The plant has produced 162 tons of agglomerated carbon black to-date, all of which has been shipped to a major industrial customer for testing at its production plant. The Company's revenue for 2007 has been generated from this activity. Until the results of the test are known, the pilot plant will be utilized to develop the Clean Coke Technology process controls mentioned above.

Distribution, Marketing, and Customer Relations

Our marketing strategy is to promote, advertise and increase our technology visibility and attract new customers through multiple channels, including:

o Developing strategic alliances;
o Establishing our technology name; and
o Direct marketing to existing and potential customers.

We believe that the use of multiple marketing channels will reduce our reliance on any one source for obtaining customers. This, in turn, will lower costs and maximize technology awareness.

Strategic alliances

In the past we have tried to develop strategic alliances with better capitalized companies that we thought would jointly develop our technology. Though we did enter into various agreements with these companies, we were unable to obtain licensing agreements or sales of our Pneumatic Accelerator System. We have had difficulty delivering our technology in an acceptable state to these partners because of our limited access to capital. We do not currently have any strategic alliances. We do, however, believe that future joint venture relationships will allow us to gain additional insight, expertise and penetration into markets where joint venture partners already operate and may serve to increase our revenue and income growth. We expect to review potential strategic alliance candidates and to enter into agreements in the future should we feel these alliances would be in the best interest of the company.

Establish our technology

We cannot guarantee that we will be able to successfully market and distribute our services or technologies in either the United States or other countries, and the failure to do so could have an adverse effect on our operations. We believe that building awareness of the Terra Systems technologies are important in establishing and expanding our customer base. We currently have a web site (www.tsyi.com) and will use traditional media as our revenues permit, to attract new customers. The information on our website should not be considered part of this report on Form 10-KSB.

Direct marketing

Through the date of this report, our marketing activity has been largely word-of-mouth referrals, on-site demonstrations, as well as contacts

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generated from our web site. We currently have two demonstrations that could significantly impact our future results. The first is the application of our pneumatic accelerator system to the coal recovery operations at the Hiawatha mine site in Hiawatha, Utah. The second is the Western Energy Training Center (WETC) pilot clean coke plant near Helper, Utah. Both projects are expected to be in the early phases of operation during the second or third quarter of 2008.

We believe that our ability to establish and maintain long-term relationships with our customers and encourage repeat business depends, in part, on the strength of our customer support and service operations and staff. We value frequent communication with and feedback from our customers to continually improve our services. We focus on designing high quality applications and engineered products that are designed to address specific customer needs. Our operating results may fluctuate due to factors such as the addition or loss of significant customers.

Industry Background and Competitive Conditions

Nearly all bulk materials used in basic industries can or must be separated, pulverized, classified, or otherwise enhanced. Opportunities exist for many applications in both organic and inorganic materials in an array of large industries, including power generation, mining, agriculture, environmental, ceramics, construction, and materials transportation. Our main competition consists of companies providing or engaging in traditional methods of pulverization and transport of bulk materials; these include manufacturers of roller mills and ball mills. We believe that we compete on the basis of the unique nature of our technology. Our competitors are generally larger, better funded and possess greater name recognition and reputation in the market than Terra Systems. There is no assurance that we will be able to compete successfully against these larger players in the industry.

Raw Materials and Suppliers

We do not purchase or supply raw materials. Numerous raw materials are used to conduct on-site demonstrations on the effectiveness of our process and equipment; however, our prospective customers provide these materials. These materials used in on-site demonstrations include rice, coal, coal ash, limestone, gypsum, agricultural waste and other materials containing various heavy minerals, such as gold, silver, and platinum.

The following is a partial list of major industries where our technologies could be adopted or utilized, possible uses in the industries and the potential benefits of the use of our technology:

o Coal
o Reduce moisture
o Reduce ash
o Increased Btu value
o Micropulverize (80% of coal throughput ground down to 325 mesh)
o Transport
o Reclaim from gob piles

o Electric Power Generation With Coal
o Reduce air pollution emissions, especially nitrogen oxides ("NOX")
o See "Coal" above
o Contain fugitive dust

o Agriculture
o Rice, coarse grains, sugar
o Drying
o Soil conditioning
o Restore depleted trace minerals

o Environmental
o Extract/dry/remove waste from
o Food processing

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o Industry
o Radioactive materials

o Mining
o Precious metals
o Classify and concentrate desired ores

o Construction
o Cement and concrete

o Ceramics
o Micropulverize

o Transportation
o Waterways
o Dredging
o Loading/unloading/transloading

o Metallurgical Coke
o Custom coke blends
o Custom coke sizes

Patents

We have licensed technology for clean coke production from a third party and we own one patent, U.S. Patent No. 6,170,768, covering our pneumatic accelerator, which was granted January 9, 2001. We expect that we will upgrade this patent or file additional applications as developments are made with our technology. We rely upon a combination of patents, copyright protection, trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position. Our future prospects depend in part on our ability to obtain and maintain patent protection for our technology. We also need to continue to preserve our copyrights, trademarks and trade secrets and we must operate without infringing the proprietary rights of third parties.

We cannot guarantee that any of our future patent applications will result in issued patents, nor can we assure that we will develop more proprietary technologies that are patentable. Patents issued may not provide a basis for commercially viable products or may not provide any competitive advantages. Third parties could challenge our patents. The patents of others could limit our ability to use some of our processes or technologies. Any of these situations could have a material adverse effect on our ability to do business. We cannot prevent others from independently developing similar or alternative technologies, duplicating any of our technologies, or, if patents are issued to us, designing around our patented technologies. We could incur substantial costs in litigation if we are required to defend ourselves in patent suits brought by third parties or if we initiate these suits against possible infringers of our patent rights.

Others may have filed and in the future are likely to file patent applications that are similar or identical to ours. To determine the priority of inventions, we may have to participate in interference proceedings declared by the United States Patent and Trademark Office. Those proceedings could result in substantial cost to us. We cannot ensure that any such third-party patent application will not have priority over ours. Additionally, the laws of some foreign countries may not protect our patent and other intellectual property rights to the same extent as the laws of the United States.

Our future prospects also depend in part on our neither- infringing patents or proprietary rights of third parties nor breaching any licenses that may relate to our technologies and products. We cannot guarantee that we will not infringe the patents, licenses or other proprietary rights of third parties. We could in the future receive notices claiming infringement from third parties as well as invitations to take licenses under third-party patents. Any legal action against our strategic partners or us that claim damages and seek to enjoin commercial activities relating to the affected products and processes could subject us to potential liability for damages. Those legal actions could also require our strategic partners or us to obtain a license in order to continue to manufacture or market the affected products and processes. We cannot ensure that our strategic partners or we would prevail in any action. We cannot ensure that any license, including licenses proposed by third parties, required

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under any patent would be available on terms that are commercially acceptable, if at all. We have not conducted an exhaustive patent search, and we cannot ensure that patents do not exist or could not be filed that would have a material adverse effect on our ability to develop and market our products. If we become involved in such litigation, it could consume a substantial portion of our managerial and financial resources, which would have a material adverse effect on our business, financial condition, results of operations, and relationships with corporate partners.

We attempt to control the disclosure and use of our proprietary technology, know-how and trade secrets under agreements with the parties involved. However, we cannot ensure that others will honor all confidentiality agreements. We cannot prevent others from independently developing similar or superior technology, nor can we prevent disputes that could arise concerning the ownership of intellectual property.

Government Regulation

We are not currently subject to direct regulation by any domestic or foreign governmental agency, other than regulations applicable to business generally, export control laws, and laws or regulations directly applicable to the industry. We are required to ensure the enforcement of the Occupational and Health Administration (OSHA) regulations.

We believe that we have complied in all material respects with the laws and regulations governing the industry and that compliance with such laws will not have a material effect on our operations. However, various federal and state agencies may propose new legislation that may adversely affect our business, financial condition and results of operations. We are not aware of any probable government regulations that may adversely affect our business.

Research and Development Activities

Our success and ability to compete will be dependent in part on the protection of our existing and potential patents, trademarks, trade names, service marks, and other proprietary rights. Thus, a majority of our research and development efforts has been focused on product development, testing, and patent application.

We seek to continue developing our products internally through research and development or if appropriate, through strategic partnerships. We expect, however, that if we can purchase or license products, services, or technologies from third parties at a reasonable cost, we will do so in order to avoid the time and expense involved in developing such products, services, or technologies.

Employees

As of December 31, 2007, we had two full-time employees, one part-time employee, and three consultants and advisors. There were no organized labor agreements or union agreements between Terra Systems, Inc. and our employees. We believe that relations with our employees have been and will continue to be good.

RISK FACTORS

We have a history of losses and had an accumulated deficit of approximately $24,023,323 as of December 31, 2007, and approximately $19,190,814 as of December 31, 2006. If we do not become profitable or maintain profitability in the future, we may not be able to continue to operate.

We incurred net losses of approximately $24,023,323 for the period from February 1996 through December 31, 2007. We expect to continue to incur substantial net losses in the foreseeable future. If we do not become profitable within the time frame expected by investors, the market price of our common stock likely will decline. If we continue to incur net losses, we may not be able to maintain or increase our number of employees or our investment in capital equipment, sales, marketing, and research and development programs. We do not know when or if we will become profitable. If we do achieve profitability, we may not sustain or increase profitability in the future. As a result, we may not be able to continue to operate.

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Our limited operating history makes it difficult to predict future results.

Our business model is still emerging, and the revenue and income potential of our business and market are unproven. We have a limited operating history on which to base estimates for future performance. Our technology represents a new approach to the challenges presented in our selected markets, which to date have been dominated by established companies with longer operating histories. Although we expect that ongoing negotiations with potential customers may result in the finalization of feasibility study and licensing agreements that would result in revenues and cash flows, there is no assurance that we will be successful in those negotiations. Key markets within our industry may fail to adopt our proprietary technologies and products, or we may not be able to establish distribution channels. Any evaluation of our business and our prospects must be considered in light of our limited operating history and the risks and uncertainties often encountered by companies in their early stages of development.

Technological and other developments in our markets may render our technologies and products obsolete or limit our ability to penetrate our key markets.

Technological change, continuing process development, and new product introductions may affect the markets for our products. Our success will depend, in part, upon our continued ability to manufacture products that meet changing customer needs, successfully anticipate or respond to technological changes in manufacturing processes on a cost-effective and timely basis and enhance and expand our existing product offerings. Current competitors or new market entrants may develop new products with features that could adversely affect the competitive position of our products. We have invested and continue to invest substantial resources in research and development in an effort to improve upon our existing processes. However, there can be no assurance that our process development efforts will be successful or that the emergence of new technologies, industry standards, or customer requirements will not render our technology, equipment, or processes obsolete or uncompetitive. Any failure or delay in accomplishing these goals could have a material adverse effect on our business, results of operations, and financial condition. In addition, to the extent that we determine that new manufacturing equipment or processes are required to remain competitive, the acquisition and implementation of the technologies, equipment, and processes required are likely to require significant capital investment.

Our reliance upon intellectual property licenses from third parties limits the control we have over aspects of our business development and may increase the expense of doing business, which would reduce profitability. In addition, the possibility of our infringing upon the intellectual property rights of third parties may result in litigation and divert the attention of our management, adversely affecting our business.

We may rely on intellectual property licenses from third parties, and may be required to license additional products or services in the future, for use in the general operations of our business plan. We cannot assure that these third party licenses will be available or will continue to be available to us on acceptable terms, if at all. The inability to enter into and maintain any of these licenses could have a material adverse effect on our business, financial condition, or operating results. In addition, policing unauthorized use of our proprietary and other intellectual property rights could be expensive if not difficult or impossible.

Additionally, we cannot guarantee that third parties will not bring claims of copyright or trademark infringement against us, or claim that aspects of our processes or other features violate a patent they may hold. There can be no assurance that third parties will not claim that we have misappropriated their creative ideas or formats or otherwise infringed upon their proprietary rights. Any claims of infringement, with or without merit, could be time consuming to defend, result in costly litigation, divert management attention, or require us to enter into costly royalty or licensing arrangements. These potentialities could have a material adverse effect on our business, financial condition, or operating results.

Our audited financial statements have been prepared on the assumption that we will continue as a going concern. If we fail to continue in business, you would lose your investment.

Our independent registered public accounting firm has issued its report dated April 14, 2008, that includes an explanatory paragraph stating that our deficit in working capital, negative cash flows from operations, shareholders deficit and recurring net losses raise substantial doubt about our ability to

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continue as a going concern. If we are not successful in generating additional sales, reducing expenses, or obtaining additional financing through this offering or otherwise, we may be required to scale back or discontinue operations, in which case our investors could lose all or substantially all of their investment.

If we are to be competitive, we need to attract and retain key personnel. Our financial resources are limited, and it may be difficult to attract and retain personnel who are or would be instrumental to our success.

Our future success depends significantly on the continued service of our senior management. The familiarity of these individuals with the industry makes them especially critical to our success. The loss of the services of one or more of our key employees could have a material adverse effect on our business. We do not currently have key man insurance on any of our employees, but we do anticipate obtaining that insurance in the future. Our future success also depends on our ability to attract and retain highly qualified design, technical, sales, marketing, customer service, and management personnel. Competition for these personnel is intense, and we cannot guarantee that we will be able to attract or retain a sufficient number of highly qualified employees in the future. The lack of qualified management personnel could limit our ability to grow our business and may limit our ability to effectively compete in our markets.

We have been unable to pay our senior management on a current basis, and have lost the services of a past officer because of our inability to keep current. Additionally, we have had to rely on the financial support of our officers and directors in the past, but cannot provide any assurance that this will continue in the future. Without the continuance of such past cooperation and support, we may be required to discontinue operations, in which case our investors could lose all or substantially all of their investment.

Our inability to effectively manage growth may increase the cost of doing business or result in inefficiencies that would reduce cash available for growth and prevent us from becoming profitable.

To execute our business plan, we must grow significantly. This growth will place a significant strain on our personnel, management systems, and resources. We expect that the number of our employees, including management-level employees, will continue to increase in the foreseeable future, and that we may need additional office space and expanded technological infrastructure. Failure to manage growth effectively will materially adversely affect our business, results of operations, and financial condition.

We may not be able to obtain sufficient patent protection, which could harm our competitive position and increase our expenses.

Our success and ability to compete depends to a significant degree upon the protection of our proprietary technology. Currently, one of our patent applications has been allowed. These legal protections afford only limited protection for our technology, and the rights that may be granted under any future patents that may be issued may not provide competitive advantages to us. Patent protection in foreign countries may be limited or unavailable where we need this protection. It is possible that:

o competitors may independently develop similar technologies or design around our patents;

o patents issued to us may not be broad enough to protect our proprietary rights; and

o any issued patent could be successfully challenged.

The occurrence of any of these factors could result in the diminution or loss of our protected intellectual property, which could have a material adverse impact on our business.

Our stock is considered a penny stock. Penny stocks are subject to special regulations, which may make them more difficult to trade on the open market.

As of the date of this Report, our common stock was traded on the OTC Bulletin Board under the ticker symbol "TSYI." Securities on the Bulletin Board market are generally more difficult to trade than those on the NASDAQ National

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Market, the NASDAQ Small Cap Market or the major stock exchanges. In addition, accurate price quotations are more difficult to obtain. Additionally, our common stock is subject to special regulations governing the sale of penny stock.

A "penny stock," is defined by regulations of the Securities and Exchange Commission as an equity security with a market price of less than $5.00 per share. However, an equity security with a market price under $5.00 will not be considered a penny stock if it fits within any of the following exceptions, which are not applicable to our securities:

o The equity security is listed on NASDAQ or a national securities exchange;

o The issuer of the equity security has been in continuous operation for less than three years, and either has (a) net tangible assets of at least $5,000,000, or (b) average annual revenue of at least $6,000,000; or

o The issuer of the equity security has been in continuous operation for more than three years, and has net tangible assets of at least $2,000,000.

If you buy or sell a penny stock, these regulations require that you receive, prior to the transaction, a disclosure explaining the penny stock market and associated risks. Furthermore, trading in our common stock would be subject to Rule 15g-9 of the Exchange Act, which relates to non-NASDAQ and non-exchange listed securities. Under this rule, broker-dealers who recommend our securities to persons other than established customers and accredited investors must make a special written suitability determination for the purchaser and receive the purchaser's written agreement to a transaction prior to sale.

Penny stock regulations will tend to reduce market liquidity of our common stock, because they limit the broker-dealers' ability to trade, and a purchaser's ability to sell the stock in the secondary market. The low price of our common stock will have a negative effect on the amount and percentage of transaction costs paid by individual shareholders. The low price of our common stock may also limit our ability to raise additional capital by issuing additional shares. There are several reasons for these effects. First, the internal policies of many institutional investors prohibit the purchase of low-priced stocks. Second, many brokerage houses do not permit low-priced stocks to be used as collateral for margin accounts or to be purchased on margin. Third, some brokerage house policies and practices tend to discourage individual brokers from dealing in low-priced stocks. Finally, broker's commissions on low-priced stocks usually represent a higher percentage of the stock price than commissions on higher priced stocks. As a result, our shareholders will pay transaction costs that are a higher percentage of their total share value than if our share price were substantially higher.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements under "Risk Factors," "Management's Discussion and Analysis or Plan of Operation," "Business," and elsewhere in this report constitute forward-looking statements. These statements involve risks known to us, significant uncertainties, and other factors which may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by those forward-looking statements.

You can identify forward-looking statements by the use of the words "may," "will," "should," "could," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential," "proposed," or "continue" or the negative of those terms. Additionally, statements relating to our business plans, financial projections, capital needs, business development, capital raising and business strategies may also consist of or contain forward-looking statements. Such forward-looking statements are only predictions. In evaluating these statements, you should specifically consider various factors, including the risks outlined above. These factors may cause our actual results to differ materially from any forward-looking statement.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We expressly disclaim any obligation or intention to update any forward-looking statement.

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Item 2. Description of Property

Terra Systems, Inc., occupies office space located at 7001 South 900 East, Ste 260. Terra Systems, Inc., is renting approximately 2300 square feet of space. The Company, through its joint venture, Mountain Island Energy Holdings, LLC, shares in the ownership of 423 acres of land near Soda Springs, Idaho. The land is strategically located near existing industrial facilities and key infrastructure. We believe that these properties and facilities will be sufficient for our needs for the foreseeable future.

Item 3. Legal Proceedings

None

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

None.

PART II

Item 5. Market for Common Equity, Related Stockholder Matters and Small

Business Issuer Purchases of Equity Securities

MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Market for Common Stock continued on the OTC Bulletin Board under the symbol TSYI

High Low 2007 1st Quarter $0.40 $0.28 2nd Quarter $0.32 $0.21 3rd Quarter $0.29 $0.12 4th Quarter $0.23 $0.14 2006 1st Quarter $0.80 $0.64 2nd Quarter $0.80 $0.45 3rd Quarter(1) $0.65 $0.35 4th Quarter $0.50 $0.34 2005 1st Quarter $2.05 $0.30 2d Quarter $1.01 $0.65 3d Quarter $1.02 $0.81 4th Quarter $0.99 $0.60

(1)In September 2006, our stock began trading on the OTC bulletin Board under the ticker symbol "TSYI".

The source of these high and low prices was the Pink Sheets and OTC Bulletin Board. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. The high and low prices listed have been rounded up to the next highest two decimal places.

The market price of the common stock is subject to significant fluctuations in response to variations in the our quarterly operating results, general trends in the market for our technologies, and other factors, over many of which we have little or no control. In addition, broad market fluctuations, as well as general economic, business and political conditions, may adversely affect the market for our common stock, regardless of our actual or projected performance. On December 31, 2007, the closing bid price of the common stock as reported by the OTC Bulletin Board was $0.15 per share.

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Holders

As of December 31, 2007, there were approximately 291 shareholders of record of our common stock.

Dividend Policy

We have not paid cash dividends on our common stock and do not intend to pay any cash dividends in the foreseeable future.

Sales of Unregistered Securities

The following sets forth certain information for all securities we sold during the past three years without registration under the Securities Act.

2005
During the twelve months ending December 31, 2005, the Company issued 2,350,000 shares of common stock at $0.10 per share for proceeds of $235,000; 600,000 shares of common stock at a price of $0.08 per share for proceeds of $50,000; 700,000 shares of common stock at a price of $0.07 per share for proceeds of $50,000; 125,000 shares of common stock at a price of $0.20 per share for proceeds of $25,000; 700,000 shares of common stock at a price of $0.25 per share for proceeds of $175,000; 60,000 shares of common stock at a price of $0.50 per share for proceeds of $30,000; 350,000 shares of common stock at a price of $0.30 per share or $105,000 for satisfaction of debt; 100,000 shares of common stock at a price of $0.85 per share or $85,000 for satisfaction of debt; 543,091 shares of common stock at a price of $0.75 per share or $407,318 for financing fees; 508,936 shares of common stock at a price of $0.75 per share or $381,702 for settlement of debt; 1,302,743 shares of common stock at a price of $0.80 per share or $1,042,194 for settlement of debt; 90,000 shares of common stock at a price of $0.81 per share or $72,900 for services rendered; 1,270,000 shares of common stock at a price of $0.95 per share or $1,206,500 for services rendered; 2,697,257 shares of common stock at a price of $0.80 per share or $2,157,806 for services rendered; 25,000 shares of common stock as a price of $0.86 per share or $21,500 for services rendered; 52,941 share of common stock at a price of $0.81 per share or $42,882 for services rendered; 50,001 shares of common stock at a price of $0.84 per share or $41,999 for services rendered; 200,000 shares of common stock at a price of $0.75 per share or $150,000 for services rendered; 878,048 shares of common stock at a price of $0.93 per share or $816,585 in connection with an acquisition; 255,812 shares of common stock at a price of $0.86 per share or $220,000 in connection with an acquisition.

2006
During the twelve months ending December 31, 2006, the Company issued 342,401 shares of common stock at $0.30 per share for proceeds of $102,720; 500,000 shares of common stock at a price of $0.50 per share for proceeds of $250,000; 28,572 shares of common stock at a price of $0.35 per share for proceeds of $10,000; 312,500 shares of common stock at $0.20 per share for proceeds of $62,500; 65,000 shares of common stock at a price of $0.65 per share for financing fees and interest valued at $42,250; 70,311 shares of common stock valued at $0.65 per share or $45,702 for satisfaction of debt; 64,284 shares of common stock at a price of $0.75 per share or $48,213 for services rendered.

2007
During 2007, the Company issued 1,000,000 shares of common stock at a price of $0.20 per share for proceeds of $200,000; 250,000 shares of common stock at a price of $0.15 per share for proceeds of $37,500; 1,200,000 shares of common stock at a price of $0.10 per share for proceeds of $120,000; 500,000 shares of common stock for proceeds of $50,000 to an individual who exercised his options to purchase common stock at an exercise price of $0.10 per share; 3,000,000 shares of common stock to employees for services rendered with a value of $901,500 at a price of $0.30 per share; 40,000 shares of common stock for financing fees of $14,000 at a price of $0.35 per share; 90,000 shares of common stock for satisfaction of accounts payable of $30,000 at a price of $0.33 per share; 1,587,700 shares of common stock, at a price of $0.41 per share, for the satisfaction of accounts payable of $28,500, related party payable of $92,203, accrued wages of $255,000, accrued interest of $162,645 and note payable to

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stockholders of $115,874; 550,000 shares of common stock for satisfaction of a note payable to stock holder of $50,000 and interest expense of $43,500 at a price of $0.17 per share. Additionally, the Company issued 2,218,750 shares of common stock in satisfaction of certain stock purchase rights.

The sales of shares to the buyers were made in privately negotiated transactions relying on Section 4(2) of the 1933 Act, and rules and regulations promulgated thereunder, as transactions not involving any public offering. No advertising or general solicitation was employed in the issuance of the securities.

The Company did not purchase any shares of its securities during 2007.

Item 6. Management's Discussion and Analysis or Plan of Operation

You should read the following description of our financial condition and results of operations in conjunction with the audited financial statements and the notes thereto included elsewhere in this report. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Our actual results and the timing of business events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause a discrepancy include, but are not limited to, those discussed in "Risk Factors," "Business," and elsewhere in this report.

General

Terra Systems was incorporated in Utah on February 17, 1996, and is a development-stage company. Our primary business is the development and commercialization of our patented pneumatic accelerator. This device is a gas linear particle accelerator that conveys and processes bulk materials at high velocity in a particle isolate state, using air as the medium of movement. The traditional and more costly medium for processing bulk materials is water. Our technology operates efficiently at ambient temperatures and at low pressures and does not use water. We believe that most if not all, organic and inorganic bulk materials used in basic industries (such as coal, gypsum, black sands, corn, rice, and wheat) can be more economically separated and classified by our dry-process technology. This capability facilitates a number of associated procedures, including: drying, micropulverizing, mixing, forming, conveying, and loading. In addition, bulk materials can be beneficiated in important ways including moisture reduction, ash reduction, Btu enhancement, and electro-customization. We believe our system can perform multiple tasks, needs less maintenance, requires no chemical additives, and can improve the surrounding environmental quality.

Our success and ability to compete will be dependent in part on the protection of our existing and potential patents, trademarks, trade names, service marks, and other proprietary rights. Thus, a majority of our research and development efforts have been focused on product development, testing, and patent application.

We seek to continue developing our products internally through research and development, or if appropriate, through strategic alliances. We expect, however, that if we can purchase or license products, services, or technologies from third parties at a reasonable cost, we will do so in order to avoid the time and expense involved in developing these products, services, or technologies.

Results of Operations

Twelve months ended December 31, 2007 compared to twelve months ended December 31, 2006

From inception through December 31, 2007, we have incurred losses totaling $24,023,323 and generated revenues of $768,136 from operations. During the years ended December 31, 2007 and 2006, we had $ 149,994 and $45,897 sales revenues respectively. This factor, among others, raises substantial doubt concerning our ability to continue as a going concern. We intend to use capital and debt financing as needed to supplement the cash flows that we expect will be provided by licensing agreements. Our primary source of capital historically has been through the sale of our securities.

Realization of licensing of our technology and sales of our products and services is vital to operations. We may not be able to continue as a going concern without realizing additional sales or raising additional capital. We

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cannot guarantee that we will be able to compete successfully or that the competitive pressures we may face will not have a material adverse effect on our business, results of operations and financial condition. Additionally, superior competitive products could force us out of business.

Our net loss for the year ended December 31, 2007 was approximately $4,832,509, compared to a net loss for the year ended December 31, 2006, of approximately $1,412,231. The net loss was attributable to lower than expected revenues from sales of our products and services. Our expenses for the year ending December 31, 2007, were approximately $4,881,042 of which approximately 97% were general and administrative expenses. The increase in general and administrative expenses in 2007 was due to the issuance of 5,218,750 shares of common stock valued at $1,895,775 for services and financing fees. Also, during 2007 the Company recognized $2,257,161 in expense relating to stock options and warrants granted during the year. Our expenses for the year ended December 31, 2006, were approximately $1,424,476, of which approximately 91% were general and administrative. For the year ended December 31, 2007, depreciation and amortization expense was $8,531 compared to depreciation and amortization expense of $8,532 for the year ended December 31, 2006.

Future Business

We see opportunities for our technology and business in an array of large industries, including power generation, agriculture, mining, environmental, construction, ceramics, and materials transportation. We anticipate that we will generate revenues through the sale of our proprietary equipment, fees, royalties, and profit sharing from licensing of our technology.

We are continuing discussions with PacifiCorp regarding pulverized coal processing for the utility industry. We have been working with management and engineering personnel in the preliminary product design and development stages. A major objective of the proposed strategic business alliance with PacifiCorp will be to design a system that has the ability to produce low ash, low moisture, and ultra fine coal, that enhances the combustion process and reduce unburned carbon and nitrogen oxide ("NOx") emissions.

Liquidity and Capital Resources

Given our current negative cash flows, it will be difficult for Terra Systems to continue as a going concern. It will be necessary to raise additional funds. Funds could be generated through the issuance of additional stock or through the sale of existing plant and office equipment. We have available to us a $500,000 line of credit that is guaranteed by two members of our board of directors, but the use of such funds are limited to the development of the Hiawatha coal recovery project, and the continuing availability of this line is contingent on achieving acceptable progress on that project, including its use as a feedstock for the clean coke pilot plant.

As mentioned in our audited financial statements included with our Form 10-KSB, our audited consolidated financial statements have been prepared on the assumption that we will continue as a going concern. Our product line is limited and it has been necessary to rely upon financing from the sale of our equity securities to sustain operations. Additional financing will be required if we are to continue as a going concern. If additional financing cannot be obtained, we may be required to scale back or discontinue operations. Even if additional financing is available there can be no assurance that it will be on terms favorable to us. In any event, this additional financing will result in immediate and possible substantial dilution to existing shareholders.

Item 7. Financial Statements

Audited financial statements for the twelve-month period ending December 31, 2007, are attached.

Report of Independent Registered Public Accounting Firm F-1

Consolidated Balance Sheets- December 31, 2007 and 2006 F-2

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Consolidated Statements of Operations for the Years Ended December 31, 2007 and 2006 and for the Cumulative Period February 17, 1996 (Date of Inception), through December 31, 2007 F-3 Consolidated Statement of Changes in Stockholders' Deficit for the Period February 17, 1996(Date of Inception), through December 31, 2007 F-4 Consolidated Statements of Cash Flows for the Years Ended December 31, 2007 and 2006, and for the Cumulative Period February 17, 1996 (Date of Inception), through December 31, 2007 F-7 Notes to Consolidated Financial Statements F-8

Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 8A.Controls and Procedures

Management's Report On Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. This rule defines internal control over financial reporting as a process designed by, or under the supervision of, the Company's Chief Executive Officer and a consultant performing services for the Company commonly performed by a chief financial officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP. Our internal control over financial reporting includes those policies and procedures that:

o Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;

o Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

o Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

With the participation of the Chief Executive Officer and the consultant performing services for the Company commonly performed by a chief financial officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2007. In making its assessment, management used the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management has concluded that our internal control over financial reporting was not effective as of December 31, 2007, as the result of a material weakness. The material weakness consisted primarily of inadequate staffing and supervision, as discussed above.

As a result of these factors, the Company's Chief Executive Officer and the consultant performing services for the Company commonly performed by a chief financial officer have concluded that the Company's internal controls and procedures are not effective as of the period covered by this report.

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Remediation of Material Weakness

As noted above, the size of the Company prevents it from being able to employ sufficient resources to enable the Company to have adequate segregation of duties within its internal control system. Management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In order to address the deficiency, management has implemented tighter cash flow controls and set-up a centralized computer system to maintain the accounting records. Management will continue to work to address and remedy the material weakness as the position of the Company permits.

Limitations on the Effectiveness of Internal Controls

Our management, including our Chief Executive Officer and the consultant performing services for the Company commonly performed by a chief financial officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting are or will be capable of preventing or detecting all errors or all fraud. Any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements, due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns may occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risk.

Item 8B. Other Information

None.

PART III

Item 9. Directors, Executive Officers,Promoters, Control Persons, and Corporate

Governance; Compliance with Section 16(a) of the Exchange Act

MANAGEMENT

The following table sets forth information about our board of directors and management team as of December 31, 2007.

Name Age Position ------------------------ --- ------------------------------------ Clayton D. Timothy 61 Chief Executive Officer and Director George W. Ford 62 President and Director L. Kent Harmon 53 Vice President and Director Mitchell Hart 50 Vice President and Director Reynold Roeder 49 Director and Chairman of the Board Frederick W Buckman, Sr. 62 Director J.R. Key 62 Director

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Clayton D Timothy, Director and Chief Executive Officer- Mr. Timothy has an Associates Degree in Mine Maintenance from the College of Eastern Utah. His career has evolved around coal mining, initially as a miner, subsequently as a foreman and in more recent years as entrepreneur and executive in the development and implementation of technological innovations in the field. In this span of experiences, he has considerable experience in handling industrial bulk materials. From 1990-1994, he was Executive Vice President of Environmental Technologies Group, Inc. (ETGP) of Lehi, Utah, which pioneered and implemented a patented technology, which agglomerated coal fines. The process became patented and qualified as a synthetic fuel, entitling it to Section 29 Investment Tax Credit status. ETGP was eventually renamed Covol Technologies, Inc., and more than two dozen plants were built to utilize the coal fines technology. From 1994 to 1996, he was Vice President of Industrial Management and Engineering, also in Lehi, UT. He was the founder of TSYI in 1996.

George W. Ford, Director and President of Terra Systems, Inc. - Mr. Ford served as Principal Scientist/Vice President of Science and Technology for Headwaters, Inc., a publicly traded company (NYSE: HW), from June 1998 until joining Terra Systems, Inc., in May, 2005. He also served as Vice President of Research and Development of Headwaters from August 1993 through June 1998. Mr. Ford served as a director of Headwaters from August 1993 until resigning from the Board in February 1997 in favor of establishing an outside Board. From 1982 to 1993, Mr. Ford was employed at Ballard Medical Products, Inc., in research and development, principally in the biomedical field. He holds 27 national and international patents covering a wide variety of technologies. He has functioned as an independent consultant working on projects in computer programming, medical product device design and process polymer chemistry design for the energy industry. Mr. Ford is a member of the American Association for the Advancement of Science, and the Iron and Steel Society.

L. Kent Harmon, Director and Vice President, Technical Development--Mr. Harmon has a broad background in the theory and practice of materials science. Immediately prior to joining TSYI, he was President of Metredyne Imaging Services, Buena Park, CA, a private company. Metredyne created and marketed diagnostic systems that quantified the extent of physical impairment caused by work-related injuries. Mr. Harmon was a founder of TSYI in 1996.

Mitchell J. Hart, P.E., Director, Vice President, Operations of Terra Systems, Inc and President of Mountain Island Energy, LLC- Mr. Hart served as Senior Specialist/Project Manager for Monsanto Company from June, 1986 until joining Terra Systems, Inc., in June 2005. During that time, he managed large capital projects, directed permitting teams, and provided raw material technical support to Monsanto's plants in Soda Springs, Idaho, and Rock Springs, Wyoming. Prior to joining Monsanto, Mr. Hart worked as a Senior Mining Engineer for Shell Oil Company, developing new mining projects along the Gulf Coast, the hills of eastern Ohio and the Powder River Basin of Wyoming. He also worked underground coal in central Illinois for Turris Coal Company. He is a registered Professional Engineer and holds Professional Miner designation. Mr. Hart was granted certification as a Glass Production Technologist, a Refractories Manufacturing Technologist, and a Ceramic Manufacturing Technologist from the American Ceramic Society. Mr. Hart is the President of the Association of Idaho Cities (which represents 176 member cities in Idaho), serves as Secretary/Treasurer of the Southeast Idaho Council of Governments, and is in his third term as a member of the Soda Springs City Council. He previously served as a member of the Board of Trustees of Joint School District #150 in Soda Springs. He is a member of the Society of Mining Engineers, of AIME, and the National Mining Association.

Frederick W. Buckman, Sr., Director - Mr. Buckman has extensive experience in leadership. Buckman was a co-founder and former Chairman and CEO of Trans-Elect, Inc., the first independent owner and developer of electrical transmission systems in the U.S. From 1994 to 1998, Buckman served as President and Chief Executive Officer of PacifiCorp. Prior to joining PacifiCorp, Buckman was President and Chief Executive Officer of Consumers Power Co., the utility subsidiary of CMS Energy. Buckman serves as a member of the board and Lead Director of StanCorp Financial Group (NYSE:SFG). He also serves as a member of the board of InfraSource Services, Inc. (NYSE:IFS) and MMC Energy (OTC BB:MMCN). A graduate of the University of Michigan with a bachelor's degree in science engineering, Buckman received his doctorate in nuclear engineering from the Massachusetts Institute of Technology and attended the advanced management program at Harvard Business School.

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Reynold Roeder, Director and Chairman of the Board - Mr. Roeder brings over 25 years experience in operations, accounting, finance, investment banking and strategic planning with Portland Family of Funds, United Fund Advisors, LECTRIX LLC, PacifiCorp, and Deloitte & Touche. Mr. Roeder's management experience includes building several organizations from the ground up, structuring and negotiating large scale transactions and helping create industry standards in IRC Section 29 tax credits for synthetic fuels produced from coal. Mr. Roeder serves on the Board of Directors of Raser Technologies (NYSE Arca:RZ) and is the CEO of LECTRIX LLC, a developer of merchant electrical transmission lines, and CEO of United Fund Advisors, an investment banking firm specializing in tax credit transactions. During his career, Mr. Roeder has held CPA licenses in the states of New York, California and Oregon. Mr. Roeder graduated with honors in Business Administration from Portland State University.

J.R. Key, Director - Mr. Key has served in various senior positions during his career. He served as superintendent for Bankhead Mining Co., Jefferson Coal Co. and Cobb Coal Company in Alabama. He was General Manager of P.V. Mining Co. in Indiana. He later served as Vice President and General Manager of Bridger Coal Co. in Wyoming. From 1994 to 1997 he held the position of Director of Technical Services at InterWest Mining Company (a division of PacifiCorp) in Salt Lake City. Mr. Key became involved in the Section 29 projects with PacifiCorp in 1996. He presently oversees operations of the four synfuels plants for Synfuel Management, LLC. Mr. Key has over 35 years of coal industry experience.

Compliance with Section 16(a) of the Exchange Act

None of the Company's executive officers or directors filed Forms 5 for the year ended December 31, 2007. During the twelve months ending December 31, 2007 executive officers or directors sold no securities.

Code of Ethics

The Company is in the process of adopting a code of ethics for our principal executive and financial officers. In the meantime, our management intends to promote honest and ethical conduct, full and fair disclosure in our reports to the SEC, and compliance with applicable governmental laws and regulations.

There have been no changes to the procedures by which security holders may recommend nominees to the Company's board of directors. As of the date of this Report, the Company did not have a nominating committee of the board of directors, and the board of directors performed that role.

As of the date of this Report, the Company had both an audit committee and a compensation committee of the board of directors. The Audit Committee is comprised of Frederick Buckman Sr., Reynold Roeder, and Jerry Robert Key. Mr. Roeder chairs the audit committee and serves as its designated financial expert. The Compensation Committee is comprised of Frederick Buckman Sr., Reynold Roeder, and Jerry Robert Key. Mr. Buckman serves as Chairman of the compensation committee. Messrs. Buckman, Roeder, and Key are independent directors within the meaning of that term under applicable Securities and Exchange Commission rules. As of the date of this report the audit committee is in the process of adopting a charter.

Item 10. Executive Compensation

EXECUTIVE COMPENSATION

The Company's compensation program is designed to encompass several factors in determining the compensation of the Company's names executive officers. The following are the main objectives of the compensation program for the Company's named executive officers:
o Retain qualified officers
o Provide overall corporate direction for the officers and also to provide direction that is specific to officer's respective areas of authority. The level of compensation amongst the officer group, in relation to one another, is also considered in order to maintain a high level of satisfaction within the leadership group. We consider the relationship that the

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officers maintain to be one of the most important elements of the leadership group.
o Provide a performance incentive for the officers.

The Company's compensation program is designed to reward the officers in the following areas:
o achievement of specific goals;
o professional education and development;
o creativity in the form of innovative ideas and analysis for new programs and projects;
o new program implementation;
o attainment of company goals, budgets, and objectives;
o results oriented determination and organization;
o positive and supportive direction for company personnel; and
o community involvement.

As of the date of this Report, there were three principal elements of named executive officer compensation. The Board of Directors determines the portion of compensation allocated to each element for each individual named executive officer. The discussions of compensation practices and policies are of historical practices and policies. Our Board of Directors is expected to continue these policies and practices, but will reevaluate the practices and policies as it considers advisable.

The elements of the compensation program include:
o Base salary;
o Stock options and stock awards
o Employee benefits in the form of:
o Health and dental insurance
o Life insurance
o Other de minimis benefits

Base salary

Base salary is intended to provide competitive compensation for job performance and to attract and retain qualified named executive officers. The base salary level is determined by considering several factors inherent in the market place such as: the size of the company; the prevailing salary levels for the particular office or position; prevailing salary levels in a given geographic locale; and the qualifications and experience of the named executive officer. Due to limited working capital, our executives have allowed the Company to defer a substantial portion of their base salary, but are not under any obligation to continue to do so.

Stock options and stock awards

Stock ownership is provided to enable named executive officers and directors to participate in the success of the Company. The direct or potential ownership of stock will also provide the incentive to expand the involvement of the named executive officer to include, and therefore be mindful of, the perspective of stockholders of the Company.

Employee benefits

Several of the employee benefits for the named executive officers are selected to provide security for the named executive officers. Most notably, insurance coverage for health, life, and liability are intended to provide a level of protection to that will enable the named executive officers to function without having the distraction of having to manage undue risk. The health insurance also provides access to preventative medical care which will help the named executive officers function at a high energy level, to manage job related stress, and contribute to the overall well being of the named executive officers, all of which contribute to an enhanced job performance.

Other de minimis benefits

Other de minimis employee benefits such as cell phones, parking, and auto usage reimbursements are directly related to job functions but contain a

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personal use element, which is considered to be a goodwill gesture that contributes to enhanced job performance.

As discussed above, the Board of Directors determines the portion of compensation allocated to each element for each individual named executive officer. As a general rule, salary is competitively based while giving consideration to employee retention, qualifications, performance, and general market conditions. Typically, stock options are based on the current market value of the option and how that will contribute to the overall compensation of the named executive officer. Consideration is also given to the fact that the option has the potential for an appreciated future value. As such, the future value may be the most significant factor of the option, but it is also more difficult to quantify as a benefit to the named executive officer.

Accordingly, in determining the compensation program for the Company, as well as setting the compensation for each named executive officer, the Board of Directors attempts to attract the interest of the named executive officer within in the constraints of a compensation package that is fair and equitable to all parties involved.

This table provides summary information concerning compensation earned by or paid to each named executive officer for services rendered in all capacities to us during fiscal year 2007.

SUMMARY COMPENSATION TABLE Non-Equity Change in Incentive Pesion Value and Salary Stock Option Plan Deferred Compensation All Other Name and (1)(2) Bonus Awards Grants Compensation Earnings Compensation Total Position Year $ $ $ $ $ $ $ $ ------------------------------------------------------------------------------------------------------------------------------------ Clayton Timothy, 2006 120,000 - - - - - - 120,000 Chief Exective Officer 2007 120,000 - - - - - - 120,000 ------------------------------------------------------------------------------------------------------------------------------------ George W. Ford. 2006 120,000 - - - - - - 120,000 President 2007 120,000 - 450,000 - - - - 570,000 ------------------------------------------------------------------------------------------------------------------------------------ Mitchell J. Hart, 2006 120,000 - - - - - - 120,000 Vice President 2007 110,000 - 450,000 - - - - 560,000 ------------------------------------------------------------------------------------------------------------------------------------

(1)During 2006 actual compensation paid to each named officer was $110,000 with $10,000 each being accrued as a liability.
(2) During 2007 actual compensation paid to each named officer was $45,000 each with $75,000 being accrued as a liability. Mr. Hart ceased employment with the Company on November 30,2007 accordlingly $65,000 was accrued for him

The following table provides summary information concerning outstanding equity awards for named executive officers as of December 31, 2007.

OUTSTANDING EQUITY AWARDS AT FISCAL 2007 YEAR-END Option Awards -------------------------------------------------------------------------------- Equity Incentive Number of Number of Plan Awards: Securities Securities Number of Underlying Underlying Securities Unxercised Unxercised Underlying Option Option Options (#) Options (#) Unexercised Exercise Expiration Name and Position Exercisable Unexercisable Unearned Options Price Date ------------------------------------------------------------------------------------------------------------ Clayton Timothy, Chief Executive Officer 300,000 - - 0.10 17-May-08 ------------------------------------------------------------------------------------------------------------ George W. Ford. President 228,572 571,428 - 0.38 30-Nov-25 ------------------------------------------------------------------------------------------------------------ Mitchell J. Hart, Vice President 228,572 571,428 - 0.38 30-Nov-25 ------------------------------------------------------------------------------------------------------------

Stock Awards -------------------------------------------------------------------------------- Equity Incentive Equity Incentive Plan Awards: Number of Market value Plan Awards: Market or payout value Shares or Units of Shares or Number of Unearned of unearned Shares, of Stock that Units of Stock Shares, Units or other Units or other Have not that have not rights that have not rights that have not vested vested vested vested Name and Position (#) ($) (#) ($) ------------------------------------------------------------------------------------------------------------ Clayton Timothy, Chief Executive Officer - - - - ------------------------------------------------------------------------------------------------------------ George W. Ford. President - - - - ------------------------------------------------------------------------------------------------------------ Mitchell J. Hart, Vice President - - - - ------------------------------------------------------------------------------------------------------------

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Stock Options Granted In 2007

During 2007, the Company granted options to purchase an aggregate of 10,000,000 shares of common stock to four individuals, three of whom are directors of the Company, discussed below, and one of whom was a consultant. The options have an exercise price of $0.28 to $0.33 per share, and an expiration date through June 2014.

Reynold Roeder, Frederick Buckman Sr., and Jerry Robert Key, each, as a Director, received 3,000,000 of the options described in the preceding paragraph.

Compensation of Directors

Directors who also serve as executive officers do not receive any additional compensation for their services as directors. Non-employee directors are not paid an annual fee for services as board members.

Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table provides information regarding beneficial ownership of our common stock as of December 31, 2007, by:

o Each person or entity known to us to own beneficially more than 5% of our common stock;

o Each of the named executive officers;

o Each of our directors; and

o All executive officers and directors as a group.

The following table assumes the applicable percentage ownership is based on 53,111,806 shares of common stock outstanding as of December 31, 2007; 4,690,478 shares of common stock options that are exercisable and 531,514 warrants to purchase shares of common stock.

Beneficial ownership is determined based on the rules and regulations of the Securities and Exchange Commission. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of common stock subject to options held by that person that are exercisable or exercisable within 60 days of the date of this Report are counted as outstanding. These shares, however, are not counted as outstanding for the purposes of computing the percentage ownership of any other person. Except as indicated in the footnotes to this table and pursuant to applicable community property laws, each shareholder named in the table has sole voting and investment power with respect to the shares set forth opposite that shareholder's name. Unless otherwise noted, the address of each beneficial owner listed below is c/o Terra Systems, 7001 South 900 East, Ste 260, Midvale, Utah 84047.

Shareholder Shares Beneficially Percentage of Owned Ownership Clayton Timothy Chief Executive Officer, Director 4,076,465(1) 7.63% George W. Ford President, Director 2,487,037(2) 4.66% L. Kent Harmon Vice President, Director 2,850,000(1) 5.34%

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Mitchell Hart Vice President, Director 2,012,037(2) 3.77% Frederick Buckman Sr. Director 2,265,757(3) 4.09% Jerry Robert Key Director 2,000,000(4) 3.63% Reynold Roeder, Director and Chairman of the Board 5,047,007(5) 9.11% All Executive Officers and Directors as A group (7 individuals) 20,738,303(6) 34.16% (1) Shares beneficially owned include options to purchase up to 300,000 shares. (2) Shares beneficially owned include options to purchase up to 228,572 shares.

(3) Shares beneficially owned include options to purchase up to 2,000,000 shares and a warrant to purchase 265,757 shares.
(4) Shares beneficially owned include options to purchase up to 2,000,000 shares.
(5) Shares beneficially owned includes 2,781,250 shares, options to purchase up to an additional 2,000,000 shares and a warrant to purchase 265,757 shares. Mr. Roeder owns the securities jointly with Wendy Roeder.
(6) Shares beneficially owned include options to purchase up to 7,057,144 shares and warrants to purchase 531,514 shares.

Securities Authorized Under Equity Compensation Plans

As of December 31, 2007, the Company had no equity compensation plans or option plans.

Item 12. Certain Relationships and Related Transactions, and Director Independence

As of the date of this Report, the Company's common stock traded on the OTC Bulletin Board (the "Bulletin Board"). The Bulletin Board does not impose on the Company standards relating to director independence or the makeup of committees with independent directors, or provide definitions of independence. Nevertheless, the Company has undertaken to appoint three individuals to its Board of Directors, Messrs. Buckman, Key, and Roeder, who are independent under the NASDAQ Marketplace Rules and those standards applicable to companies trading on NASDAQ.

Specifically, none of Mr. Buckman, Mr. Key, or Mr. Roeder:

- has been any time during the past three years employed by the Company or by any parent or subsidiary of the Company;

- has accepted or has a family member who accepted any compensation from the Company in excess of $60,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than compensation for board or board committee service;

- is a family member of an individual who is, or at any time during the past three years was, employed by the Company as an executive officer;

- is, or has a Family Member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the Company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient's consolidated gross revenues for that year, or $200,000, whichever is more:

23

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- is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the Company serve on the compensation committee of such other entity; or

- is, or has a family member who is, a current partner of the Company's outside auditor, or was a partner or employee of the Company's outside auditor who worked on the Company's audit at any time during any of the past three years.

Item 13. Exhibits

Exhibit No. Title of Document ----------- ----------------- 2 Articles of Merger of Terra Systems, Inc., with and into Terra Merger Subsidiary, Inc., incorporated by reference from the Company's Form 10-SB, filed with the Commission on September 6, 2000. 3.1 Amended and Restated Articles of Incorporation of Terra Systems, Inc., formerly known as Xullux, Inc., incorporated by reference from the Company's Form 10-SB, filed with the Commission on September 6, 2000. 3.2 Articles of Incorporation of Terra Merger Subsidiary, Inc., incorporated by reference from the Company's Form 10-SB, filed with the Commission on September 6, 2000. 3.4 Revised Bylaws of Terra Systems, Inc. (formerly known as Xullux, Inc.), incorporated by reference from the Company's Form 10-SB, filed with the Commission on September 6, 2000. 10.1 Agreement Between Terra Systems, Inc., and XCEL Associates, Inc., dated March 29, 2000, incorporated by reference from Amendment No. 1 to the Company's Form 10-SB, filed with the Commission on December 1, 2000. 10.2 Memorandum of Affiliation between the Company and Clayton Timothy, dated May 12, 2005 (filed as an exhibit to the Company's Annual Report on Form 10-KSB filed April 17, 2006) 10.3 Memorandum of Affiliation between the Company and George W. Ford Jr., dated May 12, 2005 (filed as an exhibit to the Company's Annual Report on Form 10-KSB filed April 17, 2006) 10.4 Memorandum of Affiliation between the Company and Mitchell J. Hart, dated May 12, 2005 (filed as an exhibit to the Company's Annual Report on Form 10-KSB filed April 17, 2006) 31.1 Rule 13a-14(a)/15d-14(a) Certification 31.2 Rule 13a-14(a)/15d-14(a) Certification 32.1 Section 1350 Certification 32.2 Section 1350 Certification 99.1 Stock Issuance with A Call Option Vesting Schedule & Stock Issued for Services - Non Employees, incorporated by reference from Amendment No. 1 to the Company's Form 10-SB, filed with the Commission on December 1, 2000.

Item 14. Principal Accountant Fees and Services

Audit Fees

Audit fees billed during 2007 and 2006 were $33,994 and $52,000, respectively.

Audit-related Fees

Not applicable.

24

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Tax Fees

Not applicable.

All Other Fees

Not applicable.

Audit Committee Policies and Procedures

As of the date of this report the audit committee is in the process of adopting a charter.

25

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SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: April 14, 2008

TERRA SYSTEMS, INC.

By: /s/ Clayton Timothy ----------------------------------------------- Clayton Timothy CEO (Principal Executive Officer) By: /s/ Mark Faerber ----------------------------------------------- Mark Faerber Consultant performing services for the Company commonly performed by a chief financial officer

In accordance with the Exchange Act this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Date: April 14, 2008 /s/ George W. Ford ------------------------------------ Name: George W. Ford Director /s/ Mitchell Hart ------------------------------------ Name: Mitchell Hart Director /s/ L. Kent Harmon ------------------------------------ Name: L. Kent Harmon Director /s/ Reynold Roeder ------------------------------------ Name: Reynold Roeder Director /s/ Frederick Buckman Sr. ------------------------------------ Name: Frederick Buckman Sr. Director /s/ Jerry Robert Key ------------------------------------ Name: Jerry Robert Key Director

26

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
AND
CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007 and 2006

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

TABLE OF CONTENTS

Report of Independent Registered Public Accounting Firm F-1 Consolidated Balance Sheets - December 31, 2007 and 2006 F-2 Consolidated Statements of Operations for the Years Ended December 31, 2007 and 2006, and for the Cumulative Period February 17, 1996 (Date of Inception), through December 31, 2007 F-3 Consolidated Statement of Changes in Stockholders' Deficit for the Period February 17, 1996 (Date of Inception), through December 31, 2007 F-4 Consolidated Statements of Cash Flows for the Years Ended December 31, 2007 and 2006, and for the Cumulative Period February 17, 1996 (Date of Inception), through December 31, 2007 F-7 Notes to Consolidated Financial Statements F-8

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HANSEN, BARNETT & MAXWELL, P.C.

A Professional Corporation CERTIFIED PUBLIC ACCOUNTANTS Registered with the Public Company 5 Triad Center, Suite 750 Accounting Oversight Board Salt Lake City, UT 84180-1128 Phone: [phone] Fax: [phone] www.hbmcpas.com

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders Terra Systems, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheets of Terra Systems, Inc. and Subsidiaries (a development stage company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders' deficit, and cash flows for the years ended December 31, 2007 and 2006 and for the cumulative period from February 17, 1996 (date of inception) through December 31, 2007. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Terra Systems, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the results of its operations and its cash flows for the years then ended and for the period from February 17, 1996 through December 31, 2007, in conformity with accounting principles generally accepted in the United States.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred losses and negative cash flows from operations during each of the two years in the period ended December 31, 2007 and from inception through December 31, 2007. As of December 31, 2007, the Company had an accumulated deficit of $24,023,323 and negative working capital of $1,870,217. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans concerning these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As explained in Note 1 and Note 6 to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards123(R) "Share-Based Payment".

HANSEN, BARNETT & MAXWELL, P.C.

Salt Lake City, Utah
April 14, 2008

F-1

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TERRA SYSTEMS, INC AND SUBSIDIARY
(A Development Stage Company)

CONSOLIDATED BALANCE SHEETS

December 31, December 31, 2007 2006 ------------ ------------ ASSETS Current Assets Cash $ 30,692 $ 52,091 Other current assets 13,894 5,391 ------------ ------------ Total Current Assets 44,586 57,482 ------------ ------------ Property and Equipment Furniture and equipment 582,407 582,407 Software 10,380 10,380 Less: Accumulated depreciation (482,659) (474,128) ------------ ------------ Net Property and Equipment 110,128 118,659 ------------ ------------ Investment in joint venture 392,251 392,251 ------------ ------------ Total Assets $ 546,965 $ 568,392 ============ ============ LIABILITIES AND STOCKHOLDERS' DEFICIT Current Liabilities Accounts payable $ 431,857 $ 531,087 Bank line of credit 43,805 - Accounts payable to related parties 105,242 197,445 Accrued liabilities 285,263 331,935 Accrued interest to related parties 243,956 326,133 Notes payable to stockholders 804,680 970,554 ------------ ------------ Total Current Liabilities 1,914,803 2,357,154 ------------ ------------ Stockholders' Deficit Common stock - $0.001 par value; 100,000,000 shares authorized; 53,111,806 and 42,675,356 issued and outstanding, respectively 53,109 42,672 Additional paid-in capital 22,602,376 17,359,380 Deficit accumulated during development stage (24,023,323) (19,190,814) ------------ ------------ Total Stockholders' Deficit (1,367,838) (1,788,762) ------------ ------------ Total Liabilities and Stockholders' Deficit $ 546,965 $ 568,392 ============ ============

See accompanying notes to condensed consolidated financial statements.

F-2

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

CONSOLIDATED STATEMENTS OF OPERATIONS

From Inception of the Development Stage on February 17, For the Year Ended 1996 December 31, Through ---------------------------- December 31, 2007 2006 2007 ------------ ------------ ------------ Revenues $ 149,994 $ 45,897 $ 768,136 Cost of Revenues 114,659 44,968 564,904 ------------ ------------ ------------ Gross Profit 35,335 929 203,232 ------------ ------------ ------------ Operating Expenses Research and development - - 2,063,996 General and administrative 4,731,644 1,296,669 19,747,486 Depreciation and amortization 8,531 8,532 803,632 ------------ ------------ ------------ Total Operating Expenses 4,740,175 1,305,201 22,615,114 ------------ ------------ ------------ Loss from Operations (4,704,840) (1,304,272) (22,411,882) ------------ ------------ ------------ Nonoperating Income/(Expenses) Other income 13,198 12,245 87,446 Interest expense (140,867) (120,204) (1,531,880) Interest income - - 1,709 Gain from settlement of debt - - 64,284 Loss on sale of securities - - (99,000) Gain (loss) on sale of assets - - (134,000) ------------ ------------ ------------ Net Nonoperating Expenses (127,669) (107,959) (1,611,441) ------------ ------------ ------------ Net Loss $ (4,832,509) $ (1,412,231) $(24,023,323) ============ ============ ============ Basic and Diluted Loss Per Share $ (0.10) $ (0.03) ============ ============ Weighted Average Shares Outstanding 48,060,906 42,072,927 ============ ============

See accompanying notes to condensed consolidated financial statements.

F-3

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TERRA SYSTEMS, INC. AND SUBSIDIARY (A Development Stage Company) CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT Deficit Common Accumulated Common Stock Additional Stock Subscrip- Deferred During the Total --------------------- Paid-In Subscrip- tion Compen- Development Stockholders' Shares Amount Capital tions Receivable sation Stage Deficit ---------------------------------------------------------------------------------------------------------------------- Balance - February 17, 1996 (Inception) - $ - $ - $ - $ - $ - $ - $ - Shares issued to founders March 1996 - $0.00 per share 48,000,000 48,000 (47,520) - - - - 480 Shares issued to acquire Xullux May 1996 - $0.00 per share 2,955,100 2,955 (2,955) - - - - - Common stock subscriptions July 1996 through September 1996 - - - 196,000 - - - 196,000 Shares issued for marketable securities September 1996 - $0.80 per share 19,000 19 15,181 174,800 - - - 190,000 Shares issued for cash September 1996 - $0.80 to $1.00 per share 706,500 707 667,793 10,000 - - - 678,500 October 1996 - $0.80 per share 350,000 350 279,650 - - - - 280,000 November 1996 - $1.75 per share 12,000 12 20,988 - - - - 21,000 December 1996 - $1.75 to $2.00 per share 57,500 58 103,692 - - - - 103,750 January 1997 - $1.00 to $1.75 per share 126,000 126 145,374 - - - - 145,500 February 1997 - $1.00 per share 100,000 100 99,900 - - - - 100,000 March 1997 - $1.75 per share 25,413 25 44,448 - - - - 44,473 April 1997 - $2.00 per share 7,500 8 14,992 - - - - 15,000 May 1997 - $1.00 per share 100,000 100 99,900 - - - - 100,000 June 1997 - $1.00 per share 90,000 90 89,910 - - - - 90,000 August 1997 - $0.50 to $1.00 per share 70,000 70 44,930 - - - - 45,000 October 1997 - $1.00 per share 25,000 25 24,975 - - - - 25,000 November 1997 - $0.72 to $0.80 per share 172,399 173 128,243 - - - - 128,416 December 1997 - $0.80 per share 84,375 84 67,416 - - - - 67,500 April 1998 - $0.50 to $0.73 per share 239,502 240 146,671 - - - - 146,911 May 1998 - $0.75 to $0.80 per share 38,333 38 29,962 - - - - 30,000 June 1998 - $0.75 per share 30,146 30 22,579 - - - - 22,609 July 1998 - $0.36 to $0.73 per share 236,846 237 119,368 - - - - 119,605 August 1998 - $0.50 per share 20,000 20 9,980 - - - - 10,000 November 1998 - $0.30 to $0.33 per share 78,000 78 24,772 - - - - 24,850 December 1998 - $0.32 to $0.33 per share 72,900 73 23,664 - - - - 23,737 January 1999 - $0.50 per share 100,000 100 49,900 - - - - 50,000 April 1999 - $0.25 per share 20,000 20 4,980 - - - - 5,000 May 1999 - $0.50 per share 20,000 20 9,980 - - - - 10,000 June 1999 - $0.50 per share 100,000 100 49,900 - - - - 50,000 July 1999 - $0.25 per share 200,000 200 50,260 - - - - 50,460 September 1999 - $0.40 and $0.50 per share 145,000 145 59,855 - - - - 60,000 October 1999 - $0.50 per share 60,000 60 29,940 - - - - 30,000 December 1999 - $0.50 per share 60,000 60 29,940 - - - - 30,000 January 2000 - $0.25 per share 12,000 12 2,988 - - - - 3,000 February 2000 - $0.25 per share 40,000 40 9,960 - - - - 10,000 March 2000 - $0.25 per share 139,340 140 34,696 - - - - 34,836 April 2000 - $0.30 per share 33,333 33 9,967 - - - - 10,000 July 2000 - $0.25 per share 32,000 32 7,968 - - - - 8,000 August 2000 - $0.25 per share 120,000 120 29,880 - - - - 30,000 January 2001 - $0.20 per share 100,000 100 19,900 - - - - 20,000 May 2001 - $0.20 to $0.25 per share 150,000 150 30,350 - - - - 30,500 June 2001 - $0.25 per share 10,000 10 2,490 - - - - 2,500 July 2001 - $0.19 per share 32,000 32 6,014 - - - - 6,046 August 2001 - $0.10 per share 500,000 500 49,500 - - - - 50,000 November 2001 - $0.20 to $0.23 per share 680,434 680 139,320 - (100,000) - - 40,000 March 2002 - $0.15 per share 75,000 75 11,175 - - - - 11,250 July 2003 - $0.10 per share 175,000 175 17,325 - - - - 17,500 November 2003 - $0.20 per share 125,000 125 24,875 - - - - 25,000 April 2004 - $0.14 per share 84,500 85 11,915 - - - - 12,000 June 2004 - $0.14 per share 35,500 36 4,964 - - - - 5,000 June 2004 - $0.19 per share 84,210 84 15,916 - - - - 16,000 December 2004 - $0.33 per share 30,000 30 9,970 - - - - 10,000 February 2005 - $0.10 per share 100,000 100 9,900 - - - - 10,000 March 2005 - $0.10 per share 2,250,000 2,250 222,750 - - - - 225,000 March 2005 - $0.20 per share 125,000 125 24,875 - - - - 25,000 March 2005 - $0.08 per share 600,000 600 49,400 - - - - 50,000 March 2005 - $0.07 per share 700,000 700 49,300 - - - - 50,000 July 2005 - $0.25 per share 400,000 400 99,600 - - - - 100,000 December 2005 - $0.25 per share 300,000 300 74,700 - - - - 75,000 December 2005 - $0.50 per share 60,000 60 29,940 - - - - 30,000 Shares issued in satisfaction of subscription agreements October - December 1996 $0.80 to $1.00 per share 246,000 245 205,755 (206,000) - - - - December 1996 - $0.76 per share 231,000 231 174,569 (174,800) - - - - Shares issued for current and future services May 1997 - $1.00 per share 75,000 75 74,850 - - (74,925) - - March 1998 - $1.13 per share 350,000 350 393,400 - - (393,750) - - March 1999 - $0.50 per share 106,286 106 53,083 - - - - 53,189 June 1999 - $0.50 per share 60,000 60 29,940 - - - - 30,000 September 1999 - $0.70 to $0.97 per share 63,000 63 49,257 - - (19,320) - 30,000 December 1999 - $0.60 per share 50,000 50 29,950 - - - - 30,000 See accompanying notes to condensed consolidated financial statements. F-4

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TERRA SYSTEMS, INC. AND SUBSIDIARY (A Development Stage Company) CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT (CONTINUED) Deficit Common Accumulated Common Stock Additional Stock Subscrip- Deferred During the Total --------------------- Paid-In Subscrip- tion Compen- Development Stockholders' Shares Amount Capital tions Receivable sation Stage Deficit ---------------------------------------------------------------------------------------------------------------------- March 2000 - $0.50 per share 60,000 60 29,940 - - - - 30,000 May 2000 - $0.48 per share 62,920 63 29,937 - - - - 30,000 July 2000 - $1.00 per share 15,000 15 14,985 - - - - 15,000 September 2000 - $0.25 per share 122,400 122 29,878 - - - - 30,000 October 2000 - $0.25 per share 75,000 75 18,675 - - - - 18,750 December 2000 - $0.39 per share 99,338 99 38,901 - - - - 39,000 January 2001 - $0.50 per share 12,500 13 6,238 - - - - 6,251 March 2001 - $0.50 per share 60,000 60 29,940 - - - - 30,000 June 2001 - $0.40 per share 97,500 98 38,902 - - - - 39,000 September 2001 - $0.20 per share 500,000 500 99,500 - - - - 100,000 October 2001 - $0.20 per share 530,000 530 105,470 - - - - 106,000 November 2001 - $0.15 per share 180,000 180 26,820 - - - - 27,000 July 2002- $0.18 to $0.19 per share 504,529 505 92,195 - - - - 92,700 November 2002 - $0.16 to $0.17 per share 501,766 501 82,799 - - - - 83,300 March 2003 - $0.14 per share 314,287 314 43,686 - - - - 44,000 May 2003- $0.15 per share 10,000 10 1,490 - - - - 1,500 October 2003- $0.19 to $0.28 per share 982,141 982 265,476 - - - - 266,458 April 2004 - $0.28 per share 375,000 375 107,625 - - - - 108,000 August 2004 - $0.22 per share 204,546 204 61,161 - - - - 61,365 April 2005 - $0.81 per share 90,000 90 72,810 - - - - 72,900 May 2005 - $0.95 per share 1,270,000 1,270 1,205,230 - - - - 1,206,500 May 2005 - $0.80 per share 2,697,257 2,697 2,155,109 - - - - 2,157,806 July 2005 - $0.86 per share 25,000 25 21,475 - - - - 21,500 July 2005 - $0.81 per share 52,941 53 42,829 - - - - 42,882 October 2005 - $0.84 per share 50,001 50 41,949 - - - - 41,999 December 2005 - $0.75 per share 200,000 200 149,800 - - - - 150,000 Shares issued for financing fees March 2003 - $0.17 to $0.20 per share 43,000 43 8,047 - - - - 8,090 July 2003 - $0.18 per share 31,500 32 5,639 - - - - 5,671 August 2003 - $0.18 per share 7,000 7 1,253 - - - - 1,260 September 2003 - $0.18 per share 10,000 10 1,790 - - - - 1,800 October 2003 - $0.18 per share 25,000 25 4,475 - - - - 4,500 May 2004 - $0.30 per share 2,713 3 811 - - - - 814 December 2005 - $0.75 per share 543,091 543 406,775 - - - - 407,318 Shares issued for settlement of liabilities January 1999 - $0.25 per share 200,000 200 49,800 - - - - 50,000 February 2002- $0.51 per share 49,020 49 24,951 - - - - 25,000 June 2003 - $0.18 per share 200,000 200 34,800 - - - - 35,000 December 2003 - $0.36 per share 1,326,216 1,326 476,112 - - - - 477,438 November 2003 - $0.25 per share 40,000 40 9,960 - - - - 10,000 May 2004 - $0.25 per share 635,966 635 158,355 - - - - 158,990 December 2004 - $0.30 per share 900,000 900 269,100 - - - 270,000 February 2005 - $0.30 per share 350,000 350 104,650 - - - - 105,000 April 2005 - $0.85 per share 100,000 100 84,900 - - - - 85,000 May 2005 - $0.80 per share 1,302,743 1,303 1,040,891 - - - - 1,042,194 December 2005 - $0.75 per share 508,936 509 381,193 - - - - 381,702 Exercise of share rights May 2000 - $0.25 per share (cash) 400,000 400 99,600 - - - - 100,000 October 2000 - $0.25 per share (cash) 300,000 300 59,700 - - - - 60,000 November 2000 - $0.20 per share (services) 225,000 225 44,775 - - - - 45,000 December 2000 - $0.20 per share (cash) 75,000 75 14,925 - - - - 15,000 Exercise of stock options April 2000 - $0.20 per share (conversion of debt) 500,000 500 99,500 - - - - 100,000 December 2000 - $0.20 per share (cash) 25,000 25 4,975 - - - - 5,000 January 2001 - $0.20-$0.25 per share 825,000 825 166,675 - - - - 167,500 Share redemptions September 1996 - no consideration (3,000,000) (3,000) 3,000 - - - - - December 1996 - $0.001 per share (36,775,000) (36,775) - - - - - (36,775) December 1999 - $1.13 per share (100,000) (100) (112,300) - - 112,400 - - March 2000 - $1.13 per share (50,000) (50) (56,150) - - 56,200 - - Shares issued as part of land acquisition August 2005 - $0.93 per share 878,048 878 815,707 - - - - 816,585 August 2005 - $0.86 per share 255,812 256 219,744 - - - - 220,000 Payment on subscription receivable - - - - 51,250 - - 51,250 Return of shares in satisfaction of subscription receivable (130,000) (130) (25,870) - 26,000 - - - Write off subscription receivable balance - - - - 22,750 - - 22,750 Compensation from grant of stock rights and options - - 1,106,626 - - - - 1,106,626 Consulting expense from grant of share right - - 818,500 - - - - 818,500 Amortization of deferred compensation - - - - - 319,395 - 319,395 Compensation relating to intrinsic value of stock options - - 728,331 - - - - 728,331 Net loss from February 17, 1996 through December 31, 2005 - - - - - - (17,778,583) (17,778,583) ----------- -------- ----------- -------- -------- ---------- ------------- ------------- Balance December 31, 2005 41,292,288 41,292 16,333,170 - - - (17,778,583) (1,404,121) See accompanying notes to condensed consolidated financial statements. F-5

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TERRA SYSTEMS, INC. AND SUBSIDIARY (A Development Stage Company) CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT (CONTINUED) Deficit Common Accumulated Common Stock Additional Stock Subscrip- Deferred During the Total --------------------- Paid-In Subscrip- tion Compen- Development Stockholders' Shares Amount Capital tions Receivable sation Stage Deficit ---------------------------------------------------------------------------------------------------------------------- Shares issued for services March 2006 - $0.75 per share 64,284 63 48,150 - - - - 48,213 Shares issued in satisfaction of liabilities and interest January 2006 - $0.65 per share 70,311 70 45,632 - - - - 45,702 Shares issued for financing fees January 2006 - $0.65 per share 65,000 65 42,185 - - - - 42,250 Shares issued for cash March 2006 - $0.30 per share 242,400 242 72,478 - - - - 72,720 June 2006 - $0.30 per share 33,334 33 9,967 - - - - 10,000 June 2006 - $0.50 per share 500,000 500 249,500 - - - - 250,000 July 2006 - $0.35 per share 28,572 29 9,971 - - - - 10,000 July 2006 - $0.30 per share 66,667 66 19,934 - - - - 20,000 September 2006 - $0.20 per share 312,500 312 62,188 - - - - 62,500 Compensation relating to fair value of stock options - - 466,205 - - - - 466,205 Net loss for period - - - - - - (1,412,231) (1,412,231) ----------- -------- ----------- -------- -------- ---------- ------------- ------------- Balance December 31, 2006 42,675,356 $ 42,672 $17,359,380 $ - $ - $ - $ (19,190,814) $ (1,788,762) Shares issued for services March 2007 - $0.20 per share 3,000,000 3,000 897,000 - - - - 900,000 Shares issued in satisfaction of liabilities and interest January 2007 - $0.35 per share 1,677,700 1,678 684,044 - - - - 685,722 November 2007 - $0.17 per share 550,000 550 92,950 - - - - 93,500 Shares issued for financing fees February 2007 - $0.35 per share 40,000 40 13,960 - - - - 14,000 Shares issued for cash March 2007 - $0.20 per share 500,000 500 99,501 - - - - 100,001 April 2007 - $0.15 per share 250,000 250 37,250 - - - - 37,500 June 2007 - $0.20 per share 500,000 500 99,500 - - - - 100,000 November 2007 - $0.10 per share 450,000 450 44,550 - - - - 45,000 December 2007 - $0.10 per share 750,000 750 74,250 - - - - 75,000 Exercise of stock options July 2007 - $0.10 per share 500,000 500 49,500 - - - - 50,000 Shares issued for compensation November 2007 2,218,750 2,219 (2,219) - Compensation relating to amendment of stock right 995,775 995,775 Compensation relating to guarentee of line of credit 94,774 94,774 Compensation relating to fair value of stock options - - 2,062,161 - - - - 2,062,161 Net loss for period - - - - - - (4,832,509) (4,832,509) ----------- -------- ----------- -------- -------- ---------- ------------- ------------- Balance December 31, 2007 53,111,806 $ 53,109 $22,602,376 $ - $ - $ - $ (24,023,323) $ (1,367,838) =========== ======== =========== ======== ======== ========== ============= ============= See accompanying notes to condensed consolidated financial statements. F-6

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

CONSOLIDATED STATEMENTS OF CASH FLOWS

From Inception of the Development Stage on For the Year Ended February 17, December 31, 1996 Through ------------------------- December 31, 2007 2006 2007 ------------ ------------ ------------ Cash Flows from Operating Activities: Net loss $ (4,832,509) $ (1,412,231) $(24,023,323) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 8,531 8,532 803,632 Gain from debt relief - - (64,284) Loss on sale of investment securities - - 99,000 (Gain) loss on disposal of assets - - 139,000 Stock compensation 4,054,210 515,120 13,445,679 Write off of stock subscription - - 22,750 Common stock issued for financing fees 57,500 42,250 529,203 Changes in current assets and liabilities: Other current assets (8,503) 4 (13,894) Accounts payable (40,730) 148,585 928,614 Accounts payable - related party - 75,000 608,330 Accrued liabilities 208,328 (3,931) 1,649,420 Accrued legal settlement expense - - 44,967 Accrued interest payable 80,468 57,888 787,577 ------------ ------------ ------------ Net Cash Used in Operating Activities (472,705) (568,783) (5,043,329) ------------ ------------ ------------ Cash Flows from Investing Activities: Purchase of equipment - (109,276) (1,003,049) Advances to related party - - (290,328) Organization costs paid - - (4,755) Proceeds from sale of assets - - 367,715 ------------ ------------ ------------ Net Cash Used in Investing Activities - (109,276) (930,417) ------------ ------------ ------------ Cash Flows from Financing Activities: Proceeds from bank line of credit 43,805 - 43,805 Proceeds from borrowings - stockholders - 250,000 1,690,111 Payments on borrowings - stockholders - (130,000) (385,730) Proceeds from stock issuance and subscriptions 407,501 425,220 4,841,892 Payments on capital leases - - (185,640) ------------ ------------ ------------ Net Cash Provided by Financing Activities 451,306 545,220 6,004,438 ------------ ------------ ------------ Net Increase (Decrease) in Cash (21,399) (132,839) 30,692 Cash at Beginning of Year 52,091 184,930 - ------------ ------------ ------------ Cash at End of Year $ 30,692 $ 52,091 $ 30,692 ============ ============ ============ Supplemental Cash Flow Information: Cash paid for interest $ - $ 20,000 Non Cash Investing and Financing Activities: Conversion of liabilities to common stock $ 734,222 $ 45,000 Transfer of land to investment in joint venture $ - $ 392,251

See accompanying notes to condensed consolidated financial statements.

F-7

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization-- Terra Systems, Inc., was incorporated on February 17, 1996, pursuant to the laws of the State of Utah. It is a development-stage company whose primary business purpose is the development and commercialization of a pneumatic conveyance system to handle materials in a bulk state in industrial research and processing.

Xullux, Inc., was incorporated under the laws of the State of Utah on November 4, 1983, under the name of Bunker Research, Inc. It changed its name to Diamond Resources, Inc. on May 15, 1984, and changed its name again to Xullux, Inc., on August 6, 1988. On May 1, 1996, Xullux, Inc., entered into a merger agreement with Terra Systems, Inc., whereby Terra Systems, Inc., was merged into a newly-formed subsidiary of Xullux, Inc., called Terra Merger Subsidiary, Inc. Following the reorganization, Xullux, Inc., changed its name to Terra Systems, Inc.

In September 2005 the Company acquired the assets of Mountain Island Energy, LLC., an Idaho-based company (MIE). At the time of the asset acquisition, MIE was not considered a business and consisted solely of land. The prior owners of MIE were all shareholders and officers of the Company. Therefore, the land was valued at the original owners' basis. See Note 8 for details.

Principles of Consolidation-- The consolidated financial statements include the accounts of Terra Systems, Inc., and its wholly owned subsidiaries, Terra Merger Subsidiary, Inc. and Mountain Island Energy, LLC. All inter-company transactions have been eliminated. The consolidated entities are collectively referred to herein as the "Company" or "Terra Systems."

Use of Estimates-- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Basis of Presentation-- The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements for the years ended December 31, 2007 and 2006, the Company received $149,994 and $45,897 in revenue, respectively and incurred net losses of $4,832,509 and $1,412,231, respectively. As of December 31, 2007, the Company had a working capital deficit of $1,870,217. These factors raise substantial doubt about the Company's ability to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to generate sufficient cash flows to meet its obligations on a timely basis, to obtain additional financing as may be required, and ultimately to attain successful operations.

The Company's management is in the process of negotiating various agreements to perform research on and the development of pneumatic conveyance systems to handle materials in a bulk state in industrial research and processing. Management also intends to use capital and debt financing as needed to supplement the cash flows that potentially could be generated through the successful negotiation of agreements.

F-8

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Cash and Cash Equivalents-- For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments maturing in three months or less to be cash equivalents.

Property and Equipment -- Property and equipment are recorded at cost and are depreciated using the straight-line method based on the expected useful lives of the assets that range from five to fifteen years. Depreciation expense for the years ended December 31, 2007 and 2006, was $8,531 and $8,532, respectively.

Long-Lived Assets -- The carrying value of long-lived assets is evaluated periodically when events or circumstances indicate a possible inability to recover the carrying amounts. An impairment loss is recognized for the excess of the carrying amount over the fair value of the assets. Fair value is determined based on estimated discounted net future cash flows or other valuation techniques available in the circumstances. This analysis involves significant management judgment to evaluate the capacity of an asset to perform within projections. Based upon these analyses, no impairment losses were recognized in the accompanying financial statements.

Financial Instruments -- The estimated fair value of financial instruments is not presented because, in management's opinion, there is no material difference between carrying amounts and estimated fair values of the financial instruments as presented in the accompanying balance sheets. The carrying amounts reported for notes payable approximate fair value because the underlying instruments are at interest rates which approximate market rates.

Revenue Recognition -- Revenue is recognized when products are shipped or when services are performed. The Company's revenues, during 2007, primarily have come from a consulting agreement with another corporation.

Basic and Diluted Loss Per Share -- Basic loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted loss per share is calculated to give effect to potentially issuable common shares except during loss periods when those potentially issuable common shares would decrease the loss per share. As of December 31, 2007 and 2006, there were 15,444,381 and 4,812,867 potentially issuable common shares, respectively, which were excluded from the calculation of diluted loss per common share as their effect would have been anti-dilutive, thereby decreasing the net loss per common share.

Stock Based Compensation -- Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123R), using the modified prospective method. SFAS 123R requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award. SFAS 123R also requires the stock option compensation expense to be recognized over the period during which an employee is required to provide service in exchange for the award (the vesting period). See Note 7 for details.

Recent Accounting Pronouncements -- In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FASB Staff Position No 157-2 which extended the effective date for certain nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The Company does not expect the

F-9

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

adoption of SFAS No. 157 to have a material impact on our consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS No. 159 to have a material impact on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations, and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquire at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 160 clarifies that a non-controlling interest in a subsidiary should be reported as equity in the consolidated financial statements, consolidated net income shall be adjusted to include the net income attributed to the non-controlling interest and consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the non-controlling interest. The calculation of earnings per share will continue to be based on income amounts attributable to the parent. SFAS No. 141 (R) and SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. The Company has not yet determined the effect on our consolidated financial statements, if any, upon adoption of SFAS No. 141 (R) or SFAS No. 160.

NOTE 2 - RELATED PARTY TRANSACTIONS

Certain officers and shareholders of the Company have from time to time advanced operating capital and settled operating expenses on behalf of the Company. As of December 31, 2007 and 2006, the Company received advances of zero and $115,000, respectively, and made payments in satisfaction of its obligations worth $92,203 and $40,000, respectively, resulting in payables to related parties of $105,242 and $197,445, respectively. All amounts are due on demand and bear no interest.

As further discussed in Note 5, the Company has notes payable to shareholders and officers. The Company did not receive proceeds from these individuals during 2007. During the year ended December 31, 2007 and 2006 the Company made payments of $165,874 and $130,000, respectively. As of December 31, 2007 and 2006, the amounts due were $804,680 and $970,554, respectively.

During the years ended December 31, 2007 and 2006, the Company accrued interest on the notes of $80,468, and $77,888, respectively. During the year ended December 31, 2007, the Company made interest payments totaling $162,645 through the issuance of common stock. During the year ended December 31, 2006, the Company made a cash payment of $20,000 related to this accrued interest. As of December 31, 2007 and 2006, the accrued interest due was $243,956 and $326,133, respectively.

NOTE 3 - OPERATING LEASE OBLIGATION

In September 2005, the Company entered into a lease agreement to rent 2,328 square feet of office space for a period of three years. During the years ended December 31, 2007 and 2006, the Company incurred rent expense of $32,685 and $32,131 respectively. Minimum payments for the remaining term of the lease are $22,208 for 2008.

F-10

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LINE OF CREDIT

The Company entered into a $500,000 line of credit with US Bank N.A. (the "Bank") on November 1, 2007. The line of credit is guaranteed by two directors (the "Guarantors"). As consideration for guaranteeing the line of credit, the Company issued 531,514 warrants to the Guarantors. The warrants vest immediately and expire in November 2017. The fair value of the warrants was $94,774 and charged to general and administrative expense. The fair value was computed using the Black-Scholes pricing model using the following assumptions: estimated volatility of 160%, estimated risk-free rate of 4.23%, an estimated yield of 0% and an estimated life of 10 years. The Guarantors are also indemnified by each of the other Directors and officers of the Company serving on the Board of Directors.

Draws under the line of credit must be approved by Mr. Roeder, one of the guarantors, before being eligible for funding by the Bank. The line of credit bears interest at Bank prime plus 50 basis points and expires on April 30, 2009. The credit agreement includes a limitation on other indebtedness and guaranties. As of December 31, 2007, the Company had drawn $43,805 on the line of credit.

NOTE 5 - NOTES PAYABLE TO STOCKHOLDERS

Notes payable to stockholders are as follows:

December 31,

2007 2006
Notes payable to stockholders, interest
rate at 10% per annum payable monthly,
notes are currently due $253,135 $369,009

Notes payable to stockholders, no stated interest; settled November 2007 through the issuance of stock - 50,000 Note payable to stockholder, interest rate at 10% per annum payable monthly, amounts are due on demand 300,000 300,000 Note payable to stockholder; interest rate at 10% per annum payable monthly, 100,000 shares of common stock valued at $93,000 are accrued and to be issued as additional interest,note is due on demand 250,000 250,000 Notes payable to stockholders for redemption of stock interest is 10% per annum payable monthly, due on demand 1,545 1,545 -------- -------- Notes Payable to Stockholders $804,680 $970,554 ======== ========

NOTE 6 - STOCKHOLDERS' DEFICIT

Common Stock Issued for Cash -- During 2007, the Company issued 1,575,000 shares of common stock and 1,900,000 warrants to purchase common stock with exercise prices ranging from $0.50 to $1.00 per share for proceeds of $195,000. 100,000 warrants vested immediately and expire in July 2008; 1,200,000 warrants vest in May 2008 and expire in November 2008; 600,000 warrants vest in November 2008 and expire in November 2009. The proceeds were allocated $152,191 to common stock and $42,809 to the warrants, based on their relative fair values

F-11

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

on the date of issuance. The fair value of the warrants was determined by the Black-Scholes option pricing model using the following assumptions: estimated volatility of 115%, estimated risk-free interest rate of 3.23%, estimated yield of 0% and an estimated life of 1.31 years.

During 2007, the Company also issued 875,000 shares of common stock for proceeds of $162,501 or at prices ranging from $0.15 to $0.20 per share and 500,000 shares of common stock for proceeds of $50,000 to an individual who exercised options to purchase common stock, at an exercise price of $0.10 per share.

During 2006, the Company issued 775,734 shares of common stock and 812,867 warrants to purchase common stock with exercise prices ranging from $0.30 to $1.25 per share for proceeds of $332,720. The warrants vest immediately with 137,867 warrants expiring in March 2008 and 675,000 warrants expiring in May 2009. The proceeds were allocated $160,817 to common stock and $171,903, to the warrants, based on their relative fair values on the date of issuance. The fair value of the warrants was $356,924 determined by the Black-Scholes option pricing model using the following assumptions: estimated volatility of 110.80% estimated risk-free interest rate of 5.17% estimated yield of 0% and life of 2.83 years. During the year ended December 31, 2006 the Company also issued 312,500 shares of common stock at a price of $0.20 per share for proceeds of $62,500.

Also during 2006, the Company issued 95,239 shares of common stock for proceeds of $30,000 or at prices ranging from $0.30 to $0.35 per share.

Common Stock Issued for Services -- During the years ended December 31, 2007 and 2006, the Company issued 3,000,000 and 64,284 shares, respectively, of common stock for consulting services. The common stock was valued at prices ranging from $0.30 to $0.95 per share. For the years ended December 31, 2007 and 2006, the Company charged $901,500 and $48,213 of consulting expense to operations, respectively. The shares were valued based on the fair value of the Company's common stock on the date of issuance.

Common Stock Issued for Satisfaction of Debt -- During the year ended December 31, 2007 the Company issued 90,000 shares of common stock at a price of $0.33 per share for satisfaction of accounts payable of $30,000; 1,587,700 shares of common stock, at a price of $0.41 per share, for satisfaction of accounts payable of $28,500, related party payable of $92,203, accrued wages of $255,000, accrued interest of $162,645 and a note payable to stockholder of $115,874; 550,000 shares of common stock, at a price of $0.17 per share, for satisfaction of a note payable to stock holder of $50,000 and interest expense of $43,500. During the year ending December 31, 2006 the Company issued 70,311 of common stock for satisfaction of its obligations. The common stock was valued at prices ranging from $0.30 to $0.85 per share. For the year ended December 31, 2006, the Company settled accounts payable of $45,702.

Common Stock Issued for Financing Fees -- During the years ended December 31, 2007 and 2006, the Company issued 40,000 and 65,000 shares, respectively, of common stock for financing fees incurred during the period. The common stock was valued at prices ranging from $0.35 to $0.75 per share. For the years ended December 31, 2007 and 2006, the Company charged the $14,000 and $42,250 of finance fee to interest expense.

Common Stock Issued for Settlement of Stock Purchase Rights -- On September 11, 2006, the Company executed a stock purchase agreement with an individual. The original agreement gave the individual the right to purchase up to five million shares of common stock at a price of $0.20 per share anytime during the twelve-month period ending September 11, 2007. For an additional six

F-12

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

months the purchase price would be 50% of the closing market price averaged over the five trading days prior to such purchase. From September 2006 through March 2007, under the agreement, 562,500 shares were purchased for cash proceeds of $112,500 and are included in the discussion of shares issued for cash above. In March 2007 the stock purchase agreement was amended allowing the purchase price could be paid either in cash or under a cashless exercise feature. The company determined that the amendment triggered a compensatory event and the remaining 4,437,500 rights should be valued at their then fair value and considered compensation. The fair value of the remaining rights was $995,775 determined using the Black-Scholes option pricing model using the following assumptions:
estimated volatility of 116.74%, estimated risk-free interest rate of 4.9%, estimated yield of 0% and an expected life of 1 year.

In November 21, 2007 the individual submitted a net issue election notice and the Company issued the individual 2,218,750 shares of common stock for the exercise of the remaining 4,437,500 stock rights under the cashless exercise feature.

NOTE 7 - STOCK OPTIONS AND STOCK WARRANTS

STOCK OPTIONS

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123R), using the modified prospective method. SFAS 123R requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award. SFAS 123R also requires the stock option compensation expense to be recognized over the period during which an employee is required to provide service in exchange for the award (the vesting period). Prior to adopting SFAS 123R, the Company accounted for stock-based compensation plans under Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB 25, generally no compensation expense is recorded when the terms of the award are fixed and the exercise price of the employee stock option equals or exceeds the fair value of the underlying stock on the date of grant. The Company had adopted the disclosure-only provision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123").

For the year ended December 31, 2007 and 2006, the Company calculated compensation expense of $3,152,710 and $453,605 related to stock options which will be recognized over the vesting period. The overall effect of adopting SFAS 123R was an increase of net loss by $176,500 or $0.00 per share and $218,954 or $0.01 per share, during 2007 and 2006 respectively.

For options granted subsequent to the adoption date of SFAS 123R on January 1, 2006, the fair value of each stock option grant will be estimated on the date of grant using the Black-Scholes option-pricing model. During the year ended December 31, 2007, the Company granted 10,000,000 stock options. The weighted average fair value of stock options at the date of grant during the year ended December 31, 2007, was $0.27 per share. The Company had no stock option grants during the year ended December 31, 2006.

F-13

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A summary of stock option activity for the year ended December 31, 2007, is presented below:

Weighted Weighted Average Shares Average Remaining Aggregate Under Exercise Contractual Intrinsic Option Price Life Value ---------- -------- ----------- --------- Outstanding at December 31, 2005 4,500,000 $ 0.20 Granted - Exercised - Forfeited - Expired (500,000) $ 0.10 ---------- Outstanding at December 31, 2006 4,000,000 $ 0.21 Granted 10,000,000 0.31 Exercised (500,000) 0.10 Forfeited - Expired (1,000,000) $ 0.10 ---------- Outstanding at December 31, 2007 12,500,000 $ 0.30 7.4 years $ 45,000 ========== Exercisable at December 31, 2007 4,690,478 $ 0.26 6.3 years $ 45,000 ========== Exercisable at December 31, 2006 2,628,572 $ 0.12 ==========

The expected life of stock options represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends. The expected volatility is based on the historical price volatility of our common stock. The risk-free interest rate represents the U.S. Treasury bill rate for the expected life of the related stock options. The dividend yield represents our anticipated cash dividend over the expected life of the stock options.

The following are the weighted-average assumptions used for options granted during the year ended December 31, 2007 and 2006:

2007 2006 ---------------- --------------- Risk free interest rate 4.57% N/A Expected life 7 years N/A Dividend yield - N/A Volatility 157.13% N/A

As of December 31, 2007, there was approximately $1,314,914 of unrecognized compensation cost related to stock options that will be recognized over a weighted average period of 1.62 years.

In May 2006, the Company changed the expiration date on 1,500,000 options from July 2006 to July 2007. Using the Black-Scholes option pricing model and a risk free interest rate of 4.99%, volatility of 114.74% and an expected life of 1 year, it was determined that an additional expense of $12,600 was incurred.

F-14

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Stock Warrants

A summary of stock warrants at December 31, 2007 is presented below;

Weighted Weighted Average Shares Average Remaining Under Exercise Contractual Warrants Price Life ---------- -------- ----------- Outstanding at December 31, 2005 - $ - Granted 812,867 $ 0.78 Exercised - Expired - ---------- Outstanding at December 31, 2006 812,867 $ 0.78 Granted 2,431,541 0.56 Exercised - Expired - ---------- Outstanding at December 31, 2007 3,244,381 $ 0.61 2.63 years ========== Exercisable at December 31, 2007 1,444,381 $ 0.54 4.35 years ========== Exercisable at December 31, 2006 812,867 $ 0.78 ==========

NOTE 8 - INVESTMENT IN JOINT VENTURES

On June 29, 2006 the Company entered into a joint venture agreement with United Fund Advisors, L.L.C. (UFA) of Portland Oregon, an entity in which Reynold Roeder, a director of the Company has a 25% interest and serves as its CEO. Under the agreement, a new entity, Mountain Island Energy Holdings, L.L.C. (MIEH) was formed. MIEH was formed for the purpose of applying to the US Department of the Treasury and US Department of Energy for an award of federal advanced clean coal project tax credits under Section 48A of the Internal Revenue Code. UFA and the Company each own 50% of MIEH. Under the agreement, Reynold Roeder of UFA and Mitchell J. Hart of the Company serve as managing directors of MIEH. Under the MIEH operating agreement, UFA was required to make capital cash contributions to MIEH totaling $1,000 along with agreed upon services. During the year ended December 31, 2006, UFA contributed $31,000 in cash, and services valued at $170,000. The Company, in accordance with the operating agreement, contributed land and certain professional service work related to the development of the land. During the year ended December 31, 2006, the Company contributed land and development costs valued at $392,251. MIEH had no substantial operations for the year ended December 31, 2007. The Company accounts for this joint venture interest under the equity method of accounting. MIEH was unsuccessful in obtaining a Section 48A of the Internal Revenue Code award, but has been pursuing opportunities to develop or liquidate the land.

MIEH and UFA also formed Sage Island Energy, LLC, a Delaware limited liability company. Sage Island Energy was formed to respond to the Wyoming Infrastructure Authority Request for Proposal, which sought to establish a public-private partnership to develop a "clean coal" demonstration project (or

F-15

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

projects). Sage Island Energy was not selected for the project. Sage Island Energy had no substantial operations for the year ended December 31, 2007

NOTE 9 - INCOME TAXES

There was no benefit or provision for income taxes during 2007 and 2006. The Company also did not pay any income taxes during the years ended December 31, 2007 and 2006. The following presents the components of the net deferred tax asset as of December 31, 2007 and 2006:

December 31, ----------------------------- 2007 2006 ----------- ----------- Tax loss carry forward $ 6,184,645 $ 5,551,762 Stock based compensation 1,210,049 445,562 Asset bases differences 386,646 386,646 Accrued and deferred compensation 105,625 116,815 Other accruals 24,785 15,444 ----------- ----------- Total Deferred Tax Assets 7,911,750 6,516,229 ) Less: valuation allowance (7,911,750) (6,516,229) ----------- ----------- Net Deferred Tax Asset $ - $ - =========== ===========

The Company has net operating loss carry forward of approximately $16,600,000 which expire from 2011 through 2027.

The following is a reconciliation of the amount of tax that would be result from applying the federal rate to pretax income with provision for income taxes for the years ending December 31, 2007 and 2006:

For the Years Ended December 31, --------------------------- 2007 2006 ----------- ----------- Benefit at US federal statutory rate (34%) $(1,643,053) $ (480,159) Non deductible items 407,274 - Deferred tax asset valuation change 1,395,521 526,762 State benefit, net of federal effect (159,742) (46,603) ----------- ----------- Benefit from Income Taxes $ - $ - =========== ===========

NOTE 10 - SIGNIFICANT FOURTH QUARTER ADJUSTMENT

As mentioned in Note 6, the Company amended a stock right agreement for the issuance of 4,437,500 common shares in March 2007 to include a cashless feature. The Company initially accounted for the amendment as a financing transaction and reported no accounting effect. As part of the year end procedures, it was

F-16

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

concluded that this amendment was not a financing transaction and was, in effect, an issuance of a compensation based stock warrant. The fair value of the warrant, using March 2007 assumptions, was $995,775 determined by the Black-Scholes option pricing model using the following assumptions; estimated volatility 116.74% estimated risk-free interest rate of 4.9% estimated yield of 0% and a life of 1 year. The restatement adjustments to the Company's consolidated balance sheets (there was no effect to assets or liabilities) and statements of operations for the interim periods ended March 31, 2007, June 30, 2007 and September 30, 2007 are summarized below. Restated statements of cash flows for the interim periods have not been presented. The restatement adjustment had no effect on previously reported total cash flows from operating, investing and financing activities:

Three Months Ended March 31, 2007
(Unaudited)

As Previously Restatement Reported Adjustment As Restated ------------ ------------ ------------ Balance Sheet - Stockholders' Deficit Additional paid-in capital $ 19,130,386 $ 995,775 $ 20,126,161 Deficit accumulated during the development stage (20,233,155) (995,775) (21,228,930) Total stockholders' deficit $ (1,054,839) $ - $ (1,054,839) Statement of Operations General and administrative $ 1,022,261 $ 995,775 $ 2,018,036 Operating expenses 1,024,394 995,775 2,020,169 Loss from operations (1,008,184) (995,775) (2,003,959) Net loss (1,042,301) (995,775) (2,038,076) Basic and diluted loss per share $ (0.02) $ (0.02) $ (0.04) Six Months Ended June 30, 2007 (Unaudited) As Previously Restatement Reported Adjustment As Restated ------------ ------------ ------------ Stockholders' Deficit Additional paid-in capital $ 20,469,743 $ 995,775 $ 21,465,518 Deficit accumulated during the development stage (21,709,887) (995,775) (22,705,662) Total stockholders' deficit $ (1,191,504) $ - $ (1,191,504) Statement of Operations General and administrative $ 2,507,071 995,775 $ 3,502,846 Operating expenses 2,511,337 995,775 3,507,112 Loss from operations (2,464,489) (995,775) (3,460,264) Net loss (2,519,073) (995,775) (3,514,848) Basic and diluted loss per share $ (0.05) $ (0.02) $ (0.07)

F-17

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TERRA SYSTEMS, INC. AND SUBSIDIARIES
(A Development Stage Company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Nine Months Ended September 30, 2007
(Unaudited)

As Previously Restatement Reported Adjustment As Restated ------------ ------------ ------------ Stockholders' Deficit Additional paid-in capital $ 20,910,769 $ 995,775 $ 21,906,544 Deficit accumulated during the development stage (22,308,443) (995,775) (23,304,218) Total stockholders' deficit $ (1,348,534) $ - $ (1,348,534) Statement of Operations General and administrative $ 3,082,426 995,775 $ 4,078,201 Operating expenses 3,088,824 995,775 4,084,599 Loss from operations (3,044,197) (995,775) (4,039,972) Net loss (3,117,629) (995,775) (4,113,404) Basic and diluted loss per share $ (0.07) $ (0.02) $ (0.09)

NOTE 11 - SUBSEQUENT EVENTS (UNAUDITED)

On February 28, 2008, the Company issued 125,000 shares of common stock for proceeds of $12,500 or $0.10 per share. The shares were issued in privately negotiated transactions.

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