** **

**U.S. SECURITIES ANDEXCHANGE COMMISSION**

**Washington, DC 20549**

# **FORM 10-KSB**

**(MarkOne)**

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**ý****ANNUAL REPORT UNDER SECTION13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For theyear ended December 31, 2001**

** **

**o****TRANSITION REPORT UNDERSECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from        to       **

** **

**Commissionfile number 0-23356**

** **

**EARFULOF BOOKS, INC.**

(Name of Small BusinessIssuer in Its Charter) 

| **Delaware**                                                         |   | **74-3014422**              |
|----------------------------------------------------------------------|--------|-----------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | IRS Employer Identification |

 

 

| **907  West 5th Street, Suite 203 Austin, Texas** |   | **78703**  |
|---------------------------------------------------|--------|------------|
| (Address of Principal  Executive Offices)         |   | (Zip Code) |

 

**512-343-2620**

(Issuer’s TelephoneNumber, Including Area Code)

 

Securities registeredunder Section 12(b) of the Exchange Act: 

 

| **Title of Each Class** |   | **Name of Each Exchange on Which Registered** |
|-------------------------|--------|-----------------------------------------------|
| NONE                    |   | NONE                                          |

Securitiesregistered under Section 12(g) of the Exchange Act:

 

**COMMONSTOCK (.001 PAR VALUE)**

(Title of Class)

 

Check whether the issuer:(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for past 90 days. Yes ýNo o. 

 

Check if there isno disclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statements incorporatedby reference in Part III of this Form 10-KSB or any amendment to this Form10-KSB. [CONFIRM THERE WERE NO LATE SECTION 16 FILINGS.]

 

Issuer’s revenuesfor the fiscal year ended December 31, 2001. $1,088,608

Aggregate marketvalue of common stock (.001 par value) held by non-affiliates at March 31,2002. $2,705,484

Common stock($.001 par value) shares outstanding at March 31, 2002. 19,834,923

 

 

**Cautionary Statement for Purposes of “Safe Harbor Provisions”of the Private Securities Litigation Reform Act of 1995:**

 

The Private Securities Litigation Reform Actof 1995 (the “Reform Act”) provides a “safe harbor” for forward-lookingstatements to encourage companies to provide information about their companies,so long as those statements are identified as forward-looking and areaccompanied by cautionary statements identifying important factors that wouldcause actual results to differ materially from those discussed in thestatement.  The Registrant desires to takeadvantage of the “safe harbor” provisions of the Reform Act.  Except for the historical informationcontained herein, the matters discussed in this report are forward-lookingstatements, which involve risks and uncertainties.  Although the Registrant believes that the expectations reflectedin such forward-looking statements are based upon reasonable assumptions, itcan give no assurance that its expectations will be achieved.  Important factors that can cause actualresults to differ materially from the Registrant’s expectations are disclosedin conjunction with the forward-looking statements or elsewhere herein.

 

 

**PART I**

 

**ITEM I. DESCRIPTION OF BUSINESS:**

 

###### Overview

 

Earful of Books, Inc., aDelaware corporation (“Earful” or the “Company”) is based in Austin, Texas, andis a leading audiobook-only retailer in the United States. Earful, one of thepioneers in the audiobook retailing industry in the United States, was foundedin 1992 and began its franchise operations in 1998.  Effective July 6, 2001, Audiobooks of Texas, Inc. d/b/a Earful ofBooks merged with a subsidiary of American Absorbents Natural Products, Inc.(“AANP”)  Subsequent to the merger, theshareholders of Earful approved the renaming of the corporation from AmericanAbsorbents Natural Products, Inc. to Earful of Books, Inc. on August 24, 2001and concurrently gave their approval to reincorporate in the state of Delawarefollowing its original incorporation in Utah on February 9, 1984.

 

Earful currentlyoffers audiobooks for sale or rent on both cassette and compact disc.  Earful’s customer base is made up ofcommuters, salespeople, exercisers, repetitive task job holders (such as postalworkers and line workers) and students (particularly those suffering fromAttention Deficit Disorder or dyslexia). At present, Earful is the largest (based upon revenue) and secondlargest (based upon number of stores open) audiobook-only retailer in theUnited States.  In the retailmarketplace, Earful competes for audiobook sales with large chain bookstores,such as Borders and Barnes & Noble. Earful also competes with independent video stores and Cracker Barrelrestaurants for audiobook rentals.

 

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                    Prior to the merger with Earful, AANP was engaged in the mining, processing and sale of zeolite through its operations in Hines, Oregon.  The Company now owns mining equipment, a 103,000 square foot production facility constructed of sheet metal, over 500,000 board feet of Douglass Fir timbers and 295 mining claims.  The mining claims are estimated to have in excess of one billion tons of zeolite, making them one of the largest deposits in the United States. There are currently no material mining or processing operations in process. These assets are being actively marketed by Earful and the company anticipates that their sale will generate substantial cash for debt reduction, expansion and working capital.  These assets are referred to in the Company’s financial statements as “Assets held for sale”.

 

AudiobooksBusiness

 

Bricks and MortarStrategy.  Earful intends to become the leadingretailer of audiobooks through its “bricks and mortar” stores and internetoperations, with the largest rental selection of any retailer in the countryfocusing on unabridged titles. Additionally, Earful will strive to complement the rental strategy witha commitment to stocking the finest audiobooks available for sale.  Management believes that Earful’s level ofcustomer service will help build customer loyalty, repeat business and customerreferrals. At present, each Earful store carries between 4,000 to 7,000 of theover 65,000 audiobook titles available for sale or rental.  In contrast, Borders and Barnes & Noblenormally only carry between 500 and 1,000 titles for sale..   Earful carries one of the largestselections of audiobooks in the retail sector and specializes in offeringunabridged audiobook selections.

Earful opened itsfirst store on November 1, 1992 in Austin, Texas. Earful opened its secondstore in Dallas in July 1993 and a third store in Plano, Texas in March1994.  Earful entered into a licenseagreement in August 1995 for a store in Charlotte, North Carolina.  The licensee entered into a license for asecond store in July 1997. In 1996, Earful also entered into a licenseagreement for an Arlington, Texas store. All three licensed stores converted to franchise stores when Earfulbegan its franchise operations in July 1998. In 1997, Earful acquired the assets of Booktronics of Houston, Texas,which operated a single store in Houston, Texas.  The store has since been converted to Earful’s format.  In April 2001, Earful opened a store in SanAntonio, Texas.

Earful also has franchisestores in operation in the following areas:

 

Arlington, Texas

Mission Viejo, California

Portland, Oregon

Redmond, Washington

Roanoke, Virginia

Rockville, Maryland

 

 

Suppliers. Earful primarily purchases itsinventory from major distributors such as Ingram Entertainment and Ingram BookCompany. The Company also buys 

 

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directfrom a number of publishers such as Books On Tape, Blackstone Audio, BrillianceAudio, Random House Audio, and Recorded Books along with a number of smallerpublishers often not carried by a distributor.

Internet Strategy. Earful has an opportunity to leverage its “bricks and mortar” operationwith an extensive Internet application. Earful’s goal is to strengthen its physical presence by combining itwith a strong Internet strategy and thereby developing brand recognition thatspans the spectrum from leisure shopping pleasure to delivery-on-demandservice.

Earful isaggressively moving to outfit its store locations to take advantage of theefficiencies offered by the Internet. Earful currently plans to equip each existing store and each newlocation added with technology that will allow stores to download, via theInternet, any content that has been digitally encoded and is available in themarket, in any format desired by the customer: cassette tape, compact disc oran appropriately-equipped personal player (such as an MP-3 player).  The customer will be able to reserve his orher selection by telephone or from the Internet, and pick it up at the storeclosest to their location, receive it by mail, or, if they are already in astore, their request will be able to be downloaded on the spot.  This concept will allow Earful to have a“virtual inventory,” thereby reducing its inventory carrying cost andincreasing its profit margin while improving its ability to meet customer needsand expanding its customer base.  Franchisestores will also benefit from this strategy in lower inventory carrying costs,translating into higher returns on their investment and an opportunity toexpand their customer base.

BlockbusterAlliance.  Earful has entered into an Alliance PartnerAgreement with Blockbuster, Inc., joining other companies such as Starbucks,Papa John’s Pizza, Quizno’s and Subway as Alliance Partners ofBlockbuster.  Pursuant to Earful’sAgreement with Blockbuster as an Alliance Partner, Earful expects to receivethe following benefits:

·              A right tosublease part of Blockbuster Stores approved by Blockbuster for downsizing.** **Earful plans to develop andbuild-out up to 150 stores in Blockbuster sites over the next three years.

·              To reduce storebuild-out costs, Blockbuster will share utilities on a pro-rata basis and whereappropriate share restroom facilities.

·              Earful willhave the opportunity to partner with Blockbuster on a fee basis foradvertising/marketing services for the Blockbuster/Earful co-located stores.

·              Blockbusterwill allow Earful to advertise in Blockbuster mailings and provide taglines inother types of advertising.

 

IntellectualProperty.  The Company markets its products under thetrademark “Earful of Books,” a registered trademark with the United StatesPatent and Trademark Office.

Customers.  Earful’s primary customers listen toaudiobooks regularly while commuting, traveling, working, and exercising.  Earful’s primary customers are typically 

 

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well-educatedand upper-middle class.  A short list oftypical primary customer profiles includes:

•                  a parent listening whilerunning errands;

•                  professionals listeningduring their morning and evening commutes;

•                  professionals listeningwhile traveling on business; and,

•                  retired persons listeningfor pleasure.

 

Primary customerscan be price sensitive.  Many of themhave exhausted the limited audiobook selections at their public libraries.  They explore used bookstores for bargains andvisit big-box bookstores to purchase newly released titles.  Initially, retail locations and mail orderserved primary customers, but a growing number of them are converting to theInternet as a source of their rentals.

Earful’s secondarycustomers enjoy their experiences with audiobooks, however, mostly as anoptional or seasonal product easily replaced by other consumer products.  Typically, secondary customers rent orpurchase audiobooks to fill a specific need, like family listening for a summervacation road trip or academic listening for a school project.

Also, Earfulenthusiastically pursues education markets and cultivates relationships withvisually impaired and special education customers, such as those diagnosed withattention deficit disorder or dyslexia.

One of every fiveAmerican households listen to audiobooks at least once a year, a trend theAudio Publishers Association (APA) sees growing in its regular marketsurveys.  In 2001, the Annual APA Surveyfound that in the most popular locations, audiobook listeners spend more thanone third of their listening time at home and in a vehicle with audiobooks.

An audiobook doesnot hold the same residual emotional value for listeners as a printed hardbackbook.  As a result, audiobooks listenersdo not have a primary need to own the product. Rather, listeners merely want easy access to the product for areasonable price.  For example, therecent APA survey found that more than half of audiobook listeners do notpurchase the product, but rent, borrow, or receive audiobooks as gifts.   Earful believes this clearly validates itsbusiness model of renting audiobooks.

Competition. Earful is aware that it has the following competitors in the industryand notes their competitive position to such competitors:

•                  Publishers, who generatecontent but do not have a strong interest in maintaining rental or saleschannels.

•                  Libraries, the largestprovider of audiobooks, which have small inventories and limited selections.

•                  Retailers such as Barnes& Noble and Borders, Wal-Mart and Target, and mall stores are occasionallysignificant sellers of best-selling audiobooks.  However, 

 

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                        publishingagreements typically preclude them from generating audiobooks rental revenues,which generate a substantial amount of Earful’s revenues.

•                  Onlineand membership/catalogue operations, which include Audible.comand Mediabay, audiobook clubs like membership-based book and record clubs, andsome small, independent audiobook publishers.

•                  Rental-basedcompetitors, such as Talking Book World and Bookears, Cracker Barrel and otherhighway-based rental outlets, and single-location independent retailers invarious cities.

 

Research and Development.  Whilethe Company continually investigates new technology related to all of itsproducts, it did not engage in any direct research and development projects inthe year ended December 31, 2000. During the year ended December 31, 2001, the Company began thedevelopment of a point of sale, inventory management, customer management anddevelopment software system specifically related to a rental concept.  The Company incurred approximately $158,163in costs associated with this research and development.  The cost is included in the accompanyingfinancial statements as a part of “Property and Equipment”.

Regulations. The Company is subject to all state and federal regulations regardingemployee relations, local zoning and compliance issues and discriminationmatters.  The Company believes it is incompliance with all such regulations.

** **Environmental Laws.  The Company has no environmental matters related toits primary business of renting and selling audiobooks.

 

Factors ThatMay Effect Future Results of the Audiobook Business

 

***Limited Operating History.***

Earful has a limitedoperating history from which to evaluate its business and operations.  Earful was founded in 1992.  Although Earful has experienced growth inboth the rental and direct-sale markets of audiobooks during its eight-yearhistory, there can be no assurance that it will continue to grow or that itwill achieve positive cash flow and profitability on an ongoing basis.  As a company in a new and evolving market,it faces numerous risks and uncertainties.

***Absence ofProfitability.***

Due in part toEarful’s aggressive growth plan, since Earful’s inception, it has not beenprofitable.  Earful has historicallyexperienced losses on a consolidated basis, including losses of $251,081 duringthe year ended December 31, 1997, $492,930 during the year ended December 31, 1998,$785,833 during the year ended December 31, 1999, $2,554,698 during the yearended December 31, 2000 and $4,596,061 during the year ended December 31, 2001.Earful is a guarantor of approximately $150,000 of debt of a partnership inwhich Earful is the general partner and a limited partner loan, which debt wasused to finance its store in Austin, and an additional loan in the amount ofapproximately $52,000, which was used to finance its store in Houston,Texas.  At 

 

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December31, 2001, Earful had accumulated a deficit of $9,711,523 and outstandingindebtedness to its stockholders of $2,618,068 including accrued interestexpense. As of December 31, 2001, Earful had approximately $8,520,097 ofindebtedness outstanding, which is substantial in relation to Earful’s totalcapitalization.  Earful’s indebtednessrequires it to make timely interest and principal payments. Earful is currentlyin default of certain loan covenants in its agreements with various lenders andis in default on the majority of its obligations under the indebtedness.  However, on April 12, 2002, Earful reachedverbal agreement with two financial institutions to renew and extend $1,750,000of the Company’s bank debt on terms acceptable to the Company. If Earful doesnot generate sufficient cash flow from operations or obtain other sources offunds to finance these payments, it could have a material adverse effect on ourbusiness, including foreclosure by the lenders on Earful assets.  Moreover, because borrowings under certaincredit agreements are at variable rates, Earful is subject to the risk ofpaying higher rates on advances under those credit agreements.

***Ability to ManageGrowth***

Earful’s internalgrowth and acquisitions have placed, and are expected to continue to place, asignificant strain on our management, administrative, operational, financialand other resources.  Earful cannotassure potential investors that it will be able to successfully integrate theacquired operations into its business or that it will be able to retain keypersonnel acquired in these transactions. Earful will be materially adverselyaffected if it is unable to successfully integrate acquired businesses andpersonnel into its operations.

***Dependence onGrowth of Audiobook Market.***

Because the marketfor audiobooks is still evolving and is a niche market, it is not certain thatthe market will continue to grow.  It ispossible that the market for audiobooks may not continue to grow at the currentrate or growth trends may reverse. The sale of audiobooks through mail orderclubs is an emerging retail concept.  Asis typically the case for products in an evolving industry, the ultimate levelof demand and market acceptance for audiobooks is subject to a high degree ofuncertainty.  A decline in thepopularity of audiobooks would adversely affect Earful’s business andprospects.  Failure to respond tofactors affecting Earful’s business could result in lost sales opportunities orexcess inventory from Earful’s inability to sell selected titles.  Earful’s success is largely dependent uponits ability to anticipate and respond to these and other factors affecting theindustry, such as economic factors affecting discretionary consumer spending,changes in consumer demographics and the availability of other forms ofentertainment.

*Responsiveness to MarketTrends.*

 

The audiobookmarket is characterized by continuous introductions of new titles and issubject to changing consumer preferences, which may adversely affect Earful’sability to plan for catalog offerings, anticipate order lead-time andaccurately assess inventory requirements. While Earful evaluates many factors to anticipate the popularity 

 

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andlife cycle of selected titles, the ultimate level of demand for specificaudiobook titles is subject to a high level of uncertainty.  Moreover, sales of a specific audiobooktitle typically decline rapidly after the first few months followingrelease.  Any unanticipated decline inpopularity of selected titles could result in excess inventory or requireEarful to sell this inventory at a reduced price. Interruption in the supply ofaudiobooks could result in increased product costs or loss of salesopportunities.

*Failure to Obtain Rights.*

 

Failure to obtainthe rights to audiobook libraries or selected audiobook titles, on commerciallyreasonable terms, or at all, could negatively affect Earful’s business.  Earful’s success is in part dependent upon itsability to establish license arrangements and license and supply arrangementswith respect to audiobook publishers’ libraries and to enter into additionalarrangements for the supply of new audiobook titles.

*Possibilityof Increased Postal Costs.*

 

Increases in costsof postage and shipping could reduce Earful’s net income or increase Earful’snet loss if it were unable to pass on the costs to its customers. Anyunanticipated increase in postal rates could have an adverse effect on Earful’soperating results to the extent that it is unable to offset these increases byraising its prices or by implementing more efficient mailing, delivery andorder fulfillment methods.  Postage andshipping are significant expenses in the operation of Earful’s business.

 

*Dependence on ProprietaryInformation.*

 

Third partiescould copy or obtain access to, and use, Earful’s member and customer databasesand other proprietary know-how, ideas and concepts. In addition,confidentiality agreements with executive officers, employees, list managersand appropriate consultants and service suppliers may not adequately protectEarful’s trade secrets. In the event competitors independently develop orotherwise obtain access to Earful’s know-how, concepts, trade secrets ordatabases, Earful might be adversely affected.

Unanticipatedevents, including delays in securing an adequate supply of popular audiobooktitles at the time of peak sales, delays in direct mailing or significantdecreases in sales, particularly during peak sales periods, could result in lossesduring a period which would not be easily reversed before the following year.

***Dependence on KeyPersonnel.***

 

Earful isdependent upon the services of its key personnel and in particular RussellGrigsby, Chief Executive Officer; Myron Sappington, Executive Vice Presidentand Chief Financial Officer; and Jefferson Baskin, Executive VicePresident-Customers.  Paul A. Rush,founder, at present is a Consultant to the Company.  The loss of the 

 

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servicesof any personnel could have a material adverse effect on Earful.  In addition, the availability of skilledpersonnel is extremely important to Earful’s growth strategy and the failure ofEarful to attract and retain such personnel could have a material adverseeffect on Earful.

***Competition forCustomers.***

Earful expectscompetition in the audiobook market, including Internet and traditional “bricksand mortar” store operations, to intensify as more competitors seek to expandtheir position in the marketplace.  Earfulexpects companies with much greater resources than it to compete for the samebusiness. Competitors could include traditional booksellers, including BordersGroup, Inc., Barnes & Noble, Internet companies such as Amazon.com andtraditional retailers such as Wal-Mart. Most of these competitors and potential competitors have substantiallygreater financial, technical and marketing resources than Earful.  Earful is also in direct competition withother audiobook retailers, including Talking Book World, a chain of audiobookstores based in Detroit, Michigan. There can be no guarantee that Earful willbe able to compete effectively or successfully implement its business plan.Earful’s business strategy depends in part on its ability to grow its brand nameand continue its expansion through the development of corporate stores andadditional franchises, as well as its ability to develop its Internet presenceas the premier destination for audiobooks on the Internet. There can be noassurance that Earful will be able to grow its business and achieve continuingrevenue growth and/or reductions in costs.

### ***Dependency onFranchise Concept.***

 

Because of itslimited available capital, Earful is dependent on attracting qualifiedfranchisees to meet its retail store expansion plan.  In the event Earful cannot attract qualified franchisees, Earfulwill not meet its store-opening schedule which could have a material adverseeffect on Earful’s business.  Becauserevenues from franchisees’ sales are a component of Earful’s revenue base,Earful’s performance also depends upon the ability of its franchisees topromote and capitalize upon the Earful concept.

### ***GovernmentRegulation.***

 

Earful is subjectto federal regulation and certain state laws that govern the offer and sale offranchises.  Many state franchise lawsimpose substantive requirements on the franchise agreement, includinglimitations on non-competition provisions and termination or non-renewal of afranchise.  Some states require thatcertain materials be registered before franchises can be offered or sold inthat state.  The failure by Earful tocomply with these laws could subject Earful to liability to franchisees and tofines or other penalties imposed by governmental authorities.  Earful believes that the franchisingindustry is experiencing an increasing trend of franchisees filing complaintswith state and federal governmental authorities and instituting lawsuitsagainst franchisors claiming that they have engaged in unlawful or unfair tradepractices or violated express or implied agreements with franchisees.  Earful believes that it is in materialcompliance with these laws and regulations and its agreements with franchisees.

 

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*Continued Availability of Retail Real Estate Sites.*

 

There is noassurance that either Earful or its franchisees will be able to continue tonegotiate acceptable retail real estate leases in which to locate its futurestores or that rental rates will continue to be at such levels that profitabilitywill continue to be possible.  There isno long-term commitment from Blockbuster that it will continue to offer Earfulor its franchisees opportunities or any incentives to locate within its retaillocations.

### ***Direct Liabilityof Earful for Real Estate Leases on Sites Occupied by Franchisees.***

 

Earful is thesub-tenant on real estate leases occupied by the franchisee-owned storesco-located with Blockbuster.  There isno assurance that any of these stores will be adequately profitable to meet thelease obligations or that Earful will have adequate capital to pay the leaserequirements in the event franchisees fail to meet their obligations under theleases.

### ***TechnologicalObsolescence Risk.***

 

There is noassurance that Earful will have adequate capital to develop or acquire any newtechnology necessary to retain its position in the market.  There currently exist other marketparticipants more favorably capitalized and better positioned than Earful todevelop new technology or acquire newly available technology.  Others may develop products or technologiesthat render our products noncompetitive or obsolete.  If Earful is not able to respond to technological change, it maylose customers, which could cause Earful’s revenues to decrease.

##### Zeolite Business

 

There are nocurrent material mining or processing operations occurring by the Company.These assets are being actively marketed by Earful and the company anticipatesthat their sale will generate substantial cash for debt reduction, expansionand working capital.

Regulations. Although the Company does not currently actively operate either the minesite or the processing plant to any material extent, should it begin these ofthe operations, it would be subject to federal and state reclamationrequirements.  These require the Companyto return the mined area to a useful status. In general, mining and milling operations are subject to compliance withthe regulations promulgated under the federal Mining and Minerals Policy Act of1970 and the requirements of the federal Occupational Safety and HealthAdministration (OSHA), as well as equivalent state regulations.

Environmental Laws. In the event the Company begins mining and milling operations again,compliance with regulations relating to the protection of the environment isnot anticipated to have a material effect upon the capital expenditures, 

 

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earningsor competitive position of the Company. Due to the limited nature of the mining operations in Oregon prior to1998, the Company’s predecessor operated under an exemption from reclamationrequirements.  However, the Company’spredecessor’s policy has always been to reclaim all of its mined areas.  A Plan of Operations for the Harney BasicClaims has been approved by the various regulatory commissions and permanentmining permits were issued on July 10, 1997. The Company posted a $15,000 mined land reclamation bond to assurecompliance.

FactorsThat May Effect Future Results of the Zeolite Business. 

 

*Sales of Assets**.***

 

TheCompany currently anticipates liquidating the assets related to the zeolitebusiness.  The zeolite deposits of theCompany contain very low traces of known carcinogenic fibrous particles.  The presence of these traces could affectthe market value of the zeolite assets and thus the potential realizable valueof these assets.  This could affect theCompany’s cash flow and need for financing. However, based on toxicology and other independent expert reports, theCompany believes that trace amounts of hazardous zeolites are common to manyzeolite deposits and that the majority of its deposits do not contain amountsin excess of those  commonly found.

*Potential Environmental Liabilities****.***

 

The Company hasbeen engaged in the mining of zeolite.  Thezeolite mine contains hazardous materials discussed above.  It is possible that the Company could beheld liable for damages related to the development of adverse health conditionsin employees or persons who purchased or were otherwise exposed to the Registrant’sproducts.  Management believes thatbecause of the trace amounts of hazardous substances present and the limitedoperations and sales conducted to date, the likelihood of this potentialliability is low.  However, if anyperson were to be successful in obtaining a judgment against the Company foradverse health conditions, it could have a material adverse impact on theCompany.  Management has obtained  insurance coverage for this potentialliability, however, there can be no assurance that such insurance coverage willbe adequate to insulate the Company from all material liability.

                *Adverse Conditions.*

 

The local climatedoes not favor year-round mining or processing on the property. The rainyseason occurs from October through April and could cause problems in stripping,crushing, and screening of the zeolites. Also, the weather could have amaterial effect on the ability to haul large quantities of the material ifpermanent roads are not constructed. The Company does not plan to construct permanentroads.  The Company does not believe itsoperations will be restricted by this since sufficient quantities of zeolitecan be mined during good weather conditions.

                *Title to Property.*

 

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The owner of anunpatented mining claim holds possessory title to the claim.  Possessory title is not legal title, nordoes it arise out of any instrument or grant by the United States or out of anyaction taken by any officer or agency of the state or federal governments.  A claim must be patented for legal title tovest ownership. Possessory title arises as a matter of law by performance bycertain acts of location, including the staking of claim boundaries and themaking of certain record filings in compliance with the requirements of federaland state laws.  The validity of anunpatented mining claim cannot be conclusively determined by an inspection ofpublic records.  It is dependent uponthe legal availability of the lands at the time the location is made and the validityof the mineral discovery within the boundaries of each claim, in compliancewith federal, state and local laws relative to location procedures.  Prior to 1992 possessory title wasmaintained against subsequent location by the annual performance of labor orimprovements on or for the benefit of each mining claim.  The Company believes all past assessmentwork requirements relating to the Company’s claims were adequately performed.  Since 1992 possessory title for personsholding ten or more claims continues to be maintained by payment of an annualclaim fee of $100 per claim. The Company believes it has met the requirementsfor holding possessory title to the claims.

Employees

 

The Company had 21full time employees and 34 part-time employees as of March 31, 2002.

##### Reports to Security Holders

 

Earful is not required todeliver an annual report to its stockholders. Earful will voluntarily send a copy of this annual report includingaudited financial statements to its stockholders upon receipt of a writtenrequest from a stockholder.  Earful isrequired to file reports pursuant to Section 13 of the Securities and ExchangeAct with the Securities and Exchange Commission (the “SEC”).  The public may read and copy any materialsthat the Company files with the SEC at the SEC’s Public Reference Room at 450Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the PublicReference Room by calling the SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that contains reports, proxyand other information statements, and other information at http://www.sec.gov.

 

**ITEM 2.DESCRIPTION OF PROPERTIES:**

 

###### Executive Officesand Audiobook Retail Properties

 

The Company’sexecutive offices are currently located at 907 W. 5th St., Suite203, Austin Texas.  Earful occupiesapproximately 4,270 combined square feet of leased office space in Austin,Texas for its headquarters and 22,852 combined square feet of leased retailspace in Austin, Dallas, Houston and San Antonio for the Earful-owned retailstores.  The monthly rent on thecombined space is approximately $59,571.65 and is at a market rate.  Substantially all of this space is leaseduntil 2004.  We believe that currentfacilities will be adequate to meet our near term requirements.

 

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###### Mining Properties

 

The Company haslocated or acquired, and controls 259 unpatented placer mining claims locatedin the Harney Basin, Harney County, Oregon, covering approximately 7.475 squaremiles (the “Harney Basin Claims”). Also, the Company has located or acquired 26unpatented zeolites placer mining claims in Malheur County, Oregon, near thetown of Sheaville (the “Sheaville Claims”). In addition, the Company haspurchased 10 unpatented lode zeolite mining claims situated in Mohave County,Arizona, (the “Arizona Claims”).  TheCompany has not been made aware of any rival claimant’s interest in orrestrictions imposed by the Bureau of Land Management that might impair theCompany’s possessory interest in the Arizona “lode” claims.

The Company is inpossession of extensive trenching and core drilling data on the HarneyBasin.  A  composite geological report prepared for the Company in 1993estimated the early sampling of the area established numerous good-qualityzeolite beds in a 7.5 square mile area with an average of slightly over 70%total zeolites content, consisting primarily of clinoptilolite, with lesseramounts of phillipsite, chabazite, mordenite and erionite. The Company intendsto concentrate its mining efforts, if any, solely on the beds of zeolitescontaining no erionite. The Company’s current operations are in an area of theHarney Basin which reports indicate may contain in excess of 880,000,000 tonsof 90% pure clinoptilolite.  The zeolitedeposits on the Harney Basin Claims are on or near the surface with little orno overburden, thus reducing the cost of extraction.

The mortgage onthe Company’s mining facility has a lien on it from a line of credit granted tothe Company by Robert Bitterli, a member of the Company’s Board of Directors.

The Harney BasinClaims have virtual year-round access by a highway and existing ranch andcounty roads.  However, sustained miningoperations may require the construction of more permanent facilities. TheCompany has no present intention to commence mining operations of the magnitudethat would require larger permanent facilities.

##### Insurance

 

All of theseproperties are all insured by standard insurance coverages for fire and otherpotential detrimental occurrences in amounts adequate to protect the Companyfrom any material potential loss.

 

# **Debt**

 

At December 31, 2001, theCompany owed $1,995,038 in bank debt to three financial institutions.

 

13

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Also at December 31, 2001,the Company owed its shareholders and certain Directors of the Company$2,486,947.

 

As of April 1, 2002,$1,300,000 of the Company’s bank debt had matured with two financialinstitutions.  On April 12, 2002, Earfulreached a verbal agreement with those financial institutions to renew andextend $1,750,000 of the Company’s bank debt on terms acceptable to theCompany.

 

**ITEM 3.LEGAL PROCEEDINGS:**

 

Neither theCompany, any of its properties, nor its subsidiaries are a party to any materialpending legal proceeding or government action, including any materialbankruptcy, receivership, or similar proceedings. Management of the Companydoes not believe that there are any material proceedings to which any director,officer or affiliate of the Company or its subsidiaries, any owner of record,beneficially, of more than 5 percent of the common stock of the Company, or anyassociate of any such director, officer or affiliate of the Company, orsecurity holder is a party adverse to the Company or its subsidiaries or has amaterial interest adverse to the Company or its subsidiaries. The Company does,from time to time, get involved in litigation in the carrying out of itsoperations.

The following details the results of litigation inwhich the Company was involved in during the year ended December 31, 2001.

 

 

1.             *Corus Bank v. Earful of Books Illinois, Inc., Earfulof Books, a Texas Corporation, Paul A. Rush, an individual, d/b/a Earful ofBooks, a Texas Corporation, Robert E. Pyeatt, an individual, and Sara Lyford,an individual,* Cause No. 01L 015961; Circuit Court of Cook County, Illinois, County Department, LawDivision.

 

Suit wasfiled  December 12, 2001.  Corus Bank, as trustee for James P. Stellas,sued pursuant to a lease agreement. According to the complaint, Earful failed to pay the full amount of rentdue for the term of the lease agreement. The Plaintiff seeks $97,691.32 from Earful and $92,919.61, in thealternative, against the individual defendants.  Defendants Earful and Paul Rush have filed appearances.

 

2.             *RTC, Inc. v. Earful of Books Franchising Company,Inc.*, Cause No. GN 103794; 126th Judicial District Courtof Travis County, Texas.

 

Filed November 16,2001.  RTC, Inc. sued Earful claimingfraud, breach of contract and fraudulent inducement in connection with RTC’spurchase of a franchise.  The partiesresolved the matter for $55,000 in January 2002, but RTC filed an AgreedJudgment against Earful on February 28, 2002 for $70,000.

3.             *Electrocast, Inc. v. Audiobooks of Texas, Inc.;*261stDistrict Court of Travis County.

 

14

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Filed January 25,2001, Electrocast claims breach of contract concerning an agreement by Earfulto have Electrocast process certain books on tape to digital format.  Amount sought is $3.725 million.  Earful believes that it has a valid defenseand that damages are grossly overstated. The parties have agreed to voluntarily mediate the case and in April2002, the Company entered into a settlement agreement whereby they will issue315,000 shares of the Company's common stock, plus pay $50,000 over a twelvemonth period beginning in May 2002.

4.             *Earful Investors, Ltd. v. Paul A. Rush*;Case No. A 0104764; Court of Common Pleas, Hamilton County, Ohio.

 

Filed December 5, 2001.  Earful Investors, Ltd. has an Agreed FinalJudgment against Paul Rush for $90,000 filed in Travis County under causenumbers GN101933 and GN101940.  Theunderlying dispute is between defendant and a franchisee regarding acquisitionof a store and payment of rent.  At thistime, post-judgment discovery is taking place, which includes Mr. Rush’sdeposition on April 22, 2002.

5.             *DavidL. Rasmussen and Linda K. Rasmussen v. Earful of books Franchising Company,Inc., Earful of Books of Houston, Inc. Audiobooks of Texas, Inc., EarfulAudiobooks, Inc. d/b/a Earful of Books, Earful Acquisition Corporation akaEarful Audiobooks, Inc. and Paul A. Rush;* Cause No. 0110-10064; Inthe Circuit Court of the State of Oregon, County of Multnomah.

 

Filed October 9,2001, Rasmussen claimed that the defendants failed to disclose materialinformation when offering to sell a franchise. The causes of action included violation of Oregon Revised Statute650.020 regarding such disclosures and fraud. The Plaintiffs sought a default judgment against the Defendants onJanuary 4, 2002.  Judgment was enteredin the amount of $374,010.00, plus costs and interest.

**ITEM 4.  SUBMISSION ORMATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None.

 

# **PART II**

 

**ITEM 5. MARKET FOR COMMON EQUITY ANDRELATED STOCKHOLDER MATTERS:**

 

The common stock of theCompany is traded on the NASD’s Over the Counter Bulletin Board under thesymbol “EARZ”. The following table sets forth the range of high and low sales prices on a per share basis during thequarters indicated.

 
| **YEAR ENDED********12-31-00** |   | **HIGH********PRICE** |   | **LOW********PRICE** |   | **YEAR ENDED********12-31-01** |   | **HIGH PRICE** |   | **LOW PRICE** |   |
|--------------------------------|--------|-----------------------|--------|----------------------|--------|--------------------------------|--------|----------------|--------|---------------|--------|
| First  Quarter                 |   | $                     | 0.92   |                 | $      | 0.52                           |   | First Quarter  |   | $             | 0.50   |   | $ | 0.13 |   |
| Second  Quarter                |   | $                     | 0.59   |                 | $      | 0.26                           |   | Second Quarter |   | $             | 0.78   |   | $ | 0.15 |   |
| Third  Quarter                 |   | $                     | 2.89   |                 | $      | 0.26                           |   | Third Quarter  |   | $             | 0.33   |   | $ | 0.17 |   |
| Fourth  Quarter                |   | $                     | 0.85   |                 | $      | 0.13                           |   | Fourth Quarter |   | $             | 0.39   |   | $ | 0.18 |   |

 

15

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As of December 31, 2001, there were approximately 502holders of record (not including shares held in street names) of the commonstock of the Company as reported to the Company by its transfer agent. Basedupon requests for proxy materials by various proxy services, the Companyestimates that it currently has approximately 950 shareholders.

 

No cash dividends have been declared or paid as yet onthe common stock. Whether dividends will be paid will be determined by theBoard of Directors of the Company and will necessarily depend on the Company’searnings, financial condition, capital requirements and other factors. TheBoard of Directors has no current plans to declare any dividends in theforeseeable future. There are no restrictions in effect, in loan documents orelsewhere, that would limit or restrict the Company’s ability to pay dividends.

 

At December 31, 2001, the Company had 50,000,000shares of common ($.001 par value) stock authorized of which 17,934,923 shareswere outstanding and had 10,000,000 shares of convertible preferred stock($.001 par value) authorized of which no shares were outstanding. At March 31,2002, 19,834,923 shares of common stock and 0 shares of convertible preferredstock were outstanding.

 

The Company issued common stock for $50,000 cashduring the year ended December 31, 2001.

 

**ITEM 6. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION, RESULTS OF OPERATIONS AND PLAN OF OPERATIONS.**

 

**Result of Operations**

 

 

 

 

YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDEDDECEMBER 31, 2000

 

Total revenue of $1,088,608 for the year endedDecember 31, 2001 decreased $124,614, or 10%, from $1,213,222 for the yearended December 31, 2000. The decrease was attributable to a small decrease inmerchandise sales and a significant decrease in franchise revenue   Although the Company opened two additionalstores during the year, rental and merchandise sales revenue decreased slightlyas a result of the early stages of the stores development and current marketconditions. Franchise revenue declined as a result of the Company’s decreasedfocus on this aspect of its business and the result of four franchise storesceasing operations in 2001.

 

16

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Cost of sales and services for the year ended December31, 2001 amounted to$1,771,170, or 163% of total revenue, comparedto$1,324,380, or 109% of total revenue, for the year ended December 31, 2000.The increase of $446,790 was primarily attributable to the opening of twocorporate stores.

 

Selling, general and administrative expenses for theyear ended December 31, 2001 amounted to $3,482,179, or 320% of total revenue,compared to $2,026,361, or 167% of total revenue for the year ended December31, 2000. Selling, general and administrative expenses increased $1,455,818 asa result of the Company’s continued expansion, business development efforts,costs associated with the settlement of potential litigation and expensesassociated with the merger.

 

Interest expense for the year ended December 31, 2001amounted to $431,320 compared to $117,171 for the year ended December 31, 2000.Interest expense increased $314,149 as a result of the overall increase in theaverage debt balance outstanding during the respective periods and due to$174,437 of common stock issued to stockholders during the year ended December1, 2001 for interest and the guarantee of the Company’s indebtedness.

 

Net cash used in operating activities for the yearended December 31, 2001 increased $1,854,390 to $2,631,148. The increase isprimarily the result of the expansion of the Company. The Company was able tofund the cash deficit from operations of $2,631,148 and the cash used forcapital expenditures of $479,952 with an increase in net cash provided byfinancing activities of $3,111,100 during the year ended December 31, 2001.

 

##### Liquidity and Financial Condition

 

The Company’s accumulated deficit through December 31,2001 was $9,711,523 compared to $5,115,462 at December 31, 2000.  The Company has a working capital deficit of$7,961,134 at December 31, 2001, and year-to-date operating losses havecontinued through the date of this report. The Company has financed its operations for the most recent two yearsprimarily through the sale of equity securities and proceeds from shareholderloans and debt to financial institutions.

 

During the last two years, the Company has incurred lossesas it has pursued various opportunities to substantially expand itsbusiness.  It has pursued expansionthrough franchising and currently has six franchise stores.  Additionally, the Company pursued expansionthrough co-locating with other retailers and has expended considerable researchand development to determine the viability of an on-line retail presence.  While the Company will continue to pursueopportunities to expand its business base, it anticipates that most of itsexpansion will occur in the addition of Company owned stores and by providingits expertise to further expand the business of other participants alreadysuccessful in other segments of the audiobook market.  In addition, the Company plans to implement a marketing strategyto increase revenue at existing Company owned stores and franchise stores.

 

17

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The Company is actively marketing its assets held for salein order to produce working capital and to reduce its dependence on short-termcredit facilities.  Management believesit will sell the mining assets in an amount in excess of the liabilitiesassociated therewith and thereby provide substantial working capital for theCompany.  Further, management believesthere are available sources of long-term capital on terms acceptable to theCompany that will provide additional working capital necessary to expandoperations, provide for the liquidation of a substantial portion of itsshort-term debt and accounts payable and provide for the necessary associateddebt service.  However, there can be noassurance that there will be additional financing available, or, if available,such financing would be available on terms acceptable to the Company.  If adequate working capital is notavailable, the Company may be required to curtail its operations significantlyor obtain funds on less favorable terms than it might desire.  The failure of the Company to raiseadditional working capital on acceptable terms would have a material adverseeffect on the Company’s business, financial condition, results of operationsand its ability to continue as a going concern.  The report of the Company’s independent accountants, whichaccompanied the consolidated and combined financial statements for the yearended December 31, 2001 and 2000, included a paragraph detailing theiruncertainty regarding the ability of the Company to continue as a goingconcern.

 

 

18

----

 

 

**ITEM7.  FINANCIAL STATEMENTS.**

 

 

 

19

----

 

 

**EARFUL OF BOOKS, INC.**

**__________**

 

 

 

 

**CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS**

**WITH REPORT OF INDEPENDENT ACCOUNTANTS**

**for the years ended December 31, 2001 and 2000**

 

 

 

20

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**EARFUL OF BOOKS, INC.**

**TABLE OF CONTENTS**

----

 
| Report of Independent  Accountants                                                                                 |   |   |
|--------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                               |   |   |
| Consolidated and  Combined Financial Statements:                                                                   |   |   |
|                                                                                                               |   |   |
| Consolidated and  Combined Balance Sheet as of December 31, 2001                                                   |   |   |
|                                                                                                               |   |   |
| Consolidated  and Combined Statement of Operations for the years ended December 31, 2001  and 2000                 |   |   |
|                                                                                                               |   |   |
| Consolidated  and Combined Statement of Cash Flows for the years ended December 31, 2001  and 2000                 |   |   |
|                                                                                                               |   |   |
| Consolidated  and Combined Statement of Stockholders’ Deficit for the years ended December  31, 2001 and 2000 |   |   |
|                                                                                                               |   |   |
| Notes  to Consolidated and Combined Financial Statements                                                           |   |   |

 

21

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**Report of Independent Accountants**

 

 

 

Tothe Board of Directors and Stockholders

Earfulof Books, Inc.

 

 

Wehave audited the accompanying consolidated and combined balance sheet of Earfulof Books, Inc. as of December 31, 2001, and the related consolidated andcombined statements of operations, stockholders’ deficit and cash flows for theyears ended December 31, 2001 and 2000. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

Weconducted our audits in accordance with generally accepted auditingstandards.  Those standards require thatwe plan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing 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 areasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated and combined financial position of Earfulof Books, Inc. as of December 31, 2001 and 2000, and the results of theiroperations and their cash flows for the years then ended in conformity withgenerally accepted accounting principles.

 

Theaccompanying financial statements have been prepared assuming the Company willcontinue as a going concern.  Asdiscussed in Note 2 to the financial statements, the Company has sufferedrecurring losses from operations and at December 31, 2001 is in a negative workingcapital position and stockholders’ deficit position.  These factors raise substantial doubt about the Company’s abilityto continue as a going concern. Management’s plans in regard to these matters are also described in Note2.  The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

 

 

 

 

 

Houston,Texas

March25, 2002

 

22

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**EARFUL OF BOOKS, INC.**

**CONSOLIDATED****AND COMBINED BALANCESHEET**

**December 31, 2001**

----

 
| **ASSETS**                                                                                                                          |   |       |      |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|------------|-----------|
| Current assets:                                                                                                                     |   |       |      |
| Cash and cash equivalents                                                                                                           |   | $          | —    |   |
| Receivables                                                                                                                         |   | 9,016      |      |
| Due from franchisees                                                                                                                |   | 199,000    |      |
| Due from stockholder                                                                                                                |   | 71,065     |      |
| Merchandise inventories                                                                                                             |   | 67,296     |      |
| Other current assets                                                                                                                |   | 43,200     |      |
|                                                                                                                                |   |       |      |
| Total current assets                                                                                                                |   | 389,577    |      |
|                                                                                                                                |   |       |      |
| Property and equipment, net                                                                                                         |   | 654,892    |      |
| Other assets                                                                                                                        |   | 233,413    |      |
| Assets held for sale                                                                                                                |   | 3,466,376  |      |
|                                                                                                                                |   |       |      |
| Total assets                                                                                                                        |   | $          | 4,744,258 |   |
|                                                                                                                                |   |       |      |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                      |   |       |      |
|                                                                                                                                |   |       |      |
| Current liabilities:                                                                                                                |   |       |      |
| Book overdraft                                                                                                                      |   | $          | 178,013   |   |
| Accounts payable                                                                                                                    |   | 1,472,554  |      |
| Accrued liabilities                                                                                                                 |   | 2,387,545  |      |
| Current portion of long-term debt                                                                                                   |   | 75,832     |      |
| Notes payable to financial institutions                                                                                             |   | 1,750,000  |      |
| Notes payable to stockholders                                                                                                       |   | 2,486,947  |      |
|                                                                                                                                |   |       |      |
| Total current liabilities                                                                                                           |   | 8,350,891  |      |
|                                                                                                                                |   |       |      |
| Long-term debt, net of current portion                                                                                              |   | 169,206    |      |
|                                                                                                                                |   |       |      |
| Total liabilities                                                                                                                   |   | 8,520,097  |      |
|                                                                                                                                |   |       |      |
| Commitments and contingencies                                                                                                       |   |       |      |
|                                                                                                                                |   |       |      |
| Stockholders’ deficit:                                                                                                         |   |       |      |
| Common stock, $.001 par value, 50,000,000 shares  authorized, 19,358,733 and 17,934,923 shares issued and outstanding, respectively |   | 19,359     |      |
| Additional paid-in capital                                                                                                          |   | 6,854,325  |      |
| Unissued common stock                                                                                                               |   | 50,000     |      |
| Stock subscription receivable                                                                                                       |   | (30,000    | )         |
| Accumulated deficit                                                                                                                 |   | (9,711,523 | )         |
| Treasury stock                                                                                                                      |   | (958,000   | )         |
|                                                                                                                                |   |       |      |
| Total stockholders’ deficit                                                                                                    |   | (3,775,839 | )         |
|                                                                                                                                |   |       |      |
| Total liabilities and stockholders’ deficit                                                                                    |   | $          | 4,744,258 |   |

 

See accompanying notes toconsolidated and combined financial statements.

 

23

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**EARFUL OF BOOKS, INC.**

**CONSOLIDATED AND COMBINED STATEMENT OF OPERATIONS**

**for the years ended December 31, 2001 and 2000**

----

 
|                                        |   | **2001**   |       | **2000**   |   |
|---------------------------------------------|--------|------------|------------|------------|--------|
| Revenue:                                    |   |       |       |       |   |
| Rental revenue                              |   | $          | 717,204    |       | $      | 722,762 |   |
| Merchandise sales                           |   | 161,328    |       | 198,804    |   |
| Franchise fee revenue                       |   | 25,000     |       | 156,973    |   |
| Other revenue                               |   | 185,076    |       | 134,683    |   |
|                                        |   |       |       |       |   |
| Total revenue                               |   | 1,088,608  |       | 1,213,222  |   |
|                                        |   |       |       |       |   |
| Cost of sales:                              |   |       |       |       |   |
| Cost of rental revenue                      |   | 1,614,750  |       | 978,945    |   |
| Cost of merchandise sold                    |   | 61,104     |       | 91,455     |   |
| Cost of franchise revenue                   |   | 95,316     |       | 253,980    |   |
|                                        |   |       |       |       |   |
| Total cost of sales                         |   | 1,771,170  |       | 1,324,380  |   |
|                                        |   |       |       |       |   |
| Gross margin                                |   | (682,562   | )          | (111,158   | )      |
|                                        |   |       |       |       |   |
| Operating expenses:                         |   |       |       |       |   |
| General and administrative                  |   | 3,336,998  |       | 1,887,525  |   |
| Depreciation and amortization               |   | 145,181    |       | 138,836    |   |
|                                        |   |       |       |       |   |
| Total operating expenses                    |   | 3,482,179  |       | 2,026,361  |   |
|                                        |   |       |       |       |   |
| Loss from operations                        |   | (4,164,741 | )          | (2,137,519 | )      |
|                                        |   |       |       |       |   |
| Other income (expenses):                    |   |       |       |       |   |
| Interest expense                            |   | (431,320   | )          | (117,171   | )      |
| Gain (loss) on disposal of assets           |   | —     |       | (66,675    | )      |
| Write-down on impairment of assets          |   | —     |       | (301,333   | )      |
|                                        |   |       |       |       |   |
| Total other income (expenses)               |   | (431,320   | )          | (485,179   | )      |
|                                        |   |       |       |       |   |
| Net loss before minority interest           |   | (4,596,061 | )          | (2,622,698 | )      |
|                                        |   |       |       |       |   |
| Minority interest                           |   | —     |       | 68,000     |   |
|                                        |   |       |       |       |   |
| Net loss                                    |   | $          | (4,596,061 | )          | $      | (2,554,698 | ) |
|                                        |   |       |       |       |   |
| Basic and diluted net loss per common share |   | $          | (0.27      | )          | $      | (0.19 | ) |
|                                        |   |       |       |       |   |
| Weighted average shares outstanding         |   | 16,949,163 |       | 13,677,268 |   |

 

See accompanying notes toconsolidated and combined financial statements.

 

24

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**EARFUL OF BOOKS, INC.**

**CONSOLIDATED AND COMBINED STATEMENT OF CASH FLOWS**

**for the years ended December 31, 2001 and 2000**

----

 

 
|                                                                         |   | **2001**   |       | **2000**  |   |
|------------------------------------------------------------------------------|--------|------------|------------|-----------|--------|
| Cash flows from operating activities:                                        |   |       |       |      |   |
| Net loss                                                                     |   | $          | (4,596,061 | )         | $      | (2,554,698 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |   |       |       |      |   |
| Depreciation and amortization                                                |   | 284,420    |       | 200,465   |   |
| Write-down on impairment of assets                                           |   | —     |       | 301,333   |   |
| Loss on disposal of assets and rental inventory                              |   | 78,669     |       | 66,675    |   |
| Loss attributed to minority interests                                        |   | —     |       | (68,000   | )      |
| Common stock, options and warrants issued for  services and interest         |   | 276,172    |       | 305,194   |   |
| Changes in operating assets and liabilities:                                 |   |       |       |      |   |
| Decrease (increase) in receivables                                           |   | 3,886      |       | (12,546   | )      |
| Increase in merchandise inventories                                          |   | (20,635    | )          | (11,102   | )      |
| Increase in due from franchisees                                             |   | (199,000   | )          | —    |   |
| Increase in advances to stockholder                                          |   | (71,065    | )          | —    |   |
| (Increase) decrease in other assets                                          |   | (40,508    | )          | 277       |   |
| Increase in accounts payable                                                 |   | 112,007    |       | 752,448   |   |
| Increase in accrued liabilities                                              |   | 1,540,967  |       | 243,196   |   |
|                                                                         |   |       |       |      |   |
| Net cash used in operating activities                                        |   | (2,631,148 | )          | (776,758  | )      |
|                                                                         |   |       |       |      |   |
| Cash flows from investing activities:                                        |   |       |       |      |   |
| Capital expenditures                                                         |   | (480,598   | )          | (407,107  | )      |
| Net proceeds from sale of assets                                             |   | —     |       | 14,800    |   |
| Investment in an affiliated company                                          |   | —     |       | (25,000   | )      |
| Cash acquired in merger                                                      |   | 646        |       | —    |   |
|                                                                         |   |       |       |      |   |
| Net cash used in investing activities                                        |   | (479,952   | )          | (417,307  | )      |
|                                                                         |   |       |       |      |   |
| Cash flows from financing activities:                                        |   |       |       |      |   |
| Increase in book overdraft                                                   |   | 72,448     |       | 105,565   |   |
| Proceeds from notes payable to stockholders                                  |   | 1,795,140  |       | 276,000   |   |
| Repayments on notes payable to stockholders                                  |   | (230,884   | )          | (59,000   | )      |
| Proceeds from long-term debt                                                 |   | —     |       | 589,000   |   |
| Repayment of long-term debt                                                  |   | (75,469    | )          | (81,649   | )      |
| Proceeds from notes payable to financial  institutions                       |   | 1,748,865  |       | —    |   |
| Repayments on notes payable to financial  institutions                       |   | (249,000   | )          | —    |   |
| Contribution from minority stockholders                                      |   | —     |       | 50,000    |   |
| Net proceeds from issuance of common stock                                   |   | 50,000     |       | 265,214   |   |
|                                                                         |   |       |       |      |   |
| Net cash provided by financing activities                                    |   | 3,111,100  |       | 1,145,130 |   |
|                                                                         |   |       |       |      |   |
| Increase (decrease) in cash and cash equivalents                             |   | —     |       | (48,935   | )      |
|                                                                         |   |       |       |      |   |
| Cash and cash equivalents, beginning of year                                 |   | —     |       | 48,935    |   |
|                                                                         |   |       |       |      |   |
| Cash and cash equivalents, end of year                                       |   | $          | —     |      | $      | — |   |

 

See accompanying notes toconsolidated and combined financial statements.

 

25

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**EARFUL OF BOOKS, INC.**

**CONSOLIDATED AND COMBINED STATEMENTOF STOCKHOLDERS’ DEFICIT**

**for the years ended December 31, 2001 and 2000**

----

 
|                                                                         |   |              |   |       |   | **Additional  Paid-In  Capital** |   | **Unissued  Stock** |   | **Stock  Subscription  Receivable** |   | **Treasury  Shares** |   | **Accumulated  Deficit** |   | **Total**  |   |
|------------------------------------------------------------------------------|--------|-------------------|--------|------------|--------|----------------------------------|--------|---------------------|--------|-------------------------------------|--------|----------------------|--------|--------------------------|--------|------------|--------|
|                                                                         |   | **Common  Stock** |   |       |   |                             |   |                |   |
|                                                                         |   | **Shares**        |   | **Amount** |   |                             |   |                |   |                                |   |
| Balance at December 31, 1999                                                 |   | 1,749,237         |   | $          | 17,492 |                             | $      | 1,312,090           |   | $                                   | 28,734 |                 | $      | —                   |   | $          | — |   | $ | (2,560,764 | ) | $ | (1,202,448 | ) |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Common stock issued for cash                                                 |   | 9,853             |   | 99         |   | 59,021                           |   | —              |   | —                              |   | —               |   | —                   |   | 59,120     |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Common stock issued in connection with acquisition                           |   | 30,000            |   | 300        |   | 179,700                          |   | —              |   | —                              |   | —               |   | —                   |   | 180,000    |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Common stock issued for debt and interest                                    |   | 207,541           |   | 2,075      |   | 809,486                          |   | —              |   | —                              |   | —               |   | —                   |   | 811,561    |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Common stock issued for services                                             |   | 4,914             |   | 49         |   | 7,322                            |   | —              |   | —                              |   | —               |   | —                   |   | 7,371      |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Unissued stock related to private placement  offering, net of offering costs |   | —            |   | —     |   | —                           |   | 206,094             |   | —                              |   | —               |   | —                   |   | 206,094    |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Exercise of options in exchange for subscription  receivable                 |   | 60,000            |   | 600        |   | 29,400                           |   | —              |   | (30,000                             | )      | —               |   | —                   |   | —     |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Issuance of unissued stock                                                   |   | 4,845             |   | 49         |   | 28,685                           |   | (28,734             | )      | —                              |   | —               |   | —                   |   | —     |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Common stock repurchased and cancelled                                       |   | (1,400            | )      | (14        | )      | (6,986                           | )      | —              |   | —                              |   | —               |   | —                   |   | (7,000     | )      |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Stock options issued as compensation                                         |   | —            |   | —     |   | 115,000                          |   | —              |   | —                              |   | —               |   | —                   |   | 115,000    |   |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Net loss                                                                     |   | —            |   | —     |   | —                           |   | —              |   | —                              |   | —               |   | (2,554,698               | )      | (2,554,698 | )      |
|                                                                         |   |              |   |       |   |                             |   |                |   |                                |   |                 |   |                     |   |       |   |
| Balance at December 31, 2000                                                 |   | 2,064,990         |   | 20,650     |   | 2,533,718                        |   | 206,094             |   | (30,000                             | )      | —               |   | (5,115,462               | )      | (2,385,000 | )      |
|                                                                              |        |                   |        |            |        |                                  |        |                     |        |                                     |        |                      |        |                          |        |            |        |  |  |  |  |  |  |  |

 

See accompanying notes toconsolidated and combined financial statements.

 

26

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**EARFUL OF BOOKS, INC.**

**CONSOLIDATED AND COMBINED STATEMENT OF STOCKHOLDERS’ DEFICIT**

**for the years ended December 31, 2001 and 2000**

----

 
|                                                  |   |              |   |       |   | **Additional  Paid-In  Capital** |   | **Unissued  Stock** |   | **Stock  Subscription  Receivable** |    | **Treasury  Shares** |   | **Accumulated  Deficit** |   | **Total**  |     |
|-------------------------------------------------------|--------|-------------------|--------|------------|--------|----------------------------------|--------|---------------------|--------|-------------------------------------|---------|----------------------|--------|--------------------------|--------|------------|----------|
|                                                  |   | **Common  Stock** |   |       |   |                             |   |                |   |
|                                                  |   | **Shares**        |   | **Amount** |   |                             |   |                |   |                                |    |
| Balance at December 31, 2000                          |   | 2,064,990         |   | $          | 20,650 |                             | $      | 2,533,718           |   | $                                   | 206,094 |                 | $      | (30,000                  | )      | $          | —   |   | $ | (5,115,462 | ) | $ | (2,385,000 | ) |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Common stock issued for debt guarantees and  interest |   | 237,282           |   | 2,373      |   | 172,064                          |   | —              |   | —                              |    | —               |   | —                   |   | 174,437    |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Stock issued for note receivable                      |   | 91,127            |   | 911        |   | 120,589                          |   | —              |   | —                              |    | —               |   | —                   |   | 121,500    |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Issuance of unissued common stock                     |   | 38,191            |   | 382        |   | 205,712                          |   | (206,094            | )      | —                              |    | —               |   | —                   |   | —     |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Return of common stock issued for services            |   | —            |   | —     |   | —                           |   | —              |   | —                              |    | (13,000              | )      | —                   |   | (13,000    | )        |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Net effect of merger                                  |   | 16,797,143        |   | (5,087     | )      | 3,668,637                        |   | —              |   | —                              |    | (945,000             | )      | —                   |   | 2,718,550  |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Common stock issued for debt                          |   | 130,000           |   | 130        |   | 38,870                           |   | —              |   | —                              |    | —               |   | —                   |   | 39,000     |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Common stock issued for cash                          |   | —            |   | —     |   | —                           |   | 50,000              |   | —                              |    | —               |   | —                   |   | 50,000     |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Issuance of warrants for loan costs                   |   | —            |   | —     |   | 49,230                           |   | —              |   | —                              |    | —               |   | —                   |   | 49,230     |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Issuance of options for com- pensation                |   | —            |   | —     |   | 65,505                           |   | —              |   | —                              |    | —               |   | —                   |   | 65,505     |     |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Net loss                                              |   | —            |   | —     |   | —                           |   | —              |   | —                              |    | —               |   | (4,596,061               | )      | (4,596,061 | )        |
|                                                  |   |              |   |       |   |                             |   |                |   |                                |    |                 |   |                     |   |       |     |
| Balance at December 31, 2001                          |   | 19,358,733        |   | $          | 19,359 |                             | $      | 6,854,325           |   | $                                   | 50,000  |                 | $      | (30,000                  | )      | $          | (958,000 | ) | $ | (9,711,523 | ) | $ | (3,775,839 | ) |

 

See accompanying notes toconsolidated and combined financial statements.

 

27

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**EARFUL OF BOOKS, INC.**

**NOTES TOCONSOLIDATED****AND COMBINED FINANCIAL STATEMENTS**

----

 

**1.             Background and Summary ofSignificant Accounting Policies**

 

**Background**

 

Earful of Books, Inc. (“Earful” or the “Parent Company”) is anaudiobook retailer founded in 1992.  TheParent Company, one of its subsidiaries, Earful of Books of Houston, Inc. andan affiliated company, Earful of Books, LLP, currently own and operate sixcorporate retail stores located throughout Texas.  In 1998 the Company began its franchise operations through itssubsidiary, Earful of Books Franchising Company, Inc. (the “FranchisingCompany”), and currently has six operating franchise stores located throughoutthe United States.

 

During 2000 the Company acquired an internet web site through one ofits subsidiaries, Audiobookcafe.com, LLC, in an effort to provide onlinedestinations for audiobooks on-demand and other audio-based literaryentertainment.

 

During 2001 the Company acquired American Absorbents Natural Products,Inc., a publicly traded company, in a reverse merger transaction (See Note 3).

 

**Principlesof Consolidation and Combination**

 

The consolidated and combined financial statements include the accountsof the Parent Company, its subsidiaries of which it has greater than 50%ownership, and an affiliated company, Earful of Books LimitedPartnership-Austin #2 (together the “Company”).  The Parent Company has a 34% ownership interest in the limitedpartnership but is the general partner with control over managementdecisions.  All significant intercompanyaccounts and transactions have been eliminated in the consolidation andcombination of the Company.

 

**Use of Estimates**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect reported amounts and related disclosures.  Actual results could differ from thoseestimates.

 

**RevenueRecognition**

 

Revenues are generally recognized at the time of sale or rental.  Merchandise sales include sales of new andused audiobooks.

 

**Franchise Fees**

 

The Franchising Company executes franchise agreements covering retaillocations which provide the terms of the arrangement with the franchisee.  The franchise agreements generally requirean initial fee, an area development fee, if additional stores are to be openedwithin a defined geographical area, and continuing fees based upon a percentageof sales.

 

The Franchising Company recognizes initial fees as revenue when allinitial services, as required by the franchise agreement, have beensubstantially performed and the store has been opened.  Area development fees are recognized uponthe opening of the applicable franchise store and when all services related tosuch store as required by the franchise agreement have been substantiallyperformed.  Continuing fees, based upona percentage of sales, are recognized when earned.

 

28

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Direct costs of sales and servicing of franchiseagreements are charged to expense as incurred.

 

**Shipping and Delivery Costs**

 

The cost of shipping and delivery of audiobooks ischarged directly to cost of sales at the time of shipment.

 

**Advertising Expenses**

 

Advertising costs are expensed as incurred.

 

**Concentrations of Credit Risk**

 

Financial instruments which subject the Company toconcentrations of credit risk include cash and cash equivalents.  The Company maintains its cash in well knownbanks selected based upon management’s assessment of the banks’ financialstability.  Balances periodically mayexceed the $100,000 federal depository insurance limit; however, the Companyhas not experienced any losses on deposits.

 

The Company purchases approximately 90% of itsaudiobook inventory from a single supplier. At December 31, 2001, the Company had prepaid approximately $40,000 tothis supplier.

 

**Cash Equivalents**

 

For purposes of reporting cash flows, the Company considersall short-term investments with an original maturity of three months or lesswhen purchased to be cash equivalents.

 

**Restricted Cash**

 

During 1998, AANP was required to place a $15,000bond to insure the reclamation of any mining done on the mining claims inOregon.  The Company has placed $15,000in certificates of deposits, which are included as other assets in theaccompanying balance sheet, as a pledge against any reclamation work that hasto be done after mining operations have ceased.  The interest earned on the certificates is directly deposited tothe Company’s operating account.

 

**Merchandise Inventories**

 

Merchandise inventories, consisting primarily ofaudiobooks held for sale, are valued at the lower of cost or market.  Cost is determined based upon the specificidentification method.

 

**Property and Equipment**

 

Property and equipment is stated at cost.  Maintenance and repair costs are charged toexpense as incurred.  Improvements thatextend the useful life of the assets are capitalized.  Depreciation is computed principally by the straight-line methodover the estimated useful lives of the assets as follows:

 

29

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| **Description**          |   | **Estimated****Useful  Lives** |
|--------------------------|--------|--------------------------------|
| Rental  library          |   | 3 years                        |
| Furniture  and equipment |   | 5-7 years                      |
| Leasehold  improvements  |   | 5 years or the  lease term     |
| Vehicles                 |   | 5 years                        |

 

**Intangible Assets**

 

Intangible assets include the cost of acquiredbusinesses in excess of the fair market value of tangible assets andliabilities acquired (“goodwill”). Goodwill, included in other assets in the accompanying consolidated andcombined balance sheet, is stated at historical allocated cost less accumulatedamortization.  The Company is amortizingits goodwill of $57,704 over a five-year period.  Accumulated amortization at December 31, 2001 was $53,393.  The Company recorded amortization expense of$11,541 during each of the years ended December 31, 2001 and 2000.

 

**Impairment of Long-Lived Assets**

 

In the event that facts and circumstances indicatethat the carrying value of a long-lived asset, including associatedintangibles, may be impaired, an evaluation of recoverability is performed bycomparing the estimated future discounted cash flows associated with the assetor the asset’s estimated fair value to the asset’s carrying amount to determineif a write-down to market value or discounted cash flow is required.

 

**Gift Certificate Liability**

 

Gift certificate liabilities are recorded at thetime of sale with the costs of designing, printing and distributing the giftcertificates recorded as expense as incurred. The liability is relieved and revenue is recognized upon redemption ofthe gift certificate at any Company store.

 

**Store Closures**

 

Reserves for store closures are established bycalculating the present value of the remaining lease obligation, adjusted forestimated subtenant agreements or lease buyouts, if any, and are expensed alongwith any leasehold improvements.  Storefurniture and equipment are either transferred at historical cost less accumulateddepreciation to another location or written down to their net realizable valueand sold.

 

**Income Taxes**

 

The Company uses the liability method of accountingfor income taxes.  Under this method,deferred income taxes are recorded to reflect the tax consequences on futureyears of temporary differences between the tax basis of assets and liabilitiesand their financial amounts at year-end. The Company provides a valuation allowance to reduce deferred tax assetsto their net realizable value.

 

30

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**Loss Per Share**

 

Basic and diluted loss per share is computed on thebasis of the weighted average number of shares of common stock outstandingduring each period.  Common equivalentshares from common stock options and warrants are excluded from the computationfor the years ended December 31, 2001 and 2000 as their effect would dilute theloss per share.

 

 

**Stock-Based Compensation**

 

The Company accounts for stock compensationarrangements under the provisions of Accounting Principles Board (“APB”) No. 25“Accounting for Stock Issued to Employees”. The Company provides disclosure in accordance with the disclosure-onlyprovisions of Statement of Financial Accounting Standard (“SFAS”) No. 123“Accounting for Stock-Based Compensation”.

 

**Fair Value of Financial Instruments**

 

The Company includes fair value information in thenotes to financial statements when the fair value of its financial instrumentsis different from the book value.  Whenthe book value approximates fair value, no additional disclosure is made.

 

**Comprehensive Income**

 

The Company has adopted SFAS No. 130, “ReportingComprehensive Income”.  Comprehensiveincome includes such items as unrealized gains or losses on certain investmentsecurities and certain foreign currency translation adjustments.  The Company’s financial statements includenone of the additional elements that affect comprehensive income.  Accordingly, comprehensive income and netincome are identical.

 

**Recent Accounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issuedFinancial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets”.  SFAS No. 142 eliminates theamortization of goodwill and requires that goodwill be reviewed annually forimpairment.  SFAS No. 142 also requiresthat the useful lives of previously recognized intangible assets be reassessedand the remaining amortization periods be adjusted accordingly.  SFAS No. 142 is effective for fiscal yearsbeginning after December 15, 2001 and affects all goodwill and other intangibleassets recorded on the Company’s balance sheet at that date, regardless of whenthe assets were initially recorded.  Theimplementation of SFAS No. 142 is not expected to have a material impact on theCompany’s results of operations or financial position.

 

In June 2001, the FASB issued SFAS No. 143, “Accounting for AssetRetirement Obligations”.  SFAS No. 143addresses accounting and reporting for obligations associated with theretirement of tangible long-lived assets and the associated asset retirementcosts.  This statement is effective forfiscal years beginning after June 15, 2002. The Company does not expect the implementation of SFAS No. 143 to have amaterial impact on the Company’s results of operation or financial position.

 

31

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In July 2001, the FASB issued SFAS No. 144, “Impairment or Disposal ofLong-Lived Assets”, which is effective for fiscal years beginning afterDecember 15, 2001.  The provisions ofthis statement provide a single accounting model for impairment of long-livedassets.  The Company does not expect theimplementation of SFAS No. 144 to have a material impact on the Company’sresults of operation or financial position.

 

 

**2.         Going Concern Considerations**

 

During the years ended December 31, 2001 and 2000,the Company has experienced negative financial results as follows:

 
|                                |   | **2001**   |       | **2000**   |   |
|-------------------------------------|--------|------------|------------|------------|--------|
| Net loss                            |   | $          | (4,596,061 | )          | $      | (2,554,698 | ) |
|                                |   |       |       |       |   |
| Negative cash flows from operations |   | (2,631,148 | )          | (776,758   | )      |
|                                |   |       |       |       |   |
| Negative working capital            |   | (7,961,314 | )          | (2,694,832 | )      |
|                                |   |       |       |       |   |
| Accumulated deficit                 |   | (9,711,523 | )          | (5,115,462 | )      |
|                                |   |       |       |       |   |
| Stockholders’ deficit          |   | (3,775,839 | )          | (2,385,000 | )      |
|                                     |        |            |            |            |        |  |  |

 

In addition to thesefinancial results, the Company has also experienced the following:

 

 
| • |   | The  Company is delinquent on payments of a significant portion of its accounts  payable to vendors and other parties, its payroll taxes payable to the  various taxing authorities, and on principal and interest payments due on  certain notes payable to financial institutions and stockholders. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                  |
| • |   | During  2001, five of the Company’s franchises ceased operations.  Without additional capital, the Company  will be dependent on attracting and retaining qualified franchise prospects  in order to expand its franchising operations and to increase its revenue  base.                   |

 

 

Management has developed specific current andlong-term plans to address its viability as a going concern as follows:

 
| • |   | Merger  with a publicly traded company.  Effective July 6, 2001, the Company  entered into a reverse merger transaction with American Absorbents Natural  Products, Inc. (“AANP”), which was listed on the NASDAQ Bulletin Board, to  gain access to public capital markets, to increase attractiveness of its equity,  to create liquidity for stockholders and to acquire assets with reasonable  expectations of near term liquidity. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| • |   | Sale  of assets acquired in merger.  In its merger with AANP, the Company  acquired certain assets that it intends to sell.  The Company has retained the services of advisors and brokers  to sell these assets in a reasonable period of time and has received numerous  inquiries with several prospects currently conducting their due diligence.                                                                                         |

 

32

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| • |   | Future debt/equity offerings.   The Company has obtained the services of several advisors to assist  the Company in both public and private placement opportunities of its equity  and/or debt.                                                                                                                                            |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| • |   | Restructure franchise operations.   The Company is currently evaluating the future plans of its franchise  operations.  While the Company intends  to continue franchising, it has recognized the need for more restrictive  franchising requirements as well as the need to establish a stronger support  system for its franchises. |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| • |   | Possible acquisition.  Subsequent  to December 31, 2001, the Company entered into discussions to purchase an  audiobook distribution business.  This  acquisition, if it occurs, could enable the Company to increase its operating  efficiency through added volume and lower operating costs.                                       |

 

There can be no assurancethat the Company’s debt reduction plans will be successful or that the Companywill have the ability to implement its business plan and ultimately attainprofitability.  The Company’s long-termviability as a going concern is dependent upon three key factors, as follows:

 
| • |   | The Company’s ability to sell the assets acquired in its merger with  AANP and to obtain adequate sources of debt or equity funding to meet current  commitments and fund the continuation of its business operations in the near  term. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                          |
| • |   | The ability of the Company to control costs and expand revenues from  existing or new businesses.                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                          |
| • |   | The ability of the Company to ultimately achieve adequate  profitability and cash flows from operations to sustain its operations.                                                                                                            |

 

**3.         Acquisitions**

 

On May 22, 2000 the Company acquired a 90%interest in all of the assets of Pearlman & Baine Media, L.L.C., whichprimarily consists of the website, Audiobookcafe.com, for 30,000 shares of theCompany’s common stock and the assumption of $150,000 of debt.  This acquisition has been accounted forusing the purchase method of accounting. Accordingly, the accompanying consolidated and combined statements ofoperations do not include any revenues or expenses related to this acquisitionprior to May 22, 2000.  The $330,000purchase price, which was based on the market value of the common stock issuedand the assumption of $150,000 in debt, has been allocated based on the fairmarket value of the assets acquired (primarily a website).  Due to the lack of revenue generated fromthe operation of the website and the inability of the Company to fund itsinternet operations, the amount allocated to the purchase of this website wasconsidered impaired and written down to $-0- as of December 31, 2000.  Proforma information is not presented due tothe immateriality of this acquisition to the operations of the Company.

 

33

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On July 6, 2001, the Company entered into areverse merger with American Absorbents Natural Products, Inc. (“AANP”), apublicly traded company.  Under theterms of the merger agreement the stockholders of the Company received 76% ofthe issued and outstanding common stock of AANP and, accordingly, the Companyis the acquirer in the merger transaction. The acquisition is accounted for using the purchase method ofaccounting.  Accordingly, the operationsof AANP are included in the Company’s consolidated and combined financial statementsbeginning July 6, 2001.  The followingrepresents proforma information as if the acquisition occurred on January 1,2000:

 
|                                     |   | **2001** |       | **2000** |   |
|------------------------------------------|--------|----------|------------|----------|--------|
| Total revenue                            |   | $        | 1,135,908  |     | $      | 1,303,956 |   |
|                                     |   |     |       |     |   |
| Net loss                                 |   | $        | (4,605,838 | )        | $      | (3,461,809 | ) |
|                                     |   |     |       |     |   |
| Loss per share (basic and fully diluted) |   | $        | (0.27      | )        | $      | (0.25 | ) |

 

 

**4.         Property and Equipment**

 

Property and equipmentconsisted of the following at December 31, 2001:

 
| Rental library                                  |   | $         | 588,391 |   |
|-------------------------------------------------|--------|-----------|---------|--------|
| Leasehold improvements                          |   | 326,521   |    |
| Furniture and equipment                         |   | 535,103   |    |
| Software                                        |   | 22,840    |    |
| Vehicles                                        |   | 19,228    |    |
|                                            |   |      |    |
|                                            |   | 1,492,083 |    |
| Less: accumulated depreciation and amortization |   | (837,191  | )       |
|                                            |   |      |    |
| Property and equipment, net                     |   | $         | 654,892 |   |

 

Depreciation expense for theyears ended December 31, 2001 and 2000 was $268,716 and $142,492, respectively,which includes depreciation on the rental library recorded in cost of rentalrevenue.

 

**5.         Assets Held for Sale**

 

As part of its merger withAANP, the Company acquired mineral reserves and other related assets located inHines, Oregon.  The Company has enteredinto letters of intent to sell up to 75% of these assets.  Accordingly, the assets are carried at theirfair value based on the estimated selling price less costs to sell.

 

 

34

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**6.         Notes Payable and Long-Term Debt**

 

Notes payable and long-termdebt consisted of the following at December 31, 2001:

 
| Note payable to a financial institution, bearing  interest at 10.25% per year, principal and interest payments of $1,718 due  monthly, maturing September 2002, collateralized by assets of the Company and  guaranteed by a director/stockholder of the Company                                                                                                                                                                             |   | $          | 15,527  |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|---------|--------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Note payable to a financial institution, bearing  interest at 9.75% per year, principal and interest payments of $436 due  monthly, maturing June 2002, collateralized by a vehicle and guaranteed by a  director/stockholder of the Company                                                                                                                                                                                                 |   | 2,593      |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Note payable to a financial institution, bearing  interest at the prime rate (4.75% at December 31, 2001) plus 1.5% per year,  principal and interest payments of $3,216 due monthly, maturing February  2005, collateralized by assets of the Company and guaranteed by five  directors/stockholders of the Company                                                                                                                         |   | 102,708    |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Note payable to a financial institution, bearing interest  at 10.5% per year, principal of $1,786 and related interest due monthly,  maturing May 2007, collateralized by the assets of Audiobookcafe.com and  guaranteed by a stockholder of the Company                                                                                                                                                                                    |   | 124,210    |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Notes payable to a financial institution, bearing  interest at the prime rate (4.75% at December 31, 2001) plus 2% per year,  interest due monthly and principal due in February and April 2002,  collateralized by the Company’s inventory, fixed assets and 1,550,017 shares  of the Company’s common stock owned by one of the guarantors, with various  portions being guaranteed by six directors/stockholders of the Company |   | 1,650,000  |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Note payable to a financial institution, bearing  interest at the prime rate (4.75% at December 31, 2001) plus 2% per year,  interest due monthly and principal due in February 2002, collateralized by  425,000 shares of the Company’s common stock                                                                                                                                                                                   |   | 100,000    |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Notes payable to stockholders of the Company,  bearing interest of 7% to 12% per year, principal and interest due on demand  or at various times through December 31, 2002, partially collateralized by  certain assets of the Company, including assets held for sale                                                                                                                                                                       |   | 2,486,947  |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Total notes payable and long-term debt                                                                                                                                                                                                                                                                                                                                                                                                       |   | 4,481,985  |    |
| Current portion                                                                                                                                                                                                                                                                                                                                                                                                                              |   | (4,312,779 | )       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |       |    |
| Long-term debt, net of current portion                                                                                                                                                                                                                                                                                                                                                                                                       |   | $          | 169,206 |   |

 

35

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Future annual maturities ofnotes payable and long-term debt are as follows:

 
| **Year Ended  December 31,** |   |   |      |
|------------------------------|--------|--------|-----------|
| 2002                         |   | $      | 4,312,779 |   |
| 2003                         |   | 53,785 |      |
| 2004                         |   | 57,311 |      |
| 2005                         |   | 27,772 |      |
| 2006                         |   | 21,432 |      |
| 2007                         |   | 8,906  |      |
|                         |   |   |      |
|                         |   | $      | 4,481,985 |   |

 

The Company is subject to various loan covenants inits note agreements with financial institutions and its stockholders of whichit is not in compliance with at December 31, 2001.  Therefore, the note holders have the right to demand payment infull at any time.

 

 

**7.         Accrued Liabilities**

 

Accrued liabilities consisted of the following atDecember 31, 2001:

 
| Accrued payroll and payroll taxes                                                     |   | $       | 1,042,668 |   |
|---------------------------------------------------------------------------------------|--------|---------|-----------|--------|
| Deferred franchise revenue                                                            |   | 65,000  |      |
| Refund of deposits to franchisees                                                     |   | 216,000 |      |
| Accrued interest expense                                                              |   | 131,121 |      |
| Gift certificates                                                                     |   | 27,889  |      |
| Advance rentals                                                                       |   | 53,269  |      |
| Customer deposits                                                                     |   | 41,873  |      |
| Liability to former franchisees for purchase of  inventory and furniture and fixtures |   | 126,000 |      |
| Accrual for lawsuits with franchisees                                                 |   | 414,010 |      |
| Accrual for lawsuit with consulting company                                           |   | 125,600 |      |
| Other accrued expenses                                                                |   | 144,115 |      |
|                                                                                  |   |    |      |
|                                                                                  |   | $       | 2,387,545 |   |

 

 

**8.         Income Taxes**

 

The Company has incurred losses since its inceptionand, therefore, has not been subject to federal income taxes.  As of December 31, 2001, the Company had netoperating loss (“NOL”) carryforwards for income tax purposes of approximately$13,000,000 which expire in various tax years through 2021.  Under the provisions of Section 382 of theInternal Revenue Code the ownership change in the Company that resulted fromthe merger with AANP could severely limit the Company’s ability to utilize itsNOL carryforward to reduce future taxable income and related taxliabilities.  Additionally, becauseUnited States tax laws limit the time during which NOL carryforwards may beapplied against future taxable income, the Company may be unable to take fulladvantage of its NOL for federal income tax purposes should the Companygenerate taxable income.

 

36

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The composition of deferred tax assets andliabilities and the related tax effects at December 31, 2001 are as follows:

 
| Deferred tax assets:               |   |       |      |
|------------------------------------|--------|------------|-----------|
| Net operating losses               |   | $          | 4,376,221 |   |
| Intangible assets                  |   | 108,581    |      |
| Valuation allowance                |   | (4,442,801 | )         |
|                               |   |       |      |
| Total deferred tax assets          |   | 42,001     |      |
|                               |   |       |      |
| Deferred tax liabilities:          |   |       |      |
| Property and equipment             |   | (42,001    | )         |
|                               |   |       |      |
| Total deferred tax liability       |   | (42,001    | )         |
|                               |   |       |      |
| Net deferred tax asset (liability) |   | $          | —    |   |

 

 

The difference between the income tax benefit in theaccompanying statement of operations and the amount that would result if theU.S. Federal statutory rate of 34% were applied to pre-tax loss for the yearsended December 31, 2001 and 2000 is as follows:

 
|                                             |   | **2001**   |       | **2000** |   |
|--------------------------------------------------|--------|------------|------------|----------|--------|
|                                             |   | **Amount** |       | **%**    |   | **Amount** |   | **%** |   |
| Benefit for income tax at federal statutory rate |   | $          | (1,562,661 | )        | (34.0  | )% | $ | (868,597 | ) | (34.0 | )% |
| Non-deductible expenses                          |   | 29,175     |       | 0.6      |   | 11,297 |   | 1.0 |   |
| Other                                            |   | —     |       | —   |   | 71,591 |   | 3.0 |   |
| Increase in valuation allowance                  |   | 1,533,486  |       | 33.4     |   | 785,709 |   | 30.0 |   |
|                                             |   |       |       |     |   |   |   |   |   |
|                                             |   | $          | —     |     | — | % | $ | — |   | — | % |

 

 

**9.       Commonand Preferred Stock**

 

On July 24, 2000, the board of directors authorizeda three-for-one stock split to shareholders of record on July 10, 2000.  All references in these consolidated andcombined financial statements and notes to consolidated and combined financialstatements to number of shares, per share amounts, and market prices of theCompany’s common stock have been restated to reflect the increased number ofshares outstanding resulting from this stock split, as well as for the pro-ratashares issued in the Company’s merger with AANP.

 

The Company is authorized to issue 10,000,000 sharesof $0.001 par value convertible preferred stock with characteristics determinedby the Company’s board of directors.  Asof December 31, 2001 there are no shares of convertible preferred stock issuedor outstanding.

 

37

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**10.     StockOptions and Warrants**

 

The Company periodically issues incentive stockoptions to employees, officers and directors to provide additional incentivesto promote the success of the Company’s business and to enhance the ability toattract and retain the services of qualified persons.  The issuance of such options are approved by the Board ofDirectors.  The exercise price of anoption granted is determined by the fair market value of the stock on the dateof grant.  The Company recognizedcompensation expense with respect to vested stock options in the amount of$89,380 and $115,000 for the years ended December 31, 2001 and 2000,respectively.

 

Following is an analysis of options and warrants andrelated activity:

 

**StockOptions**

 

In 2001, the Company entered into agreements withemployees to buy-out certain stock options originally issued to purchase 67,750shares of the Company’s common stock that were outstanding at December 31, 2000at a repurchase price of $0.50 per share. The expense associated with this repurchase of $33,875 was included asgeneral and administrative expenses in the statement of operations for the yearended December 31, 2001.

 

The Company has issued stock options to employees asfollows:

 
| ** **                               |   | **Number of  Shares** |   | **Exercisable** |   | **Exercise  Price** |       | **Weighted  Average  Exercise  Price** |   |
|------------------------------------------|--------|-----------------------|--------|-----------------|--------|---------------------|------------|----------------------------------------|--------|
| Options outstanding at December 31, 1999 |   | 80,000                |   | 30,000          |   |                |       | $                                      | 1.06   |   |
|                                     |   |                  |   |            |   |                |       |                                   |   |
| Options granted                          |   | 97,750                |   | —          |   | $                   | 0.50-$3.34 |                                   | $      | 2.47 |   |
| Options vested                           |   | —                |   | 50,000          |   | $                   | 0.50-$2.75 |                                   | $      | 1.40 |   |
| Options exercised                        |   | (60,000               | )      | (60,000         | )      | $                   | 0.50       |                                   | $      | 0.50 |   |
|                                     |   |                  |   |            |   |                |       |                                   |   |
| Options outstanding at December 31, 2000 |   | 117,750               |   | 20,000          |   |                |       | $                                      | 2.52   |   |
|                                     |   |                  |   |            |   |                |       |                                   |   |
| Options granted                          |   | 165,000               |   | 165,000         |   | $                   | 0.09       |                                   | $      | 0.09 |   |
| Options vested                           |   | —                |   | 26,863          |   | $                   | 0.09-$0.61 |                                   | $      | 0.48 |   |
| Options repurchased and cancelled        |   | (67,750               | )      | (20,000         | )      | $                   | 2.75-$3.34 |                                   | $      | 3.17 |   |
| Effect of merger                         |   | 120,884               |   | 120,884         |   | $                   | 0.09-$0.61 |                                   | $      | 0.48 |   |
| Options forfeited                        |   | (23,137               | )      | —          |   | $                   | 0.50       |                                   | $      | 0.50 |   |
|                                     |   |                  |   |            |   |                |       |                                   |   |
| Options outstanding at December 31, 2001 |   | 312,747               |   | 312,747         |   |                |       | $                                      | 0.27   |   |
|                                          |        |                       |        |                 |        |                     |            |                                        |        |  |  |  |  |  |  |  |  |  |  |  |

 

 

Following is a summary of outstanding options atDecember 31, 2001:

 

| **Number of  Shares** |   | **Vested** |   | **Expiration  Date** |   | **Exercise  Price** |   |
|-----------------------|--------|------------|--------|----------------------|--------|---------------------|--------|
| 110,000               |   | 110,000    |   | 2003                 |   | $                   | 0.61   |   |
| 202,747               |   | 202,747    |   | 2002                 |   | $                   | 0.09   |   |
|                  |   |       |   |                 |   |                |   |
| 312,747               |   | 312,747    |   |                 |   |                |   |

 

38

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The Company has elected to follow AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”(APB 25) and related Interpretations in accounting for its employee stockoptions because, as discussed below, the alternative fair value accountingprovided for under FASB Statement No. 123, “Accounting for Stock-BasedCompensation”, requires use of option valuation models that were not developedfor use in valuing employee stock options.

 

Proforma information regarding net income andearnings per share is required by Statement 123, and has been determined as ifthe Company had accounted for its employee stock options under the fair valuemethod of that Statement.  The fairvalue for these options was estimated at the date of grant using aBlack-Scholes option pricing model with the following weighted-averageassumptions for 2001 and 2000, respectively: risk-free interest rate of 5% and 6%; no dividend yield; weightedaverage volatility factor of the expected market price of the Company’s commonstock of 80% and 80%; and a weighted-average expected life of the options of 1to 2 years.

 

The Black-Scholes option valuation model wasdeveloped for use in estimating fair value of traded options which have novesting restrictions and are fully transferable.  In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility.  Because the Company’s employee stock optionshave vesting restrictions and other characteristics significantly differentfrom those of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

For purposes of proforma disclosures, the estimatedfair value of the options and warrants is included in expense at the date ofissuance, as required by Statement 123. The Company’s proforma information follows:

 
|                                               |   | **2001** |       | **2000** |   |
|----------------------------------------------------|--------|----------|------------|----------|--------|
| Net loss available to common stockholders          |   | $        | (4,596,061 | )        | $      | (2,554,698 | ) |
|                                               |   |     |       |     |   |
| Proforma net loss available to common stockholders |   | $        | (4,597,711 | )        | $      | (2,594,084 | ) |
|                                               |   |     |       |     |   |
| Proforma basic and dilutive loss per share         |   | $        | (0.27      | )        | $      | (0.19 | ) |

 

 

**Warrants**

 

During 2001, the Company issued warrants to purchase100,000 shares of the Company’s common stock to a financial institution forloan origination costs.  The warrantshave an exercise price of $0.01 and expire September 3, 2006.  The warrants were exercisable upon issuance. The value of these warrants was$49,280, which was recorded as interest expense in the accompanying statementof operations.  No other warrantactivity occurred during the years ended December 31, 2001 or 2000, and noother warrants are outstanding at December 31, 2001.

 

39

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**StockOption, Stock Warrant and Stock Award Plan**

 

Effective in February 2002 the Company adopted aStock Option, Stock Warrant and Stock Award Plan (the “Plan”) under whichincentive stock options and warrants for up to 4,000,000 shares of theCompany’s common stock may be awarded to directors, key employees andconsultants.  The Plan is designed toattract and retain highly qualified key executive personnel, directors andconsultants.  Stock options and warrantsgranted pursuant to the Plan expire not more than ten years from the date ofgrant.  The price of all options andwarrants granted by the Company will be based on the fair market value of thecommon stock at the date of grant.

 

 

**11.      Lease Obligations**

 

The Company has entered into long-term operatingleases for offices and retail operations. Certain of the leases provide for renewal options, payment of taxes andutilities by the Company, and increases to rent should certain costs to thelandlord increase.  Rental expense underoperating leases was $833,187 and $510,230 for the years ended December 31,2001 and 2000, respectively.

 

Minimum lease payments due under leases withremaining lease terms of greater than one year and expiration dates subsequentto December 31, 2001 are summarized as follows:

 
| **Year Ended  December 31,** |   |    |      |
|------------------------------|--------|---------|-----------|
| 2002                         |   | $       | 719,054   |   |
| 2003                         |   | 575,499 |      |
| 2004                         |   | 396,031 |      |
| 2005                         |   | 278,081 |      |
| 2006                         |   | 99,581  |      |
| Thereafter                   |   | 8,546   |      |
|                         |   |    |      |
|                         |   | $       | 2,076,792 |   |

 

 

**12.      Commitments and Contingencies**

 

The Company entered into an agreement withBlockbuster, Inc. whereby the Company received a right of first refusal tosublease a part of certain Blockbuster stores. As a part of this agreement, the Company must remain the sub-tenant onany of these leases occupied by franchise-owned stores co-located withBlockbuster.  As such, if the franchiseedefaults on its lease payments to Blockbuster, the Company is obligated to makethe lease payments on behalf of the franchisee.

 

40

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As addendums to the Company’s franchise agreements,the Company has offered incentives to various franchisees which include theCompany’s guarantee of a buyback of the franchisee’s inventory, abatement ofroyalty payments owed to the Company for a specific period and refunds of theinitial franchise fee if a suitable location cannot be found or there issignificant delay in opening a location. In addition, the Company has agreed to purchase six franchise storesfrom the franchisees and has been paying the lease obligations or guaranteeingto reimburse the franchisee for its continued payment of its leaseobligation.  The Company is involved invarious lawsuits and potential lawsuits relating to its franchiseoperations.  Included in accruedliabilities at December 31, 2001 is an amount accrued for lease and repurchaseobligations and for potential lawsuit settlements with the franchisees of$756,010, which the Company believes is sufficient for any potential loss andthat there will be no additional financial loss from these matters.

 

The Company entered into a binding letter of intentwith a consulting company whereby that company was to facilitate the secureelectronic distribution of digital asset and electronic commerce with aninitial focus on establishing a digital courier service for the Company and itsfranchise stores.  On January 9, 2001,the letter of intent was cancelled and the parties entered into a SettlementAgreement whereby the company agreed to loan $300,000 to Earful at 7% per annumwith principal and interest originally due February 6, 2002, which has beenextended to May 31, 2002.  This note iscollateralized by the right, title and interest in Audiobookcafe.com.  During the year ended December 31, 2000, thecompany had advanced $150,000 to Earful. Under the Settlement Agreement this $150,000 was converted to Earfulcommon stock.

 

In 1999 and 2000, Earful entered into two separateagreements with a company to convert a portion of Earful’s rental inventory toan electronic format.  After a period ofnegotiation, Earful determined that, in its judgment, the company lacked thecapacity and technical ability to provide the contracted service and notifiedthe company of the termination of the contracts.  On January 25, 2001 a lawsuit was filed by the company in the261st District Court of Travis County against the Company.  The lawsuit is for breach of contractrelating to these agreements.  The amountclaimed as damages by the consulting company is approximately $3,725,000.  The Company filed a general denial.  In April 2002 the Company entered into asettlement agreement whereby they will issue 315,000 shares of the Company’scommon stock plus pay $50,000 over a twelve-month period beginning in May2002.  Included in accrued liabilitiesis $125,600 accrued for this settlement.

 

Two former owners and now current 10% owners ofAudiobookcafe.com entered into employment contracts with the Company wherebythey are to receive $50,000 each in salary beginning May 15, 2000 and ending May15, 2002.

 

In 1998, the Company guaranteed a $121,500 notepayable for one of its franchisees with 91,127 shares of its common stock.  In January 2001, the Company issued the91,127 shares of its common stock to the original note holder and recorded $121,500in other assets, which consists of all assets of the franchisee’s store.

 

As a result of its merger with AANP, the Company isobligated to pay royalties to certain stockholders of the Company of $5 per tonfor zeolite that has been mined, milled and sold.  The amount of royalties to be paid is limited to thestockholders’ investment in the Company. Due to the very limited operating activity associated with the mining ofzeolite, the royalties paid each year, it any, have been insignificant.

 

41

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**13.      RelatedParty Transactions**

 

The Company and certain franchisees purchase itsinsurance through an insurance agency owned by the father of a majorstockholder of the Company.  During theyear ended December 31, 2001 and 2000, $85,317 and $26,855, respectively, ofinsurance premiums were paid to this insurance agency.

 

The Company’s board of directors guarantee certainbank loans of the Company and have provided $464,437 of other loans to theCompany as of December 31, 2001.  TheCompany has issued 234,283 and 13,775 shares of the Company’s common stock forsuch guarantees and as interest payments on the directors’ loans during theyears ended December 31, 2001 and 2000, respectively.  Included in the consolidated and combined statement of operationsfor the years ended December 31, 2001 and 2000 is $156,445 and $30,686 ofinterest expense related to the issuance of this common stock.  Included in accrued liabilities in theaccompanying consolidated and combined balance sheet is accrued interest of$15,050 and $36,238 owed to these related parties as of December 31, 2001 and2000, respectively.

 

 

**14.      SupplementalDisclosure of Cash Flow Information**

 

The supplemental disclosure of cash flowinformation, including the non-cash investing and financing activities, are asfollows:

 
|                                                                |   | **2001** |    | **2000** |   |
|---------------------------------------------------------------------|--------|----------|---------|----------|--------|
| **Cash paid for interest and income taxes:**                        |   |     |    |     |   |
|                                                                |   |     |    |     |   |
| Cash paid for interest expense                                      |   | $        | 319,290 |     | $      | 42,537 |   |
|                                                                |   |     |    |     |   |
| Cash paid for income taxes                                          |   | $        | —  |     | $      | — |   |
|                                                                |   |     |    |     |   |
| **Non-cash investing and financing activities:**                    |   |     |    |     |   |
|                                                                |   |     |    |     |   |
| Notes payable to stockholders converted to common  stock            |   | $        | —  |     | $      | 478,738 |   |
|                                                                |   |     |    |     |   |
| Note payable to another company converted to  common stock          |   | $        | —  |     | $      | 150,000 |   |
|                                                                |   |     |    |     |   |
| Issuance of common stock for the purchase of assets                 |   | $        | 121,500 |     | $      | — |   |
|                                                                |   |     |    |     |   |
| Issuance of common stock for the purchase of  Audiobookcafe.com     |   | $        | —  |     | $      | 180,000 |   |
|                                                                |   |     |    |     |   |
| Assumption of long-term debt for the purchase of  Audiobookcafe.com |   | $        | —  |     | $      | 150,000 |   |
|                                                                |   |     |    |     |   |
| Repurchase of common stock through issuance of accrued  liability   |   | $        | —  |     | $      | 7,000 |   |

** **

**42**

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** **

# **PART III**

 

 

**ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURES.**

 

None.

 

**ITEM 9. DIRECTORS AND EXECUTIVEOFFICERS.**

 

Set forth below is the name, age, position and briefaccount of the business experience of the current officers and directors of theRegistrant:

 
| **NAME**             |   | **AGE** |   | **POSITION**                         |
|----------------------|--------|---------|--------|--------------------------------------|
| Russell Grigsby      |   | 43      |   | Chief Executive Officer and Director |
|                 |   |    |   |                                 |
| Myron E. Sappington  |   | 56      |   | Executive Vice President & CFO   |
|                 |   |    |   |                                 |
| Jefferson J. Baskin  |   | 35      |   | Executive Vice President, Customers  |
|                 |   |    |   |                                 |
| Kenneth W. Anderson  |   | 70      |   | Director                             |
|                 |   |    |   |                                 |
| Jim L. Peterson      |   | 66      |   | Director                             |
|                 |   |    |   |                                 |
| Goodhue W. Smith III |   | 52      |   | Director                             |
|                 |   |    |   |                                 |
| Robert Bitterli      |   | 45      |   | Director                             |
|                 |   |    |   |                                 |
| Roy D. Terracina     |   | 55      |   | Director                             |
|                 |   |    |   |                                 |
| Garrett Boone        |   | 58      |   | Advisory Director                    |
|                 |   |    |   |                                 |

 

 

**RUSSELL GRIGSBY — CHIEF EXECUTIVEOFFICER AND DIRECTOR**

 

Mr. Grigsby joined the Earful Board in 2001. Prior tothat, Mr. Grigsby was Founder, President and CEO of Cornerstone SecuritiesCorporation (now Instinet), a stock trading company with brokerage operationsin 19 cities. Before that he worked as CFO of GPS Technology. Mr. Grigsby has aBA from Baylor University and an MBA from Southern Methodist University.

 

 

43

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**MYRONE. SAPPINGTON-EXECUTIVE VICE PRESIDENT & CHIEF FINANCIAL OFFICER**

 

Mr. Sappington is a CPA who joined Earful in December1999. He has a BBA and an MBA from the University of North Texas. He began hiscareer on the audit staffs of Price Waterhouse and Peat, Marwick &Mitchell. Mr. Sappington was previously Executive Vice-President of FSAMortgage Corporation, and from 1987 to 1993, served as President of QuantusCorporation, a real estate service-consulting firm. Prior to joining Earful,Mr. Sappington was a consultant to community banks in the area of asset-basedlending.

 

**JEFFERSON J. BASKIN - EXECUTIVE VICEPRESIDENT, CUSTOMERS**

 

Jefferson J. Baskin joined the Earful staff inSeptember 2001 and oversees all marketing, retail stores and Internetinitiatives. Prior to joining Earful, Mr. Baskin was the Director of Marketingand Strategic Alliances for iluvcamp, an Internet company serving the summercamp industry. Previous to iluvcamp, he created BaskinGroup, a smallbusiness-consulting firm. He spent two years providing services to economicdevelopment clients of the Greater Austin Chamber of Commerce (GACC), where hedesigned and developed marketing programs that increased new prospect activityand new primary employers. He received a Bachelor of Arts degree from TrinityUniversity in 1988 and a Master of Public Affairs degree from the University ofTexas at Austin in 1994.

 

**KENNETH W. ANDERSON - DIRECTOR**

 

Ken Anderson joined Earful’s Board in March 1999.Since 1992, he has been an investor and business consultant and serves onseveral boards including Fossil, Inc. Fossil is a reporting company. Mr.Anderson is the Co-Founder and former Director and President of bothBlockbuster Entertainment Corporation (1985-1987) and Amtech Corporation(1987-1991) in Dallas, Texas. Mr. Anderson retired as a Director of Earful onJanuary 22, 2002.

 

**JIM L. PETERSON - DIRECTOR**

 

Jim Peterson also joined Earful’s Board in March 1999.For 23 years, Mr. Peterson was the CEO of Whataburger, Inc. Since 1994, Mr.Peterson has been Chairman of the Board and Chief Executive Officer ofBojangles Restaurants, Inc. which is headquartered in Charlotte, NorthCarolina, and which operates and franchises a chain of more than 250 fast foodrestaurants.

 

**GOODHUE W. SMITH III - DIRECTOR**

 

Goodhue Smith has served as a Director on Earful’sBoard since May 1994. In 1978, Mr. Smith founded Duncan-Smith Co., aninvestment-banking firm with an emphasis on regional transactions. He iscurrently Secretary and Treasurer of Duncan-Smith Co. Mr. Smith is also a Boardmember of Consolidated Healthcare, Inc. of Waco, Texas and is Chairman of theBoard of Citizens National Bank, Cameron, Texas.

 

44

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**ROBERT BITTERLI - DIRECTOR**

 

Robert Bitterli served as a director of the Companyfrom June 1995 until June 1996 and became a director of the Company again inMay 1999. He also became Chief Executive Officer and President of the Companyin May 1999 until the date of the Merger. Mr. Bitterli founded and served asPresident of Windfall Corporation, a management consulting firm, specializingin corporations seeking and working with government contracts. He holds a B.S.degree in Psychology from Campbell University in Bueise Creek, North Carolinaand an M.A. in Business Administration and Personnel Management, both fromWebster University in St. Louis, Missouri.

 

**ROY D. TERRACINA - DIRECTOR**

 

Roy Terracina, since January 1994, has been ChiefExecutive Officer of Sunshine Ventures, Inc., an investment firm in SanAntonio, Texas. Mr. Terracina is also a Board member of US Global Investors,Inc., Norwood Promotional Products, Inc. and Chase Bank - San Antonio. From1984 to December 1993 when he sold the company, Mr. Terracina was the Presidentand principal shareholder of Sterling Foods, Inc. of San Antonio, a majorsupplier of baked and packaged goods. Mr. Terracina has been an Earful Boardmember since 1994.

 

**GARRETT BOONE - ADVISORY DIRECTOR**

 

Garrett Boone served as a Director on Earful’s Boardfrom 1994 to June, 2001. As of July 6, 2001, he became an Advisory Director tothe Company. He is co-Founder, Director and Chief Executive Officer of TheContainer Store, Inc., headquartered in Dallas, Texas. He established the firstContainer Store specializing in storage and organization items in 1978. TheContainer Store chain of retail stores has grown to 37 and continues to expand.

 

**PAUL A. RUSH — FOUNDER AND CONSULTANT TO COMPANY**

 

Paul Rush was thefounder and since Earful’s 1992 inception until April 1, 2002 served as aDirector, President, and Chief Executive Officer of Earful.  Mr. Rush has resigned as an Officer andDirector, but is presently serving as a consultant to the Company.  Mr. Rush established the first Earful storein November 1992.  From that time untilApril 1, 2002, as President, Chief Executive Officer, and Chairman of the Boardof Directors, he directed the development and operation of Earful’s stores, aswell as the establishment of Earful of Books Franchising Company, Inc.  In May 1996, Paul Rush served as Treasurerof the Audio Publishers Association (APA), and was re-elected in 1997 and alsoserved that year as Vice President.  InJune 1999, he became the first non-publisher to be elected President of theAudio Publishers Association.  Mr. Rushwas re-elected President of the APA in May 2000 and completed his tenure as ofJune 30, 2001.

 

45

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**ITEM10.  EXECUTIVE COMPENSATION.**

 

The following table shows all compensation receivedduring the fiscal years ended December 31, 1999, 2000, and 2001 by Earful’sChief Executive Officer and the four other highest-paid executive officers.

 

 
|                                    |   | **ANNUAL COMPENSATION** |   |
|-----------------------------------------|--------|-------------------------|--------|
| **NAME AND PRINCIPAL**                  |   | **YEAR**                |   | **SALARY** |   |   |   |
| **POSITION**                            |   | **($)**                 |   | **($)** |   | **BONUS** |   |
| PAUL RUSH, CEO (1)                      |   | 2001                    |   | $ | 85,000 |   | $ | 7,660 |   |
|                                    |   | 2000                    |   | $ | 50,000 |   | $ | 1,000 |   |
|                                    |   | 1999                    |   | $ | 50,001 |   | $ | 750 |   |
|                                    |   |                    |   |   |   |   |   |
| MYRON SAPPINGTON,  CFO(2)               |   | 2001                    |   | $ | 88,862 |   | $ | —0— |   |
|                                    |   | 2000                    |   | $ | 62,292 |   | $ | 1,000 |   |
|                                    |   | 1999                    |   | —0— |   | —0— |   |
|                                    |   |                    |   |   |   |   |   |
| JEFFERSON J. BASKIN,  EVP, Customers(3) |   | 2001                    |   | $ | 45,525 |   | $ | —0— |   |
|                                    |   | 2000                    |   | N/A |   | N/A |   |
|                                    |   | 1999                    |   | N/A |   | N/A |   |
|                                    |   |                    |   |   |   |   |   |
| JIM GRANT                               |   | 2001                    |   | $ | 81,006 |   | $ | —0— |   |
|                                    |   | 2000                    |   | $ | 80,000 |   | $ | 750 |   |
|                                    |   | 1999                    |   | $ | 80,000 |   | $ | 750 |   |

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(1)  Includesamounts accrued and unpaid.  Mr. Rushresigned from his positions as an executive officer and a director of theCompany on April 1, 2002.

 

(2)  Mr.Sappington’s employment with Earful commenced in December, 1999.

 

(3)  Mr.Baskin’s employment with Earful commenced in September, 2001.

 

 

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**ITEM 11.****  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT.**

 

The following table contains information regarding theshareholdings of the Registrant’s current directors and executive officers andthose persons or entities who beneficially own or control more than 5% of theRegistrant’s common stock based on 17,934,923 shares issued and outstanding asof December 31, 2001.

 
|                                                                                  |   | **SHARES BENEFICIALLY OWNED** |   |
|---------------------------------------------------------------------------------------|--------|-------------------------------|--------|
| **NAME OF BENEFICIAL OWNER**                                                          |   | **NUMBER**                    |   | **PERCENT** |   |
| Directors and Named Executive  Officers (1):                                          |   |                          |   |   |   |
|                                                                                  |   |                          |   |   |   |
| Russell Grigsby, Chief  Executive Officer and Director                                |   | 717,156                       |   | 4.0 | % |
|                                                                                  |   |                          |   |   |   |
| Myron E.  Sappington,  Executive Vice-President  and Chief Financial Officer (3) |   | 0                             |   | 0 |   |
|                                                                                  |   |                          |   |   |   |
| Jefferson J. Baskin,  Executive Vice-President, Customers                             |   | 0                             |   | 0 |   |
|                                                                                  |   |                          |   |   |   |
| Kenneth L. Anderson,  Director                                                        |   | 734,250                       |   | 4.1 | % |
|                                                                                  |   |                          |   |   |   |
| Jim L. Peterson,  Director                                                            |   | 975,574                       |   | 5.4 | % |
|                                                                                  |   |                          |   |   |   |
| Goodhue W. Smith, III,  Director                                                      |   | 766,425                       |   | 4.3 | % |
|                                                                                  |   |                          |   |   |   |
| Roy D. Terracina,  Director                                                           |   | 1,153,840                     |   | 6.4 | % |
|                                                                                  |   |                          |   |   |   |
| Robert Bitterli,  Director and former CEO                                             |   | 599,956                       |   | 3.3 | % |
|                                                                                  |   |                          |   |   |   |
| Executive Officers and  Directors as a Group (9 persons)                              |   | 6,497,218                     |   | 36.2 | % |
|                                                                                  |   |                          |   |   |   |
| Holders of 5% or More  Not Named Above                                                |   |                          |   |   |   |
| Paul A. Rush (2)                                                                      |   | 1,550,017                     |   | 8.6 | % |
| 907 W. 5th Street                                                                     |   |                          |   |   |   |
| Austin, Texas 78703                                                                   |   |                          |   |   |   |
|                                                                                  |   |                          |   |   |   |
| Dr. Jack Burrow                                                                       |   | 1,050,000                     |   | 5.9 | % |
| 5927 Laurium Road                                                                     |   |                          |   |   |   |
| Charlotte, NC  28226                                                             |   |                          |   |   |   |
|                                                                                  |   |                          |   |   |   |
| Donald J. Douglass                                                                    |   | 1,014,855                     |   | 5.7 | % |
| 145 Oenoke Lane                                                                       |   |                          |   |   |   |
| New Canaan, CT  06840                                                            |   |                          |   |   |   |

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(1)  The  business address  of each director and executive officer is care of Earful ofBooks, Inc., 907 West 5th Street, Suite 203, Austin, Texas 78703.

 

(2)  The numberof shares owned by Mr. Rush does not include warrants to purchase 202,747  shares of the Registrant’s common stock atan exercise price of $ 0.09 per share, all of which vested as of December 31,2001.

 

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(3)  The  number of shares owned by Mr. Sappington does not include warrants to purchase110,000 shares of the Registrant’s common stock at an exercise price of $0.73per share all of which have vested as of December 31, 2001.

 

48

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**ITEM12.   CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS.**

            The Company and certainfranchisees purchase its insurance through an insurance agency owned by thefather of a major stockholder of the Company. During the year ended December 31, 2001 and 2000, $85,317 and $26,855,respectively, of insurance premiums were paid to this insurance agency.

 

            TheCompany’s board of directors guarantee certain bank loans of the Company andhave provided $464,437 of other loans to the Company as of December 31,2001.  The Company has issued 234,283and 13,775 shares of the Company’s common stock for such guarantees and asinterest payments on the directors’ loans during the years ended December 31,2001 and 2000, respectively.  Includedin the consolidated and combined statement of operations for the years endedDecember 31, 2001 and 2000 is $156,445 and $30,686 interest expense related tothe issuance of this common stock. Included in accrued liabilities in the accompanying consolidated andcombined balance sheet is accrued interest of $15,050 owed to these relatedparties as of December 31, 2001.

 

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### **SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Act of 1934, the Registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 

 

**EARFUL OF BOOKS, INC.**

 

 

 
|   |   |   |   |   | By:                  | /s/ Russell Grigsby |
|--------|--------|--------|--------|--------|----------------------|---------------------|
|   |   |   |   |   | Russell Grigsby, CEO |

 

 

Date: April 15, 2002

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed by the following persons onbehalf of the Company and in their capacities and on the dates indicated.

 
|                 |   |                                  |   |            |
|----------------------|--------|---------------------------------------|--------|-----------------|
| **SIGNATURE**        |   | **TITLE**                             |   | **DATE**        |
|                 |   |                                  |   |            |
| /s/ Russell Grigsby  |   |                                  |   |            |
| Russell Grigsby      |   | Chief Executive Officer and  Director |   | April  15, 2002 |
|                 |   |                                  |   |            |
| /s/ Jim L. Peterson  |   |                                  |   |            |
| Jim L. Peterson      |   | Director                              |   | April  15, 2002 |
|                 |   |                                  |   |            |
| /s/ Roy D. Terracina |   |                                  |   |            |
| Roy D. Terracina     |   | Director                              |   | April  15, 2002 |
|                 |   |                                  |   |            |
| /s/ Robert Bitterli  |   |                                  |   |            |
| Robert Bitterli      |   | Director                              |   | April  15, 2002 |

 

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|                    |   |                                |   |            |
|-------------------------|--------|-------------------------------------|--------|-----------------|
| /s/ Myron E. Sappington |   |                                |   |            |
| Myron E. Sappington     |   | Chief Financial Officer,  Principal |   | April  15, 2002 |
|                    |   | Accounting Officer                  |   |            |
|                    |   |                                |   |            |

 

 

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